Comprehensive core competency I Lecture Note

CHAPTER 1
FINANCIAL REPORTING AND ACCOUNTING STANDARD
INTERNATIONAL ACCOUNTING STANDARDS BOARD (IASB) AND ITS GOVERNANCE
STRUCTURE
The International Accounting Standards Board (IASB) is an independent, private-sector body that develops
and issues International Financial Reporting Standards (IFRS), which are widely adopted and used by
companies around the world to prepare financial statements. The IASB's goal is to promote transparency,
accountability, and efficiency in financial markets by creating a single set of high-quality global accounting
standards.
Key Functions of IASB:
Develops and issues IFRS Standards and Interpretations.

Ensures the consistency and improvement of international accounting practices.

Engages in consultations with stakeholders, including financial professionals, governments, and investors.

Provides guidance on the application of IFRS standards.
GOVERNANCE STRUCTURE OF IASB:
The standard-setting structure internationally is composed of the following four organizations:
The IFRS Foundation provides 
 It appoints board members and oversees the Board's activities.
Oversight to the work of IASB, IFRS Advisory Council, and IFRS Interpretations Committee. The IFRS
Foundation
 is a not-for-profit organization and has responsible for fund raising, and administration of the
 IASB.
IASB
The IASB consists of up to 16 members with  diverse geographical and professional backgrounds
 (accountants, auditors, financial analysts).
International Accounting Standards Board (IASB) have Sole responsibility for establishing for
setting International Financial Reporting Standards (IFRSs), standards and making technical decisions.
The IFRS Advisory Council (the Advisory Council) provides advice and counsel to the IASB on major
policies and technical issues.
The IFRS Interpretations Committee Develops interpretations for approval by the IASB, and undertakes
under tasks at the request of the IASB seeks to resolve accounting issues and interpret existing IFRS.

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5. Monitoring Board
This group of public authorities oversees the IFRS Foundation and ensures its operations serve the public
interest. It helps maintain accountability to regulators and stakeholders.
In addition, as part of the governance structure, a Monitoring Board was created. The purpose of this board is
to establish a link between accounting standard-setters and those public authorities (e.g., IOSCO) that generally
oversee them. The Monitoring Board also provides political legitimacy to the overall organization. It also
oversees the IFRS Foundation Trustees, participates in the Trustee nomination process, and approves
appointments to the Trustees. The following diagram shows the organizational structure for the setting of
international accounting standards.

ROLE OF INTERNATIONAL ACCOUNTING STANDARDS BOARD  (IASB)

 Designed for general purpose financial reporting by profit-oriented entities

 
Develop, promote and coordinate the use of a single set of high-quality, understandable, and enforceable
global and harmonized accounting standards known as International Financial  Reporting Standards.
 Development of International Financial Reporting Standards (IFRS)

 Promoting Global Convergence of Accounting Standards

Enhancing Transparency and Accountability

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
 Improving Comparability of Financial Information

 Facilitating Investment Decisions

Interpretation of IFRS

LIST OF IASB PRONOUNCEMENTS

The IASB issues three major types of pronouncements:
International Financial Reporting Standards (IFRS).
Conceptual Framework for Financial Reporting.
International Financial Reporting Standards Interpretation
HIERARCHY OF IFRS
Because it is a private organization, the IASB has no regulatory mandate and therefore no enforcement
Mechanism. Similar to the U.S. setting, in which the Securities and Exchange Commission enforces the use
of FASB standards for public companies, the IASB relies on other regulators to enforce the use of its
Standards.
Any company indicating that it is preparing its financial statements in conformity with IFRS must use all of the
standards and interpretations. The following hierarchy is used to determine that recognition, valuation, and
disclosure requirements should be used. Companies first look to

 International Financial Reporting Standards

 International Accounting Standards; and

Interpretations originated by the International Financial Reporting Interpretations Committee (IFRIC) or

the former Standing Interpretations Committee (SIC.

THE IASB’S CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING
The IASB Conceptual Framework for Financial Reporting is a set of guidelines issued by the
International Accounting Standards Board (IASB). It provides a foundation for the development and
 interpretation of accounting standards and ensures consistency and transparency in financial reporting.
The Conceptual Framework serves as a theoretical structure that outlines the principles and objectives of
financial reporting. It guides the preparation and presentation of financial statements,ensuring they provide
 relevant and reliable information to users such as investors, creditors, and regulators.
 of accounting standards and principles that
It provides a logical structure and direction to the development
guide the practices of financial accounting and reporting. 
A conceptual framework is a coherent system of concepts that flow from an objective.

To be useful, rule-making should build on and relate to an established body of concepts.

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
 To identify the purpose of financial reporting.

 To identify the boundaries of financial reporting;

 selecting the transactions, other events, and circumstances to be represented;

 how they should be recognized and measured; and

How they should be summarized and reported.

Key Objectives
Provide Useful Information: The primary objective is to ensure financial reports provide
information useful in making economic decisions.
Support Standard Development: It guides the IASB in developing and revising International Financial
Reporting Standards (IFRS).
Assist Preparers and Auditors: It helps preparers apply accounting standards and auditors evaluate
compliance with them.
Promote Consistency: Ensures consistency in accounting practices and reduces ambiguity
Need for the Conceptual Framework of IASB
Guidance for Standard-Setters:
Provides a reference point for the IASB when developing or revising International Financial
Reporting Standards (IFRS).
Ensures that new standards are conceptually sound and consistent with existing principles.
Consistency in Financial Reporting:
Promotes uniform application of accounting standards across different companies and industries,
enhancing comparability of financial statements.
Assistance to Preparers of Financial Statements:
Guides accountants in situations where specific IFRS do not exist.
Helps in selecting appropriate accounting policies when standards allow a choice.
Enhanced Comparability for Users:
Assists investors, regulators, and other stakeholders in interpreting and comparing financial reports
from different entities.
Improvement in the Quality of Financial Information:
Ensures the presentation of relevant, reliable, and useful information, enhancing the decision-
making process.
Basis for Judgments and Decisions:

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Provides a conceptual foundation for accountants, auditors, and regulators to make consistent
decisions about financial reporting issues.
Transparency and Accountability:
Strengthens the accountability of entities by ensuring that financial information faithfully represents
economic phenomena.
Support for International Convergence:
Facilitates global harmonization of accounting standards, improving cross-border financial
Communication and investment decisions.
THE IASB'S REVISED CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING
The IASB's Revised Conceptual Framework for Financial Reporting (2018) provides a foundation for
developing and interpreting International Financial Reporting Standards (IFRS). Below are the key
components and concepts outlined in the framework:

 First Level = identifies basic Objectives of General purpose Financial Reporting

  Qualitative Characteristics and

Second Level = identifies fundamental concept: which include
Elements of Financial Statements [Fundamental Concepts] 
Third Level relates to Recognition, Measurement, and Disclosure Concepts
First Level: Basic Objectives of General purpose Financial Reporting
 investors and creditors and other users in
To provide information that is useful to present and potential
 making rational investment, credit, and similar decisions.
flow – financial reporting shows different stakeholders where cash is
To track business cash 
 coming and going from.
To provide information to help present and potential investors and creditors and other users in assessing
the amounts, timing, and uncertainty of prospective cash receipts from  dividends or interest and the
 proceeds from the sale, redemption, or maturity of securities or loans.
To provide information about the economic resources of an enterprise, the claims to those resources, and
the effectsof transactions, events, and circumstances that change resources and claims to those
 resources.
To provide information
 about an enterprise’s performance provided by measures of earnings and its
 components.
To provide information about how management of an enterprise has discharged its stewardship 
responsibility to owners (stockholders) for the use of enterprise resources interested to it.

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
 To provide information that is useful to managers and directors in making decisions.
Second Level: Fundamental Concepts / Qualitative Characteristics of Accounting Information
Qualitative characteristics - are the attributes that make financial information useful to users.
To be useful, information must full fill two qualities:
Fundamental Characteristics
Relevance: Information is relevant if it influences decision-making (predictive value or confirmatory
value).

Faithful Representation: Information should be complete, neutral, and free from error.
Enhancing Characteristics
Comparability

Verifiability

Timeliness

Understandability

A. Relevance
Relevance is the capacity of accounting information to make a difference to the external decision makers who
use financial reports. If certain information is disregarded because it is perceived to have no bearing on a
decision, it is irrelevant to that decision.
Relevance can be evaluated according to three qualitative criteria,
Timeliness – means available to decision makers before it loses its capacity to influence their decisions.
Accounting information should be timely if it is to influence decisions, like the news of the world; state
financial information has less impact than fresh information.
Predictive value – Accounting information should be helpful to external decision makers by increasing
their ability to make predictions about the outcome of future events. Decision makers working from
accounting information that has little or no predictive value are merely speculating. For example,
information about the current level and structure of asset holdings help users to assess the entity’s ability to
exploit opportunities and react to adverse situations
Feedback value: Accounting information should be helpful to external decision makers who are confirming
past predictions or making updates, or corrections to predictions.
B. Reliability
Reliability means that users can depend on accounting information to represent the underlying economic
conditions or events that it purports to represent. Reliability of information is a necessity for individuals who

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have neither the time nor the expertise to evaluate the factual content of financial statements. It is especially
important to the independent audit process. Like relevance, reliability must meet three qualitative criteria.
Representational faithfulness – Accounting information should represent what it purports to represent and
should ensure that the selected method of measurement has been used without error or bias. This attribute is
some times called Validity: - Information must give a faithful picture of the facts and circumstances
involved. Accounting information must report the economic substance of transactions, not just their form
and surface appearance.
Verifiability:- Verifiability pertains to maintenance of audit trials to information source documents that can
be checked for accuracy. It also pertains to the existence of alternative information sources as backing.
Verification implies a consensus and implies that independent measures using the same measurement
methods would reach substantially the same conclusions.
Neutrality: - Accounting information must be free from bias regarding a particular view point,
predetermined result, or particular party. Accounting information can not be selected to favor one set of
interested parties over another. It should be factual and truthful.
Components of Primary Qualities

Relevance Reliability

PredictiveSecondaryvalue
Feedback Timelines Verifiability Represent Neutrality
value Faithfulness
Fundamental qualitative characteristics
Relevance
Materiality
Faithful representation
Enhancing qualitative characteristics
Comparability
Verifiability
Timeliness
Understandability
Elements of Financial Statements
1. Assets.

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Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past
transactions or events.
2. Liabilities
Liabilities are probable future sacrifices of economic benefits arising from present obligations of a particular
entity to transfer assets or provide services to other entities in the future as result of past transactions or events.
3. Equity
Equity is the residual (ownership) interest in the assets of an entity that remains after deducting its liabilities.
While equity in total is a residual, it includes specific categories of items, for example, types of share capital,
contributed surplus and retained earnings Are increases in net assets of a particular enterprise resulting from
transfers to it from other entities of some thing of value to obtain or increase ownership interests (or equity) in
it.
Are decreases in net assets of a particular enterprise resulting from transferring assets, rendering services, or
incurring liabilities by the enterprise to owners
4. Revenues
Revenues are inflows or other enhancements of assets of an entity or settlement of its liabilities (or combination
of both) during a period from delivering or producing goods, rendering services, or other activities that
constitute the entity’s ongoing major or central operations.
5. Expenses
Expenses are outflows or other using up of assets or incurrence of liabilities (or combination of both) during a
period from delivering or producing goods, rendering services, carrying out other activities that constitute the
entities ongoing major or central operations.
Third Level: Recognition and Measurement Criteria
Recognition Criteria:- recognition pertains to the point in time when business transactions are recorded in the
accounting system. The term recognition is broadly defined as the process of recording and reporting an item as
an asset, liability, revenue, expense, gain, loss or change in owners’ equity. Recognition of an item is required
when all four of the following criteria are met:
Definition: the item in question must meet the definition of an element of financial statements.
Measurability: The item must have a relevant quality or attribute that is reliably measurable
(historical cost, current cost, market value, present value or net realizable value).
Reliability:- The accounting information generated by the item must be representational faithful,
verifiable (Subject to audit confirmation or second – Source collaboration) and neutral (bias – free).

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Relevance – The accounting information generated by the item must be significant, that is, capable
of making a difference to external users in making decision.

NATURE OF AN ACCOUNT
Account: is the type of traditionally used for the purpose of recording the individual transactions.
Ledger/general ledger/: is a group of related accounts that compromise a complete unit, such as all of the
accounts of a specific business enterprise. It is a complete collection of all the accounts of a business unit.
Accounts fall into two general broad categories:
Balance Sheet Accounts
Income Statement Accounts
The balance sheet accounts are called real or permanent accounts & classified as assets, liabilities & owner`s
equity
CLASSIFICATION OF ACCOUNTS
Accounts are classified into five: assets, liabilities, capital, and revenue and, expenses.
Assets: Resources owned by a business or individual are called assets. An asset is any physical thing
(tangible) or right (intangible) that has a value is an asset.
Current asset: asset that may reasonably be expected to be realized in cash or sold or used up usually
within one year or less through the normal operation of the business.
Example: cash, account receivable, supplies, inventory, short term notes receivable.
Plant assets (fixed assets): It is tangible asset used in the businesses that are of a permanent or
relatively fixed nature. Fixed assets include: equipment, machinery, buildings, and land.
Liabilities: debts owed to outsiders (creditors).
Current liabilities: liabilities due within a short time (usually one year or less) and that are to be
paid out of current assets.
Example: account payable, short note payable, salaries payable, interest payable, tax payable, unearned
revenue.
Long-term liability: liability that will not be due for a comparatively long time (usually more than one
year) or company’s obligations not expected to be paid within one year (or a longer operating cycle).
Example: long-term notes payable, bonds payable, lease liabilities.
Owner’s equity: residual claim against the business asset after the total liabilities are deducted.

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Revenues: gross increase in owner’s equity as a result of the operation such as sale of merchandize,
performance of service to customer, rental of property, lending of money, and other business and
professional activities.
Expenses: decrease in owner’s equity as a result of the operation. And costs that have been consumed in the
process of producing revenue are expired costs or expenses.
Drawings: drawings represent account that is used to record the amount of withdrawals made by the owner
of sole proprietor ship, and partnership form of business organizations. And dividend is used to record
payment made to shareholders by a corporation.
Every account has three major parts:
The account title and number
The left side, which is called the debit side
The right side, which is called the credit side

 Chart of accounts is the list of accounts with their names and account numbers in the ledger.
CHART OF ACCOUNTS
 
The accounts are normally listed in the order in which they appear in the financial statements.

For example:
The balance sheet accounts are listed first, in the order of assets, liabilities, and owner’s equity.
The income statement accounts are then listed
 in the order of revenues and expenses
Accounts beginning with number:
1-represents assets;
2-liability;
3-Owner’s equity (Owner’s equity capital and drawings);
4-Revenue and
5-Expenses.
RULES OF DEBITS AND CREDITS
As shown above every account has three parts. These parts are discussed below:
Title – The name of the account. This is written at the top of the account
Debit – is the left hand side of an account –Debit is abbreviated as ‘Dr.’. When an amount is entered on the left
side of an account we say the account is debited or charged.
Credit – is the right hand side of an account. Credit is abbreviated as Cr. An account is said to be credited
when an amount is entered on the right hand side of the account.
An account may increase or decrease on the debit side or on the credit side depending on the nature of the
account. In general, accounts appearing on the left hand side of the accounting equation increase on their left

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side (Dr. side) and decrease on their right side (Cr. Side); whereas accounts on the right side of the equation
increase on their right side and decrease on their left side.
The above general rule will be expanded as follows
Debit Credit
-Increase in assets -Decrease in assets
-Increase in expenses -Decrease in expenses
-Decrease in capital -Increase in Liabilities
-Decrease in liabilities -Increase in liabilities
-Decrease in revenue -Increase in revenue.

The normal balance of an Account

Normal balance refers to the side of an account (Dr. or Cr.), which will have greater entries than the other. The
increasing side will be the normal balance for accounts.
Example: The normal balance of all asset accounts is debit
Asset and expenses decreases are recorded as credits, whereasliability, capital, and income decreases are
recorded as debits. The following tables summarize the rule.

Debit and Credit rules of accounts:

Account Increase side Decrease side Normal Balance

All Asset Debit Credit Debit
All Liability Credit Debit Credit
Owner’s equity (Capital) Credit Debit Credit
All Revenue Credit Debit Credit
All Expense Debit Credit Debit
Owner’s drawing Debit Credit Debit

Summarized below:
Transaction
Recording business transactions and events in the journal.(Journal)
Classifying data by posting from the journals to the ledger.(Posting
Prepare an unadjusted trial balance from the general ledger

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Analyze the trial balance and make end of period adjusting entries
Post adjusting journal entries and prepare the adjusted trial balance/Work sheet
Use the adjusted trial balance to prepare financial statements
Close all temporary income statement accounts with closing entries
Prepare the post closing trial balance for the next accounting period
Prepare reversing entries to cancel temporary adjusting entries if applicable
When these steps are completed, the cycle begins again for the next accounting period.
JOURNALIZING BUSINESS TRANSACTION
The process of recording a transaction in the journal is called journalizing. The entry in the journal is called
a journal entry.
The journal is the book of original entry for accounting data.. On the basis of this evidence, the transactions are
entered in chronological order in the journal.
Thus, Journal
Is the book in which the records of business are written.
It is a chronological record of events.
Is the original book of entry
General journal
Information recorded on this book is usually extracted from the source documents such as
invoices, receipts, contracts agreements and many other relevant documents.
It would usually show the account to be debited and credited and short description on the transaction.
Information on this book will be posted to the ledger.
General journal is used to record all kinds of entries
Typically, a general journal has; spaces for dates, account titles and explanations, references, and two amount
columns.
The journal makes several significant contributions to the recording process:
It discloses in one place the complete effect of a transaction.
It provides a chronological record of transactions.
It helps to prevent or locate errors because the debit and credit amounts for each entry can be
readily compared.

A journal in which only one kind of business transaction is recorded is a special journal used to
record only one type of entries.
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Special journals differ from the general journal or the combination journal in that they are meant only
for specified types of transactions-only one type.
Posting: Is the process of transferring debits and credits from the journal entries to the ledger for the purpose of
summarizing is called posting and is ordinarily carried out in the following steps:
 The date and the amounts of the debits and credits are entered in
Record the amount and date.
 the appropriate accounts.
 reference in the account. The number of the journal page is entered in
Record the posting
the account.
Illustration of Analyzing and Recording Transactions
To illustrate recording a transaction in an all-purpose journal and posting in a manual accounting system, we
will use the following steps:
Step- 1: The date of the transaction is entered in the Date column.
Step -2: The title of the account to be debited is recorded at the left-hand margin under the Description column,
and the amount to be debited is entered in the Debit column.
Step-3: The title of the account to be credited is listed below and to the right of the debited account title, and the
Amount to be credited is entered in the Credit column.
Step-4: A brief description may be entered below the credited account.
Step-5: The PR(Posting Reference) column is left blank when the journal entry is initially recorded. We will
use this column later in this chapter when we transfer the journal entry amounts to the accounts in the
Ledger.
Illustration
To illustrate the complete accounting cycle, we will consider the following list of selected transactions. The
transactions were completed by Bati Transport in the month of January 2003.
January 1. Ato yimer took Birr 450,000 from his personal savings and deposited it in the name of Bati transport .
January 2. Bati Transport purchased two used trucks for Birr 150,000 each, on cash.
January 4. Bati Transport received a check for Birr 1550 for services given to Alem Trading.
January 11. buy an insurance policy for Birr 600 for its trucks.
January 16. Ato Yimer issued a check for Birr 9,400 to the workers as a salary for two weeks.
January 20. Bati trading Billed Muradu Supermarket for goods transported from
Djibouti to Gondar Birr 2,650
January 22. Purchased stationary materials and other supplies of Birr 740 on account
January 23. Office equipment of Birr 11,600 is bought on account.
January 24. Purchased an additional truck for Birr 250,000 paying birr 100,000 in cash

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and issuing a note for the difference.

January 25. Recorded services billed to customers on account birr 14,600.
January 26. Received cash from customers on account Birr 15,000
January 27. The owner withdrew Birr 500 in cash for his personal use.
January 29. Paid telephone expense of Birr 95 and electric expenses of Birr 125
January 30. Paid other miscellaneous expenses Birr 50
January 31. Paid Birr 4,000 as a rent for a building used for office space
These transactions are journalized as follows:

Date Description Debit Credit

2003 Cash 450,000
Jan.1 Yimer Capital 450,000
To record investment by owner
2 Purchase truck 300,000
Cash 300,000
Purchase of trucks
4 Cash 1550
Service Income 1550
Cash received from customers
11 Prepaid Insurance 600
Cash 600
Purchase of insurance policy
16 Salary Expense 9,400
Cash 9,400
Payment of salary
20 Accounts Receivable 2,650
Service Income 2,650
Provision of service
21 Truck Expense 450
Cash 450
Cash paid to repaint truck
22 Supplies 740
Accounts Payable 740
Purchase of supplies of account
23 Office Equipment 11,600
Accounts Payable 11,600
Purchase of equipment
24 Truck 250,000
Cash 100,000
Notes Payable 150,000
Purchase of truck
25 Accounts Receivable 14,600
Service Income 14,600
Provision of service on account
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26 Cash 15,000
Accounts Receivable 15,000
Collection of cash
27 Drawings 500
Cash 500
Owner withdrawals
28 Salary Expense 9,400
Cash 9,400
Payment of salary
29 Utilities Expense 220
Cash 220
Payment for telephone, electricity
30 Miscellaneous Expenses 50
Cash 50
Payment for various expenses
31 Rent Expense 4,000
Cash 4,000
Payment of Rent
POSTING FROM THE JOURNAL TO THE LEDGER
After the information about a business transaction has been journalized, that information is transferred to the
specific accounts affected by each transaction. This process of transferring the information is called posting. An
account could be of two types; the two-column account and the four-column account. We will use the four-
column account for our illustration. The two forms of accounts are given below.

The two-column account:

Account Account number
Date Item P.R Debit Date Item P.R Credit

The four-column account:

Account Account number
Date Item P.R Debit Credit Balance
Debit Credit

The steps in posting are given below:

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Record the date and amount of Dr. and Cr. Entry to the account
Insert the Journal page number in the P.R (Post Reference) column of the account.
Insert the account number in the P.R column of the journal.
Note. The P.R Column is used for reference purposes. The P.R column of the journal shows whether the entry is
posted and the account to which it is posted. In the account, the P.R Column shows the Journal page number
from which the entry was brought.
The group of accounts used by an organization is called ledger.
Illustration. As mentioned above, to illustrate the posting process the four column account is used and the
entries to the cash account are posted as follows.
Account Cash Account Number
Balance
Date Item P.R Debit Credit Debit Credit
2003 450,000 00 450,000 00
Jan 1
2 300,000 00 150,000 00
4 1,550 00 150,650 00
11 600 600 00 150050 00
16 9,400 00 140650 00
21 450 00 140200 00
23 100,000 00 40200 00
25 15,000 00 55200 00
27 500 00 54200 00
28 9,400 00 45300 00
30 220 00 45,080 00
30 50 00 45,030 00
31 4,000 00 41,930 00

Note. The item column is usually left blank. In some cases the word balance is written when the account is
carried forward to a new page.
THE TRIAL BALANCE
A trial balance is the listing of the ledger accounts & their debit & credit balances to determine the equality of
the two sides. The accounts appear on the trial balance in the following order:

 asset accounts

 liability accounts

 owner`s equity accounts/ capital

revenue accounts

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
expense accounts
Note that the most liquid assets are listed first & the least liquid assets are listed last, liabilities with short due
date appear first & expenses are to be listed in their ascending order
The trial balance for our illustration, Bati Transport is presented bellow. The amounts are taken from the
balances of the accounts after all the transactions have been posted. Therefore, after posting the above
transactions, you should get the final balances shown on the trial balance in the end.
Bati Transport
Trial Balance
January 31, 2003

Cash 41,930 00
Accounts Receivable 2,250 00
Supplies 740 00
Prepaid Insurance 600 00
Office equipment 11,600 00
Truck 550,000 00
Accounts payable 12,430 00
Notes payable 150,000 00
Yimer capital 450,000 00
Yimer drawing 500 00
Service income 18,800 00
Salary expense 18,800 00
Rent expense 4,000 00
Utilities expense 220 00
Truck expense 540 00
Miscellaneous expense 50 00
Total 631,230 00 631,230 00

2.8.1 Proof Provided by the Trial Balance

The trial balance debit totals and credit totals are equal implies that the accounting work is more likely to be free
from any one or more of the following errors.
Error in preparing the trial balance including
-Addition error
-The amount of an account balance was in correctly listed on the trial balance
A debit balance was recorded as a credit or vice versa
A balance was entirely omitted.
Error in posting, including
An erroneous amount was posted to the account.

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A debit amount was posted as a credit or vice versa

A debit or credit posting was omitted
2.8.2 Limitations of the Trial Balance
The trial balance amounts are equal doesn’t mean that the accounting work is free from error. That is, there are
errors that may take place without affecting the trial balance totals. Some examples are mentioned below:
Failure to record a transaction or to post a transaction
Recording the same erroneous amount for both the debit and the credit parts of a transaction.
Recording the same transaction more than once.
Posting part of a transaction to the correct side but the wrong account.
Note: All these errors have the same affect (increasing or decreasing) on the debit totals and credit totals
ADJUSTMENTS
Definition: - adjustment is the process of updating the accounts & assuring the proper matching of revenues &
expenses at the end of an accounting period; adjusting entries are required entries to record the adjustment
process.

Example. Stationary materials totaling Birr 1,900.00 were purchased and recorded during the year. At the end of
the year, only Birr 150 of the supplies is left in hand.
The adjusting entry prepared at the end of the year to adjust the supplies account will be
1990 Supplies expense 1,750
Dec31 Supplies 1,750

Note: 1. Adjustments are dated as the last day of the year.

The accounting year here – we assume, runs from January 1- December 31.
Additional examples on adjustments will be given below under the topic ‘worksheet’
2.9.1 The Accrual Basis and the Cash Basis of Accounting
The cash basis of accounting – In this basis of accounting revenues are reported in the period in which cash is
received and expenses are reported in the period in which cash is paid. Net income will, therefore, be the
difference between the cash receipts (Revenues) and cash payments (expenses). This method will be used by
organizations that have very few receivables and payables. For most businesses, however, the cash basis is not
an acceptable method. Under cash-basis accounting, companies record revenue when they receive cash. They
record an expense when they pay out cash. The cash basis seems appealing due to its simplicity, but it often
produces misleading financial statements. It fails to record revenue for a company that has provided services but

Page 18
 Comprehensive core competency I Lecture Note

for which it has not received the cash. As a result, it does not match expenses with revenues. Cash basis
accounting is not in accordance with International Financial Reporting Standards (IFRS).
The accrual basis of accounting – Under this method revenues are reported in the period in which they are
earned, and expenses are reported in the period in which they are incurred. For example, revenue will be
recognized as services are provided to customers or goods sold and not when cash is collected. Most
organizations use this method of accounting and we will apply this method in this course.
Types of Adjusting Entries
Adjusting entries are classified as either deferrals or accruals. As the next Illustration shows, each of
these classes has two subcategories.
Deferrals: Categories of adjusting entries
Prepaid expenses: Expenses paid in cash before they are used or consumed.
Unearned revenues: Cash received before services are performed.
Accruals:

1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded.
2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.
WORKSHEET FOR FINANCIAL STATEMENTS
A worksheet is a multiple column form that maybe used in the adjustment process & in preparing financial
statements. As its name suggests, the worksheet is a working tool. A worksheet is not a permanent accounting
record. It is a device used to make it easier to prepare adjusting entries & the financial statements. In small
businesses with relatively few accounts & adjustments, a work sheet may not be needed while it is
indispensable for large companies with numbers accounts.
The heading has three parts:
Name of the Organization
Name of the form (worksheet)
Period of time covered
1. The adjusted trial b
There are five steps to prepare worksheet
Prepare a trial balance on the work sheet
Enter the adjustments in the adjustments columns
Enter adjusted balances in the adjusted trial balance columns.
Extend adjustment trial balance amounts to appropriate financial statement columns
Total the statement columns, compute the Net Income /loss, and complete the worksheet

Page 19
 Comprehensive core competency I Lecture Note

To prepare a worksheet for Bati Transport, the following adjustments are given.
Adjustment data:
At the end of July31 supplies on hand shows $400.
Prepaid insurance policy showed that three – fourth of the policy is expired
At the end of the month unbilled fees for services performed to clients totaled Birr 6,500.
The accounts in the ledger of our illustration that require adjustment and the adjusting entry for the accounts are
presented below.
Supplies – The supplies account has a debit balance of Birr 740. The cost of supplies in hand on July 31 is
determined to be Birr 400. The following adjusting entry is required to bring the balance of the account up to
date:
Supplies expense…………………………….340
Supplies……………………………………..340
Prepaid insurance – Analysis of the policy showed that three – fourth of the policy is expired. That is only
Birr 150 of the policy is applicable to future periods. The adjusting entry to transfer the expired part of the
insurance to expense will be.
Insurance expense ……………………….450
Prepaid insurance………………………..450
Service Income – At the end of the month unbilled fees for services performed to clients totaled Birr 7,400.
This amount refers to an income earned but to be collected in the future. The journal entry to record it will be
Accounts receivable…………………………7,400
Service income………………………………7,400
All the above adjusting entries will be inserted in the adjustment column of the worksheet in front of the
accounts affected.

Page 20
 Bati Transport
Work Sheet
For th3e month ended jan.31,2003

Account Title Trial Balance Adjustment Adjusted Trial Income Balance sheet
Dr Cr Dr Cr balance statement
1 Cash 41,930 41,930 41,930
©
2 Accounts receivable 2,250 7,400 9,650 9,650
3 Supplies 740 (a)340 400 400
4 Prepaid Insurance 600 (b)450 150 150
5 Office equipment 11,600 11,600 11,600
6 Truck 550,000 550,000 550,000
7 Accounts payable 12,430 12,430 12,430
8 Notes payable 150,000 150,000 150,000
9 Yimer Capital 450,000 450,000 450,000
10 Yimer drawing 500 500 500
©
11 Service income 18,800 7,400 26,200 26200
12 Salary expense 18,800 18,800 18,800
13 Rent expense 4,000 4,000 4,000
14 Utilities expense 220 220 220
16 Truck expense 540 540 540
17 Miscellaneous 50 50 50
Expense
18 631,230 631,230
(a)
19 Supplies expense 340 340 340
(b)
20 Insurance expense 450 450 450
21 7290 7290 636,830 636,830
22 Net income 1,800
23 26200 26200 614,230 614,230

FINANCIAL STATEMENT PREPARATION

After the work sheet is completed financial statements could be prepared easily. In chapter one we
have discussed four basic financial statements prepared by most organizations. Here, we will prepare
three of these statements for Bati Transport form the worksheet.
Income statement All the data required to prepare the income statement is brought from the
worksheet.
Bati Transport
Income statement
For the month ended. Jan 31, 2003
Service Income …………………………………………………………Birr 26,200
Operating expenses
Salary expense………………………..Birr 18,800
Rent “…………………………………….4,000
Insurance “ ……………………………450
Supplies “ …………………………….340
Utilities “……………………………..220
Truck “ …………………………….. 540
 Miscellaneous “………………………………50
Total operating expense………………………………………24,400
Net Income…………………………………………………Birr 1,800
Statement of owner’s equity – This statement shows the beginning balance of capital and the
changes that affected it.
The balance of the owners equity account (Yimer capital) in the worksheet may not be the beginning
one. Therefore, the ledger has to be reviewed to see if there was an additional investment during the
priod or not. In our illustration there is no additional investment.

Bati Transport
Statement of Owner’s equity
For the month ended January 31, 2003
Yimer capital January 1, 2003………………………………Birr 450,000
Net income for the month………………….birr 1,800
Less: Withdrawal………………………………….. .500 1,300
Yimer capital, January 31, 2003……………….…………….Birr 451,300
Balance sheet – The data to prepare this statement will be taken from the worksheet and the other
financial statements. Note that assets and liabilities are classified as current and non – current.
Bati Transport
Balance sheet
January 31, 2003
Assets
Current Assets:
Cash…………………………………………Birr 41, 930
Accounts Receivable…………………………….. 9,650
Supplies…………………………………………… 400
Prepaid insurance…………………………………….150
Total current assets……………………………………………Birr 52,130
Plant Asset (None-Current Assets):
Office equipment……………………………..Birr 11,600
Truck………………………………………………550,000 561,600
Total asset………………………………………………………Birr 613,730
Liabilities
Current liabilities
Accounts payable……………………………..Birr 12,430
Non-current liabilities
Notes payable……………………………………..150,000
Total liabilities……………………………………………………Birr 162,430
Owner’s equity
Ato Yimer Capital…………………………………………………………….. 451,300
Total liability and owners equity………………………………………….Birr 613,730
THE CLOSING PROCESS
The net effect of all temporary/nominal accounts will be summarized to the capital account at the
end of the accounting period.
These nominal accounts must have a zero balance at the end of the fiscal year, so that they will be
ready for use in the following accounting period. These two activities take place through the
closing entries.

Steps in closing:
Closing revenue accounts - Debit each revenue account by its balance and credit the ‘Income
Summary’ account by the total revenue for the period.
Note: Income summary is an account used to close revenue and expense accounts. This account will
immediately be closed to the capital account at the end of the closing process and Income summary
account has NO NORMAL BALANCE, and it is only opened & closed during the closing process
Closing expense accounts – Debit the income summary account by the total of expenses for the
period and credit each expense account by its balance.
c. Closing the income summary account – Income summary will be closed to the capital account.
The balance of his account depends on the nature of operation; credit if result is profit and debit if
result is loss.
Closing Withdrawal – Debit the owners equity account by the total of drawings for the period and
credit the drawing account.
The temporary accounts of Bati transport are closed as follows.
2003 Income summary………………….26,200
January Service income…………………………………26,200
31 Closing revenue
Salary expense………………………..18,800
rent expense……………………………4,000
Maintenance expense………………….. 450
Insurance expense………………………..450
Supplies expense…………………………340
Utilities expense………………………….220
Truck expense …………………………… 90
Miscellaneous expense…………………….50
Income expense…………………………………24,400
Closing expenses
2003 Income summary………………1,800
January 31 Yemer Capital………………………..1,800
Closing income summary
31 Yimer capital…………………...500
Yimer drowing………………………..500
Closing with draw
The above closing entries have transferred the balance of the temporary accounts to the permanent
capital account.
POST CLOSING TRIAL BALANCE
The last procedure of the accounting cycle is the preparation of the post-closing trial balance; after all
nominal accounts are closed, to make sure that the ledger is in balance at the beginning of the new
accounting period. The post-closing trial balance incorporates only the balance sheet accounts &
contra plant assets accounts_ accumulated depreciation.
This is because the temporary income statement accounts are closed during the closing process. This
trial balance is called the post – closing trial balance. In practice the ledger balance after closing
may be checked by a simple calculator print out rather than a formal trial balance. The post-closing
trial balance for Bait Transport is presented below.
Bati Transport
Post – Closing trial balance
Jan 31, 2003
Cash……………………………………………Birr 41,930
Accounts Receivable ………………………………...9,650
Supplies…………………………………………………400
Prepaid insurance……………………………………….150
Office equipment……………………………………11,600
Truck……………………………………………….550,000
Accounts payable…………………………………………………….Birr 12,430
Nots payable……………………………………………………………..150,000
Yimer capital……………………………………………………………..451,300
Total……………………………………Birr 613,730 Birr 613,730

CHAPTER 2

IAS 1: Presentation of Financial Statements

IAS 1 provides guidelines on how financial statements should be presented to ensure consistency,
comparability, and clarity.
Key Components:

Complete Set of Financial Statements

IAS 1 requires an entity to present the following:
o Statement of Financial Position (Balance Sheet)
o Statement of Profit or Loss and Other Comprehensive Income
o Statement of Changes in Equity
o Statement of Cash Flows (per IAS 7)
 Notes to the Financial Statements
Comparative Information for the previous period
General Principles
Fair presentation: Financial statements should present a true and fair view of the
entity's financial position.
Going concern: Assumes the business will continue operating.
Accrual basis: Financial statements should be prepared using the accrual accounting
method.
Materiality and aggregation: Similar items should be grouped together.
Offsetting: Assets and liabilities, or income and expenses, should not be offset unless
required by IFRS.
Consistency: The presentation and classification of financial items should remain
consistent across periods.
Statement of Profit or Loss and Other Comprehensive Income
Can be presented as:
A single statement (combining profit or loss and other comprehensive income)

Two separate statements (one for profit or loss and one for other comprehensive
income)

Statement of Financial Position (Balance Sheet)
No mandatory format, but items should be categorized into:
Current and non-current assets

Current and non-current liabilities

Equity components

Statement of Changes in Equity
Shows changes in equity components (e.g., share capital, retained earnings) during the
reporting period.
IAS 7: Statement of Cash Flows
IAS 7 provides guidelines for preparing and presenting the Statement of Cash Flows, which shows
cash movements categorized into three activities:
Key Components:
Operating Activities
Cash flows from the core business operations (e.g., cash received from customers, cash paid
to suppliers).
Can be presented using:
 Direct method (showing actual cash receipts and payments)

Indirect method (starting with net income and adjusting for non-cash items)

Investing Activities
Cash flows related to investments (e.g., purchase or sale of property, equipment,
investments).
Financing Activities
Cash flows from borrowing and equity transactions (e.g., issuing shares, repaying loans,
dividend payments).
Additional Considerations:
Non-cash transactions (e.g., issuing shares for assets) are disclosed in notes.

Foreign currency cash flows must be translated using exchange rates at the time of
transaction.

7
 CHAPTER 3
CASH AND RECEIVABLE
MEANING OF CASH
Cash, the most liquid of assets, is the standard medium of exchange and provide the basis for
measuring and accounting for all other item. It is generally classified as a current asset. To be
reported as cash, it must be readily available for the payment of current obligations, and must
be free from any contractual restrictions that limit its use in satisfying debts
Cash consists of coins, currency, and available funds on deposit at the bank. Negotiable instruments
such as money orders, certified checks, cashiers’ check, personal checks, and bank drafts are viewed
as cash.
The following items are commonly mixed together to be cash; but actually they are not qualified
as cash:
Postage Stamps- These are classified as short term prepayments or prepaid expenses.
Post-dated checks and NSF( not-sufficient fund) checks-Post-dated checks are checks
received for deposit but to be deposited and cashed only after a certain period of time and not
available for immediate payment. NSF checks include checks that cannot be covered by funds
in the debtor’s bank account and thus, rejected by the bank after being deposited.
IOU- This is an abbreviation for ‘I owe you’ and represents a promissory note received for
later receipt of money. Thus, it is classified as receivables.
Travel Advances- These are amounts paid in advance for officers or employees commonly
classified as receivables or prepaid expenses.
Deposit with a trustee such as a bond sinking fund that is not under the control of management
of a business.
Cash in a foreign bank that is restricted as to use or withdrawal and cash in closed (block)
banks
5.3 CHARACTERISTICS OF CASH
The following are some of the characteristics of cash:
Cash is used as medium of exchange
Cash is the most liquid asset
Cash is mostly affected by business transactions
Cash is used to measure the value of other assets
Cash is mostly exposed to embezzlements
REPORTING CASH
Although the reporting of cash is relatively straightforward, a number of issues merit special
attention. These issues relate to the reporting of:

8
 Cash equivalents.
Restricted cash.
Bank overdrafts
CASH EQUIVALENTS
Cash equivalents are short-term, highly liquid investments that are both (a) readily convertible to
known amounts of cash, and (b) so near their maturity that they present insignificant risk of changes
in value due to changes in interest rates. Generally, only investments with original maturities of three
months or less qualify under these definitions.
Examples of cash equivalents are Treasury bills, commercial paper, and money market funds. Some
companies combine cash with temporary investments on the statement of financial position. In these
cases, they describe the amount of the temporary investments either parenthetically or in the notes.
RESTRICTED CASH
Restricted cash refers to money that is held for a specific purpose, meaning it's not available for
immediate or general business use. Restricted cash appears separately from cash on the balance
sheet, while its purpose is disclosed in the financial statement footnotes.
Petty cash, payroll, and dividend funds are examples of cash set aside for a particular purpose. In most
situations, these fund balances are not material. Therefore, companies do not segregate them from
cash in the financial statements. When material in amount, companies segregate restricted cash from
“regular” cash for reporting purposes. Companies classify restricted cash either in the current assets or
in the non-current assets section, depending on the date of availability or disbursement. Classification
in the current section is appropriate if using the cash for payment of existing or maturing obligations
(within a year or the operating cycle, whichever is longer). On the other hand companies show the
restricted cash in the non-current section of the statement of financial position if holding the cash for a
longer period of time.
Bank overdrafts occur when a company writes a check for more than the amount in its cash account.
Companies should report bank overdrafts in the current liabilities section, adding them to the amount
reported as accounts payable. If material, companies should disclose these items separately, either on
the face of the statement of financial position or in the related notes.
Bank overdrafts are included as a component of cash if such overdrafts are repayable on demand and
are an integral part of a company’s cash management (such as the common practice of establishing
offsetting arrangements against other accounts at the same bank). Overdrafts not meeting these
conditions should be reported as a current liability.
5.4 MANAGEMENT OF CASH
Cash management refers to planning, controlling and accounting for cash transactions and cash
balances. Efficient management of cash is essential to the survival and success of every business
organization. Managing cash requires planning wisely so that there will not be excess cash held on

9
hand at any point in time; or there is no shortage of cash at any point in time to meet the business’s
needs.
5.5 INTERNAL CONTROL OF CASH
An internal control system is a set of policies and procedures designed to protect assets, provide
accurate accounting records and evaluate performances .The need to safeguard cash is crucial in most
businesses because cash is mostly exposed to embezzlement. Firms address this problem through the
internal control system.
Establish responsibilities/segregation of duty.
Maintain adequate records
Insure assets and key bond employees
Separation of recordkeeping from custody of assets
Divide responsibility for related transactions
Apply technological controls
Perform regular and independent reviews

The individuals who receive cash should not also disburse (pay) cash
The individuals who handle cash should not access accounting records
Cash receipts are immediately recorded and deposited and are not used directly to make
payments.
Disbursements are made by serially numbered checks, only upon proper authorization by
someone other than the person writing the check
Safeguarding Assets: Protect the organization’s cash on hand by placing them in a locked
cabinet or drawer with limited access (or better yet a drop safe).

Bank accounts are reconciled monthly.

The following are the most common elements of cash control and managements: bank account
system, petty cash fund, voucher system, change fund, and cash short and over.
5.5.1 Control of Cash through Bank Accounts
Bank accounts are one of the most important means of controlling cash that provide several
advantages such as:
Cash is physically protected by the bank,
A separate record of cash is maintained by the bank,
And customers may remit payments directly to the bank.
If a company uses a bank account, monthly statements are received from the bank showing beginning
and ending balances and transactions occurring during the month including checks paid, deposits
received, and service charges. These monthly statements (reports) received from the bank are called

10
bank statements. Bank statements generally are accompanied by checks paid and charged to the
accounts during the month, debit and credited memos, which inform the company about changes in
the cash accounts. For a bank, the depositor’s cash balance is a liability, the amount the bank owes to
the firm. Therefore, a debit memo describes the amount and nature of decrease is the company’s cash
accounts. A credits memo indicates an increase in the cash balance of the depositor that it has with the
bank.
[Link] Reconciliation of Bank and Book Cash Balances
Monthly reconciling of the bank balance with the depositor’s cash accounts balance is essential cash
control procedure. To reconcile a bank statement means to verify that the bank balance and the
accounting records of the depositor are consistent. The balance shown in a monthly bank statement
seldom equals the balance appearing in the depositor’s accounting records. Certain transactions
recorded by the depositor may not have been recorded by the bank and vice versa.
The most common examples that cause disparity between the two balances are:
a) Outstanding checks: Checks issued and recorded by the company, but not yet presented to the
bank for payment.
Deposits in transit: is Cash receipts recorded by the depositor, but not reached the bank to be
included in the bank statement for the current month.
Service charges:
Banks often charge a fee for handling checking accounts. The amount of this charge is deducted
by the bank form bank balance and debit memo is issued for the depositor.
Charges for depositing NSF- checks:
NSF stands for “Not Sufficient Funds.” When checks are deposited in an account, the bank
generally gives the depositor immediate credit. On occasion, one of these checks may prove to be
uncollectible because the maker of the check does not have sufficient funds in his or her account.
In such a case, the bank will reduce the depositor’s account by the amount of this uncollectible
item and return the check to the depositor marked “NSF”.
Notes collected by bank:
If the bank collects a note receivable on behalf of the depositor, it credits the depositor’s
account and issues a credit memorandum for the depositor.
When the depositor prepares bank reconciliation, the balances shown in the bank statement and in the
accounting records both are adjusted for any unrecorded transactions. Additional adjustments may be
required to correct any errors discovered in the bank statements or in the accounting records.
[Link] Steps in Preparing Bank Reconciliation
A bank reconciliation is a schedule prepared by the depositor to bring the balance shown in the bank
statement and the balance shown in the depositor’s accounting into agreement.

11
The steps to prepare a bank reconciliation are:
The deposits listed on the bank statement are compared with the deposits shown in the
accounting records. Any deposits not yet recorded by the bank are deposits in transit and
should be added to the balance shown in the bank statements.
The paid and received checks from the bank are compared with the check stubs. Any checks
issued but not yet paid by the bank are outstanding checks and should be deducted from the
balance reported in the bank statements.
Any credit memorandums issued by the bank that have not been recorded by the depositor, are
added to the balance per depositor’s record.
Any debit memorandums issued by the bank that have not been recorded by the depositor are
deducted from the balance per depositor’s record.
Any errors in the bank statement or depositor’s accounting records are adjusted.
The equality of adjusted balance of statement and adjusted balance of the depositor’s record is
compared.
Journal entries are prepared to record any items delayed by the depositor.
[Link] Illustration of Bank Reconciliation
On January31, 2000 Cash balance (depositor) balance Shows that Br. 4,262.83. Assume also that on
January 31, 2000, bank statement s shows of Br. 5,000.17 and the information
A deposit of Br. 410.90 made on Jan. 31 does not appear on the bank statement.
Outstanding checks are
Check No. 301 Br. 110.25
Check No. 342 607.50
A credit memorandum (collection of a non-interest bearing note receivable from MAN
Company Br. 524.74.
NSF for the month is 50.25 received from a customer, RON Company.
Banks service charge by bank for the month of January amounts to Br. 17
Check No. 305 was issued by RAM Company for payment of telephone expense in the
amount of Br. 85 but was erroneously recorded in the cash payments journal as Br. 58.
The January 31 bank reconciliation for RAM Company is shown below:
RAM Company

Bank Reconciliation
January 31, 2000
Balance per bank statement, Jan. 31,2000 Br. 5,000.17
Add: Deposit of Jan. 31 not recorded by bank 410.90
Subtotal Br. 5,411.07

12
Deduct: outstanding checks:
No. 301 Br. 110.25
No. 342 607.50 117.75
Adjusted cash balance Br. 4,693.32
Balance per depositor’s record, Jan. 31,2000 Br. 4,262.83
Add: Note Receivable collected by bank 524.74
Subtotal Br. 4,787.57
Deduct: Bank service charge Br. 17.00
NSF check of Ron Co. 50.25
Error on check stub No. 305 27.00 94.25
Adjusted cash balance Br. 4,693.32
The following are journal entries related to the bank reconciliation.
2000
Jan. 31 cash 524.74
Notes Receivable 524.74
To record collection of Note Receivable collected by bank
31. Miscellaneous Expense (bank service charge) 17
Cash 17
To record bank service charges,
Accounts Receivable 50.25
Cash 50.25
NSF check and error in recording
Accounting payable 27
Cash 27
To record depositor error
EXERCISE
PROBLEM 1 On November 30, 1991, the Cash T-account (after all postings have been made) for
Company AA shows a balance of $4,200. The bank statement, however, shows a balance of $5,000
After an examination of the bank statement, the books, and the returned checks, the accountant
noted the following:
Check no. 482 for $1,200 and check no. 491 for $800 are still outstanding.
A check for $200 that was received from Mr. Poor has "bounced." It has been returned with the
bank statement and marked "NSF," for "not sufficient funds." This check was in payment for
services performed by us on account for Mr. Poor.
A deposit we made on November 29 for $3,000 does not appear on the bank statement.
The bank charged us a $10 service fee to handle the NSF check.
The bank also charged us a $15 monthly checking account fee.
Check no. 474 for $85 was mistakenly charged by the bank for only $58.
The bank collected a $2,000 note for us and deposited the proceeds into our account.
The checking account earned $30 interest during the month.

13
 The bank mistakenly charged us for a check of $32 as 62 by Company AB.
prepare bank reconciliation
prepare necessary journal entry
PROBLEM 1: On May 31, 2002 lee company showed a balance in its cash account of Birr 1891. On
June 2, Lee received its bank statement for the month ended May 31, which showed an ending
balance of Birr 3,252.00.
A matching of debits to the cash account on the books with deposits on the bank statement
showed that the Birr 452.00 receipts of May 31 are included in cash but not included as
deposit on the bank statement.
An examination of checks issued and checks cleared showed three checks outstanding:
No 9544…………………………Birr 322.00
No 9545…………………………. ” 168.00
No 9546……………………………” 223.00
Total………………………………” 713.00

Include with the bank statement a credit memo for Birr 1225 (principal of Birr 1,200.00 + Birr
25 interest) for collection of a note owed to Lee by Ship Co.
Included with the bank statement is a Birr 102.00 debit memo for an NSF check written by
Johnson and deposited by Lee
Charges made to Lee’s account include Birr 12 for safe – deposit box rent and Birr 8 for
service charges
Check No 9550 for 669 to Taylor Co. on account recorded in cash payments Journal as 666.
prepare bank reconciliation
prepare necessary journal entry
5.5.3 Petty Cash Fund
Petty cash fund, which is part of the total cash balance, is used to handle many types of small
payments such as employee transportation costs, purchase of office supplies, purchase of postage
stamps, and delivery charges. Many businesses find it convenient to make minor expenditures instead
of writing checks. The petty cash amount various from Br. 50 or less to more than Br. 1,000, which
will cover small expenditures for a period of two or three weeks.
[Link] Establishment of Petty Cash
To establish a petty cash fund a check is issued to a bank. This check is cashed and the money is kept
on hand in a petty cash box. One employee is designated as custodian of the fund. The issuance of the
check for establishment is recoded by debiting petty cash account and crediting cash.
[Link] Replenishment of Petty Cash

14
During the period, the custodian makes small payments form the petty cash fund and obtains a receipt
or prepares a petty cash voucher. This petty cash voucher explains the nature and amount of every
expenditure and is kept with the fund. When the fund runs low or at the end of the company’s fiscal
period, a check is issued to reimburse the fund for the expenditures made during the period. The
issuance of this check is recorded by debiting the appropriate expense accounts and crediting cash or
vouchers payable.
The following transactions are typical of petty cash funds:
Establishment of the petty cash fund-Cash is drawn out of the checking account and placed into the
hands of the custodian. An entry is made at this time debiting Petty Cash and crediting Cash (cash in
the bank).
Usage of the fund-Employees draw money out of the fund for various expenditures and fill out a
petty cash receipt. No entry is made at this time (to require an entry each time cash is disbursed from
the fund would be too time-consuming).
Replenishment of the fund-The fund is replenished when it reaches a low level, and an entry is
made at this time to record the various expenditures, based on the petty cash receipts.
Raising the fund level-The fund level is raised above its originally established amount in order to
handle a large volume of transactions. Once again, as was done originally, an entry is made debiting
Petty Cash and crediting Cash.
These transactions are illustrated in the following example.
For example, if the fund established is Br. 400, the journal entry will be
Petty cash fund 400
Cash 400
During the first month of the fund's existence, employees draw cash from the fund for the following
purposes:
Postage-------------------- 110
Office Supplies------------- 30
Freight In------------------- 125
Office Food------------------ 120
Total $385 Total cash remaining: $15
No entries were made for these disbursements; however, petty cash receipts were filled out. At this
point, Petty Coat decides to replenish the fund to its original level of $400. The entry is:
Postage-------------------------------- 110
Office Supplies------------------------ 30
Freight In------------------------------- 125

15
Office Food Expense------------------120
Cash (in bank)---------------------------------------------385
Notice that Petty Cash is neither credited at the time of disbursement nor debited at the time of
replenishment. The only time we "touch" Petty Cash is when we originally establish the fund, and
when we raise the fund level, as we will soon see.
Petty Coat now decides to raise the fund level from $400 to $500. The entry is:
Petty Cash-----------------100
Cash-----------------------100
Exercise Star Company has a Birr 1800.00 petty cash fund. The following transactions occurred in
December.
Dec. 2. The petty cash fund was increased to Birr 2,700.00
Dec. 8. Petty cash voucher No. 318 for Birr 48. 42 of delivery expense was prepared and Paid. The
fund was not replenished at this time.
Dec. 20. The company decided that the fund was too large and reduced it to Birr 2,250.00
Prepare any necessary journal entries for the above transactions.
CONTROLLING CASH RECEIPTS
Businesses ordinarily receive cash from two main source (1) over the counter from cash customers:
and (2) form charge customers making payments on account. The cash that is received immediately
over the counter is usually recorded and placed in a cash register. At the end of each day, the cash in
each cash register is reconciled with the cash register tape or computer printout for that register. The
cash is then taken to the cashier's office and the tapes are forwarded to the accounting department,
where they become the basis for entries in the cash receipts journal.
When cash is received later, usually in the form of checks, a record of the checks received should be
prepared as soon as they are received. Then the cash is combined with the receipts from cash sales
and should be deposited immediately.
In general, though each business varies in its specific procedures for controlling cash receipts, the
following basic principles are used:
A record of all cash receipts should be prepared as soon as cash is received most thefts of cash
occur before a record is made of the receipt.
All cash receipts should be deposited in a bank on the day they are received or on the next
business day. Un deposited cash is more susceptible to misappropriation.
The employee who handles cash receipts should not also be the employee who records the
receipts in the Controlling Cash Disbursements
5.5.4 Change Fund

16
A change fund is used to facilitate the collection of cash from customers. The amount of the change
fund is deducted from the total cash (including checks, money orders, etc) on hand at the close of
business each day to determine the daily cash collections. The cash should be counted and compared
with the cash register tape daily. In general, change and petty cash funds are combined with cash on
hand and in the bank and are presented as a single amount in the balance [Link] businesses that
receive cash directly from customers should maintain a fund of currency and coins in order to make
change (Amharic=>”zirzir”). Once a change fund is established, there will be no change in its balance
unless there is a decision by management to increase or decrease the fund balance.
5.5.5 Cash Short and Over
In handling cash receipts from daily sales, a few errors in making changes will occur. These errors
may cause a cash shortage or overage at the end of the day. The account cash short and over is debited
if there is shortage and credited if there is overage. At the end of the period if the account had a debit
balance, it appears in the Income statement as miscellaneous expense; if it has a credit balance, it is
shown as miscellaneous revenue.

For example, assume that the total cash sales recorded during the day amounts to Br. 12,420.
However, the cash receipts in the cash register drawer (actual cash count) total Br. 12,415.
The following entry would be made to adjust the accounting records for the shortage in the cash
receipts:
Cash Short and Over 5.00
Cash 5.00
To record a Br. 5.00 (Br. 12,420 – 12,415)
Shortage in cash receipts for the day
RECEIVABLES AND ITS CLASSIFICATION
Receivables are all money claims against people or other entities (debtors). Many companies
sell on credit/ on accounts in order to sell more services or goods. Broadly, Receivable can be
classified as Accounts receivables and Note Receivable
ACCOUNTS RECEIVABLE
Accounts receivable are coral promises of the purchaser to pay for goods and services sold. For
financial statement purposes, companies classify Accounting receivables as:
Current (short-term) receivables
Noncurrent (long-term) receivables

Trade receivable-
Non trade receivables
Valuation of Accounts Receivable

17
When merchandise or services are sold without the immediate receipt of cash, a part of the
claims against customers usually proves to be uncollectible. That is, a debtor fails to pay an
account according to a sale contract or dishonors a note on the due date do not necessarily mean
that the account will be uncollectible.
Indications are as follows: bankruptcy, closing of the business, disappearance of the debtor, &
Failure of repeated attempts to collect receivable.
There are two methods of accounting for uncollectible receivable that is believed to be
uncollectible:
Allowance method which is sometimes called reserve method which provides in advance for
uncollectible receivable. It uses estimates to recognize bad debts before they happen. The
amount of trade receivable estimated to become uncollectible in the future.
They are recognized via an adjusting journal entry on December 31, as follows:
Dec. 31 Bad Debt Expense ……………………………………xxx
Allowance for Doubtful
Accounts…………………… xxx
2) Direct write-off method. It recognizes the expense only when certain accounts are judged
worthless.
The direct write-off method makes an entry for bad debts at the time they take place. The entry
is:
Bad Debt Expense……………………xxx
Accounts Receivable…………………………xxx
This method makes sense but is deficient on theoretical grounds. Because, according to the matching
principle
expenses should be recognized in the same accounting period as their related revenue. However, this
often will not be the case under this method. For example, if a sale is made late in 1991, bad debts
will not arise until January and February of 1992. Thus the revenue has been recognized in 1991 but
the expenses are recognized in 199 2-an improper matching of the two. Therefore, since this method
violates generally accepted accounting principles, it is unacceptable and will not be used in this book
EXAMPLE 1
On December 31, 1991, X Company estimates its bad debts at $5,000. The adjusting entry is:
Bad Debt Expense ………………………………………………….5, 000
Allowance for Doubtful Accounts
……………………………………5,000

18
On January 20, 199 2, Mr. X defaults on his $1,000 balance. Thus, part of the original estimate of
$5,000 has now come to fruition. Should we debit Bad Debt Expense for this $1,000? The answer is
definitely no--we already did so on December 31! The entry for now is:
Allowance for Doubtful Accounts……………….1, 000
Account Receivable (and Mr. X)………………….1000
This is called a write-off entry. What is the logic behind this entry? The answer is that until now, as
explained earlier, we couldn't credit Accounts Receivable directly because we didn't know who the
person is, and we thus could not go to the subsidiary ledger. Now, however, we know it is Mr. X, so
we remove his portion from the allowance account, and directly credit both the controlling account
and the subsidiary account.
EXAMPLE 2 Refer to Example 1 above. Assume that on February 1, Mr. X feels guilty and
decides to pay the $1,000. We, therefore, must first reverse the write-off entry:
Accounts Receivable………………………………. 1,000
Allowance for Doubtful Accounts …………………..1,000
We then make the regular, routine entry for the collection, which is:
Cash………………………………………1,000
Accounts Receivable ………………………….1,000
NOTES RECEIVABLE
Promissory notes are used in many transactions, including paying for products and services, in
the lending and borrowing of money, and to pay for accounts receivable. In this section, we will
discuss computations of maturity date and maturity value of a note, how to record receipt of a
note, how to account for discounting of a note before it matures. We also discuss cases of
dishonored note.
Interest bearing note
The typical notes receivable requires the payment of a specified face amount, also called
principal, at a specified maturity date or dates. In addition, interest is paid at a stated percentage
of the face amount. Interest is the cost of borrowing money for the borrower or the profit for
lending money for the lender. Unless otherwise stated, the rate of interest on a note is the rate
charged for the use of the principal for one year.
Interest on notes is calculated as: I= (P) (R) (T)
Where, I=Interest, P=Principal, R=Annual Interest Rate, and T=Time (Period)
For example-On January 1, 2017, Chilalo Trading sold fertilizers to cooperatives agreeing to
accept, Br 700,000, 12-month, 12% notes. The note is payable on December 31, 2017. The
entry is:

19
 Jan-1, 2007 Notes receivable............. 700,000
Sales revenue...................... 700,000
(To record the sale of fertilizers)
Dec, 31, 2017. Cash................................ 784,000
Notes receivable................................. 700,000
Interest income (700,000x12%x1yr) ...84,000
(To record the collection of cash at maturity)
Maturity Date and Period
The maturity date of a note is the day on which the note (principal and interest) must be repaid.
The period of a note is the time from the date of the note to its maturity date. Many notes
mature in less than a full year, and the period covered by them is often expressed in days. When
the time of a note is expressed in days, the maturity date is the specified number of days after
the date of the note. As an example, a five-day note dated June 15 matures and is due on June
20. A 90-day note dated July 10 matures on October 8. Thus October 8, due date, is computed
as shown below:
Maturity Date Computation:
Terms of Note…………………………………………….90 days
July days………………………………….31
Less days of note…………………………10 21
Remaining days …………………………………………..69
Less Augest days …………………………………………… 31
Remaining days……………………………………………… 38
Less September days …………………………………………30
Maturity Date is October…………………………………… . ..8
The period of a note is sometimes expressed in months or years. When months are used, the
note matures and is payable in the month of its maturity on the same day of the month as its
original date. A three-month note, dated July 10, for instance, is payable on October 10. The
same analysis applies when years are used.
Receipt of a Note
Notes receivable is usually recorded in a single notes receivable account to simplify record
keeping. We need only one account because the original notes are kept on file. This means, that
we can understand the maker, rate of interest, due date, and other information by examining the
actual note.

20
To illustrate the recording for the receipt of a note, assume ABC receives a note of the Birr 1,000,
90-day, 12%. This transaction is recorded as:

July 10 Notes receivable ……………… 1,000

Although it is not a commonSales…………………………..transaction,acompanyin 1,000need of cash may transfer its notes
( Sold merchandise in exchange forcharged90-day,
receivable to a bank. The discount or (interest) by the bank is computed on the
12% note)
maturity value of the note for the period of time the bank must hold the note, namely the
time that will pass between the date of the transfer and the due date of the note. The amount
of the proceeds paid to the endorser is the excess of the maturity value over the discount.
To illustrate, assume that a 90-day,12% note receivable for $1,800, dated November 8, is
discounted at the payee’s bank on December 3 at the rate of 14%. The data used in
determining the effect of the transaction are as follows:
Face value of the note dated Nov.8................................. $1,800
Interest on note-90 days at 12%........................................ 54
Maturity value of note due Feb. 6..................................... $1,854
Discount period-Dec 3 to Feb.6........................................ 65days
Discount on maturity value-65 days at 14%...................... 46.87
Proceeds........................................................................... $1,807.13

The excess of the proceeds received by the endorser from discounting the note, $1,807.13
over its face value, $1800, is recorded as interest income. The entry for the transaction, in
general journal form, is as follows:
Dec 3. Cash................................... $1,807.13
Note receivable................................. 1,800
Interst income................................... 7.13
Honoring and dishonoring a Note
A note is said to be honored, if he principal and interest of a note are due on its maturity date.
The maker of the note usually honors the note and pays it in full. But sometimes a maker
dishonors the note and does not pay it at maturity.
Recording an Honored Note
We use the ABC note transaction above to illustrate the honoring of a note. When ABC collects
a note on its due date, It records its receipt as:
Cash……………………….. 615
Interest Earned, also called Interest Revenue, is reported on the current period’s income

Notes receivable……..….600
statement.
Interest income….....……15
Recording a Dishonored Note
( Collected note with interest of
Birr 600 x 15% x 60/360).

21
 CHAPTER FOUR: INVENTORIES

DEFINITION AND CLASSIFICTION INVENTORY ISSUES

Inventories are asset items that a company holds for sale in the ordinary course of business, or
goods that it will use or consume in the production of goods to be sold. They are mainly divided into
two major:
Inventories are assets:
held for sale in the ordinary course of business;
in the process of production for such sale; or
In the form of materials or supplies to be consumed in the production process or in the
rendering of services. They are mainly divided into two major:
Inventories of merchandising businesses
Inventories of manufacturing businesses
A merchandising concern, are merchandise Business are purchased for resale in the normal
course of business. These types of inventories are called merchandise inventories. Only one
inventory account, Merchandise Inventory, appears in the financial statements.
Manufacturing concerns, Inventories of manufacturing businesses manufacturing businesses are
businesses that produce physical output. They normally have three types of inventories. These are:
Raw material inventory
Work in process inventory
Finished goods inventory
2.1 PHYSICAL GOODS INCLUDED IN INVENTORY
Goods in Transit
Companies usually determine ownership by applying the “passage of title” rule. If a supplier ships
goods f.o.b. shipping point, title passes to the company when the supplier delivers the goods to the
common carrier, who acts as an agent for the buyer. (The abbreviation f.o.b. stands for free on
board.) If the supplier ships the goods f.o.b. destination, title passes only when it receives the goods
from the common carrier. “Shipping point” and “destination” are often designated by a particular
location, for example, f.o.b. Djibouti.
Consigned Goods
Companies market certain products through a consignment shipment. Under this arrangement, a
company (the consignor) ships various merchandise to another company (the consignee), who acts as
consignor’s’ agent in selling the consigned goods.
Example: Williams Art Gallery (the consignor) ships various art merchandise to ABC Holdings
(USA) (the consignee), who acts as Williams’ agent in selling the consigned goods.

22
 ABC agrees to accept the goods without any liability, except to exercise due care and 
 reasonable protection from loss or damage, until it sells the goods to a third party.

 When ABC’s sells the goods, it remits the revenue, less a selling commission and
expenses incurred, to Williams. 
Goods out on consignment remain the property of the consignor (Williams).
2.2 COSTS INCLUDED IN INVENTORY
Product Costs: are those costs that “attach” to the inventory. These costs are directly connected
with bringing the goods to the buyer’s place of business and converting such goods to a salable
condition. Such charges include freight charges on goods purchased, other direct costs of acquisition,
and labor and other production costs incurred in processing the goods up to the time of sale.
Period costs are those costs that are indirectly related to the acquisition or production of
goods. Period costs such as

 selling expenses and,

General and administrative expenses are not included as part of inventory cost.

2.3 COST FLOW ASSUMPTION

Specific Identification
IASB requires in cases where inventories are not ordinarily interchangeable or for goods
and services produced or segregated for specific projects.

Specific identification calls for identifying each item sold and each item in inventory. This method
is appropriate when the variety of merchandise carried in stock is small and the volume of sales is
relatively small. We can specifically identify the items sold and the items on hand.

 Specific identification matches actual costs against actual revenue.

 Company reports ending inventory at actual cost.

Flow matches the physical flow of the goods.

On closer observation, however, this method has certain deficiencies. 

 Some argue that specific identification allows a company to manipulate net income.

Arbitrary allocation of costs that sometimes occurs with specific inventory items.

Illustration:
Beza Company began the year and purchased merchandise as follows:
Jan-1 Beginning inventory 80 units@ Br. 60
Feb. 16 Purchase 400 units@ 56
Sep.2 Purchase 160 units @ 50
Nov. 26 Purchase 320 units@ 46
Dec. 4 Purchase 240 units@ 40
The ending inventory consists of 300 units, 100 from each of the last three purchases.
Required: Compute cost of ending inventory and cost of goods sold
Cost of ending inventories under specific identification method

23
Br. 40 x 100= Br. 4,000
Br. 46 x 100= Br 4,600
Br. 50 x 100= Br 5,000
300units Br. 13,600
Cost of Ending inventory cost = Br. 13,600
The cost of merchandise sold = Cost of goods available for sale - Ending inventory
Cost of good sod= Br. 59,520 – Br. 13,600= Br. 45,920
vii. Average Cost
As the name implies, the average cost method prices items in the inventory on the basis of the
average cost of all similar goods available during the period. Example

Beza Company the ending inventory and cost of goods sold using a weighted average method
as follows.
Jan-1 Beginning inventory 80 units@ Br. 60 = Br. 4,800
Feb. 16 Purchase 400 units@ 56 = 22,400
Sep.2 Purchase 160 units @ 50 = 8,000
Nov. 26 Purchase 320 units@ 46 = 14,720
Dec. 4 Purchase 240 units@ 40 = 9,600
Total 1200 units Br.59, 520
To calculate the cost of ending inventory, we will calculate first the cost per unit of goods
available for sale
Average cost per unit = Cost of goods available for sale Total
units available for sale
Weighted average unit cost = Br. 59,520 = Br. 49.60
1,200

 Ending inventory cost = Br. 49.60x 300
Br. 14,880
 Cost of merchandise sold = Br. 59,520-Br. 14,880
Br. 44,640
First-In, First-Out (FIFO)
The FIFO (first-in, first-out) method assumes that a company uses goods in the order in which it
purchases them. In other words, the FIFO method assumes that the first goods purchased are the first
used (in a manufacturing concern) or the first sold (in a merchandising concern). The inventory
remaining must therefore represent the most recent purchases. FIFO Method is a method of inventory
costing based on the assumption that the costs of merchandise sold should be charged against revenue
in the order in which the costs were incurred.
Dec4 Purchase 240 units@ 40= 9,600
Nov. 26Purchase 60units@ 46 = 14,720
Total 300 units Br.59, 520

Cost of Ending inventory Br. 12,360 
Cost of merchandise sold = Br. 59,520 – Br. 12,360= Br. 47,160
In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the
end of the month whether a perpetual or periodic system is used. Why?

24
Because the same costs will always be first in and, therefore, first out. This is true whether a company
computes cost of goods sold as it sells goods throughout the accounting period (the perpetual system) or
as a residual at the end of the accounting period (the periodic system).Some advantage of FIFO

 FIFO is to approximate the physical flow of goods.

 It prevents manipulation of income.

 With FIFO, a company cannot pick a certain cost item to charge to expense.

Ending inventory is close to current cost.

However, the FIFO method fails to match current costs against current revenues on the income
statement. A company charges the oldest costs against the more current revenue, possibly
distorting gross profit and net income.
EXERCISE
To illustrate, assume that ABI Company had the following transactions in its first month of operations
March 2 beginning inventory 2000 units@ Br. 4
March 10 sold 500 units
March 15 Purchase6000 units@ 4.4
March 19sold 4000units
March 30 Purchase 2000 units@ 4.75
Compute cost of ending inventory and cost of goods sold by
Specific identification Method assume that ABI CO 5,500 units of inventory consists of 1,000
Units from the March 2 purchase, 3,000 from the March 15 purchase, and 1,500 from the
March 30 purchase,
Perpetual FIFo
Periodic FIFo
Perpetual LIFo
Periodic LIFo
Weighted Average Method (Perpetual)
Weighted Average Method(Periodic)
SPECIAL INVENTORY VALUATION METHODS

LOWER-OF-COST-OR-MARKET/NET REALIZABLE VALUE

GAAP and IFRS have some different requirements when it comes to inventory. Under GAAP,
inventory must be valued at the lower of cost or market value, while IFRS requires inventory to
be valued at the lower of cost or net realizable value.

The lower of cost or net realizable value concept means that inventory should be reported at
the lower of its cost or the amount at which it can be sold.

25
 
Under normal circumstances, cost of inventory is always lesser than the net amount
 business can earn by selling the inventory, called net realizable value (NRV).
Net Realizable Value is the value at which the asset can be sold in the market by the company
after subtracting the estimated cost which the company could occur for selling the said asset
in the market, and it is one of the essential measures for valuation of the ending inventory or

 receivables of the company.
Net realizable value is defined as the estimated selling price of the goods in theordinary
 course of business less reasonable predictable cost of completion and disposal
NRV = Market Value of Asset/selling price – Selling Cost of the Asset

Example1.
ABC International has a green widget in inventory with a cost of $50. The market value of the
widget is $130. The cost to prepare the widget for sale is $20. Required: Determine net
realizable value
Net realizable value = ($130 market value - $50 cost - $20 completion cost) =60
Since the cost of $50 is lower than the net realizable value of $60, the company continues to
record the inventory item at its $50 cost.
Assume In the following year, the market value of the green widget declines to $115. The cost is
still $50, and the cost to prepare it for sale is $20.
Net realizable value =115 market value - $50 cost - $20 completion cost).
Since the net realizable value of $45 is lower than the cost of $50, ABC should record a loss of $5 on
the inventory item, thereby reducing its recorded cost to $45.
Example 2: Assume that XYZ Co has unfinished inventory with a cost of €950, a sales value of
€1,000, estimated cost of completion of €50, and estimated selling costs of €200. ABC net realizable
value is computed as follows.
Inventory Value 1,000
Less Estimated cost of completion 50
Estimated cost to sell 250 250
Net Realizable Value 750

 XYZ Co reports inventory on its balance sheet at €750.

 statement, XYZ reports a Loss on Inventory Write-Down of €200 (€950

In its income
− €750).
Illustration below graphically presents the guidelines for valuing inventory at the lower-of-cost-or-
market.

26
How Lower-of-Cost-or-Market Works when Replacement cost  Exist
 The upper (ceiling) is the net realizable value of inventory.

 The lower (floor) is the net realizable value less normal profit.

The maximum limitation, not to exceed the net realizable value (ceiling), prevents
overstatement of the value of obsolete, damaged, or shopworn inventories. That is, if the
replacement cost of an item exceeds its net realizable value, a company should not report
inventory at replacement cost. To report the inventory at replacement cost would result in an

overstatement of inventory and understatement of the loss in the current period. 
 Ceiling (upper): Market should not exceed the net realizable value of the inventory
The minimum limitation (floor) is not to be less than net realizable value reduced by an
allowance for an approximately normal profit margin. The floor establishes a value below
which a company should not price inventory, regardless of replacement cost. It makes no
sense to price inventory below net realizable value less a normal margin. Use of a floor deters

 understatement of inventory and overstatement of the loss in the current period.

  value reduced by an
Floor (lower): Market should not be less than the net realizable

allowance equal to the approximate normal profit margin.
Floor (lower)=NRV- Normal profit Margin
The designated market value is the amount that a company compares to cost. It is always the
middle value of three amounts: replacement cost, net realizable value (ceiling), and net
realizable value less a normal profit margin (floor).

27
 
 Replacement cost is used as “market” price if it falls between the ceiling and the floor

 The ceiling amount is used as “market” price when replacement cost is above the ceiling;

 The floor amount is used as “market” price when replacement cost is below the floor.

When the ceiling, replacement cost, and floor amount are ranked from highest to lowest, the

amount in the middle is used as the “market” price.

Example, Assume the following data for Abay Company to illustrate the concept of the LCM to
inventories:
Item Cost Replacement Selling Cost of
Normal profit
cost Price Completion
A 20.5 Br. 19 Br. 25 Br. 1 Br. 6
B 26 20 30 2 7
C 10 12 15 1 3
X 40 55 60 6 4
Y 15 10 11 2 2
Given the above data, determine the lower of cost/NRV
Solution: -
Ceiling floor Designe Final inventory of
d Value
Market
Cost Replace [Link] [Link] (3)Norm (4) 1-2 (5)
completi
ment cost g price al profit 4-3
on
A 20.5 19 25 1 6 Br. 24 18 19 19
B 26 20 30 2 7 28 21 21 21
C 10 12 15 1 3 14 11 12 10
X 40 55 60 6 4 54 50 54 40
Y 15 10 11 2 2 9 7 9 9

Additional Exercise
Assume the information relative to the inventory of Gibe Foods as shown in Illustration 2-4.

28
To illustrate, assume that Gibe Foods separates its food products into two major categories, frozen
and canned, as shown in Illustration 2-6 below.

29
 CHAPTER 5
ACCOUNTING SYSTEMS FOR PAYROLL AND PAYROLL TAXES
Definition
Payroll accounting is the process of paying and recording employee salaries , including the
compensation
 to employees as well as all mandated and optional withholdings, such as taxes and
 benefits.
Payroll is the process of providing compensation to employees for their efforts on behalf of a
business.
 the calculation, management, recording, and analysis of
Payroll accounting is essentially
 employees’ compensation
IMPORTANCE OF PAYROLL ACCOUNTING
Accounting for payroll is particularly important because:

 Payroll often represents the largest expense that a company incurs.

 Both federal and state governments require that detailed payroll records be kept and

 Employees are sensitive to payroll errors or irregularities.
 To maintain good employee morale payroll must be paid on a timely and accurate basis.

DEFINITION OF PAYROLL RELATED TERMS
Salary and Wages: Salary and wages are usually used interchangeably. However, the term wages
is more correctly used to refer to payments to unskilled-manual labor. It is usually paid based on the
number of hours worked or the number of units produced. Therefore, wages are usually paid when a

particular piece of work is completed or weekly.
 Pay Period: A pay period refers to the length of time covered by each payroll payment.
The
3 The Pay Day: The pay day- is the day on which wages or salaries are paid to employees. This is

usually on the last day of the pay period.
A Payroll Register (sheet): is the list of employees of a business along with each employee’s gross
earnings; deductions and net pay (take home pay) for a particular pay period. The payroll register
 is prepared based on attendance sheets, punched (clock) cards or time cards.
(sheet)
Pay Check: A business can pay payroll by writing a check for the amount of the net pay. A check
is prepared in the name of each employee and handed to employees. Alternatively a check for the
total net pay can be prepared for employees to the paid by cash at the organization.
Gross Earnings: are taxes collected from the earnings of employees by t he employer organization
as per the regulations of the government. These have to be submitted (paid) to the government
because3d employer organization is only acting as an agent of the government in collecting these
 from employees.
taxes


30
 Payroll Deductions: are deductions from the gross earnings of an employee such as employment
income taxes (with holding taxes), labor union dues, fines, credit association pays etc.
Net Pay: Net Pay is the earning of an employee after all deductions have been deducted. This is the
take home pay amount collected by an employee on the payday.
POSSIBLE COMPONENTS OF A PAYROLL REGISTER
1 Employee Number is Number assigned to employees for identification purpose when a relatively
large number of employees are involved in a payroll register.
2 Names of Employees
3 Earnings
Money earned by an employee from various sources. This may include.
Basic Salary- a flat monthly salary of an employee for carrying out the normal work of
employment and subject to change when the employee is promoted.
Allowances- money paid monthly to an employee for special reasons, like: 
 Position allowance- a monthly paid to an employee of earning a particular office responsibility.
Housing allowance- a monthly allowance given to cover housing costs of the individual employee
when  the employment contract requires the employer to provide housing but the employer fails to
 do so.
Hardship allowance- a sum of money given to an employee to compensate for an inconvenient
circumstance caused by the employer. For instance, unexpected transfer to aw different and
 distant work area or location.

Desert allowance- a monthly allowance given to an employee because of assignment to a
 relatively hot region.
Transportation (fuel) allowance- a monthly allowance to an employee to cover cost of
transportation
 up to her workplace if the employer has committed itself to provide transportation
 service.
C. Overtime Earning: Overtime work is the work performed by an employee beyond the regular
working hours.
Overtime earnings are the amount paid to an employee for overtime work performed.
Article 33 of proclamation No. 1156/2011 discussed the following about how overtime work should
be paid:
A worker shall be entitled to the paid at a rate of
One and one-quarter (1.5) times his ordinary hourly rate for overtime work performed
between 6 am and 10:00 P.M in the evening.

31
 One and one half (1.75 times his ordinary hourly rate for overtime work performed between
10:00 P.M and six (6:00 A.M) in the morning.
iii. 2 times the ordinary hourly rate for overtime work performed on weekly rest days
2.5 times the ordinary hourly rate for overtime work performed on a public holiday.
Exercise
An employee earns Br. 50 per hour with one and quarter (1.5 times than regular hourly rate for all
hours in excess of 40 per week. If the employee worked 50 hours during the current week, what
was the gross earnings for the week?
4 Deduction: are subtractions made from the earnings of employees required by the government or
permitted by the employee himself.
Employment Income Tax: Every citizen is required to pay employee tax to the government in
almost all countries. In Ethiopia Income tax proclamation as follows
Employment Income Income
(per month) Tax rate Deduction

Over Birr To Birr

0 Exempt (Free from Tax) 0
600
601 1650 10% 60
1651 3200 15% 142.5
3201 5250 20% 302.5
5251 7800 25% 565
7801 10900 30% 955
Over 10900 35% 1500

Exercise
What is the total amount deducted as income tax for an employee who earns a basic monthly
salary of Br. 1800, a monthly non taxable allowance of Br. 300, and an overtime earning of Br.
400?
b. Pension Contribution
Permanent employees a governmental organization in Ethiopia is expected to pay or contribute 7% of
their basic salary to the governments’ pension trust fund.
This amount is withheld by the employer from each employee on every payroll and later be paid to
the respective government body.
The employer is also expected to contribute towards this same fund 9% of the basic salary of every
permanent government employee.
Therefore, the total contribution to the pension fund of the Ethiopian government is equal to 16% of
the basic salary of all of its permanent employees.

32
That is, 7% comes from the employees and 9% comes from the employer.
This enables a permanent employee of a government organization to be entitled to the pension pay
when retiring provided the employee satisfies the minimum requirements to enjoy the benefits.
Business and non-governmental not-for profit organization (NGO’s) also have this kind of a scheme
to benefit their employees with some modifications. A fund known as provident fund is established
and both the employer and the employee contribute towards this fund monthly. When an employee
retains or leaves employment, a lump sum amount is paid to him/her.
4. c. Other Deductions
Apart from the above two kinds of deductions, employees may individually authorize additional
deductions such as deductions to pay life insurance premiums, to repay loan from the employer, to
pay for donation to charitable organization, contributions to "ldir" etc.
5 Net Pay
Net pay represents the excess of gross earnings over total deductions of an employee.
Signature
Exercise
Assume an employee's regular hourly pay is Br. 16, with a time and a half for every hour worked
in excess of 48 during a week. The following data are available:
Hours worked during current month Br. 200
Regular monthly salary Br. 3072
Allowance (transportation) Br. 300
Assume that according to company policy transportation allowance in excess of Br. 200 is subject to
employment income tax.
Based on the above data, compute the amount of the employee's:
net pay for the current month;
employment income tax,
total deductions, assuming the employee is permanent civil servant..
ILLUSTRATION OF A PAYROLL REGISTER
Godanaye is a government agency recently organized to rehabilitate street children. It has five
employees whose salaries are paid according to the Ethiopian calendar month. The following data
relates to the month of Yekatit, 2005.
Serial Name of Employee Basic Transp. Overtime Duration of
No. __________________ Salary Allowance worked(hr) OT Work
01 Aregash Shewa Br. 730 200 4 before-10:00 P.M
02 Paulos Chala 1720 ___ 8 Sunday

33
 03 Tola Modesir 11300 ___ ___ ___
04 Tensay Belay 1470 ___ ___ ___
05 Haile Olango 7950 ___ 6 Public Holiday
Additional Information
The management of the agency usually expects a worker to work 40 hours in a week and
during Yekatit there are four weeks.

There were no absentees during the month

All employees are permanent except Tenssay and Haile

Paulos agreed to contribute monthly Br. 300 from his salary as a monthly saving in the credit
association of the agency.
Required
Prepare a payroll register (sheet) for the agency for the month of Yekatit, 2005
Record the payment of salary as of yekatit 30,2005using check stub No. 0123.
Record the payment of the claim of the credit Association of their agency on Megabit 1, 2005
use check stub No. 0124.
Compute and recognize the total payroll tax expense for the month of Yekatit, 2005
Record the payment of the withholding taxes and pension contribution to the concerned
government body on Megabit 7,2005.
Computation of Earnings, Deductions and Net Pay

Gross Earnings = Basic salary + Allowance + Overtime Earning

Overtime Earning
Overtime earning = OT hrs worked X (ordinary hourly rate X relevant OT rate)
1. AREGASH:
OT Earning = 4 hours X br. 730 X 1.5 = br. 27.375 160
hours
NB Every employee is expected to work 160 hours per
month (i.e. 40 hours x 4 weeks)
You should compute the regular hourly rate first:

br. 730
160 Hours
Therefore, the regular Hourly payment = br. 4.56

34
2. PAULOS
 OT Earning = 8 hours X br. 1720 x 2 ---------------- br. 172
160 hours
3. HAILE
 OT Earnings = 6 hours X br.7950 x 2.5 ------------- br.745.31
160 hours
GROSS EARNINGS
Gross Earnings = Basic salary + Allowance + OT Earnings
AGEGASH

Gross Earnings = br. 730 + br. 200 + br. 27.375 = br. 957.375

Remember taxable income in this case is br. 757.375 because the transportation
allowance of br. 200 is not subject to taxation.

PAULOS

Gross Earning = br. 1720 + br. 172 = br. 1892

TOLA

Gross Total Earnings = br. 11300, which include the basic salary alone

TENSAY

Gross Total Earnings = br. 1470, which is the basic salary.

HAILE

Gross Total Earnings = br. 7950 + 745.31 = br. 8695.31
DEDUCTIONS AND NET PAY
 AREGASH:
 Gross Total Earnings----------------------------------------- br. 957.375
 Gross Taxable Income (br. 957.38 – br. 200)----------------- 757.375
Employee Income Tax=Taxable income *tax rate

952.81*0.1-60
TOTAL br. ----------------------------------------------------- br. 15.7375
Pension contribution=Basic salary x 7%
= br. 730 x 0.07------------------------------------------------- 51.1
Total deduction=Income tax+ pension + other deduction
Total Deduction (br. 15.7375 + br. 51.1)----------------- br. 66. 8375
Net pay = Gross Total Earnings – Total Deductions
Net pay= 957.375- 66.8375
=890.5375

35
 PAULOS:
 Gross Total Earning----- br. 1892
Income tax=1892*0.15-142.5=141.3
 Pension Contribution (br. 1720 x 0.07)--------------------- 120.4
 Credit Association-------------------------------------------- 300.00
Total deduction=141.3+120+300
 Total Deduction--------------------------------------------- br.561.7

Net pay =1892-561.7

=1330.3
TOLA
 Gross Total Earnings------------------------------------ br. 11300.00
Employee Income Tax= 11300*0.35-1500

=2455
Pension contribution (br. 11300 x 0.07) ---------------------- 791.00
 Total Deductions------------------------------------------ br. 3246
Net pay=11300-3246
=8054
 TENSAY:
 Gross Total Earnings------------------------------------ br. 1470.00
 Gross Taxable Income-------------------------------------- 1470.00
Income tax=1470*0.1-60
=87
NB. No pension contributions because she is not permanent employee of the organization.
Net pay=1470-87
=1383
 HAILE:
 Gross Total Earnings-------------------------------------- br. 8695.31
Income Tax=8695.31*.3 -955
=1653.4

Pension contribution should not be computed for Haile because he is not permanent
employee of the agency.

Total deduction=1653.4
NET PAY=8695.31-1653.4
=7041.91

36
 Todanaye
Payroll Register(sheet)
For the month of Yekatit,1995
Se Name of Earnings Deductions
r Employee BS All OT GE IT Pen. Othe Total Net Sig
N o Ded Deduc. Pay n.
o.
01 Aregash Sima 730 200 27.375 957.375 15.7375 51.1 ___ 66.8375 890.534
02 Paulos Chala 1720 ___ 172 1892 141.3 120.4 300 561.7 1330.3
03 Tola Daba 11300 ___ ___ 11300 2455 791 ___ 3246 8054
04 Tensay Belay 1470 ___ ___ 1470 87 ___ ___ 87 1383
05 Haile Olango 7950 ___ 745.31 8695.31 1653.4 ___ ___ 1653.4 7041.91
Total 23170 200 944.685 24314.685 4352.44 962.5 300 5614.94 18699.75

Prepared by_______________ .Checked by________________. Approved by___________

2. To record payment of salary

Salary expense……………………………………………..24314.685
Income tax…………………………………………………………….4352.44
Pension contribution………………………………………………….962.5
Credit association………………………………………………………300
Cash…………………………………………………………………….18699.75
3 Record the payment of the claim of the credit Association
Credit association ………………………………………………………….300
cash……………………………………………………………………………300
5 .Compute and recognize the total payroll tax expense
Payroll tax expense =total basic salary of permanent
employee*0.09 =(730+1720+11300)*0.09=1237.5

Payroll tax expense………………………….1237.5

Pension contribution payable……………………………1237.5
5 Record the payment of the withholding taxes and pension contribution
Income tax…………………………………………………….4352.44
Pension contribution payable (Pen+payroll exp)…………….2200

37
 Cash…………………………………………………………..6552.44
The agency has a total liability of 6552.44
Income tax…………………………………………………4351.98
Pension contribution payable (962.5+1237.5)………………2200
TOLAL……………………………………………………..6552.44

EXERCISE
1 .a permanent employee of a government organization with basic salary of br640and monthly
allowance of br 100(not taxed)has worked 20overtime hours during weekend. This employee usually
works 148 hours in month to earn his basic salary.
required: a)ordinary hour rate d) pension contribution
b)gross earning e) total deduction
c)incone tax f) net pay
2 Tola, the employee of ABC agency has worked 10 hours, 8 hours, 12 hours during holy day,
after mid night weekend respectively in a given month .In the same month he has earned a salary
of 1120as a result of working 140 regular working hours
determine a) gross earning
b )net pay

ASSIGMENT 3
PROBLEM – 1
The following data relates to the payroll of the employees of a privately owned business organization
known as”ALAZAR Retail Enterprise”, for the month of Megabit, 2006 E.C.

Serial Name Basic Overtime Worked

No. Salary Hours Duration
01 Aleme T. br. 4300 4 up to 10 PM
02 Banchayehu S. 960 12 b/n 10PM to 6 AM
03 Chemdessa N. 1450 8 weekly rest days
04 Deniel T. 632 10 public holiday
05 Leilena A. 2000 ___ ____

Additional Information

38
 The management of the business organization usually expects a woker to work 40 hours in a
week.

There were no absentees during Megabit.
Required:
Prepare a payroll sheet for the month of Megabit

Record the payment of salary as of Miazia 1, 2006

Record the recognition of the payroll tax expense as of Miazia 1, 2006

Record the payment of withholding taxes to the proper government units as of Miazia 15,

PROBLEM – 2
HABESHA Trading co. is a private business enterprise. The company pays the salary of its
employees according to the Ethiopian calendar month. The following data relates to the month of
Hidar, 2004.

Serial No. Name Basic Salary

A 101 Abeje Belew br. 2710
P 102 Haragua Delelegn 2500
P 103 Zeleke Belayneh 1800
M 104 Zinash Manahlot 4200

Additional information
The organization expects every worker to work 48 hours in a weekand during Hidar there are
 four weeks and all workers have done as they have been expected.

Ato, Abeje Belew and W/r, Haregua Delelegn are entitled to get a monthly allowance of birr
 500 and br. 400 respectively.
All workers are permanent except W/t, Zinash Manahlot, and they are entitled to a
total of
 15% provident fund of which 10% from the employer and 5% from the employee.
 and W/t Zinash Manahlot have worked 12 hours of overtime each on
Ato Zeleke Belayneh
public holidays. 
According to the company rule, any allowance more than birr 200 is subject to income tax.

Required: based on the information given above:

Compute the income tax for each employee.
Compute the total deductions for each employee.
Determine the net pay (take-home-pay) for each employee.
Compute the total withholding tax for the month.

39
 Compute the total payroll tax expense.
Pass the journal entry to record the payment of salary as of Hidar 30,2004
PROBLEM – 3
CHILALO Retail Enterprise, a government owned business, pays its employees salaries according to
the Ethiopian calendar Month. The following data relate to the month of Meskerem, 1995 E.C.

[Link] Employee Name Basic Salary

001 Animut Anley birr 2500
002 Nebiyat Girma 1880
003 Erecha Megersa 1790

Additional information
All workers are expected to work 40 hours per week
and during Meskerem there are 4 weeks.
 The workers have done as they have been expected.
Nebiyat Girma has worked 10 hours of overtime during Meskerem: 3 hours during ‘Meskel’
 and the other 7 hours before 10 p.m.
Erecha Megersa has also worked 5 hours of overtime: 2 hours during weekly rest days and 3
 hours between 10 p.m. – 6 a.m.
 a monthly position allowance of br. 350 and br 300 respectively
Animut and Nebiyat received
which are both taxable. 
 Animut Anley agreed to have a monthly deduction of br. 250 for credit association.

All workers are permanent except Animut Anley.

Required:
Compute the total deductions and net pay for each employee.
Compute (calculate) the total:
Withholding Taxes
Payroll Tax
Record the payment of salary as of Meskerem 30,1995.
D)Pass the entry to pay the withholding taxes to the appropriate government unit

40
 CHAPTER 6

ACQUISITION AND DISPOSITION OF PROPERTY, PLANT AND EQUIPMENTS

=========================================================
PROPERTY, PLANT AND EQUIPMENT Property,
plant and equipment are tangible assets that:
are held for use in the production or supply of goods or services, for rental to others, or for
administrative purposes; and
Are expected to be used during more than one period.
PPE is non-current assets in nature and an entity must recognize depreciation expense in
each accounting period when preparing financial statements.
as follows.
The major characteristics of property, plant, and equipment are
 They are acquired for use in operations and not for resale.

 They are long-term in nature and usually depreciated.

 They possess physical substance.

 day-to-day operation of the company

It is held for rental to others to generate revenue, or for any administrative purposes within the

Measurement at recognition
An entity shall measure an item of property, plant and equipment at initial recognition at its cost
Elements of cost
The cost of an item of property, plant and equipment comprises all of the following
Its purchase price, including legal and brokerage fees, import duties and non-refundable
purchase taxes, after deducting trade discounts and rebates.
Any costs directly attributable to bringing the asset to the location and condition necessary for
it to be capable of operating in the manner intended by management. These can include the
costs of site preparation, initial delivery and handling, installation and assembly and testing of
functionality.
the initial estimate of the costs of dismantling and removing the item and restoring the site on
which it is located, the obligation for which an entity incurs either when the item is acquired or
as a consequence of having used the item during a particular period for purposes other than
to produce inventories during that period
The following costs are not costs of an item of property, plant and equipment and an entity
shall recognize them as an expense when they are incurred:

 costs of opening a new facility;


costs of introducing a new product or service (including costs of advertising and promotional
activities);

41
  in a new location or with a new class of customer (including
costs of conducting business
costs of staff training); 
 administration and other general overhead costs; and

borrowing costs

COST OF LAND
All expenditures made to acquire land and ready it for use are considered part of the land cost. Cost
of land includes:
purchase price, closing costs, such as title (fees) to the land, attorney’s fees, recording
fees, sales taxes, broker’s
 commission , costs of surveying, grading, filling, leveling,
 draining, and clearing;
Razing or removing unwanted buildings, less the salvage , assumption of any liens
(delinquent real estate taxes), mortgages, or encumbrances on the property;  and
additional land improvements that have an indefinite life (Paving a public street
bordering the land)
Cost of Land improvement

 Improvements with limited lives, such as private driveways,walks, fences, and parking
lots, are recorded as Land Improvements and depreciated. 
 Land acquired and held for speculation is classified as an investment.

Land held by a real estate concern for resale should be classified as inventory

Cost of an asset = Sum of all the costs incurred to bring the asset to its intended purpose
Illustration: Suppose that, M &M enterprise acquired a plot of land on January 1, 2006.
So, the following are information with regard to the acquisition of the land.
– Br 500,000 is paid for the land, birr 20,000 for real estate commissions
– Br 30,000 is paid for insuring the title
– Br 2,000 is paid for legal fees
– Br 10,000 is paid for surveying, clearing, grading and landscaping
– Br 6,000 was paid for removing the old building
– Br10,000 paid for fence
– Br 12,000 is paid for brokers’ commissions
Compute and record cost of Land
The journal entry needed to record the purchase of land is as follows
Land ………………………………… 580,000
Cash ………………………………………580,000
Cost of Buildings
The cost of buildings should include all expenditures related directly to their acquisition or
construction. These costs include:
Purchase costs:

42
 Purchase price, closing costs (attorney’s fees, title insurance, etc.) and real estate
broker’s commission, Remodeling, and replacing or repairing the roof, floors, 
electrical wiring, and plumbing. Reconditioning (purchase of an existing building)
Cost of Equipment
Include all expenditures incurred in acquiring the equipment and preparing it for use. Costs include:
Cash purchase price, freight and handling charges, insurance on the equipment while
in transit, cost of special foundationsif required, assembling and installation costs,
Repairs (purchase of used equipment)
COST OF ACQUIRING FIXED ASSETS EXCLUDES: 
 Vandalism (deliberate destruction of property)

 Mistakes in installation

 Uninsured theft

 Damage during unpacking and installing

Fines for not obtaining proper permits from government agencies

Costs of opening a new facility;

Costs of introducing a new product or service (including costs of advertising and promotional
activities);
Costs of conducting business in a new location or with a new class of customer (including staff
costs of staff training);
Administration and other general overhead costs.
SELF-CONSTRUCTED ASSETS
Most companies decide to construct an asset for their own use rather than purchasing it from another
source. This is called self constructed asset. Companies finance construction of their capital-intensive
assets either by raising new equity capital or arranging loans from banks or issue of bonds to
bondholders. The interest expense (also called borrowing cost) incurred on the debt is effectively a
cost of the asset and matching principle of accounting requires such costs to be capitalized and
depreciated over the useful life of the asset.
BORROWING COSTS
In US GAAP, ‘capitalized interest’ is the part of interest expense that is capitalized as part of the
cost of asset. IFRS on the other hand, uses the term ‘borrowing costs’ to refer to the costs incurred
in relation to a debt used for construction of the asset. This may include (effective) interest
expense on debt, finance cost of a finance lease, etc.
Not all interest costs are capitalized. Instead, only such costs are capitalized that are incurred on
qualifying assets during the eligible capitalization period and that too only to a certain maximum
limit.

43
The cost of self-constructed assets includes: Direct labor, direct materials and Overhead costs.
CAPITALIZED INTEREST
Capitalized interest is an accounting practice required under the accrual basis of
accounting. Capitalized interest is interest that is added to the total cost of a long-term asset or
loan balance. This makes it so the interest is not recognized in the current period as an interest
expense. Instead, capitalized interest is treated as part of the fixed asset or loan balance and is
included in the depreciation of the long-term asset or loan repayment. Capitalized interest

 appears on the balance sheet rather than the income statement.
Capitalized interest is the cost of borrowing to acquire or construct a long-term asset. Unlike
an interest expense incurred for any other purpose, capitalized interest is not expensed
immediately on the income statement of a company's financial statements. Instead, firms
capitalize it, meaning the interest paid increases the cost basis of the related long-term asset on

the balance sheet. Capitalized interest shows up in installments on a company's income
statement through periodic depreciation expense recorded on the associated long-term asset
over its useful life.
Three approaches have been suggested to account for the interest incurred in financing
the construction of property, plant, and equipment:
Capitalize no interest charges during construction. Under this approach, interest is considered a
cost of financing and not a cost of construction. Some contend that if a company had used stock
(equity) financing rather than debt, it would not incur this cost. The major argument against this
approach is that the use of cash, whatever its source, has an associated implicit interest cost,
which should not be ignored.
Charge construction with all costs of funds employed, whether identifiable or not. This method
maintains that the cost of construction should include the cost of financing, whether by cash, debt,
or stock. Its advocates say that all costs necessary to get an asset ready for its intended use,
including interest, are part of the asset’s cost. Interest, whether actual or imputed, is a cost, just as
are labor and materials. A major criticism of this approach is that imputing the cost of equity
capital (stock) is subjective and outside the framework of a historical cost system.
Capitalize only the actual interest costs incurred during construction. This approach agrees in
part with the logic of the second approach—that interest is just as much a cost as are labor and
materials. But this approach capitalizes only interest costs incurred through debt financing. (That
is, it does not try to determine the cost of equity financing.) Under this approach, a company that
uses debt financing will have an asset of higher cost than a company that uses stock financing.
Some consider this approach unsatisfactory because they believe the cost of an asset should be the
same whether it is financed with cash, debt, or equity.

44
IFRS requires the third approach—capitalizing actual interest (with modification).
To implement this general approach, companies consider three items:
Qualifying assets.
Capitalization period.
Amount to capitalize.
Qualifying Assets
A qualifying asset is an asset for which capitalization of borrowing cost is allowed. It is an asset
that takes substantial period of time for internal use, sale or as an investment property. Typical
examples of qualifying assets include plant, buildings, intangible assets, Asset s int ended for
sale or lease t hat are constructed or produced as discrete projects, etc.
 are
Examples of assets that do not qualify for interest capitalization
 Assets that are in use or ready for their intended use, and
 Assets  activities and that are not undergoing the
that the company does not use in its earnings

activities necessary to get them ready for use.
Inventories that are routinely manufactured.
Capitalization Period
The capitalization period is the period of time during which a company must capitalize interest. It
begins with the presence of three conditions:
Expenditures for the asset have been made.
Activities that are necessary to get the asset ready for its intended use are in progress.
Interest cost is being incurred.
The capitalization period ends when the asset is substantially complete and ready for its intended
use. AMOUNT TO CAPITALIZE
The maximum interest to be capitalized is lower of the actual interest or avoidable interest.
Avoidable Interest is the amount of interest that could have been avoided had the project not taken
place. The amount of interest to capitalize is limited to the lower of actual interest cost incurred
during the period or avoidable interest.
Steps to Calculate Capitalized Interest
Find the Capitalization Period. The first step is to understand the time period until when the
construction of the fixed asset will take place, and by when the asset will be ready for use.
Calculate Weighted Average Accumulated Expenditure = Expenditure x (months in
capitalization/12)
Determine the Weighted average expenditure interest rate =Total interest on general debt
/total principal

45
 Note this should be computed from general loan only does not include specific loan
Calculate Actual Interest on Loans= specific debt * interest rate +general debt*interest
rate
Calculate Avoidable Interest=weighted-average accumulated expenditures up to the principal
balance of specific borrowing * interest rate on that specific borrowing + weighted- average
accumulated expenditures in excess of specific borrowing * weighted-average interest rate.

Weighted Average Accumulated Expenditure*Weighted average expenditure interest rate

For the portion of weighted-average accumulated expenditures that is less than or equal
to any amounts borrowed specifically to finance construction
 of the assets, use the
 interest rate incurred on the specific borrowings.
For the portion of weighted-average accumulated expenditures that is greater than any
debt incurred specifically to finance construction of the assets, use a weighted
 average of interest rates incurred on all other outstanding debt during the period.
Select the lower of Actual Interest and Avoidable Interest.
Capitalized Interest = Lower (Actual Interest, Avoidable Interest)
Example1.
RKDF construction started construction of a building that is to be used for production. The
construction of the building will end by 31st December, and the building will be ready to
use. The following Debt was outstanding from 1st January 2017.
$60,000 at a 10% interest rate (taken for the specific purpose of constructing the building)

$75,000 at 8% interest rate (general loan)
The following payments were made for the construction of the building –
1st Feb, 2017 – $50,000
1st August, 2017 – $75,000
Calculate and record Capitalized Interest
Step 1 - Determine which assets qualify for capitalization of interest.
A self construction qualifies because it requires a period of time to get ready and it will
be used in the company’s operations

Step 2 – Capitalizing Period

The capitalization period will be from 1st January 2017 to 31 st December 2017.

Step 3 – Calculate Weighted Average Accumulated Expenditure.

Actual capitalization Weighted Average

Expenditure period
Date Accumulated Expenditure

46
 Feb 1 50,000 11/12 $45,833

August1 75000 5/12 $31,250

$77,083

Step 4 – Determine Weighted-average interest rate on general debt =total interest general /total
principal
Principal Interest

August1 75,000 *0.08 6000

Total 75,000 6,000

Weighted average expenditure interest rate on general debt =6000/75000=0.08

Step 5 – Calculate Actual Interest on the Loans
Actual Interest on the Loans = Specific debt $60,000 x 10% +general debt $75,000 x 8%

Avoidable Interest = Weighted Average Accumulated Expenditure*interest rate

Avoidable Interest= Weighted Average Accumulated Expenditure * interest rate
$60,000 x 10% 6000
(77,083 – $60,000) x 8% $1,367
Avoidable interest $7,367
Step 7 – Lower of Actual Interest and Avoidable Interest
Capitalized Interest = ($7,367, $12,000) = $7,367

Building 7,367
Interest Expense 7,367
Example 2
Assume a company borrowed $200,000 at 12% interest from State Bank on Jan. 1, 2015, for specific
purposes of constructing special-purpose equipment to be used in its operations. Construction on the
equipment began on Jan. 1, 2015, and the following expenditures were made prior to the project’s
completion on Dec. 31, 2015:
Actual expenditures during 2015
Jan1 100,000
April 30 150,000
November 1 300,000
Dec 31 100,000
Total Expenditure 650,000

47
Other general debt existing on Jan. 1, 2015:
500,000, 14%, 10-year bonds payable
$300,000, 10%, 5-year note payable
Steps 1 - Determine which assets qualify for capitalization of interest.
Special purpose equipment qualifies because it requires a period of time to get ready and it will be
used in the company’s operations
Step 2 - Determine the capitalization period.
The capitalization period is from Jan. 1, 2015 through Dec. 31, 2015, because expenditures are being
made and interest costs are being incurred during this period while construction is taking place.
Step 3 - Compute weighted-average accumulated expenditures (WAAE).

Actual capitalization Weighted Average

Expenditure period
Date Accumulated Expenditure

Jan 1 100,000 12/12 100,000

April 30 150,000 8/12 100,000

Nov 1 300,000 2/12 50,000

Dec 31 100,000 0/12 -

650,000 250,000

Step 4 - Compute the Actual and Avoidable Interest.

Selecting Appropriate Interest Rate:
For the portion of weighted-average accumulated expenditures that is less than or
equal to any amounts borrowed specifically to finance construction of the assets, use
the interest rate incurred on the specific borrowings.
For the portion of weighted-average accumulated expenditures that is greater than any
debt incurred specifically to finance construction of the assets, use a weighted average
of interest rates incurred on all other outstanding debt during the period.
Debt Interest rate Actual interest
Specific debt , 200,000 12% 24,000
General debt , 500,000 14% 70,000
300,000 10% 30,0000
Total 1000,000 124,000
Weighted-average interest rate on general debt =Actual interest on long term debt only
Total general debt only
Weighted-average interest rate on general debt=70,000+30,000 = 12.5%
500,000+300,000

48
Avoidable Interest=weighted-average accumulated expenditures up to the principal balance of
specific borrowing * interest rate on that specific borrowing + weighted- average accumulated
expenditures in excess of specific borrowing * weighted-average interest rate

Debt Avoidable interest

WAAE up to the principal balance of specific borrowing 24,000
200,000*0.12
WAAE in excess of specific borrowing 6,250
50,000*0.125
Total Avoidable interest 30,250

Step 5 – Capitalize the lesser of Avoidable interest or Actual interest.

Avoidable interest 30, 2250
Actual interest 24,000
Equipment 30,250
Interest Expense 30,250
VALUATION OF PROPERTY, PLANT, AND
EQUIPMENT Lump-Sum Purchases
Lump-sum purchase of fixed assets refers to purchase of different classes of fixed assets such as
property, plant and equipment in exchange for a single sum paid. Each of the assets must be
recorded separately as a fixed asset in the accounting records; to do so, t he purchase price is
allocated among the various acquired assets based on their fair market values.
Lump-sum purchases of fixed assets are common because fixed assets such as land, machinery
and equipment are usually attached and inseparable. When this common situation occurs, the
company allocates the total cost among the various assets on the basis of their relative fair values.
The assumption is that costs will vary in direct proportion to fair value.
This is the same principle that companies apply to allocate a lump-sum cost among
different inventory items.
Value of Asset = Fair Value of the Asset × Lump sum Paid
Fair Value of all the Assets Purchased
Example
TPI purchased a factory for lump-sum of $500,000 paid via bank. The fair value of each of
component of the purchase is given below:
Land 44,000

Building 32,000

Equipment 324,000
Required: Calculate the amount at which each of the above components shall be recognized
on purchase date and record the purchase transaction. Solution:

49
 Fair Value % of total FV Lamp –sum cost Recognition Value
Land 44,000 11.0% 500,000 55,000
Building 32,000 8.0% 500,000 40,000
Equipment 324,000 81.0% 500,000 405,000
Total 400,000 100.0% 500,000 500,000
The journal entry to record the lump-sum purchase shall be:
Land 55,000
Building 40,000
Equipment 405,000
Cash 500,000
EXERCISE
Norduct Homes, Inc. decides to purchase several assets of a small heating concern, Comfort
Heating, for $80,000. Comfort Heating is in the process of liquidation. Its assets sold are:

Norduct Homes allocates the $80,000 purchase price on the basis of the relative fair values
(assuming specific identification of costs is impracticable) in the following manner.

COSTS SUBSEQUENT TO ACQUISITION

Subsequent costs refer to such costs which are incurred after the asset is recognized in the financial
statement and brought to the location and condition intended. Examples of such expenditures
include repair and maintenance, overhauling, up gradation, replacement costs etc.
After installing plant assets and readying them for use, a company incurs additional costs that range
from ordinary repairs to significant additions. The major problem is allocating these costs to the
proper time periods. In general, costs incurred to achieve greater future benefits should be
capitalized, whereas expenditures that simply maintain a given level of services should be
expensed. In order to capitalize costs, one of three conditions must be present:
The useful life of the asset must be increased.
The quantity of units produced from the asset must be increased.
The quality of the units produced must be enhanced.

50
Capital expenditures – are expenditures that result in additional asset services, more valuable asset
services or extension of economic life. Future benefit is a characteristic of all capitalized costs
relating to a plant asset. The distinction between a capital expenditure (asset) and revenue
expenditure (expense) is not always clear-cut. Yet, in most cases, consistent application of a
capital/expense policy is more important than attempting to provide general theoretical guidelines
for each transaction. Generally, companies incur four major types of expenditures relative to existing
assets.

 and equipment in subsequent periods using either the

Companies value property, plant,
 cost method or

 Fair value (revaluation) method.

Cost-model
Under the cost model, the carrying value of fixed assets equals their historical cost less
accumulated depreciation and accumulated impairment losses
Carrying amount of PPE = Cost – accumulated depreciation – accumulated impairment losses
There is no upward adjustment to value due to changing circumstances.
REVALUATION MODEL UNDER IFRS
Under the revaluation model, PPE is carried in the books of account at cost or revalued amount
less accumulated depreciation and accumulated impairment losses, if any.
Carrying amount of PPE = Cost or revalued amount – accumulated depreciation
To practice this method, the fair value should be measured reliably.
Revaluation of fixed assets is the process by which the carrying value of fixed assets is adjusted
upwards or downwards in response to major changes in its fair market value under the IFRS
framework but not under US GAAP. In revaluation model, an asset is initially recorded at cost just
like in the cost model. The difference between the cost model and the revaluation model is that the
revaluation model allows both downward and upward adjustment in value of an asset while cost
model allows only downward adjustment due to impairment loss.
REVALUATION GAINS

51
 Where an asset’s carrying amount is increased as a result of a revaluation (ie a revaluation
gain), this gain is normally recognized in other comprehensive income and accumulated in
 equity under the heading of revaluation surplus.
However, the gain should be recognized in the statement of profit or loss to the extent that it
reverses a revaluation decrease (iea revaluation loss) of the same asset which had previously
 been recognized in profit or loss.
Upward revaluation is not considered a normal gain and is not recorded in income
statement rather it is directly credited to a shareholders' equity account called
 revaluation surplus.
 all the upward revaluations of a company's assets until those
Revaluation surplus holds
assets are disposed of.
Revaluation losses
If an asset’s carrying amount is decreased as a result of a revaluation, the decrease shall be
 recognized in profit or loss.
However, the decrease shall be recognized in other comprehensive income to the extent of any
credit balance existing in the revaluation surplus in respect of that asset. The decrease
recognized in other comprehensive income reduces the amount accumulated in equity under

the heading of revaluation surplus.
Depreciation of revalued assets
The asset must continue to be depreciated following the revaluation. However, now that the asset has
been revalued the depreciable amount has changed. In simple terms the revalued amount should be
depreciated over the asset’s remaining useful life.
Depreciation in periods after revaluation is based on the revalued amount.
What is the difference between Cost Model and Revaluation Model?

Cost Model vs Revaluation Model

In Cost model, assets are valued at the In Revaluation model, assets are shown at
cost incurred to acquire them. fair value (an estimate of market value).
Class of Assets
Class is not effected under this model. The entire class has to be revalued.
Valuation Frequency
Valuation is carried out only once Valuations are carried out at regular intervals.
Cost
This is a less costly method. This is costly compared to Cost Model.
Example—measurement after initial recognition: cost model

52
At 31 December 20X1, an entity owns plant with an original cost of 500,000 and accumulated
depreciation of 80,000. The entity determines that, due to damage to the plant, an impairment of
120,000 is necessary.
The entity uses the cost model for all its property, plant and equipment.
What is the carrying amount of the plant on 31 December 20X1?
Cost 500,000
Accumulated depreciation (80,000)
Carrying amount before impairment 420,000
Impairment (120,000)
Carrying amount 300,000

Examples—measurement after initial recognition: revaluation model

Revaluation surplus
On 1 January 20X1, an entity acquired a piece of land for 500,000. At 31 December 20X1, the
land was valued at 600,000. The entity uses the revaluation model for its land and buildings.
How must the entity account for the increase in the value of the land for the year ended 31
December 2001?

Land 100,000
Other comprehensive income – revaluation gain 100,000
To record the increase in the fair value of land at 31 December 2001.

Revaluation decrease reversing previous revaluation surplus

The facts are the same as in example above. At 31 December 20X2, the land was valued at 300,000.
The land is not impaired as its value in use is higher than its fair value.
How must the entity account for the revaluation of the land for the year ended 31 December 20X2?
Other comprehensive income – revaluation gain 100,000
Profit or loss – revaluation loss 200,000
Land 300,000
To record the decrease in the fair value of the land at 31 December 20X2.

Calculation
The 100,000 reverses the previous revaluation surplus recognized at 31 December 20X1
Decrease in revaluation at 31 December 2002 = 600,000 – 300,000 = 300,000.
Excess of deficit over previously recognized revaluation surplus = 300,000 – 100,000 = 200,000.
Revaluation surplus reversing previous revaluation loss
On 1 January 2001, an entity acquired a piece of land for 500,000. At 31 December 2001, the
asset was valued at 300,000. At 31 December 2002, the land was valued at 600,000.
How must the entity account for the revaluation of the asset for the year ended 31 December 2001
and 31 December 2002?

53
 December 31, 2001
Profit/loss - Revaluation loss 200,000
Land 200,000
To record the decrease in the fair value of the land at 31 December 2001

December 31, 2002

Land 300,000
Profit or loss –revaluation loss 200,000
Other comprehensive income – revaluation gain 100,000
To record the increase in the value of the land at 31 December 2002.

Calculation
Revaluation decrease for the year ended 31 December 2001: 500,000 – 300,000 = 200,000.
Revaluation increase for the year ended 31 December 2002: 600,000 – 300,000 = 300,000.
To reverse the revaluation decrease previously recognized in profit or loss i.e 200,000
The amount of revaluation increase for the year ended 31 December 2002 of 300 000 less the reversal
of previous revaluation decrease of 200,000 = 100,000.
EXERCISE
On 1 January 2001, an entity acquired an office building for 500,000 with a useful life of 20 years
and a nil residual value. At 31 December 2005, the building has a fair value of 300,000. The entity
uses the revaluation model. At 31 December 2010, the building was valued at 400,000.
How must the entity account for the revaluation of the asset for the year ended 31 December
2005 and 31 December 2010?
31 December 2005

Accumulated depreciation 125,000

Profit/loss- Revaluation loss 75,000
Building 200,000
To record the decrease in the value of the asset for the year ended 31 December 20X5.

31 December 2010
Accumulated depreciation 100,000
Building 100,000
Profit/ loss -reversal 75,000
Other comprehensive income – revaluation gain 125,000
To record the increase in the value of the asset at 31 December 2010.

Annual depreciation: 500,000/20 years = 25,000

Cumulative depreciation: 2001 to 2005 = 25,000 x 5 years = 125,000
Carrying amount at 31 December 2005 = 500,000 – 125,000 = 375,000
Revaluation decrease at 31 December 2005: 375,000 – 300,000 = 75,000
Annual depreciation: 2006 to 2010 = 300,000/15 years = 20,000

54
Carrying amount at 31 December 2010 = 300,000 – 100,000 = 200,000
Revaluation increase at 31 December 2010 = 400,000 – 200,000 = 200,000
Cumulative depreciation: 2006 to 2010 = 20,000 x 5 years = 100,000, 75,000 previously
recognized in profit or loss is reversed.
Amount recognized in other comprehensive income at 31 December 20X10 = 200,000 – 75,000
= 125,000
DEPRECIATION OF PROPERTY PLANT AND EQUIPMENT AND DEPLETION Definition
Depreciation is the accounting process of allocating the cost of tangible assets to expense
in a systematic and rational manner to those periods expected to benefit from the use of the asset. The
term depreciation, as used in accounting, does not refer to the physical deterioration of an asset or the
decrease in market value of asset overtime
To accountants, however, depreciation is not a matter of valuation. Rather, depreciation is a means of
cost allocation.
Allocating costs of long-lived assets: 
 Fixed assets = Depreciation expense

 Intangibles = Amortization expense

Mineral resources = Depletion expense

Factors Involved in the Depreciation Process

Before establishing a pattern of charges to revenue, a company must answer three basic questions:
What depreciable base is to be used for the asset?
What is the asset’s useful life?
What method of cost apportionment is best for this asset?
Depreciable Base for the Asset
The base established for depreciation is a function of two factors: the original cost, and salvage or
disposal value. Salvage value is the estimated amount that a company will receive when it sells the
asset or removes it from service. It is the amount to which a company writes down or depreciates
the asset during its useful life.
Methods of Depreciation
The third factor involved in the depreciation process is the method of cost apportionment. The
profession requires that the depreciation method employed be “systematic and rational.”
Companies may use a number of depreciation methods, as follows.
Straight-line method
Activity method (units of use or production).
Decreasing charge methods (accelerated):
a. Declining-balance method.

55
 b. Sum-of-the-years’-digits.
Special depreciation methods:
Group and composite methods.
Hybrid or combination methods.
Straight-Line Method 
 is based on the assumption that depreciation depends only on the passage/ function of time

 Yearly depreciation is the same each year

 the accumulated depreciation increases uniformly

 Carrying (Book) value decrease uniformly until it reaches the estimated residual value

Straight Line rate 1/n.

Annual depreciation expense = Cost - Salvage value or Cost or Depreciable cost

Est useful life Est useful life Est useful life

Example
Corporation purchased equipment on January 1, 2000 for Br 20,000 which has an expected life of
5 years and salvage value of Br 1,000. Instruction: calculate the declining balance rate and the
amount of depreciation for its useful life.
Compute
a yearly (annual) depreciation
Depreciation Rate
Prepare Depreciation schedule
a) Annual depreciation = Cost – Salvage value
Estimated useful life
= Birr 20,000 – Birr 1000 = Birr 3,800
5 years
Depreciation Rare=1/5=20%
The depreciation to schedule for each of the four years would be as follows:
Depreciation Method- Straight-Line Method
Year Yearly Accumulated Carrying value (Book Value)
Depreciation Depreciation 20,000
End of first year 3,800 3,800 16,200
End of second year 3,800 7,600 12,400
End of third year 3,800 11,400 9,600
End of fourth year 3,800 15,200 4,800
End of Fifth Year 3,800 19,000 1000

2. Decreasing-Charge Methods (Accelerated Method)

The decreasing-charge methods provide for a higher depreciation cost in the earlier years and
lower charges in later periods. Because these methods allow for higher early-year charges than in the
straight-line method, they are often called accelerated depreciation methods. What is the main

56
justification for this approach? The rationale is that companies should charge more depreciation
in earlier years because the asset is most productive in its earlier years
Declining-Balance Method. The declining-balance method utilizes a depreciation rate
(expressed as a percentage) that is some multiple of the straight-line method. For example, the
double-declining rate for a 10-year asset is 20 percent (double the straight line rate, which is
1/10 or 10 percent). Companies apply the constant rate to the declining book value each year.
Unlike other methods, the declining-balance method does not deduct the salvage value in
computing the depreciation base. is based on the assumption of the passage of time

 results in relatively large amount of depreciation in the early years of an assets life

 is also called an accelerated method of depreciation

 Does not used salvage value to determine Depreciation

 
Depreciation expense = declining-balance rate is multiplied by the book value of the asset at
the beginning of each period. 
 computed by applying a fixed rate to the book value of the asset

 sometimes appropriately called the “fixed percentage of book value method

Depreciation Rate is calculated by 1/n*2

Illustration Take the fact in the Example, Except the Method is double declining Balance
method Compute
Depreciation Fixed Rate
Yearly Depreciation
Depreciation
Schedule Solution
1/5*2 =40%
Yearly Depreciation= Book value*Fixed depreciation Rate
Depreciation Schedule, Double-Declining Balance Method
Year Fixed Yearly Depn Accumulated Book Value (BV)
Depn Depn 20,000
Rate
1st year 40% 20,000*0.4 =Br. 8000 Br. 8000 12000
2nd year 40% 12000*0.4=4,800 12,800 7,200
3rd year 40% 7,200*0.4=2880 15680 4320
4rd year 40% 4320*0.4=1728 17408 2592
5th year 40% 1592 19000 1000

Sum-of-the-Years’-Digits.
 amount of periodic depreciation expense in the earlier use of
Provides a higher
the asset's life

57
 First we must determine the denominator of the fraction, which is the sum of the digits
representing the years of life. For example, for a plant asset
 with an estimated life of 4
years, the denominator of the fraction is 4+3+2+1 =  10.
 is also called an accelerated method of depreciation

 Denominator of the fraction is unchanged and would remain the same.

At the end of the asset’s

 useful life, the balance remaining should be equal to
the salvage value.
Determine
Yearly Depreciation Rate
Yearly Depreciation
Depreciation Schedule
Solution
a) SOYD = 5+4+3+2+1=15

DEPRECIATION SCHEDULE- SUM - OF - THE - YEARS - DIGITS METHOD

Year Depreciable Rate Yearly Accumulated Book Value
Cost Depn Depn 20,000
st
1 year 19,000 5/15 6,333.33 6,333.33 13666.67
2nd year 19,000 4/15 5066.67 11400.04 8599.96
3rd year 19,000 3/15 3800 15,200.04 4799.96
4th year 19,000 2/15 2533.33 17733.37 2266.63
5th year 19000 1/15 1266.67 19000.04 1000

Activity Method(Unit of production Method)

Based on the assumption that depreciation is mainly the result of use and that the passage
 of time plays no role in the depreciation process.
relation between the amounts of depreciation each year and the units of output or
Direct
 use.

 
The life of the asset is expressed in terms of production capacity such as machine hours,
miles, kilo meters, etc. 
 Accumulated depreciation increases each year indirect relation to units of output or use.
Carrying amount decreases each year in direct relation to units of output or use until it
 reaches the estimated residual value. 
Depreciation Expense = Depreciation Rate * cost
Illustration - 1
Suppose for example a business enterprise acquires office equipment for Birr 6000. It is estimated
that the computer has an estimated residual value of Birr 1000 and has an estimated useful life of
10,000 hours. If we assume that the use of the equipment was 2800 hours for the first year, 3600
hours for the second, 2400 hours for the third, and 1200 hours for the fourth.

58
 Compute Hourly Depreciation
Compute Yearly Depreciation
Compute depreciation schedule
Solution
A. Hourly depreciation = Cost – Salvage value = Br. 6000.00 – 1000 = 0.5
Estimated units of useful life
10,000 operating hrs.
B. Yearly Depreciation=Cost *depreciation Rate

1st year 2,800*0.5=1,400

2nd Year 3,600*0.5=1,800
3rd Year 2,400*0.5=1,200
4th Year 1,200*0.5=600
C. Depreciation Schedule – Production Method
Year Hours Depreciation Per Yearly Dep’ Accum. Carrying value
Hour Dep’ (Book value)
1st year 2,800 0.50 Br. 1,400.00 1,400.00 4,600.00
2nd year 3,600 0.50 1,800.00 3,200.00 2,800.00
3rd year 2,400 0.50 1,200.00 4,400.00 1,600.00
4th year 1,200 0.50 600.00 5,000.00 1,000.00

Depreciation and Partial Periods

Companies seldom purchase plant assets on the first day of a fiscal period or dispose of them on the
last day of a fiscal period. A practical question is: How much depreciation should a company
charge for the partial periods involved? In computing depreciation expense for partial periods,
companies must determine the depreciation expense for the full year and then prorate this
depreciation expense between the two periods involved.
Illustration: GG Company purchases a delivery truck on April 13, 1991 for Br 180,400. The
expected life of the truck was 4 years or 200,000 KMs and has an estimated salvage value of Br
6,400. During the year 1991 and 1992 the truck was driven for 60,000 and 40,000 KMs, respectively.
The company’s fiscal period ends on December 31 of each year and depreciation must be recorded
for three months, April through December, or three – twelfths of the year.
Compute depreciation expense for the year 1991 and 1992 under all the methods of
depreciation. Straight Line Method
 Annual Depreciation= (180,400 – 6,400)/4 =Br 43,500

 1991- Partial Year Depreciation(April-Dec)= 9/12 * Br 43,500 = Br 32,625

1992 Depreciation (January-March) = 3/12 * Br 43,500 = Br 10,875

Declining Balance Method

59
 Annual Depreciation, 1st Year = 2/4 (Br 180,400 – 0)=Br 90,200
 Annual Depreciation, 2nd Year = 2/4 (Br 180,400 – 90,200)=Br 45,100

 1991- Partial Year Depreciation= 9/12 * 90,200=Br 67,650

1992 Depreciation =?

SOYD Method 
 SOYD = 4 (4 + 1)]/2= 10
 Annual Depreciation, 1st Year = 4/10 (Br 180,400 – 6,400)= Br 69,600
 Annual Depreciation, 2nd Year = 3/10 (Br 180,400 – 6,400)= Br 52,200

 1991- Partial Year Depreciation= 9/12* 69,600 = Br 52,200

1992 Depreciation = ?

Units-of Production 
 Depreciation Rate = (180,400 – 6,400) / 200,000KMs =Br 0.87/ km

 1991 Depreciation= 60,000 KMs * 0.87/km= Br 52,200

1992 Depreciation= 40,000 KMs * 0.87/km = Br 34,800

Revision of Depreciation Rates

Residual value and estimated economic life are estimates. There may be an error in estimates. Thus,
estimates may be revised or changed. The change in estimates is applicable only to the value or cost
not depreciated so far ignoring the portion of acquisition cost depreciated in the previous
accounting periods. Revision in estimates does not apply retroactively to the past accounting
periods. When purchasing a plant asset, companies carefully determine depreciation rates based on
past experience with similar assets and other pertinent information. The provisions for depreciation
are only estimates, however. They may need to revise them during the life of the asset. Unexpected
physical deterioration or unforeseen obsolescence may decrease the estimated useful life of the
asset. Improved maintenance procedures, revision of operating procedures, or similar developments
may prolong the life of the asset beyond the expected period.
Illustration: assume that on January 1, 1992 AA Company purchased a delivery truck for Br 52,000.
At the time of purchase the truck was estimated to last 5 years with salvage value of Br 2,000 and it
was depreciated accordingly on the straight line method for two years and at the beginning of the
year 1994, the life was estimated to last 6 more years with a salvage value of Br 2,600. Determine the
revised annual depreciation per annum.
 Givens: cost Br 52,000
 
Salvage value=Br 2,000
 EUL = 5 Years
 
Depreciation/Year = (52,000 – 2,000)
 /5
 Depreciation /Year = Br 10,000
Depreciation

from 1992 to 1993 
Accumulated Depreciation = Br 10,000
 * 2 years
Accumulated Depreciation = Br 20,000

60
 Revised Depreciation starting from 1994
 Revised Cost (Carrying Amount) = Br 52,000 – 20,000
 
Revised Cost (Carrying
Amount) =Br 32,000
 Revised EEL = 6 years 
 Revised RV = Br 2,600
Revised Depreciation = Br 32,000 – 2,600 / 6 = Br 29,400/6=Br
 4,900 The entry
to record depreciation for each of the remaining 6 years is:
Depreciation Expense 4,900
Accumulated Depreciation—Machinery 4,900
It has therefore overstated depreciation, and understated net income, by $3,825 for each of the past 2
years, or a total amount of $7,650 .The following table shows this computation
Per year for 2year
Depreciation charge per book (52,000 – 2,000) / 5 10,000 20,000
Depreciation based on (52,000 – 2,600) / 8 6,175 12,350
Excess deprecation charged 3,825 7,650
Exercise
For example, assume that International Paper Co. purchased machinery with an original cost of
$90,000. It estimates a 20-year life with no salvage value. However, during year 11, International Paper
estimates that it will use the machine for an additional 20 years. Compute Partial Depreciation.
Solution

The entry to record depreciation for each of the remaining 20 years is:
Depreciation Expense 2,250
Accumulated Depreciation—Machinery 2,250
DISPOSITION OF PROPERTY, PLANT, AND EQUIPMENT
Plant assets, such as equipments, delivery trucks or machineries, cannot be used forever. The assets
many wear out or the business may replace them with newer model.
When a plant (fixed) asset is no longer useful to a business the asset may be disposed of by:
discarding it as worthless;
selling it; or
Trading it in on a new asset.
Discarding Plant Assets
If a plant asset is of no further use to the business and cannot be sold or traded, then the plant asset
is discarded.
If the asset has no book value (i.e. if it is fully depreciated),
The plant asset account is credited for t he amount of the original cost of the item being 
discarded. At the same time, the accumulated depreciation account is debited for the amount

61
 of the total accumulated depreciation of the item being discarded In this case no gain or loss is
realized.
 value (if not fully depreciated) at the time it is discarded, the
If a plant asset has a book
business incurs a loss.
For example, on March 10, year 4 an office machine that was acquired on Jan 2, Year 1 at a cost of
birr 7000.00, is discarded as worthless. The book value is computed as the difference between the
cost of the asset birr 7000.00 and accumulated Depreciation, Birr 5500.00. A loss equal to the
carrying value (book value) should be recorded when the machine is discarded. When the machine is
discarded. Therefore, the entry to record the disposal of the disposal of the asset would be:
March 10. Accumulated depreciation, Machinery…………5500.00
Loss on disposal of plant Asset……………………..1500.00
Office Machine……………………………………….7000
Discarding machinery no longer used in the business.
2. Selling Old Plant Asset
The entry to record the sale of a plant asset is like the entry of discarding a plant asset except that
the cash or other asset to be received must be accounted for.

 If the selling price > book value, there will be a gain on disposal

If the selling price < book value, there will be a loss on disposal

Recording the Sale of Plant Assets for Cash

Assume the fact in the example above and Plan asset is sold under three assumptions.
Assuption1 plant asset is sold at Birr 1500, equal to the book value of the machine
Assuption2 plant asset is sold at Birr 1000, less than book value of the machine
Assuption3 plant asset is sold at Birr 3000, greater than book value of the machine
Assuption1 selling plant asset equal to book value
Required: Record necessary entry under each Assumption
Solution
March 10. cash……………………………1500.00
Accumulated Depr- equipment …………..5500.00
Equipment……………………………………7000.00
Sale of equipment at an amount equal to Birr; no gain or loss
Assuption2 selling plant asset less than book value,
Sold at Birr. 1000.00 cash; Loss of Birr 500, (BV= Birr 500)
July cash………………………….1000.00
Loss on sale of equip……...500.00

62
 Accumulated Depr……….5500.00
Equipment………………….7000.00
Sale of Equipment at less than the BV. Loss of Birr
500.00 Assuption3. Selling plant asset above book value
(Book Value of the asset (Birr 3000- Birr 1500).
July 5 Cash …………………………………..3000.00
Accumulated Depreciation Equip……...5500.00
Equipment………………………………..7000.00
Gain on sale of Plant Asset ………………1500.00
Sale of Equipment at more than the BV; gain of Birr 1000, (3000 – 1500) recorded.
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. The trade-in allowance
can be considered an agreed selling price for the old asset. This amount is deducted from price of
new asset as consideration for old plant asset. The balance paid to the seller of the new asset after the
trade-in allowance is deducted from the purchase price is called Boots. The GAIN or LOSS on
exchange is determined by comparing the TIA and the Book Value of the old Asset:

 If the TIA > book value, there will be a gain on disposal

If the TIA < book value, there will be a loss on disposal

According to GAAP on exchange of similar plant assets, loss should be recognized and gain should
be adjusted to the price the new asset. That is, the new asset exchanged must be recorded at the book
value of the old asset plus the cash paid (Boots) or the purchase price which ever is lower.
Illustration 2.10: BB Company acquired a machine at Br 80,000 by trading in a similar old asset
that has a cost of Br 75,000 and up-to-date accumulated depreciation account balance of this asset
was Br 72,000. Make the necessary journal entries if the TIA was:
A. Br 4,000 B) Br 3,000 C) Br 2,000
SOLUTION
A. TIA=Br 4,000
Book Value = Br 75,000 – 72,000 = Br 3,000

 IfCash  But the gain will not be recognized

the TIA is Br 4,000, there is a gain of Br 1,000.
paid (Boots) = (Purchase price) – (TIA) 
 Cash paid(Boots) = Br 80,000 – 4,000 = Br 76,000

 Purchase Price = Br 80,000

New machine (plant asset) price= Cash paid (Boots)+Book Value

New machine (plant asset) price = Br 76,000 + 3,000 = Br 79,000.

63
 Machinery (New) ............................................. 79,000
Accumulated Depreciation ............................... 72,000
Cash ..................................................... 76,000
Machinery (Old) ................................... 75,000
B. TIA=Br 3,000
Book Value = Br 75,000 – 72,000 = Br 3,000
 If the TIA is Br 3,000, there is neither a gain nor a loss
 
Cash paid(Boots) = Br 80,000 – 3,000 = Br 77,000
 
Purchase Price = Br 80,000

Boots + Book Value = Br 77,000 + 3,000 = Br 80,000. Thus, the new machine should be

recorded at Br 80,000 because boots plus book value and purchase price are the same.
Machinery (New) ............................................. 80,000
Accumulated Depreciation ............................... 72,000
Cash ..................................................... 77,000
Machinery (Old) ................................... 75,000
TIA=Br 2,000

 IfofthetheTIA is Br
2,000, there is a loss of Br 1,000. This loss is recorded in the accounting records
period. 
 Boots = Br 80,000 – 2,000 = Br 78,000

 Purchase Price = Br 80,000

Boots + Book Value = Br 78,000 + 3,000 = Br 81,000. Thus, the new machine should be recorded
at Br 80,000 since the purchase price is the lower amount.
Machinery (New) ............................................. 80,000
Accumulated Depreciation ............................... 72,000
Loss on Exchange ............................................ 1,000
Cash ..................................................... 78,000
Machinery (Old) ................................... 75,000

64
 CHAPTER 7

CURRENT AND LONG TERM

LIABILITIES WHAT IS A LIABILITY?
Current liabilities are short-term financial obligations that a company is required to settle within one
year or within its operating cycle, whichever is longer.
The operating cycle is the period of time elapsing between the acquisition of goods and services
and the final cash realization resulting from sales and subsequent collections.
Three essential characteristics of liabilities
Present Obligation – A liability arises
from past transactions or events that result in a present
 duty or responsibility to another party.
Future Economic Sacrifice – Settlement of the liability will involve
 an outflow of resources
 (e.g., cash, goods, or services) that provide economic benefits.
Unavoidable Settlement – The entity is legally or contractually required to settle the liability,
making it an unavoidable obligation.

Classifications of Current Liabilities

Accounts Payable: Amounts owed to suppliers for goods or services purchased on credit.
Short-Term Loans and Notes Payable: Obligations that must be repaid within a year, such as
bank loans.
Accrued Expenses: Expenses incurred but not yet paid, such as wages, utilities, and interest.
Unearned Revenues: Payments received in advance for services or products yet to be delivered.
Dividends Payable: Declared dividends that are yet to be distributed to shareholders.
Income Taxes Payable: Obligations related to income tax, payroll tax, and sales tax that are due
within the current period.
Current Portion of Long-Term Debt: The portion of a company's long-term liabilities due
within a year.
Accounts payable (Trade Accounts Payable)
Accounts payable, or trade accounts payable, is balances owed to others for goods, supplies, or
services purchased on open account. A company must pay special attention to transactions
occurring near the end of one accounting period and at the beginning of the next. It needs to
ascertain that the record of goods received (the inventory) agrees with the liability (accounts
payable), and that it records both in the proper period. These liabilities typically are noninterest-
bearing and are reported at their face amounts
PROMISSORY NOTE/NOTE PAYABLE

65
 Notes payable are written promises to pay a certain sum of money on a specified future date. They
may arise from purchases, financing, or other transactions
Notes may be referred to as interest bearing or non-interest bearing:
Notes may be classified as short-term (current) or long-term payables

Interest-bearing notes have a stated rate of interest that is payable in addition to the face value of
the note.

Notes that are zero-bearing or non-interest bearing do not have a stated rate of interest.
Interest-Bearing Note Issued
An interest-bearing note is a type of debt instrument that promises to pay interest in addition to the
principal amount
Here are some important components of an interest-bearing note:
Principal: This is the amount initially borrowed, which must be repaid to the lender at maturity.

Interest Rate: The note specifies an annual interest rate, which is the cost of borrowing the money.
The borrower is obligated to pay interest on the outstanding principal at this rate.

Payment Schedule: The note sets out a schedule for when interest payments will be made (for
example, monthly, quarterly, or annually) and when the principal will be repaid (at maturity).

Maturity Date: This is the date when the note is due, and the borrower must repay the principal.
The maturity can range from a few months to several years, depending on the terms of the note.
Assume that Castle National Bank agrees to lend $100,000 on March 1, 2010, to Landscape Co. if
Landscape signs a $100,000, 6 percent, four-month note. Landscape records the cash received on
March 1 as follows:
March 1 Cash 100,000
Notes Payable 100,000
(To record issuance of 6%, 4-month note to Castle National Bank)
If the company prepare financial statements semi annually, the following adjusting entry to
recognize interest expense and interest payable of $2,000 ($100,000* 6% *4/12) at June 30:
June 30 Interest Expense (100,000 x 6% x 4/12) 2,000
Interest Payable 2,000
(To accrue interest for 4 months on Castle National Bank note)

At maturity (July1), Landscape must pay the face value of the note ($100,000) plus $2,000 interest
($100,000 x 6% x 4/12). Landscape records payment of the note and accrued interest as follows.
July 1 Notes Payable 100,000
Interest Payable 2,000
Cash 102,000
(To record payment of Castle National Bank interest bearing note and accrued interest at maturity)

Zero-Interest-Bearing Note Issued

66
  does not explicitly state an interest rate on the face of the note.
A zero-interest-bearing note
 Interest is still charged.
Sometimes bank requires a borrowers to pay an interest in advance .On the issue date, the
bank deducted an interest from the face values of a note. This reduces the amount of money
the borrowers receives. When the interest is deducted in advance from face value of the note,
the note is called non-Interest-Bearing because no interest rate is stated on the note.
Interest is deducted in advance is called bank discount. The interest rate used to calculate bank

discount is called discount rate. The cash received by borrower is called proceeds.
Proceed=Face value of the note – Bank discount
For non interest bearing note, Maturity value is equal to face value. This is because the interest
is deducted from face value of the note on issue date.
At maturity the borrower must pay back an amount greater than the cash received at the issuance date. In
other words, the borrower receives in cash the present value of the note. The present value equals the face
value of the note at maturity minus the interest or discount charged by the lender for the term of the note.
In essence, the bank takes its fee “up front” rather than on the date the note matures.
Characteristics of Zero-Interest-Bearing Notes
No stated interest rate.

Issued at a discount (less than face value).

The borrower repays the full face value at maturity. 

The difference between the issuance price and face value is treated as imputed interest

Example
To illustrate, assume that Landscape issues a $102,000, four-month, zero-interest bearing note to
Castle National Bank. The present value of the note is $100,000. Landscape records this
transaction as follows.
March 1Cash 100,000
Discount on Notes Payable 2,000
Notes Payable 102,000

 Bank)
(To record issuance of 4-month, zero-interest-bearing note to Castle National
 Cash (Debit $100,000): Represents the present value of the note received.

  (Debit $2,000): Represents the implicit interest cost to be

Discount on Notes Payable
recognized over time. 
Notes Payable (Credit $102,000): Records the full obligation of the note.

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 Landscape credits the Notes Payable account for the face value of the note, which is $2,000
more than the Present value (actual cash received). It debits the difference
 between the cash
received and the face value of the note to Discount on Notes Payable. 
Discount on Notes Payable is a contra account to Notes Payable, and therefore is
subtracted from Notes Payable on the balance sheet.
The following shows the balance sheet presentation on March 1.
Current liabilities:
Notes payable $102,000
Less: Discount on notes payable 2,000 $100,000
The amount of the discount, $2,000 in this case, represents the cost of borrowing $100,000 for 4
months. Accordingly, Landscape charges the discount to interest expense over the life of the note.
That is, the Discount on Notes Payable balance represents interest expense chargeable to
future periods.
July 1 Note payable 102,000
Cash 102,000
EXAMPLE 2
Suppose Company A borrows $10,000 from Company B for one year. The market interest rate for
similar loans is 5%. However, the promissory note does not mention any interest rate. Here’s how to
account for the non-interest-bearing note from both companies’ perspectives:
Step 1:
Calculate the present value of the note using the market interest rate: Present value = Face value / (1 +
Market interest rate) Present value = $10,000 / (1 + 0.05) = $9,523.81
Step 2:
Record the initial transaction:
At issuance date Cash 9,523.81
Discount on N/P Interest Expense $476.19
Note payable
10,000
At Maturity date Notes Payable $10,000
Cash $10,000

EXERCISE
Oct. 1 - Borrowed $75,000 from the Shore Bank by signing a 12-month, zero-interest-bearing
$81,000 note.

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PROVISION (IAS 37) –is
Stands for liability of uncertain timing or amount.

Reported either as current or non-current liability.

Provisions include warranties, income tax liabilities, future litigation fees, etc.

They appear on a company’s balance sheet and are recognized according to certain criteria of
the IFRS.
RECOGNITION OF A PROVISION
As International Financial Reporting Standards (IFRS), Companies accrue an expense and
related liability for a provision only if the following three conditions are met:
A provision is recognized only when
An entity has a current obligation arising from past events;

It is probable that an outflow of funds will occur during the settlement of the obligation;

A company can make a reliable estimate of the amount of the obligation; and

COMMON TYPES OF PROVISION

Obligations related to litigation (lawsuit).
Warrantees or product guarantees.
Business restructurings.
Environmental damage.
WARRANTY PROVISIONS
A warranty provision is a liability recognized for expected costs of repairing or replacing defective
products under warranty. It is recorded when a product is sold, based on the estimated future
expenses related to warranty claims.
A warranty (product guarantee) is a promise made by a seller to a buyer to make good on a
deficiency of quantity, quality, or performance in a product.
Why is a Warranty a Provision and Not a Contingent Liability?
Provision: Recognized as a liability because:
There is a present obligation from selling the product.

An outflow of resources (repair/replacement costs) is probable.

The costs can be estimated based on past experience.
❌ Not a Contingent Liability:
A contingent liability is disclosed only if the obligation is uncertain or cannot be estimated.
Since warranty costs are predictable, they must be recorded as a provision.

69
CONTINGENT LIABILITY IAS 37
According to IAS 37, Contingencies refer to potential liabilities that depend on the occurrence or non-
occurrence of future events.
A contingent liability is a possible obligation that arises from past events but is not recognized
in the financial statements because:
It depends on uncertain future events that are not under the company’s control.

The outflow of resources is not probable.

The obligation cannot be reliably measure

Contingent liabilities are not recognized in the financial statements because they depend
on uncertain future events.

However, they must be disclosed in the notes to the financial statements unless the possibility
of an outflow of economic benefits is remote.
Accounting for Contingencies (GAAP & IFRS Guidelines)
Probable and Estimable: If a liability is likely to occur and its amount can be reasonably
estimated, it must be recorded as a liability and disclosed in financial statements.

Reasonably Possible: If the liability is not certain but possible, it must be disclosed in the
notes to the financial statements.

Remote: If the likelihood of occurrence is low, no financial recognition or disclosure is
required.
CONTINGENT GAIN/ASSET
Gain contingencies are possible future events that may increase assets or reduce liabilities .Gain
contingencies are claims or rights to receive assets (or have a liability reduced) whose existence is
uncertain but which may become valid eventually. Contingencies that might result in gains are not
recorded until the gains are realized or realizable. The typical gain contingencies are:
Possible receipts of monies from gifts, donations, bonuses, and so on.
Possible refunds from the government in tax disputes.
Pending court cases with a probable favorable outcome.
Tax loss carries forwards.
LOSS CONTINGENCIES
Loss contingencies involve possible losses. A liability incurred as a result of a loss contingency is
by definition a contingent liability. Contingent liabilities depend on the occurrence of one or more
future events to confirm the amount payable, the payee, the date payable, or its existence. That is,
these factors depend on a contingency.
Examples of loss contingency include

70
 
 Collectability of receivable (i.e. loss as a result of failing to collect)

 Liabilities for product warranties

 Risk of damage to property by fire

 Pending or threatened litigation

 Selling of receivable or other assets through recourse

 Litigation, claims, and assessments.

 Premiums and coupons.

Environmental liabilities

Key Differences between Provision and Contingent Liability

The points listed below will explain the difference between provision and contingent liability:
A provision is a present obligation of uncertain amount and timing but Contingent Liability
is a possible obligation that results from past events and whose existence will rely upon the
happening or non-happening of the future event.
Provision is a recognized liability whose occurrence is certain. But contingent liability is an
unrecognized liability. This means that we do not pass any accounting entry for such
liability. This is because of the following reason:
It is not foreseeable that the settlement of that liability will need an outflow of
funds.

An accurate estimation of the amount is not possible.

The occurrence of contingent liability is uncertain. But the occurrence of provision is
certain.
Provision is accounted for at present and arises as a result of past events. Whereas
contingent Liability is disclosed at present as a note to account for the outflow of funds
which are likely to occur in future.
Increase or decrease of provisions is recorded in the Income statement where Contingent
liability is not recorded in the Income statement.
Provision is recorded as a decrease in assets in Statement of financial position where as
Contingent liability is recorded as an increase in liabilities in Statement of financial
position
The occurrence of provisions is certain where the occurrence of contingent liability is
conditional.
8. Provision is recognized as a liability in financial statements but contingent is not
recognized but disclosed in notes

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 NON- CURRENT/LONG-TERM LIABILITIES
Long-term debt: are obligations that are not payable within a year or the operating cycle of the
company, whichever is longer. Bonds payable, long-term notes payable, mortgages payable,
pension liabilities, and lease liabilities are examples of long-term liabilities.
Examples:
Bonds Payable
Long-Term Notes Payable
Mortgages Payable
Lease Obligations (Capital Leases/Finance Leases)
Deferred Tax Liabilities
Pension Obligations (Long-Term Portion)
Long-Term Warranty Obligations
BONDS
A bond is a written promise by a corporation to pay back the principal on a loan, plus interest. When
you "buy" a bond, you are really lending money to the corporation and receiving in exchange a
piece of paper (the bond) containing a promise to pay back the loan plus interest.
TYPES AND RATINGS OF BONDS
By Issuer:
Government Bonds (Sovereign Bonds):
Bonds issued by a national government. They are generally considered to be among
the safest investments,
 particularly those issued by developed countries with strong
 credit ratings.
 Characteristics:
Low risk (especially from developed nations).

Relatively low yields compared to corporate bonds.

Often used as a benchmark for pricing other bonds.
Municipal Bonds (Munis):

Bonds issued by state and local governments (municipalities) to finance public
 projects such as schools, roads, and infrastructure.
Corporate Bonds:

 for various purposes, such as expansion,
Bonds issued by corporations to raise capital
 acquisitions, or refinancing existing debt.
 Characteristics:
Higher yields compared to government bonds due to higher risk.

72
 Credit ratings vary widely depending on the financial health of the issuing
company.

Subject to credit risk (risk of default).

Supranational Bonds: 
 Bonds issued by international organizations or institutions.

II. by Security and Credit Quality:

Secured Bonds:


  equipment). If the issuer defaults,

Backed by specific assets of the issuer (e.g., property,
bondholders have a claim on the pledged assets.
 o Examples: Mortgage bonds, equipment trust certificates.
 o Characteristics: Lower risk compared to unsecured bonds.
Unsecured Bonds (Debentures): 
 Not backed by specific assets but by the general creditworthiness of the issuer.

 Higher risk than secured bonds.

Senior Bonds:

 Have a higher claimon the issuer's assets and earnings in the event of bankruptcy than
subordinated bonds. 
 Lower risk than subordinated bonds.
Subordinated Bonds:

Have a lower claim on the issuer's assets and earnings in the event of bankruptcy.

Higher risk and higher yield than senior bonds.
III. By Coupon Rate:
Fixed-Rate Bonds:
Definition: Pay a fixed coupon rate (interest rate) throughout the life of the bond.
Floating-Rate Bonds (FRNs):
Pay a coupon rate that adjusts periodically based on a benchmark interest rate (e.g.,
LIBOR, SOFR) plus a spread.

Zero-Coupon Bonds:

Do not pay periodic interest payments. Sold at a deep discount to their face value and
mature at par. The investor's return comes from the difference between the purchase
price and the face value.
IV. By Special Features:
Callable Bonds:

73
 Give the issuer the right to redeem the bond before its maturity date at a specified call
price.

Putable Bonds:

Give the bondholder the right to sell the bond back to the issuer at a specified price on
a specified date.

Convertible Bonds:

Can be converted into a predetermined number of shares of the issuer's common stock.

Perpetual Bonds (Consols):

Do not have a maturity date. Pay interest indefinitely.

Primarily issued by governments.

Catastrophe Bonds (CAT Bonds):

Definition: High-yield bonds that transfer specific risks from natural catastrophes
(e.g., hurricanes, earthquakes) to investors. If a qualifying event occurs, the bond's
principal may be reduced or forfeited.
RECOGNITION OF LONG-TERM DEBT
A long-term debt liability is recognized when the entity becomes a party to the contractual
provisions of the borrowing agreement, and it is probable that future economic benefits will
flow from the entity to settle the obligation. In simpler terms, when the company has a legal

obligation to repay the debt. 
Initially, Long-term debt is initially measured at fair value, which is usually the transaction
price (amount received).

After initial recognition, long-term debt is generally
measured at amortized cost using the effective-interest method.
ACCOUNTING FOR ISSUANCE OF BONDS AND INTEREST EXPENSE
The interest rate written in the terms of the bond indenture (and often printed on the bond
certificate) is known as the stated, coupon, or nominal rate. The issuer of the bonds sets this rate.
The stated rate is expressed as a percentage of the face value of the bonds (also called the par
value, principal amount, or maturity value).

 If market rate is equal to contract (Coupon) rate- the bond will be issued exactly for its par.

 If market rate is Greater than contract (Coupon) rate- the bond will be issued at discount

 If market rate is less than contract (Coupon) rate- the bond will be issued at premium

The rate of interest actually earned by the bondholders is called the effective yield or market rate.

ISSUANCE OF BONDS-PAR
EXAMPLE 1

74
Assume a bond whose par value is $100,000 and whose contract rate is 10% payable annually is
issued by the Greenfield Corporation. If the market rate is also 10%, the selling price will be the par
value of $100,000. Assuming the date of issue is January 1, 2001, interest is payable every
December 31 and the life of the bond is 4 years, the journal entries will be as follows:
Jan. 1, 2001 Cash 100,000
Bonds Payable 100,000

Dec. 31, 2001 Interest Expense 1 0,000

Cash 10,000
(This entry will be repeated every December 31 through 2004

Jan. I, 2005 on this date, Greenfield Corporation will pay back the principal and make the
following entry:

Bonds Payable 100,000

Cash 100,000

ISSUANCE OF BONDS-At DISCOUNT

EXAMPLE
H. Rubin Company wants to issue a $10,000 bond with a 4-year life on January 1, 19X1. The contract
rate specifies 10%; however, the market rate has risen to 12%. To induce a buyer to buy the bond, it
offers to sell it at 96. In bond terminology this means a price of 96% of the par (102 would mean
102% of the par). The entry will be:
Jan. 1, 19X1 Cash 9,600
Bond Discount 400
Bonds Payable 10,000
The discount account is a contra-liability to the Bonds Payable account. At this point in time the
company only owes $9,600 ($10,000 - $400). However, as we will soon see, the discount account will
slowly start to become smaller, until it reaches zero at the maturity date. At that point, therefore, there
will be no contra and the company will pay back the full par value.
Dec. 31, 19X1 Interest Expense 1,000
Cash 1,000
The $1,000 is based upon $10,000 x 10% = $1,000. Remember the handy rule: You always pay
what the bond says.
The bond says $10,000 and 10%. It does not say $9,600 or 12%.
Dec. 31, 19X1 Interest Expense 100
Bond Discount 100

As mentioned earlier, the discount is really additional interest to the buyer as compensation for the low
contract rate. Rather than recognizing this interest in one large amount at the maturity date, the

75
matching principle requires that it be recognized piecemeal over the life of the bond. This is called
amortizing the discount. The amortization per year can be calculated under the straight-line method
as follows:
Amortization per year = discount 400=100
Bond life 4

If the market rate has fallen below the contract rate, then it is the corporation that will be reluctant to
issue these bonds that pay such a relatively high rate. Accordingly, to compensate itself, the
corporation will issue the bond at a premium-above the par. At maturity, however, it will only have
to pay back par (you always pay what the bond says!). Thus the premium may be viewed as a
reduction of the interest expense.

It is January 1, 19X1. A corporation wishes to sell a $10,000, 4-year bond. The contract rate is 10%
but the market rate is only 8%. Accordingly the price is set to 104 (104% of $10,000 = $10,400).
This is a premium situation.
Cash 10,400
Bonds Payable 10,000
Bond Premium 400

The premium account is not a contra; it is an addition to the Bonds Payable account. However, as
time goes by, the premium will be slowly amortized down to zero by the maturity date. Thus, at that
time, the corporation will only have to pay back the par of $10,000.
Every Dec. 31 Interest Expense 1,000
Cash 1,000

Bond Premium 100

Interest Expense 100
400/4= 100
BONDS ISSUED AT PAR ON INTEREST DATE
When a company issues bonds on an interest payment date at par (face value), it accrues no interest.
No premium or discount exists. The company simply records the cash proceeds and the face value
of the bonds.
To illustrate, if Abi Company issues at par 10-year term bonds with a par value of $800,000, dated
January 1, 2010, and bearing interest at an annual rate of 10 percent payable semi annually, January 1
and july1 the entry would be as follows
January 1 Cash 800,000
Bonds Payable 800,000
To record the issuance of bond

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July 1 Bond Interest Expense 40,000
Cash 40,000
To records the first semiannual interest payment of $40,000 ($800,000 x .10 x 1/2)
Bond Interest Expense 40,000
Bond Interest Payable 40,000
It records accrued interest expense Jul 1-December 31, 2010 (year-end) as follows.
Bonds Issued at Discount on Interest Date
If Abi Company issues the $800,000 of bonds on January 1, 2010, at 97 (meaning 97 percent of par),
it records the issuance as follows.
Jan1 Cash ($800,000 x .97) 776,000
Discount on Bonds Payable 24,000
Bonds Payable 800,000
Companies amortize the discount and charge it to bond interest expense over the period of
time that the bonds are outstanding.
The straight-line method amortizes a constant amount each interest period (in this case 20 interest
periods). For example, using the bond discount of $24,000, Abi amortizes $1,200 to interest expense
each period for 20 periods ($24,000 / 20).
To records the first semiannual interest payment of $40,000 ($800,000 x 10% x 1/2) and the
bond discount on July 1, 2010 interest + discount amortization as follows:
Bond Interest Expense (40,000+1,200) 41,200
Discount on Bonds Payable 1,200
Cash 40,000
BONDS ISSUED AT PREMIUM ON INTEREST DATE
Example If Abi dates and sells 10-year bonds with a par value of $800,000 on January 1, 2010, at
103, it records the issuance as follows.
Cash ($800,000 x 1.03) 824,000
Premium on Bonds Payable 24,000
Bonds Payable 800,000
With the bond premium of $24,000, Abi amortizes $1,200 to interest expense each period for 20
periods ($24,000 / 20).
Abi records the first semiannual interest payment of $40,000 ($800,000 x 10% x 1/2) and the bond
premium on July 1, 2010 as follows:
Bond Interest Expense 38,800
Premium on Bonds Payable 1,200
Cash 40,000
Amortization of a discount increases bond interest expense. Amortization of a
premium decreases bond interest expense.

77
BONDS ISSUED BETWEEN INTEREST DATES
Companies usually make bond interest payments semiannually, on dates specified in the bond
indenture. When companies issue bonds on other than the interest payment dates, buyers of the
bonds will pay the seller the interest accrued from the last interest payment date to the date of
issue. The purchasers of the bonds, in effect, pay the bond issuer in advance for that portion of the
full six -months’ interest payment to which they are not entitled because they have not held the bonds
for that period. Then, on the next semiannual interest payment date, purchasers will receive the
full six months’ interest payment.
BONDS ISSUED AT PAR BETWEEN INTEREST DATES
To illustrate, assume that on March 1, 2010, Taft Corporation issues 10-year bonds, dated January
1, 2010, with a par value of $800,000. These bonds have an annual interest rate of 6 percent,
payable semiannually on January 1 and July 1. Because Taft issues the bonds between interest
dates, it records the bond issuance at par plus accrued interest as follows.
Cash 808,000
Bonds Payable 800,000
Bond Interest payable ($800,000 x .06 x 2/12) 8,000
(Interest expense might be credited instead)
The purchaser advances two months’ interest. On July 1, 2010, four months after the date of purchase,
Taft pays the purchaser six months’ interest. Taft makes the following entry on July 1, 2010.
Bond Interest payable 24,000
Cash 24,000
The Bond Interest payable account now contains a debit balance of $16,000, which represents
the proper amount of interest expense—four months at 6 percent on $800,000.
Bonds Issued at premium between Interest Dates
Example. Assume the fact in the example above except, Taft issued the 6 percent bonds at 102,
because Taft issues the bonds between interest dates, it records the bond issuance at premium ,
premium + accrued interest as March 1 follows.
March 1 Cash [($800,000 x 1.02) + ($800,000 x .06 x 2/12)] 824,000
Bonds Payable 800,000
Premium on Bonds Payable ($800,000 x .02) 16,000
Bond Interest Expense 8,000
Taft would amortize the premium from the date of sale (March 1, 2010), not from the date of the
bonds (January 1, 2010).

THE PRICE OF A BOND

We've seen that when the market rate of interest is different from the contract rate, the bond will sell at a
premium or discount. But precisely how much will the premium or discount be? How does one

78
go about calculating this premium or discount? The answer is that the price is based upon
the following formula:
Bond selling price/proceed = Discounted present value at market rate for n period + present
value of the interest payments (annuity) discounted at market interest rate.

METHODS OF DISCOUNT OR PREMIUM AMORTIZATION

Straight-Line Method
The discount or premium is divided equally over the number of interest periods (or the life
of the bond) and amortized in equal amounts each period.

Amortization Amount = (Discount or Premium) / (Number of Interest Periods)
Interest Expense Calculation:
 Interest Expense = Cash Interest Payment + Discount Amortization
Interest Expense = Cash Interest Payment - Premium Amortization
Under IFRS (International Financial Reporting Standards), the effective interest method is
required for the amortization of discounts or premiums on financial instruments. The straight-
line method is generally not allowed, except in certain limited cases where the effect is not
materially different from the effective interest method.
EFFECTIVE-INTEREST METHOD

 Calculates interest expense based on the carrying value of the bond and the market interest
rate (yield) at the time of issuance. 
 This method accurately reflects the constant rate of return on the bond investment

 Also called present value amortization).

Required under IFRS and preferred under U.S. GAAP.


Under the effective-interest method, companies:

Compute bond interest expense first by multiplying the carrying value (book value) of the bonds
at the beginning of the period by the effective interest rate.
Determine the bond discount or premium amortization next by comparing the bond interest
expense with the interest (cash) to be paid. The following depicts graphically the computation of
the amortization

79
 Discount accumulated = Interest expense Computed - Periodic cash paid
By effective rate of interest
Interest Expense computed
Premium amortized = - by effective interest rate
Periodic cash paid

Comparison between strsigh Line method and Interest Method

Feature Straight-Line Method Effective-Interest Method
Complexity Simple More Complex
Accuracy Less accurate More Accurate
Varies each period (as carrying value
Interest Expense Constant amount each period
changes)
Allowed if immaterial differences from
GAAP Required
Effective-Interest(not preferred
IFRS Not allowed Required
Time Value of Money Ignores time value of money Considers time value of money
Illustration Assume that Br. 5000,000 of five-year, 10% term bonds are authorized and issued by
a corporation. Assume also that the effective (yield) rate of interest for such types of bonds is:
Case 1. 12% compounded annually
Case 2. 8% compounded annually

Required
Compute the amount of annual interest.
Compute the amount of proceeds from bonds under case 1.
Compute the amount of discount on bonds under case 1.
Present the journal entry to record the issuance of the bonds under case 1.
Compute the amount of proceeds and premium on bonds under case 2.
Present the journal entry to record the issuance of the bonds under case 2.
Compute the amount of effective interest expense over the term of the bonds under case 1.
Compute the amount of effective interest expense over the term of the bonds under case 2.
Prepare discount amortization table under case 1 using interest method.
Present journal entries to record the first two annual interest payments under case 1 using
interest method.
Prepare premium amortization table under case 2 using interest methods.
Present journal entries to record the first two annual interest payments under case 2 using
interest method.
Prepare discount amortization table under case 1 using straight-live method.
Present journal entries to record the first two annual interest payments under case 1 using
straight-line method.
Prepare premium amortization table under case 2 using straight-line method.
Present journal entries to record the first two annual interest payment under case 2 using
straight – line method.

80
 Solution
1. Amount of annual interest
= 0.10 x Br. 5000,000 = Br. 500,000
2. Amount of proceeds under case 1 (12%)
Present value of Br. 500,000 due in 5 years at 12% (Br. 5000,000 x 0.56743) Br. 2,837,150
+ Present value of ordinary annuity of 5 year 12% (Br. 500,000 x 3.60478) 1,802,390
Proceeds of bond issue Br. 4,639,540
Amount of discount under case 1 (12%)
Face value of bonds Br. 5000,000
Present value of bonds 4,639,540
Discount on bonds Br. 360,460
Journal entry to record issuance of bards under case 1
Cash 4,639,540
Discount on Bonds payable 360,460
Bonds payable 5000,000
Amount of proceeds under case 2 (8%)
Present value of Br. 5000,000 due in 5 years at 8% (Br. 5000,000 x 0.68068) Br. 3,402,900
Present value of ordinary annuity of 5 years at 8% (Br. 500,000 x 3.99271) 1,996,355
Proceeds of bond issue Br. 5,399,255
Amount of premium on bonds = Br. 5399,255 – Br. 5000,000 = Br. 399,255
Journal entry to record issuance under case 1
Cash 5,399,255
Bonds payable 5000,000
Premium on Bonds payable 399,255
Amount of effective interest expense over the term of the bond under case 1
Effective interest for n period =Book value*n plus discount or Book value*n less
Premium
Nominal interest (Br. 500,000 x 5) Br. 2,500,000
Add: discount 360,460
Five year interest expense Br. 2,860,460
Amount of effective interest expense over the term of bonds under case 2
Nominal interest (Br. 500,000 x 5) Br. 2,500,000
Less: Premium 399,255
Five-year interest expense Br. 2,100,754
Discount amortization table under case 1 using interest method
Time Interest paid Effective Discount Bond Carrying amount of
(10%) interest Amortization discount bonds issue
expenses balance
(12%)
Beginning - - - Br. 360,460 Br. 4,639,540
End of year 1 Br.500,000 Br. 556,745 Br. 56,745 303,715 4,696,285
End of year 2 500,000 563,554 63,554 240,161 4,759,839
End of year 3 500,000 571,181 71,181 168,980 4831,020
End of year 4 500,000 579,722 79,722 89,258* 4,910,742

81
End of year 5 500,000 589,289 89,258* -- 5,000,000
* Result of rounding up of some amounts.
Interest paid=5000, 000*0.1=500,000 Discount = 556,745—500,00=56,745
Effective interest=4,639,540*0.12= 556,745 Carrying amount =
4,639,540+56,745=4,696,285

10 Journal entries to record the first two annual interest payments under case 1 using
interest method.
End of year 1: Bond interest Expense ---------- 556,745
Cash------------------------------------------- 500,000
Discount on bonds payable------------------- 56,745
End of year 2: Bond interest Expense ---------- 563,554
Cash------------------------------------------- 500,000
Discount on bonds payable------------------ 63,554

Premium amortization table under case 2 using interest method

Time Interest paid Effective Premium Bond premium Carrying amount
(10%) interest Amortizatio Balance of bonds issue
expenses n
(8%)
Beginning - - Br. 399,255 Br. 5,399,255
-
End of year 1 Br.500,000 Br. 431,940 Br. 68,060 331,195 5,331,195
End of year 2 500,000 426,496 73,504 257,691 5,257,691
End of year 3 500,000 420,615 79,385 178,306 5,178,306
End of year 4 500,000 414,264 85,736 92,570* 5,092,570
End of year 5 500,000 407,406 92,594* 0 5,000,000
* Result of rounding up of some amounts.
Interest paid=5000, 000*0.1=500,000 premium= 500,000-431,940=68,060
Effective interest=5,399,255*0.08= 431,940 Carrying amount = 5,399,255-
68060=5,331,195

Journal entries to record the first two annual interest payments under case 2 using interest
method.
End of year 1: Bond interest Expense 431,940
Premium on Bonds payable 68,060
Cash 500,000
End of year 2: Bond interest Expense 426,496
Premium on Bonds payable 73,504
Cash 500,000
13. Discount amortization table under case 1 using straight-line method.

Time Interest paid Effective Discount Bond Carrying amount

(10%) interest Amortization Discount of bonds issue
expenses Balance
(12%)

82
Beginning - - - Br. 360,460 Br. 4,639,540
End of year 1 Br.500,000 Br. 572092 72,092 288,368 4,711,632
End of year 2 500,000 572092 72,092 216,276 4,783,724
End of year 3 500,000 572092 72,092 144,184 4,855,816
End of year 4 500,000 572092 72,092 72,092* 4,927,908
End of year 5 500,000 572092 72,092* -- 5,000,000
* Result of rounding up of some amounts.

Interest paid =5000, 000*0.1=500,000 discount Amortization=360,460/5=72,092

Interest expense=500,000+72,092=572,092 Carrying amount=4,639,540+72,092=54,711,632

Journal entries to record the first two annual interest payments under case 1 using
straight – line method.
End of year 1: Bond Interest Expense 572,092
Cash 500,000
Discount on Bonds payable 72,092
End of year 2: Bond Interest Expense 572,092
Cash 500,000
Discount on Bonds payable 72,092
Premium amortization table under case 2 using straight – line method.
Time Interest paid Effective Premium Bond Carrying amount
(10%) interest Amortization premium of bonds issue
expenses Balance
(8%)
Beginning - - - Br. 399,255 Br. 5,399,255
End of year 1 Br.500,000 420,149 79,851 319,404 5,319,404
End of year 2 500,000 420,149 79,851 239,553 5,239,553
End of year 3 500,000 420,149 79,851 159,702 5,159,702
End of year 4 500,000 420,149 79,851 79,851* 5,079,851
End of year 5 500,000 420,149 79,851* - 5,000,000

Interest paid =5000, 000*0.1=500,000 premium Amortization=399,255/5=79,851

Interest expense=500,000-79,851=420,149 Carrying amount=5,399,255-79,851=5,319,404

Journal entries to record the 1st two interest payment under case 2 using straight-
line method.
End of year 1: Bond interest expense 420,149
Premium on Bonds payable 79,851
Cash 500,000
End of year 2: Bond interest expense 420,149
Premium on Bonds payable 79,851
Cash 500,000
Exercise

83
Corporation issued 5 years, $100,000 of 8 percent term bonds on January 1, 2010, , with
interest payable semi annually each July 1 and January 1 and unfortunately market rate risen to
10% By using the effective-interest method, Compute
Proceed/bond price
Amount of discount
Prepare discount amortization schedule
Record necessary journal entry
SOLUTION

Amortization schedule is done as follows.

To records the issuance of its bonds at a discount on January 1, 2010, as follows:

Cash 92,278
Discount on Bonds Payable 7,722
Bonds Payable 100,000
To records the first interest payment on July 1, 2010, and amortization of the discount as follows:
Bond Interest Expense 4,614
Discount on Bonds Payable 614
Cash 4,000
To records the interest expense accrued at December 31, 2010 (year-end) and amortization
Bond Interest Expense 4,645

84
 Bond Interest Payable 4,000
Discount on Bonds Payable 645
Bonds Issued at a Premium
Example assumes the fact in the example above, except effective interest rate of 6 percent.
By using the effective-interest method, Compute
Proceed/bond price
Amount of Premium
Prepare premium amortization schedule
Record necessary journal entry
Solution

The five-year amortization schedule appears as follows.

To records the issuance of its bonds at a premium on January 1, 2010, as follows:

Cash 108,530
Premium on Bonds Payable 8,530
Bonds Payable 100,000
To records the first interest payment on July 1, 2010, and amortization of the premium as follows:
Bond Interest Expense 3,256
Premium on Bonds Payable 744
Cash 4,000

85
 CHAPTER 8

LONG TERM INVESTMENTS

===============================================
INVESTMENT ACCOUNTING APPROACHES
Long-term investments refer to the investments made in various financial instruments that the
investors plan to hold for a longer period, normally a year or more. TYPES OF
INVESTMENT
Debt Investment/security Investment
Equity Investment
INVESTMENTS IN DEBT SECURITIES
Debt investment represents a creditor relationship with another entity. Example government
securities, municipal securities, corporate bonds, convertible debt, and commercial paper
Your gains are not directly based on the performance of the borrower/ the profitability of the
company borrowing money from you. If the borrower company happens to prosper, you have
nothing to do with the profits it makes. For instance, if you buy a $1,000 corporate bond from X
corporation and then X Corporation makes a record profit; your profit is the same as if X

 Corporation has earned no profit at all.
Debt based investments are 
seen as lower risk and therefore usually earn a lower rate of return
 (again, over the long term)
 payments on specified dates of principal and
Debt investments are characterized by contractual
interest on the principal amount outstanding 
 Debt investment is Investing in lending, saving

 In debt investment, the investors Return is from interest.

 In debt investment, investor earned fixed income periodically

In debt investment, Return is based on Maturity

For Reporting purpose, Companies categories debt Investment into three separate
Held-to-maturity: Are the debt securities acquired with the intent to hold them until maturity.
Key Characteristics:

These securities are typically debt instruments, such as bonds or notes.


The company must have the intent and ability to hold the securities until maturity. If this
intent changes, the securities must be reclassified.

They are measured and recorded at amortized cost, using the effective interest method.

Unrealized gains or losses are not recognized in profit or loss,

86
 Companies mostly use held to maturity securities to protect themselves against interest rate
fluctuations, diversify their investment portfolios, and realize a small, low-risk capital gain
over a longer period of time.

EXAMPLEOFDEBTINVESTMENTS—AMORTIZEDCOST
To illustrate the accounting for held-to-maturity debt securities ,assume that Robinson Company
purchased 5Years,$100,000 of 8percent bonds of Ever Master Corporation on
January1,[Link] bonds yield10%;interest is payable semi annually each July1and January1.
Record journal entries on January 1, for the purchase of held-to-maturity security
Prepare amortization schedule
Records the receipt/ payment of the first two semiannual interests
Compute the amortized cost of the held-to-maturities after each interest receipt/payment
Solution 1.

Robinson Company Ever Master Corporation

Jan1, 2009 Debt investments/ Held-to-maturity securities92,278 Cash 92,278
Cash 92,278 Bond discount 7,722
Bond payable 100,000

2 Amortization table is follows

8% Bond Purchased to yield 10%

Year Cash received Interest Bond Carrying Value
(8%) revenue (5%) discount/premium of Bond
amortization
0 - ------ ____ 92,278
1 4,000 4,614 614 92,892
2 4,000 4,645 645 93,537
3 4,000 4,677 677 94,214
4 4,000 4,711 711 94,925
5 4,000 4,746 746 95,671
6 4,000 4,783 783 96,454
7 4,000 4,823 823 97,277
8 4,000 4,864 864 98,141
9 4,000 4,907 907 99,048
10 4,000 4,952 952 100,000
Total 40,000 47,722 7,722 0

3. Records the receipt/ payment of the first two semiannual interests

Robinson Company Ever Master Corporation

st
1 Cash 4,000 Interest Expense 4,614
Debt investment 614 Bond discount 614

87
 Interest revenue Cash 4,000
4,614
2nd Cash 4,000 Interest Expense 4,614
Debt investment 614 Bond discount 614
Interest revenue Cash 4,000
4,614

Amortized cost of securities after 1st interest received

Held-to-maturity securities 92,278
Add Discount on securities 614
Amortized cost of securities after 1st interest received 92,892
Amortized cost of securities after 2nd interest received
Held-to-maturity securities 92,978
Add Discount on securities 645
Amortized cost of securities after 2 nd interest received 93,537
Trading securities Trading securities are the types of short-term investments that the company
usually purchases with the intention of selling them back in a short period of time for a profit

 Initially recognized at fair value, including transaction costs.
 at each reporting date,
Subsequently, trading securities are measured at fair value
 with changes in fair value recognized in profit or loss.
 gains or losses from trading securities are reported in the
Realized and unrealized
 income statement.
 can be found on the balance sheet at the fair value on the balance
These securities
 sheet date.
  in trading securities is reported in the balance sheets of the company in the form of
Investment
assets. 
If market value is more than the original cost, there is an unrealized gain. Else, it is known
as unrealized loss.
TRADING SECURITIES EXAMPLE
On June 1, ABC Company purchases 10,000 shares of X corporations for $200,000 for the trading
purpose in which the company intends to realize a gain by holding the shares for a short period of
time. On August 31, the ABC Company sells all 10,000 of the purchased shares of X corporations for
$220,000.
What are the journal entries for the trading securities above?
Solution:
On June 1 Trading securities 200,000
Cash 200,000

88
When the company ABC sells the 10,000 shares of X corporations for $220,000 on August 31, it can
make the sale of trading securities journal entry by recording the $20,000 ($220,000 – $200,000) in
the realized gain on sale of investments
On August 31 Cash 220,000
Realized gain on sale of investments 20,000
Trading securities 200,000
Example 2
For example, on July 1, the company ABC purchases 5,000 shares of Z corporations for trading
purposes. On the purchasing date, the company ABC pays $5 per share which totals to $25,000 for
the 5,000 shares of Z corporations (including brokerage fee). On September 30, due to the market
situation, the company ABC decides to sell all 5,000 shares of Z corporations for $20,000 resulting in
a loss of $5,000.
What are the journal entries for the purchase and sale of trading securities from Z Corporation
above?
Solution:
On July 1 Trading securities 25,000
Cash 25,000
When the company ABC sells the trading securities for a loss of $5,000 on September 30, it can make
the journal entry for the loss on sale of trading securities as below:
On September 30 Cash 20,000
Realized loss on sale of investments 5,000
Trading securities 25,000

Available-for-sale: Debt securities not classified as held-to-maturity or trading securities.

Available for Sale Securities are those debt or equity securities investments by the company that
are expected to sell in the short run and therefore will not be held to maturity. These are reported on
the balance sheet at fair value.

 Available-for-sale securities are reported at fair value.

Therefore, it cannot be held to maturity and recorded on the balance sheet at fair value.

Unrealized gains and losses are includedin accumulated other comprehensive income within
 the equity section of the balance sheet.
Nevertheless, any unrealized gains and losses from such securities are not recorded inthe
 Income Statement but in other comprehensive income as a shareholders’ equity part.
Under IFRS, any change in fair value is broken down into two components: change in fair
value due to currency fluctuation and change in fair value due to change in investment value. 
The change in fair value due to fluctuation in currency value is taken to the income statement

89
 while the change in fair value due to change in value of investments is taken to the
shareholders' equity.
If the fair value of an investment increases, the carrying amount of the investments is debited
and the 'changes in fair value of AFS investments' (equity) is credited. If the fair value of the
investments decreases, the carrying amount of the investments is decreased and the changes in

 fair value of AFS investments (equity) is debited.
But any unrealized gains and losses are not recognized in the income statement but are
reported in other comprehensive income as a part of shareholders’ equity.
Comparison Among Available For Sale Securities, Trading Securities, Held To
Maturity Securities

Feature Held-to-Maturity (HTM) Trading Securities Available-for-Sale (AFS)

Debt securities with intent to Short-term securities for Non-trading, not HTM or
Classification
hold trading Trading
Fair value, recognized in
Measurement Amortized cost Fair value, recognized in OC
profit
Recognition of Only realized gains/losses in Realized and unrealized Unrealized gains/losses in
Gains/Losses profit in profit OCI, realized in profit
Reclassification on
Required if intent changes Not allowed Not required
Change of Intent
Typical
Bonds, notes Stocks, bonds, derivatives Bonds, equity securities
Instruments

Illustration below identifies these categories, along with the accounting and reporting treatments
required for each.

EQUITY INVESTMENT

90
 Equity investment is buying shares directly from companies or other individual investors with
the expectation
 of earning dividends or reselling the same to make gains when the prices are
 high.
Equity based investments are seen as higher risk and therefore typically earn a higher rate of
return over the long term. This is why we even bother with equity-based  investments, instead
 of putting our money into (theoretically) safer debt based investments.
An equity investment is money that is invested in a company by purchasing shares  of that
 company in the stock market. These shares are typically traded on a stock exchange.
Equity securities represent ownership interests such as common, preferred, or other capital
stock. They also include rights to acquire or dispose of ownership interests at an agreed-upon
or determinable price, such as in warrants, rights, and call or put options. By definition, equity

securities have no maturity date. 
 Equity investment is investing in companies and real state

 In Equity investment, Return is from regular dividend

 In Equity investment, investors Earn from the growth of the company each year

 In Equity investment, Return is based on the complete revenue of total profit


In Equity investment, the dividend that shareholders usually receive cannot be predicted or
controlled
Equity securities receive the same treatment, except that they are divided into only two categories:
Trading securities
Available-for-sale securities
There is no held-to-maturity category, since stocks do not have a maturity date.
EQUITY METHOD (IAS 28)

The equity method is used when the investor has significant influence over the investee, typically
in cases where the investor holds between 20% and 50% of the voting rights of the investee or has
significant influence over the financial and operating decisions of the investee.
This occurs when an investor has the power to participate in the financial and operating policy
decisions of the investee but does not control or jointly control those decisions.

The investor records the investment in the investee at cost initially,

The investor recognizes its share of the investee’s profits or losses in its financial statements.

These are included in the investor's income statement.

Dividends received from the investee reduce the carrying value of the investment, as they are
seen as a return on investment.

91
 Changes in the Carrying Amount of the investment is adjusted for the investor's share of
profits or losses, dividends, and other changes in the investee's equity (such as revaluation of
assets).
 ways. Examples include
Significant influence may be indicated in several
 representation on the board of directors

 Participation in policymaking processes

 Material intercompany transactions,

 Interchange of managerial personnel, or

Technological dependency

The Fair Value Method (IFRS 9)

The fair value method is primarily used when the investor does not have significant influence or
control over the investee. This is often the case when the investor holds less than 20% of the voting
rights or lacks the ability to significantly affect the investee’s financial and operational decisions.

 Investments are initially recorded at fair value.

 Changes in fair value are recognized directly in profit or loss.

 Investment income includes dividends received and changes in the market value of the
investment. 
 No recognition is given to the income earned by the subsidiary.

 Dividends received from the investee increase the carrying value of the investment

Holdings of less than 20 percent (fair value method)—investor has passive interest.
Holdings between 20 percent and 50 percent (equity method)—investor has significant influence.
Holdings of more than 50 percent (consolidated statements)—investor has controlling interest.
The following illustration lists these levels of interest or influence and the corresponding
valuation and reporting method those companies must apply to the investment.

The accounting and reporting for equity securities therefore depend on the level of influence and
the type of security involved, as shown below.

92
Comparison of Equity Method and Fair Value Method

Criteria Equity Method Fair Value Method

No significant influence or control
Control/Influence Significant influence (20%-50% ownership)
(less than 20%)
Initial Recognition Recorded at cost initially Recorded at fair value initially
Subsequent Adjusted for share of profit/loss, dividends, other Measured at fair value (FVTPL or
Measurement OCI FVTOCI)
Income Statement Gains/losses on fair value changes
Share of profit or loss included
Impact recognized
Balance Sheet Impact Investment shown as a non-current asset Investment shown at fair value
Dividends Reduces the carrying amount of the investment Recognized in profit or loss
Applicability Significant influence or joint control (IAS 28) No significant influence (IFRS 9)

HOLDINGS OF LESS THAN 20%

To illustrate the equity method and compare it with the fair value method, assume that Maxi
Company purchases a 20 percent interest in Mini Company. To apply the fair value method in this
example, assume that Maxi does not have the ability to exercise significant influence, and classifies
the securities as available-for-sale. Where this example applies the equity method, assume that the 20
percent interest permits Maxi to exercise significant influence. The following illustration shows the
entries.

93
Note that under the fair value method, 
 Maxi reports as revenue only the cash dividends received from Mini.
The earning of net income by Mini (the investee) is not considered a proper basis for
recognition of income from the investment by Maxi (the investor). Why? Mini may
permanently retain in the business any increased net assets resulting from its profitable

operation. Therefore, Maxi only earns revenue when it receives dividends from Mini.
Under the equity method, 
 Maxi reports as revenue its share of the net income reported by Mini.
Maxi records the cash dividends received from Mini as a decrease in the investment carrying
value. As a result, Maxi records its share of the net income of Mini in the year when it is
earned. With significant influence, Maxi can ensure that Mini will pay dividends, if desired,

on any net asset increases resulting from net income.

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CHAPTER 9: ACCOUNTING FOR PARTNERSHIP FORM OF BUSINESSES
Definition: A partnership is an association of two or more persons to carry on, as co-owners, a
business for profit. According to the definition the following key terms are very important to be
considered:
An association: formed based on the willingness of the partners.
Two or more parsons: it is necessary to form to have at least two persons. The maximum number is
determined by the commercial law of the country of operation. Carry-on: partners are highly
involved in operational and managerial activities.
Co-owners: once the partners contribute identifiable assets to the partnership and the partnership is
formed, it never will be claimed further by the individual partners who have contributed.
Characteristics of Partnerships
A partnership form of business may have the following basic characteristics:
Ease of Formation: in contrast with a corporation, a partnership may be created by an oral or written
contract between two or more persons.
Limited Life: a partnership may be ended by death, retirement, bankruptcy, or incapacity of a partner.
The admission of a new partner to the partnership legally dissolves the former partnership and
establishes a new one.
Mutual Agency: each partner has the authority to act for the partnership and to enter in to contracts
on its behalf.
Co- Ownership of Partnership Assets and Earnings: when individuals invest assets in a partnership,
they retain no claim to those specific assets but acquire an ownership equity interest in net assets of
the partnership. Every member of a partnership also has an interest in partnership earnings.
Unlimited liability: all partners have unlimited personal liability for unpaid debts of the partnership.
In the case of limited partnership, only general partners are responsible for the contractual obligations
of the partnership.
It is not viewed as a taxable entity: a partnership pays no income tax but is required to file an annual
information return showing its revenue and expenses, the amount of its net income, and the division
of income among the partners. Thus, the partners do pay tax from their respective shares of income
from the partnership operations. And hence there is no double taxation like a corporation.
Active participation in management by partners: the partners are directly involved in managing the
organization.
Advantages and Disadvantages of Partnerships
Advantages of Partnerships

95
  Any oral or written agreement is necessary to create legally binding
Ease of formation:
 partnership.
purposes, the government
Tax related: partnership itself pay no income taxes. For taxation
does not view a partnership as an entity apart from its owners.

Unlimited liability: Any partner can be held personally liable for all debts of the business.
Because, if the partnership fails to pay its debts; creditors
 can seek satisfactory remuneration
 assets of any partner that they choose.
from the personal
 Limited life:
 to raise as much capital
Growth limitations: for a partnership form of businesses it is difficult
as corporations due to the limited number of partners involved.
Types of Partnership
According to the type of agreements made by the partners, partnerships normally are classified in to
two:
General partnership consists of several general partners who may act publicly on behalf of the firm
and who are personally liable for obligations of the partnership.
A limited partnership consists of one or more general partners and one or more limited or special
partners who contribute capital but do not participate in management of the firm. The limited
partners’ liability for partnership obligations is limited to their interest in the partnership.
The partnership Contract
Although a partnership may exist on the basis of an oral agreement, in written or implied by the
actions of its members, good business requires that the partnership contract be in written.
This legal covenant is often referred to as the “Articles of Partnership” and forms the central
governance for the operation of a partnership.
The articles of Partnership may contain a number of requirements; an explicit understanding should
always be reached in regard to the following:

 Name and address of each partner and Business location

 Description of the nature of the business

 Authority, rights and responsibilities of each partner

 Initial contribution along with the method to be used for valuation

 Insurance on the lives of partners, or surviving partners named as beneficiaries.

 Specific method by which profits and losses are to be allocated

 Periodic withdrawal of assets by each partner

Procedures for admitting new partner

96
Accounting for Partnership formation
Cash Contributions
The accounting treatment of such contribution would be handled simply by debiting the total of cash
contributed and crediting the specific capital of each partner. Example:

Assume that Alem and Belay form a business to be operated as a partnership. Alem contributes Birr
50,000 in cash whereas belay invests Birr 20,000.
The initial journal entry to record the creation of this partnership is as follows:
Cash ........................................................................ 70,000
Alem, Capital ................................................ 50,000
Belay, Capital .............................................. 20,000
To record cash contributed to start new
partnership Non-Cash Assets Contributions
When one or more of the partners transfer non-cash assets such as receivable, inventory, land,
equipment, or a building to the business.
Each item transferred to a partnership is initially recorded for external reporting purposes at current
fair value.
Example:
Assume that Lema invests Birr 50,000 in cash while Mamo contributes the following assets to form
LM- Partnership:
Book Value Fair Market Value
Inventory ................................... Birr 9,000 Birr 10,000
Land ........................................ 12,000 14,000
Building ..................................... 32,000 46,000
Total ........................................... 53,000 70,000
Ato Mamo has a Birr 20,000 mortgage payable on the building that the partnership has agreed to
assume.
Considering the fair values of the accounts, Ato Mamo's net investment is equal to Br. 50,000 (Br.
70,000 less Br. 20,000). The following journal entry records the formation of the partnership created
by these contributions:
Cash ................................................................ 50,000
Inventory........................................................ 10,000
Land ............................................................... 14,000
Building ......................................................... 46,000

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 Mortgage, payable ................................. 20,000
Lema, capital......................................... 50,000
Mamo, Capital...................................... 50,000
To record properties contributed to start partnership.
The Br. 50,000 capital balance represents an ownership interest in the business as a whole but does
not constitute a specific claim.
The bonus method and the goodwill method.
Each of these approaches achieves the desired result of establishing equal capital account balances.
Recorded figures, however, can vary significantly depending on the procedure selected.
The Bonus Method
This approach recognizes only the assets that are physically transferred to the business (such as cash,
inventory, building etc…).
Ato Kebede and w/r Hana have contributed a total of Birr 70,000 in identifiable assets to their
partnership and have decided to have equal capital balance. According to the bonus method, this
agreement is fulfilled simply by splitting the Birr 70,000 capital figure evenly between the two
partners. Under this circumstance, Ato Kebede essentially pays a bonus of Br. 15,000(i.e. the
recorded capital balance in excess of the Br. 20,000 cash contribution) to w/r Hana, in the form of an
increased monetary equity in the firm, as an incentive to enter the partnership venture. Therefore, the
following entry records the formation of this partnership under this assumption.
Cash 70,000
Kebede, capital 35,000
Hana, capital 35,000
To record cash contribution with bonus to w/r Hana because of artistic abilities
The Good will Method
The goodwill method is based on the assumption that an implied value can be calculated
mathematically and recorded for any intangible contribution. In the above illustration Hana
contributes br 30,000 less cash than Kebede but receives an equal amount of capital according to
partnership agreement. proponent of the good will argue that Hana’s artistic talent has an apparent
value of 30,000, a figure that should be included as part of this partner’s investment. The following
entry records the formation of partnership under this assumption.
Cash…………………………………………………..70,0000
Goodwill………………………………………………30,0000
Kebede Capital…………………………………………………..50,000
Hana Capital………………………………………..……………50,000
To record cash contribution with goodwill attributed to Hana in recognition of artistic abilities

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Withdrawals
Withdrawals are allowed on a regular periodic basis as a reward for ownership or as compensation for
work done in the business. Often such distributions are recorded initially in a separate drawing
account that is closed into the individual partner's capital account at year's end.
Assume, for illustration purposes, that Kebede and Bekele take out Birr. 1,200 and Birr. 1,500
respectively, from their business. The journal entry to record these payments is as follows:
Kebede, drawing .................................................................. 1,200
Bekele, Drawing .................................................................. 1,500
Cash ........................................................................ 2,700
To record withdrawal of cash by partners
Larger amounts might also be withdrawn from a partnership on occasion. Such transactions are
usually infrequent occurrences and in amounts significantly greater than the partner's periodic
drawing. Prior approval by the other partners may be required by the Articles of Partnership.
ALLOCATION OF INCOME OR NET LOSS AMONG PARTNER
There are many possible plans for sharing net income or loss among the partners of a partnership are
summarized in the following categories:

Equally or in some other ratio

Ratio of partner's capital account balances on a particular date, or in the ratio of average capital
balances in the year.

  account balances and dividing the remaining net

Allowing interest on partners' capital
income or loss in a specified ratio 
 Division of Income Based on the partners' Capital Account Balances

  salaries to partners and dividing the resultant net income or loss in a specified
Allowing
ratio. 
Division of Income Equally or in Some Other Ratio
Many partnership contracts provide that net income or loss is to be divided equally. Also, if the.
Example:
On January 1, 2004, Addis, Belete and Chala have formed a partnership by investing cash of Birr
150,000, Birr 90,000 and Birr 60,000, respectively. At the end of the first year of operations, the
partnership reports net income of Birr 60, 000.
The income allocation under alternative plans will be:
They agreed to share profit and losses equally. Therefore, the net income of the partnership is
transferred by closing entry on December31, from the income summary ledger account to the
partners' capital accounts by the following journal entry:

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 Income summary ............................................................. 60,000
Addis, Capital ...................................................... 20,000
Belete, Capital ..................................................... 20,000
Chala, Capital ..................................................... 20,000
Assume that the partners agreed to share profit and loss in the ratio of [Link] respectively.
In this case the allocation would be :
Addis=4/10 x 60,000=24,000
Belete=3/10 x 60,000= 18,000
Chala=3/10x 60,000 = 18,000
Total .......................... 60,000
The journal entry to close the Income summary ledger account would be similar to the journal entry
illustrated above
Division of Income Based on the partners' Capital Account Balances
When the partners' capital investments are to be used as the basis for allocating profits, to avoid
controversy the partnership agreement should specify whether the amount of capital investments for
allocation purposes is to be:
The original capital investments
Example:
Continuing the illustration for Addis, Belete and Chala partnership, assume that the partnership
contract provides for division of net income in the ratio of original capital investment. The net income
of Birr 60,000 for 2004 is divided as follows:
Addis: Br.60, 000 X Br150, 000/300,000= Br30, 000
Belete: Br60, 000 XBr.90, 000/300,000= Br. 18,000
Chala: Br.60, 000 X Br.60, 000/Br.300,000= Br.12,000
The journal entry to close the Income summary ledger account would be similar to the journal entry
illustrated in the first example.
Example:
Alex and Ayalew form 2A-parrtnership at the beginning of the year 2005. Ayalew invested Birr
400,000 on January1, 2005 and an additional Birr 100,000 on April [Link] invested Birr
800,000 on January 1 and withdrew Birr 50,000 on July1. During 2005, the first year of operations
the partnership reported a net income of Birr 300,000.
Case one: Assuming that the net income is divided in the ratio of capital account balance at the end of
each accounting period (before distribution of net income or loss).
Under this case the net income of the period is allocated between the partners as follows:

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 Alex: Br. 300,000 X Br. 500,000 /Br 1,200,000 =Br. 120,000
Ayalew: Br.300,000 X Br. 750,000/ Br.1,200,000=Br.180,000
Case Two: Assuming that the net income is divided in the ratio of average capital account balance.
The computations of average capital balances and to the nearest month and the division of net income
for 2A-Ppartnership for the year 2005 are as follows:

PARTII: PARTNERSHIP DISSOLUTION AND LIQUIDATION

This part of the chapter focuses on two major issues: accounting for partnership dissolution and
partnership liquidation. The first section is dealing about the major reasons of partnership dissolution
as well as the accounting treatment of partnership dissolutions.
Section One: Accounting for Partnership Dissolution
The term dissolution maybe used to describe events ranging from minor change of ownership interest
not affecting operations of the partnership to a decision by the partners to terminate the partnership.
There is a change in the relation of the partners caused by any partner ceasing to be associated in the
carrying on as distinguished from the winding up of the business.
Dissolution of a partnership may result from the retirement, death of a partner, by the admission of a
new partner, from the bankruptcy of the firm or of any partner, the expiration of a time period stated
in the partnership contract or the mutual agreement of the partners to end their association.
1.1. Nature of Partnership Dissolution
Most changes in the ownership of a limited liability of a partnership are accomplished with out
interruption of its operations. For instance, when a large partnership promotes one of its employees to
partner, there is usually no significant change in the finances or operating routines of the partnership.
However, from a legal viewpoint a partnership is dissolved by the retirement or death of a partner or
by the admission of a new partner.
Dissolution of a partnership also may result from the bankruptcy of the firm or any partner, the
expiration of a time period stated in the partnership contract, or of mutual agreement of the partners to
end their association. Thus, the term dissolution maybe used to describe events ranging from minor
change of ownership interest not affecting operations of the partnership to a decision by the partners
to terminate the partnership.

The following components of this section describe and illustrate the principal kinds of changes in the
ownership of a partnership.
1.2. Admission of a New Partner

101
When a new partner is admitted to a firm of two or three partners, it is particularly appropriate to
consider the fairness and adequacy of past accounting policies and the need for correction of errors in
prior years' accounting data. The terms of admission of a new partner often are influenced by the level
and trend of past earnings, because they may be indicative of future earnings. Adjustments are
commonly made for the partnership accounting records to restate the carrying amounts of assets and
liabilities to current fair values before a new partner is admitted.
1.2.1. Admission through Purchase of a Current Interest
A new partner also may be admitted to the partnership by acquiring all or part of the capital interest of
one or more existing partners in exchange for some consideration (assets). In this case, the new
partner deals directly with an existing partners or partners rather than with the partnership entity.
Therefore, the acquisition price is paid to the selling partner(s) and not to the partnership it self.
The partnership records to redistribution of capital interests by transferring all or a portion of the
seller's capital to the new partner's capital account but does not record the transfer of any assets.
Example:
The following information is available relating to the partners Lema, Melat and Nebyou :
Partner Capital Balance Profit and Loss ratio
Lema. ....................................... Br.50,000 20%
Melat ...................................... 30,000 50
Nebyou ...................................20,000 30
Total .............................. Br.100.000

Assume that each of these three partners elects to transfer a 20 percent interest to Kula for a total
payment of Birr 30,[Link] to the agreement , the money is to be paid directly to the owners.
There are different approaches of recording the admission of Kula. One approach to the recording of
this transaction is that, since Kula purchase is carried out between the individual parties, the
acquisition has no impact on the assets and liabilities held by the partnership. Because the business is
not involved, the transfer of ownership requires a simple capital reclassification without any
accompanying revaluation. Book value is retained. This approach is similar to the bonus method; only
a legal change in ownership is occurring so that neither revaluation of assets or liabilities nor goodwill
is appropriate. Thus, this approach is also called as a book value approach. According to this approach
the admission of Kula would be recorded as follows:
Lema, Capital ....................................................... 10,000
Melat, Capital ....................................................... 6,000
Nebyou, Capital...................................................... 4,000
Kula, Capital ........................................ 20,000

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 Reclassification of capital to reflect Kula acquisition
Exercise
Assume A and B are the partner with the capital balance of br 25000 and 15000 respectively who
share profit and loss equally. Assume C is admitted to the partnership by purchasing one fifth
interest from A and B by paying br 10,000
Reqiured:a.
prepare add mission of C
calculate total capital balance after admission of C

1.2.2. Admission by Contribution of Assets Made to the Partnership

A new partner may admitted solely by the partnership by contributing cash or other assets directly to
the business rather than to the partners. In this case, the exchange represents an arm's - length
transaction between the entity and the incoming partner.
A. Bonus to Original Partners
When an incoming partner’s contribution indicates the existence of unrecorded net asset appreciation
and/or unrecorded goodwill the bonus method does not record these previously unrecorded items but
rather grants a ''bonus'' to the old partners. The bonus, which increases the capital accounts of the old
partners, is made possible by recording in the new partner’s capital account only a portion of the
actual contribution to the partnership. In this case a newly coming partner contributed more asset to
the partnership but obtained less amount of ownership interest in the partnership. Example:

Assume that Dejene and Zeleke maintain a partnership and presently report capital balances of Birr
80,000 and Birr 20,000 respectively. According to the Articles of Partnership, Dejene is entitled to 60
percent of all profits and losses with the remaining 40 percent credited to Zeleke. By agreement of the
partners, Elias being allowed to enter the partnership for payment of Birr 20,000.
Therefore the admission of Elias would be recorded:
Cash ......................................................................... 20,000
Dejene, Capital ......................................... 4,800
Zeleke, Capital .......................................... 3,200
Elias, Capital ............................................. 12,000
To record Elias's admission in to the partnership
B. Bonus to New Partner
As previously discussed, a new partner also may be contributing some attributes such as valuable
skills or business contacts other than tangible assets to this partnership. To ensure the admission of

103
the new partner, the present firm may offer the new partner a larger equity in net assets than the
amount invested by the new partner. Therefore, the Articles of Partnership may be written to credit a
bonus to the new partner rather than the original partners.
Take the admission of Elias to the partnership of Dejene and Zeleke. And assume, because of an
excellent professional reputation, and valuable business contacts, Elias receives a 20 percent interest
in the partnership in exchange for the Birr 20,000 cash investment.
The bonus method sets Elias's initial capital at Birr 24,000(20 percent of the Birr120,000 book value
).To achieve this balance, a capital bonus of Birr 4,000 must be credited to Elias by the present
partners:
Cash ......................................................................... 20,000
Dejene, Capital ......................................................... 2,400
Zeleke, Capital .......................................................... 1,600
Elias, Capital...................................... 24,000
To record Elias's entrance into partnership

1.3. Withdrawal of a Partner

Admission of a new partner is not the only method by which a partnership can undergo a change in
composition. Over the life of the business, partners occasionally leave the organization. Death or
retirement can occur, or a partner may simply elect to withdraw from the partnership. The Articles of
Partnership also can allow for the expulsion of a partner under certain conditions.

[Link] an Interest to One or More Continuing Partners

As in the case with the admission of a partner the withdrawal of a partner may involve (1) a
transaction with existing partners or a new partner, or (2) a transaction with the partnership entity it
self. In the first case, the equity of the withdrawing partner will be purchased with the personal assets
of existing or new partners rather that with the assets of the partnership. Example:

Assume the following data for XYZ-Partnership.

Partner

X Y Z
Capital balance Br. 30,000 Br. 50,000 Br. 20,000
Profit & loss percentage 40% 40% 20%
Percentage interest in capital 30% 50% 20%

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Now assume that partner X withdraws from the partnership and that Z purchases X's interest at its
current value of Birr 36,000. If the price paid by Z is not used to impute the value of the entity the
transaction would be recorded as follows:

X, Capital ............................................................ 30,000

Z, Capital............................................................... 30,000
To record the withdrawal of partner X

As previously discussed, an alternative treatment would be to recognize any value increment

indicated by the transaction and then transfer the adjusted capital balances.

1.3.2. Selling an Interest to the Partnership

When a withdrawing partner sells an interest to the partnership rather than to an individual partner,
the bonus or goodwill methods may be employed. In this case, the cash or other asset distributed to
the retiring partner will not necessarily equal to his/her capital book value. Rather the amount will be
determined through negotiations and appraisal . However, the bonus method is used most frequently
but the choice between methods should be based on a thorough analysis of the transaction. A. Bonus
Method
Depending on the amount of cash or other asset distributed to the withdrawing partner in relation to
his/her capital balances in the partnership, a bonus may be given either to the the retiring partner or to
the continuing partners. These issues will be covered in the the following paragraphs. I. Bonus to a
Retiring Partner
If it is believed that the partnership has internally generated goodwill or the retiring partner's capital
balance is less than what he/she is worth, the retiring partner will receive his capital balance plus his
share of internally generated goodwill or a bonus.
Example:
Using the same facts as in the previous illustration and assuming the use of the bonus method the
purchase of X's equity by the partnership would be recorded as follow:
X, Capital ........................................................ 30,000
Y, Capital ......................................................... 4,000
Z, Capital .......................................................... 2,000

105
 Cash ....................................................... 36,000
To record the withdrawal of partner X
II. Bonus to Continuing Partners
On the other hand, a retiring partner may receive a settlement price less than the carrying amount of
his/her ownership equity in the partnership. The possible explanations of this may include
unsatisfactory business situation, personal problems of the retiring partner as well as the reduction in
the value of the net assets of the partnership. In such type of cases the difference between settlement
price and his/her ownership equity in the partnership would be credited to the continuing partner as
bonus.
Example:
Using the same facts as in the previous illustration and assuming the use of the bonus method the
purchase of X's equity by the partnership and also assume the retiring partner X is paid Birr 24,000
rather than Birr 36,000 upon withdrawal. Accordingly, the withdrawal partner X would be recorded
as follow:
X, Capital ........................................................ 30,000
Y, Capital ......................................................... 4,000
Z, Capital .......................................................... 2,000
Cash ....................................................... 25,000
To record the withdrawal of partner X
Accounting for Partnership Liquidation
The liquidation of a partnership means winding up its activities, usually by selling assets, paying
liabilities, and distributing any remaining cash to the partners. In some cases, the partnership net
assets may be sold as a unit; in other cases, the assets may be sold in installments, and most or all of
the cash received must be used to pay creditors. A business enterprise that has ended normal
operations and is in the process of converting its assets to cash and making settlement with its
creditors is said to be in liquidation, or in the process of being liquidated. This process of liquidation
may be completed quickly, or it may require several months or even years.

 Process must record:

In generating this data for a partnership, The Liquidation
 The conversion of partnership assets into cash

 The allocation of the resulting gains losses

 The payment of liabilities and expenses

Any remaining unpaid debts to be settled or the distribution of any remaining assets to the
partners base on their final capital balances

106
Illustration

The partnership of Resom, Sultan, and Tassew is liquidated on September 1,2002. The income and
loss sharing ratio of the partners is: Resom 40%, Sultan 35%, and Tassew 25%. After discontinuing
the ordinary business operations of their partnership and closing the accounts, the following summary
of a trial balance is prepared:

R, S And T
Trial Balance
Septamber 1, 2002

Debit Credit
Cash 10,000
Other assets 90.000
Liabilities 10,000
R. Capital 30,000
S. Capital 30,000
T. Capital ________ 30,000
Total 100,000 100,000

Based on the information on the trial balance, accounting for liquidation of R,S, and T partnership
will be illustrated using different selling prices for the non cash assets.

Case One: Gain On Realization

Assume that Resom, Sultan, and Tassew sell all noncash assets for Birr 95,000,
Case two: Loss on Realization: No capital Deficiencies

Assume that Resom, Sultan, and Tassew sell all non cash assets for Birr 70,000,
Case three: Loss on Realization with Deficiency in one Partner Capital
Assume the non-cash assets of R,S and T partnership are sold for only Birr 10,200.
Required a) prepare a partnership schedule under each case
b) Prepare a necessary journal entry for each case.

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 CHAPTER 10 ACCOUNTING FOR CORPORATION

DEFINITION: A corporation is a legal entity having an existence separate and distinct from that of
its owners. In the eyes of the law there are two persons and a corporation is an ‘artificial person’
having many of its own rights and responsibilities.
Characteristics of 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:
Income tax on its earnings;
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

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ADVANTAGES OF THE CORPORATE FORM OF ORGANIZATION
A corporate entity has many advantages not available in other forms of organization. Among the
advantages are the following:
Continuous existence: A corporation has perpetual existence in that its continuous existence is
not dissolved by the death on retirements of any of its members.
No personal liability for owners: Since a corporation is a separate legal entity, the creditors of a
corporation have a claim against the assets of the corporation, not the personal property of the
owners.
Separation of managements from ownership: the owners of a corporation (called stock holders
or shareholders) own the corporation but they do not manage it on a daily basis. To administer the
affairs of the corporation, president and other officers are hired for it. Thus, individual stockholder
has no rights to participate in the management's activity of the corporation unless the stockholder
has been hired as a corporate officer.

Easily transferable ownership shares: ownership of a corporation is evidenced by transferable

shares of stocks. These shares of stocks may be sold by one investor to another without dissolving
or disrupting the business organization.
DISADVANTAGES OF CORPORATE FORM OF ORGANIZATION
Double taxation: corporate earnings are taxed two times. The earnings are taxed first as a
corporate income taxes and again as personal income taxes if the corporation. Distributes its
earnings to stockholders.
Difficulties to control: since ownership is usually separated from managements, owners are
unable to exercise active control over management actions.
Greater regulation: since a corporation comes into existence according to the law of the state,
the law may provide for considerable regulation of the corporation’s activities.
FORMATION OF A CORPORATION
A corporation is created by obtaining a corporate charter. The charter is given from the states in
which the corporation is to be incorporated. To obtain a corporate charter an application called
articles of incorporation are prepared by t he organizers called incorporators and submitted to the state
corporations commissioner or other designated officials. These articles of incorporation specify the
purpose of the business, its location, the names of the organizers, the classes and numbers of shares of
capital stock authorized, and the consideration to be paid in by the organizers for their respective
shares. The article of incorporation is approved by the state and charter is issued. Once a charter is

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obtained a board of directors is elected. The directors in turn hold meetings at which officers of the
corporation are appointed.

Organization costs
In the process of incorporation, the organizers must pay for necessary costs such as payment of an
incorporation fee to the state, payment of fees to attorneys for their services in drawing up the articles
of incorporation, payment to promoters and variety of other outlays necessary to bring the corporation
into existence. These costs are charged to an asset account called organization costs. In the balance
sheets, organization costs appear under the ‘other assets’ caption.

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
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.

Authorized stock-is the number of shares that a corporation is authorized to issue in its charter by
the government
Issued Stock-a number of authorized shares that has been issued to date
Treasury Stock-a number of issued stock that are reacquired under various circumstances
Outstanding Stock-a number of issued stocks that are currently in the hands of the shareholders
(Issued Stock – Treasury Stock).
Par value or stated Value – is a monetary figure assigned to a stock. It the legal capital of a
corporation on a per share basis.
Stock Certificate – is the evidence of ownership issued to the shareholders

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 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.
Basic Rights of Stockholders
The stockholders who are the owners of a corporate entity have the following basic rights:
The rights to votes: the common stockholders have the right to elect the board of directors,
and thereby to be represented in the management of the business.
The rights to participate in the earnings of a corporation: Stockholders in corporations may
not make withdrawal of company assets. However, the earnings of a profitable corporation
may be distributed to stockholders is the form of cash dividend. The payment of a dividend
always requires formal authorization by the board of directors.
The rights to share in the distribution of assets upon liquid action: when a corporation ends
its existence, the creditors of the corporation must first be paid is full; any remaining assets are
dividend among stockholders in proportion to the number of shares owned.
Pre-emptive rights: the current stockholders has the right to purchase the shares of the
corporation on a prorate basis when new stocks are offered for sale. This preemptive rights is
designed to provide each stockholder the opportunity to maintain a proportional ownership in
the corporation.
AUTHORIZATION AND ISSUANCE OF STOCKS

The state officials approve the articles of incorporation, which specify the number of shares a
corporation is authorized to issue. The total number of shares that may be issued is known as the
authorized shares. When the corporation receives cash is exchange for stock certificates, which
represents the number of shares issued, the shares become issued shares. Shares that are issued and
held by the stockholders are called outstanding shares. Sometimes a corporation requires shares from
its own shareholders. These shares are called treasury stocks, which reduce the number of outstanding
shares.
A corporation may choose not to issue immediately all the authorized shares even though it is
customary to have a large number of authorized shares than presently needed. If more capital is
needed, the previously authorized shares will be readily available for issue. A corporation can apply
to the state for permission to increase the number of authorized shares.

Classes of capital stock

There are two classes of stock: common stock and preferred stock

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Common Stock: The basic types of stock issued by every corporation are called common stock.
Common stock possessed the traditional rights of ownership such as voting rights, participation
residual dividends, and residual claim to assets in the event of liquidation

 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 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
Allocation of Dividend among Preferred and Common Stock
A corporation with both preferred stock and common stock may declare dividends on the preferred
stock first, which may be stated in monetary terms or as a percent of par, and then on common stock.

Example 6.1: Assume that a corporation has 10,000 shares of Br 5 preferred Stock (that is preferred
stock has a prior claim to an annual Br 5 dividend per share) and 15,000 shares of Br 100 par,
common stock. In the first three years of operations net income was Br 80,000, 140,000, and 200,000
and the BOD decided to retain Br 30,000 each year in the business. 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 ........................................... 80,000 140,000 200,000
Retained Earnings ................................. (30,000) (30,000) (30,000)
Total Dividend ...................................... 50,000 110,000 170,000
Preferred Div. (Br 5 * 10,000 shares) .... (50,000) (50,000) (50,000)
Common Dividend ................................ 0 60,000 120,000
Dividend per Share (DPS):
Preferred DPS (Dividend Br 5 Br 5 Br 5
50,000/10,000 .......................................
Common DPS (Dividend /15,000 Br 0 Br 4 Br 5
shares) ..................................................

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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 6.2: A corporation has 3,000 shares of Br 5 preferred stock and 15,000 shares of common
Stock. Assuming the dividend declared is Br 180,000 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 Preferred Dividend (Br5 * 3,000)....... 15,000 − 15,000
Comparable Common Dividend (Br5 * − 75,000 75,000
15,000
Remainder (90,000/18,000 shares 15,000 75,000 90,000
=3000+15000) ................................................
Dividend of Each Class ................................... 30,000 120,000 180,000
Dividend per Share =Dividend/share............... Br 10 Br 10 Br 10

Cumulative and Non-cumulative Preferred Stock

Most preferred stocks are not participating. However, most preferred stocks are cumulative. That is,
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 means, in turn, dividends should not be
paid on the common stock unless regular preferred dividend and preferred dividends in
arrears, if any, are paid. Dividend in arrears means dividend 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.

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Example 6.3: A corporation has 5,000 outstanding shares of cumulative, 7 %, Br 100 par preferred
stock and 10,000 shares of common stock. Assume that dividends have not been declared for the
preceding three years. The Board declared a dividend of Br 200,000 in the year 2004. Instruction:
distribute the dividend between the preferred and the common stock

Amount of Dividend ............................................................................... Br 200,000
Preferred Dividend:


Dividend in arrears (7% * Br100 * 5,000 shares * 3 Years) .... Br 105,000
Regular Dividend (7% * Br 100 * 5000 shares) ...................... 35,000
Total Preferred Dividend ........................................................................ 140,000


Common Dividend ................................................................................. Br 60,000
Dividend per share:
 Preferred Stock: Dividend/share = Br 140,000 / 5,000 Shares = ............. Br 28
 Common Stock: Dividend /share =Br 60,000 / 10,000 Shares = .............. Br 6

6.4 Issuing Capital Stock

Stock Issuance at Par Value
Example 6.4: assume that a corporation with an authorization of 10,000 shares of preferred stock of
Br 100 par and 100,000 shares of common stock of Br 20 par, issued on half of each authorization at
par for cash. Instruction: record the investment
Cash ............................................... 1,500,000
Preferred Stock ...................... 500,000
Common Stock ...................... 1,000,000

Stock Issuance at 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 6.5: DMN Share Company issued 5,000 shares of Br 20 par preferred stock for cash at Br
30 per share. Record the investment by the shareholders Cash = 5,000 shares * Br 30 = Br 150,000

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Preferred Stock = 5,000 shares * Br 20 = Br 100,000
Additional Paid in Capital= Br 50,000
Cash ............................................... 150,000
Preferred Stock ...................... 100,000
PIC in excess par-PS ............. 50,000

Example 6.6: GG Share Company issued 10,000 shares of Br 10 par common stock for cash each at
Br 8. Record the transaction
Cash ................................................................. 8,000
Discount on CS/ PIC in Excess par-CS ............ 2,000
Cash ........................................................ 10,000

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.

Assume that 120,000 shares of RAM corporation common stock, par br. 10, are subscribed for at Br.
12 by Misrak Binda. The total is payable in three equal installments. The following entries are
processed by RAM Corporation.

Common stock subscription Receivable (120,000*12) 1,440,000

Common stock subscribed 1,200,000
Paid-in-capital in excess of par 240,000
To record receipt of subscription for 120,000 shares
Cash 480,000
Common stock subscription receivable 480,000

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 To record receipt of 1st payment
Cash 480,000
Common stock subscription Receivable 480,000
To record receipt of final payment
Cash 480,000
Common stock subscription Receivable 480,000
To record receipt of final payment

Exercise on January 1, 2004 BCD Corporation received subscription to 10,000 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%,
respectively and the stock certificate was issued on October 1. Instruction: record the stock
subscription and the related transaction
January 1: Stock Subscription Receivable .......................... 150,000
Common Stock Subscribed ...................... 100,000
Premium on common Stock ..................... 50,000
January 1: Cash ................................................................. 75,000
Stock Subscription Receivable ................. 75,000
June 1: Cash ................................................................. 30,000
Stock Subscription Receivable ................. 30,000
October 1: Cash ................................................................. 45,000
Stock Subscription Receivable ................. 45,000
October 1: Common Stock Subscribed ............................... 100,000
Common Stock ........................................ 100,000

Example of Participating and non-participating preferred stock

A participating preferred stock receives a minimum dividend but also receives higher dividend when
the company pays substantial dividends on common shares. The preferred stockholders’ right may be
to receive dividend only a stated amounts. Such stock is said to be nonparticipating. To illustrated,
assume the following information

Common stock issued 4,000

Preferred stock issued 2,000

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 
Dividend per share of preferred stock Br. 10

The corporation reported net income of Br. 150,000 for the third year and the BOD declared both of
the net income as dividend. If the preferred stock issued by the corporation is participating, the
preferred stockholders will receive. Br. 30,000 (Br. 20,000 + Br. 10,000), and the common
stockholders will receive Br. 60,000 (Br. 40,000 + Br. 20,000).

Example of Cumulative and Non-cumulative preferred stock

Cumulative preferred means that if the company fails to pay a preferred dividend, its obligation
accumulates and all omitted dividends must be paid in the future before any common dividends are
paid. The cumulative preferred stockholders would receive all accumulated unpaid dividends (called
dividend in arrears) before the holders of common shares receive anything. Preferred stock not having
these cumulative rights is called no cumulative. Example

Cumulative preferred, 10% of Br. 100 par (10,000 shares issued)


Common stock of Br. 90 par (40,000 shares issued)

The Board of Directors (BOD) did not declare dividend in year 2

Year 3 dividend declared by the BOD amounts to Br. 320,000.

Year 1 dividend declared and distributed amounts to Br. 200,000.
If the preferred stock is cumulative, the preferred stockholders will receive Br. 200,000 (Br. 100,000
+ Br. 100,000), and the common stock holders will receive Br. 120,000 (Br. 320,000 – Br. 200,000)

ACCOUNTING FOR TREASURY STOCKS

Treasury stock is a corporation’s own stock (preferred or common) that has been issued and required
by the issuing corporation. A corporation may also accept shares of its own stock in payment of debits
owed by a stockholder or as a donation from a stockholder. Treasury stock does not reduce the
number of shares issued, but does reduce the number of outstanding shares. The purchase of treasury
stock decreases both assets and stockholders’ equity. Moreover, treasury stock does not carry voting,
dividend, preemptive, or liquidating rights and is not assets.
Reasons to acquire Treasury Stocks
In general treasury steps are to acquire for the following reasons:
to support (increase) the markets price of the stock
To increase earnings par share by reducing the number of shares outstanding.
To reduce dividend payment payments by reducing the number of shares outstanding.
To provide shares for reassurance to employees as a bonus

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 To use the share acquired for stock dividend
To reissue with a higher price

Recording and reporting Treasury stock Transactions

There are several methods of accounting for the purchase and the resale of treasure stock. A
commonly used method is the cost basis. When the stock is purchased by the corporation, treasury
stock account is debited for the price paid for it. The par and the price at which the stock was
originally issued are ignored. When the stock is resold, treasury stock is credited at the price paid for
it, and the difference between the price paid and the selling price is debited or credited to an account
entitled paid in capital from sale of treasury stock.

Example 6.10: 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 (20,000 shares authorized and issued) ..... Br 1,000,000
Premium on Common Stock ........................................................... 300,000
Further assume that the following transactions were occurred involving treasury stock:
1. Purchased 1,000 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

Paid in capital from sale of treasury stock is reported in the paid in capital section of the balance
sheet. Treasury stock is deducted from the total of the paid in capital and Retained earnings.

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EQUITY PER SHARE

The amount appearing on the balance sheet as total stockholders’ equity can be stated in terms of the
equity per share. When there is only one class of stock, the equity per share is determined by dividing
total stockholders’ equity by the number of shares outstanding. For a corporation with both preferred
and common stock, it is necessary first to allocate the total equity between the two classes. if there is
no preferred dividend in arrears, the computation of earnings per share are as follows:

Preferred EPS = Equity allocated to preferred stock

Number of o/s shares of preferred stock
Common EPS = Equity allocated to common stock
Number of o/s shares of common stock

CHAPTER 11
LEASING ENVIRONMENT

IFRS 16 defines Lease as a contract that conveys to the customer (‘lessee’) the right to use an
identified asset in exchange for consideration for agreed period of time. A lease is a contractual
agreement between a lessor and a lessee. This arrangement gives the lessee the right to use specific
property, owned by the lessor, for a specified period of time. In return for the use of the property, the
lessee makes rental payments over the lease term to the lessor. Lease transactions involve two
parties: the lessor who owns the property, and the lessee, who obtains use of the property in exchange
for one or more lease, or rental, payments.
CLASSIFICATIONS OF LEASE
Leasing takes several different forms, the five most important being (1) operating leases, (2) financial,
or capital, leases, (3) sale-and-leaseback arrangements, (4) combination leases OPERATING
LEASES

 Operating leases generally provide for both financing and maintenance.

 They are not fully amortized.

  to cancel the lease and return the

Contain a cancellation clause that gives the lessee the right
asset before the expiration of the basic lease agreement. 
It does not transfer substantially all the risks and rewards incidental to ownership.
FINANCIAL OR CAPITAL, LEASES

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 A capital lease is a lease in which the lessee records the underlying asset as though it owns the asset.
This means that the lessor is treated as a party that happens to be financing an asset that the lessee
owns.
Capital Lease accounting follows the principle of substance over form, wherein the assets are
recorded in the lessee’s books as fixed assets. The lease rent payments are divided into principal and
interest and charged to the profit and loss account. Depreciation is charged on the asset as normal
over the term of the agreement.

 Financial leases, sometimes called capital leases,

 do not provide for maintenance service,

 are not cancellable
 
are fully amortized 
 It transfers substantially all the risks and rewards incidental to ownership.
SALE-AND-LEASEBACK ARRANGEMENTS
A sale and leaseback transaction occurs when the seller transfers an asset to the buyer, and then
leases the asset from the buyer. This arrangement most commonly occurs when the seller needs the
funds associated with the asset being sold, despite still needing to occupy the space. When such a
transaction occurs, the first accounting step is to determine whether the transaction was at fair value.

Under a sale-and-leaseback arrangement, a firm that owns land, buildings, or equipment sells the
property to another firm and simultaneously executes an agreement to lease the property back for a
stated period under specific terms. The sale-and-leaseback plan is an alternative to a mortgage.
Sale-and-leaseback arrangements are almost the same as financial leases, the major difference being
that the leased equipment is used, not new, and the lessor buys it from the user-lessee instead of a
manufacturer or a distributor. A sale-and leaseback is thus a special type of financial lease.
COMBINATION LEASES
Many lessors now offer leases under a wide variety of terms. Therefore, in practice leases often do
not fit exactly into the operating lease or financial lease category but combine some features of each.
Such leases are called combination leases. To illustrate, cancellation clauses are normally associated
with operating leases, but many of today’s financial leases also contain cancellation clauses.
However, in financial leases these clauses generally include prepayment provisions whereby the
lessee must make penalty payments sufficient to enable the lessor to recover the unamortized cost of
the leased property
FINANCIAL LEASE Vs OPERATING LEASE
Basis for Comparison Financial Lease Operating Lease

A commercial contract in A commercial contract where the lessor

1. Meaning
which the lessor lets the allows the lessee to use an asset in place of

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 lessee use an asset instead of periodical payments for a small period;
periodical payments for the
usually long period.

A financial lease is a long-

2. What it’s all about? An operating lease is a short-term concept.
term concept.

The ownership is transferred

3. Transferability The ownership remains with the lessor.
to the lessee.

It is a contract for the long

4. The term of the lease It is a contract for a short term.
term.

The contract is called a loan The contract is called the rental

5. Nature of contract
agreement/contract. agreement/contract.

In the case of a financial

In the case of an operating lease, the lessor
lease, the lessee would need
6. Maintenance would need to take care of and maintain the
to take care of and maintain
asset.
the asset.

7. Risk of obsolescence It lies on the part of the lessee. It lies on the part of the lessor.

Usually, during the primary In the case of an operating lease, the

8. Cancellation terms, it can’t be done; but cancellation can be made during the
there can be exceptions. introductory period.

The expenses for the asset,

such as depreciation and Even the lease rent deduction from the tax is
9. Tax advantage
financing, are allowed for a allowed.
tax deduction to a lessee.

In a financial lease, the lessee

In an operating lease, the lessee is not given
10. Purchasing option gets an option to purchase the
any such option.
asset he has taken on a lease.

Criteria for Lessee:

For lessees, IFRS 16 requires that most leases be accounted for in a single model, recognizing right-
of-use (ROU) assets and lease liabilities on the balance sheet. The key criteria for lessees under
IFRS 16 are:

Identification of a Lease:
A lease is an agreement in which the right to control the use of an identified asset
for a period of time in exchange for consideration is conveyed.
The agreement must convey the right to control the use of an identified asset. This
control is demonstrated if the lessee can:
 Direct the use of the asset (e.g., where and how it is used).
 Obtain substantially all of the economic benefits from the asset.
Lease Term:

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 The lessee must evaluate the lease term, which includes the non-cancellable period of
the lease, plus any extension options if it is reasonably certain that the lessee will
exercise them. Conversely, it must exclude any termination options unless it is
reasonably certain that the lessee will not exercise them.
Recognition of Lease Liability:
Lessees must recognize a lease liability for all leases, which is the present value of
future lease payments. This liability is calculated using the interest rate implicit in
the lease, or if that cannot be readily determined, the lessee’s incremental borrowing
rate.
The lease liability is subsequently measured by applying the effective interest method
to allocate interest expense and reducing the liability for lease payments made.
Right-of-Use Asset:
Lessees must recognize a right-of-use (ROU) asset, which represents the lessee’s
right to use the leased asset over the lease term.
The initial measurement of the ROU asset is based on the lease liability, adjusted for
initial direct costs, prepaid lease payments, and incentives received.
Measurement:
After initial recognition, the ROU asset is depreciated over the lease term (or the
useful life of the asset, if shorter).
The lease liability is re-measured when there is a change in future lease payments due
to a change in the lease term, payments, or a change in the index used to determine
payments.
Exemptions for Short-Term and Low-Value Leases:
Lessees have the option to not apply IFRS 16 to leases with a term of 12 months or
less (short-term leases) and leases for low-value assets (e.g., personal computers,
small office furniture). These leases can be accounted for using an expense recognition
approach.

Criteria for Lessor:

For lessors, the accounting treatment under IFRS 16 remains relatively similar to the previous
standard, IAS 17, with two types of leases identified: operating leases and finance leases. The
lessor’s accounting depends on whether the lease is classified as an operating lease or a finance
lease.

Finance Lease (Lessor’s Criteria): A lease is classified as a finance lease if substantially all
of the risks and rewards of ownership of the leased asset are transferred to the lessee.

Criteria for Finance Lease:

Transfer of Ownership: The lease transfers ownership of the asset to the lessee by the
end of the lease term.
Option to Purchase: The lessee has the option to purchase the asset at a bargain price,
which is expected to be exercised.
Lease Term: The lease term is for the major part of the asset’s economic life
(typically considered if the lease term is 75% or more of the asset’s useful life).

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 Present Value of Lease Payments: The present value of the lease payments amounts
to at least substantially all of the fair value of the leased asset (typically considered if it
is 90% or more).
Specialized Nature of Asset: The leased asset is of such a specialized nature that only
the lessee can use it without major modifications.

If the lease meets these criteria, it is classified as a finance lease, and the lessor accounts for
the transaction as a sale, recognizing:

Lease receivables for the amount of future lease payments.

Interest income over the lease term, using the interest method.
Operating Lease (Lessor’s Criteria): A lease is classified as an operating lease if it does
not transfer substantially all of the risks and rewards of ownership to the lessee. Under
this classification, the lessor continues to recognize the asset on its balance sheet.

Criteria for Operating Lease:

The risks and rewards associated with ownership of the leased asset remain with the
lessor.
The lessor recognizes lease income on a straight-line basis over the lease term or
another systematic basis.
The leased asset remains on the lessor's balance sheet, and depreciation continues to be
recognized as usual.
Sales-Type Lease (for Lessors):
A sales-type lease occurs when a lessor transfers ownership to the lessee by the end of
the lease term or has an option to transfer ownership. In such cases, the lessor
recognizes revenue from the sale of the asset in addition to interest income over the
lease term.
The lessor’s accounting for the cost of goods sold and lease receivable reflects the
sale of the leased asset.

Key Differences in Criteria:

Criteria Lessee Lessor
Lease Right to control use of the asset for a Right to lease the asset under a contract
Identification period in exchange for consideration with a lessee
Must include non-cancellable Not applicable unless the lease is a
Lease Term
period and likely extensions finance lease
Finance lease: Recognize lease
Initial Lease liability and right-of-use asset
receivables; Operating lease: Asset
Measurement at present value of future payments
remains on balance sheet
Finance lease: Recognize interest income;
Subsequent Depreciate ROU asset, adjust
Operating lease: Continue to recognize
Measurement lease liability
asset and depreciation

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Criteria Lessee Lessor
Option to not apply IFRS 16 to
Short-Term
short-term leases and low- Not applicable
Exemption
value leases
All leases (except short-term or
Classification of Finance leases vs Operating leases based
low-value) result in recognition on
Lease on risk/reward transfer
balance sheet

ACCOUNTING BY THE LESSEE

If Delta Airlines (the lessee) capitalizes a lease, it records an asset and a liability generally equal
to the present value of the rental payments. ILFC (the lessor), having transferred substantially all
the benefits and risks of ownership, recognizes a sale by removing the asset from the balance sheet
and replacing it with a receivable.
The typical journal entries for Delta and ILFC, assuming leased and capitalized equipment, appear as
shown below
Delta (Lessee) ILFC(Lessor)
Leased Equipment XXX Lease Receivable XXX
Lease Liability XXX Equipment XXX
Having capitalized the asset, Delta records depreciation on the leased asset. Both ILFC and Delta
treat the lease rental payments as consisting of interest and principal.

If Delta does not capitalize the lease, it does not record an asset, nor does ILFC remove one from its
books. When Delta makes a lease payment, it records rental expense; ILFC recognizes rental revenue .
In order to record a lease as a capital lease, the lease must be non cancelable
Capital lease Criteria (Lessee)
The lease transfers ownership of the property to the lessee.
The lease contains a bargain-purchase option.
The lease term is equal to 75 percent or more of the estimated economic life of the leased property.
The present value of the minimum lease payments (excluding executory costs) equals or exceeds
90 percent of the fair value of the leased property.
Executory costs include utilities, repairs, maintenance, insurance, common area expenses, and
taxes paid for the leased asset during its economic life.
Executory costs, such as costs for repairs, maintenance, taxes and insurance incurred by the lessee are
charged to expense when incurred.

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Minimum lease payments are the least amount that a lessee is obligated to pay over the lease term to
a lessor under a lease agreement. These payments usually include basic rent payments plus any other
payments that the lessee is obligated to make to the lessor. Minimum Lease Payment includes the
following.
Minimum Rental Payments— this is the regular payment, typically made monthly, quarterly,
or annually, that the lessee must pay to the lessor over the lease term.
Guaranteed Residual Value— these are guarantees made by the lessee to the lessor that the leased
property will have a certain value at the end of the lease. If the actual value of the property is less
than the guaranteed value, the lessee must make up the difference to the lessor.
The residual value is the estimated fair (market) value of the leased property at the end of the
lease term. ILFC may transfer the risk of loss to Delta or to a third party by obtaining a guarantee
of the estimated residual value..
Penalty for Failure to renew or extend the Lease— If the lease agreement stipulates that the
lessee must pay a penalty if they choose not to renew or extend the lease, this penalty is also included
in the minimum lease payments.

The amount Delta must pay if the agreement specifies that it must extend or renew the lease
and it fails to do so.
1. Bargain-Purchase Option— A bargain purchase option is a clause in a lease agreement that
allows the lessee to purchase the leased asset at the end of the lease period at a price
substantially below its fair market value.
A bargain purchase option (BPO) is the contractual right of a lessee to purchase the leased asset at a
fixed price that is substantially below its expected fair value when the option becomes exercisable at
the end of the basic lease term, with the option so priced to ensure its exercise. A bargain purchase
option is capitalized by both the lessor and lessee, it increasing the present value of the minimum
lease payments by its present value and is equal to the difference in the value of the leased asset and
the lease obligation recorded by the lessee (Leased Asset - Lease Obligation
Bargain Purchase happens because of a liquidity crisis, or very few investors are interested
in competitive bidding for the company.

Executory Costs: Like most assets, leased tangible assets incur insurance, maintenance, and tax
expenses—called executory costs—during their economic life. If ILFC retains responsibility for the
payment of these “ownership-type costs,” it should exclude, in computing the present value of the
minimum lease payments, a portion of each lease payment that represents executory costs.
Executory costs do not represent payment on or reduction of the obligation.

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Depreciation Concept
In accounting for leases, lessors capitalize and amortize finance leases, while lessees capitalize
and depreciate the leased asset; lessors capitalize and depreciate only operating leases.
It should depreciate the leased asset by applying conventional depreciation methods: straight-line,
sum-of-the-years’-digits, declining-balance, units of production, etc.
CAPITAL LEASE EXAMPLE (LESSEE)
To illustrate a capital lease, assume that Caterpillar Financial Services Corp. and Sterling
Construction Corp. sign a lease agreement dated January 1, 2011, that calls for Caterpillar to lease
a front-end loader to Sterling beginning January 1, 2011. The terms and provisions of the lease
agreement, and other pertinent data, are as follows.
 equal
The term of the lease is five years. The lease agreement is non cancelable, requiring
 rental payments of $25,981.62 at the beginning of each year (annuity due basis).
 of the lease of $100,000, an estimated economic
The loader has a fair value at the inception
 life of five years, and no residual value.
 taxes of
Sterling pays all of the executory costs directly to third parties except for the property
 $2,000 per year, which is included as part of its annual payments to Caterpillar.

 The lease contains no renewal options. The loader reverts to Caterpillar at the termination of
the lease. 
 Sterling’s incremental borrowing rate is 11 percent per year.

 Sterling depreciates, on a straight-line basis, similar equipment that it owns.

to earn a rate of return on its investment of 10 percent per

Caterpillar sets the annual rental
 year; Sterling knows this fact.
 REQUIRED: DETERMINE
Present value of lease payment and amount capitalized
Amortization schedules
Calculate and record Lease liability
All necessary journal entry
Solution

The lease meets the criteria for classification as a capital lease for the following reasons:
The lease term of five years, being equal to the equipment’s estimated economic life of five years,
satisfies the 75 percent test. I,e Term of the lease/ estimated economic life=5/5=100%
The present value of the minimum lease payments ($100,000 as computed below) exceeds
90 percent of the fair value of the loader ($100,000).
The computation of lease liability and the amount capitalized as a right-of-use asset as follows:

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 Payment (25,981.62-2000) …………………… ………………. 23981.62
Present value of annuity due factor (i=10%,n=5) x 4.16986
PV of lease payments 100,000

STERLING CONSTRUCTION
LEASE AMORTIZATION SCHEDULE
ANNUITY-DUE BASIS
Date Annual lease Executory Interest (10%)on Reduction Lease
payment(a) liability (c) of lease
cost(b) liability(e)
liability (d)
1/1/11 $100,000.00
1/1/11 25,981.62 2000 –0– 23,981.62 76,018.38
1/1/12 25,981.62 2000 7,601.84 16,379.78 59,638.60
1/1/13 25,981.62 2000 5,963.86 18,017.76 41,620.84
1/1/14 25,981.62 2000 4,162.08 19,819.54 21,801.30
1/1/15 25,981.62 2000 2,180.32* 21,801.30 -0-
$129,908.10 10,000 $19,908.10 $100,000.00
a) Lease payment as required by lease.
(b) Executory costs included in rental payment.
(c) Ten percent of the preceding balance of (e) except for 1/1/11; since this is an annuity due,
no time has elapsed at the date of the first payment and no interest has accrued. (d) (a) _ (b) -
(c).
(e) Preceding balance minus (d).
*Rounded by 19 cents.
Sterling records the capital lease on its books on January 1, 2011, as:
Leased Equipment under Capital Leases …………………100,000
Lease Liability ………………………………………………….100,000
Sterling records the first lease payment on January 1, 2011, as follows:
Property Tax Expense 2,000.00
Lease Liability 23,981.62
Cash 25,981.62
At the end of its fiscal year, December 31, 2011, Sterling records accrued interest as follows.
Interest Expense 7,601.84
Interest Payable 7,601.84
Depreciation of the leased equipment over its five-year lease term, applying Sterling’s normal
depreciation policy (straight-line method), results in the following entry on December 31, 2011.

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 Depreciation Expense—Capital Leases 20,000
Accumulated Depreciation—Capital Leases 20,000
($100,000 /5 years)
At December 31, 2011, Sterling separately identifies the assets recorded under capital leases on
its balance sheet. Similarly, it separately identifies the related obligations.
Sterling classifies the portion due within one year or the operating cycle, whichever is longer, with
current liabilities, and the rest with noncurrent liabilities. For example, the current portion of the
December 31, 2011, total obligation of $76,018.38 in Sterling’s amortization schedule is the
amount of the reduction in the obligation in 2012, or $16,379.78. The liabilities section as it relates
to lease transactions at December 31, 2011.
Current liabilities
Interest payable $ 7,601.84
Lease liability 16,379.78
Noncurrent liabilities
Lease liability $59,638.60
Sterling records the lease payment of January 1, 2012, as follows.
Property Tax Expense 2,000.00
Interest Payable 7,601.84
Lease Liability 16,379.78
Cash 25,981.62
Entries through 2015 would follow the pattern above. Sterling records its other executor costs
(insurance and maintenance) in a manner similar to how it records any other operating costs
incurred on assets it owns.
Upon expiration of the lease, Sterling has fully amortized the amount capitalized as leased
equipment. It also has fully discharged its lease obligation. If Sterling does not purchase the loader,
it returns the equipment to Caterpillar. Sterling then removes the leased equipment and related
accumulated depreciation accounts from its books.
If Sterling purchases the equipment at termination of the lease, at a price of $5,000 and the
estimated life of the equipment changes from five to seven years, it makes the following entry.
Equipment ($100,000 _ $5,000) 105,000
Accumulated Depreciation—Capital Leases 100,000
Leased Equipment under Capital Leases 100,000
Accumulated Depreciation—Equipment 100,000
Cash 5,000

OPERATING EXAMPLE (LESSEE)

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Under the operating method, rent expense (and the associated liability) accrues day by day to the
lessee as it uses the property. The lessee assigns rent to the periods benefiting from the use of the
asset and ignores, in the accounting, any commitments to make future payments. The lessee
makes appropriate accruals or deferrals if the accounting period ends between cash payment
dates. For example, assume that the capital lease illustrated in the previous section did not qualify
as a capital lease. Sterling therefore accounts for it as an operating lease.
The first-year charge to operations is now $25,981.62, the amount of the rental payment.
Sterling records this payment on January 1, 2011, as follows.
Rent Expense 25,981.62
Cash 25,981.62
Sterling does not report the loader, as well as any long-term liability for future rental payments, on the
balance sheet. Sterling reports rent expense on the income statement.
ACCOUNTING BY THE LESSOR
IFRS 16 requires that Lessor classifies leases in to two for accounting purpose: An Operating
Lease and Financing Lease
Three important benefits are available to the lessor:
Interest Revenue. Leasing is a form of financing. Banks, captives, and independent leasing
companies find leasing attractive because it provides competitive interest margins.
Tax Incentives. In many cases, companies that lease cannot use the tax benefit of the asset,
but leasing allows them to transfer such tax benefits to another party (the lessor) in return for a
lower rental rate on the leased asset.
High Residual Value. Another advantage to the lessor is the return of the property at the end of the
lease term. Residual values can produce very large profits.
CAPITAL LEASE EXAMPLE (LESSOR)
To illustrate a capital lease, assume the fact in the Caterpillar Financial Services Corp. and Sterling
Construction Corp. above
Calculate and Record Lease receivable
Prepare amortization schedules
Prepare all Necessary journal entry
Solution

The Lease Receivable is the present value of the minimum lease payments (excluding executory
costs which are property taxes of $2,000). Caterpillar computes it as follows.
A) Lease receivable = ($25,981.62 _ $2,000) *Present value of an annuity due of 1 for 5
Periods at 10% (Table 6-5)
=$23,981.62* 4.16986
=$100,000

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Caterpillar records the lease of the asset and the resulting receivable on January 1, 2011 (the
inception of the lease), as follows.
Lease Receivable 100,000
Equipment 100,000

Companies often report the lease receivable in the balance sheet as “Net investment in capital
leases.” Companies classify it either as current or noncurrent, depending on when they recover the
net investment. Caterpillar replaces its investment (the leased front-end loader, a cost of $100,000),
with a lease receivable.

CUTTER PILLAR FNANCIAL

LEASE AMORTIZATION SCHEDULE
ANNUITY-DUE BASIS
Date Annual lease Executory Interest (10%)on Lease Lease
payment(a) lease recivablele (c) receivable
cost(b) Receivable(e)
recovery (d)
1/1/11 $100,000.00
1/1/11 25,981.62 2000 –0– 23,981.62 76,018.38
1/1/12 25,981.62 2000 7,601.84 16,379.78 59,638.60
1/1/13 25,981.62 2000 5,963.86 18,017.76 41,620.84
1/1/14 25,981.62 2000 4,162.08 19,819.54 21,801.30
1/1/15 25,981.62 2000 2,180.32* 21,801.30 -0-
$129,908.10 10,000 $19,908.10 $100,000.00
Annual rental that provides a 10% return on net investment.
Executory costs included in rental payment.
Ten percent of the preceding balance of (e) except for 1/1/11.
(a) minus (b) and (c).
Preceding balance minus (d).
*Rounded by 19 cents.

On January 1, 2011, Caterpillar records receipt of the first year’s lease payment as follows.
Cash 25,981.62
Lease Receivable 23,981.62
Property Tax Expense/Property Taxes Payable 2,000.00

On December 31, 2011, Caterpillar recognizes the interest revenue earned during the first year
through the following entry.
Interest Receivable 7,601.84

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 Interest Revenue—Leases 7,601.84
At December 31, 2011, Caterpillar reports the lease receivable in its balance sheet among current
assets or noncurrent assets, or both. It classifies the portion due within one year or the operating
cycle, whichever is longer, as a current asset, and the rest with noncurrent assets. Shows the assets
section as it relates to lease transactions at December 31, 2011.
Current assets
Interest receivable $ 7,601.84
Lease receivable 16,379.78
Noncurrent assets (investments)
Lease receivable $59,638.60
The following entries record receipt of the second year’s lease payment and recognition of the
interest earned.
January 1, 2012 Cash 25,981.62
Lease Receivable 16,379.78
Interest Receivable 7,601.84
Property Tax Expense/Property Taxes Payable 2,000.00

December 31, 2012 Interest Receivable 5,963.86

Interest Revenue—Leases 5,963.86
Journal entries through 2015 follow the same pattern except that Caterpillar records no entry in 2015
(the last year) for earned interest. Because it fully collects the receivable by January 1, 2015, no
balance (investment) is outstanding during 2015. Caterpillar recorded no depreciation. If Sterling
buys the loader for $5,000 upon expiration of the lease, Caterpillar recognizes disposition of the
equipment as follows.
Cash 5,000
Gain on Sale of Leased Equipment 5,000

OPERATING METHOD (LESSOR)

Under the operating method, the lessor records each rental receipt as rental revenue.
It depreciates the leased asset in the normal manner, with the depreciation expense of the period
matched against the rental revenue. The amount of revenue recognized in each accounting period is a
level amount (straight-line basis) regardless of the lease provisions, unless another systematic and
rational basis better represents the time pattern in which the lessor derives benefit from the leased
asset. In addition to the depreciation charge, the lessor expenses maintenance costs and the cost of
any other services rendered under the provisions of the lease that pertain to the current accounting
period. The lessor amortizes over the life of the lease any costs paid to independent third parties,
such as appraisal fees, finder’s fees, and costs of credit checks, usually on a straight-line basis.

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 To illustrate the operating method, assume that the direct-financing lease illustrated in the previous
section does not qualify as a capital lease. Therefore, Caterpillar accounts for it as an operating lease. It
records the cash rental receipt, assuming the $2,000 was for property tax expense, as follows.
Cash 25,981.62
Rental Revenue 25,981.62
Caterpillar records depreciation as follows (assuming a straight-line method, a cost basis of
$100,000, and a five-year life).
Depreciation Expense—Leased Equipment 20,000
Accumulated Depreciation—Leased Equipment 20,000
If Caterpillar pays property taxes, insurance, maintenance, and other operating costs during the
year, it records them as expenses chargeable against the gross rental revenues.
If Caterpillar owns plant assets that it uses in addition to those leased to others, the company
separately classifies the leased equipment and accompanying accumulated depreciation as
Equipment Leased to Others or Investment in Leased Property.
If significant in amount or in terms of activity, Caterpillar separates the rental revenues and
accompanying expenses in the income statement from sales revenue and cost of goods sold.
WHAT IS THE DIFFERENCE BETWEEN COMMENCEMENT DATE AND INCEPTION
DATE?
The inception date of a lease is either the date of the creation of the lease agreement or the date of the
commitment by both parties for principal provisions of a lease. Thus, the inception date is whichever
of these two dates is earlier.
date of lease agreement

date of commitment by the parties for principal provisions of the lease
The distinction between the two is extremely important for accounting purposes. Some of the
many reasons are as follows:
Classification of lease i.e. whether it is a finance lease or an operating lease is done at the
inception of the lease and not at commencement

The recognition (under finance lease) takes place at the commencement of the lease and not at
the inception of the lease

The amounts to be recognized (under finance lease) are determined at the inception of the
lease and not at the commencement of the lease.
CHAPTER 12
OVERVIEW OF COST COS AND MANAGEMENT ACCOUNTING
Definition

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  accounting process that involves recording, analyzing, and
Cost accounting is a managerial
 reporting a company's costs
 analyses past, present, and future
Cost accounting is a management information system, which
 data to provide the basis for managerial decision making.
 of relevant cost data for interpretation
Cost Accounting primarily deals with collection, analysis
 and presentation for various problems of management.

Cost accounting is concerned with the collection, processing, and evaluation of operating data in
order to achieve goals relating to internal planning, control, and external reporting
Types of Accounting Information
Accounting may be divided into three parts:
Management Accounting
 and non financial information that helps managers to fulfil the
Measures and reports financial
 goals of the organization.
 to mangers, i.e. people inside the organization who
Concerned with providing information

direct and control its operations.
 Focuses on internal reporting.
Financial Accounting
Measures and reports the financial results of an accounting year (i.e. profit or losses) as well
as the assets and liabilities position, by recording various transactions in a systematic manner.

is defined as, ‘an Art and science of classifying, analyzing and recording business transactions
in a systematic manner in order to prepare a summary at the end of the year to find out the
results of the concerned accounting year based on generally accepted accounting principles
(GAAP/IFRS

 Concerned withproviding information to stockholders, creditors and other who are outside the
organization? 
 Focuses on reporting to external parties.
Managers are responsible for the financial statements issued to investors, government
regulators, and other outside parties.
Therefore, managers are interested in both management
accounting and financial accounting.

MANAGEMENT ACCOUNTING (MA) VS FINANCIAL ACCOUNTING (FA)

Features Management Accounting Financial Accounting
1. Users of Information Managers at various levels Interested parties outside the organization.

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 within the organization.
1. Level of Aggregation Detailed information on Summarized information on the company
subunits within the as a whole
organization
2. Information type Economic any physical data Financial data
as well as financial data
3. Regulation Unregulated, limited only by Regulated by GAAP or IFRS.
the value-added principle.
4. Information Estimates that promote Factual information that is characterized
Characteristics relevance and enable by objectivity, reliability, consistency, and
timeliness. accuracy.
5. Time Horizon Past, present, and future Past only, historically based
6. Reporting Frequency Continuous reporting Delayed with emphasis on annual reports
7. Sources of data The organization’s basic The organization’s basic accounting
accounting system plus system.
various other sources.
8. Delineation of activates Field is less sharply defined. Field is more sharply defined
9. Report Requirement Not mandatory Mandatory for external reports
1.2 objectives of cost accounting
To provide information to enable management to make short-term decisions of various types,
such as quotation of price to special customers or during a slump, make or buy decision,
assigning priorities to various products
To analyses and classify all expenditures with reference to the cost of products and operations.
To indicate to the management any inefficiencies and the extent of various forms of waste,
whether of materials, time, expenses or in the use of machinery, equipment and tools. Analysis
of the causes of unsatisfactory results may indicate remedial measures.
To provide data for periodical profit and loss accounts and balance sheets at such intervals, e.g.,
weekly, monthly or quarterly, as may be desired by the management during the financial year,
not only for the whole business but also by departments or individual products.
1.3 Cost Terms, Concepts, and Classifications
Cost: cost in general is a monetary measure of economic resources sacrificed to achieve a specific
objective or purpose. It also refers to an outlay or expenditure (i.e. actual or notional) of money to
acquire goods or services. It is an asset initially; however, it will ultimately be converted to an
expense. Costs are all disbursements that are incurred in the course of generating revenue.

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All costs initially represent assets. As the assets are used in generating revenue, the amount consumed
becomes an expense.

Expenses: - a cost that has given a benefit and is now expired. When the benefits are received, the
cost becomes an expense. In contrast, an unexpired cost is classified as an asset because benefits are
still to be received.

Loss: - a cost that occurs when goods or services are purchased or acquired and are determined
valueless without having provided any benefit are referred to as losses not expenses. This loss appears
as a deduction from revenues. Expenses and losses both reduce operating income, but are separately
disclosed to highlight the loss.
Cost accumulation—a collection of cost data in some organized manner (such as material, labor
fuel etc) through accounting system.
Cost assignment—a general term that includes both tracing and allocating accumulated costs to
cost object.
Cost tracing: - is the assigning of direct costs to the chosen cost object.
Cost allocation: - is the assigning of indirect costs to the chosen cost object.
Direct costs are costs that are related to the particular cost object whereas indirect costs are costs
that are common to two or more cost objects.
Cost object: Anything for which a separate measurement of costs is desired. Example: a product, a
service, a project, a customer, an activity, a department, and a program.
Relevant range: - is the span of normal activity or volume level in which there is a specific
relationship between the activity or volume level and the cost in question.
Cost driver: - is a variable, such as the level of activity or volume, that causes costs to increase or
decrease over a given time period. In other words, a cause-and-effect relationship exists between a
change in the level of activity or volume and a change in the level of total costs i.e. any factor that
affects costs. For example, the number of trucks assembled is a cost driver of the cost of steering
wheels for the trucks.
Cost allocation base––a factor that links in a systematic way an indirect cost or group of indirect
costs to a cost object.

1.3 Classification of costs

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 Classification is the process of grouping of costs according to their common characteristics.
Therefore costs can be classified in different ways from different point of view

Classification on the Basis of Time

Historical Costs: These costs are ascertained after they are incurred. Such costs are available
only when the production of a particular thing has already been done. They are objective in nature
and can be verified with reference to actual operations.
Pre-determined Costs: These costs are calculated before they are incurred on the basis of
a specification of all factors affecting cost.

Classification on the Basis of function

Manufacturing Costs
A. Manufacturing is the process of converting materials into finished goods using labor and
other operating costs (F.O.H). The three major costs incurred in the process are:-
Direct Material Costs: are those materials that become an integral part of the finished product
and that can be physically and conveniently traced to it. This would include for example  the
 furniture factory purchase lumber material from farmer to producer commercial furniture.
Direct Labour Cost is reserved for those labour costs that can be easily i.e. physically and
conveniently traced to individual units of product. Direct labour is sometimes called  touch
 labour, since direct labour workers typically touch the product while it is being made.
Manufacturing Overhead Costs are all costs incurred for items that cannot be considered as
direct material or direct labor cost. It is also known as factory overhead, manufacturing
expense factory burden. It is sub divided in to three categories:-
Indirect material: - is materials that are small in amount and cannot easily allocate/traced to
specific product. Ex. The glue used making chair, Cleaning supplies ,Oil for machineries, Minor
 repair parts, etc
Indirect Labor: - are the wages of factory personnel who does not
work directly on raw
 materials. Such as, Store room clerks, Janitors, Maintenance crew.
 Depression,
Other manufacturing overhead:- it include such costs as Payroll tax on factory wage,
Rent, Tax, Heat, Light, Power, Repair and, maintenance of machinery and equipment,
Amortization of patent. It also includes all cost of manufacturing except direct materials and
direct labour.
B. Non-Manufacturing Costs.
Generally, non-manufacturing costs are sub classified into two categories:
Marketing or selling costs: include all cost categories to secure customer orders and get the 
finished product or service into the hands of the customer. These costs are often called order-

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 getting and order filling costs. Like advertising, shipping, sales travel, sales commissions,
sales salaries, and costs of finished goods warehouses.
Administrative costs: include all executive, organizational associated with the general
management of an organization rather than with manufacturing, marketing or selling. Like
executive compensation, general accounting, secretarial, public relations, and similar costs

involved in the overall, general administration of the organization as a whole.
4. Based on Association with the Product
Product Costs: Product costs are those which are traceable to the product and included in
inventory values.
In a manufacturing concern it comprises the cost of direct materials, direct labor and
manufacturing overheads. Product cost is a full factory cost. Product costs are used for
valuing inventories which are shown in the balance sheet as asset till they are sold. The
product cost of goods sold is transferred to the cost of goods sold account.
Period Costs: Period costs are incurred on the basis of time such as rent, salaries, etc.,
include many selling and administrative costs essential to keep the business running.
5. Based on the Changes in Activity or Volume (behavior)
Fixed Costs: “the cost which is incurred for a period, and which, within certain output and turnover
limits, tends to be unaffected by fluctuations in the levels of activity (output or turnover)”. These costs
arise due to contractual obligations and management decisions. They arise with the passage of time
and not with production and are expressed in terms of time. Examples are rent, property-taxes,
insurance, and supervisors’ salaries etc. It is wrong to say that fixed costs never change. Variable
Cost is a cost that varies, in total, in direct proportion to change in the level of activity.
Based on Decision Significance
A decision involves making choices among alternative courses of action the decision maker generally
collects cost information to assist in making the decision.
Relevant costs are future costs that differ with the various decision alternatives. They are costs
that make a difference in a decision making process.
Irrelevant costs do not relate to any of the decision alternatives, are historical in nature, or are the
same under all decision alternatives
Irrelevant costs are generally excluded from the cost analysis
Costs are an important feature of many business decisions. In making decisions, it is essential to have
a firm grasp of the concepts of differential cost, opportunity cost, and sunk costs.
8. Depending on the controllability of cost

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 Controllable costs are those costs that can be controlled (influenced) at some level of
management. The controller of such costs is responsible of it. E.g. all costs are controllable for the
top level manager.
Non-Controllable Costs are those costs that cannot be controlled (influenced) by a particular level
of management. The manager is not responsible for these costs. E.g. factory building rent is not
controllable for a supervisor.
Opportunity Cost
 cost is the potential benefit that is given up when one alternative is selected over
Opportunity
 another.

Opportunity cost is not usually entered in the accounting records of an organization, but it is a
cost that must be explicitly considered in every decision a manager makes.
Sunk Cost
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made
now or in the future. Since sunk costs cannot be changed by any decision, they are not differential
costs. Therefore, they can and should be ignored when making a decision.
Sank costs are costs that are already incurred and cannot be reversed by subsequent decisions. Except
for its impact on income tax, sunk costs are irrelevant for future decision making
Budgeted, standard and actual costs and their comparisons and analyses
 expected to take place over the
Budgeted costs: Future costs, for transactions and operations
 coming period, based on forecasts and established goals.

Budgeted cost is an estimate of the expenses that a company expects to spend going ahead.

Standard costs: Standard costs are called predetermined costs. The different standards regarding
all the elements of costs, i.e., material, labor and overheads, are determined on the basis of
historical cost and many other factors. These factors are cautiously studied before determining

the standards.

CHAPTER 13
COSTING METHODS: THE COSTING OF RESOURCE OUTPUTS
Job order, Process costing, batch and contract costing methods
3.1Job Order/Specific order Costing Method:

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 Job-order costing is used in situations where many different/heterogeneous products are produced
each period. In this
 system, the cost object is a unit or multiple units of a distinct product or
 service called job

Job order costing is the process of tracking and allocating the cost of manufacturing or producing
 products and services associated with producing specific products or jobs.
This method is used when the cost object isa specific job, order, or contract that is performed
 according to the customer's specifications.
The primary purpose of this system is to accumulate all costs related to a specific job, including
direct materials, direct labor, and manufacturing overhead, enabling businesses to assess
profitability and make informed pricing decisions. The costs of all labor worked on that specific
 item of furniture would be recorded on a time sheet and then compiled on a cost sheet for that job.

Per unit cost = Total manufacturing cost= Variable cost +Fixed cost
 Total unit produced Total unit produced
Total job cost = Direct materials cost + direct labor cost + overhead cost
Examples of business that use job order costingincludes:
 construction companies
 
Furniture manufacturers
 
printing firms
 
Repair shops
 
 Service giving organization.
Garages etc


BASIC CHARACTERISTICS OF JOB  ORDER COSTING
 Used for custom or unique product

 Relatively small quantities/low volume products

 Each product/job is unique in some way.

The costs 
of each job are ascertained by adding direct materials, direct labor, and allocated
overhead. 
 Each job is distinguishable from other jobs, and direct costs can be clearly traced to each job

 Costs are pooled according to the job.

Unitcost is calculated by dividing the total job cost with the unit produced for that particular
 job

  materials, direct labor, and manufacturing overhead costs are assigned to each specific
Direct
 job 
 Enables job-by-job cost analysis



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 3.2. PROCESS COSTING SYSTEM
Process costing is used in companies that produce many units of a single product for long period/
in a continuous
 process .In this system, the cost object is masses of identical or similar units of a
 product .
A process costing is most commonly used in  industries that produce essentially homogeneous
 (i.e. uniform) products on a continuous basis
Process costing involves the accumulation of costs for lengthy production runs involving
products that are indistinguishable from each other. For example, the production of 100,000
gallons of gasoline would require that all oil used in the process, as well as all labor in the
refinery facility be accumulated into a cost account, and then divided by the number of units
produced to arrive at the cost per unit.
This method is used when the cost object is a mass-produced product or service that goes

through a series of standardized processes or stages.
 Companies that use process costing system are:

 Cement factories

 Petroleum refineries

 Flour companies

 Beer factories

 Textile factories

Beverage companies

FEATURS OF PROCESS COSTING SYSTEM

The production is continuous
The product is homogeneous/Identical
The production processes are standardized, high-volume products like chemicals, oil, paper,
etc.
The output of last process is transferred to finished stock
For each process, a separate account is maintained.
Both direct and indirect cost is recorded separately for each process
The sequence of processes and operations employed is pre-determined.
Generally large quantities
DIFFERENCES BETWEEN THE TWO COSTING METHODOLOGIES,
Job order Costing Process Costing
Suitable for custom or unique products/services. Ideal for standardized, homogeneous products/services

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Costs are accumulated for each specific job. Costs are accumulated for specific processes or
departments.
Involves tracking direct materials, labor, and overhead Focuses on tracking costs per process or department.
costs per job.
Labor costs are often the most significant component. Overhead costs tend to be more prominent.
Allows for precise cost allocation to individual jobs. Allocates costs to processes or departments, resulting
in average costs per unit.
Offers flexibility in pricing for customized Pricing is typically standardized due to homogeneous
products/services. production.
More suitable for smaller-scale operations. Better suited for larger-scale production.
Requires detailed tracking of job-specific costs. Emphasizes tracking costs on a broader scale.
Provides detailed information on individual job Offers insights into overall process or department
profitability. profitability.
Examples: Construction projects specialized Examples: Continuous production, oil refineries.
manufacturing.
Finished goods inventory is valued at actual costs Finished goods inventory is valued at average per unit
cost based
3.3 BATCH COSTING:
A batch is a group of identical but separately identifiable products that are made together.Batch
 costing is a form of job order costing in which costs are attributed to batches of products
Batch costing is a cost accounting method used by companies that manufacture or produce goods
in batches and kept in inventory. The production process is divided into batches, and the costs
incurred during the production of each batch are recorded separately. It helps businesses improve

operations by providing cost information to facilitate effective decision-making. 
 Batch costing is a costing system that composes costs for a defined group or ‘batch’ of products.
The critical characteristic of batch costing is that the production run for a group of products is
usually of a homogeneous or similar nature. This enables the application of a production order or
 job number to the group of products.
Each batch of products is treated as a cost unit in a batch costing system. This means that all the
costs associated with producing a batch of products are recorded and then allocated to that batch.
This includes direct materials, direct labour, and overhead costs
Total production cost of batch
Cost per unit in batch = Number of units in batch

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 For example, suppose a bakery produces cookies in a batch. If the total cost cookies produced
is 100,000 and the number of units produced is 10,000, the batch cost is $10 per unit. If the lot
size is 500 units, the total cost will be $5,000.
FEATURES OF BATCH COSTING
Products are produced in batches: The cost of each batch of products is calculated separately.

Direct costs are assigned to each batch: Direct costs, such as materials and labour, are assigned
to each batch of products.
Overhead costs are allocated to each batch: Overhead costs, such as factory rent and utilities,
are allocated to each batch of products based on the proportion of the total production time that
the batch consumes.
The cost per unit is calculated: The total cost of a batch is divided by the number of units in the
batch to calculate the cost per unit.
Batch costings can be used for external reporting: Batch costing can be used for external
reporting purposes, such as customer quotes and invoicing.
Batch costing is used in industries that produce large quantities of products in a single production
run.
3.4 CONTRACT COSTING METHOD
Contract costing is an accounting method primarily used for large-scale, long-term projects, such
as construction or civil engineering contracts.
 In this approach, costs are accumulated and
 monitored for the duration of a contract.
Contract costing is a form of job order costing in which costs are attributable to individual
contract. It is the method of costing applied in a business where separate contracts of a non-
 repetitive nature are undertaken. It is also known as terminal costing
This methodis used by firms engaged in ship building, construction of buildings, bridges, dams
and roads.
Features of Contract Costing
Separate Account: A separate contract account is maintained for each contract.
Cost Unit: Each contract is considered as a cost unit.
Contract Site: A major portion of contract work is done at the contract site.
Direct Expenses: Expenses incurred at the contract site e.g., electricity, telephone, insurance, etc
considered to be direct expenses.
Higher proportion of direct cost and low indirect costs
Duration of contracts are relatively for a long period

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 typically seen in the construction and civil engineering sectors
ACCOUNTING FOR SPOILAGE, DEFECTIVE (REWORK) UNITS AND
SCRAP, REWORK
Accounting for spoilage
Spoilage- Are completed or semi-completed products that do not meet the standard or specification and that
are discarded or are sold at reduced price.
It can also be used to classify badly damaged material that is used for processing a product
Examples of spoilage are defective shirts, jeans, shoes, and carpeting sold as “seconds, or defective aluminum
cans sold to aluminum manufacturers for re melting to produce other aluminum products

Types of Spoilage
Normal and
Abnormal.
Normal Spoilage
Normal spoilage is a spoilage that arises under efficient operating conditions; it is an inherent
result of the particular process and is uncontrollable in the short run. Management must
establish the rate of spoilage that is to be regarded as normal within its selected set of

 production conditions.
Normal spoilage is the kind of spoilage that happens during the production process that business
owners can say is normal and acceptable. For example, a fruit importer understands  that
 transporting fruits by sea or ground will definitely incur spoilage for various reasons.
The costs of normal spoilage are typically viewed as part of the costs of good units (products)
because the production of good units necessitates the simultaneous presence of spoiled units. In
other words normal spoilage is planned spoilage, in the sense that the choice of a given
combination of factors of production entails a spoilage rate that management is willing to

 accept.
Normal spoilage is computed by using total good units as a base, not total units started in 
production, since these units include any abnormal spoilage in addition to the normal spoilage.

Normal Spoilage Rate =Total Number of spoilage unit X 100%

Total number of unit produce
Normal spoilage = Accepted Rate X good units completed.

Abnormal spoilage = Total Spoiled – Normal Spoilage

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 Any spoilage beyond what is calculated above can be considered” as abnormal spoilage,” prompting
your operations to audit the situation.
Abnormal spoilage
Abnormal spoilage is a spoilage that is not expected toarise under efficient operating conditions. It
 is not an inherent part of the manufacturing process.
Abnormal spoilage, on the other hand, is spoilage that is beyond the normal point, wherein the
level is unexpectedly high. It may be due to defective
machinery, low quality of materials, poorly-
trained employees and even incompetent operators.
 It is treated as loss

Abnormal spoilage is simply any amount in excess of the calculated normal spoilage.

Accounting Treatment for Spoilage

When inventory spoilage occurs, companies must remove the spoiled goods from the balance sheet
and record them as an expense. This process involves debiting the Cost of Goods Sold (COGS)
and crediting the Inventory account.
Here is an example of a journal entry for inventory spoilage:

Account Debit Credit

Cost of Goods Sold (COGS) $X,XXX

Inventory $X,XXX
This entry ensures that both the expense and reduction in inventory are accounted for accurately,
reflecting the financial impact of spoilage.
In accounting, normal spoilage is included in the standard cost of goods, while abnormal spoilage
is charged to expense as incurred. This means that the cost of normal spoilage may initially be
recorded as an asset and then charged to expense in a later period. Thus, Normal spoilage should
be capitalized into inventory since it is an inventoriable cost and is incurred in the normal course
of business. Abnormal spoilage is considered unusual and should not be capitalized into inventory.
Thus abnormal spoilage is treated as a period cost and recorded as a loss.
IN Job ordering spoilage
Normal spoilage in Job order costing
When the spoilage is the results of efficient operation and related to that particular Job, the job should
absorb this cost of the spoilage by net of the salvage value of the spoiled units, if salable
Attributable/or applied to specific job
Material control(spoiled goods inventory)……………………..XXX
WIP inventory job xx…………………………………………………….XXX

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 Common/or applied to all jobs.
Normal spoilage may accidentally occur due to the inherent problem in the manufacturing process
where a job is being worked on.
Under this condition, the costs of the spoilage cannot be assigned to that particular job but to all jobs.
So, these common costs are considered as manufacturing overhead.
Material control(spoiled goods inventory)……………………..XXX
Manufacturing overhead …………………………………………XXX
WIP inventory job xx…………………………………………………….XXX
Example#1 Assume that in Semhal company 10,000 units were put in to production for job #073.
The total cost of production was birr 300,000. Normal spoilage for the job is estimated to be 50 units.
At the completion of production only 9,910 units were good. All spoiled units are estimated to have a
salvage of Birr 5 each.
Required: [Link] the required journal entries assuming normal spoilage is-
Applied to a specific job
Calculate cost per good unit
Applied to all jobs
Compute the unit cost of the remaining finished good units
Solution
To record normal spoilage:
a. Spoiled goods inventory ............................ ………………………..250
WIP inv. Job#073 ................................. ……………………..250
(250 = 50 unit x 5 birr)
b. Cost per good unit=Total production cost/total unit cost
=300,000/10,000
=30 per unit cost
c. To all jobs
Spoiled goods inventory....................... ……………………………250
FOH-control .................................... ……………………………..1,250
WIP inv. Job#073 ............................................................................ 1,500
(1,500 = 50 units x 30 birr)
(To record normal spoilage)
Spoiled goods inventory (40 units x 5 birr)...................... 200
Loss from abnormal spoilage ............... …………………….1,000
WIP inv. Job#073 ........................................................................... 1,200
(1,200 = 40 units x 30 birr)
(To record abnormal spoilage)
Total spoiled units =) = 10,000 units - 9,910 units = 90 units
So, 50 units are normal spoilage and 40 units are abnormal spoilage

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 ACCOUNTING FOR REWORK
Reworks are completed units that do not meet the production standard or the specification but while can
subsequently repaired and sold as acceptable finished goods with incurrence of additional costs which are
 called Rectifying or rework costs.
Rework refers to the correction of a product that does not initially meet an entity's minimum 
quality standards. Once all rework activities have been completed, a reworked product should
meet the organization’s quality standards.
For example, defective units of products (such as computers, and telephones) detected during or
after the production process but before units are shipped to customers can sometimes be reworked
and sold as good products
Rework is distinguished as
normal rework attributable to specific job
normal rework common to all jobs
abnormal rework
ACCOUNTING FOR REWORK IN JOB COSTING
Rework is done on finished products or components, that did not meet specifications and after
rework they become acceptable finished goods of components. There can be an estimated or
accepted as normal rework. Any rework above this normal rework is abnormal rework.
NORMAL REWORK
Normal rework attributable to specific job entry would be

WIP Account of specific Jon XXX

Material Control XXX
Wage payable/payroll XXX
Manufacturing overhead allocated XXX
Normal rework common to all jobs entry would be

FOH control XXX

Material Control XXX
Wage payable/payroll XXX
Manufacturing overhead allocated XXX
ABNORMAL REWORK
Abnormal rework is not charged to job so that it will not appear future estimates for similar jobs. It is
recorded in a separate loss account.

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Loss from Abnormal rework Account XXX
Material Control XXX
Wage payable/payroll XXX
Manufacturing overhead allocated XXX
Example
Assume that 40,000 units are placed into production for Job 10. Normal reworks for this Job are
estimated to be 400 whereas actual rework units were 1,000. The total cost to rework the 1,000
rework units was as follows
Direct materials…………………………………….. Birr 500…………Birr 0.50
Direct labor ………………………………………… 1,000………… 1.00
FOH applied ………………………………………. 500………… … 0.50
Birr 2,000 Birr 2.00
Required: prepare the require entry assuming that normal rework costs are applied to
Applied to a specific job
Applied to all jobs
Solution:
Abnormal rework = total rework – normal rework
Abnormal rework =1,000 units – 400 units =600
To record normal rework
To specific Job

WIP – Job (400 X 2.00)……………….. 800

Materials (400 X 0.5) ………………… 200
Payroll (400 X 1) …… …………….. 400
FOH-Applied (400 X 0.5) …………. 200
To all Jobs
FOH – control (400 X 2.00)……………….. 800

Materials (400 X 0.5) ………………… 200

Payroll (400 X 1) …… …………….. 400

FOH-Applied (400 X 0.5) …………. 200

To record abnormal reworks:
Loss from abnormal defects (600 X 2.00)……………….. 1,200
Materials (600 X 0.5) …………………………………… 300
Payroll (600 X 1) …… ………………….…………….. 600
FOH-Applied (600 X 0.5)…………….………………. 300

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 CHAPTER 14
ACCOUNTING FOR SCRAP, SPOILED & DEFECTIVE UNITS
Accounting for scrap materials in job order costing
Scrap Material: are raw materials left over from the production process that cannot be put back into the
production for the same purpose. They may be useful for other purpose or in other production processes.
This can include metal shavings, broken parts, or any waste material generated during production. Scrap is
typically considered waste but can often be recycled or repurposed.
In some cases, scrap materials can be sold to other manufacturers or consumers, but the value is fairly
negligible when compared to the value of the finished product.
Common examples include:
Automobiles: Old cars and parts such as engines, frames, and body panels.
Bicycles: Old bikes that are no longer usable can be recycled for their metal components.
Tools: Broken or obsolete hand tools made from steel or other metals, etc
THE KEY CHARACTERISTICS OF SCRAP
Origin: Scrap arises from the production process itself, often as a result of cutting, shaping, or
assembling materials.
Value: While generally viewed as waste, scrap can have economic value if it can be recycled. For
example, metal scrap can be melted down and reused in new products.
Management: Companies often have specific processes for managing scrap to minimize waste and
maximize recovery through recycling.
When the amount of scrap produced exceeds the norm it could be an indicator of inefficiency. When the
scrap value is small no entry s made until the scrape is sold. At the time the scrap is sold the following
entry will be made:
Cash (A/R)…………………… xxx
Scrap revenue………………………..xxx
The income from scrap sales is usually reported as OTHER INCOME in the income statement. When
the value of scrap is relatively high and both the quantity and the market value of the scrap are
known, the following journal entries are made.
To record the inventory:
Scrap material……………………… xxx
Scrap revenue (WIP or FOH-control)……………….. xxx
When the scrap is sold:
Cash (A/R)……………………. xxx
Scrap materials …………………….. xxx

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2.1. THE FLOW OF COSTS IN PROCESS COSTING SYSTEM WITH
SEQUENTIAL PRODUCTION DEPARTMENTS
As direct materials and direct labor are used in production department A, these costs are added
to the Work-in Process inventory account for Department A..
Work-in Process: Production Department A xxx
Raw Materials xxx
Wage Payable xxx
Manufacturing overhead applied xxx
2. . The costs assigned to these goods are transferred from the Work-in Process Inventory account
for department A to work-in Process inventory account in department B, the costs assigned to
those partially completed products are called transferred-in costs1.
Work-in Process: Production Department B xxx
Work-in Process: Production Department A xxx
Direct material and direct labor are used in production department B, and manufacturing
overhead is applied using POR.
Work-in Process: Production Department B xxx
Raw Materials xxx
Wages Payable xxx
Manufacturing overhead applied xxx
Goods are completed in production department B and transferred to the finished goods
warehouse.
Finished-Goods xxx
Work-in Process: Production Department B xxx
5. Goods are sold
Cost of Goods Sold xxxx
Finished-Goods xxxx
2.2. Cost Accumulation Methods in Process Costing System
When a firm produces identical lots of goods repetitively, maintaining a separate job cost
sheet would be unnecessarily expensive. The aggregate cost and the unit cost can be computed
without a job cost sheet, thus saving the costs associated with producing such records.

150
 Costs accumulate by department over a certain period and the unit cost can be found by
dividing the total cost to the units produced during that period. Process costing system fit
among others to, paint manufacturers, oil refineries, sugar refineries, and salt producers.
o In process costing system, manufacturing costs, direct material, direct labor, and
manufacturing overhead costs are accumulated in the same way as job order costing system.
However, the costs are accumulated by department over some period of time than by
individual jobs.
The time period over which the cost is to be accumulated depends on the information needs of
the company. It can be a week, two weeks, but no longer than a month most often. Cost
accumulation is much simpler for a process costing system than for a job order cost system.

The five steps of process costing are as follows:

Step 1: Summarize the flow of physical units of output. Where did physical units come from?
Where did they go?
Step 2: Compute output in terms of equivalent units.
Step 3: compute equivalent unit costs.
Step 4: Summarize total costs to account for.
Step 5: Assign total costs to units completed and to units in ending work in process
Illustrating Process Costing
Assumptions: ABC Manufacturing Company manufactures thousands of Products A. These
components are assembled in the Assembly Department, upon completion the units are
completely transferred to the Testing Department. The process-costing system for Product A has a
single direct cost category (direct materials) and a single indirect-cost category (conversion costs).
Direct materials are added at the beginning of the process in Assembly. Conversion costs are
added evenly during Assembly.
Prime Cost = Direct Material Cost + Direct Labor Cost
Conversion Cost = Direct Labor Cost + Manufacturing Overhead Cost
Case 1: Process costing with zero beginning and zero ending work in process inventory .That is, all
units are started and fully completed within the accounting period.
On January 1, 2001, there were no beginning inventory units in the assembly department. During the
month of January, Pacific Electronics started, completely assembled, and transferred out to the testing
department 400 units.
Data for the Assembly Department for January 2001

151
 Physical Units for January 2001
Work in Process, beginning inventory (January 1) 0 units
Started during January 400 units
Completed and transferred out during January 400 units
Work in Process, ending inventory (January 31) 0 units
Total Costs for January 2001
Direct materials costs added during January Br.32, 000
Conversion costs added during January 24,000
Total Assembly Department costs added during January 56,000

Pacific Electronics records direct material costs and conversion costs in the assembly department as
these costs are incurred.

Calculate
Average unit costs
Direct Material costs per unit
Conversion costs per unit
Assembly Department costs per unit
Average unit cost =$56,000 ÷ 400 units = $140 per unit, itemized as follows
2. Direct Material costs per unit (32,000 ÷400) Br. 80
3. Conversion costs per unit (24000 ÷400) 60
4. Assembly Department costs per unit Br 140

Case 2: Process Costing with zero beginning but some ending work in process inventory
Data for the Assembly Department for February 2001
Physical Units for February 2001
Work in Process, beginning inventory (February 1) 0 units
Started during February 400 units
Completed and transferred out during February 175 units
Work in Process, ending inventory (February 28) 225 units
Direct Materials (100% complete)
Conversion costs (60% complete)

152
 Total Costs for February 2001
Direct materials costs added during February Br.32, 000
Conversion costs added during February 18,600
Total Assembly Department costs added during February Br. 50,600

Required
Summarize the flow of physical units of output.
Compute output in terms of equivalent units.
Compute equivalent unit costs.
Summarize total costs to account for.
Assign total costs to unit’s completed and to units in ending work in process.
Prepare necessary journal entries
Solution:
Step1: summarize the flow of physical units
Physical unit express the physical flow of production. It is a measure of the units of production
that have been started and that may or mat not be completed. It does not consider the degree of
completion.
Physical flow
Beginning WIP ----------------------------------------------- XX
Add Units started ---------------------------------------------- XX
=To account ----------------------------------------------------- .XX
Ending WIP------------------------------------------------------ XX
Add Units completed and transfer--------------------------- XX
= Accounted for ------------------------------------------------ XX
Step-2: compute output in terms of equivalent units (EU)
Equivalent units measure output in terms of the physical quantity of each of the input (factor of
production) that has been consumed when producing the units. Equivalent units are computed
using physical units. It disregard dollar amount. Equivalent unit of each major category of
production inputs is calculated:
Equivalent unit = physical unit * percentage of
completion Step 3: compute equivalent unite cost
Cost per EU= Production cost
Equivalent
Equivalent Units(Step 2)

153
Flow of Production Physical Direct Conversion
Units Materials Costs
(Step 1 (DM) (CC
Work in process, beginning 0
Started during current period 400
To account for 400
Completed and transferred out during current period 175 175 175
WIP ending DM =(225*100%=225); CC=(225*60%=135 225 225 135
Accounted for 400
Work done in current period 400 310
Calculation of Product Costs (Steps 3, 4, and 5)
Total Direct Conversion
production Materials Costs
Cost (DM) (CC
Step 3 Cost per equivalent units.
Beginning Work in process 0
Add Costs added during February 50,600 32,000 18,600
=Total cost to account for 50,600 32,000 18,600
Cost per equivalent unit= Total Costs during February 32,000 18,600
Equivalent unit 400 310
=80 =60
Step 4) Total costs to account for 24,500 175*80 175*60
Cost per equivalent units*unit completed and transfer
(Step 5) Assignment of costs:
Completed & transferred out (175 units) 24,500 175*80 175*60
WIP ending (225 units) 26,100 225*80 135*60
Total cost to account for 50,600 32,000 18,600

Journal Entries
Work in Process- Assembly 32,000
Account Payable Control 32,000
(To record direct materials purchased and used in production)
Work in Process- Assembly 18,600
Various accounts 18,600

154
 (To record Assembly department conversion costs)
Work in Process- Testing 24,500
Work in Process- Assembly 24,500
(To record cost of goods completed and transferred from Assembly to
Testing Department)
Case 3: Process costing with some beginning and some ending work in process inventory.
Data for the Assembly Department for March 2001
Physical Units for March 2001
Work in Process, beginning inventory (March 1) 225 units
Direct Materials (100% complete)
Conversion costs (60% complete)
Started during March 275 units
Completed and transferred out during March 400 units
Work in Process, ending inventory (March 31) 100 units
Direct Materials (100% complete)
Conversion costs (50% complete)
Total Costs for March 2001
Work in process, beginning inventory
Direct materials (225 equivalent units * Br. 80/unit) Br. 18,000
Conversion costs (135 equivalent units * Br.60/unit) 8,100 Br. 26,100
Direct materials costs added during March 19,800
Conversion costs added during March 16,380
Total costs to account for Br.62, 280

Required: Using weighted average and FIFO method

Compute equivalent units for direct materials and conversion costs.
Calculate the cost per equivalent unit for direct materials and conversion costs,
Summarized total cost to account for.
Weighted-Average process costing method
calculate the equivalent unit of
cost of all work done to date regardless of the
 accounting period it was done
 unit in beginning WIP with equivalent unit of work done in the
It merges equivalent
current period.

155
 
The weighted average cost is the total of all costs entering in the work in process account
(regardless of whether it is from the beginning work in process or from work started
during the period) divided by total equivalent units of work done to date.
Physical units and Equivalent units (Step 1and 2)
Equivalent Units(Step 2)
Flow of Production Physical Direct Conversion
Units Materials Costs(CC)
(Step 1) (DM)
Work in process, beginning march 1 225
Started during current period 275 400 400
To account for 500
Completed and transferred out during current period 400 400 400
WIP, ending DM=(100*100%=100); CC=(100*50%=50) 100 100 50
Accounted for 500
Equivalent unit of Work done in current period 500 450

Calculation of Product Costs (Steps 3, 4, and 5) Total Direct Conversion

Production Materials(DM) Costs(CC)
Costs
Step 3 Cost per equivalent units.
Work in process, beginning cost Br.26,100 Br.18,000 Br.8,100
Add Costs added during the current period 36,180 19,800Br. 16,380
Total cost account for Br. 62,280 37,800 24,480
Cost per equivalent unit= Total Costs during march 37,800/500 24,480/450
Equivalent unit 75.6 54.4
Step 4. Total costs to account for 52,000 37,800*75.6 24,480*54.4

(Step 5) Assignment of Costs

Completed and transferred out (400 units) 52,000 (400*75.60) (400*54.40)
Work in process, ending (100 units) 10,280 (100*75.60) (50*54.40)
Total cost account for 62,280 37,800 24,480

Journal Entries:
Work in Process- Assembly 19,800
Account Payable Control 19,800

156
 (To record direct materials purchased and used in production)
Work in Process- Assembly 16,380
Various accounts 16,380
(To record Assembly department conversion costs)
Work in Process- Testing 52,000
Work in Process- Assembly 52,000
(To record cost of goods completed and transferred from Assembly to Testing Department)
First-in, First-out Method
The FIFO process costing method assigns the cost of the previous period’s equivalent units in
beginning work-in process inventory to the first units completed and transferred out of the
process, and assigns the cost of equivalent units worked on during the current period first to
complete beginning inventory, then to start and complete new units in ending work in process

 inventory.
 that the earliest equivalent units in the work in process-Assembly account are
This method assigns
 completed first.
 inventory
A distinct feature of the FIFO process-costing method is that work done on beginning
 before the current period is kept separate from work done in the current period.

Costs incurred in the current period and units produced in the current period are used to calculate
 costs per equivalent unit of work done in the current period.
In contrast equivalent unit and cost per equivalent unit calculations in the weighted average method
merge the
 units and costs in beginning inventory with units and costs of work done in the current
period.

Physical units and Equivalent units (Step 1and 2)

Equivalent Units(Step 2)
Flow of Production Physical Direct Conversion
Units Materials Costs(CC)
(Step 1) (DM)
Work in process, beginning march 1 225
Started during current period 275 400 400
To account for 500
Completed and transferred out during current period
From Beginning WIP:-DM(225*(100%-100%=0);
CC(225*(100%-60%=90 225 0 90

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 Started & completed DM(175*100%=175), CC(175*100%=175) 175 175 175
WIP, ending DM=(100*100%=100); CC=(100*50%=50) 100 50
Accounted for 500
Equivalent unit of Work done in current period 275 315
Calculation of Product Costs (Steps 3, 4, and 5)
Total Direct Conversion
Production Materials(DM) Costs(CC)
n Costs
(Step 3) Work in process, beginning Br.26,100 Br.18,000 Br.8,100
Costs added during the current period 36,180 19,800Br. 16,380
Total cost account for Br. 62,280 37,800 24,480

Step 4. Total costs to account for 19,800 16,380

divided by Equivalent units of work done to date 275 315
= Cost per equivalent unit of work done Br.72 Br.52

(Step 5) Assignment of Costs

Completed and transferred out (400 units)
Work in process, beginning (225 units) 26,100 18,000 8,100
Cost added to beginning WIP 4,680 0*72 9*52
Total from beginning Inventory 30,780
Started and completed (175 units) 21,700 175*72 175*52
Total costs of units completed & transferred out 52,480
Work in process, ending (100 units) 9,800 100*72 50*52
Total cost accounted for 62.280 37,800 24,480
Journal Entries:
Work in Process- Testing 52,480
Work in Process- Assembly 52,480
(To record cost of goods completed and transferred from Assembly to Testing
Department)
Important points to note:

The first physical units assumed to be completed and transferred out during the period are the 225
units from the beginning work-in process inventory.

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 Of the 275 physical units started, 175 are assumed to be completed. 400 physical units were
completed during March, the FIFO method assumes that the first 225 of these units must have
 been started and completed during March.
 Ending work-in process inventory consists of 100 physical units-the 275 physical units started
minus the 175 of these physical units completed. 
 Note that the physical units “to account for” equal the physical units “accounted for” (500 units)
The equivalent unit calculated for each cost category focus on the equivalent units of work done in
the current period only. Under the FIFO method, the work done in the current period is assumed
to first complete the 225 units in beginning work in process. The equivalent unit’s works done in
March on the beginning work-in process inventory are computed by multiplying the 225 physical
units by the percentage of work remaining to be done to complete these units: 0% for direct

materials, and 40% for conversion cost

CHAPTER 15
COST ALLOCATION TO JOINT PRODUCTS AND BYPRODUCTS
JOINT PRODUCTS
Joint products arethe products that are simultaneously produced with the same input, by a
 common process
These products typically have significant economic value and are produced up to a certain
 point known as the “split-off point,” after which they can be processed separately.
There is a separation point called as a split-off point, from where the products are separated
and identified. At this stage, either the products are sold directly or go for further processing,
to turn out as finished product. The amount incurred up to the split-off point is termed as joint
cost.

Dairy Processing: The production of milk results in various joint products such as butter, cheese,
and cream. These dairy products cannot be produced separately until after the milk has been
processed to a certain point.
Crude Oil Refining: In the refining of crude oil, several joint products emerge, including
gasoline, diesel fuel, kerosene, and jet fuel. All these products are derived from the same raw
material (crude oil) through a common refining process.
Meat Processing: In the meat packing industry, when an animal is processed, several joint
products are obtained, including cuts of meat (like steaks and roasts), leather, and by-products like
gelatin or lard.
BY-PRODUCTS

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 By-products are products that have a relatively low salesvalue compared to the main products,
such as sawdust from lumber, or molasses from sugar. 
 By-products are an unintended result of the production process:

By Product can be understood as the subsidiary or secondary product which is incidentally

produced, along with the main product, and has saleable or usable value.
These are produced from the discarded material, i.e. scrap or waste of the main process. The split-off
point is the stage, at which the by-products are separated from the main product. On the basis of
market conditions, by product can be classified as:
Products sold in their original form.
Products that undergo subsequent processing before sale.
By-products are secondary products generated during the manufacturing process that have less
economic value compared to the main product. They often arise incidentally during the production of
joint products but can still be sold or utilized in other ways. Examples include:
Wood Processing: When lumber is cut from trees, sawdust is produced as a by-product. While
sawdust may not have as high a market value as lumber itself, it can be used for making particleboard
or as animal bedding.
Sugar Production: During sugar extraction from sugarcane or sugar beets, molasses is produced as a
by-product. Although molasses has lower economic importance than refined sugar, it can still be sold
for use in food production or fermentation processes.
Brewery Operations: In brewing beer, spent grains are generated after extracting sugars from malted
barley. These grains serve as a by-product that can be used for animal feed or in baking.
Fish Processing: When fish is filleted for consumption, fish heads and bones become by-products
that can be used to make fish meal or fish stock

KEY DIFFERENCES BETWEEN JOINT PRODUCT AND BY-PRODUCT

ASIS FOR JOINT PRODUCT BY-PRODUCT
COMPARISON
When the production of two or more The term by-product means a product
products of similar value, are made which is incidentally produced, during
Meaning together with same input and process, is the processing operation of another
called joint product product
Sales value Relatively high sales value compared to Relatively low sales value compared
other products with main product.
Production Consciously Consequently

160
 Input produced from the raw materials Produced out of discarded material
from the main process.
subsequent required to enhance the quality or turn By-products are sold in the original
processing them into finished products, in which form but can be further processed, if it
additional money is expensed can generate high value.

Accounting for Joint Product:

Approaches to Allocating Joint Costs:-
Physical measure method: This method s allocates costs based on physical quantities such as
weight or volume
Sales Value at Split-Off Method: Costs are allocated based on the relative sales values of each
product at the split-off point. This method is often favored because it reflects market conditions.
Steps
Step 1. Calculate Sales Value at Split-Off =Units Produced× Selling Price per Unit
Step [Link] Total Sales Value=∑(Sales Value of Each Product)

Estimated net realizable value method: allocates joint cost on the basis of there relative
estimated net realizable value.
Net realizable value= final sales value – separable cost
Constant gross-margin percentage NRV method.

CHAPTER 16
ACTIVITY-BASED COSTING AND ACTIVITY BASED MANGEMENT
Definition of Activity-Based Costing (ABC)
In ABC, activities are defined as any event, task, or unit of work with a specific goal.
Thus
 of accounting you can use to find the total
The activity-based costing (ABC) system is a method
 cost of activities necessary to make a product.

Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as
 salaries and utilities—to related products and services.
 is based on "activities"; an activity is any event, unit of work, or
This system of cost accounting
task with a specific goal.

161
 Activity-based costing (ABC) is mostly used in the manufacturing industry. It enhances the
reliability of cost data, hence producing nearlytrue costs and better classifying the costs incurred
 by the company during its production process.
The ABC system assigns costs to each activity that goes into production, such as
workers testing a
 product, setting up of machines, orders passed for purchase of raw materials etc.
ABC defines  production as consisting of a variety of activities, and it assigns costs to those
activities.

Key Components of ABC

Activities: The work performed within an organization that consumes resources and drives
costs (setup, machining, inspection)

Cost pools: Groupings of overhead costs associated with specific activities or processes

Cost drivers: Factors that cause or influence the cost of an activity (number of setups,
machine hours, number of inspections)

Activity cost driver rates: The cost per unit of the cost driver, calculated by dividing the total
cost of an activity by the total quantity of the cost driver

Activity-based cost assignment: The process of tracing costs from activities to products or
services based on their consumption of those activities

Hierarchy of activities: Categorizing activities based on their level of aggregation (unit-
level, batch-level, product-level, facility-level)
Steps in ABC
Identify all the activities required to create the product.
Divide the activities into cost pools, which include all the individual costs related to an
activity. Calculate the total overhead of each cost pool.
Assign each cost pool activity cost drivers, such as hours or units.
Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost
drivers.
Multiply the cost driver rate by the number of cost drivers.

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Features of Activity Based Costing (ABC)
 costs. Costs allocated to each activity
ABC is a modern approach to the allocation of indirect
 symbolise the resources consumed by the activity.
As done in conventional costing, ABC is not restricted to the allocation of indirect costs to
departments.It moves further to identify the individual activity for indirect cost allocation as the
lowest unit. 
 Based on consumption, resources are allotted to each activity and then to cost objects.
 the activities using the activity cost drivers and results in a more accurate cost
ABC identifies
 calculation.
This approach facilitates easy identification of cost according to activities cost driver. This costing
method is suitable if thereis more than one product in the manufacturing line and overheads have
a high share in total cost. 
 This approach creates a straight cause and effect association with various resource

OBJECTIVES OF ACTIVITY BASED COSTING (ABC)

To recognize several activities in the process of production, including the activities that add
value. 
 To eliminate the non value-adding activities.

 To put emphasis on the high-cost activities

 To incorporate activities based on distribution overheads.

 To help indecision-making process in the identification of a suitable price of product and

services. 
 To ensure accurate and precise cost determination of products and services.

To find options to improve the process and reduction of costs

Advantages of Activity Based Costing

Improved Accuracy: By linking costs more closely with actual resource consumption,
organizations can achieve more accurate product costing.

Enhanced Decision-Making: Better visibility into cost structures allows managers to make
informed pricing and product mix decisions.

Identification of Non-Value-Added Activities: Organizations can identify areas where they can
reduce waste and improve efficiency by analyzing value-added versus non-value-added activities

It provides the actual cost of production of specific products.

It allocates manufacturing overhead accurately to products and processes that use those activities.

Identifies inefficient products and sets targets to reach the goal of improvements.

163
 Determines product's profits margin more precisely. 

Evaluates the processes which have waste and unnecessary costs.

Provides better justification of costs in overhead manufacturing.
Disadvantages of Activity Based Costing 
 Collection and preparation of ABC costing is time-consuming.

 It takes huge cost to accumulate and analyze the information.

 Source data will not be available readily from normal accounting reports.

 useful for all types of accounting principles and cannot be

Reports from ABC are not always
 used for external reporting.
ABC costing may not be as useful for companies where overhead is small in proportion to
 total operating cost.
 say five or six, or number in
The number of activities a company has may be small,
the hundreds. Computers make using ABC easier.
ACTIVITY COST POOL

Cost pool: It is an aggregate of all the costs associated with performing a particular business
 activity such as making a particular product.
 incurred in a particular task, it is simpler to get an accurate estimate of the
By pooling all costs
 cost of that task.
An activity cost pool includes both fixed and variable costs and is a temporary account, used
only to get an idea of how much a certain activity costs a business.

 For example
Materials Handling: This cost pool includes all expenses related to receiving, storing, and
distributing raw materials and finished goods. The costs might encompass labor for handling
materials, equipment used in the process, and storage facilities. The cost driver for this pool could
 be the number of material movements or the weight of materials handled.
Machine Setup: This pool captures costs incurred during the preparation of machines for
production runs. It includes labor costs for setup personnel, equipment adjustments, and tooling
expenses necessary for different production batches. The relevant cost driver here could be the
 number of setups performed or the total setup hours required.
Quality Inspection: Costs associated with inspecting and testing products to ensure they meet
quality standards fall into this category. This can include salaries for quality control inspectors,
testing equipment maintenance, and any materials used during inspections. The cost driver might
 be the number of inspections conducted or inspection hours logged.



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 Production Scheduling: This activity cost pool encompasses costs related to planning and
scheduling production runs. It may include salaries for scheduling staff, software tools used for
scheduling, and communication expenses between departments. A suitable cost driver could be
the number of production schedules created or changes made to existing schedules.
Customer Order Processing: This pool includes costs tied to processing customer orders from
receipt through fulfillment. It covers labor costs for order entry personnel, systems used for order
management, and shipping expenses related to fulfilling orders. The cost driver could be the
number of orders processed or order complexity.
Maintenance Activities: Costs associated with maintaining machinery and equipment can also
form an activity cost pool. This includes routine maintenance labor, parts replacement, and
downtime incurred during maintenance activities. The appropriate cost driver might be machine
hours operated or maintenance requests submitted.
Training Costs: In organizations where ongoing training is necessary, this activity cost pool
would capture all expenses related to employee training programs—such as instructor fees,
training materials, and lost productivity during training sessions. The cost driver could be the
number of employees trained or training hours completed.
ACTIVITY COST DRIVER
cost driver refers to actions that cause variable costs to increase or decrease for a
An activity
 business.
 is a specific action or event that causes a change in the cost of an activity
An activity cost driver
 within a business
cost driver, also known as a causal factor, causes the cost of an activity to increase or
An activity
decrease. 
Cost drivers are essential in ABC, a branch of managerial accounting that allocates the indirect
costs, or overheads, of an activity.
Examples of cost drivers include

Machine setups
Maintenance requests
Consumed power
Purchase orders
Quality inspections
Production order.
Key Differences between Activity cost pool and Activity cost driver

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 Activity cost pools Activity cost driver
is a collection of all costs associated with a is a measure or factor that causes changes in those
specific type of activity costs
Example all expenses related to machine setups number of machine setups performed during a period
Purchasing department Number of purchase order
Receiving department Number of purchase order
Material handling Number of material requisition
Setup Number of machine setup required
Inspection Number of inspection
Engineering department Number of engineering change order
Personal processing Number of employees hired or laid down
Supervisor Number of direct labor hours

TRADITIONAL COSTING
Traditional costing is a costing method that allocated all manufacturing overhead to products based
on a single cost driver
The traditional costing systems utilize a single, volume-based cost driver
Traditional costing is a method used to assign costs to products based on the volume of resources
used, such as labor hours or machine hours. It aims to determine the cost of producing or providing a
service by allocating indirect costs to the products based on the volume of resources consumed, such
as direct labor or machine hours.
It aims to allocate indirect costs to products based on a predetermined cost driver. This method
assumes that all overhead costs result from a single factor. For example, direct labor hours or machine
usage, and this factor is the primary driver of overhead expenses.

Basis Traditional ABC

1. Cost pools One or limited number Many
2. Cost driver Uses a single cost driver, such as Uses multiple cost drivers, such as several
direct labor or machine hours, to setups, inspections, or orders, to give
allocate indirect costs to products. indirect costs to products.
3. Applied Rate Volume based Activity Based
4. Accuracy allocate indirect costs inaccurately, Provides a more accurate view of cost
assuming that all products behavior by identifying and giving costs
consume indirect costs similarly based on the activities that generate them.
5. Emphasis Traditional costing emphasizes ABC emphasizes indirect costs, such as
direct costs, such as direct labor overhead expenses and support costs.
and direct materials
6. Applied for Labour Intensive Capital Intensive

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 7. Benefits Simple, Inexpensive Accurate product costing, identification
of necessary activities etc.
8. Focus Departments or Processes and activities
responsibility centers

Activity-Based Management
Activity-based management (ABM) is a system for determining the profitability of every
aspect of a business so that its strengths can be enhanced and its weaknesses can either be
improved or eliminated altogether.
Activity-based management (ABM), which was first developed in the 1980s, seeks to highlight
the areas where a business  is losing money so that those activities can be eliminated or improved
 to increase profitability.
ABM analyzes the costs of employees, equipment, facilities, distribution, overhead, and other
factors in business to determine and allocate activity costs.
Activity-based management (ABM) is a procedure used by businesses to analyze the
profitability of every segment
 of their company, enabling them to identify problem areas and
areas of particular strength
Understanding Activity-Based Management (ABM)
Activity-based management can be applied to different types of companies, including
Manufacturer
Service providers
Non-profits
Schools and
Government agencies.

5.3 What is activity-based costing for customer profitability?

Activity-based costing (ABC) is a strategy implemented by an organization to accurately
identify the true profitability of its customers; this approach also may be applied when determining
the profitability of other key variables such as product lines and geographic segments

Customer Profitability Analysis

Customer Profitability Analysis is a tool from managerial accounting that shifts the focus from
product line profitability to individual customer profitability. 
Activity Based Costing looks at the various cost drivers to accurately isolate costs and determine
a product’s profitability.

  of looking at the various activities and

In contrast, Customer Profitability Analysis is a method
expenses incurred in servicing a particular customer. 
In other words, it focuses on analyzing profit per customer rather than profit per product.

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 CHAPTER 17
COST VOLUME-PROFIT RELATIONSHIP (CVP)
The study of the interrelations of sales, costs, and net income is usually called CVP analysis. CVP
analysis is a tool for management planning, control and decision making. Managers should know their
costs and classify as fixed and variable when making decisions that affect the volume of output.
Decisions on volume of output will affect costs and revenues. Although many factors in addition to
volume of output will affect cost, yet it is a useful starting point in the manager’s decision process to
specify the relationship between the volume of output, costs, and revenue.

CVP analysis helps to answer questions such as: 

 How much does a firm have to sell just to cover its total cost?

 How much does a firm have to sell to reach its target profit?

How will a change in a firms fixed costs affect its net income? etc

The study of CVP relationships is often called break-even analysis. Break-even is a point of zero
profit (i.e. no profit, no loss).
Assumptions of CVP analysis 
 The selling price per unit remains constant.

 The total expense can be separated into variable expense and fixed expenses.

 The variable cost (expense) per unit remains constant.

 The fixed expenses do not change as sales volume change.

 For a multi-product firm the sales tax rate remain constant.

Production volume and sales volume are equal.

Contribution Margin (CM)

The contribution margin is the different between sales revenue and variable costs. It is a measure of
the amount available to cover fixed costs and there after to provide profits for an organization.
Contribution Margin can be expressed in four ways. In total, in unit basis and in percentage basis.
Total CM=Total revenue-Total variable cost
Unit CM= Unit sales price-unit Variable cost
.CM Ratio=Total CM/Total sale Or
CM Ratio=Unit CM/unit sales price

Example1:
Assume that Top Company produces and sales shampoo called hair success. The shampoo is
produced at a cost of Br 80 per bottle and is sold for Br100 per bottle. The company fixed costs
amounts to Br 120,000 per year. The normal plant capacity is 10,000 bottles of shampoo annually.
Required: Compute the contribution margin per bottle (Unit).

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Solution
Sales price per bottle………………………………Br 100
Less: variable expense (cost)/bottle………………. 80
Contribution margin per bottle…………………… Br 20 Represent the amount of birr added to
Profit for each bottle sold before fixed cost is covered.
Example 2:
Assume all the data in example one above and assume also that Top company’s sales in no of bottles
is 5998; 5999; 6000; 6001 and 6002 in different periods.
Required: Prepare the contribution income statement
Solution Top company
Contribution income statement
Number of bottles sold (say a)…….5,998 5,999 6,000 6001 6002
Sales (B100×’a’)…………………599,800 599,900 600,000 600,100 600,200
Less: variable expense (B80×’a’)….479,840 479,920 480,000 480,080 480,160
Contribution margin……………….119,960 119,980 120,000 120,020 120,040
Less fixed expenses………………..120,000 120,000 120,000 120,000 120,000
Net income (loss)……………….. Br (40) (20) 0 20 40

Note:
Contribution margin is used first to cover the fixed expenses and then whatever remains goes
toward profit.

When contribution margin equal to fixed cost, there will be neither profit nor loss. The sale of
6000 bottles of shampoo in the above case or Br 600,000 is called the break-even point (BEP).

After the BEP, net income will increase by the unit contribution margin for each additional
 unit sold.
 Each unit sold below the BEP decreases (reduce) the companies net loss.
If there were no sales, the company’s loss would equal its fixed expenses.
Break-even point Analysis (BEP) 
 The point where total revenue equals total costs is called the break-even point (BEP).

 At BEP the company’s revenues simply cover its costs, thus profit/loss is zero.

Break-even analysis is one important element of CVP analysis.

There are three techniques or methods for computing BEP

Equation (formula) technique
Contribution margin technique
Graphic technique

Equation method:
This method uses algebraic method to make CVP analysis and to determine break even point,
target profit, etc
Let: Q= number of units produced and sold
TC= Total cost of producing and selling ‘Q’ units
TR= Total sales revenue from selling ‘Q’ units
P= Selling price per unit
VC= Variable expenses per unit
F= total fixed expenses
To drive the sales revenue and total cost formula.

169
 1. BEP in units, Q = F
(SP-Vc)
2. BEP in sales = F = F
CM ratio SP-Vc OR BEP.Q ×P
SP
Example: Top Company’s manufactures and sells shampo. The company recent income statement is
as follows
Total per unit
Sales (6000)………………… 600,000 100
Less: variable expense… . ………….480,000 80
Contribution margin………………. 120,000 20
Less fixed expenses……………….. 120,000
Net income (loss)……………….. ….Br 0

Based on the above data, answer the following questions

Compute the number of bottles of shampoo the company should produce and sale per
year so as to break even in unit
Determine the break even sales in birr.

Solution
a. Qat BEP= FC = Br120,000 =6,000 bottles, which represent 60% of the plant capacity.
SP-Vc Br 100-80

BEP in sales = BEP.Q ×P = 6000×Br 100 = Br 600,000

Or
BEP in sales = F = 120,000 = Br 600,000
P-VC 100-80
P 100

Example: Using the data of Top co, compute BEP in units and in sales birr following the
contribution margin method.
Solution
BEP in units = F , but unit Cm = p/u –Vc/u
Unit cm =Br 100-Br 80
= Br 120,000=6000 bottle =Br 20
Br 20
BEP in sales = F , but cm ration= cm/p×100%
CM ration =20/100×100=20%
=Br 120,000
0.2
Br 600,000
Graphing or Graphic method

Information may be presented to management in a more visual format, such as graphs. A chart
called CVP graph (or break-even chart) can be prepared to depict the relationships among
revenue, cost, volume and profit. The break even point on the break even chart is located at the
point where the total revenue and total cost lines cross or intersect.

170
 Example: Using Top Company data graph the cvp relationship on the break even chart and
determine/show:
The BEP in units and in birr
The profit and loss area on the graph.

BEP Graph
Reading the BEP Graph
BEP- BEP is determined by the intersection of the total revenue line and the total expense line. The
Company in our example breaks even at 6000 units, or Br 600,000 of sales.
Profit and loss area - The CVP graph discloses more information than the BEP calculation. From the
graph, a manager can see the effects on profits of changes in volume. The vertical distance between
the lines on the graph represents the profit and loss area at a particular sales volume. If sales are fewer
than 6000 units, the organization will suffer a loss. The organization will have a profit if sales exceed
6000 units a year.

Target Profit Analysis

  or planned profit is the level of profit that managers need to achieve in a particular period
Target profit
of time. 
Here the sales volume should not only cover total expenses but also provide the

 
How much sales (quantity and birr) should a company sell if a fixed amount of profit before and /or
after tax is desired?
to generate a target profit could be
The number of units to be sold and the sales in birr to be earned
computed using either of the methods used to determine BEP.

Target profit could be: Profit before tax (PBT) or

Profit after tax (PAT) 
To drive a formula for determining sales units to generate a target PBT.

171
 Qt = F + PBT Q at target profit before tax
P-Vc
If management is in need of a target profitafter tax (PAT), the formula would be: Qt at
target profit after tax = F+PAT
1-t
P-Vc
Example: Assume that the management of Top Company has planned that the companies operation
should produce a profit before tax of Br 40,000 by the year 2008 and a profit after tax of Br 90,000 by
the year 2009, given this, determine:
The number of bottles of shampoo the company should produce and & sale to achieve its
target profit
By the year 2008
By the year 2009 (assume a 40% tax rate)
The sales volume in Birr, which the company should generate to attain its target profits for the
two years.

Solution
a) i. Qt = F + PBT = Br 120,000 +Br 40,000
P-Vc Br 20
8,000 bottle

Qt= F+PAT =120,000 +Br 90,000

1-t0.6
P-Vc Br 20
13,500 bottles
Target sales = QT×P
Thus, for the year 2008, Target sales = 8,000 × Br 100 = Br 800,000
For the year 2009, Target sales = 13,500 ×Br 100= Br 1,350,000

The margin of safety

The margin of safety is a measure of risk as it indicates (show) the number of units or amount of sales
birr that can decline before a firm suffers a loss.
Margin of safety=Total sales-break even sale
Absolute margin of safety = Total budgeted (actual) sales – BEP sales
Relative margin of safety = Total budgeted (actual) sales –BEP sales X 100%
Total budgeted (or actual) sales

Example. Assume Xyz Company (in the previous example) is currently selling7, 500 bottles of
shampoo.
Required:
compute and interpret the absolute margin of safety
Compute and interpret the relative margin of safety
Solution
BEP in sales = Br 600,000
BEP in bottles =6000
Actual sales
Current sales in birr (7,500 ×Br 100) =Br
750,000 Current bottles sold = 7,500
Absolute margin of safety = Total actual sales –BEP-sales

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 Br 750,000 -600,000
Br 150,000
In units : Absolute margin of safety = 7,500-6,000
= 1,500 bottles
Relative margin of safety = Br 150,000 × 100%= 20%
750,000
Based on the given data (cost, price, units sold) a decline in sales 1,500 bottles or Br 150,000 birr or
by 20% from the current sale would result in zero profit.

Sensitivity Analysis
Sensitivity analysis is a “what if” technique that examine how a result will change if the original
predicted data are not achieved or if an underlying assumption changes. In the context of CVP,
sensitivity analysis answers such questions as, what will operating income be if the output level
decreases by a given percentage from the original reduction? And what will be operating income if
variable costs per unit increase?

change in fixed cost and sales volume

Example: Assume all the data given for Xyz Company which produce and sale
7,500 bottles of shampoo per year. A 20,000 increase in advertising would increase
sales to 8,300 bottles, should the budget for advertising be increased?
Solution (Using incremental approach or competitive income statement approach)

Expected increase in sales unit (8,300*100*0.2 CM ratio ) …………………166,000

Less current contribution margin75000*100*0.2 CM ratio ) …………B150,000
=Incremental contribution Margin ……………………………………….. 16,000
Less incremental advertising expense…………………………………….Br (20,000)
Decline in net income (profit)…………………………. ……………...(Br 4,000)
Because the increment in advertising expense would decline net income by Br 4,000 it should not
be approved.

Competitive income statement approach

Current sales Sales with advertising Different
(7,500 bottles) Budget (8,300 bottles) (800 bottle)
Sales Br 750,000 Br 830,000 Br 80,000
Less variable expense 600,000 664,000 64,000
Contribution margin Br 150,000 166,000 16,000
Less fixed expense 120,000 140,000 20,000
Net income Br 30,000 Br 26,000 Br (4000)

2. Change in variable costs and sales volume

Example: Assume that Xyz Company plans to use quality raw material that would reduce
contribution margin by Br 5 per bottle so that sales would increase to 10,000 from the current
7,500 bottles. Should this quality raw material used?
Solution
Expected CM with quality raw material (10,000×100*0.15 Cm Ratio )………..Br150,000
. Less Current total contribution margin (7,500×100*0.2 CM ratio ) ………….150,000
Increase /decrease in total contribution margin………………………………….…0

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 The company would be indifferent to use or not of the quality material as it will not affect the
profitable of the company.
Assume the quality material would increase sales by 3,000 units. Should the material be used?
Expected CM with quality raw material (10,500×100*.15 C M ratio )…………..157,500
Less Current total contribution margin (7,500×100*0.2 Cm ratio)…………….150,000
Increase in total contribution margin………………………………………….Br 7,500
The quality material should be used since profit will increase by Br 7,500 (

Change in fixed cost, sales price and sales volume

Example: current sales in bottles of shampoo =7,500
To increase sales by 40% the sales manager propose to cut selling price by Br 5 per
bottle and to increase the advertising budget by Br 20,000 per year. Should the
proposal be accepted?
Solution
Expected sales if the proposal is accepted = 7,500 +(40%×7,500)
=10,500 bottle
Proposed CM= P-VC=95-80=Br 15
Expected total CM with lower selling price (10,500×95*0.157895)…………….157,500
Less Present total contribution margin (7,500×100* 0.2 Cm ratio)…………….150,000
=Incremental contribution margin……………………………………………..Br 7,500
Less incremental fixed cost (advertising expense)……………….................... 20,000
 Decline in net income………………………………………………………12,500 
The proposal should not be accepted as it will decline net income by Br 12,500
CVP ANALYSIS WITH MULTIPLE PRODUCTS
For organizations selling multiple products, the relative proportion of each type of product
 sold is called the sales mix. Because all products are not equally profitable, net income of such
organization depend on their sales mix.
 Profits will be greater if 
the high margin rather than low margin items make up relatively large
proportion of total sales. 
Change in the sales mix can change a company’s profit.
Example: Suppose ABC Company produces and sales products x and y and budgeted to sell 15,000
units of product x and 5,000 units of product y per year. This sales mix is estimated to remain
constant. The company’s annual fixed costs are Br 246,500.
Product X Product Y
Sales price per unit Br 30 Br 10
Variable costs per unit 12 6

Given this you are required to:

Determine the total breakeven point in units for the two product
Determine the number of units of each product that must be sold so as to break even
Compute the break even point in sales birr for the company as a whole and for each
product.
Solution
First we have to compute the weighted average unit contribution margin of the company.
Weighted average unit CM= Σ(CM/unit of each product × sales mix of each product
(WAVCM)
From the given data the sales mix can be computed as follows:
Product Budgeted sales in Budgeted sales= (Budgeted sales of each product) ×100%
Units mix in units total budgeted sales of all

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 Products
X……..15,000……………………75%
Y…….. 5,000………………….…25%
Total……...20,000 100%

Weighted average unit CM = (Br 18×0.75)+(4×0.25) = Br 14.50

Weighted average unit selling price=30×0.75)+(10×0.25=25
Since there are two products the CM ratio =Weighted average unit CM 14.5
Weighted average unit selling price 25=0.58

Then break even point in units= Fixed expenses =Br 246,500 =17,000 units
Weighted average unit CM Br 14.50
Product X= 75% of the units at BEP
=0.75×17,000=12,750 units
Product Y= 0.25 ×17,000=4,250 units
Absolute margin of safety (product X= 15,000-12,750 =2,250 units
Product Y=5,000-4,250=750 units

Since there are two products the CM ration=Weighted average unit CM ×100%
Weighted average unit selling price
=Br 14.5
(30×0.75)+(10×0.25)=WASP
= 14.5 = 58%
25
3. BEP in birr = FC ,
CM ratio
=Br 246,500
0.58
=Br 425,000

Sales mix in birr

Products Budgeted sales Sales mix CM ratio of Overall CM
In Birr (PQ) in birr each product
X Br 450,000 90% 60% 54%
Y 50,000 10% 40% 4%
Total Br 500,000 100% 58%
So, BEP in sales birr for
Product X= BEP sales of birr of × Sales mix in birr of P.x
All products
Br 425,000 ×90%=Br 382,500
Product Y= Br 425,000 × 10% =42,500
Note that the sales mix based on sales birr is not necessary equal to the sales mix based on units.
ABSORPTION VERSUS DIRECT COSTING
Definition:-Absorption costing treats the costs of all manufacturing components (direct material,
direct labor, and variable overhead and fixed overhead) as inventoriable or product costs in
accordance with generally accepted accounting principles (GAAP). Absorption costing is also known
as full costing.

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Absorption costing indicates that all of the manufacturing costs have been assigned to (absorbed by)
the units of goods produced
Absorption costing “absorbs” all of the costs used in manufacturing and includes fixed manufacturing
overhead as product costs where as Variable costing considers the variable overhead costs and does
not consider fixed overhead as part of a product’s cost. Absorption costing is in accordance with
GAAP, which states that expenses should be recognized in the period in which revenues are incurred
where as variable cost is not in accordance with GAAP, because fixed overhead is treated as a period
cost and is not included in the cost of the product

There are two Method for Absorption cost

Absorption costing (full costing) and
Direct costing (variable costing).
Under the absorption method of costing
 (full costing), the following costs go into the product:
 Direct material (DM).

 Direct labor (DL).

 Variable manufacturing overhead (VMOH).

Fixed manufacturing overhead (FMOH).

Absorption cost formula = (DL cost + DM cost + VMOH cost + F MOH cost)
No. of units produced
Under absorption costing, the costs below are considered period costs anddo not go into
 the cost of a product. They are, instead, expensed in the period occurred:

 Variable selling and administrative.

Fixed selling and administrative.

 Direct material (DM).

 Direct labor (DL).
Variable manufacturing overhead (VMOH)
While companies use absorption costing for their financial statements, many also use variable costing
for decision-making.
The difference between absorption costing and variable is shown as follows

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 CHAPTER 18
RELEVANT INFORMATION AND DECISION MAKING
Relevant and irrelevant information
Relevant cost is a management accounting term that describes avoidable costs incurred when making
specific business decisions. This concept is useful in eliminating unnecessary information that might
complicate the management’s decision-making process. Businesses use relevant costs in management
accounting to conclude whether a new decision is economical. A particular cost may be relevant for
one situation but irrelevant for another. The opposite of relevant costs is sunk cost or irrelevant costs,
which refers to the expenses already incurred. Thus, incurring an expense may be avoided by deciding
not to perform a certain activity.
On the other hand, irrelevant information is information that doesn’t help decision making. Revenues
and costs that have already earned or incurred are irrelevant information in making decisions.
Steps in decision making process
 process.
There are six steps that characterize the decision making
 Define or clarify the decision problem

 Identify alternative solutions to the problem

 Evaluate alternatives through cost benefit analysis

 Develop a decision model: brings the criterion, constraints and alternatives together.

 Gather the data

 Select an alternative

Implement and follow up

2.1.1 Relevant, Irrelevant Costs and Revenues

The most important element in decision-making process is identifying relevant and non-relevant
information (revenues and costs). Relevant costs and revenues are those future costs and revenues
that will be changed by decision while irrelevant costs and revenues are those costs and revenues
that will remain unchanged irrespective of the decision made.
All in all, relevant costs and revenues satisfy the following two criteria:
They affect the future
They differ between alternatives

Types of Relevant Costs

There are four types of relevant costs;
Avoidable costs
The term is also called variable costs. If a company decides not to undertake an activity, the company
can avoid some expenses. It happens when the companies opt-out of other activities that can

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 save it from incurring expenses. Variable costs vary with different levels of production. It means that
if there is zero production, there is no spending.
Incremental costs
Along the line of business, there is the production of several units. These additional units have a price
tag. Thus, these costs increase as the production increases or drops with low production. They are
called incremental costs. The incremental costs are avoidable costs, since a company can change a
cost by taking one alternative as opposed to the other.
Opportunity costs
Opportunity Cost is the cost of the next best alternative, forgiven. When a business must decide
among alternate options, they will choose the one that provides them the greatest return.
Opportunity costs are associated with choosing between two alternative options. The loss of benefit
due to an alternative option is the opportunity cost, also known as the alternative cost.
Future cash flows
The future expenses that might occur due to a decision made in the present are called future cash
flows. The current value is used to project future revenues to see if a decision will incur future
costs. Here, we can price the expected ongoing-project revenues with the current value.

Features of Relevant cost

Relevant costs have three features,
Relevant are future oriented. That means that a relevant cost is one that we will incur in the future
as a direct result of a management decision. Past costs are irrelevant, as we cannot affect them by
current decisions and they are common to all alternatives that we may choose.

Relevant costs are cash transactions rather than accounting or paper transactions. This means
that a relevant cost is not going tobe depreciation. Expenses such as depreciation are not cash
 flows and are therefore not relevant
Relevant costs are incremental in nature. This means that the cost will increase or maybe
the revenue will increase in direct relation to a particular decision.

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Non-Relevant Costs
We also need to consider non-relevant costs and revenues. These would be costs and revenues that we
would not consider in short-term decision making. There are four main non-relevant costs that we're
going to run through - sunk costs, committed costs, notional costs, and fixed costs.
Sunk costs. Sunk costs are costs that we have already incurred. They're never relevant in short-
term decision making. A good example of a sunk cost would be as follows; suppose we're
producing a new product and we've paid for customer surveys to see how good this product is or
what our customers’ reaction is to this proposed idea. If we decide to produce the product, we
will have incurred that cost anyway. No matter what decision we make, we've already incurred
that cost. Therefore, it's a sunk cost and it's never relevant in short-term decision making.
Committed cost. A committed cost is one that we've committed to and so, regardless of
whichever decision we intend to make or whichever decision we decided to choose, we will
incur this cost regardless. Therefore, it is a non-relevant cost because we will incur this
regardless of whether we decide to pursue a particular course of action or not.
Notional cost. Very simply, these are non-cash items. As you'll recall from earlier on in this
article, in order to be considered a relevant cost, it has to be a cash transaction. So, a non-cash
transaction or a non-cash item would be depreciation or notional rent, or maybe a translation
gain or loss on foreign exchange. Those would be examples of non-cash items.
Finally, we have fixed costs. Fixed costs are a little tricky because some fixed costs we do
include as being relevant, and some we would say are non-relevant. Relevant fixed costs would
be fixed costs that are specific to that particular decision. So, what do I mean by that? Let's say
we have a shutdown decision. If we avoid certain fixed costs, maybe rental payments or salaries
for supervisors, as a result of shutting down a particular division, then fixed costs would be
considered a relevant cost. That's really important. Fixed costs can be relevant but they have to
be related to a specific decision. On the other hand, fixed costs that are general in nature (i.e.
fixed costs that we incur regardless of whichever decision is made), would not be considered
relevant. Also, fixed cost absorption is normally non-relevant, because it's more of an
accounting entry rather than actual fixed costs being incurred for a particular decision.
Fixed costs are divided into two categories, avoidable and unavoidable.
Avoidable costs are costs that will not continue if an ongoing operation is changed, deleted or
eliminated. These costs are relevant costs in decision-making. Examples of avoidable costs include
departmental salaries and other costs that could be avoided by not operating the specific department.

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Unavoidable costs are costs that continue even if a subunit or an activity is eliminated and are not
relevant for decision. The reason for this is that such costs are not affected by a decision to delete a
particular activity. Unavoidable costs include many common costs, which are defined as those costs
of facilities and services that are shared by users. Examples are store depreciation, heating, air
conditioning, and general management expenses

2.2 PRODUCTION (MAKING) OR MARKETING (BUY) DECISION

Manufactured products consist of several components that are assembled into final product. Many of
these components can be bought from an outsider or made inside.
Decisions about whether to buy or produce within the organization are often called make-or-buy
decisions. The make or buy decision is also called in-sourcing and outsourcing.
Make or buy decisions are resolved by identifying which decision will result in lower costs and thus,
higher profits. Relevant costs of making a product, including direct materials, direct labor, variable
overhead, avoidable fixed costs, and opportunity costs are compared to the purchase cost if it was
bought from a supplier.
Example
Assume a company is deciding between manufacturing a part in-house that costs $6 per unit, cost of
producing a normal required volume of 10,000 units per month including direct Material cost, direct
labor cost, fixed overheads, and variable overheads, as given in the table below.
Manufacturing cost
Dm 8000
DL 12500
Variable Overhead 10,000
Fixed overhead 29,500
Total cost of Manufacturing unit per Month 60,000
Average Manufacturing cost per 6
unit(60,000/10,000
If a company can buy for $5 per unit a part, all the cost of direct materials and direct labor plus
$9,000 of variable overhead would be eliminated. In addition, $2,500 of the fixed overhead would, be
eliminated. These are the relevant costs in producing the 10,000 units of the component.
Should the co be purchased from market or Make?
Solution
Manufacturing cost Make Buy
Direct Material cost 8000
Direct Labor cost 12500
Variable Overhead cost 10,000 1000

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Fixed overhead Cost 29,500 27,000
Purchase Price of parts 5 per unit ___ 50,000
Total cost of Manufacturing unit per Month 60,000 78,000
The company should make not buy. Is it cheaper to make rather than buy.
Analysis
Our analysis shows that, making the part will cost $60,00d per month while buying the part will cost
$78, 000. Thus the company will save $18,000 per month by continuing to’ make the part.
XYZ saves Br. 18,000 by making the component.
What if the’ company could have used its production facilities to manufacture a new product line that
would increase overall profitability by $25,000 per month? If this were the case, the $25,000 profit
would be viewed as the opportunity cost of using the company’s production facilities to manufacture
a component part. Obviously, the company should not forego a $25,000 profit in order to save
$18,000. Thus, when the opportunity cost is considered, it becomes evident that the company should
buy the part and use its production facilities to manufacture the new product. Example

The estimated cost of producing 6000 units of the components are as follows
Per unit Total
Dm 10 60,000
DL 8 48,000
Variable Overhead 9 54,000
Fixed overhead ,1.5 per Dl 12 72,000
Total 39 234,000
The same components can be purchased from market at a price of birr 29 per unit. If the components
purchased from the market, Direct material , Direct labor, and variable over head is eliminated. In
addition 25% of the fixed factory overhead will saved. Should the co be purchased from market or
Make?
Solution
Make Buy
Purchase Price - 174,000
Dm 60,000
DL 48,000
Applied Variable O 54,000
Applied FOH ,1.5 per Dl 72,000 54,000
Total 234,000 228,000
Difference in Favor of buying 6,000
Thus the company will save $6,000 per month by buying product
Example3: Suppose XYZ Company now makes a component for its major product. A manager has
prepared the following estimates of costs at the volume of 10,000 units per year.
Total cost for Cost per
unit
10,000 units
Direct material Br.20,000 Br.2
Direct labor 50,000 5

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 Variable overhead 30,000 3
Fixed overhead 60,000 6
Total costs Br.160,000 Br.16
An outside supplier offers to supply the component at Br.14 per unit for a two year period; all the cost
of direct materials and direct labor and variable overhead would be eliminated. In addition, $2per unit
of fixed overhead would, be eliminated
Should the company accept the offer?
Solution
10000 Units
Decisions___
Make Buy-_ Difference
Direct materials Br. 20,000 Br. 0
Direct labor 50,000 0
Variable overhead 30,000 0
Direct fixed overhead 60,000 40,000
Purchase price 0 140,000
Total Br. 160,000 Br. 180,000
Difference in favor of buying 20,000

XYZ saves Br. 20,000 by making the component.

Considering only the quantitative data, XYZ should make the components until some other
opportunity cost arises-the benefit to be gained by using the space and equipment for other purpose-
exceeds the Br. 20,000 cost savings available by using those resources to make the component. Such a
benefit could come from renting the space and equipment or using them to make another product that
would bring more than br. 20,000 incremental profits.
In such situations, the company might consider buying the component from outside supplier.
1. Special sales order decisions:
A special order is an order that the company did not anticipate when developing its budget for the
year. Therefore, this is an additional opportunity to generate revenue above sales goals. Special orders
typically request a lower price than normally offered and/or might include additional costs
At a time a customer may offer special sales orders at less than full cost. At the beginning, it may
appear that accepting the offer reduce the overall profitability of the firm. However, the full cost
(production cost) contains fixed costs that do not change whether the special order is accepted or not.
Such special orders should come once in a while.
Factors that should be considered under such type of decisions are:

 The special orders must not be with regular customers

There has to be an excess capacity within the organization

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 The price should be more than the Manufacturing variable cost, and additional costs
associated with the special offer
Example
In a month, ABC Company normally produces and sells 8,000 units of its product for $20. Variable
manufacturing cost per unit is $10. Total fixed manufacturing costs (up to the maximum capacity of
10,000 units) are $38,000. Variable operating cost is $1 per unit and fixed operating costs total
$10,000.
A customer placed a special order for 1,500 units for $15 each. The customer is willing to shoulder
the delivery costs; hence the business will not incur additional variable operating costs. Should the
company accept or reject the special order?
Analysis
The company has 2,000 units excess capacity to fill up the special order of 1,500 units. The only
costs to be considered in this case are the variable manufacturing costs. The total fixed cost is the
same regardless of the level of activity. Even if an additional 1,500 units are to be produced, the
total fixed cost remains the same. In addition, both parties agreed that the company will not incur in
additional variable operating costs.
Should the company accept the offer? Yes.
The selling price of $15 exceeds the variable manufacturing cost of $10. This will result in
additional income of $7,500 (1,500 x $5).
Proof
Without Special With Special Order
Difference
Order 1,500 9,5000Units
8000 Units
Sales $160,000 22,500 $182,500
Less: Variable costs
Variable manufacturing
80,000(8000*10) 15000 95,000(9500*10)
cost
Variable operating 8,000 8,000
Contribution margin $72,000 7500 $79,500
Less: Fixed costs
Fixed manufacturing 38,000 38,000
Fixed operating 10,000 10,000
Operating Income $24,000 7500 $31,500

The $182,500 sales revenue includes regular sales 8,000 units sold at $20 and 1,500 units sold at
$15 each. Additional variable operating costs is avoided as mentioned in the problem. Fixed
costs remain constant regardless of the level of activity.

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EXAMPLE - WITHOUT EXCESS CAPACITY
Using the same information in the above scenario but this time, Except that the company normally
manufactures and sells 9,000 units instead of 8,000 and a customer placed a special order for 1,500
units for $15 each. The conditions of the special order specify that it has to be accepted in full as
acceptance of partially quantity is not allowed.
In this requirement, the company has no sufficient capacity to produce the special order without
affecting normal sales. To accept the special order for 1, 500 units Kora Company must cut back
normal sales by 500 units because production capacity cannot be expanded in the short run .
Therefore, the relevant costs to be used in evaluating the special order include an opportunity cost.
The opportunity cost is the contribution margin forgone on regular sales.
Should the company accept the special order?
Solution:
Since the company has excess capacity of 1,000 units only, it is not enough to fill up the special
order of 1,500 units to produce the special order without affecting normal sales.
Hence, a portion of the regular sales (500 units) must be sacrificed to fill up the entire special order.
The lost contribution margin should be considered.
Contribution margin is equal to sales (at $20) minus variable costs ($10 variable manufacturing
plus $1 variable operating).
Contribution margin = Sale-variable manufacturing cost-variable operating cost
Contribution margin = $20) - 10 -1 variable operating).
Lost contribution margin = ($20 - $11) x 500 units = $4,500
The lost contribution margin is allocated over the items sold through the special order.
Lost contribution margin per unit = $4,500 / 1,500 units = $3
This cost is an additional consideration in the decision. Should the company accept the offer? The
answer is still yes since the selling price ($15) is higher than the cost ($13, i.e. variable
manufacturing cost per unit of $10 plus lost CM per unit of $3). This will result in additional income
of $3,000 (1,500 x $2).
Proof
Without Special Order With Special Order
Sales $180,000 $192,500
Less: Variable costs
Variable manufacturing
90,000 100,000
cost
8,500 (9000-500 lost
Variable operating 9,000
contribution
Contribution margin $81,000 $84,000
Less: Fixed costs
Fixed manufacturing 38,000 38,000
Fixed operating 10,000 10,000
Operating Income $33,000 $36,000

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The $192,500 sales revenue includes regular sales of 8,500 units (sold at $20 each) and 1,500
specially ordered units (sold at $15). As mentioned in the problem, the company will incur the
variable operating cost only for regular sales. Fixed costs remain the same.
2. Add or Drop decisions
Add or drop decisions require the computation of segment income. Segment income excludes
allocated fixed costs, since these are not traceable to the segment and are unavoidable. The entire
business will still incur them regardless. If the product line or segment has a positive segment margin,
it is recommended to keep (or add, if new) that segment.
EXAMPLE
XYZ Company has three product lines. The company is considering dropping Product 2 because
it has been operating at a loss. The following summarizes the income of the three product lines.
Product 1 Product 2 Product 3 Total
Sales $15,000 $22,000 $37,000 $74,000
Less: Variable Costs 9,000 10,000 19,000 38,000
Contribution Margin $ 6,000 $12,000 $18,000 $36,000
Less: Fixed Costs
Traceable Fc 3,000 10,000 6,000 19,000
Allocated Fc 1,000 3,500 5,000 9,500
Net Income $ 2,000 ($ 1,500) $ 7,000 $ 7,500
Solution:
The allocated fixed costs should be removed when analyzing segment income. Hence, Product 2
should not be dropped since it has a positive segment margin.
Product 1 Product 2 Product 3
Sales $15,000 $22,000 $37,000
Less: Variable Costs 9,000 10,000 19,000
Contribution Margin $ 6,000 $12,000 $18,000
Less: Traceable Fixed Costs 3,000 10,000 6,000
Segment Income $ 3,000 $ 2,500 $ 12,000
Why are we removing the allocated fixed costs in our analysis? Because the company would still
incur the entire allocated fixed costs with or without Product 2. A portion of these costs is actually
absorbed by Product 2's segment income. If Product 2 is dropped, it will result in lesser overall
profits.
With Product 2 Without Product 2
Sales $74,000 $52,000
Less: Variable Costs 38,000 28,000
Contribution Margin $36,000 $24,000
Less: Fixed Costs
Traceable Fixed Cost 19,000 9,000
Allocated Fixed cost 9,500 9,500
Net Income $ 7,500 $ 5,500

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The allocated fixed costs are unavoidable costs. The entire $9,500 would be incurred with or
without Product 2. If Product 2 is dropped, it will result in lower overall net income. Hence, the
product line should not be dropped.

Exercise
There are many ways to segment a company. Determining the best mix of segments is a problem for
managers who have to decide whether to drop a segment or to replace one segment with another.
Relevant information plays a great role in such type of decision.
Example: (adapted from Managerial Accounting, 9th edition) assume RTV Fashions uses its
available space for three product lines. The following is the income statement for last month and
management of RTV expects these results to continue in the near future.
Clothing Shoes Jewelry Total
Sales Br.45,000 Br.40,000 Br.15,000 Br.100,000
Variable costs 25,000 18,000 11,000 54,000
Contribution Br.20,000 Br.22,000 Br. 4,000 Br. 46,000
margin
Fixed costs:
Direct all (4,000) (3,400) (1,500) (8,900)
avoidable
Indirect (common) (9,450) (8,400) (3,150) (21,000)
Profit (loss) Br.6,550 Br.10,200 Br.(650) Br.16,100
Should the store drop the jewelry line because it shows a loss? To answer that question we should
know what would change if RTV dropped the line. Let’s start with a choice between two simple
alternatives:
Keep jewelry or drop it and rent the available space to another company for Br. 400 per month. If it
dropped jewelry, RTV would lose Br. 15,000 of sales but could avoid the Br. 11,000 of variable costs
of those sales as well as the Br. 1,500 avoidable fixed costs.
Suppose RTV’s analysis shows that dropping jewelry would reduce common costs by Br. 1,000. The
following analysis summarizes the decision.
Decision: Rent out the space rather than sell jewelry
Differential revenues:
Lost sales from jewelry Br. 15,000
New rent revenue 400
Net revenue lost Br. 14,600
Differential costs:
Variable costs saved on jewelry Br. 11,000
Direct fixed costs saved 1,500

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 Indirect fixed costs saved 1,000
Total cost saving 13,500
Differential loss from dropping jewelry Br. 1,100
Keeping jewelry seems the better choice because dropping it and renting the space will reduce income
by Br. 1,100 or total income drops from Br. 16,100 to Br. 15,000.

CHAPTER 19
INFORMATION FOR BUDGETING, PLANNING AND CONTROL
2.1OVERVIEW OF BUDGETING
A budget is the quantitative expression of a proposed plan of action by management for a future
time period
Budget is a statement that shows the financial plan for accomplishment of an operation.
Budgeting is a plan to balance expenditure against income, to balance the financial books. It is
what governments, government departments, businesses and individuals have to do to keep
financial demand in place between what they earn and what they spend. Budgeting is a plan for
spending, saving and paying debts within income. In any economic forecast, planning and
budgeting are crucial when it comes to conserving and increasing your resources. The use of a
budget can be helpful to not only individuals and companies but governments and government
departments to stay afloat. The services of accounting professionals are often utilized by these
departments to keep track of their finances in order to succeed.
Budgeting is a process of looking at a business’ estimated incomes (the money that comes into the
business from selling products and services) and expenditures (the money that goes out form
paying expenses and bills) over a specific period in the future. It allows a business to see if they
will be able to continue operating at their expected level with these projected incomes and
expenditures.
Budgeting is the process of allocating scarce resources to unlimited demands. More specifically, it
can be defined as a plan of financial operation embodying an estimate of proposed expenditures
for a given time and the proposed means of financing them. n. It is plan stated in terms of money.
When we assigned/estimate resources required for a certain task on our plan that is called
budgeting.

Where will we get the money from?


How much can we send?

Why will we spend it?

188
Budgets covering financial aspects quantify management’s expectations regarding future income,
cash flows, and financial position. Just as individual financial statements are prepared covering past
periods, so they can be prepared covering future periods – for example, a budgeted income statement
of cash flows, and a budgeted balance sheet. Underlying these financial budgets can be non-financial
budgets, say, units manufactured or sold and number of new products being introduced to the market.
Planning and Control
A good budgeting system should provide for both planning and control. Planning involves
developing objectives and preparing various budgets to achieve those objectives. Control involves
the steps taken by management to ensure that the objectives set down at the planning stage are
attained and that all parts of the organization work together towards those objectives.
Thus, budgets can be used as a benchmark that allows managers to compare actual performance with
expected or desired performance.
Advantages of Budgeting
There are many advantages of budgeting, including:
Forces all levels of management to plan ahead.

facilitate communication and coordination

Provides definite objectives for controlling profit and operations.

motivates personnel throughout the organization to meet planned objectives

Evaluating performance and providing incentives.
DIFFERENT TYPES OF BUDGET
Coverage wise budget:
Functional Budget

Master Budget
Capacity wise budget:
-Fixed budget
-Flexible budget
Capital Budget
Current Budget
Period wise budget:
Long term budget
Short term budget

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Approaches to Budgeting
There are different types of budgetary approaches which differ to each other in their emphasis on
planning, control and evaluation. These approaches fall in to two categories: Modern and Traditional
Approaches
Modern (Rational) Approaches to budgeting
The modern approaches to budgeting are sometimes called rational. That is because they all advocate
thinking carefully about the relationship of inputs, with a special concern for the outputs. Outputs are
the goods or services actually provided; inputs are the resources that go in providing those goods or
services. Thinking carefully also involves analyzing the costs and benefits of alternative methods of
achieving objectives. The ―big-picture is the idea that lawmaking bodies should focus on broad
policy objectives rather than details of spending for particular departments is emphasized. Long term,
ultimate goals are stressed rather than annual budget requests.

Performance Budgeting
Performance budget is a budget that bases expenditures primarily up on measurable performance of
activities and work programs. It focuses on the outputs generated by the department or organizational
unit, rather than looking primarily at the cost of the inputs. In this type budgets attempt will be made
to relate the input of governmental resources to the output of governmental services.
PLANNING-PROGRAMMING-BUDGETING (PPB)
Program budgeting refers to a variety of different budgeting systems that base expenditures primarily
on programs of work and secondarily on objects
PPB emphasizes broad policy goals, strategies and objectives, rather than details of spending. In
looking at these broad goals and objectives, it considers long-range plans. In those longrange plans
both ultimate goals and intermediate objectives must be explicitly stated. After formulating the long-
range plans, it then evaluates costs and benefits of different ways of meeting the goals and objectives.
It also emphasized the government‘s overall program, rather than a specific department. For instance,
both the Ministry of Health and the Ministry of Education might have some sort of AIDS program –
one for treatment and one for education. If the idea of PPB were adopted, both of these programs
would be looked at together to see they complemented each other in meeting the government‘s
overall objectives.
Zero-Base-Budgeting (ZBB)

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ZBB is one method of continually evaluating programs and services. The primary idea of ZBB is that
each program must justify its existence every year. No program is assumed to be continuing from one
year to the next. In this approach, the starting point for the budget each year is zero. First the program
itself must be justified, then different ways of carrying out the program are examined and the best is
chosen.
The basic tenet of zero-based budgeting (ZBB) is that program activities and services must be
justified annually during the budget development process. The budget is prepared by dividing all of a
government's operations into decision units at relatively low levels of the organization.
INCREMENTAL BUDGETING
Incremental budgeting takes last year’s actual figures and adds or subtracts a percentage to obtain the
current year’s budget. It is the most common method of budgeting because it is simple and easy to
understand. Incremental budgeting is appropriate to use if the primary cost drivers do not change
from year to year.
TRADITIONAL APPROACH TO BUDGETING
For the reasons stated above, the modern approaches have not been adopted as widely as might be
expected. The traditional approach, called object-of-expenditure (OOE) is still the most widely used.
The objective of the OOE budget has an expenditure control orientation. It is to simply list expected
expenditures, and then say how much is required for each one
Choosing a Budget Period
Budget periods vary in length. Some may be as short as a month, whereas others may cover many
years. The most common budgeting period, however, is a year. The annual budget is often subdivided
by months for the first quarter and by quarters for the remainder of the year. The budgeted data for a
year are frequently revised as the year unfolds. For example, at the end of the first quarter, the budget
for the next three quarters is changed in light of new information.
The Master Budget: Overall Plan
Master budget: a set of interrelated budgets covering all phases of an organization's operations for a
specific period of time.
The master budget consists of a number of separate, but interrelated budgets. The components of the
master budget for manufacturing firms are discussed in the following paragraphs.

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The two major parts of a master budget are the operating budget and the financial budget. Operating
budget (profit plan) is a major part of a master budget that focuses on the income statement and its
supporting schedules.
sales budget
Purchase budget
Cost of goods sold budget
Operating expense budget.
Budgeted income statement
Financial budget is the part of the master budget that focuses on the effects that the operating budget
and other plans (such as capital budgets and repayments of debt) will have on cash.
capital budget
Cash budget
Budgeted balance sheet
The relationship between the master budget’s components can be presented as follows.

Sales budget

Budgeted EI. Purchase budget

Operating Budget
Cost of goods sold budget
Operating expense budget

Budgeted income
statement
Financial budget

Capital Cash Budgeted

Budget Budget balance sheet

The Assumptions of Master Budget

Typically, the following simplifying assumptions are made when preparing a master budget:
Sales prices are constant during the budget period,
Variable costs per unit of output are constant during the budget period,
Fixed costs are constant in total and
Sales mix is constant when the company sells more than one product.
These assumptions facilitate the planning process by removing many of the economic
complexities Steps in preparing the master budget
The Sales Budget –The Sales budget is the starting point in preparing the master budget.
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The sales or revenue budget is a detailed schedule showing the expected sales for the coming
period expressed in both birr and units of the product. It helps to determine how many units of
a product will have to be produced. The sales budget is usually accompanied by a schedule of
expected cash receipts.
Budgeted Sales $ = (Budgeted Unit Sales)(Budgeted Sales Prices)
Current Period Cash Collections = Current Period Cash Sales + Current Period Credit Sales
Collected in Current Period + Prior Period Credit Sales Collected in Current Period
The Production Budget – lists the number of units that must be produced during the budgeted
period to meet the sales demand and to provide for desired ending inventory.

Units to Be Produced = Budgeted Unit Sales + Desired Ending Finished Goods- Beginning
Finished Goods

The desired ending inventory in units for each period is usually a predetermined percentage of
budgeted unit sales for the following period.
In a merchandising firm, a merchandise purchases budget would replace the production budget.
The merchandise purchases budget shows the amount of goods to be purchased from suppliers each
period. This can be determined by adding together the budgeted sales and the desired ending
inventory and then subtracting the beginning inventory
As in a manufacturing firm, the desired ending inventory in units is usually some predetermined
percentage of the unit sales for the following period.
The Direct Materials Budget - Once production needs have been determined, a direct
materials budget should be prepared. This budget details the materials that will be required to
fulfill the production budget and to ensure adequate inventory levels.
The direct materials budget includes five separate calculations.
1. Quantity of Material Needed for Production = (Units to be Produced)(Quantity of Material
Budgeted per Unit)
[Link] of Material to be purchased = Quantity of Material Needed for Production +
Desired Ending Material - Beginning Material
Budgeted Cost of Material Purchases = (Quantity of Material to be Purchased)(Budgeted Material
Prices)
Cost of Material Used = (Quantity needed for Production)(Budgeted Material Prices)
Cash Payments for Direct Material Purchases= Current Period Purchases Paid in
Current Period + Prior Period Purchases Paid in Current Period

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The desired ending inventory in units is usually a predetermined percentage of the number of units
that are expected to be used in production the following period. The direct materials budget is usually
accompanied by a schedule of expected cash disbursements for raw materials.
The Direct Labor Budget – is a quantitative estimate of the total direct labor hours required
to complete the expected production during the budget period.
Direct Labor Hours Needed For Production = (Units to be Produced)(D.L. Hours Budgeted per Unit)

Budgeted Direct Labor Cost= (D.L. Hours needed for Production)(Budgeted Rates Per Hour)
The Manufacturing Overhead Budget - The manufacturing overhead budget lists all production
costs other than direct materials and direct labor. Manufacturing overhead costs should be broken
down by cost behavior for budgeting purposes. The factory overhead budget is based on a flexible
budget calculation. More specifically, the calculation is as follows:
Budgeted Factory Overhead Costs = Budgeted Fixed Overhead + (Budgeted Variable
Overhead Rate)(D.L. Hours needed for Production
Cash Payments for Overhead= Budgeted Factory Overhead Cost - Depreciation and other
costs that do not require cash payments
Multiplying the total overhead rate by the number of direct labor hours needed for production
provides the standard or applied overhead costs.
Ending Inventory Budget - This budget details the amount and value of ending inventory on
the budgeted balance sheet. Data for the computations in this schedule are found in the direct
materials, direct labor, and manufacturing overhead budgets.
Ending Direct Materials = (Desired Ending Materials from 3b)(Budgeted Prices)
Ending Finished Goods= (Desired Ending Finished Goods)(Budgeted Unit Cost)
The Selling and Administrative Expense Budget - The selling and administrative budget
lists the anticipated non-manufacturing expenses for the budget period.
Budgeted Selling and Administrative Expenses = Budgeted Fixed Selling & Administrative Expenses
+ (Budgeted Variable Rate as a Proportion of Sales $)(Budgeted Sales $)
Cash Payments for Selling & Administrative Expenses = Budgeted Selling & Administrative
Expenses - Depreciation and other cost which do not require cash payments
8. Budgeted Income Statement

Budgeted Sales $ - Budgeted Cost of Goods Sold = Budgeted Gross Profit

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b. Budgeted Gross Profit - Budgeted Selling & Administrative Expenses = Operating Income
c. Operating Income - Interest Expense - Bad Debts Expense = Net Income Before Taxes
d. Net Income Before Taxes - Income Taxes = Net Income After Taxes
The Cash Budget - The cash budget is composed of four major sections:
The receipts section.
The disbursements section.
Cash receipts, plus the beginning cash balance, less cash disbursements results in cash excess
or deficiency. If a deficiency exists, additional funds must be arranged for. If excess exists,
previous borrowing can be repaid or short-term investments made.
The financing section of the cash budget provides a detailed account of the borrowing and
repayments projected to take place during the budget period. It also includes a detailing
Budgeted Financial Statements - The last components of the master budget consist of the
budgeted income statement and the budgeted balance sheet.
Preparation of Master Budget (Manufacturing Company)
Example (2) Great Company manufactures and sells a product whose peak sales occur in the third
quarter. Management is now preparing detailed budgets for 2004- the comin
g year and has assembled the following information to assist in the budget preparation:
Sales budget information
The company’s product selling price is Br. 20 per unit. The marketing department
has estimated sales as follows for the next six quarters.
Year 2004 Year 2005
Q1 Q2 Q3 Q4 Q1 Q2
Budgeted sales in units 10000 30000 40000 20000 15000 15000
Cash collection budget
Sales are collected in the following pattern: 70% of sales are collected in the quarter in which the
sales are made and the remaining 30% are collected in the following quarter. On January1, 2004,
the company’s balance sheet showed Br.90, 000 in account receivable, all of which will be
collected in the first quarter of the year. Bad debts are negligible and can be ignored.
Production budget information
The company maintains an ending inventory of finished units equal to 20% of the next quarter’s
sales. The requirement was met on December 31, 2003, in that the company had 2, 000 units on
hand to start the New Year.

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Direct material Budget information

Fifteen pounds of raw materials are needed to complete one unit of product. The company
requires an ending inventory of raw materials on hand at the end of each quarter equal to 10% of
the following quarter’s production needs of raw materials. This requirement was met on
December 31, 2003 in that the company had 21, 000 pounds of raw materials to start the New
Year.
Raw material purchase budget information
The raw material costs Br.0.20 per pound.
Cash disbursement budget for DM purchase information
Raw material purchases are paid for in the following pattern: 50% paid in the quarter the
purchases are made, and the remainder is paid in the following quarter. On January 1,2004, the
company’s balance sheet showed Br.25, 800 in accounts payable for raw material purchases, all of
which be paid for in the first quarter of the year.
Direct Labor Budget information
Each unit of Great’s product requires 0.8 hour of labor time. Estimated direct labor cost
per hour is Br.7.50.
Budgeted Manufacturing overhead information
Variable overhead is allocated to production using labor hours as the allocation base as
follows:
Indirect materials Br.0.40
Indirect labor 0.75
Fringe benefits 0.25
Payroll taxes 0.10
Utilities 0.15
Maintenance 0.35
Total variable overhead 2
Fixed overhead for each quarter was budgeted at Br. 60, 600. Of the fixed overhead amount, Br. 15,
000 each quarter is depreciation. Overhead expenses are paid as incurred.
Selling and administrative budget Information
8. The company’s quarterly budgeted fixed selling and administrative expenses are as follows:
2004 Quarters
1 2 3 4
Advertising Br.20, 000 Br.20, 000 Br.20, 000 Br.20, 000
Executive salaries 55, 000 55, 000 55, 000 55, 000

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Insurance - 1, 900 37,750 -

Property taxes - - - 18, 150
Depreciation 10, 000 10, 000 10, 000 10, 000
The only variable selling and administrative expense, sales commission, is budgeted at Br.1.80 per
unit of the budgeted sales.
Selling and administrative disbursement expenses Budget
All selling and administrative expenses are paid during the quarter, in cash, with exception of
depreciation. New equipment purchases will be made during each quarter of the budget year for Br.
50, 000, Br. 40, 000, & Br.20, 000 each for the last two quarter in cash, respectively. The company
declares and pays dividends of Br.8, 000 cash each quarter.
Cash budget information
The company’s balance sheet at December 31, 2003 is presented below:
ASSETS
Current assets:
Cash Br. 42, 500
Accounts Receivable 90, 000
Raw Materials Inventory (21, 000 pounds) 4, 200
Finished Goods Inventory (2, 000 units) 26, 000
Total current assets Br.162, 7 00
Plant and Equipment:
Land Br.80, 000
Building and Equipment 700, 000
Accumulated Depreciation (292, 000)
Plant and Equipment, net 488, 000
Total assets Br.650, 700
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable (raw materials) Br.25, 800
Stockholders’ equity:
Common stock, no par Br.175, 000
Retained earnings 449, 900
Total stockholders’ equity 624, 900
Total liabilities and stockholders’ equity Br.650, 700
The company can borrow money from its bank at 10% annual interest. All borrowing must
be done at the beginning of a quarter, and repayments must be made at the end of a quarter.
All borrowings and all repayments are in multiples of Br. 1,000.

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The company requires a minimum cash balance of Br.40, 000 at the end of each quarter. Interest
is computed and paid on the principal being repaid only at the time of repayment of principal.
The company whishes to use any excess cash to pay loans off as rapidly as possible.
Instructions: Prepare a master budget for the four-quarter period ending December 31. Include the
following detailed budget and schedules:
a) A sales budget, by quarter and in total
A schedule of budgeted cash collections, by quarter and in total
A production budget
A direct materials purchase budget
A schedule of budgeted cash payments for purchases by quarter and in total
A direct labor budget
A manufacturing overhead budget
A selling and administrative budget
A cash budget, by quarter and in total
A budgeted income statement for the four- quarter ending December 31, 2004
A budgeted balance sheet as of December 31, 2004.
a) Sales Budget
Quarter
1 2 3 4
Expected sales in units 10, 000 30, 000 40, 000 20, 000
Selling price per unit x Br. 20 x Br. 20 x Br.20 x Br.20
Total sales Br.200, 000 Br.600, 000 Br.800, 000 Br.400, 000
b) Schedule of Expected Cash Collections
Quarter
1 2 3 4 Total
30% of the previous quarter Br. 90, 000 Br.60, 000 Br.180, Br.240, 000 Br.570, 000
sales 000
70% of the current quarter 140, 000 420, 000 560, 000 280, 000 1, 400, 000
sales
Total collections 230, 000 Br.480, 000 740, 000 Br. 520, 000 1, 970, 000
c) Production Budget
After the sales budget has been prepared, the production requirements for the forth-coming budget period
can be determined and organized in the form of a production budget. Sufficient goods will have to be
available to meet sales and provide for the desired ending inventory. A portion of these goods will

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already exist in the form of a beginning inventory. The remainder will have to be produced. Therefore,
production needs can be determined as follows:
Budgeted sales in units ………………………………………… xxxx
Add desired ending inventory……………….…………………. xxxx
Total needs……………………………………………………… xxxx
Less beginning inventory……………………………………….. xxxx
Required production……………………………………………. .xxxx

The schedule given below shows the production budget for Great Company. Note that the desired
level of the ending inventory influences production requirements for a quarter. Inventories should
be carefully planned. Excessive inventories tie up funds and create storage problems. Insufficient
inventories can lead to lost sales or crash production efforts in the following period

Quarter Total
1 2 3 4
Expected sales(units) 10, 000 30, 000 40, 000 20, 000 100, 000
Add: Desired Ending Inventory 6, 000 8, 000 4, 000 3, 000 3, 000
Total needs 16, 000 38, 000 44, 000 23, 000 103, 000
Lees: Beginning Inventory 2, 000 6, 000 8, 000 4, 000 2, 000
Units to be produced 14, 000 32,000 36, 000 19, 000 101, 000

Direct Materials Budget

Returning to Great Company’s budget data, after the production requirements have been computed, a direct
materials budget can be prepared. The direct materials budget details the raw materials that must be
purchased to fulfill the production budget and to provide for adequate inventories. The required purchases
of raw materials are computed as follows:
Raw materials needed to meet the production schedule……………………….xxxx
Add desired ending inventory of raw materials……………….…………………xxxx
Total raw materials needs…………………………………………………… .xxxx
Less beginning inventory of raw materials………………………….………… xxxx
Raw materials to be purchased………………………………………………… .xxxx
Quarter Total
1 2 3 4
Production needs(pounds)(15*14000) 210, 000 480, 000 540, 000 285, 000 1, 515, 000
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 Comprehensive core competency I lecture note

Add: Desired ending inventory 48, 000 54, 000 28, 500 22, 500 22, 500
Total needs 258, 000 534, 000 568, 500 307, 500 1, 537, 500
Less: Beginning inventory 21, 000 48, 000 54, 000 28, 500 21, 000
Raw materials to be purchased(pounds) 237, 000 486, 000 514, 500 279, 000 1, 516,500
Raw Materials to be purchased (in birrs)
1 2 3 4 Total
Raw materials to be purchased 237, 000 486, 000 514, 500 279, 000 1, 516, 500
Raw materials cost per pound x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20 x Br.0.20
Total Material purchased. Br.47, 400 Br.97, 200 Br.102, 900 Br.55, 800 Br.303, 300

e) Schedule of Expected Cash Disbursements (for Materials Purchase)

Quarter Total
1 2 3 4
50% of the current quarter 23, 700 48, 600 51, 450 27, 900 151, 650
50% of the previous quarter Br. 25, 800 Br.23, 700 Br.48, 600 Br.51, 450 Br.149, 550
Total cash disbursement Br.49, 500 Br.72, 300 Br.101, 050 Br.79, 350 Br.301, 200

f) Direct Labor Budget

The direct labor budget is also developed from the production budget. In schedule given below, the
management of Great Company has assumed that the direct labor force will be adjusted as the work
requirement change from quarter to quarter (for example as units produced changes from l4, 000 units in
quarter 1 to 32, 000 units in quarter 2 for Great Company, the direct labor work force will be fully
adjusted to the workload, i.e., total hours of direct labor time needed). In that case, the total direct labor
cost is computed by simply multiplying the direct labor-hour required by the direct labor rate hour as
was done in the schedule here under.
Direct labor time need= Production budget * required hour of labor time
Quarter Total
1 2 3 4
Direct labor time 11, 200 25, 600 28, 800 15, 200 80, 800
needed(14000*0.8
x
Direct labor cost per hour x Br.7.50 x Br.7.50 x Br.7.50 Br.7.50 x Br.7.50
Total direct labor cost Br.84, 000 Br.192, 000 Br.216, 000 Br.114, 000 Br.606, 000
g) Manufacturing Overhead (MOH) Budget
The manufacturing overhead budget provides a schedule of all costs of production other than direct
materials and direct labor. These costs should be broken down by cost behavior for budgeting
purposes and a predetermined overhead rate developed. This rate will be used to apply

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manufacturing overhead to units of product throughout the budget period. At Great Company, the
only significant noncash manufacturing overhead cost is depreciation. Any depreciation charges
included in manufacturing overhead must be deducted from the total in computing expected cash
payments, since depreciation is a noncash charge.
Variable overhead = (Total Variable overhead * Direct labor time needed
Quarter Total
1 2 3 4
Variable overhead(2*11,200) Br.22, 400 Br.51, 200 Br.57, 600 Br.30, 400 Br.161,600
Fixed overhead 60, 600 60, 600 60, 600 60, 600 242,400
Total MOH Br.83, 000 Br.111, 800 Br.118, 200 Br.91, 000 Br.404,000
Less: Depreciation 15, 000 15, 000 15, 000 15, 000 60, 000
Cash disbursements for MOH Br.68, 000 Br.96, 800 Br.103, 200 Br.76, 000 Br.344, 000

Selling and Administrative Expenses Budget

Variable selling expenses=1.8* Budgeted sales in units
Quarter Total
1 2 3 4
Variable selling expenses(1.8*10,000) B18, 000 Br.54, 000 Br.72, 000 Br.36, 000 Br.180, 000
Fixed selling & administrative
Advertising 20, 000 20, 000 20, 000 20, 000 80, 000
Executive salaries 55, 000 55, 000 55, 000 55, 000 220, 000
Insurance - 1, 900 37, 750 - 39, 650
Property taxes - - - 18,150 18,150
Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000
Total budgeted selling & 103, 000 Br.140, 900 Br.194, 750 Br.139, 150 Br.577, 800
administrative expenses

J Disbursement for Selling & Administrative Expenses

Quarter Total
1 2 3 4
Budgeted Selling & Br.103, 000 Br.140, 900 Br.194, 750 Br.139, 150 Br.577, 800
Administrative
Less: Depreciation 10, 000 10, 000 10, 000 10, 000 40, 000
Total Cash Disbursements Br.93, 000 Br.130, 900 Br.184, 750 Br.129, 150 Br.537, 800
2. a) Cash Budget

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Quarter Total
1 2 3 4
Cash balance, beginning Br.42, 500 Br.40, 000 Br.40, 000 Br.40, 500 Br.42, 500
Add : Collection from 230, 000 480, 000 740, 000 520, 000 1, 970, 000
customers
Total cash available before 272, 500 520, 000 780, 000 560, 500 2, 012, 500
financing
Less: Disbursements for
Direct materials 49, 500 72, 300 100,050 79, 350 301,200
Direct labor 84, 000 192, 000 216,000 114, 000 606,000
Manufacturing overhead 68, 000 96, 800 103,200 76, 000 344,000
Selling & Administrative 93, 000 130, 900 184,750 129, 150 537,800
Equipment purchases 50, 000 40, 000 20,000 20,000 130,000
Dividend 8, 000 8, 000 8, 000 8, 000 32,000
Total disbursements 352, 500 540,000 632,000 426,500 1,951,000
Minimum cash balance 40, 000 40, 000 40, 000 40, 000 40, 000
Total need 392, 500 580, 000 672, 000 466, 500 1, 991,000
Excess (deficiency) of cash (120, 000) (60, 000) 108, 000 94, 000 21, 500
available over total need
Financing:
Borrowing(at beginning) 120,000 60, 000 - - 180, 000
Repayments( at ending) - - (100, 000) (80,000) (180,000)
Interest(at 10% per annum) - - (7,500) (6,500) (14,000)
Balance 0 0 500 7500
Add Minmum cash balance 40, 000 40, 000 40,000 40,000 (14,000)
Cash balance, ending Br.40,000 Br.40, 000 Br.40, 500 Br.47, 500 Br.47, 500

Note : Computation of interest is as follows

1.100,000*0.1*3/4=7,500
20,000*0.1*4/4=2000 though out a year
60,000*0.1*3/4=4,500

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CHAPTER 20
NATURE AND SCOPE OF FINANCIAL MANAGEMENT
Financial management refers to the strategic planning, organizing, directing, and controlling of
financial resources in an organization. It plays a crucial role in ensuring that financial goals are met
efficiently and effectively.
It aims to ensure the effective allocation and utilization of funds to achieve business objectives,
maximize profitability, and enhance shareholder wealth.
Finance refers to the management of money, investments, and financial resources. It involves the
processes of acquiring, allocating, and utilizing funds efficiently to achieve personal, corporate, or
governmental financial objectives. Finance encompasses various activities such as budgeting,
investing, borrowing, lending, and risk management.

Key Aspects of Finance:

Personal Finance – Managing individual income, expenses, savings, and investments.
Corporate Finance – Handling a company's financial activities, including capital structure,
funding, and investment decisions.
Public Finance – Government revenue generation, expenditures, and financial policies
Nature of Financial Management
Financial management encompasses various aspects of finance and decision-making processes within
an organization. The key characteristics include:
Strategic Decision-Making: Financial management involves making critical financial decisions that
impact the overall growth and sustainability of the organization.
Dynamic in Nature: Financial management continuously evolves due to changes in economic
conditions, government policies, and market trends.
Goal-Oriented Approach: It focuses on maximizing shareholder value, optimizing profits, and
ensuring financial stability.
Risk and Return Trade-off: Financial managers must balance risk and return to ensure the
organization remains financially viable.
Interdisciplinary Approach: It integrates elements of economics, accounting, and business
management to make informed financial decisions.
Focus on Wealth Maximization: Unlike traditional profit maximization, modern financial
management aims at enhancing the value of the firm and shareholders' wealth.

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Art and Science: Financial management is both an art and a science. It relies on quantitative
analysis and scientific methods, but also requires judgment, creativity, and intuition to make
sound decisions in complex situations.
Scope and Function of Financial Management
The scope of financial management can be categorized into the following key areas

Investment Decisions (Capital Budgeting)

Concerned with the allocation of funds to long-term assets.

Involves evaluating potential investment opportunities.

Financing Decisions
Deals with determining the optimal capital structure (debt vs. equity).

Involves decisions related to raising funds through shares, debentures, loans, etc.

Dividend Decisions
Concerned with determining the amount of profit to be distributed as dividends versus
retained earnings.

Factors affecting dividend policy include profitability, growth opportunities, liquidity,
and shareholder preferences.

Liquidity/ Working Capital Management
Deals with short-term assets and liabilities.

Ensures sufficient liquidity to meet operational expenses and short-term debts.

Components include inventory management, accounts receivable, and accounts payable.

Financial Risk Management
Identifies and mitigates financial risks such as market risk, credit risk, and liquidity risk.

Use of derivatives, hedging strategies, and insurance to manage risks effectively.
FINANCIAL MANAGEMENT APPROACHES
1. Traditional Approach to Financial Management
The traditional approach to financial management, dominant until the mid-20th century, focused
mainly on obtaining funds and financing activities.

Features of the Traditional Approach:

Emphasis on Fund Procurement: The primary focus was on acquiring funds through equity,
debt, and other sources.

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Limited Scope: It concentrated on external financing and ignored financial decision-making

related to operations.
Neglected Working Capital Management: Short-term financial planning and liquidity
management were overlooked.
Lack of Risk Consideration: Financial risks, such as market volatility and interest rate
fluctuations, were not given much attention.
Focus on Large Corporations: Primarily applied to large enterprises with structured
financial systems.

Advantages of the Traditional Approach

Simple and Easy to Apply – The approach primarily focuses on securing funds, making it
easier for organizations to implement without complex financial planning.
Clear Focus on Fund Procurement – Helps businesses, especially startups and small firms,
secure necessary capital through loans and external financing.
Legal and Institutional Framework – Emphasizes compliance with financial contracts and
regulations, ensuring businesses meet their obligations.
Useful for Large-Scale Industries – Beneficial for industries requiring significant external
funding, such as infrastructure and heavy manufacturing.

Limitations of the Traditional Approach:

Narrow scope, focusing only on fund acquisition.

Ignores investment and dividend decisions.

Does not consider risk factors affecting financial decisions.

Not suitable for modern businesses requiring dynamic financial strategies.
Modern Approach to Financial Management
The modern approach to financial management emerged as a response to the limitations of the
traditional approach. It considers all aspects of financial decision-making, emphasizing efficient
resource utilization and wealth maximization.

Features of the Modern Approach:

Comprehensive Financial Planning: Covers investment, financing, and dividend decisions.
Wealth Maximization Goal: Focuses on increasing shareholder value rather than merely acquiring
funds.

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Incorporates Risk Management: Evaluates and mitigates financial risks through strategies like
hedging and diversification.
Working Capital and Liquidity Management: Ensures sufficient liquidity for smooth business
operations.
Performance Measurement: Uses financial metrics like return on investment (ROI), earnings per
share (EPS), and economic value added (EVA).

Advantages of the Modern Approach:

Provides a holistic view of financial management.

Focuses on value creation and shareholder wealth.

Enhances financial decision-making using advanced techniques.

Adapts to changing economic and financial environments.
Comparison of Traditional and Modern Approaches
Aspect Traditional Approach Modern Approach
Focus Fund Procurement Wealth Maximization
Decision Areas Raising funds Investment, Financing, and Dividend Decisions
Risk Consideration Not considered Integrated Risk Management
Working Capital Overlooked Actively Managed
Applicability Large Corporations Only All Business Types
1.7 An Overview of the Financial Environment
The financial environment refers to the system in which financial activities occur, including markets,
institutions, instruments, and regulations that facilitate the flow of money. It plays a crucial role in
economic growth, investment, and financial stability.

Key Components of the Financial Environment

Financial Institutions
These entities provide financial services such as savings, loans, and investment
opportunities. They include:
Commercial banks
Investment banks
Insurance companies
Mutual funds

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Pension funds
Financial Markets
Financial markets facilitate the buying and selling of financial assets. They are categorized as:
Money Market – Deals with short-term securities (e.g., Treasury bills, commercial paper).
Capital Market – Focuses on long-term securities (e.g., stocks, bonds).
Primary Market – Where new securities are issued.
Secondary Market – Where existing securities are traded among investors.
Financial Instruments
These are assets that can be traded in financial markets. Common financial
instruments include:
Equity instruments (e.g., stocks)
Debt instruments (e.g., bonds, loans)
Derivatives (e.g., futures, forward, options)
Regulatory Framework
Financial markets and institutions operate under regulations to ensure stability,
transparency, and fairness. Key regulatory bodies include:
Securities and Exchange Commission (SEC) – Regulates stock markets.
Central Banks (e.g., Federal Reserve, European Central Bank) – Control monetary
policy and financial stability.
Financial Conduct Authorities – Monitor banking and investment practices.
Global Financial System
The financial environment is interconnected globally through international trade, capital
flows, and exchange rates.
1.7.1 Functions of Financial Markets
Facilitating Capital Formation
Financial markets help businesses and governments raise funds by issuing securities such as
stocks and bonds.

Investors provide capital in exchange for financial instruments, ensuring economic growth.

Providing Liquidity
Financial markets enable the buying and selling of assets easily, ensuring that investors can
convert their securities into cash quickly.

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Price Determination
Prices of financial assets are determined based on supply and demand.

Stock markets reflect investor sentiment, company performance, and economic conditions.

Risk Management and Hedging
Derivative markets (futures, options) help individuals and institutions manage financial risks
associated with fluctuations in interest rates, exchange rates, and commodity prices.

Efficient Allocation of Resources
Financial markets ensure that capital flows to the most productive investment opportunities,
maximizing returns for investors and economic development.

Reducing Transaction Costs
By providing a structured platform for trading, financial markets lower costs associated
with buying, selling, and transferring financial assets.

Providing Information and Transparency
Financial markets provide price signals and performance indicators that help investors make
informed decisions.

Encouraging Savings and Investment
They offer individuals and businesses various investment options, promoting long-term
financial planning and wealth accumulation.

Supporting Government and Monetary Policy Implementation
Governments and central banks use financial markets to regulate money supply, control
inflation, and stabilize the economy through bonds and interest rate adjustments. 
1.8 The Goal of a Firm in Financial Management
Profit Maximization as a Decision Rule
Meaning of Profit Maximization
Profit maximization is a function of maximizing revenue and /or minimizing costs. If a firm is able
to maximize its revenues for a given level  of costs or minimizing costs for a given level of
 revenues, it is considered to be efficient.
Profit maximization focuses on the total amount of benefits of any courses of action. This decision
rule as applied to financial management
 implies that the functions of managerial finance should
be oriented to making of money.

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Under the profit maximization decision criteria, actions that increase profit of a firm should be
undertaken; and actions that decrease profit should be rejected. Similarly, given alternative
 courses of actions, decisions would be made in favor of the one with the highest expected profits.
 II. Wealth Maximization as a Decision Rule
 Wealth maximization means maximization of the value of a firm. Hence wealth maximization is also
called value maximization or net present value (NPV) maximization. 
 There are several reasons why wealth maximization decision criterion is superior to other criteria.

Wealth maximization as a decision criterion considers the quality as well as the time pattern of
 benefits.
 to the interest of other stakeholders and to the societal
Wealth maximization gives recognition
welfare on the long-term basis.

CHAPTER 21
FINANCIAL ANALYSIS
Introduction
In the previous accounting courses you have learned that financial statements report both on a firm’s
financial position and financial performance. The four basic financial statements present about
different aspects of financial conditions, operating results, and cash flows. The balance sheet shows a
firm’s assets and claims against assets at a particular point in time – time. The income statement, on
its part, reports the results of the firm’s operations over a period of time. Similarly, the statements of
retained earnings and cash flows show the change in retained earnings and cash between two balance
sheet dates.
2.2 Meaning and Objectives of Financial Analysis
Financial analysis refers to analysis of financial statements and it is a process of evaluating the
relationships among component parts of financial statements.

The focus of financial analysis is on key figure in the financial statements and the significant
relationships that exist between them. Financial analysis is used by several groups of users like
managers, credit analysts, and investors.

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2.3 Tools and Techniques of Financial Analysis

A. Comparative Financial Statements
This technique involves comparing financial statements of different periods to assess trends in
revenue, expenses, and overall financial health.
Trend Analysis (Horizontal Analysis): compares line items across different periods (e.g.,
year-over-year growth). This highlights trends and patterns. For example, comparing Revenue
in 2023 to Revenue in 2022 to calculate the growth rate. This helps to understand how a
company's performance has changed over time.

Vertical Analysis (Common Analysis : Shows each item as a percentage of a base figure
(e.g., total assets or total revenue). Expresses each line item as a percentage of total assets.
This facilitates comparison of different periods and companies. For example, Cash is
expressed as a percentage of Total Assets

Ratio Analysis – is a mathematical relationship among money amounts in the financial
statements. They standardize financial data by converting money figures in the financial
statements. Ratios are usually stated in terms of times or percentages.


Ratios help to identify trends, compare a company's performance to industry benchmarks, and
assess its strengths and weaknesses.
2.4 Types of Financial Ratios
There are several key ratios that reveal about the financial strengths and weaknesses of a firm. We
will look at five categories of ratios, each measuring about a particular aspect of the firm’s
financial condition and performance.
a) Liquidity Ratios
Liquidity ratios measure the ability of a firm to meet its immediate obligations and reflect the short –
term financial strength or solvency of a firm. In other words, liquidity ratios measure a firm’s ability
to pay its current liabilities as they mature by using current assets. There are three commonly used
liquidity ratios are
Current Ratio = Current Assets
Current Liabilities)
Quick Ratio= (Current Assets - Inventory)
Current Liabilities)
Cash Ratio= Cash +cash equivalent
Current Liabilities)

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The following financial statements pertain to Zebra Share Company. We will perform the necessary
ratio analyses using them, and then evaluate and interpret each analysis.
Zebra Share Company
Comparative Balance Sheet
December 31, 2001 and 2002
(In thousands of Birrs)
Assets 2002 2001
Current assets:
Cash 9,000 7,000
Marketable securities 3,000 2,000
Accounts receivable (net) 20,700 18,300
Inventories 24,900 23,700
Total current assets 57,600 51,000
Fixed assets:
Land and buildings 33,000 27,000
Plant and equipment 130,500 120,000
Total fixed assets 163,500 147,000
Less: accumulated depreciation 67,200 61,200
Net fixed assets 96,300 85,800
Total assets 153,900 136,800
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable 20,100 17,100
Notes payable 14,700 13,200
Taxes payable 3,300 3,000
Total current liabilities 38,100 33,300
Long-term debt:
Mortgage bonds –5% 60,000 60,000
Total liabilities 98,100 93,300
Stockholders’ equity:
Preferred stock –5% (Br. 100 par) 6,000 -
Common stock (Br. 10 par) 33,000 30,000
Capital in excess of par value 7,500 4,500
Retained earnings 9,300 9,000
Total stockholders’ equity 55,800 43,500
Total liabilities and stockholders’ equity 153,900 136,800
Zebra Share Company
Income Statement
For the Year Ended December 31, 2002
________________________________________________________________________
Net sales Br. 196,200

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Cost of goods sold 159,600

Gross profit Br. 36,600
Operating expenses* 26,100
Earnings before interest and taxes (EBIT) Br. 10,500
Interest expense 3,000
Earnings before taxes (EBT) Br. 7,500
Income taxes 3,600
Net income Br. 3,900

* Included in operating expenses are Br. 6,000,000 depreciation and Br. 2,700,000 lease payment.

Zebra Share Company

Statement of Retained Earnings
For the Year Ended December 31, 2002
Retained earnings at beginning of year Br. 9,000
Add: Net income 3,900
Sub-total Br. 12,900
Less: Cash dividends
Preferred Br. 300
Common 3,300
Sub-total Br. 3,600
Retained earnings at end of year Br. 9,300

Current ratio – measures the ability of a firm to satisfy or cover the claims of short-term creditors by
using only current assets. This ratio relates current assets to current liabilities
Current ratio = Current assets
Current liabilities
Zebra’s current ratio (for 2002) = Br. 57,600 = 1.51 times
Br. 38,100
Interpretation: means that for every 1 birr of current liabilities, the company has 1.51 birr in
current assets. This suggests a reasonable short-term liquidity position.

A ratio above 1 indicates that the company has more assets than liabilities.

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
Relatively high current ratio is interpreted as an indication that the firm is liquid and in good position
 to meet its current obligations.

Relatively low current ratio is interpreted as an indication that the firm may not be able to easily
 meet its current obligations.

 A very 
high current ratio, however, may indicate excessive inventories and accounts receivable, or a

firm is not making full use of its current borrowing capacity.
A very high ratio may suggest inefficient asset utilization.

Quick ratio (Acid – test ratio)- measures the short-term liquidity by removing the least liquid current
assets such as inventories. Inventories are removed because they are not readily or easily convertible
into cash. Thus, the quick ratio measures a firm’s ability to pay its current liabilities by
using its most liquid assets into cash.
Quick ratio = Current assets – Inventory
Current liabilities
Zebra’s quick ratio (for 2002) = Br. 57,600 – Br. 24,900 = 0.86 times
Br. 38,100

Interpretation: Zebra has Br. 0.86 in quick assets available for every one birr in current liabilities.
The quick ratio of 0.86 means that liquid assets (excluding inventory) can cover 86% of short-
term liabilities
Like the current ratio, the quick ratio reflects the firm’s ability to pay its short-tem obligations, and
the higher the quick ratio the more liquid the firm’s position. But the quick ratio is more detailed and
penetrating test of a firm’s liquidity position as it considers only the quick asset. The current ratio, on
the other hand, is a crude measure of the firm’s liquidity position as it takes into account all current
assets without distinction.
b) Activity Ratios/Efficiency Ratio
Activity ratios measure the degree of efficiency a firm displays in using its assets. These ratios
include turnover ratios because they show how rapidly assets are being converted (turned over) into
sales or cost of goods sold. Activity ratios are also called asset management ratios, or asset utilization
ratios, or efficiency ratios. Generally, high turnover ratios are associated with good asset management
and low turnover ratios with poor asset management. Activity ratios include:

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Accounts Receivable turnover – measures how efficiently a firm’s accounts receivable is being
managed. It indicates how many times or how rapidly accounts receivable are converted into cash
during a year.

Accounts receivable turnover = Net sales

Accounts receivable
Zebra’s accounts receivable turnover (for 2002) = Br. 196,200 = 9.48 times
Br. 20,700
Interpretation: Zebra’s accounts receivable get converted into cash 9.48 times a year.
In general, a reasonably higher accounts receivable turnover ratio is preferable. A ratio substantially
lower than the industry average may suggest that a firm has more liberal credit policy, more
restrictive cash discount offers, poor credit selection or in adequate cash collection efforts.

There are alternate ways to calculate accounts receivable value like average receivables and ending
receivables. Though many analysts prefer the first, in our case we have used the ending balances. In
computing the accounts receivable turnover ratio, if available, only credit sales should be used in the
numerator as accounts receivable arises only from credit sales.
Days sales outstanding (DSO) – also called average collection period. It seeks to measure
the average number of days it takes for a firm to collect its accounts receivable. In other
words, it indicates how many days a firm’s sales are outstanding in accounts receivable.
Days sales outstanding = 365 days
Accounts receivable turnover
Zebra’s days sales outstanding = 365 days = 39 days
9.48
Interpretation: Zebra’s credit customers on the average are paying their bills in almost 39 days. If
Zebra’s credit period is less than 39 days, some corrective actions should be taken to improve the
collection period.
The average collection period of a firm is directly affected by the accounts receivable turnover ratio.
Generally, a reasonably short-collection period is preferable.
Inventory turnover – measures how many times per year the inventory level is sold (turned over).
Inventory turnover = Cost of good sold
Inventory
For Zebra Company (2002) = Br. 159,600 = 6.41times

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Br. 24,900
Interpretation: Zebra’s inventory is on the average sold out 6.41 times per year.
In computing the inventory turnover, it is preferable to use cost of goods sold in the numerator rather
than sales. But when cost of goods sold data is not available, we can apply sales. In general, a high
inventory turnover is better than a low turnover. But abnormally high inventory turnover might result
from very low level of inventory. This indicates that stock outs will occur and sales have been very
low. A very low turnover, on the other hand, results from excessive inventory levels, presence of
inferior quality, damaged or obsolete inventory, or unexpectedly low volume of sales.
Fixed assets turnover – measures how efficiently a firm uses it fixed assets. It shows how many
birrs of sales are generated from one birr of fixed assets
Fixed assets turnover = Net sales___
Net fixed assets
Zebra’s fixed assets turnover = Br. 196,200 = 2.04X
Br. 96,300
Interpretation: Zebra generated Br. 2.04 in net sales for every birr invested in fixed assets.
A fixed assets turnover ratio substantially lower than other similar firms indicates under utilization of
fixed assets, i.e., idle capacity, excessive investment in fixed assets, or low sales levels. This
suggests to the firm possibility of increasing outputs without additional investment in fixed assets.

The fixed assets turnover may be deceptively low or high. This is because the book values of fixed
assets may be considerably affected by cost of assets, time elapsed since their acquisition, or method
of depreciation used.
Total assets turnover – indicates the amount of net sales generated from each birr of total tangible
assets. It is a measure of the firm’s management efficiency in managing its assets.
Total assets turnover = Net Sales
Total assets
Zebra’s total assets turnover = Br. 196,200 = 1.27X
Br. 153, 900
Interpretation: Zebra Share Company generated Br. 1.27 in net sales for every one birr invested in
total assets.
A high total assets turnover is supposed to indicate efficient asset management, and low turnover
indicates a firm is not generating a sufficient level of sales in relation to its investment in assets.
c) Leverage Ratios/solvency ration

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Leverage ratios are also called debt management or utilization ratios. They measure the extent to
which a firm is financed with debt, or the firm’s ability to generate sufficient income to meet its debt
obligations. While there are many leverage ratios, we will look at only the following three.
Debt-to-Equity Ratio
Debt-to-Assets Ratio
Times Interest Earned Ratio (EBIT / Interest Expense)
Debt-to-Equity Ratio=Total liability
Share holder equity
=98,100/ 55,800=1.76
Interpretation: A 1.76 ratio means the company uses 1.76 birr of debt for every 1 birr of equity. A
high debt-to-equity ratio indicates financial leverage, which can be risky if earnings decline.
Debt to total assets (Debt) Ratio – measures the percentage of total funds provided by debt.

Debt ratio = Total liabilities

Total assets
Zebra’s debt ratio = Br. 98,100 = 64%
Br. 153,900
Interpretation: At the end of 2002, 64% of Zebra’s total assets was financed by debt and 36%
(100% - 64%) was financed by equity sources.

A high debt ratio implies that a firm has liberally used debt sources to finance its assets. Conversely,
a low ratio implies the firm has funded its assets mainly with equity sources. Debt ratio reflects the
capital structure of a firm. The higher the debt ratio, the more the firm’s financial risk.
Times – interest earned – measures a firm’s ability to pay its interest obligations.
Times interest earned = Earnings before interest and taxes (EBIT)
Interest expense
Zebra’s times interest earned = Br. 10,500 = 3.50X
Br. 3,000
Interpretation: Zebra has operating income 3.5 times larger than the interest expense.
The times interest earned ratio implicitly assumes a firm’s operating income (EBIT) is available to
meet its interest obligations. However, earnings before interest and taxes is an income concept and
not a direct measure of cash. Hence, this ratio provides only an indirect measure of the firm’s ability
to meet its interest payments.

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Fixed charges coverage – measures the ability of a firms to meet all fixed obligations rather than
interest payments alone. Fixed payment obligations include loan interest and principal, lease
payments, and preferred stock dividends.
Fixed charges coverage = Income before fixed charges and taxes
Interest
For Zebra Company, the other fixed charge payment in addition to interest is lease payment.
Therefore,
Zebra’s fixed charges coverage = Br. 10,500 = 3.5X
Br. 3,000
Interpretation: the fixed charges (interest and lease payments) of Zebra Share Company are safely
covered 3.5 times.
Profitability Ratios- Measure a company's ability to generate profits
These ratios measure the earning power of a firm with respect to given level of sales, total assets, and
owner’s equity. The following ratios are among the many measures of a firm’s profitability.
Net Profit Margin
Gross Profit Margin
Operating Margin
Return on Assets (ROA) (Net Income / Total Assets)
Return on Equity (ROE) (Net Income / Total Equity)
Net Profit Margin – shows the percentage of each birr of net sales remaining after deducting all
expenses.
Net Profit Margin= Net Income
Net sales ×100

Net Profit Margin = 3,900

196,200×100=2%

The company has a low net profit margin (1.99%), meaning expenses significantly reduce profits.
Gross Profit Margin

Gross Profit Margin= Gross Profit

Net sale ×100
Zebra’s Gross profit margin = Br. 36,600 18.65% Br.
196,200

Interpretation: For every 100 birr in sales, the company earns 18.65 birr in gross profit, indicating
good cost control.

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3) Operating Profit Margin

Operating Profit Margin=EBIT
Net Sales ×100
Operating Profit Margin=10,500/196,200=5.35%
Interpretation: The Company retains 5.35% of sales as operating profit after covering operating
expenses
4) Return on investment (assets) – measures how profitably a firm has used its investment in total
assets.
Return on investment = Net income
Total assets
Zebra’s return on investment = Br. 3,900 = 2.53 %
Br. 153,900
Interpretation: Zebra earned more than 2 cents of profits for each birr in assets.
Generally, a high return on investment is sought by firms. This can be achieved by increasing sales
levels, increasing sales relative to costs, reducing costs relative to sales, or efficiently utilizing assets.
Return on equity – indicates the rate of return earned by a firm’s stockholders on investments made
by them selves
Return on equity = Net income___
Stockholders’ equity
Zebra’s return on equity = Br. 3,900 = 6.99%
Br. 55,800
Interpretation: Zebra earned almost 7 cents of profit for each birr in owner’s equity
We can also use the following alternative way to calculate return on equity.

Return on equity = Return on investment

1 – Debt ratio
A high return on equity may indicate that a firm is more risky due to higher debt balance. On the
contrary, a low ratio may indicate greater owners capital contribution as compared to debt
contribution. Generally, the higher the return on equity, the better off the owners.
e) Marketability Ratios
Marketability ratios are used primarily for investment decisions and long range planning. They
include:

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Earnings per share (EPS) – expresses the profits earned on each share of a firm’s common stock
outstanding. It does not reflect how much is paid as dividends.

Earnings per share = Net income – Preferred stock dividend

Number of common shares outstanding

Zebra’s Eps for 2002 = Br. 3,900 – Br. 300 = Br. 1.09
Br. 33,000 Br. 10
Interpretation: Zebra’s common stockholders earned Br. 1.09 per share in 2002.
Dividends Per Share (DPS) – represents the amount of cash dividends a firm paid on each share
of its common stock outstanding.

Zebra’s DPs for 2002 =Br. 3,300 _ = Br. 1.00

Br. 33,000 Br. 10

Dividend pay-out (pay-out) ratio – shows the percentage of earnings paid to stockholders.

Total dividends to common stockholders

Total earnings to common stockholders
Zebra’s pay-out ratio = Br. 1.00 = Br. 3,300 = 92%
Br. 1.09 Br. 3,600
Interpretation: Zebra paid nearly 92% of its earnings in cash dividends.
Comparing Financial Ratios
To address whether a given ratio is high or low, good or bad, a meaningful basis is needed for
comparison. Two types of ratio comparisons can be made.
Cross – sectional analysis – is the comparison of a firm’s ratios to those other firms in the same
industry at the same point in time. Here, the firm is interested in how well it has performed in relation
to other firms. Generally, cross – sectional analysis is preformed based on industry averages of
different financial ratios.

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Time – series analysis – is an evaluation of a firm’s financial ratios over time. Here, the current
period ratios are compared with those of the past years. The purpose is to determine whether the firm
is progressing or deteriorating.
To obtain the highest possible information about a firm, usually, a combination of both cross –
sectional and time-series analyses are applied.
2.5 Limitations of Ratio Analysis
Even though ratio analysis can provide useful information about a firm’s financial conditions and
operations, it has the following problems and limitations.
Generally, any single financial ratio does not provide sufficient information by itself.
Sometimes a comparison of ratios between different firms is difficult. One reason could be a single
firm may have different divisions operating in different industries. Another reason
could be the financial statements may not be dated at the same point in time.
The financial statements of firms are not always reliable, particularly, when they are not audited.
Different accounting principles and methods employed by different companies can distort
comparisons.
Inflation badly distorts comparison of ratios of a firm over time.
Seasonal factors inherent in a business can also lead us to deceptive conclusion. For example, the
inventory turnover ratio for a stationery materials selling company will be different at
different time periods of a year.

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CHAPTER 22
THE COST OF CAPITAL
4.1 Meaning of the cost of capital
The cost of capital is the minimum rate of return that a firm must earn in order to satisfy the overall
rate of return required by its investors. It is also the minimum rate of return a firm must earn on its
invested capital to maintain the value of the firm unchanged. The second definition considers the cost
of capital as a break even rate. If a firm’s actual rate of return exceeds its cost of capital, the value of
the firm would increase. If on the other hand, the cost of capital is not earned, the firm’s market value
will decrease. So the cost of capital is the rate of return that is just sufficient to leave the price of the
firm’s common stock unchanged.
The cost of capital serves as a discount rate when a firm evaluates an investment proposal. Suppose a
firm is considering investment on a plant. The finance required for this investment is to be raised by
selling a common stock issue. Now, after raising capital, the firm is expected to provide required rate
of return to those who invest on the common stock. This in effect is the firm’s cost of capital. So to
decide to invest on the plant, the minimum rate of return from the investment at least should be equal
to the required rate of return by the common stockholders. If the required rate of return by the firm’s
common stockholders is 13%, then the firm should earn a minimum of 13% on its investment on the
plant. The 13% minimum rate of return that should be earned by the firm is, therefore, its cost of
capital.

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4.2 Measuring the specific cost of capital

The cost of capital for any particular capital source or security issue is called the specific cost of
capital. It is also called individual cost of capital or component cost of capital. Each type of capital
contained the capital structure of a firm include:
Debt
Preferred stock
Common stock
Retained earnings
Two important points you should bear in mind about the specific cost of capital. One is that it is
computed on an after-tax basis. Meaning, if there would be any tax implication on the individual
source of capital, it should be considered. In almost all circumstances, the tax implication is only on
debt sources of finance. The second point is that the specific cost of capital is expressed as an annual
percentage or rate like 6%, 9%, or 10%. The cost of capital is not stated in terms of birr.
4.2.1 The cost of debt
This is the minimum rate of return required by suppliers of debt. The relevant specific cost of debt is
the after-tax cost of new debt. Generally, debt is the cheapest source of finance to a firm and, hence,
the cost of debt is the lowest specific cost of capital. There are two basic explanations for this. First,
debt suppliers, generally, assume the lowest risk among all suppliers of capital. They receive interest
payments before preferred and common dividends are paid. Since they assume the smallest risk, their
return is the lowest. Their lowest return would be the lowest cost of capital to the firm. Second,
raising capital through debt sources entails interest expense. The interest expense in turn reduces the
firm’s income which ultimately would cause tax payment to be reduced. So raising money in the
form of debt results in the smallest tax burden, and finally, the firm’s cost of debt would be the
lowest. Debt sources of finance may take several forms like bonds, promissory notes, bank loans.
Here, for our convenience we consider bond issue to illustrate the cost of debt. Computing the cost of
new bond issue involves three steps:
i) Determine the net proceeds from the sale of each bond
NPd = Pd – f
Where:
NPd = The net proceeds from the sale of each bond
Pd = The market price of the bond
f = Flotation costs
ii) Compute the effective before tax cost of the bond using the following approximation formula:
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Pn NPd
I
n
Kd =
Pn NPd
2
Where:
Kd = The effective before tax cost of debt
I = Annual interest payment
Pn = The par value of the bond
n = Length of the holding period of the bond in years.
iii) Compute the after-tax cost of debt
Kdt = Kd (1 – t)
Where:
Kdt = The after-tax cost of debt
t = The marginal tax rate
Example: Currently, Chamo Industrial Group is planning to sell 15-year, Br. 1,000 par-value bonds
that carry a 12% annual coupon interest rate. As a result of lower current interest rates, Abyssinia
bonds can be sold for Br. 1,010 each. Flotation costs of Br. 30 per bond will be incurred in the
process of issuing the bonds. The firm’s marginal tax rate is 40%. Required: Calculate the after tax
cost of Chamo’s new bond issue:
Solution:
Given:Pn = Br. 1,000; I = Br. 120 (Br. 1,000 x 12%); n = 15; Pd = Br. 1,010; f = Br. 30;
t = 40%; Kdt= ?
Then apply the three steps:
i) NPd = Br. 1,010 – Br. 30 = Br. 980
Br.1,000 Br.980
Br.120
15
ii) Kd =  12.26%
Br.1,000 Br.980
2
iii) Kdt = 12.26% (1 – 40%) = 7.36%
Therefore, the after – tax cost of Chamo’s new bond issue is 7.36%. That is, Chamo should be able to
earn a minimum of 7.36% to satisfy bondholders otherwise, the firm’s value will decline.
4.2.2 The cost of preferred stock
The cost of preferred stock is the minimum rate of return a firm must earn in order to satisfy the
required rate of return of the firm’s preferred stock investors. It is also the minimum rate of return a
firm’s preferred stock investors require if they are to purchase the firm’s preferred stock. When a firm
raises capital by issuing new preferred stock, it is expected to pay fixed amount of dividends to the
preferred stockholders. So it is the dividend payment that is the cost of the preferred stock to the firm
stated as an annual rate.
The cost of a new preferred stock issue can be computed by following two steps:
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i) Determine the net proceeds from the sale of each preferred stock.
NPpf = Ppf – f
Where:
NPpf = Net proceeds from the sale of each preferred stock
Ppf = Market price of the preferred stock
f = Flotation costs
Compute the cost of preferred stock issue
Kps = Dps__
NPpf
Where:
Kps = The cost of preferred stock
DPs = The pre share annual dividend on the preferred stock
Example: Apple Computer Systems Company has just issued preferred stock. The stock has 12%
annual dividend and Br. 100 par value and was sold at 102% of the par value. In addition, flotation
costs of Br. 2.50 per share must be paid. Calculate the cost of the preferred stock.
Solution:
Given: Pps = Br. 102 (Br. 100 x 102%); Dps = Br. 12 (Br 100 x 12%); f = Br. 2.50;
Kps =?
Then apply the two steps:
i) NPpf = Br. 102 – Br. 2.50 = Br. 99.50
ii) Kps = Br. 12 =12.06%
Br. 99.50
Therefore, Apple Company should be able to earn a minimum of 12.06% on any investment financed
by the new preferred stock issue. Otherwise, the firm’s value will decrease.
4.2.3 The cost of common stock
The cost of common stock is the minimum rate of return that a firm must earn for its common
stockholders in order to maintain the value of the firm. A firm does not make explicit commitment to
pay dividends to common stockholders. However, when common stockholders invest their money in
a corporation, they expect returns in the form of dividends. Therefore, common stocks implicitly
involve a return in terms of the dividends expected by investors and hence, they carry cost. Generally,
common stock dividends are paid after interest and preferred dividends are paid. As a result, common
stock investors assume the maximum risk in corporate investment. They compensate the maximum
risk by requiring the highest return. This highest return expected by common stockholders make
common stock the most expensive source of capital.
The cost of common stock can be computed using the constant growth valuation model.
Ks = D1+ g
NPo
Where:
Ks = The cost of new common stock issue

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D1 = The expected dividend payment at the end of next year

NPo = Net proceeds from the sale of each common stock
g = The expected annual dividends growth rate
The net proceeds from the sale of each common stock (NPo) is computed as follows:
NPo = Po – f
Where:
Po = The current market price of the common stock
f = flotation costs
Example: An issue of common stock is sold to investors for Br. 20 per share. The issuing corporation
incurs a selling expense of Br. 1 per share. The current dividend is Br. 1.50 per share and it is
expected to grow at 6% annual rate. Compute the specific cost of this common stock issue.
Solution
Given: Po = Br. 20; D1 = Br. 1.50; g = 6%; f = Br. 1; Ks = ?
Then apply the two steps:
NPo = Br. 20 – Br. 1 = Br. 19
Ks = D1 + g = Br. 1.50 +.06) = 13.9%
Npo Br. 19
Therefore, the firm should be able to earn a minimum return of 13.9% on investments that are
financed by the new common stock issue.
4.2.4 The cost of Retained Earnings
Retained earnings represent profits available for common stockholders that the corporation chooses
to reinvest in itself rather than payout as dividends. Retained earnings are not securities like stocks
and bonds and hence do not have market price that can be used to compute costs of capital. The cost
of retained earnings is the rate of return a corporation’s common stockholders expect the corporation
to earn on their reinvested earnings, at least equal to the rate earned on the outstanding common
stock. Therefore, the specific cost of capital of retained earnings is equated with the specific cost of
common stock. However, flotation costs are not involved in the case of retained earnings.
Computing the cost of retained earnings involves just a single procedure of applying the following
formula:
Kr = D1 + g
Po
Where:
Kr = The cost of retained earnings
D1 = The expected dividends payment at the end of next year
Po = The current market price of the firm’s common stock
g = The expected annual dividend growth rate.
Example:Zeila Auto Spare Parts Manufacturing Company expects to pay a common stock dividend
of Br. 2.50 per share during the next 12 months. The firm’s current common stock price is Br. 50 per
share and the expected dividend growth rate is 7%. A flotation cost of Br. 3 is involved to sale a
share of common stock.
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Required: Compute the cost of retained earnings

Solution
Given: Po = Br. 50; D1 = Br. 2.50; g = 7%; Kr = ?
Then apply the formula:
Kr = D1+ g = Br. 2.50 + 7% = 12%
Po Br. 50
4.3 Weighted average cost of capital (WACC)
In the previous section we have seen how to compute the cost of capital for each individual source of
capital. The specific cost of capital is used in evaluating an investment proposal to be financed by a
particular capital source. Practically, however, investments are financed by two or more sources of
capital. In such a situation, we cannot make use of the individual cost of capital. Rather we should
use the average cost of capital employed by the firm.
The firm’s capital structure is composed of debt, preferred stock, common stock, and retained
earnings. Each capital source accounts to some portion of the total finance. But the percentage
contribution of one source is usually different from another. So we must compute the weighted
average cost of capital rather than the simple average.
The weighted average cost of capital (WACC) is the weighted average of the individual costs of debt,
preferred stock and common equity (common stock and retained earnings). It is also called the
composite cost of [Link] the weights of the component capital sources are all given, the weighted
average cost of capital can be computed as:
WACC = WdKdt + WpsKps + WceKs
Where:
WACC = The weighted average cost of capital
Wd = The weight of debt
Wps = The weight of preferred stock
Wce = The weight of common equity
Kdt = The after – tax cost of debt
Kps = The cost of preferred stock
Ks = The cost of common equity
The WACC is found by weighting the cost of each specific type of capital by its proportion in
the firm’s capital structure. Weights of the individual capital sources can be calculated based on
their book value or market value.
To illustrate the computation of the WACC, look at the following example.

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Sodo Tools Manufacturing Company’s financial manager wants to compute the firm’s weighted
average cost of capital. The book and market values of the amounts as well as specific after-tax costs
are shown in the following table for each source of capital.

Source of capital Book value Market value Specific cost

Debt Br. 1,050,000 Br. 1,000,000 5.3%
Preferred stock 84,000 125,000 12.0
Common equity 966,000 1,375,000 16.0
Total Br. 2,100,000 Br. 2,500,000
Required: Calculate the firm’s weighted average cost of capital using:
book value weights
market value weights

Solution:
1) Total book value = Br. 2,100,000
Wd = Br. 1,050,000 = 0.5; Wps = Br. 84,000__ = 0.04; Wce = Br. 966,000 = 0.46
Br. 2,100,000 Br. 2,100,000 Br. 2,100,000 WACC = WdKdt +
WpsKps + WceKs
0.5 (5.3%) + 0.04 (12.0%) + 0.46 (16.0%)
2.65% + 0.48% + 7.36%
10.49%
The minimum rate of return on all projects should be 10.49%. Meaning, Sodo should accept
all projects so long as they earn a return greater than or equal to 10.49%
2) Total Market value = Br. 2,500,000
Wd = Br. 1,000,000 = 0.4; Wps = Br. 125,000 = 0.05; Wce = Br. 1,375,000 = 0.55
Br. 2,500,000 Br. 2,500,000 Br. 2,500,000 WACC = 0.4 (5.3%) +
0.05 (12.0%) + 0.55 (16.0%)
2.12% + 0.60% + 8.80%
11.52%
If the market value weights are used, Sodo should accept all projects with a minimum rate of
return of 11.52%

CHAPTER 23
RISK AND RETURN
Introduction
Risk and return are most important concepts in finance. In fact, they are the foundation of the
modern finance theory. Risk (or uncertainty) refers to the variability of expected returns

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associated with a given investment. Risk, along with the concept of return, is a key consideration
in investment and financial decisions. This chapter will discuss procedures for measuring risk
and investigate the relationship between risk, returns, and security valuation.

6.2 Return on a Single Asset

Ethiopia Cement is a large company with several thousand shareholders. Suppose you bought 100
shares of the company, at the beginning of the year, at a market price of Br 225. The par value of
each share is Br 10. Your total investment is cash that you paid out is:
Investment = Br 225 × 100 = Br 22,500
Returns: Suppose during the year, Ethiopia Cements paid a dividend at 25 per cent. As the dividend
rate applies to the par value of the share, your dividend per share would be: Br 10 × 25% = Br 2.50
and total dividend would be:
Dividend = (Dividend rate x Par value) x Number of
shares Dividend = Dividend per share x Number of shares
Dividend = Br 2.50 × 100 = Br 250

Further, suppose the price of the share at the end of the year turns out to be Br 267.50. Since the
ending share price increased, you have made a capital gain:
Capital gain/loss = (Selling price – Buying price) × Number of shares
Capital gain/loss = (Br 267.50 – Br 225) × 100 = Br 4,250
Your total return is:
Total return = Dividend + Capital gain
Total return = Br 250 + Br 4,250 = Br 4,500

If you sold your shares at the end of the year, your cash inflows would be the dividend income plus
the proceeds from the sale of shares:
Cash flow at the end of the year = Dividends + Value of sold shares
= Br 250 + (`267.50 × 100) = Br 27,000
This amount equals to your initial investment of Br 22,500 plus the total return of Br 4,500: Br 27000
You can express your return in percentage term as given below Return in percentage = 4,500/ 22,500
= 0.20 or 20%

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Percentage returns are frequently calculated on per share basis. We have seen in the example above
that returns from each share have two components: the dividend income and the capital gain. Hence,
the rate of return on a share would consist of the dividend yield and the capital gain yield. The rate of
return of a share held for one year is as follows:

Rate of return = Dividend yield + Capital gain yield

R1 =D1 …………………………..(1)

Where: R1 is the rate of return in year 1,

D1 is dividend per share received in year 1,
P0 is the price of the share in the beginning of the year and
P1 is the price of the share at the end of the year.
Dividend yield is the percentage of dividend income, and it is given by dividing the dividend per
share at the end the year by the share price in the beginning of the year; that is, D1/P0. Capital gain is
the difference of the share price at the end and the share price in the beginning divided by the share
price in the beginning; that is, (P1 – P0)/P0. If the ending price were less than the beginning price,
there would be a negative capital gain or capital loss. In the example of Ethiopia Cements, your rate
of return would be as follows:

R = 0.011

= 0.011 + 0.189 = 0.20 or 20%

The total return of 20 per cent on your investment is made up of 1.1 per cent dividend yield and 18.9
per cent capital gain. What would be your return if the market price of Ethiopia Cements’ share were
Br 200 after a year? The expected rate of return would be:

R = 0.011

= 0.011 – 0.111 = –0.10 or –10%

You would earn a negative rate of return (–10 per cent) because of the capital loss (negative capital
gain). The return of a share significantly depends on the change in its share price. The market price of
a share shows wide fluctuations. Hence investment in shares is risky. The risk of a security depends
on the volatility of its returns.

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Unrealized capital gain or loss: If an investor holds a share and does not sell it at the end of a
period, the difference between the beginning and ending share prices is the unrealized capital gain (or
loss). The investor must consider the unrealized capital gain (or loss) as part of her total return. The
fact of the matter is that if the investor so wanted, she could have sold the share and realized the
capital gain (or loss).

Annual Rates of Return

Example of ABC The rate of return of a company’s shares may be calculated for a period longer than
one year. Let us consider ABC data of the market prices and dividend per share for the 11-year period
from 2001 to 2011 to calculate the 10-year annual rates of return. Table blows shows calculations.
Year Dividend per Dividend Share price Capital gain Return (R)
share (D1) yield (P) (Pt-Pt-1)/Pt-1
(D1/Po t=1)
2000 3.50 - 206.35 - -
2001 5.00 2.42 223.65 8.38 10.81
2002 5.50 2.46 181.75 -18.73 -16.28
2003 5.50 3.03 204.70 12.63 15.65
2004 5.00 2.44 143.50 -29.90 -27.45
2005 5.00 3.48 197.25 37.46 40.94
2006 6.00 3.04 216.55 9.78 12.83
2007 9.00 4.16 213.90 -1.22 2.93
2008 7.50 3.51 237.50 11.03 14.54
2009 6.50 2.74 238.70 0.51 3.24
2010 6.50 2.72 284.60 19.23 21.95
2011 7.50 2.64 409.90 44.03 46.66
Average 6.27 2.97 232.00 8.47 11.44
The yearly returns show wide variations. During the 11-year period, the highest return of 46.66 per
cent was obtained in 2011 and lowest return of –27.45 per cent was obtained in 2004

Average Rate of Return ( )

Given the yearly returns, we can calculate average or mean return. The average rate of return is the
sum of the various one-period rates of return divided by the number of periods. The simple arithmetic
average rate of return of ABC shares for ten years, as given in Table above, 11.44 per cent. The
formula for the average rate of return is as follows:

Rates of Return and Holding Periods Investors may hold their investment in shares for longer periods
than for one year.
How do we calculate holding period returns?

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Suppose you invest Br 1 today in a company’s share for five years. The rates of return are 18 per
cent, 9 per cent, 0 per cent, –10 per cent and 14 per cent.
What is the worth of your shares?

You hold the share for five years; hence, you can calculate the worth of your investment assuming
that each year dividends from the previous year are reinvested in shares. The worth of your
investment after five years is:

Investment worth after five years = (1 + 0.18) × (1 + 0.09) × (1 + 0.0) × (1 – 0.10)

(1 + 0.14)
1.18 × 1.09 × 1.00 × 0.90 × 1.14 = Br 1.32
Your Br one investment has grown to Br1.32 at the end of five years. Thus your total return is: 1.32 –
= 0.32 or 32 per cent. Your total return is a five-year holding-period return.
How much is the annual compound rate of return?

We can calculate the compound annual rate of return as follows:

Compound annual rate of return = -1
1.057 – 1 = 0.057 or 5.7%
This compound rate of return is the geometric mean return. You can verify that one rupee invested
today at 5.7 per cent compound rate would grow to approximately Br 1.32 after five years: (1.057)5 =
Br 1.32.

Risk of Rates of Return

Variance and Standard Deviation
We can observe in Table above that the annual rates of return of ABC share show wide fluctuations
ranging from –27.45 per cent in 2004 to 46.94 per cent in 2011. These fluctuations in returns were
caused by the volatility of the share prices. The changes in dividends also contributed to the
variability of ABC rates of return. We can think of risk of returns as the variability in rates of return.
How could one measure the variability of rates of return of a share (or an asset)?

The variability of rates of return may be defined as the extent of the deviations (or dispersions) of
individual rates of return from the average rate of return. There are two measures of this dispersion:

 Variance

Standard deviation Or Standard deviation is the square root of variance.

How to Calculate Variance and Standard Deviation

The following steps are involved in calculating variance or standard deviation of rates of return of
assets or securities using historical returns:
1. Calculate the average rate of return using Equation

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= …………………………………..2
2. Calculate the deviation of individual rates of return from the average rate of return and square
it (R- 2
Calculate the sum of the squares of the deviations as determined in the preceding step and divide it by
the number of periods (or observations) less one to obtain variance,

Var. = = )2
In the case of sample of observations, we divide the sum of squares of the deviations by n – 1 to
account for the degree of freedom. If you were using population data, then the divider will be n.
Calculate the square root of the variance to determine the standard deviation, i.e.
Standard deviation=
σ=
We can summarize the formulae calculating variance and standard deviation of historical rates of
return of a share as follows:

σ2= )2………………………………3

σ= ……………………………………………………………..4

In Table above the ten annual rates of return for ABC share are calculated. The average rate of return
is 11.43 per cent. For ABC rates of return of 10 years, you can calculate the variance and the standard
deviation using Equations (3) and (4) as follows:

Variance (σ2) = [(10.81 – 11.44)2 + (– 16.28 – 11.44)2 + (15.65 – 11.44)2 + (– 27.45 – 11.44)2 +
(40.94 – 11.44)2 + (12.83 – 11.44)2 + (2.93 – 11.44)2 + (14.54 – 11.44)2 + (3.24 – 11.44)2 + (21.95
– 11.44)2 + (46.66 – 11.44)]

(4,671.61)
467.16

Standard deviation (σ)=

21.61
The annual rates of return of ABC share show a high degree of variability; they deviate on an
average, by about 21.61 per cent from the average rate of return of 11.44 per cent. Can we use ABC
past returns as a guide for the future returns?

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It is difficult to say that past returns will help in assessing the future returns since ABC returns are
quite volatile. The actual rate of return in any given period may significantly vary from the historical
average rate of return.

6.3 Expected Return and Risk

Suppose you are considering buying one share of Ethiopia Cements, which has a market price of Br
261.25 today. The company pays a dividend of Br 2.50 per share. You want to hold the share for one
year.
What is your expected rate of return?
This will depend on the dividend per share you would actually receive and the market price at which
you could sell the share. You do not know both the outcomes. The outcomes may depend on the
economic conditions, the performance of the company and other factors. You will have to think of the
outcomes of dividend and the share price under possible economic scenarios to arrive at a judgment
about the expected return. You may, for example, assume four (equally likely) possible states of
economic conditions and performance: high growth, expansion, stagnation and decline. You also
expect the market price of share to be Br 305.50, Br 285.50, Br 261.25 and Br 243.50 and the
dividend per share Br 4, Br 3.25, Br 2.50 and Br 2 respectively under four different states of
economic conditions.
Thus the possible outcomes of return can be calculated as follows in Table blow. Note that the current
share price is Br 261.25, and depending on the economic conditions, there are four possibilities. The
rates of return calculations can be shown as follows:

Rates of Returns under Various Economic Conditions

Economic Share price Dividend Dividend Capital gain Return
condition yield
High growth 305.50 4 0.015 0.169 0.185
Expansion 285.50 3.25 0.012 0.093 0.105
Stagnation 261,25 2.50 0.010 0.000 0.010
Decline 243.50 2 0.008 – 0.068 -0.060

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Your total return is anticipated to vary between –6 per cent under the unfavorable condition to +18.5
per cent under the most favorable conditions. What is the chance or likelihood for each outcome
anticipated by you to occur? Probability is the percentage of the chance or likelihood of an outcome.
On the basis of your judgment, you may, for example, say that each outcome is equally likely to
occur, i.e., each outcome has a chance of 0.25 or 25 per cent. This is your subjective assessment. The
subjective probability is based on the judgment of the investor rather than on an objective assessment
of events to occur. The objective probability is based on the appraisal of the occurrence of an event
for a very large number of times. The sum of probabilities of the occurrence of outcomes is always
equal to 1.

Expected Rate of Return

Table below summarizes the range of returns under the possible states of economic conditions along
with probabilities. You can put this information together to calculate the expected rate of return. The
expected rate of return [E(R)] is the sum of the product of each outcome (return) and its associated
probability:
Expected rate of return = rate of return under scenario 1 × probability of scenario 1 + rate of return
under scenario 2 × probability of scenario 2 +… + rate of return under scenario n × probability of
scenario n.
Economic Rate of Probability Expected rate of return
condition return%
Growth 18.5 0.25 4.63
Expansion 10.5 0.25 2.62
Stagnation 1.0 0.25 0.25
Decline -6.0 0.25 – 1.50
100 6.00

Thus, the expected rate of return is as given below:

E(R) = (18.5 × 0.25) + (10.5 × 0.25) + (1.00 × 0.25) + (–6.0 × 0.25) = 0.06 or 6%
You can convert this simple procedure of calculation in the following equation:

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E(R) = R1 × P1 + R2 × P2 + ... + RnPn

E(R)= …………………………………………..5

Note that E(R) is the expected rate of return, Ri the outcome i, Pi is the probability of the occurrence
of i and n is the total number of outcomes.
The expected rate of return is the average return. It is 6 per cent in our example. We know that the
possible outcomes range between –6 per cent to +18.5 per cent. How much is the average dispersion?
As stated earlier, this is explained by the variance or the standard deviation. The steps involved in the
calculation of the variance and the standard deviation are the same as already discussed in the
preceding section, except that the square of the difference of an outcome (return) from the expected
return should be multiplied by its probability. The following formula can be used to calculate the
variance of returns:
σ2 = [R1 – E (R)]2 P1 + [R2 – E(R)]2 P2 + ... + [Rn – E(R)]2Pn
E(R)= …………………………………………..6

In the above example, the variance of returns is:

σ2 = [(18.5 – 6)2 × 0.25] + [(10.5 – 6)2 × 0.25] + [(1 – 6)2 × 0.25)] + [(–6 – 6)2 × 0.25]

= 86.375
The standard deviation is:
σ=
= 9.29
Should you invest in the share of Ethiopia Cement?
The returns are expected to fluctuate widely. The expected rate of return is low (6 per cent) and the
standard deviation is high (9.29 per cent). You may like to search for an investment with higher
expected return and lower standard deviation.

6.4 Portfolios
A portfolio is a bundle or a combination of individual assets or securities. Portfolio theory provides a
normative approach to investors to make decisions to invest their wealth in assets or securities under
risk. It is based on the assumption that investors are risk-averse. This implies that investors hold well-
diversified portfolios instead of investing their entire wealth in a single or a few assets. One important
conclusion of the portfolio theory, as we explain later, is that if the investors hold a well-diversified
portfolio of assets, then their concern should be the expected rate of return and risk of the portfolio
rather than individual assets and the contribution of individual asset to the portfolio risk. The second
assumption of the portfolio theory is that the returns of assets are normally distributed. This means

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that the mean (the expected value) and variance (or standard deviation) analysis is the foundation of
the portfolio decisions. Further, we can extend the portfolio theory to derive a framework for valuing
risky assets. This framework is referred to as the capital asset pricing model (CAPM). An alternative
model for the valuation of risky assets is the arbitrage pricing theory (APT).

6.4.1 Portfolio Return: Two-Asset Case

The return of a portfolio is equal to the weighted average of the returns of individual assets (or
securities) in the portfolio with weights being equal to the proportion of investment value in each
asset. Suppose you have an opportunity of investing your wealth in either asset X or asset Y. The
possible outcomes of two assets in different states of economy are given in Table below.

Possible Outcomes of Two Assets, X and Y

State of economy Probability P Return % (R)
X Y
A 0.10 -8 14
B 0.20 10 -4
C 0.40 8 6
D 0.20 5 15
E 0.10 -4 20

The expected rate of return of X is the sum of the product of outcomes and their respective
probability. That is:
E(R) = (R1*P1)+(R2*P2)+…+(Rn*Pn)
E(R)x= …………………………………………………………1
E(R)x =(-8*0.1)+(10*0.2)+(8*0.4)+(5*0.2)+(-4*0.1) = 5%

Similarly, the expected rate of return of Y is:

E(R) y= (14*0.1)+(-4*0.2)+(6*0.4)+(15*0.2)+(20*0.1) = 8%
Note that E(Rx) is the expected return on asset X, Ri is ith return and Pi is the probability of ith
return. Consider an example. Suppose you decide to invest 50 per cent of your wealth in X and 50 per
cent in Y. What is your expected rate of return on a portfolio consisting of both X and Y ? This can
be done in two steps. First, calculate the combined outcome under each state of economic condition.

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Second, multiply each combined outcome by its probability. Table below shows the calculations.
There is a direct and simple method of calculating the expected rate of return on a portfolio if we
know the expected rates of return on individual assets and their weights. The expected rate of return
on a portfolio (or simply the portfolio return) is the weighted average of the expected rates of return
on assets in the portfolio. In our example, the expected portfolio return is as follows:

In the case of two-asset portfolio, the expected rate of return is given by the following formula:
Expected return on portfolio = weight of security X × expected return on security X + weight of
security Y × expected return on security Y
E(Rp) = w × E(Rx) + (1 – w) × E(Ry)
= (0.50*5)+(0.50*8) = 6.50%

Note that w is the proportion of investment in asset X and (1 – w) is the remaining investment in asset
Y. Given the expected returns of individual assets, the portfolio return depends on the weights
(investment proportions) of assets. You may be able to change your expected rate of return on the
portfolio by changing your proportionate investment in each asset.
How much would you earn if you invested 20 per cent of your wealth in X and the remaining wealth
in Y?
The portfolio rate of return under this changed mix of wealth in X and Y will be:
E(Rp) = 0.20*5+(1-0.20)*8 = 7.40%

You may notice that this return is higher than what you will earn if you invested equal amounts in X
and Y. The expected return would be 5 per cent if you invested entire wealth in X (i.e., w = 1.0). On
the other hand, the expected return would be 8 per cent if the entire wealth were invested in Y (i.e., 1
– w = 1, since w = 0). Your expected return will increase as you shift your wealth from X to Y. Thus,
the expected return on portfolio will depend on the percentage of wealth invested in each asset in the
portfolio. What is the advantage in investing your wealth in both assets X and Y when you could
expect highest return of 8 per cent by investing your entire wealth in Y? When you invested your
wealth equally in assets X and Y, your expected return is 6.5 per cent. The expected return of Y (8
per cent) is higher than the portfolio return (6.5 per cent). But investing your entire wealth in Y is
more risky. Under the unfavorable economic condition, Y may yield a negative return of 4 per cent.

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The probability of negative return is eliminated when you combine X and Y. Further, the portfolio
returns are expected to fluctuate within a narrow range of 3 to 10 per cent (see column 3 of Table
below). You may also note that the expected return of X (5 per cent) is not only less than the portfolio
return (6.5 per cent), but it also shows greater fluctuations. We discuss the concept of risk in greater
detail in the following sections.
Expected Portfolio Rate of Return
State of economy Probability P Combined returns % Expected return %
X (50%)+Y(50%)
A 0.10 (-8*.50)+(14*.50) =3.0 0.10*3.0 = 0.3
B 0.20 (10*.50)+(-4*.50) =3.0 0.20*3.0 = 0.6
C 0.40 (8*.50)+ (6*.50) =7.0 0.40*7.0 = 2.8
D 0.20 (5*.50)+(15*.50) =10.0 0.20*10.0 = 2.0
E 0.10 (-4*.50)+(20*.50) =18.0 0.10*18.0 = 0.8
Expected return on portfolio = 6.50

6.4.2 Portfolio Risk: Two-Asset Case

We have seen in the previous section that returns on individual assets fluctuate more than the
portfolio return. Thus, individual assets are more risky than the portfolio. How is the risk of a
portfolio measured?
As discussed in the previous chapter, risk of individual assets is measured by their variance or
standard deviation. We can use variance or standard deviation to measure the risk of the portfolio of
assets as well.
Why is a portfolio less risky than individual assets?
Let us consider an example. Suppose you have two investment opportunities A and B as shown in
Table below.
Table: Investments in A and B
Economic condition Probability Returns %
A B
Good 0.50 40 0
Bad 0.50 0 40

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Assuming that the investor invests in both the assets equally, the expected rate of return, variance and
standard deviation of A are:
E(RA) = 0.50*40+.50*0 = 20%
σ2A = .50(40-20)2 + .50(0-20)2 = 400
σ=
= 20%
Here σA represents the standard deviation of assets A, σ2A is the variance of asset A and E(RA) is
the estimated rate of returns. Note that variance is the square of standard deviation. Similarly, the
expected rate of return, variance and standard deviation of B are:
E(RA) = 0.50*0+.50*40 = 20%
σ2A = .50(0-20)2 + .50(40-20)2 = 400
σ=
= 20%
Both investments A and B have the same expected rate of return (20 per cent) and same variance
and standard deviation (20 per cent). Thus, they are equally profitable and equally risky. How does
combining investments A and B help an investor?
If a portfolio consisting of equal amount of A and B were constructed, the portfolio return would
be: E(Rp)= (0.50*20)+(0,50*20) = 20%
This return is the same as the expected return from individual securities, but without any risk. Why?
If the economic conditions are good, then A would yield 40 per cent return and B zero and the
portfolio return will be:
E(Rp)= (0.50*40)+(0,50*0) = 20%
When economic conditions are bad, then A’s return will be zero and B’s 40 per cent and the portfolio
return would still remain the same:
E(Rp)= (0.50*0)+(0,50*40) = 20%
Thus, by investing equal amounts in A and B, rather than the entire amount only in A or B, the
investor is able to eliminate the risk altogether. She is assured of a return of 20 per cent with a zero
standard deviation. It is not always possible to entirely reduce the risk. It may be difficult in practice
to find two assets whose returns move completely in opposite directions like in the above example of
securities A and B. It needs emphasis to state that the risk of portfolio would be less than the risk of

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individual securities, and that the risk of a security should be judged by its contribution to the
portfolio risk.
Measuring Portfolio Risk for Two Assets
Like in the case of individual assets, the risk of a portfolio could be measured in terms of its variance
or standard deviation. As stated earlier, the portfolio return is the weighted average of returns on
individual assets.
Is the portfolio variance or standard deviation a weighted average of the individual assets’ variances
or standard deviations? It is not.
The portfolio variance or standard deviation depends on the co-movement of returns on two assets.
Covariance When we consider two assets, we are concerned with the co-movement of the assets.
Covariance of returns on two assets measures their co-movement.
How is covariance calculated?
Three steps are involved in the calculation of covariance between two assets:
Determine the expected returns on assets.

Determine the deviation of possible returns from the expected return for each asset.

Determine the sum of the product of each deviation of returns of two assets and respective
probability.
Let us consider the data of securities of X and Y given in Table below.
State of Probability Returns Deviation from Product of deviation
economy X returns Y expected &probability
X Y
A 0.1 -8 14 -13 6 -7.8
B 0.2 10 -4 5 -12 -12
C 0.4 8 6 3 -2 -2.4
D 0.2 5 15 0 7 0.0
E 0.1 -4 20 9 12 -10.8
E(Ry) = 8 Covariance =-33.00

The expected return on security X is:

E(Rx) = (-8*0.1)+(10*0.20)+(8*0.4)+(5*0.2)+(-4*0.1) =5%

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The expected return on security Y is:

E(Ry) = (14*0.1)+(-4*0.20)+(6*0.4)+(15*0.2)+(20*0.1) =8%

If the equal amount is invested in X and Y, the expected return on the portfolio is:
E(Rp)= (5*0.50)+(8*0.50) = 6.50%
Table above shows the calculations of variations from the expected return and covariance, which is
the product of deviations of returns of securities X and Y and their associated probabilities:
The covariance of returns of securities X and Y is –33.0. The formula for calculating covariance of
returns of the two securities X and Y is as follows:

Covariancexy= …………………………..3
[Link]= 0.1(-8-5)(-14-8)+0.2(10-5)(-4-8)+0.4(8-5)(6-8)+0.2(5-5)(15-8)+0.1(-4-5)(20-8)
-7.8-12-2.4+0-
10.8 =-33.0

Positive covariance X’s and Y’s returns could be above their average returns at the same
 time. Alternatively, X’s and Y’s returns could be below their average returns at the same time.
In either situation, this implies positive relation between two returns. The covariance would
 be positive.
Negative covariance X’s returns could be above its average return while Y’s return could be
below its average return and vice versa. This denotes
 a negative relationship between returns
 of X and Y. The covariance would be negative.

Zero covariance Returns on X and Y could show no pattern; that is, there is no relationship.
In this situation, covariance would be zero. In reality, covariance may be non-zero due to
randomness and the negative and positive terms may not cancel out each other.
In our example, covariance between returns on X and Y is negative, that is, –33.0. This is akin to the
second situation above; that is, two returns are negatively related. What does the number –33.0
imply?

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As in the case of variance, covariance also uses squared deviations and therefore, the number cannot
be explained. Wecan, however, compute the correlation to measure the relationship between two
returns.
How can we find relationship between two variables?

Correlation is a measure of the linear relationship between two variables (say, returns of two
securities, X and Y in our case). It may be observed from Equation (3) that covariance of returns of
securities X and Y is a measure of both variability of returns of securities and their association. Thus,
the formula for covariance of returns on X and Y can also be expressed as follows:
Covariance XY = standard deviation X * standard deviation Y *Correlation XY

σxσyCorxy………………………………………………………4
Note that σx and σy are standard deviations of returns for securities X and Y and Corxy is the
correlation between returns of X and Y. From Equation (4), we can determine the correlation by
dividing covariance by the standard deviations of returns on securities X and Y

Covxy = ……………………………………5
The value of correlation, called the correlation coefficient, could be positive, negative or zero. It
depends on the sign of covariance since standard deviations are always positive numbers. The
correlation coefficient always ranges between –1.0 and +1.0. A correlation coefficient of +1.0 implies
a perfectly positive correlation while a correlation coefficient of –1.0 indicates a perfectly negative
correlation. The correlation between the two variables will be zero (or not different from zero) if they
are not at all related to each other. In a number of situations, returns of any two securities may be
weakly correlated (negatively or positively). Let us calculate correlation by using data given in Table
above. The covariance is –33.0. We need standard deviations of X and Y to compute the correlation.
The standard deviation of securities X and Y are as follows:

σ2x = = 0.1(-8-5)2 +0.2(10-5)2 +0.4(8-5)2+ 0.2(5-5)2+ 0.1(-4-

5)2 = 16.9+5+3.6+0+8. = 33.6

σx = = 5.8%

σ2y = 0.1(-14-8)2+0.2(-4-8)2+0.4(6-8)2+0.2(15-8)2+0.1(20-
8)2 = 3.6+28.8+1.6+9.8+14.4 =58.2

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σy = = 7.63%
The correlation of the two securities X and Y is as follows:

Covxy = = -0.746
Securities X and Y are negatively correlated. The correlation coefficient of –0.746 indicates a high
negative relationship. If an investor invests her wealth in both instead any one of them, she can
reduce the risk.

6.5 Risk Diversification

Can diversification reduce all risk of securities? We just explained that when more and more
securities are included in a portfolio, the risk of individual securities in the portfolio is reduced. This
risk totally vanishes when the number of securities is very large. But the risk represented by
covariance remains. Thus, risk has two parts: diversifiable (unsystematic) and non-diversifiable
(systematic).
Systematic Risk Systematic risk arises on account of the economy-wide uncertainties and the
tendency of individual securities to move together with changes in the market. This part of risk
cannot be reduced through diversification. It is also known as market risk. Investors are exposed to
market risk even when they hold well-diversified portfolios ofsecurities. The examples of systematic
or market risks are given below:

 The government changes the interest rate policy.

 The corporate tax rate is increased.

 The government resorts to massive deficit financing.

 The inflation rate increases.

 a restrictive credit policy

 The government  relaxes the foreign exchange controls and announces full convertibility of
the Indian rupee. 
 The government withdraws tax on dividend payments by companies.

The government eliminates or reduces the capital gain tax rate.

Unsystematic Risk Unsystematic risk arises from the unique uncertainties of individual securities. It
is also called unique risk. These uncertainties are diversifiable if a large numbers of securities are
combined to form well-diversified portfolios. Uncertainties of individual securities in a portfolio

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cancel out each other. Thus unsystematic risk can be totally reduced through diversification.
Examples of unsystematic risks: 
 The company workers declare strike.

 The R&D expert leaves the company.

 A formidable competitor enters the market.

 The company loses a big contract in a bid.

 The company makes a breakthrough in process innovation.

 The government increases custom duty on the material used by the company.

The company is unable to obtain adequate quantity of raw material

Total Risk
Total risk of an individual security is the variance (or standard deviation) of its return. It consists of
two parts:
Total risk of a security = Systematic risk + Unsystematic risk
Systematic risk is attributable to macroeconomic factors. An investor has to suffer the systematic
risk, as it cannot be diversified away. The unsystematic risk is firm specific. Thus, Total risk =
variance attributable to macroeconomic factors + (residual) variance attributable to firm-specific
factors
Total risk is not relevant for an investor who holds a diversified portfolio. The systematic risk cannot
be diversified, and therefore, she will expect a compensation for bearing this risk. She will be more
concerned about that portion of the risk of individual securities that she cannot diversify. Since
unsystematic risk is diversifiable, there is no compensation to an investor for bearing such risk.

Combining a Risk-Free Asset and a Risky Asset

In the preceding sections, we have discussed the riskreturn implications of holding risky securities,
and the construction of the portfolio opportunity set. What happens to the choices of investors in the
market if they could combine a risk-free security with a single or multiple risky securities? If
investors could borrow and lend at the risk-free rate of interest, how would the portfolio opportunity
set be shaped and how could securities be valued in the market? A risk-free asset or security has a
zero variance or standard deviation. The risk-free security has no risk of default. The government
treasury bills or bonds are approximate examples of the risk-free security as they have no risk of
default.

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What happens to return and risk when we combine a risk-free and a risky asset?
Let us assume that an investor holds a risk-free security f, of which he has an expected return (Rf ) of
5 per cent and a risky security j, with an expected return (Rj) of 15 per cent and a standard deviation
of 6 per cent.
What is the portfolio return and risk if the investor holds these securities in equal proportion? The
portfolio return is:
E(Rp) = wE(Rj) + (1-w)Rf
=0.50 x 0.15 + (1-0.5)0.05
0.075 + 0.025
10%
Since the risk-free security has zero standard deviation, the covariance between the risk-free security
and risky security is also zero. The portfolio risk is simply given as the product of the standard
deviation of the risky security and its weight. Thus
σp = wσj
0.50 x 0.06
3%
Capital Asset Pricing Model (CAPM)
We have so far discussed the principles of portfolio choices as made by investors. We also considered
the significance of the risk-free asset in portfolio decisions. In the presence of the risk-free asset, the
capital market line (CML) is the relevant efficient frontier, and all investors would choose to remain
on the CML. This implies that the relevant measure of an asset’s risk is its covariance with the market
portfolio of risky assets. How do we determine the required rate of return on a risky asset? How is an
asset’s risk related to its required rate of return? The capital asset pricing model (CAPM) provides a
framework to determine the required rate of return on an asset and indicates the relationship between
return and risk of the asset.12 The required rate of return specified by CAPM helps in valuing an
asset. One can also compare the expected (estimated) rate of return on an asset with its required rate
of return and determine whether the asset is fairly valued. As we explain in this section, under
CAPM, the security market line (SML) exemplifies the relationship between an asset’s risk and its
required rate of return.

Assumptions of CAPM

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The capital asset pricing model, or CAPM, envisages the relationship between risk and the expected
rate of return on a risky security. It provides a framework to price individual securities and
determines the required rate of return for individual securities. It is based on a number of simplifying
assumptions. The most important assumptions are:
Market efficiency: The capital market efficiency implies that share prices reflect all available
information. Also, individual investors are not able to affect the prices of securities.
 This
 means that there are large numbers of investors holding a small amount of wealth.
Risk aversion and mean-variance optimization Investors are risk-averse. They evaluate a
security’s return and risk, in terms of the expected return and variance or standard deviation
respectively. They prefer the highest expected returns for a given level of risk. This implies

 that investors are mean-variance optimizers and they form efficient portfolios.

 Homogeneous expectations:  All investors have the same expectations about the expected
returns and risks of securities. 
 Single time period: All investors’ decisions are based on a single time period.
Risk-free rate: All investors can lend and borrow at a risk-free rate of interest. They form
portfolios from publicly traded securities like shares and bonds.

Characteristics Line
The unsystematic risk which can be eliminated through diversification, and systematic risk, which
cannot be reduced. Since unsystematic risk can be mostly eliminated without any cost, there is no
price paid for it. Therefore, it will have no influence on the return of individual securities. Market will
pay premium only for systematic risk since it is non-diversifiable.

Security Market Line (SML)

Under CAPM, the risk of an individual risky security is defined as the volatility of the security’s
return vis-vis the return of the market portfolio. This risk of an individual risky security is its
systematic risk. Systematic risk is measured as the covariance of an individual risky security with the
variance of the market portfolio. The security market line (SML) shows the expected return of an
individual asset given its risk. The covariance of any asset with itself is represented by its variance
(covj,j) = σ2j). The return on market portfolio should depend on its own risk, which is given by the
variance of the market return (σ2m). Therefore, the risk-return relationship equation is as follows:

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E(Rj) = Rf+ (Covj,m)

E(Rj) = Rf+ (E(Rm)-Rf)

E(Rj) = Rf+ (E(Rm)-Rf)

The term, covj,m/σ2mis called the security beta, βj. Beta is a standardized measure of a security’s
systematic risk. The beta of the market portfolio is 1. The market portfolio is the reference for
measuring the volatility of individual risky securities. Since a risk-free security has no volatility, it
has zero beta. We can rewrite the equation for SML as follows: E(Rj) = Rf+ (E(Rm)-Rf) βj

Where E (Rj) is the expected return on security j, Rf the risk-free rate of interest, E(Rm) the expected
return on the market portfolio and βj the undiversifiable risk of security j.
Example
The risk free rate of return is 8 per cent and the market rate of return is 17 per cent. Betas for four
shares, P, Q, R and S are respectively 0.60, 1.00, 1.20 and –0.20. Required: What are the required
rates of return on these four shares?
E(Rj) = Rf+ (E(Rm)-Rf) βj
E(RP) = 0.08 + (0.17-0.08)x0.60 = 13.4%
E(RQ) = 0.08 + (0.17-0.08)x1.0 = 17%
E(RR) = 0.08 + (0.17-0.08)x1.20 = 18.8%
E(RS) = 0.08 + (0.17-0.08)x-0.20 = -6.2%

Q with beta of 1.00 has a return equal to the market return. P has beta lower than 1.00, therefore its
required rate of return is lower than the market return. R has a return greater than the market return
since its beta is greater than 1.00. S has a return lower than the risk-free rate since it has a negative
beta.
Limitations
CAPM has the following limitations:

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
 It is based on unrealistic assumptions.

 It is difficult to test the validity of CAPM.

Betas do not remain stable over time.
The Arbitrage Pricing Theory (APT)
The act of taking advantage of a price differential between two or more markets is referred to as
arbitrage. The Arbitrage Pricing Theory (APT) describes the method of bringing a mispriced asset in
line with its expected price. An asset is considered mispriced if its current price is different from the
predicted price as per the model. In APT, there are a number of industry-specific and macro-
economic factors that affect the security returns. Thus, a number of factors may measure the
systematic (non-diversifiable) risk of an asset under APT. The fundamental logic of APT is that
investors always indulge in arbitrage whenever they find differences in the returns of assets with
similar risk characteristics.

Concept of Return under APT

In APT, the return of an asset is assumed to have two components: predictable (expected) and
unpredictable (uncertain) return. Thus, return on asset j will be:
E(Rj) = Rf+ UR

Where Rf is the predictable return (risk-free return on a zero-beta asset) and UR is the unanticipated
part of the return. The predictable or expected return depends on the information available to
shareholders, that has a bearing on the share prices. The unpredictable or uncertain return arises fro m
the future information. This information may be the firm-specific and the market-related
(macroeconomic) factors. The firm-specific factors are special to the firm and affect only the firm.
The market-related factors affect all firms. Thus the uncertain return may come from the firm-specific
information and the market related information. We can rewrite Equation as follows:
E(Rj) = Rf+ URs + URm

URs the unexpected component of return arising from the specific factors related to the firm. URm is
that component of the unexpected return, which arises from the economy wide, market-related factors

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Concept of Risk under APT

The risk arising from the firm-specific factors is diversifiable. It is unsystematic risk. The risk arising
from the market-related factors cannot be diversified. This represents systematic risk. In CAPM,
market risk primarily arises from the sensitivity of an asset’s returns to the market returns and this is
reflected by the asset’s beta. Just one factor—the market risk—affects the firm’s return. Hence,
CAPM is one-factor model. The betas of the firm would differ depending on their individual
sensitivity to market. On the other hand, APT assumes that market risk can be caused by economic
factors such as changes in gross domestic product, inflation, and the structure of interest rates and
these factors could affects the firms differently. For example, different firms may feel the impact of
inflation differently. Therefore, under APT, multiple factors may be responsible for the expected
return on the share of a firm. Therefore, under APT the sensitivity of the asset’s return to each factor
is estimated. For each firm, there will be as many betas as the number of factors. Equation can be
expressed as follows:
E(Rj) = Rf+(β1F1+β2F2+β3F3+…+βnFn)+URs
Where β1 is firm j’s factor one beta, β2 is factor two beta and so on. F represents a surprise in factors.
Let us consider an example as given as follows:
Total Return under APT
Suppose that GNP, inflation, interest rate, stock market index and industrial production affect the
share return of the firm – Divine Home Company. Further, we have information about the forecasts
and actual values of these factors, and the firm’s GNP beta, inflation beta, interest rate beta and the
stock market beta. An investor is considering making an investment in the share of Divine Home
Company. The following in the table are the attributes of five economic forces that influence the
return on Divine’s share. The risk-free (anticipated) rate of return on the Divine’s share is 9 per cent.
How much is the total return on the share?
Factors Beta Expected value % Actual value %
GPN 1.95 6 6.5
Inflation 0.85 5 5.75
Interest rate 1.20 7 8
Stock market index 2.50 9.5 11.50
Industrial production 2.20 9 10

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It is anticipated return plus unanticipated return. The anticipated return includes the effect of known
information such as expected inflation and other factors. Therefore we need to determine the surprise
part in the systematic factors. The difference in the expected and actual values of the factors is the
surprise. Shareholders will be compensated for this. The difference multiplied by a factor beta will
compensate shareholders for that factor’s systematic risk. The expected value of a factor is the
riskfree part. The total return will consist of anticipated (riskfree) return and unanticipated return as
follows:
E(Rj) = Rf+β1(RF1– Ra)+β2(RF2 - Ra)+…+ βn(RFn- Ra)
9+1.95(6.5-6)+0.85(5.75-5)+1.20(8-7)+2.5(11.5-9.5)+2.20(10-9)
9+10 = 19%

CHAPTER 24
CAPITAL BUDGETING DECISION

Definition of Capital Budgeting

Capital budgeting decision can be defined as follows:
Capital budgeting is concerned with allocation of the  firm’s scarce financial resources in long
 term projects, the benefits occur over a future period.
Capital budgeting may be defined as the firm’s decision to invest current funds in long term
assets to get the benefits over the years. 
 Capital budgeting is the process of making investment decisions in capital expenditures

 Capital budgeting is a long-term planning for making and financing proposed capital out lays


Capital budgeting is concerned with the allocation of the firm’s financial resources among the
available opportunities. 
 Capital budgeting is acquiring inputs with long-term return
Capital budgeting consists in planning development ofavailable capital for the purpose of
maximizing the long-term profitability of the concern


Characteristics of capital budgeting decisions are:
 Change of current assets for future benefits

Investment of funds in non-flexible and long term assets or activities

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
 Huge funds are involved

 Future benefits of cash flows occur over a series of years

 Decisions are irreversible

Significant impact on the profitability of the firm

Need and Importance of Capital Budgeting Decisions

Capital budgeting decision is an important function because of the following reasons:

Huge investments: Capital budgeting requires huge investments of funds, but the available
funds are limited, therefore the firm before investing projects, plan are control its capital
expenditure
Long-term: Capital expenditure is long-term in nature or permanent in nature.

Therefore financial risks involved in the investment decision are more. If higher risks are
involved, it needs careful planning of capital budgeting

Irreversible: The capital investment decisions are irreversible, are not changed back. Once
the decision is taken for purchasing a permanent asset, it is very difficult to dispose off those
assets without involving huge losses

Long-term effect: Capital budgeting not only reduces the cost but also increases the revenue
in long-term and will bring significant changes in the profit of the company by avoiding over
or more investment or under investment. Over investments leads to be unable to utilize
assets or over utilization of fixed assets

Risk: Long term commitment of funds changes the risk profile of the firm. Adoption of a
profitable investment increases the earning per share but cause a change in the earning
pattern. As future is uncertain, there is no guarantee for the continuation of the same
earnings, positively. Thus, investment decisions shape the basic character of the firm.

Strategic Direction: Finally, a firm’s capital budgeting decisions includes its strategic direction
since its entrance into new products, services, or markets must be preceded by capital
expenditures.

5.2 CAPITAL BUDGETING PROCESS

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Capital budgeting is a difficult process to the investment of available funds. The benefit will attained
only in the near future but, the future is uncertain. However, the following steps followed for capital
budgeting, then the process may be easier are

 Identification of Various Investments Proposals

 Screening or Matching the Available Resources

 Evaluation of Proposals

 Fixing Property

 Final Approval

 Implementation

Identification of various investments proposals:

The capital budgeting may have various investment proposals. The proposal for the investment
opportunities may be defined from the top management or may be even from the lower rank.
The heads of various departments analyze the various investment decisions, and will select
proposals submitted to the planning committee of competent authority.
Screening or matching the proposals:
The planning committee will analyze the various proposals and screenings. The selected proposals
are considered with the available resources of the concern. Here resources referred as the financial
part of the proposal. This reduces the gap between the resources and the investment cost.
Evaluation of proposal:
After screening, the proposals are evaluated with the help of various methods, such as payback
period proposal, net discounted present value method, accounting rate of return and risk analysis.
The proposals are evaluated by.

 Independent proposals

 Contingent of dependent proposals

 Partially exclusive proposals.

Fixing property:
After the evolution, the planning committee will predict which proposals will give more profit or
economic consideration. If the projects or proposals are not suitable for the concern’s financial
condition, the projects are rejected without considering other nature of the proposals.
Final approval:
The planning committee approves the final proposals, with the help of the following:

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
 Profitability

 Economic constituents

 Financial viability

Market conditions.

The planning committee prepares the cost estimation and submits to the management.

Implementing:
The competent authority spends the money and implements the proposals. While implementing
the proposals, assign responsibilities to the proposals, assign responsibilities for completing it,
within the time allotted and reduce the cost for this purpose.
Performance review of feedback:
The final stage of capital budgeting is actual results compared with the standard results. The
adverse or unfavorable results identified and removing the various difficulties of the project. This
is helpful for the future of the proposals

Assumptions of Capital Budgeting

The set of conditions within which the financial aspects of long-term investments can be
evaluated:

Shareholder Wealth Maximization is the Basic Motive:

All capital-budgeting investment alternatives considered here are accepted or rejected on the basis
of their effect on shareholder wealth. No other corporate goals influence the investment selection
decision.
Costs and Revenues are Known With Certainty:
The costs and revenues associated with each investment alternative are known with certainty, or
there exists a forecasting technique that can generate the values with a very small error. It may be
very difficult to estimate revenues and costs more than two or three years into the future.
However, if a proposed investment has a ten-year economic life, accurate forecasts must be
available for all the ten years.

(iii)Inflows and Outflows are Based on Cash:

The data required for evaluating investment proposals must be stated in cash as opposed to
accounting income. This is because a corporation uses cash to pay its bills and to pay cash dividends
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on common and preferred stock. If the corporation does not generate cash returns from its
investments, it will sooner or later become insolvent.

Inflows and Outflows Occur Once a Year:

Cash inflows or outflows occur only once a year-either at the end of a given year or at discrete
yearly intervals. Compounding and/or discounting occur only once a year. Investment alternatives
are assumed to exhibit conventional cash flows

The Required Rate of Return is Known and Constant:

From the perspective of the investor, the cost of capital is the required rate of return (RRR), the
return that suppliers of capital demand on their investment (adjusted for tax deductibility of interest).
The minimum required rate of return on investment alternatives is assumed to be known with
certainty and constant over the life of the proposed investment alternatives. Having an appropriate
required rate of return is important for two reasons
If the rate is set too high, the corporation will reject quite profitable projects and
If the rate is set too low, the corporation will accept projects that decrease shareholder wealth.

5.3 INVESTMENT ANALYSIS TOOLS

Traditional Method
[Link] Period
[Link] Accounting Rate of Return
Discounted Cash Flow Method
[Link] Present Value
[Link] Index
[Link] Rate of Return
The Payback Period
The payback period in capital budgeting refers to the period of time required for the return on an
investment to "repay" the sum of the original investment. The time value of money is not taken into

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account in this method. Payback period intuitively measures how long something takes to "pay for
itself." All else being equal, shorter payback periods are preferable to longer payback periods.
Payback period is widely used because of its ease of use despite the recognized limitations described
below.

Payback period as a tool of analysis is often used because it is easy to apply and easy to understand
for most individuals, regardless of academic training or field of endeavor. When used carefully or to
compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment
to "doing nothing." Payback period has no explicit criteria for decision-making (except, perhaps, that
the payback period should be less than infinity).

Payback period is one of the simplest methods to find out the period by which the investment on the
project may be recovered from the net cash inflows, i.e., gross cash in flow less the cash outflows. In
short it is defined as the period required recovering the original investment cost. Payback period starts
with a preconceived notion that the management wants to recover the cost of investment within a
"specific period". When the analysis under such system shows that the payback period is less than
such "specified period", decision may be taken in favor of the investment for such project. There are
two methods in use to calculate the payback period.
Uniform cash Flow
mple 1 If a project has an investment of Br. 60,000 and annual cash inflow is Br. 15,000 per year for 10 years.
Compute the PBP?
PBP = 60,000/15000= 4 years

Example 2
If the project cash inflow is not in “annuity form”, cumulative cash inflow method may be used to
compute that PBP. Assuming an initial investment of Br. 30,000 for the following stream of cash
flows and compute the PBP
Year Cash Flow Cumulative
(30,000)
1. 10,000 10,000
2. 8,000 18,000
3. 12,000 30,000

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4. 7,000 37,000
5. 9,000 46,000
6. 3,000 49,000

Hence, PBR, is 3 years

 Unequal cash flows: In this situation the pay back period id calculated as:
Payback period = E + B
C
E = number of years immediately preceding
the year of final recovery
B = the balance amount to be recovered
C = cash flow during the final recovery
Example: A company is considering investing on a particular project. The alternative projects available are: Project A
that costs Br. 100,000, and Project B that Costs Br. 70,000. The net cash in flows estimates are as
follows:
Net Cash Inflow
Year Project A Project B
1 30,000 7,000
2 30,000 15,000
3 35,000 20,000
4 35,000 56,000
5 40,000 45,000

Which project is good?

Solution:
Project A Project B
sh inflow Net cash inflow cash inflow Net cash inflow
0,000 0,000 7,000 000
0,000 0,000 15,000 ,000
5,000 5,000 20,000 ,000
5,000 0,000 56,000 ,000

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0,000 0,000 45,000 3,000

Payback period for Project A:

Payback = =3 years + 5000*

period 35,000
3.14 year or 3 years and 2 months
Payback period for Project B
= 3 years + 28,000
56,000
= 3.5 year or 3 years and 6 months
Note: * represent the balance to be recovered from the cash inflow in period four; i.e.,
100,000 – 95,000 = 5,000

The Decision Rule for Payback Period Criterion

If PBP < Target period** - Accept the proposal (project)
If PBP >Target period - Reject the proposal (project)
If PBP = Target period - Further analysis is required
(**Target period is the minimum period targeted by management to cover initial investment.
It acts as benchmark for those involved in capital budgeting decision.)
For example, if the required payback period were 3 years in the above example, the project would be
rejected because the payback period of the project (or 4.18 years) is greater than the maximum
acceptable payback period (or 3 years).

Limitations of the Payback Period Criterion

The payback criterion measures the time required for a project to break even. However, this criterion
in capital budgeting has the following limitations:
Ignore cash flow after payback period, hence, cannot measure of profitability
The maximum acceptable cutoff payback period is subjective decision
It ignores the time value of money
Finally, the rule is biased against long-term projects.
It is one of the misleading evaluations of capital budgeting

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Advantages of the Payback Period Criterion

While being a poor criterion to measure profitability, the payback period gives a rough indication of the liquidity of a
project. The payback period was among the first capital-budgeting criteria to be widely accepted. It
continues to be in common use even today for the following reasons:

 It is easy to calculate and simple to understand.

 Pay-back method provides further improvement over the accounting rate return

 Pay-back method reduces the possibility of loss on account of obsolescence

 It favors projects that “pay back quickly” and contributes to the firm’s overall liquidity.

Because it favors short-term investments, the rule is often employed when future events are
 difficult to quantify.

The Accounting Rate of Return-(ARR)

The ARR method (also called the return on capital employed (ROCE) or the return on investment
(ROI) method) of appraising a capital project is to estimate the accounting rate of return that the
project should yield. If it exceeds a target rate of return, the project will be undertaken.
ARR= Average annual profit x 100
Average investment
 Averageinvestment = Net working capital + Salvage value + 1/2(Initial cost of plant – salvage
value) 
 Net working capital = current assets – current liabilities

Average profits = total annual profit
Number of years

Ex: Initial investments of plant Br 10, 000

Installation costs Br 1, 000
Salvage value Br 1, 000
Working capital Br 2, 000
Life of plant 5 years
Annual profit per year Br 2, 500
Calculate ARR 
Average profit = 2, 500 x 5 =12, 500=2500

5
Average investment = Wc + Sal.V. +1/2 (Cost + Inst. Charges – Salv. Val)
2, 000 + 1, 000 +1/2 (10, 000 + 1, 000 – 1, 000)
3, 000 + 5, 000
= 8, 000
ARR =2500/8000 x 100
31.25%
Decision rule

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If ARR > Target rate** - Accept the proposal (project)

If ARR < Target rate - Reject the proposal (project)
If ARR = Target rate - Further analysis is required
(**Target rate is the minimum rate of return targeted by management. It acts as benchmark for those
involved in capital budgeting decision which is usually between 15% and 30% ─ are accepted
otherwise, rejected.
Advantages of the Accounting Rate of Return (ARR)
It considers the total benefits associated with the project
It is easy to calculate and simple to understand.
(iii)It is based on accounting profit hence measures the profitability of investment.

Disadvantages of the Accounting Rate of Return (ARR)

It does not take account of the timing of the profits from an investment.
It implicitly assumes stable cash receipts over time.
Accounting profits are subject to a number of different accounting treatments.
Takes no account of the size of the investment.
It does not consider terminal value of the project.
It ignores the time value of money.
It ignores the reinvestment potential of a project

Note that the payback period and accounting rate of return methods are said to be traditional or non-
discounted cash flow methods.
2. Discounted Payback Period

i. Net Present Value (NPV)

Net present value method is one of the modern methods for evaluating the project proposals. In this
method cash inflows are considered with the time value of the money. Net present value describes as
the summation of the present value of cash inflow and present value of cash outflow. Net present
value is the difference between the total present value of future cash inflows and the total present
value of future cash outflows
The formula for computation of NPV is given below:
NPV = CF1 + CF2 + CF3---------- + CFn - ICO
(1+r) (1+r) (1+r)3----- +(1+r)n
1 2
Where, CFt is the expected net cash flow at period
is the project’s cost of capital,

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I0 is initial outlay cost, and

is the project’s life.
Accept/Reject criteria (Decision rule) 
 If NPV is greater than zero accept the project

 If NPV is less than zero reject the project

If NPV is equal to zero indifference

Advantages
It recognizes the time value of money.
It considers the total benefits arising out of the proposal.
It is the best method for the selection of mutually exclusive projects.
It helps to achieve the maximization of shareholders’ wealth.
Disadvantages
It is difficult to understand and calculate.
It needs the discount factors for calculation of present values.
When mutually exclusive projects, it is not suitable for the projects having different
effective lives.
It may not give good results while comparing projects with unequal lives.
The NPV is an absolute figure and it does not consider for the size of the project.
It is not easy to determine an appropriate discount rate
EXAMPLE
To illustrate the calculation of the NPV consider a project which has the following cash flow streams.
Year Cash Flow
0 (1,000,000)
1 200,000
2 200,000
3 300,000
4 300,000
5 350,000
The cost of capital, r, for the firm is 10%.
Calculate The NPV of proposal
Accept or Reject the project?
Solution

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NPV= 200,000+200,000+300,000+300,000+350,000 _1000,000

(1.10)1 (1.10)2 (1.10)3 + (1.10)4 + (1.10)5
=181,818.182+165,289.256+225,394.440+204,904.037+217,322.463
=994,728.378
994,728.378- 1000,000
-Br. 5,273
Reject the project Since NPV is Negative
Example 2: NPV calculation

AMA Company is considering investing in a particular project. The initial investment cost is Br.
100,000. It is expected that the project may generate a benefit for 5 years as shown below:

Year Operating cost Annual cash inflow

0 Br. 100,000 --
1 6,000 Br. 20,000
2 10,000 30,000
3 2,000 40,000
4 1,000 40,000
5 1,000 35,000
The discounting rate is 10%
Required: Calculate the NPV
The approach is discounting the cost and revenue streams separately. This is shown as follows.
Present Value PV of Cost PV of
Year Cost Revenue
Factor Revenue
(Cash in flows)
0 Br. 100,000 -- 1 Br. 100,000 --
1 6,000 Br. 20,000 0.9091 5,454.6 Br. 18,182
2 10,000 30,000 0.8264 8,264 24,792
3 2,000 40,000 0.7513 1502.6 30,052
4 1,000 40,000 0.6830 683 27,320

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5 1,000 35,000 0.6209 620.9 21732

Br. 122,078
Total Br. 116524.8

Net present value of the project = PV of Revenue – PV of Costs

122078– 116524.8
Br. 5553.2

Decision: If you are talking about only one project, the decision is to accept
this project since its NPV is positive (Br. 4,789).
EXERCISE ABC PLC is considering to invest in a cement project. It has on hand Br 180, 000. It is
expected that the project may work for seven years and likely to generate the following annual cash
flows. Calculate the Net present value.
Year ACF
1 30,000
2 50,000
3 60,000
4 65,000
5 40,000
6 30,000
7 16,000

The cost of capital is 8%

Solution: Year ACF PV factor Present value

1 30, 000 .926 27, 780
2 50, 000 .857 42, 850
3 60, 000 .794 47, 640
4 65, 000 .735 47, 775
5 40, 000 .681 27, 240
6 30, 000 .630 18, 900
7 16, 000 .583 9, 328
221, 513
- Original investment 180, 000
Net present value 41, 513

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NPV is greater than zero hence, it may be accepted.

Profitability Index (PI) or Benefit Cost Ratio
Profitability index method is the relationship between the present values of net cash inflows and the
present value of cash outflows. It can be worked out either in unitary or in percentage terms. The
formula is
Pr esent Value of Cash Inflows
Profitability Index =
Initial Investment
Accept/Reject criteria (Decision rule)
PI>1 Accept
PI=1 indifference
PI<1 reject
Higher the profitability index more is the project preferred.
From the above example we can calculate the profitability index as below
Present value of cash outflows Br 100,000
Present value of cash inflows Br 118,730
Br.118,730
:-PI=
Br.100,000
Example:
Consider The Expected Cash Flows For Project L And You Are Expected To Decide Whether The
Project Is Accepted Or Rejected. Discounting Rate Or The Project’s Cost Of Capital Is 10%.
Expected Net Cash Flow
Year Project L
0 (Br. 100,000)
1 10,000 (30)
2 60,000
3 80,000

Solution:
Year Cash Flows Present Value Interest Present Value
(1) Factor At 10% (2) (3)= (1) X (2)
0 (Br.100,000)
1 10,000 1/ (1.10)1 = .909 9,090
2 60,000 1/ (1.10)2 = .826 49,560
3 80,000 1/ (1.10)3 = .751 60,080
Total Present Value Of Inflows 118,730

It Follows That,
Pi = Pr esent Value of Cash Inflows = Initial Br.118,730
1.1873
Investment Br.100,000
Decision: Accept The Project As Pi > 1.
Advantages and Disadvantages of Profitability Index

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Example: Consider the two mutually exclusive projects X and Y with the following cash flow
streams. The cost of capital for both the projects is 14%.

Year Project X Project Y

Cash PVIF Present Cash PVIF Present
Flow @14% value Flow @14% value
0 -155, 000 - 48,000
1 38,000 0.877 33,326 13,500 0.877 11,839.5
2. 44,000 0.769 33,836 14,700 0.769 11,304.
3. 49,000 0.675 33,075 17,300 0.675 11,677.5
4. 54,500 0.592 32,264 18,800 0.592 11,129.6
5. 60,000 0.519 31,140 20,500 0.519 10,639.5
163,641 56,590.4

The NBCR of both the projects is calculated as follows:

Project X = Present Value / Initial Investment
= 163641/155000 = 1.05575
Project Y = Present Value / Initial Investment
= 56590.4/48000 = 1.17896
Though the NBCR of both the projects is more than 1, Project Y should be accepted as it has a higher
BCR than Project X.

The Internal Rate of Return (IRR) is defined as the discount rate the net present value is
zero. IRR method finds out the rate at which – when applied on future cash inflows – the
present value of such inflows taken together should equal with the present value of the cost of
investment. It is called "Internal", as it is purely related to the return of the particular projected
investment only. 
 It is that rate at which present value of benefits equals the initial investment.
 
In other words, it is that discount rate at which NPV equals zero.
 
IRR represents Return on Investment in terms of percentage.
 
IRR is popular appraisal criterion for capital budgeting decision.
 
It is a method of ranking project proposals using the rate of return on an investment.

IRR is calculated through trial and error method

Advantages
It considers the time value of money.
It takes into account the total cash inflow and outflow.
If a firm has to rank mutually exclusive projects, choosing the project with the highest IRR
may result in suboptimal outcome
It does not use the concept of the required rate of return.
It gives the approximate/nearest rate of return.
It gives the same acceptance rule as the NPV method
Consistent with shareholders wealth maximization objective

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Disadvantages
It involves complicated computational method.
It may have multiple rates (or may not have unique rate of return)
It fails to indicate a correct choice between mutually exclusive project
It is assume that all intermediate cash flows are reinvested at the internal rate of return.
Decision Rule of IRR Criterion
The decision rule when the IRR criterion is used tomake accept-reject decisions is as follows:
 If IRR > cost of capital- Accept the proposal (project)
 
If IRR < cost of capital - Reject the proposal (project)
 
If IRR = cost of capital - Further analysis is required
 the same net initial investment but different
Other things being equal, when two projects have
IRR, the project with higher IRR is preferred.

To calculate IRR we can use interpolation method using the following formula:
NPVL
IRR = LRD +
 DR
PV
where; IRR = Internal Rate of Return
LRD = Lower Rate of Discount
NPVL = Net present value at lower rate of discount
(i.e., difference between present values of cash)
PV = The difference in present values at lower and higher discount values at lower.
DR = The difference between two rates of discount.
As you can see in the formula, you need to have two net present values i.e., positive and negative
NPVs that can be determined by the trial and error method. The higher the discount rate is the lower
NPV and the lower the discount rate is the higher the NPV. Example 1 The expected cash flows of a
project are as followed
Year Cash Flow
0 Br 100, 000
1 20, 000
2 30, 000
3 40, 000
4 50, 000
5 30, 000
The cost of capital is 12 percent
Calculate IRR
Solution
The calculation of r involves a process of trial and error. We try different values or r till we find that
the right-hand side of the above equation is equal to Br 100,000. Let us, to begin with, try r=18%
and 19% to equate the right-hand side and left hand side
At Discount Factor 18% At Discount Factor 19%
Year ACFS PV Factor PV in Br PV Factor PV in Br
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1 20, 000 .847 16,940 .840 16,800

2 30, 000 .718 21,540 .706 21,180
3 40, 000 .608 24,320 .593 23,720
4 50, 000 .516 25,800 .499 24,950
5 30, 000 .437 13,110 .419 12,570
101,713 99,220
NPV@18%=101,713-100,000=1,713
NPV@19%=99,220-100,000= 780
Total 2,493
NPVL
IRR = LRD +
 DR
PV
1,713
=18+
1
2493
= 18.70 percent

Accordingly, under this assumption, the cost of Capital is 12% and IRR is 18.70%
Thus, accept the project

Exercise

Nissan Plc. has Br 100, 000 on hand. This amount is invested in a project, where the annual benefits
after taxes are as below. It would like to know the rate of return earned by the company at the end of
the life of the project.
Year Cash Flows
1 Br 40, 000
2 35, 000
3 30, 000
4 25, 000
5 20, 000

Solution
At Discount Factor 20% At Discount Factor 10%
Year ACFS PV Factor PV in Br PV Factor PV in Br
1 40, 000 .833 33, 300 .909 36, 400
2 35, 000 .694 24, 300 .826 28, 900
3 30, 000 .579 17, 400 .751 22, 500
4 25, 000 .482 12, 100 .683 17, 100

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5 20, 000 .402 8, 000 .621 12, 400

95, 100 117, 300
NPVL
IRR = LRD +
 DR
PV
17,300
=10+
10
22,200
= 17.8

CHAPTER 25
MANAGING CURRENT ASSET
Introduction
Working capital refers to the amount the company requires to finance the day-to-day operation.
Working capital management – defined as current assets minus current liabilities – is a business tool
that helps companies effectively make use of current assets and maintain sufficient cash flow to meet
short-term goals and obligations. Working capital management is abusiness strategy designed to
ensure that a company operates efficiently by monitoring and using its current assets and liabilities to
their most effective use.
What are the Components of Working Capital?
Major components of working capital are its current assets and current liabilities, and the difference
between them makes up the working capital of a business. Current assets comprise trade receivables,

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inventory, and cash & bank balances, and current liabilities majorly comprise trade payables. The
efficient management of these components ensures the profitability of the business and ensures the
smooth running of the business.
Types of Working Capital
1. Gross Working Capital
Gross working capital refers to total investment in current assets. The current assets employed in
business give the idea about the utilization of working capital and idea about the economic position of
the company. A gross working capital concept is popular and acceptable concept in the field of
finance.
Gross working capital refers to the total current assets of the company, i.e., all the assets of the
company that can be converted into cash within a year; examples of which include accounts
receivables, inventory of raw material, WIP inventory, finished goods inventory, cash, and bank
balance, marketable securities such as T-Bills, commercial paper, etc. and short term investments.
2. Net Working Capital
Net working capital means current assets less current liabilities. The difference between current assets
and current liabilities is called the net working capital. If the net working capital is positive, business
is able to meet its current liabilities. Net working capital concept provides the measurement for
determining the creditworthiness of company.
Working capital, also known as net working capital (NWC), is the difference between a company's
current assets—such as cash, accounts receivable/customers' unpaid bills, and inventories of raw
materials and finished goods—and its current liabilities, such as accounts payable and debts.
Permanent Working Capital
Permanent working capital is the minimum amount of capital required to carry on the operations
without interruption or difficulty. For example, a company will need minimum cash to keep the
operations smooth and running; here, the minimum amount of money required will act as
permanent working capital.
Regular Working Capital
Regular working capital is the amount of funds businesses require to fund its day to day operations.
For example, cash needed for making payment of wages, raw materials, salaries comes under
regular working capital.
Reserve Margin Working Capital

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Apart from conducting day-to-day activities, a business may need some amount of capital to face
unforeseen circumstances. Reserve margin working capital is nothing, but the money kept aside
apart from the regular working capital. These funds are held separately against unexpected events
like floods, natural calamities, storms, etc.
Variable Working Capital
Variable working capital can be defined as the capital invested for a temporary period in the
business. Variable working capital is also called fluctuating working capital.
Such capital differs with respect to changes in the business assets or the size of the
business. Working Capital Formula
Working capital is calculated by subtracting current liabilities from current assets. That means that
the working capital formula can be illustrated as:
Working capital = current assets – current liabilities
Gross Working Capital Formula = Total Value of Current Assets
Gross Working Capital Formula = Receivables + Inventory + Cash and Marketable Securities
Short Term Investments + Any other Current Asset
If Current Assets > Current Liabilities → Positive Working Capital

If Current Assets < Current Liabilities → Negative Working Capital
Example 1
Suppose ABC Limited has Current Assets of $ 5, 00,000 and Current Liabilities of $ 300,000. Fixed
Assets are $ 1, 00,000. Long Term Debt is $1, 00,000.
Required: Calculate the Working Capital of the Company and analyze the same.
Solution:
Gross Working Capital/Current Assets of the Company: $5,00,000

Permanent Working Capital/Fixed Assets of the Company: $1,00,000

Current Liabilities: $300,000

Long Term Debt: $100,000

$500,000 – $300,000
$200,000
Analysis:

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In the above example of working capital, ABC Limited has a Strong Working Capital to meet its
Short Term and Long Term Financial needs.
Temporary WC = NWC – Permanent Working Capital
$2, 00,000 – $1, 00,000
$1, 00,000
In this case, the Gross Working Capital will be $200, 000
NWC= 200,000-300,000=(100,000)
NWC of the Company would be (-$1, 00,000) since the Current Liabilities are more than the Current
Assets of the Company. ABC Limited is suffering from Liquidity Crisis due to the negative Working
Capital of the Company, which will hinder Business Operations in the long term.
Such a high negative WC is a negative sign as far as the Credit Rating Agencies are concerned,
forcing them to downgrade the rating by one notch if the situation does not improve.
EXERCISE
Balance sheet of XYZ company
Cash 60,000 Accounting payable 30,000
Marketable security 10,000 Accrued Expense 20,000
Accounting Receivable 40,000 Note payable 5,000
Inventory 50,000 Interest payable 10,000
Total 160,000 65,000

Calculate
Gross working capital
Working capital
Networking capital
Solution
Gross working capital = Total current Asset
Gross working capital = 160,000
Working capital=Total current asset-total current Liability
Working capital=160,000-65000
Working capital=95,000
Networking capital=working capital
CASH CONVERSION CYCLE
What is the Cash Conversion Cycle
The cash conversion cycle, also known as Net Operating Cycle, measures the time the company takes
for converting its inventory and other inputs into cash and considers the time required for selling the
inventory and collecting receivables.

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The Cash Conversion Cycle (CCC) is a metric that shows the amount of time it takes a company to
convert its investments in inventory to cash. The conversion cycle formula measures the amount of
time, in days, it takes for a company to turn its resource inputs into cash

Cash Conversion Cycle = DIO + DSO – DPO

Where
DIO stands for Days Inventory Outstanding

DSO stands for Days Sales Outstanding

DPO stands for Days Payable Outstanding
Days Inventory Outstanding (DIO) is the number of days, on average; it takes a company to turn its
inventory into sales. Essentially, DIO is the average number of days that a company holds its
inventory before selling it
Days Inventory Outstanding (DIO) = Average or Inventory / Cost of Sales * 365
Days Inventory Outstanding signifies the total number of days taken for the company to convert the
inventory into the finished product and complete the sales process.
Days Sales Outstanding (DSO) is the number of days, on average; it takes a company to collect its
receivables. Therefore, DSO measures the average number of days for a company to collect payment
after a sale
Days Sales Outstanding (DSO) = Average or Accounts Receivable / Net Credit Sales * 365
Days Payable Outstanding (DPO) is the number of days, on average; it takes a company to pay back
its payables. Therefore, DPO measures the average number of days for a company to pay its invoices
from trade creditors, i.e., suppliers
Days Payable Outstanding (DPO) = Average or Accounts Payable / Cost of Sales * 365
INTERPRETATION OF THE CASH CONVERSION CYCLE
This ratio explains how much time it takes for a firm to receive cash from customers after it has
invested into purchasing the inventory.
Let’s say that the due date for payment for the purchase is 1st April. And the date of receiving the
cash from customers is on 15th April. That means the Cash Cycle would be the difference between
the date of payment and the day of receiving cash. And here it is, 14 days.
If CCC is shorter, it’s good for a firm; because it can quickly buy, sell, and receive cash from
customers and vice versa.

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Example
We will be taking two companies, and here are the details below.

In US $ Company A Company B

Inventory 3000 5000

Net Credit Sales 40,000 50,000

Accounts Receivable 5,000 6,000

Accounts Payables 4,000 3,000

Cost of Sales 54,000 33,000

Calculate DIO
Calculate DSO
CalculateDPO
Calculate cash conversion cycle

Formula Company A Company B

DIO = Inventory / Cost of Sales * 365 3,000/54,000*365 5,000/33,000*365
DIO= 20 days 55 days (approx.)
DSO= Accounts Receivable /Net Credit 5,000/40,000*365 6,000/50,000*365
Sales * 365 =46 days (approx.) 44 days (approx.)

DPO = Accounts Payable / Cost of Sales * 4,000/54,000*365 3,000/33,000*365

365 27 days (approx.) 33 days (approx.)
CCC DIO+DSO-DPO 20+46-27 55+44-33
=39 days 66 Days

We now have the cash cycle for both of the companies. And if we imagine that these companies are
from the same industry and if other things remain constant, then in a matter of comparison, Company
A has a better hold on their cash cycle than Company B.

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You should remember that when you add DIO and DSO, it’s called the operating cycle. And after
deducting the DPO, you may find a negative Cash Cycle. A negative Cash Cycle means the firm is
getting paid by their customers long before they ever pay their suppliers.
CASH MANAGEMENT
Definition: The Cash Management is concerned with the collection, disbursement and the
management of cash in such a way that firm’s liquidity is maintained. In other words, it is concerned
with managing the cash flows within and outside the firm and making decisions with respect to the
investment of surplus cash or raising the cash from outside for financing the [Link] cash is the
most significant and highly liquid asset the firm holds. It is significant as it is used to pay the firm’s
obligations and helps in the expansion of business operations.
Objectives of Cash Management
The objective of cash management is to have adequate control over the cash position, so as to avoid
the risk of insolvency and use the excessive cash in some profitable way

Cash Management is useful for the preparation of cash budgets and doing cash forecasts.
It helps in determining the minimum cash balance to be maintained.

It is used in balancing liquidity and profitability.
Identifying the opportunity cost and investing accordingly.


Example #1

A computer manufacturing company, Abc Limited, uses supplier Alpha & Co. to purchase raw
materials. Alpha & Co. has the policy of allowing credit of 30-days. Abc limited has $10 million in
cash resources available and has to pay $2 million to Alpha & Co. after the 30-day period. However,
after the 30-day period, it has an investment opportunity of $10 million.
Suppose the company can renegotiate its terms with suppliers allowing more periods. In that case, the
delay in payment will allow the company to use cash in the investment and then pay off the amount
to Alpha & Co. at a later date from cash generated from other sources. Thus, proper cash
management can take investment opportunities and maintain business operations.
Example #2

A Company has 120 days of inventory and receivables are due in 60 days. The payable terms are 30
days. The company will face a cash crunch as the funds are blocked in debtors and inventory, and the
payables are due in a lesser period.

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To manage the cash prudently, the company should either speed up the realization of inventory or
debtors; or renegotiate the payment terms with creditors. If the company fails to do so, it would need
to borrow funds to fill the deficit.
Example #3
Beta limited has the policy to pay off its creditors in 60 days and gives its customers a credit period of
30 days. Also, it doesn’t hold an inventory of more than ten days. How should the company manage
cash flows?
Since the payment is made in 60 days and realization is made for debtors and inventory in 40 days,
there is idle cash for 20 days. To optimally utilize the same, the company should find an opportunity
to invest and maximize profitability.
CASH MANAGEMENT CYCLE
Cash management can basically categorized into (a) cash outflow like, purchases, payment to
expenses and services; (b) cash inflows like, sales, other revenues; and (c) cash balance held at any
point of time. A cash management cycle is used to explain the basic function of cash management. It
seeks to accomplish the objective of cost minimization by achieving liquidity and profitability. Every
business transaction result as cash inflow will increase the cash balance, while cash outflow
transaction will decrease cash balance.
Cash management cycle is defined as “ the process of identifying various cash inflows and making
them available to business needs as cash outflows, maintaining the objective of liquidity and
profitability”. The following diagram explains the basic process of cash management cycle.

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Cash management demands

To have an efficient cash forecasting and reporting systems
To achieve optimal conservation and utilization of funds. The cash budget tells us the
estimated levels of cash balances for the given period on the basis of expected revenues and
expenditures.
However, if there are shortfalls and surplus, how should these be arranged and what should
be done with surplus, are the questions which are not answered by the cash budget.
Any firm can be successful with its cash management, when it is able to achieve the following
objectives:
Cash Planning: Is the process of estimating cash inflows and outflows to project cash surplus
or deficit for future planning period. A cash budget is used to serve this objective.
Managing cash flows: The cash flows should be properly managed to avoid the variance
between planned events to actual event. Accelerating cash inflows and decelerating cash
outflows can achieve this.
Optimum Cash Balance: It is always essential to determine appropriate cash balance. The cost
of excess of cash holding and also the danger of cash deficiency should be matched to
determine the optimum level of cash balance.
Investing supplies/Borrowing deficit: The surplus cash balance over and above the minimum
balance should be always is invested in the profitable ventures, while the deficit balance
should be arranged from various financing sources.
CASH MANAGEMENT MODELS

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BAUMOL MODEL (1952) – EOQ MODEL

to that of economic order quantity (EOQ model) used in the
Baumol model is similar
 inventory management
 is an approach to establish a firm's optimum cash balance under
Baumol model
certainty. 
 The firm is able to forecast its cash needs with certainty
The purpose of the model to minimize the total cost of cash holding which is summation of
opportunity cost and transaction cost.
Holding cost, also known as the carrying cost of inventory, refers to the cost that an entity incurs for
handling and storing its unsold inventory during the accounting period (monthly, quarterly, annual)
and is calculated as the total of storage cost, finance cost, insurance, and taxes as well as
obsolescence and shrinkage cost.
There are two types of cost involved in holding cash.
Opportunity cost:-The opportunity cost of holding money is the cost that could be realized if
money were invested instead of held.
Transaction cost also known as conversion cost
The firm incurs a holding cost for keeping the cash balance. It is an opportunity cost; that is, the
return foregone on the marketable securities. If the opportunity cost is k, then the firm’s holding
cost for maintaining an average cash balance is as follows:
Inventory Holding Cost Formula = Storage Cost + Cost of Capital + Insurance & Taxes
+ Obsolescence Cost

EXAMPLE

XYZ Inc. has taken a warehouse facility to store its inventories. The handling and storage cost is US
$ 20,000, and the insurance cost is US $ 3,500. The total inventory of the entity for the years is US $
200,000. In addition, the entity is paying interest of $ 7,500 as the cost of warehouse financing.
Inventory Holding Cost = Storage Cost + Cost of Capital + Insurance Cost = $ 20,000 + $ 7,500 + $
3,500.
= $ 31,000.

ASSUMPTIONS OF THE MODEL

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
 The requirement for cash for a given period is known.

 The requirement of cash is distributed evenly throughout the period.

Selling of securities can be done immediately (There is no delay in placing and receiving
 orders).

 
There are two distinguishable costs associated with cash holding: opportunity cost and
transaction cost. 
 The opportunity cost of holding cash is known and it does not change over time.

 The cost per transaction is constant regardless of the size of transaction.

The opportunity is a fixed percentage of the average value of cash holding

2 EAdC
1. = I
Where
EAd = Estimated Annual demand for the cash
C = Cost per transaction (purchase or sale or both of securities)
I = Interest rate for the said period
O = Optimum cash injection
Number of transaction=Estimated annual demand/optimum cash balance
Annual opportunity cost = Optimum cash balance/2
Annual transaction cost=Number of transaction*cost per transaction

ILLUSTRATION
The outgoings of Gemini Ltd. are estimated to be Rs. 500,000 per annum, spread evenly throughout
the year. The money on deposit earns 12% p.a. more than money in a current account. The switching
cost per transaction is Rs. 150.
Calculate the optimum point
Number of transactions
Annual opportunity cost
Annual transaction cost
Solution

1) =35,355
Number of transactions = Rs. 500,000/Rs. 35,355 = 14.14 transactions
Annual opportunity cost = Rs. 35,355/2 = Rs. 17,677.5
Annual transaction cost= 14.14 transactions x Rs. 150 = Rs. 2,121
EXERCISE

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Subsonic Speaker Systems (SSS) has annual transactions of $9 million. The fixed cost of
converting securities into cash is $264.50 per conversion. The annual opportunity cost of
funds is 9%.
What is the optimal deposit size?
Square root (2 x 264.5 x 9,000,000 / 0.09) = 230,000
If cash resources are steadily used up by a constant daily demand for cash, the model suggests that
the optimum regular cash injections say ‘a’ into the business can be determined as follows:
2 EAdC
O=
I
Where
EAd = Estimated Annual demand for the cash
C = Cost per transaction (purchase or sale or both of securities)
I = Interest rate for the said period
O = Optimum cash injection
Illustration: A firm has annual demand of cash equal to $ 240,000 per annum. Investment earnings
rate is given as 12 percent per annum and the cost per transaction of investment is $ 100 per
sale/purchase. Calculate the optimum cash balance of the firm?
Sol:
2 EAdC
O=
I

Given EAd = $ 240,000

C=$100
I = 12 percent or 0.12
A =?

2$240,000$100
A= 0.12
A = $ 20,000
Tarus Ltd. has an estimated cash payments of Rs. 8,00,000 for a one month period and the
payments are expected to steady over the period. The fixed cost per transaction is Rs. 250 and
the interest rate on marketable securities is 12% p.a. Calculate the optimum transaction size.
2 EAdC
O=
I
Optimum transaction size = Rs. 2,00,000
Average cash balance = Rs. 2,00,000/2 = Rs. 1,00,000
Number of transactions = Rs. 8,00,000/Rs. 2,00,000 = 4 transactions

2.6.2 Miller-Orr Model

The Miller-Orr model of cash management is developed for businesses with uncertain cash inflows
and outflows.
This approach allows lower and upper limits of cash balance to be set and determine the return point
(target cash balance).
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If the firm’s cash flows fluctuate randomly and hit the upper limit, then it buys sufficient marketable
securities to come back to a normal level of cash balance (the return point
Similarly, when the firm’s cash flows wander and hit the lower limit, it sells sufficient marketable
securities to bring the cash balance back to the normal level (the return point).
Uncertainty of both cash receipts and cash payments are considered in Miller-Orr model.
It is an improvement over Baumol’s model.
Assumptions
The changes in cash balances are random. This is applicable for cash inflows as well as for cash
outflows.
There are opportunities for transaction of marketable securities.
Transaction of marketable securities has transaction cost.
Holding of cash has opportunity cost as well.
The firms maintain a minimum level of cash balances.
MILLER-ORR CASH MANAGEMENT MODEL
UPPER LIMIT
CASH
BALANCE
LOWER LIMIT

TIME INTERVAL
To use the Miller-Orr model, the manager must do 4 things
Set the lower control limits for the cash balance.
This lower limit can be related to a minimum safety margin decided by management
Estimate Standard deviation of daily cash flows
Determine Interest Rate
Estimate the trading costs of buying and selling marketable securities.
The lower limit is set by the firm based on its desired minimum “safety stock” of cash in hand
Estimation of Return Point and Upper Limit

Or

Spread = 3

Interest rate must be daily. If not convent it to dailyby dividing annual rate by 365
The return point= Lower limit + (1/ 3 x spread)
Upper limit=lower limit + spread
In finance, a spread refers to the difference between two prices, rates, or yields

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Illustration
If a company must maintain a minimum cash balance of 8,000, and the variance of its daily cash
flows is br4m (i, e std deviation£2,000). The cost of buying/ selling securities is 50 & the daily
interest rate is 0.025%.
Required:
Calculate the spread, the upper limit (max amount of cash needed) & the return point (target level)
Solution
Lower limit = 8,000 (per question)

Spread =3

Upper limit = 8,000 + 25,303 = 33,303

Return point = 8,000 + (1/3 x 25,303) = 16,434
NOTE
The cash flow variance is DAILY. Also the standard deviation is the square root of the variance.
Therefore if given the standard deviation then you need to square it before putting it into the
equation.
The interest rate is also a daily one. A quick (if oversimplified way) of reaching this simply to divide
the annual rate by 365)
Example2
The management of Stilmill Inc. has set safety cash balance of $50,000. The standard deviation (σ) of
the daily cash balance during the last year was $37,500, and the transaction cost was $75. The
company also has the opportunity to invest idle cash in marketable securities at an annual interest rate
of 8%.i, daily interest =8%/365=0.022%
Determine
a) Spread
b) Return point
c) Upper limit
Solution

A. Spread =3
1
B. Return point = $50,000 + × $213,325 = $121,108
3
C. Upper limit = $50,000 + $213,325 = $263,325

RECEIVABLES MANAGEMENT
The receivable management definition can be said to be the management of accounts not just for the
receivables but also of the entire process of defining the policy on credit and deciding payment terms.
It also consists of ensuring the timely collection of payments and dues, sending follow up letters and
reminders for timely payments, which are essential areas of managing the account receivables.

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The accounts receivable management process typically follows some steps listed below:
Customer invoicing mentioning credit policy and date due.
Recording transactions with their due dates.
Monitoring the due through a collection and follow-up schedule.
Generating bills that are overdue and bills due chronologically.
Sending letters of reminder with bill details and due date.
 
To Monitoring and improve cash flow
 
To Minimizing bad debt losses
 
To Avoid invoice disputes
 
To Boots up sales volume
 
To Improve customer satisfaction
 
To Helps in facing competition

To minimize cost of credit sales
Nature of Receivable Management
Regulate Cash Flow
Receivable management regulates all cash flows in an organization. It controls all inflow and outflow
of funds and ensures that an efficient amount of cash is always available. Proper management of
receivables enables organizations in efficient functioning at all the times.
Credit Analysis
It perform proper analysis of customer credentials for determining their credit ratings. Monitoring and
scanning of customers before provide them any credit facility helps in minimizing the credit risk.
Decide Credit Policy
Receivable management decides the credit policy and standards as per which credit facility should be
extended to customers. A company may have a lenient credit policy where customer credit-
worthiness is not at all considered or a stringent policy where credit-worthiness is considered for
providing credit.
Credit Collection
Receivable management focuses on efficient and timely collection of business payments from its
customers. It works towards reducing the time gap in between the moments when bills are raised and
payment is collected.
Maintain Up-To-Date Records
Receivable management maintains a systematic record of all business transactions on a regular basis.
All transactions are maintained fairly in the form of proper billing and invoices which helps in
avoiding any confusion or settling of disputes arising later.
SCOPE OF RECEIVABLE MANAGEMENT

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1. Formulation of Credit Policy

Receivable management is the one which formulates and implements an effective credit policy in an
organization. Credit policies are decided as per the capabilities of an organization. A company may
either follow a liberal policy or stringent credit policy for providing credit facilities to its customers.
Credit Evaluation
Credit evaluation involves examining the credit worthiness of customer before approving any
credit amount. Proper investigation of customer’s information lowers the risk of bad debts.
Receivable management acquires all credentials of client for determining their borrowing capacity
and repaying ability. The analysis is done based on five Cs factors:
Character: It is a moral attribute reflecting the integrity of the person and his willingness to repay
the credit obligation.

Capacity: It refers the customer’s ability to meet credit obligations out of operating cash flows.

Capital:It indicates the customer’s financial reserves.

Condition: It refers the prevailing economic conditions that might affect a firm’s ability to pay.

Collateral: It refers to the assets that are offered by the customer as a security.
3. Credit Control
Receivable management implements a proper structure for monitoring all credit functions of
business. It records credit sales with proper documents on a daily basis. Invoices are raised
immediately after goods get dispatch and amount is collected soon as they become due for payment.
4. Maximize Profit
It plays an efficient role in maximizing the profit of organizations. Receivable management helps in
boosting the sales volume by providing credit facilities to customers. More and more people are able
to purchase goods on credit which maximizes the overall profit level.
FACTORS TO CONSIDER
While it’s true that the end goal of all credit policies is to maximize the company revenue while
minimizing the risk generated by extending credit – the ways to get there can vary depending on
many factors, such as:

 Type, size and nature of business

 The overall economic climate

 Price level variations

Availability of funds

Issues of Receivable Management:

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The management of receivables is a very critical area in the total working capital management as it
can be very costly and time-consuming activity. The efficient receivables management results ample
opportunities for a firm to achieve advantages through improvements in customer service, cash
management and reductions in costs. The management of receivables can be divided into:
Credit Policy
Credit Analysis
Collection Policy
ESTABLISHMENT OF CREDIT POLICY
Credit policy: It covers the questions concerning terms of credit, credit limits, cash discounts, etc. A
business firm is not required to accept the credit policies employed by its competitors, but the optimal
credit policy cannot be determined without considering competitors’ credit policies. A firm’s credit
policy has an important influence on its volume of sales, and thus on its profitability.
The terms of credit policy is used to refer to the combination of three decision variables. They are:
Credit standards: This criterion will decide the type of customer to whom credit can be
allowed with the credit limit. Allowing credit to more slow-repaying customer will increase
investment in receivables and vice-versa. Increase in investment may result in increase in risk
of default (non-collection of debt).
Credit Period: Credit Period refers to the duration of time given by the seller to the customer
to pay off the amount of the product that the customer has purchased from the seller.
It specifies duration of credit (in time) and terms of payments (discounts) by the customer.
Investment in accounts receivables will be high if customers are allowed extended credit
period in making payments, and decreases with reduction in credit period.
Collection Policy;Collection policy involves the methods adopted by the organizations for
the recovery of accounts receivable. It also prescribes the late fees, interest, and other charges
payable if the payment is delayed. Lower the collection period lower will the collection
charges and vice-versa.
Cash Discount Terms: The cash discount is granted by the firm to its debtors, in order to
induce them to make the payment earlier than the expiry of credit period allowed to them.
Granting discount means reduction in prices entitled to the debtors so as to encourage them
for early payment before the time stipulated to the i.e. the credit period. Grant of cash

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Discount beneficial to the debtor is profitable to the creditor as well. A customer of the firm
i.e. debtor would be realized from his obligation to pay Soon that too at discounted prices

Types of Credit Policies:

The credit policy will never be balanced unless managed with all precautions. A rider on horse if not
careful will get slipped. Similarly, if the credit policy is not carefully designed, it will end- up in
losses. The credit policies are different types.
Liberal credit policy: Under this policy, the firm is ready to sell more on credit so as to maximize
the sales. Profits will increase in liberal credit policy as a result of increased sales. More sales by way
of liberal credit policy would also give rise to bad debts and losses there upon.
Stringent credit policy: The firm is highly careful in extending credit to customers. The financial
manager through rigid standards often sacrifices profitable sales opportunities and profits in the name
of rigid and cautious credit norms. Therefore, the objective of profit maximization is partially
fulfilled.
Optimum Credit Policy: Optimum Credit policy is one, which maximizes the firm’s value. To
achieve this goal the evaluation of investment in receivables should involve the estimation of
incremental operating profit; investment in receivables; estimation of the rate of return of investment;
comparison of the rate of return with the required rate of return Sales increase by credit extension is
associated with bad debt costs, because of defaulting accounts. Thus, an optimum credit policy covers
the following aspects:
Investment in receivables: Financial manager has to offer certain sales on credit, which means the
credit sales is financed by the firm. Firms if rich in cash, credit extension is desirable. If firms are not
strong financially, finance has to be obtained from outside which means inviting interest burden that
goes to reduce profitability of the firm. So, financial manager has to reduce the capital tied up on
credit sales.
Terms of credit: If credit terms are not competitive it will affect sales and consequently the
shareholders’ wealth. Here terms refers to what is the price if sold for cash, otherwise, what is the
credit period and cash discount, how much percentage for how many days are the issues. Like wise
the financial manager has to decide as and when situation arises.
(iii) Credit standard

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Credit standards have a bearing on sales of the firm. These standards refer to minimum requirements
for the evaluation of credit worthiness of a customer. The company may be liberal or strict in defining
the requirement in getting credit. The standards imposed by the company are to assess the credit
worthiness of customers. As long as company’s profitability is higher, it can lower credit standards,
which it would adversely, affect the sales.
Illustration 12.1
Illustration 1: A firm has an investment in the credit sales as $ 100,000 and the average collection
period allowed to the customers as 15 days. Find the amount of investment gained and lost when the
return on investment in the business is at 7 percent and borrowings demand an interest at the rate of 4
percent per annum. The firm has a proposal to expand its sales by extending the credit days from 15
days to 30 days. Does the proposal worth accepting when increase in sales is expected as 5 percent?
Ignore all other expenses as constant.

Solution
Existing situation: Average collection period = 15 days
Average investment in receivables = $ 100,000
Total credit sales =?
Total credit sales = (Average investment X 360 days) / average collection period.
Therefore total credit sales = ($ 100,000 X 360 days) / 15 days
Total credit sales = $ 2,400,000
Profitability with the existing situation:
Return on investment (sales) = $ 2,400,000 X 7 % $ 168,000
Less: Interest expenses on investment 2,400,000X 4 % X15/360(4,000)
Net returns $ 164,000
Revision in the credit period:
Average collection period = 30 days
Total credit sales = $ 2,400,000 + 5 % on $ 2,400,000= $ 2,520,000
Average investment in receivables = ?
Average receivables = (total credit sales X Average collection period) / 360 days
Average receivables = ($ 2,520,000 X 30 days) / 360 days
Average receivables = $ 210,000
Profitability with the revised situation:
Return on investment (sales) = $ 2,520,000 X 7 % $ 176,400
Less: Interest expenses on investment 2,520,000X 4 %X30/360(8,400)
Net returns = $ 168,000

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