financial accounting

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MicroLink Information Technology College
Department of Accounting Information System
Financial Accounting II
October, 2017
Mekelle

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CHAPTER ONE
1. Inventories: Cost and Cost Flow Assumption
1.1.Nature of inventories: procedures
Inventories represent one of the most important elements of a business. Much of a company's
resources are invested in this asset, which is usually its chief source of revenue. In recent years,
accountants have given much consideration to the primary inventory problems of determining
quantity and determining birr/dollar value.
Classes of Inventories
In a merchandising business at the retail or wholesale level, inventories consist of goods held for
sale in the same form as purchased and are designated merchandise inventory. A manufacturing
business, in contrast, has several. Types of inventories: finished goods, goods in process, and raw
materials.
Finished Goods:
Finished goods are completed products awaiting sale. All costs (i.e., those for raw materials, direct
labor and manufacturing overhead) have been incurred. Finished parts of assemblies purchased or
produced for use in the completed product, however, are classified as raw materials.
Goods in Process:
Goods in process or work in process consists of partly completed goods. Generally, the cost of raw
material, direct labor and manufacturing overhead applied to date can be identified and included in the
cost of goods in process.
Raw Materials:
Raw materials may be obtained directly from natural resources or from production. Thus, they may be
produced by the company manufacturing the finished product or purchased as the finished product of
another company. Raw materials cost includes the purchase price, freight, receiving, storage and/or other
charges necessary to make the finished goods ready for use{ Factory supplies are auxiliary materials that
do not become an integral part of the finished product, such as cleaning supplies, lubricating oils, and
fuels.

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Procedures for an Effective Physical Inventory
The most important element to a successful and accurate physical inventory is proper planning
and preparation. Written procedures that are understood by all involved is a good first step that
will help to assure a well-controlled and disciplined count and allow you to focus on an accurate
count which will be more efficient and take less time. The more time you spend on the
preparation of a count, the less time it will take to perform the count and the more likely you will
have an accurate count and minimize re-counts.
Preparing for a Physical Inventory
1. Schedule the Count Date(s)
Set the count date well in advance so everyone has time to prepare for it and schedule around it.
Avoid busy seasonal times and times when your team may not be available or will be
preoccupied and less likely to be focused on the task at hand. If you have multiple stores or stock
locations, multiple dates can be selected. Often this is preferable, especially as it allows your
management staff to be available for supervision.
2. Human Resource Considerations
While you must consider the availability and experience of your staff, you must also consider the
importance of checks and balances and personal accountability. If internal theft is a problem, you
can’t depend on a completely accurate count; it’s like letting the fox guard the hen house. Where
ever possible, you should rotate your staff to areas for which they don’t have direct
responsibility.
3. Select Your Counting Method(s)
There are various methods for counting. The best method depends in part on how merchandise is
managed and how your stores or stock locations are laid out.
Computer Generated Count Sheets – Computer Generated Count Sheets are preprinted lists of
inventory generated by your software that can be used to record your on hand counts.
Manual Count Sheets – Manual Count Sheets are merely ruled forms that allow you to record
the product id, quantity and, if needed, retail of merchandise being counted.

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4. Create a Fixture Map
A fixture map is a physical layout of the store and all stock locations. Each fixture, display, rack,
and back stock location should be assigned a Fixture Map code that relates to a slip code that will
be used for counting. If either computer generated count sheets or manual count sheets are used,
the form number(s) are recorded on the fixture map as the sheets are distributed. If a count sheet
is missing later you know where to look.
This provides a critical road map to a well-planned wall-to-wall inventory that assures all
products are counted. You can quickly identify when sections of your inventory are missed.
Additionally, it provides an excellent tool to enable verification counts to be compared against
detail counts..
5. Prepare/Order Supplies & Test Procedures
Make sure count slips, physical scanners, and borrowed or rented scanning devices are all
ordered and scheduled. Make sure you have either a fresh supply of batteries or have recharged
rechargeable batteries for your scanners.
Make sure portable devices are tested and that you can upload the data in a format readable by
your software. Make sure all prior counts have been deleted from memory and retest the
download process to make sure prior counts don’t get mixed in with new counts. Refresh your
memory of procedures: the last thing you want to do at the end of a long day counting is to
inadvertently delete data from a reader before it is captured and confirmed!
6. Visit Your Inventory
Prior to counting inventory it is important to reacquaint yourself with it. Go through each display
and ensure that inventory isn’t misplaced, damaged or obsolete, and make sure all merchandise is
tagged. Not only will this save time during the counting process, but it will provide an
opportunity to clean up, re-steam, and markdown, or even return aged or damaged inventory.
When counting your inventory your focus should be solely on an accurate count. In preparation
for an inventory not only will it be more organized but it will offer the opportunity to carefully
review it for age, damage or other presentation issues that prevent it from selling.

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1.2. Inventory cost and quantity accumulation
1.2.1. Inventory Cost accumulation
Inventory cost includes all expenditures relating to inventory acquisition, preparation and
readiness for sale. Any purchase discounts are treated as reductions in the cost of inventory.
Accounting for inventory costs for goods in process and finished goods can be best accomplished
by means of a good cost accounting system, a topic which will be treated in depth in later
volumes of this series.
In a manufacturing company, the two primary methods for accumulating costs are
(1) By job order and
(2) By process or operation.
Job Order Cost System
This system is generally used by companies which manufacture a number of different products in
limited quantities. The costs for each job are accumulated separately on a job order cost record
and are included in goods in process until the job is completed. The completed job and its
associated costs are considered finished goods until the job is sold. Examples of companies using
job order cost systems are printing shops and construction companies.
Process Cost System
This system is used where large amounts of similar units are produced on an assembly-line basis.
The controlling factor is the cost center or department. Costs of raw material, direct labor, and
manufacturing overhead are accumulated by cost center rather than by individual job. The unit
cost is obtained by dividing total costs by the quantity produced for the week, month, etc.
Examples of companies using process cost systems are steel mills, paper companies, and other
large-volume enterprises.

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1.2.2. Inventory Quantity accumulation
Inventory Systems
The two principal systems for determining the inventory quantities on hand are the periodic
system and the perpetual system. Both systems may be used simultaneously by companies with
different classes of inventory.
The Periodic System
This system requires a physical count of goods on hand at the end of the period. A cost basis
(i.e., FIFO, LIFO, etc.) is then applied to derive an inventory value. This system is widely used
because it is simple and requires records and computations primarily only at the end of the
period. It is not as useful as the perpetual system, however, in the planning and control of
inventories.
The Perpetual System
This system calls for a continuous record of receipt and disbursement for every item of
inventory. Physical counts of the quantities on hand are usually made at least once a year and
reconciled to the perpetual records. Most large manufacturing and merchandising companies use
the perpetual system to provide continuous control over the quantities and the investment in
inventory. Adequate supplies are assured for production or sale and costly machine shut-downs
and customer complaints are minimized.
Determining the actual quantities in the inventory
 Inventory is a significant asset and for many companies the largest asset.
 Inventory is central to the main activity of merchandising and manufacturing companies.
 Mistakes in determining inventory cost can cause critical errors in financial statements.
 Inventory must be protected from external risks (such as fire and theft) and internal fraud
by employees.
The actual quantity of an inventory is determined by conducting a physical count. The physical
count may be undertaken continually or once a year.

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Example: Lucy Company has the following data
Units Cost Price
Jan.1 beginning inventory 10 $20
4 sale 7 $30
10 purchase 8 $21
22 sale 4 $31
28 sale 2 $32
30 purchase 10 $22
Required: Determine the actual quantity of inventory on January 31
Beginning inventory ……………………………………. 10 units
Add: purchase: (8units+10 units)……………………….. 18 units
Number of units available for sale……………………… 28 units
Less: Number of units sold (7units+4units+2units)…….. 13 units
Actual quantity of ending inventory on January 31 ...15 units
1.3. Cost flow assumption
Cost Flow Methods
Since it is likely that during a specified time period a given item may be purchased at a variety of
prices, it is necessary to determine which costs relate to units remaining in inventory and which
costs relate to units sold. The concept of a cost flow refers to the entire flow of costs through the
system, from purchase or production of goods to their sale. It does not involve the physical flow
of goods, because the value assigned to inventory has a direct effect on net income for both the
current and subsequent accounting period, the objective in selecting a cost flow method is the
matching of appropriate costs with revenue.
The main cost flow methods are:
1. First-in, First-out (FIFO),
2. Last-in, First-out (LIFO),
3. Weighted average, and
They all resolve the basic costing problem: what is the combination of costs in the units on hand,
and in the units shipped out.

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1.4. Inventory valuation at lower cost or market
Lower of Cost or Market
Compare the Cost and Market
Item Cost Market
Lower of Cost or
Market (LCM)
Units LCM Inventory
1 $65 $68 $65 500 $32,500
2 $80 $72 $72 300 $21,600
3 $90 $102 $90 400 $36,000
4 $38 $36 $36 700 $25,200
5 $20 $22 $20 900 $18,000
6 $55 $48.5 $48.5 600 $29,100
Total $162,400
Inventory valuation at Cost, Market and LCM
Item Units Inventory at Cost Inventory at Market Inventory at LCM
1 500 $32,500 < $34,000 $32,500
2 300 $24,000 > $21,600 $21,600
3 400 $36,000 < $40,800 $36,000
4 700 $26,600 > $25,200 $25,200
5 900 $18,000 < $19,800 $18,000
6 600 $33,000 > $29,100 $29,100
Total $170,100 < $170,500 $162,400
LCM applied to each inventory item
--> Inventory at LCM = $162,400
LCM applied to all inventories as one pool
--> Total inventory at cost < Total inventory at market
--> Inventory at LCM = $170,100

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CHAPTER TWO
2. Inventories: Special Valuation Methods
2.1. Retail Method of Estimating Inventory Cost
Retail method is a technique used to estimate the value of ending inventory using the cost to
retail price ratio.
Retail method is based on relationship between cost of merchandise available for sale and the
retail price.
 Retail prices of all merchandise must be accumulated and totaled.
 Inventory at retail is calculated at retail price of merchandise available for sale less
net sales at retail.
 Ratio is calculated as cost divided by retail price.
 Inventory at retail price times cost ratio equals estimated cost of inventory.
Step 1: Determine the ratio of cost to the retail price
Retail Inventory Method
Cost Retail
Merchandise inventory, Jan. 1 $19,400 $36,000
Purchases in January (net) $42,600 $64,000
Merchandise available for sale $62,000 $100,000
Ratio of cost to retail price = $62,000 = 62%
$100,000
Step 2: Determine the ending inventory at retail.
Retail Inventory Method
Cost Retail
Merchandise inventory, Jan. 1 $19,400 $36,000
Purchases in January (net) $42,600 64,000
Merchandise available for sale $62,000 $100,000
Sales for January (net) 70,000
Merchandise inventory, January 31, at retail $30,000

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Step 3: Calculate the estimated inventory at cost.
Merchandise inventory, January 31, at cost
($30,000 x 62%) $18,600
2.2. Gross Profit Method of Estimating Inventory Cost
Gross profit method (also known as gross margin method) is a technique used to estimate the
value of ending inventory and cost of goods sold of a period on the basis of the historical or
projected gross profit ratio of the business. Gross profit method assumes that gross profit ratio
remains stable during the period.
This method is an alternative to the retail method of inventory estimation and it is usually used to
estimate the value of inventory when the retail values of beginning inventory and purchases are
not available.
1. A gross profit percentage rate is estimated based on previous experience adjusted for known
changes.
2. Estimated gross profit is calculated by multiplying the estimated gross profit rate times the
actual net sales.
3. Estimated cost of merchandise sold is calculated by subtracting the gross profit from actual
sales.
4. The cost of merchandise sold estimate is deducted from actual merchandise available for sale
to determine the estimated cost of merchandise inventory.
Gross Profit Method
Merchandise inventory, January 1 $ 57,000
Purchases in January (net) $180,000
Merchandise available for sale $237,000
Sales in January (net) $250,000
Less: Estimated gross profit
($250,000 x 30%) 75,000
Estimated cost of merchandise sold 175,000

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Estimated merchandise inventory, January 31 $ 62,000
The gross profit method is useful for estimating inventories for monthly or quarterly financial
statements in a periodic inventory system.
2.3. Other Valuation Methods
Specific Identification method
It is the simplest method of valuing inventories. When an inventory item is sold, the inventory
account should be reduced or credited, and cost of goods sold should be increased or debited for
the amount paid for each inventory item. This method works only when a company knows the
cost of every individual item that is sold. Specific identification method works well when the
quantity of inventory a company has is limited and each inventory item is unique. The specific
identification method can be practiced in businesses such as car dealerships, jewelers, and art
galleries.
First-In, First-Out (FIFO) method:
FIFO is a method of valuing the cost of goods sold that uses the cost of the oldest items in
inventory first. This method is based on the assumption that goods that are sold or used first are
those goods that are bought first. Therefore, the cost of goods bought first (first-in) is the cost of
goods sold first (first-out). According to FIFO, at the end of a year an inventory would consist of
goods most recently placed in inventory. If there is inflation, the cost of goods sold will be at its
lowest possible amount. This would help in maximizing net income within an inflationary
environment. The downside of that effect is that income taxes will be at their greatest.
Last-In, First-Out (LIFO) method:
LIFO is an inventory valuing method that assumes that the last items placed in inventory are the
first sold during an accounting year. Therefore, when the LIFO method is applied, the inventory
at the end of a year consists of the goods placed in inventory at the beginning of the year, rather
than at the end. During inflation, when prices are rising, the LIFO method yields a lower ending
inventory, a higher cost of goods sold, a lower gross profit, and a lower taxable income. The

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LIFO Method is preferred by many companies because it has the effect of reducing a company’s
taxes and therefore increasing cash flow.
Average Cost method:
The average cost method takes the average of all units available for sale during the accounting
period. The average cost method uses the average cost to determine the value of the cost of
goods sold and ending inventory.

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CHAPTER THREE
3. Current Liabilities and Contingencies
3.1. Distinction Between Current and Long Term liabilities
Current Liabilities Definition
Current liabilities are considered short term debt for a company. Current liabilities are amounts
that can be paid off within one year.
The following is a list of current liabilities:
Accounts payable: These are the trade payables due to suppliers, usually as evidenced by
supplier invoices.
Sales taxes payable: This is the obligation of a business to remit sales taxes to the government
that it charged to customers on behalf of the government.
Payroll taxes payable. This is taxes withheld from employee pay, or matching taxes, or
additional taxes related to employee compensation.
Income taxes payable. This is income taxes owed to the government but not yet paid.
Interest payable: This is interest owned to lenders but not yet paid.
Accrued expenses: These are expenses not yet payable to a third party, but already incurred,
such as wages payable.
Customer deposits: These are payments made by customers in advance of the completion of
their orders for goods or services.
Dividends declared: These are dividends declared by the board of directors, but not yet paid to
shareholders.
Short-term loans: This is loans that are due on demand or within the next 12 months.

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Current maturities of long-term debt: This is that portion of long-term debt that is due within
the next 12 months.
The types of current liability accounts used by a business will vary by industry, applicable
regulations, and government requirements, so the preceding list is not all-inclusive. However, the
list does include the current liabilities that will appear in most balance sheets.
Long Term Liabilities Definition
Long term liabilities are items that a company intends to keep on their financial balance sheet
for longer than a one year period of time.
They are obligation payable in goods or services at a future period more than 12 months away
from today or the date of balance sheet.
Long-term liability is usually formalized through paperwork that lists its terms such as the
principal amount involved, its interest payments, and when it comes due.
Typical long-term liabilities include
 bank loans
 notes payable
 bonds payable and
 Mortgages.
A firm must disclose its long-term liabilities in its balance sheet with their interest rates (or other
charges) and date of maturity.
3.2. Recognition and valuation of current liabilities
Valuation of Current Liabilities
Current liabilities (i.e., legal debts and obligations) are generally recorded in the accounts and
reported in financial statements at face value. Four distinct categories can be identified with
respect to the element of uncertainty which affects the valuation of these future payments as
current liabilities:
 definitely determinable liabilities,

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 liabilities arising from operating results,
 estimated liabilities and
 Contingent liabilities.
3.3. Definitely Determinable Liabilities
These liabilities generally originate from contracts or legal statutes which fix the amount of the
obligation and its due date rather precisely.
Trade Accounts and Notes Payable: Procedures for handling the recording and control of trade
accounts and trade notes payable center around purchase journals, voucher registers, accounts
payable ledgers or open invoice files, etc.
Loan Obligations: Items of this type include notes and loans payable and any portion of long-
term debt that will mature during the coming operating cycle.
Dividends Payable: Dividend obligations are created only by action of a company's board of
directors. The declaration by the board represents a legal Obligation to pay the cash dividend in
the amount specified at the specified time. It always creates a current liability.
Accrued Liabilities: Unpaid obligations resulting from contractual commitments (e.g., payrolls)
or government legislation (e.g., taxes) are referred to as accrued liabilities or accrued expenses.
Income Taxes: This liability applies only to corporate, estate and trust income. Earnings from
the operation of sole proprietorships and partnerships are treated as personal income of the
parties involved, and generally require no disclosure of a liability.
Liabilities under Guarantees and Warranties: This liability group arises from product sales
(e.g., cars, televisions, etc.) or contracts (e.g., rentals where the lessee must restore property to a
specified condition on termination).
3.4. Liabilities dependent on operating results
Some liabilities cannot be measured until the results of operations are known. In these cases, the
basic accounting problem is estimating appropriate amounts for interim monthly or quarterly
statements.

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Income Taxes: This liability applies only to corporate, estate and trust income. Earnings from
the operation of sole proprietorships and partnerships are treated as personal income of the
parties involved, and generally require no disclosure of a liability. Any liability not covered by
the advance payment is due at specified dates in the following taxable year.
3.5. Contingency
Contingent Liabilities
The term contingent liabilities refer to potential future obligations which may or may not in fact
materialize. It is thus distinguished, from estimated liabilities, which do exist but are uncertain as
to amount, due date and/or payee.

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CHAPTER FOUR
4. Plant Assets: Acquisition, Depreciation and Disposal
4.1. Nature and classification of plant assets
Long - Life Assets/ Fixed Assets/Plant assets
Long-life assets are grouped under various headings in balance sheet presentations. The term
fixed assets or plant assets are frequently used for tangible productive assets that are used over a
number of years in the operations of an entity. Tangible assets are properties that have physical
substance, in other words, assets that can be seen and touched. Intangible assets, on the other
hand are property rights, which have value but no physical substance. Patents, copyrights,
goodwill etc., are examples of intangible assets.
Furniture, equipment, machinery, buildings and the land on which they are located are usually
included under the main heading "Fixed Assets".
Characteristics of Fixed Assets:
The basic characteristics necessary for an asset to be classified as a fixed are:
1. It is tangible (has physical properties);
2. It has long-life i.e. it will last more than one year;
3. It is used in the operations of business; and
4. It is not held for the purpose of normal resale.
A major distinction in determining an asset to be classified as a plant or fixed asset is whether it
is to be used by the business in its operations. For example, a truck is a plant or fixed asset to a
distributor, but a truck is an item of inventory when held for resale, to automobile dealer. A
typewriter is a plant asset (office equipment) to a law firm, but a typewriter is an item of
inventory to an office equipment supply company.
4.2. Determining the Cost of Fixed Assets:

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Plant or fixed assets should be recorded at cost. The cost of plant assets consists of all
expenditures incurred to acquire the asset and get it ready for use. This cost includes the
purchase price of the asset (net of any cash discount) plus delivery charges, sales taxes, insurance
in transit, installation charges, and other costs incurred in getting the asset at site ready for
operation.
When an asset is constructed, its cost will included, all construction cost, architect's fees,
insurance during construction, interest paid on money borrowed for the construction and any
other related cost, such as cleaning up and getting the building ready for use.
Categories of Plant Assets
There are four categories of Plant Assets:
 Land
 Buildings
 Equipment
 Furniture
Cost of plant assets
Determining the Cost of Land
Land
 Cost, commissions, survey fees, legal fees, taxes, costs for grading land, demolish
buildings.
A business signs a $300,000 note payable to purchase land for a new store site. It also pays:
 $10,000 in back property tax
 $8,000 in transfer taxes
 $5,000 for removal of an old building
 $1,000 survey fee
 $260,000 to pave the parking lot.
What is the cost of the land?
Purchase price of land $300,000
Add related costs:
Back property taxes $10,000
Transfer taxes 8,000

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Removal of buildings 5,000
Survey fees 1,000 24,000
Total cost of land $324,000
What about $260,000 for Paving?
 Land Improvements
Determining the Cost of Buildings: Construction
 Architectural fees
 Building permits
 Contractor’s charges
 Materials
 Labor
 Overhead
 Cost of interest
Determining the Cost of Buildings: Purchase
 Purchase price
 Brokerage commissions
 Sales and other taxes
 Repairing or renovating building for its intended purpose
Determining the Cost of Machinery and Equipment
 Purchase price less discounts
 Transportation charges
 Insurance in transit
 Sales and other taxes
 Purchase commission
 Installation costs
 Expenditures to test the asset

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 Special platforms
Determining the Cost of Land and Leasehold Improvements
 Land improvements
 Paving
 Fences
 Sprinkler systems
 Lights in parking lot
4.3. Depreciation methods and management decisions
Depreciation results from
 Physical wear and tear
 Obsolescence
Depreciation is an allocation of the cost of an asset over its useful life.
We accumulate the assets depreciation in a Contra-Asset account Accumulated Depreciation or
Accumulated Depletion
The Asset account minus the Accumulated account = Book Value of the Asset
Accumulated Depreciation
 Contra-Asset Account
 Opposite normal balance from assets
 Credit Balance
Book Value of Asset
 Asset Value – Accumulated Depreciation
To estimate depreciation expense you need to know:
 Cost
 Estimated useful life
 Estimated residual value
Depreciation Methods
 Straight-line

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 Units-of-production
 Double-declining-balance
 Sum of the years digits method
Recording Entries
Depreciation
Debit Depreciation Expense
Credit Accumulated Depreciation
Depletion
Debit Depletion Expense
Credit Accumulated Depletion
Amortization
Debit Amortization Expense
Credit Intangible Asset (e.g. Patents)
1. Straight-Line Depreciation
Depreciation per year = Cost – Residual Value
Useful Life in years
2. Units-of-Production
Units-of-production = Cost – Residual Value
Depreciation
Per unit of output Useful life in units of production
3. Double-Declining Balance
DDB Depreciation = 100 X2
Rate per year Useful life years
Rate X Book Value = Annual Depreciation Expense
Depreciation Example
Data Items Amount
Cost of truck $41,000
Estimated residual value (1,000)
Depreciable cost $40,000

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Estimated useful life 5 years
Units of production 100,000 miles
Straight-Line Method
(Cost – Residual value) ÷ Years of useful life
($41,000 – $1,000) ÷ 5 = $8,000
Year 1 depreciation: $8,000
Year 2 depreciation: 8,000
Year 3 depreciation: 8,000
Year 4 depreciation: 8,000
Year 5 depreciation: 8,000
Total depreciation: $40,000
Units-of-Production Method
($41,000 – $1,000) ÷ 100,000 = $.40/mile)
Year 1: 20,000 miles × $.40 = $ 8,000
Year 2: 30,000 miles × $.40 = 12,000
Year 3: 25,000 miles × $.40 = 10,000
Year 4: 15,000 miles × $.40 = 6,000
Year 5: 10,000 miles × $.40 = 4,000
$40,000
Double-Declining-Balance Method
Straight-line rate per year: 100% ÷ 5 = 20%
Double-declining balance:
2 times the straight-line rate = 40%
Book value of truck at the end of the first year:
$41,000 × 40% = $16,400
$41,000 – $16,400 = $24,600

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What is Depreciation at the end of year 2?
What is Book Value at the end of year 2?
Year 3?
Year 4?
Year 5?
Comparing Depreciation Methods
Amount of Depreciation per Year
Year SL UOP DDB
1 $8,000 $8,000 $16,400
2 8,000 12,000 9,840
3 8,000 10,000 5,904
4 8,000 6,000 3,542
5 8,000 4,000 4,314
Total $40,000 $40,000 $40,000
4.4. Retirement, disposal and exchanges
Steps for Disposal of Plant Assets
 First, record depreciation to the date of disposal.
 Remove the asset and related accumulated depreciation from the books.
 Record the asset received in exchange (may be cash or other assets).
 Record the gain or loss on the disposal.
Discarding of an Asset
To dispose of a fully depreciated asset with cost and accumulated depreciation of $60,000:
Accumulated Depreciation – Machinery 60,000
Machinery 60,000

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To dispose of fully depreciated machine
To dispose of an asset with cost of $60,000 and accumulated depreciation of $50,000:
Accumulated Depreciation – Equipment 50,000
Loss on Disposal of Equipment 10,000
Equipment 60,000
To dispose of equipment
Selling an Asset
Messebo sells equipment on Sep 30, 2014 for $7,000 cash. The equipment cost $10,000 when
purchased and has been depreciated on a straight-line basis (10 year useful life, no residual
value). First update depreciation then record the sale.
Depreciation expense (10,000 / 10 x 9/12) 750
Accumulated Depreciation – Equipment 750
To update depreciation
Accumulated Depreciation - Equipment $3,750
Cash 7,000
Equipment 10,000
Gain on sale of equipment 750
To dispose of equipment
Exchanging an Asset
Mesfin Industrial Engineering traded its delivery car with cost of $9,000 and accumulated
depreciation of $8,000 and $10,000 cash for a new car.
Delivery Automobile (new) 11,000
Accumulated Depreciation (old) 8,000
Delivery Auto (old) 9,000
Cash 10,000

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Traded-in old delivery car for new Automobile
4.5. Depletion of natural resource
Natural Resources
 Natural resources are expensed through depletion.
 Depletion rate is calculated similar to units-of-production method for depreciation.
 Accumulated depletion is the contra account used for natural resources.
Accounting for Natural Resources and Depletion
Assume an oil lease cost $100,000 and contains an estimated 10,000 barrels of oil.
Depletion rate:
$100,000 ÷ 10,000 = $10 per barrel.
If 3,000 barrels are extracted during the year, depletion expense is $30,000.
Accumulated Depletion is a contra account similar to Accumulated Depreciation

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CHAPTER FIVE
5. Intangible Assets
Intangible Asset
Definition:
An intangible asset is a non-physical asset having a useful life greater than one year. If an
intangible asset is determined to have a useful life, then its book value is amortized over that
useful life. If at any point there is judged to be a decline in the remaining value of an intangible
asset below its carrying amount, then the difference is recognized as an impairment expense in
the current period (that is, the impairment charge is not spread out over a number of periods).
Intangible assets include
 patents
 copyrights
 trademarks
 franchises/permits
 goodwill
Goodwill
Goodwill is an intangible which is recognized when a business acquires another business. It
represents the excess of cost paid by the purchasing business to the purchased business over the
fair value of purchased business identifiable assets.
Copyrights
Copyrights grant a business sole authority to reproduce and sale software, book, magazine,
journal, etc.
Patents
Patents grant a manufacturing and research company control over the use and sale of a specific
design in manufacturing process, etc.

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Amortization of Intangible Assets
Amortization is the write-off of an asset over its expected period of use, which shifts the asset
from the balance sheet to the income statement. It essentially reflects the consumption of the
asset.
Amortization is most commonly used for the gradual write-down of the cost of those intangible
assets that have a specific useful life.
If an intangible asset has a finite useful life, you should amortize it over that useful life. The
amount to be amortized is its recorded cost, less any residual value. However, intangible assets
are usually not considered to have any residual value, so the full amount of the asset is usually
amortized. If there is any pattern of economic benefits to be gained from the intangible asset,
then you should adopt an amortization method that approximates that pattern. If not, the
customary approach is to amortize it using the straight-line method.
Accounting for Amortization
The journal entry to record amortization for an intangible asset is:
Debit Credit
Amortization expense xxx
Accumulated amortization xxx
Example
1. ABC International has spent $100,000 to acquire a broadcast license that will expire and be
put up for auction in five years. This is an intangible asset, and should be amortized over the
five years prior to its expiration date. The entry in each year would be:
Debit Credit
Amortization expense 20,000
Accumulated amortization 20,000
To amortize cost of license

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2. Suppose a company pays $170,000 to acquire a patent on January 1. The company believes
that its expected useful life is 5 years.
Jan 1 Patents 170,000
Cash 170,000
To record acquisition of patent
Dec 31 Amortization Expense 34,000
Patents 34,000
To amortize cost of patent
Accounting for research and development costs
The Financial Accounting Standards Board in Statement No. 2 ruled that firms must expense all
research and development costs when incurred, unless they were directly reimbursable by
government agencies and others.

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CHAPTER SIX
6. Long-Term Debt
The nature of long-term liabilities
Long-term liabilities include many different accounts, all of which have the same common
characteristic that they must be paid but not within 12 months of the end of the accounting period
being considered.
Long-term liabilities are obligations that are due at least one year into the future, and include
debt instruments such as bonds and mortgages.
Accounting for long term bonds
Assume:
 Repayment is in equal payments
 The payments must cover interest expense and repayment of principle
You must determine how much of the payment is for interest expense and how much is for
repayment of loan.
Example: You borrowed $800,000 bond at 10% and your annual payment is $89,750.
Payment Interest 10% Difference: Amount Owed
to repay principle (Carrying Value)
$800,000
1) $89,750 $80,000 $9,750 $790,250
2) $89,750 $79,025 $10,725 $779,525
Journal entries:
Borrow:
Cash $800,000
Bond Payable $800,000

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Interest – 1st
year payment
Interest Expense $80,000
Bond Payable $9,750
Cash $89,750
Interest – 2nd
year payment
Interest Expense $79,025
Bond Payable $10,725
Cash $89,750
Accounting for serial bonds
Serial bonds are bonds issued in groups that mature at different dates.
For example, $5,000,000 of serial bonds, $500,000 of which mature each year from 5–14 years
after they are issued.

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7. Statement of Cash Flows
Definition
Statement of Cash Flows, also known as Cash Flow Statement, presents the movement in cash
flows over the period as classified under operating, investing and financing activities.
The cash flow statement explains the change during the period in cash and cash equivalents.
Cash includes currency on hand and demand deposits. Cash equivalents are short-term, highly
liquid investments that are readily convertible to cash.
The purpose and general usefulness of the statement of cash flows
Statement of cash flows provides important insights about the liquidity and solvency of a
company which are vital for survival and growth of any organization. It also enables analysts to
use the information about historic cash flows to form projections of future cash flows of an entity
on which to base their economic decisions. By summarizing key changes in financial position
during a period, cash flow statement serves to highlight priorities of management. For example,
increase in capital expenditure and development costs may indicate a higher increase in future
revenue streams whereas a trend of excessive investment in short term investments may suggest
lack of viable long term investment opportunities.
A cash flow statement is important for any business because it can be used to assess the timing,
amount and predictability of future cash flows and it can be the basis for budgeting. A cash flow
statement can answer the questions, “Where did the money come from?” and “Where did it go?”
The cash flow statement’s primary purpose is to provide information regarding a company’s cash
receipts and cash payments.
Components of a cash flow statement
Operating Activities The statement provides information about the cash generated from a
company’s daily operating activities. Operating activities are those which produce either revenue
or are the direct cost of producing a product or service.

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Operating activities which generate cash inflows include customer collections from sales of their
primary products or services, receipts of interest and dividends, and other operating cash
receipts.
Operating activities which create cash outflows include payments to suppliers, payments to
employees, interest payments, payment of income taxes and other operating cash payments.
Investing Activities
Investing activities include buying and selling noncurrent assets which will be used to generate
revenues over a long period of time; or buying and selling securities not classified as cash
equivalents.
Cash inflows generated by investing activities include sales of noncurrent assets such as
property, plant, and equipment. Investing activities can also include the purchase or sale of stock
and securities.
Lending money and receiving loan payments would also be considered investing activities.
Financing Activities
Financing activities include borrowing and repaying money, issuing stock (equity) and paying
dividends.
For example, if you borrow funds to purchase equipment or pay off a loan, the cash flow
statement will enable you to determine how much cash was either generated or used as a result of
those transactions.
Cash Flows by Activities
The operating activities section of a cash flow statement reports the information listed below.

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Inflows of Cash
Operating Activities
 Collections from Customers
 Interest Income
 Dividends Receipts
 Other Operating Cash Receipts
Investing Activities
 Collection on Loans
 Sale of Debt Instruments
 Sale of Equity Instruments
 Sale of Productive Assets
Financing Activities
 Issuance of Long-Term Debt
 Issuance of Equity Securities
Outflows of Cash
Operating Activities
 Payments to Suppliers
 Payments to Employees
 Interest Payments
 Payment of Income Taxes
 Other Operating Cash Payment
Investing Activities
 Purchase of Productive Assets
 Purchase of Debt Instruments
 Purchase of Equity Instruments
 Making Loans
Financing Activities
 Payment of Dividends
 Acquisition of an Entity’s Own Equity
Securities
 Repayment of Amounts Borrowed
Requirements of FASB Statement No. 95
Statement No. 95 requires that cash receipts and payments be classified as operating, investing
and financing activities. The cash flow statement will summarize the cash flows so that net cash
provided or used by each of the three types of activities is reported. Beginning and ending cash
must be reconciled based on the net effect of these activities.