Fa Ii Note Edited By Nesredin Y.pdf

Microsoft Word FA II Note edited by Nesredin Page 1 Chapter One Property, Plants and Equipment Classifications of long lived assets typically found on a balance sheet are  Property, Plant, & Equipmen[.]

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Chapter One Property, Plants and Equipment Classifications of long-lived assets typically found on a balance sheet are:

 Property, Plant, & Equipment

 Investments - Long terms assets acquired for resale in the normal course of business operation

 Intangibles- are used in the operation of the business, but have no physical substance eg Patent, Goodwill,

Fixed (plant) Assets – are tangible long-lived resources that are used in the operation of the business & are not intended for sale to customers Property, plant, and equipment include land, building structures (offices, factories, warehouses), and equipment (machinery, furniture, tools) Unique features of fixed (plant) assets 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: they can be seen & founded, they have physical existence Acquisition costs of plants, properties and equipment

The cost of a plant asset is the amount of all expenditures incurred to acquire the asset and make it ready for use

Cost of land improvements

The cost of land improvements includes all expenditures incurred to improve the land that are maintained and replaced by the owner These costs include costs of private driveways, sidewalks, fences, parking lots and lighting Note that the major reason to separate land and land improvements will be clear when we consider depreciation issues As you will soon see, land is considered to have

an indefinite life and is not depreciated Alternatively, you know that parking lots, irrigation systems, fences and other land improvements do wear and tear out, and, therefore these are subjected to depreciation

Cost of buildings

The costs of buildings include all expenditures incurred that are directly related to purchase or construction of buildings These costs include purchase price, professional fees that means, the costs architect fees to design the building, construction costs incurred from excavation to completion and costs of building permits

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Costs of machineries and equipment

Costs of equipment and machineries include all expenditures incurred in acquiring the equipment and preparing it for use which includes purchase price, shipping costs like freight, handling charges and insurance on the equipment while in transit, installation costs like the cost of special foundation, assembly and installation and set up costs or costs of conducting trial runs

Special Considerations

A Cash Discounts

When a plant asset is purchased subject to a cash discount, the discount (whether taken or not) is considered a reduction in the cost of the asset The ground reason is that the additional payment made due to the deferring of the payment is not the cost of the asset rather it is the penalty of late payment And the amount of discount lost will be treated as loss and not part of cost of the asset acquired

Example:

1 A corporation purchased equipment for Br 70,000 and arranged to pay a cash discount of 2% provided that payment was made within 10 days Suppose that cash payment was made within the discount period, the cost of the equipment is Br 68,600 [70,000 – (2% x 70,000)]

2 Again consider company purchasing equipment for Br 50,000 with cash discount of 2% made available if payment was made within 10 days Suppose that payment is not made within the discount period, the cost of the equipment is Br 49,000 [50,000 – (2% x 50,000)]

C Issuance of securities

When a plant asset is acquired by issuing securities, the cost of the plant asset is equal to either the fair market value of the securities issued or the fair market value of the plant assets themselves provided that the fair market value of the securities is not determinable

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Illustration:

i Mega Corporation purchased machinery by issuing 2,000 shares of common stock with a par value of Br 40 and a fair market value of Br 75 Suppose that the fair market value of the machinery was Br 154,000, then, the cost of the machine acquired is Birr 150,000, computed as follows: (Birr 75 per share X 2,000 shares) = Br.150, 000

ii If the value of the common stocks of Mega Corporation is unknown, the value of the machine shall be equal to the fair market value of the machine which is equal to Birr 154,000

D Lump-sum purchase

It is not unusual for a group of operational assets to be acquired for a single sum If these assets are indistinguishable, for example, 5 identical delivery trucks purchased for a lump sum price of Br 200,000, valuation is obvious, each of the trucks would be valued at Br 40,000 (Br.200,0005).however, if the lump-sum purchase involves different assets, it is necessary to allocate the lump sum acquisition price among the separate items, usually in proportion to the individual assets’ relative fair market values

Illustration:

ABC Company purchased an existing factory for a single sum of Birr 2,100,000 This price includes the costs of title to the land, factory building and equipment An independent appraisal estimated the market values of the assets (if these would be purchased separately) at Birr 800,000 for the land, Birr 1,000,000 for the factory and Birr 700,000 for the building The lump sum purchase price of Birr 2,100,000 is allocated to the individual separate assets as follows:

 Step 1: Determine the percentage of the market value of each asset to the total sum

Assets Market value Percentage

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departure from historical cost valuation The treatment of the transaction is equivalent to the donor contributing cash to the company and the company using the cash to acquire the asset The contribution revenue should be recognized for the excess of the fair market value of the plant asset over any costs incurred to acquire the plant asset (legal fees, title costs, etc)

Illustration: XYZ Manufacturing Company a corporation received land with a fair market value of

Br 790,000 from a city with the stipulation that a factory be built on the land; the corporation incurred legal fees of Birr 20,000 to obtain title to the land

Required:

i Determine the cost of the land and contribution revenue

ii Pass the journal entry on the book of the XYZ Company

i Assign no fixed overhead to the cost of the constructed asset or

ii Assign a portion of all overhead to the construction process

G Interest costs during construction

The proper accounting for interest costs has been a long-standing controversy Three approaches have been suggested to account for the interest incurred in financing the construction or acquisition

of property, plant, and equipment:

1 Capitalize no interest charges during construction approach under this approach interest is considered a cost of financing and not a cost of construction

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2 Charge construction with all costs of funds employed, whether identifiable or not Under this method maintains that one part of the cost of construction is the cost of financing, whether by debt, cash, or stock financing and

3 Capitalize only the actual interest costs incurred during construction This approach relies on the historical cost concept that only actual transactions are recorded

Concept of Depreciation

Depreciation- is the process of allocating the cost of a plant asset over its useful (service) life in a

rational and systematic manner The basic purpose of depreciation is to provide the proper matching of expense with revenues in accordance with the matching principle

 Depreciation is a process of cost allocation, not a process of assets valuation Accountants make

no attempt to measure the change in an assets mkt value during ownership, because plant assets are not held for resale

 Depreciation does not mean that the business sets aside or accumulates cash to replace assets as they become fully depreciated Establishing such a cash fund is decision entirely separate from depreciation Accumulate depreciation is that portion of the plant asset's cost that has already been recorded as expense

Causes of Depreciation

The two major causes of depreciation are physical deterioration & obsolescence

a Physical Deterioration – occurs from wear & tear while in use as well as from the action of the weather (exposure to sun, wind, and other climatic factors)

b Obsolescence (Function Depreciation) - is the process of becoming out of date before the assets physically wears out

In today’s rapidly advance in technology, obsolescence is a more important consideration than physical deterioration E.g a personal computer made in the 1980's would not be able to provide an Internet connection

Assets like computers, other electronic equipment & airplanes may become obsolete before they physically deteriorate An asset is obsolete when another asset can do the job better or more efficiently

Depreciation Methods

There are several alternative methods of computing depreciation A business need not use the same method of depreciation for all its various assets

Depreciation is computed using one of the following different methods:

1 Straight line method

2 Chapters of output method

3 Declining balance method

4 Sum-of-the-years’-digits method

5 Interest method of computing depreciation

6 Composite method of computing depreciation

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Like the inventory costing method, each method is acceptable under GAAP, thus it is up to the management of the business to select a method, which is believed to be appropriate in the circumstance Depreciation affects the Balance sheet reports through the account of accumulated depreciation, as well as the Income statement through the account of depreciation expense Thus, its proper accounting and record is imperative for financial reporting

Three factors affect the computation of depreciation:

a Cost - is the initial cost incurred in acquiring the asset Cost is measured in accordance with the cost principle of accounting

b Useful Life - is an estimate of the expected productive life, also called service life, of the asset Useful life maybe expressed in term of time, Chapters of activity such as machine hours, or in Chapters of output

c Salvage Value - also called scrap or residual value is an estimate of the asset's value at the end

of its useful life

o The full cost of a plant asset is depreciated if the asset is expected to have no residual value

o The plant assets cost minus its estimated residual value is called the depreciable cost

1 Straight - Line Method

Under the Straight - Line Method, an equal portion of the cost of the asset is allocated to each period of use; consequently, this method is most appropriate when usage of an asset is fairly uniform from year to year

 It is the simplest & most widely used method of computing depreciation

 The Straight Line Method depreciation assumed that a business receives equal benefits from

an asset each day of the asset's life Straight Line, then, allocates an equal part of the total cost to each day of an asset's useful life

To illustrate, assume a delivery truck has a cost of Br.17, 000 a residual value of Br 2,000 and an estimated useful life of five years The annual computation of depreciation exp will be as follows: Straight - Line depreciation per year = Cost - Residual value

Useful life in years = Br 17,000.00 - Br 2,000.00

Accumulated Depreciation Book value Depreciable Rate x Cost

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Depreciation rates for various types of assets can conveniently be stated as percentages

In the illustration, it was assumed that the asset was acquired on Jan 1, the beginning of the

accounting period If the asset had been acquired during the year, on October 1, it would have been

in use for only 3 months, or 3/12 of a year Then, the depreciation expense for the three months

would be computed as follows:

Depreciation on December 31 = Br 15,000.00 x 20% x 3/12 = 750

The straight-line method predominates in practice It is simple to apply, & it matches expenses with

revenues appropriately when the use of the asset is reasonably uniform throughout the service life

2 Chapter of Output Method

This method is used for assets whose useful life is limited by physical wear- and -tear rather than

obsolescence The asset life is expressed in expected Chapters of output, such as hours, miles, or

number of Chapters This method is appropriate when the service of a fixed asset is related to use

rather than time It is based on the assumption that an asset depreciates only as it is used Thus the

asset life is expressed in expected Chapters of output such as miles,

To illustrate, assume that the delivery truck in the previous example has an estimated useful life of

100,000 miles, and in the first year of its usage it is driven 15,000.00 miles The depreciation for the

first year is then computed as follows:

Depreciation Per Chapter of output = Cost - Residual Value

Est Chapters of Output (Miles) = Br 17,000 - Br 2,000 100,000 Miles

= Br 0.15 Dep per mile

In the Chapters-of-output method, a fixed amount of depreciation is assigned to each Chapter of

output produced or each Chapter of capacity used by the plant assets

Year 1 depreciation exp = Br 0.15 x 15,000miles

= Br 2,250

So, when the amount if use of a fixed asset varies from year to year, the Chapters- of – output

method is more appropriate than the straight –line method In such a case, the Chapters-of-output

method better matches the expense with related revenue

3 Declining Balance Method

The basic idea behind the declining balance method is that more service benefits are received in the

early years of an asset's life when it is new, & fewer benefits are received each year as the asset

grows older So this method assigns more (greater) depreciation exp to the early years of the asset's

life & less to later ones

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To illustrate, consider the previous e.g of the Br 17,000 delivery truck To depreciate the truck by the double declining balance method, we double the straight-line rate of 20% & apply the doubled rate of 40% to the book value at the beginning of each year

Depreciation Schedule Declining Balance Method

Depreciation Book Value Book Value

Beg Of year

Depreciation Rate

 The depreciation rate remains constant from year to year, but the book value to which the rate

is applied declines each year

 Unlike the other depreciation methods, salvage value is ignored in determining the amount to which the declining balance is applied Salvage value, however, does limit the total depreciation that can be taken Depreciation stops when the asset's B.V equals expected salvage value

 Because the declining balance method produces higher depreciation expense in the early years than in the later years, it is considered an accelerated depreciation method

If the asset has been acquired on October 1, rather than on January 1, depreciation for only 3 months would be computed as follows:

40% x Br 17,000.00 x 3/12 = Br 1,700

For the next year, the calculation would be, 40% x (17,000 -1,700) =Br 1,620

4 Sum of the years Digits method

Like the declining balance method, the sum of the year's digit allocates a large portion of the asset cost to the early years of its use as accelerated depreciation method The depreciation rate to be used

is a fraction, of which the numerator is the remaining years of useful life (as of the beginning of the year) & the denominator is the sum of the individual years that comprise total service life

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SYD is an appropriate method for assets that provide more service benefits in the early years of their lives & less in later years Many assets are efficient when first purchased but become less efficient as time passes This decrease in utility may be caused by technological obsolescence or by accumulated effects of physical wear and tear Copying machines & computer are examples of assets that are depreciated by an accelerated depreciation method

Consider again the example of the delivery truck costing Br 17,000 having an estimated life of Five (5) years & an estimated residual value of Br 2,000

First the sum of the digits of the years of the asset’s useful life has to be determined through a short cut formula that yields the same results as the more tiresome addition process

Sum of the digits = n (n+1), where n is number of years in the assets life

2 5- years sum of the digits = 5(5+1) = 5 (3) = 15

Year Computation Annual Dep exp Accumulated Depreciation Book Value

Depreciable Cost SYD Fraction

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5 Interest method of depreciation

Under interest method of depreciation, a plant asset is considered as a bundle of future service to be received periodically over the economic life of the asset The cost of such an asset is viewed as the present value of the equal periodic rents of services discounted at a rate of interest consistent with the risk factors identified with the investment in the plant asset There are two kinds of interest methods of depreciation

Annuity Method: Annuity method of depreciation is appropriate when the periodic cost (depreciation) of using a long lived plant asset is considered to be equal to the total of the expired cost of the asset and the implicit interest on the unrecorded investment in the asset Depreciation expense is debited and accumulated depreciation and interest revenue are credited The following is the formula used to calculate depreciation under annuity method

i

SVAC

n

i)(1

n- Useful life

Example 5: Assume a machine with an economic life of five years and a net residual value of Br 67,388 is acquired by ABC Company for Br 800,000 If the fair rate of interest for this type of investment is 10% compounded annually, the yearly depreciation is computed as follows under annuity method

000,200.1

0 0.1)

1(

1 (1 0.1)

388,67.000,800

5

5

Br

BrBr

(10% of carrying amount)

accumulated depreciation ledger account

Balance of accumulated depreciation ledger account

Carrying amount of the plant asset

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Journal entries Year 1 _ Year 2 _ _Year 3

Depreciation expense 200,000 200,000 200,000 Interest revenue 80,000 68,000 54,800

Accumulated depreciation 120,000 132,000 145,200

2 Sinking Fund Method: Sinking fund method of depreciation might be used when a fund is to be

accumulated to replace a plant asset at the end of its economic life Under sinking fund method, the

amount of depreciation expense is equal to the increase in the asset replacement fund The increase

in the fund consists of equal periodic deposit plus the interest revenue realized at the assumed rate

on the sinking fund balance Annual deposit in the sinking fund under this method is given using the

following formula:

i i

n

SVAC

depositFund

Sinking

1

) 1

We shall illustrate the sinking fund method of depreciation with the same example as we

illustrated in the annuity method The annual sinking fund deposit is calculated using the above

formula as follows:

1.0

1

388,67.000

,800

) 1 0 1

FundSinking

= Br 120,000

A summary of the result of the sinking fund method of depreciation and the journal entry to record

deprecation for the five years is given below

Year Annual deposit

Realized interest revenue (10% of fund balance)

Total fund Increase Fund balance

Depreciati

on expense

Balance of Accumulated depreciation ledger account

Carrying amount

of the plant asset

6 Composite Depreciation Method

Most business enterprises find it expedient to account for depreciation of certain kinds of plant asset

on a composite or group basis, to minimize the record keeping for individual asset Composite or group depreciation is a process of averaging the economic life of a number of plant assets and computing depreciation on the entire class of assets as if it was an operating Chapter The term composite refers to a collection of somewhat dissimilar plant assets; the term group usually refers to

a collection of similar assets The procedures for the computation of periodic depreciation are essentially the same in either case Several methods may be used to develop composite or group depreciation rate to be applied to the total cost of a group of plant assets The computation of a straight line composite depreciation rate for a group of machines owned by Mettu trading is illustrated below

Net Residual Depreciable Economic Annual

Machines Cost value base life Depn Expense

Composite depreciation rate based on cost = Br 5,200/50,000 = 10.4%

Composite economic life of machines = Br 46,800/5,200 = 9 years

The composite depreciation rate is 10.4%, and the composite economic life of the machine is 9 years Thus, the application of the 10.4% composite rate to the cost of Br 50,000 will reduce the composite net residual value of the machines to Br.3, 200 in exactly 9 years

Disposal of Plant Asset

Eventually, a plant asset ceases to serve a Company’s needs The asset may have become worn out, obsolete, or for some other reason no longer useful to the business

Plant assets of various types may be disposed of in three ways:

1 Retirement – the plant asset is scrapped or discarded

2 Sale – the plant asset is sold to another party

3 Exchange – an existing plant asset is traded in a new plant asset

At the time of disposal, it is necessary to determine the book value of the plant asset The book value is the difference between the cost of the plant asset and the accumulated depreciation to date

If the disposal accounts at any time during the year, depreciation for the fraction of the year to the date of the disposal must be recorded

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1 Retirement (Discarding) Fixed Asset

Under fixed asset are no longer useful to the business and have no residual or market value, they are discarded

To illustrate, the accounting for a retirement, assume that ABC Company retires its computer printers, which cost Br 32,000.The accumulated depreciation on these printers is also Br 32, 000;

to equip, is therefore, fully depreciated (zero book value), the entry to record this retirement is: Accumulated depreciation – printing equip - 32,000

Printing equip -32,000 (To record instalment of fully depreciation equip.)

What about if a fully depreciated plant asset is still useful to the company?

Assume that moon light company discards its delivery equipment, which cost Br 18,000, and has accumulated depreciation of Br 14,000 at the date of retirement The entry to record the retirement

is as follows:

Accumulated depreciation-Deliver equip - 14,000

Loss on disposal - 4,000

Delivery equip - 18,000

2 Selling of Plant Assets

In a disposal by sale, the book value of the asset is compared to the proceeds received for the sale

If the proceeds received from the sale exceed the book value of the plant asset, a gain on disposal occurs If, however, the proceeds of the sale are less than the book value of the plant asset sold, a loss on disposal occurs

To illustrate, assume that on July 1, 2020 Guna Trading Company sells Office Furniture for Br 16,000 cash The Office- furniture originally cost Br 60,000 and as of Jan 1, 2020, had accumulated depreciation of Br 41,000 The yearly depreciation is Br 16,000

Depreciation for the first six months of 2020 is Br 8,000 The entry to record depreciation expense and update accumulated depreciation to July 1 is as follows:

July 1, Depreciation expense - 8,000

Accumulated depreciation of furniture - 8,000

(To record depreciation expense for the 1st six months of 2020) After the accumulated depreciation balance is updated, a gain on disposal of Br 5,000 is computed

Cost of furniture - Br 60,000

Less: Accumulated Depreciation (41,000 + 8,000) 49,000

Book value at date of disposal 11,000

Gain on disposal Br 5,000

Loss on Disposal

Assume that instead of selling the office furniture for Br 16,000, Guna trading sells it for Br 9,000

In this case, a loss of Br 2,000 is computed as follows:

Cost of office furniture - Br 60,000

Less: accumulated depreciation. - 49,000

Book value at date of disposal - 11,000

Proceeds from sale - 9,000

3 Exchanging Fixed Asset

Plant assets may also be disposed of trough exchange Business often exchange (trade – in) their old plant assets for similar assets that are newer and more efficient Exchange can be for either similar

or dissimilar assets because exchanges of similar assets are more common; we will focus more on the exchange for similar assets

Exchange of similar assets involves assets of the same type This occurs for example, when old equipment is exchanged for new delivery equipment or when old office furniture is exchanged for new office furniture

At the time of exchange, the seller allows the buyer an amount for the old equipment traded in This amount called the trade in-allowance may be either greater or less than the book value of the old equipment The remaining balance- the amount owed – is either paid in cash or a liability is recorded It is normally called boot, which is its tax name

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The cost recorded for the new asset can be determined in either of two ways:

i Cost of new asset = List price of new asset - unrecognized gain

ii Cost of new asset = Cash given or liability assumed + Book value of old asset

The cost of the new equipment and the gain, which is not recognized, is computed as follows:

Similar equipment acquired (new):

List price of new equipment - Br 5,000

Trade-in allow on old equipment - 1,100

Cash to be paid at June 19, date of exchange 3,900

Equip Traded - in (Old):

Cost of old equipment - Br 4,000

Accumulated Depreciation at date of exchange 3,200

Book value at date of exchange - 800

Recorded Cost of New Equipment:

Method One

List price of new equipment - Br 5,000

Trade-in allowance - Br 1,100

Book value of old equipment - 800

Unrecognized gain on exchange - - 300

Cost of new equipment - Br 4,700

Method Two

Book value of old equipment - Br 800

Cash paid at date of exchange - 3,900

Cost of new equipment - 4,700

The trade-in allowance and the list price of the new equipment are not recorded in the purchaser’s accounting records These amounts are only used in order to determine the amount the purchaser must pay in addition to turning in the old truck

List price of new equipment - Br 5,000

Less: Trade-in allowance on old equip - 400 _

Cash paid - 4,600

Cash payment = List price – trade-in allowance

Trade-in allow = List price – Cash Pmt

= Br 400 Loss on Disposal = Book Value – Trade in allowance

= Br 800 – 400 = Br 400 The entry to record the exchange, loss & cash Payment is as follows:

Equipment (new) - 5,000

Accumulate depreciation – equipment - 3.200

Loss on disposal - 400

Equipment (old) - 4,000 Cash - 4,600 (To record exchange of equipment at loss)

Consider again another related example: the cost of old equipment is Br.7, 000; its accumulated depreciation is Br 4,600 Cash paid is Br 8,000 and the list price of the new equipment is Br 10,000 Then, the amount of trade-in allowance, loss, and the value of the new equipment is determined as follows: following exchange:

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Similar equipment acquired (new):

List price of new equipment - Br 10,000

Trade – in allowance on old equip _ ?_

Cash paid Br 8,000

Equipment Traded - in (old)

Cost of old equipment - Br 7,000

Accumulated Depreciation at time of exchange - 4,600

Book Value at date of exchange - 2,400

Trade-in allow on old equip - 2,000

Loss on exchange - Br 400

The entry to record to exchange is as follows:

Accumulated Depreciation - equip - 4,600

Equipment (new) - 10,000

Loss on disposal of fixed assets - 400

Equip - 7,000 Cash - 8,000 (To recode exchange of equipment to loss)

Natural Resources

The fixed assets of some businesses include standing timber and underground deposits of oil, gas, minerals or other natural resources As this business harvest or mine and sell these resources, a portion of the cost of acquiring them must be debited to an expense account This process of transferring the cost of natural resources to an expense account is called depletion

A natural resource as its name implies is a resource existing naturally, not constructed by humans Examples of typical natural resources are deposits of coal, oil, and other minerals These natural resources are typically used as raw manufacture in the production of other goods A quantity of natural resource can be considered as consisting of a total bundle of materials, tons of coal, barrels

of oil, etc As these materials are removed, a part of the natural resource is used up – depleted The acquisition cost of a natural resource is the cash or cash equivalent price, necessary to acquire the resource and prepare it for its intended use For already discovered resources such as an existing Coal Mine ,cost is the price paid for the property

The systematic write-off of the cost of natural resources is called depletion The Chapters of activity (output) method are generally used to compute depletion, because periodic depletion generally is a function of the Chapters extracted during the year

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Depletion Cost Total Cost – Salvage

Per Chapter = Total Estimated Chapters

Periodic Depletion Depletion Cost Number of Chapters

Expense = Per Chapter X Extracted & Sold

To illustrate, assume that the Global Coal Co invests Br 5,000,000 in a mine estimated to have 10 million tons of coal and no salvage value In the first year, 800,000 tons of coal are extracted and sold Using the above formula, the computations are as follows:

Depletion Cost = $ 5,000,000

per Chapter 10,000,000

= Br 0.5 depletion cost per ton

Depletion expense = Br 0.5 x 800,000 tons

= Br 400,000 The enter to record depletion expense for the first year of operation is as follows:

Dec 31 Depletion expense - 400,000

Accumulated depletion - 400,000 (To record depletion expense on coal deposits)

Accumulated depletion, a contra asset account similar to accumulated deprecation, is deducted from the cost of the natural resources in the balance sheet as follows:

Coal Mines - Br 5,000,000

Less: Accumulated depletion - 400,000 Br 4,600,000

 Sometimes, natural resources extracted in one accounting period will not be sold until a later period In this case, depletion is not expensed until the resource is sold The amount not sold is reported in the current asset section as inventory

There are few differences between accounting for intangible assets and accounting for plant assets

 The term used to describe the write-off of an intangible asset is amortization, rather than depreciation

 The amortization period of an intangible asset cannot be longer than 40 years

 Unlike plant assets, all intangible assets are typically amortized on a straight-line basis The universal use of this method adds comparability

To illustrate, assume that a patent is purchased from the investor at a cost of Br 100,000 after five years of the legal life have expired (its legal life is 17 years) It is estimated that the useful life after purchase is only four years The entry to be made to record the purchase and the annual amortization expense would be:

Jan 1, Patent - 100,000

Cash - 100,000 (To record acquisition of patent that until have a legal life of 17 years)

Dec 31 Amortization Expense - Patent - 25,000

Patents - 25,000 (To amortize cost patent on a straight-line basis and estimated life of four years)

Note that although the remaining life is 12 years, the estimated useful life is only four years., amortization should be based on this shorter period

2 Copy right

A copyright is on exclusive right granted by government to protect the production and sell of literary or artistic materials for the life of the creator plus 50 years The useful life of a copyright generally is shorter than its legal life Similar to other intangible assets, the maximum write-off is

40 years However, because of the difficulties of determining the period over which benefits are to

be received, copyrights usually are amortized over a relatively short period of time

3 Trade mark and Trade Names

A trademark or trade name is a word, phrase, or symbol that distinguishes or identifies a particular enterprise or product E.g Co-Ca Cola, Sony, Dell, Nike etc…

The creator or original user may obtain exclusive legal right to the trademark or trade name by registering it with the government office

4 Franchise and Licenses

A franchise is a right granted by a company or a governmental Chapter to conduct a certain type of business in a specific geographical area

When the cost of franchise is small, it may be charged immediately to expense or amortized over a short period such as five years When the cost is material, amortization should be based upon the life of the franchise (if limited) and the amortization period, however, may not exceed 40 years

5 Goodwill

In business, goodwill refers to an intangible asset of a business that is created from such favorable factors as location, product quality, reputation, and managerial skill Goodwill allows a business to earn a rate of return on its investment that is often in excess of the normal rate for other firms in the same business

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Chapter Two Current Liabilities WHAT IS A LIABILITY?

FASB, as part of its conceptual framework, defined liabilities as “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 a result of past transactions or events.” In other words, a liability has three essential characteristics:

1 It is a present obligation that entails settlement by probable future transfer or use of cash, goods, or services

2 It is an unavoidable obligation

3 The transaction or other event creating the obligation has already occurred

Because liabilities involve future disbursements of assets or services, one of their most important features is the date on which they are payable A company must satisfy currently maturing obligations in the ordinary course of business to continue operating Liabilities with a more distant due date do not, as a rule, represent a claim on the company’s current resources They are therefore

in a slightly different category This feature gives rise to the basic division of liabilities into

(1) Current liabilities and

(2) Long-term debt

WHAT IS A CURRENT LIABILITY?

Current liabilities are “obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets, or the creation of other current liabilities.” This definition has gained wide acceptance because it recognizes operating cycles of varying lengths in different industries This definition also considers the important relationship between current assets and current liabilities

The operating cycle is the period of time elapsing between the acquisition of goods and services involved in the manufacturing process and the final cash realization resulting from sales and subsequent collections Industries that manufacture products requiring an aging process, and certain capital-intensive industries, have an operating cycle of considerably more than one year On the other hand, most retail and service establishments have several operating cycles within a year Here are some typical current liabilities:

7 Sales taxes payable

8 Income taxes payable

9 Employee-related liabilities

Accounts Payable

Accounts payable, or trade accounts payable, are balances owed to others for goods, supplies,

or services purchased on open account Accounts payable arise because of the time lag between the receipt of services or acquisition of title to assets and the payment for them The terms of the sale (e.g., 2/10, n/30 or 1/10, E.O.M.) usually state this period of extended credit, commonly 30

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to 60 days Most companies record liabilities for purchases of goods upon receipt of the goods If title has passed to the purchaser before receipt of the goods, the company should record the transaction at the time of title passage 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 Measuring the amount of an account payable poses no particular difficulty The invoice received from the creditor specifies the due date and the exact outlay in money that is necessary to settle the account

Notes Payable

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 Some industries require notes (often referred to as trade notes payable) as part of the sales/purchases transaction in lieu of the normal extension of open account credit Notes payable to banks or loan companies generally arise from cash loans Companies classify notes as short-term or long-term, depending on the payment due date Notes may also be interest bearing or zero-interest-bearing

Interest-Bearing Note Issued

Assume that Dashen Bank agrees to lend Br.100,000 on March 1, 2012, to ABC Co if ABC signs a Br.100,000, 6 %, four-month note ABC 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 Dashen Bank)

If ABC prepares financial statements semiannually, it makes the following adjusting entry to recognize interest expense and interest payable of Br.2,000 (Br.100,000*6%*4/12) at June 30

June 30 Interest Expense 2,000

Interest Payable 2,000 (To accrue interest for 4 months on Dashen Bank note)

If ABC prepares financial statements monthly, its adjusting entry at the end of each month is Br.500 (Br.100,000* 6% * 1/12)

At maturity (July 1), ABC must pay the face value of the note (Br.100,000) plus Br.2,000 interest (Br.100,000 * 6% * 4/12) ABC 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 Dashen Bank interest bearing note and accrued interest at maturity)

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Zero-Interest-Bearing Note Issued

A zero-interest-bearing note does not explicitly state an interest rate on the face of the note Interest is still charged, however 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 not eat 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

To illustrate, assume that ABC issues a Br.102,000, four-month, zero-interest bearing note to Dashen Bank The present value of the note is Br.100,000 ABC records this transaction as follows

March 1

Cash 100,000

Discount on Notes Payable 2,000

(To record issuance of 4-month, zero-interest-bearing note to Dashen Bank)

Discount on Notes Payable is a contra account to Notes Payable, and therefore is subtracted from Notes Payable on the balance sheet

The balance sheet presentation on March 1

Current liabilities

Less: Discount on notes payable Br.100,000

2,000 The Discount on Notes Payable balance represents interest expense chargeable to future periods Thus, ABC should not debit Interest Expense for Br 2,000 at the time of obtaining the loan

Current Maturities of Long-Term Debt

Companies, exclude long-term debts maturing currently as current liabilities if they are to be:

1 Retired by assets accumulated for this purpose that properly have not been shown as current assets,

2 Refinanced, or retired from the proceeds of a new debt issue, or

3 Converted into capital stock

In these situations, the use of current assets or the creation of other current liabilities does not occur

Dividends Payable

A cash dividend payable is an amount owed by a corporation to its stockholders as a result of board of directors’ authorization At the date of declaration, the corporation assumes a liability that places the stockholders in the position of creditors in the amount of dividends declared Because companies always pay cash dividends within one year of declaration (generally within three months), they classify them as current liabilities

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On the other hand, companies do not recognize accumulated but undeclared dividends on cumulative preferred stock as a liability Why? Because preferred Dividends in arrears are not an obligation until the board of directors authorizes the payment

Dividends payable in the form of additional shares of stock are not recognized as a liability Such

as stock dividends do not require future outlays of assets or services Companies generally report such undistributed stock dividends in the stockholders’ equity section because they represent retained earnings in the process of transfer to paid-in capital

Customer Advances and Deposits

Current liabilities may include returnable cash deposits received from customers and employees Companies may receive deposits from customers to guarantee performance of a contract or service or as guarantees to cover payment of expected future obligations

The classification of these items as current or noncurrent liabilities depends on the time between the date of the deposit and the termination of the relationship that required the deposit

August 6

Unearned Sales Revenue 500,000 (To record sale of 10,000 season tickets) After each game, Allstate University makes the following entry

September 7

Unearned Sales Revenue 100,000

Sales Revenue 100,000 (To record football ticket revenues earned) Sales Taxes Payable

The Sales Taxes Payable account should reflect the liability for sales taxes due various governments The entry below illustrates use of the Sales Taxes Payable account on a sale of Br.3,000 when a 4 percent sales tax is in effect

Cash 3,120

Sales Revenue 3,000 Sales Taxes Payable 120

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Income Taxes Payable

Corporations should classify as a current liability the taxes payable on net income, as computed per the tax return Unlike a corporation, proprietorships and partnerships are not taxable entities Because the individual proprietor and the members of a partnership are subject to personal income taxes on their share of the business’s taxable income, income tax liabilities do not appear

on the financial statements of proprietorships and partnerships

Employee-Related Liabilities

Companies also report as a current liability amounts owed to employees for salaries or wages at the end of an accounting period In addition, they often also report as current liabilities the following items related to employee compensation

Compensated Absences

Compensated absences are paid absences from employment such as vacation, illness, and holidays Companies should accrue a liability for the cost of compensation for future absences if all of the following conditions exist

(a) The employer’s obligation relating to employees’ rights to receive compensation for future absences is attributable to employees’ services already rendered

(b) The obligation relates to the rights that vest or accumulate

(c) Payment of the compensation is probable

(d) The amount can be reasonably estimated

The following considerations are relevant to the accounting for compensated absences Vested rights exist when an employer has an obligation to make payment to an employee even after terminating his or her employment Thus, vested rights are not contingent on an employee’s future service Accumulated rights are those that employees can carry forward to future periods

if not used in the period in which earned For example, assume that you earn four days of vacation pay as of December 31, the end of your employer’s fiscal year Company policy is that you will be paid for this vacation time even if you terminate employment In this situation, your four days of vacation pay are vested, and your employer must accrue the amount

Now assume that your vacation days are not vested, but that you can carry the four days over into later periods Although the rights are not vested, they are accumulated rights for which the employer must make an accrual However, the amount of the accrual is adjusted to allow for estimated forfeitures due to turnover

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Bonus Agreements

Many companies give a bonus to certain or all employees in addition to their regular salaries or wages Frequently the bonus amount depends on the company’s yearly profit A company may consider bonus payments to employees as additional wages and should include them as a deduction in determining the net income for the year

To illustrate the entries for an employee bonus, assume that Palmer Inc shows income for the year 2012 of Br.100,000 It will pay out bonuses of Br.10,700 in January 2013 Palmer makes an adjusting entry dated December 31, 2012, to record the bonuses as follows

Salaries and Wages Expense 10,700

Salaries and Wages Payable 10,700

In January 2013, when Palmer pays the bonus, it makes this journal entry:

Salaries and Wages Payable 10,700

CONTINGENCIES

Companies often are involved in situations where uncertainty exists about whether an obligation

to transfer cash or other assets has arisen and/or the amount that will be required to settle the obligation

A contingency is “an existing condition, situation, or set of circumstances involving uncertainty

as to possible gain (gain contingency) or loss (loss contingency) to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur

GAIN CONTINGENCIES

Gain contingencies are claims or rights to receive assets (or have a liability reduced) whose existence is uncertain but which may become valid eventually

The typical gain contingencies are:

1 Possible receipts of monies from gifts, donations, asset sales, and so on

2 Possible refunds from the government in tax disputes

3 Pending court cases with a probable favorable outcome

4 Tax loss carry forwards

Companies follow a conservative policy in this area Except for tax loss carry forwards, they do not record gain contingencies A company discloses gain contingencies in the notes only when a high probability exists for realizing them As a result, it is unusual to find information about contingent gains in the financial statements and the accompanying notes

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 either the amount payable, the payee, the date payable, or its existence That is, these factors depend on a contingency

Likelihood of Loss

When a loss contingency exists, the likelihood that the future event or events will confirm the incurrence of a liability can range from probable to remote The FASB uses the terms probable,

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reasonably possible, and remote to identify three areas within that range and assigns the following meanings

Probable The future event or events are likely to occur

Reasonably possible The chance of the future event or events occurring is more than remote but less than likely

Remote The chance of the future event or events occurring is slight

Companies should accrue an estimated loss from a loss contingency by a charge the expense and

a liability recorded only if both of the following conditions are met

1 Information available prior to the issuance of the financial statements indicates that it is probable that a liability has been incurred at the date of the financial statements

2 The amount of the loss can be reasonably estimated

To record a liability, a company does not need to know the exact payee nor the exact date payable What a company must know is whether it is probable that it incurred a liability

To meet the second criterion, a company needs to be able to reasonably determine an amount for the liability To determine a reasonable estimate of the liability, a company may use its own experience, experience of other companies in the industry, engineering or research studies, legal advice, or educated guesses by qualified personnel

Practicing accountants express concern over the diversity that now exists in the interpretation of

“probable,” “reasonably possible,” and “remote.” Current practice relies heavily on the exact language used in responses received from lawyers (such language is necessarily biased and protective rather than predictive) As a result, accruals and disclosures of contingencies vary considerably in practice Some of the more common loss contingencies are:

1 Litigation, claims, and assessments

2 Guarantee and warranty costs

3 Premiums and coupons

4 Environmental liabilities

Litigation, Claims, and Assessments

Companies must consider the following factors, among others, in determining whether to record

a liability with respect to pending or threatened litigation an actual or possible claims and assessments

1 The time period in which the underlying cause of action occurred

2 The probability of an unfavorable outcome

3 The ability to make a reasonable estimate of the amount of loss

To report a loss and a liability in the financial statements, the cause for litigation must have occurred on or before the date of the financial statements It does not matter that the company became aware of the existence or possibility of the law suitor claims after the date of the financial statements but before issuing them To evaluate the probability of an unfavorable outcome, a company considers the following: the nature of the litigation; the progress of the case; the opinion of legal counsel; its own and others’ experience in similar cases; and any management response to the lawsuit

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Guarantee and Warranty Costs

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 Manufacturers commonly use it as a sales promotion technique For a specified period of time following the date of sale to the consumer, the manufacturer may promise to bear all or part of the cost of replacing defective parts, to perform any necessary repairs or servicing without charge, to refund the purchase price,

or even to “double your money back.”

Warranties and guarantees entail future costs These additional costs, sometimes called “after costs” or “post-sale costs,” frequently are significant Although the future cost is indefinite as to amount, due date, and even customer, a liability is probable in most cases

Companies should recognize this liability in the accounts if they can reasonably estimate it The estimated amount of the liability includes all the costs that the company will incur after sale and delivery and that are incident to the correction of defects or deficiencies required under the warranty provisions Warranty costs are a classic example of a loss contingency Companies use two basic methods of accounting for warranty costs:

(1) The cash basis method and

(2) The accrual method

Cash Basis

Under the cash-basis method, companies expense warranty costs as incurred In other words, a seller or manufacturer charges warranty costs to the period in which it complies with the warranty The company does not record a liability for future costs arising from warranties, nor does it charge the period of sale Companies frequently justify use of this method, the only one recognized for income tax purposes, on the basis of expediency when warranty costs are immaterial or when the warranty period is relatively short A company uses the cash-basis method when it does not accrue a warranty liability in the year of sale either because:

1 it is not probable that a liability has been incurred, or

2 it cannot reasonably estimate the amount of the liability

Accrual Basis

If it is probable that customers will make warranty claims and a company can reasonably estimate the costs involved, the company must use the accrual method Under the accrual method, companies charge warranty costs to operating expense in the year of sale The accrual method is the generally accepted method Companies should use it whenever the warranty is an integral and inseparable part of the sale and is viewed as a loss contingency We refer to this approach as the expense warranty approach

Example of Expense Warranty Approach To illustrate the expense warranty method, assume that Denson Machinery Company begins production on a new machine in July2012, and sells

100 Chapters at Br.5,000 each by its year-end, December 31, 2012 Each machine is under warranty for one year Denson estimates, based on past experience with a similar machine, that the warranty cost will average Br.200 per Chapter Further, as a result of parts replacements and

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services rendered in compliance with machinery warranties, it incurs Br.4,000 in warranty costs

in 2012 and Br.16,000 in 2013

1 Sale of 100 machines at Br.5,000 each, July through December 2012:

Cash or Accounts Receivable 500,000

The December 31, 2012, balance sheet reports “Warranty liability” as a current liability of Br.16,000, and the income statement for 2012 reports “Warranty expense” ofBr.20,000

3 Recognition of warranty costs incurred in 2013 (on 2012 machinery sales):

Warranty Liability 16,000

Cash, Inventory, Accrued Payroll 16,000 (Warranty costs incurred)

If Denson Machinery applies the cash-basis method, it reports Br.4,000 as warranty expense in

2012 and Br.16,000 as warranty expense in 2013 It records all of the sale price as revenue in

2012 In many instances, application of the cash-basis method fails to record the warranty costs relating to the products sold during a given period with the revenues derived from such products

As such, it violates the expense recognition principle Where ongoing warranty policies exist year after year, the differences between the cash and the expense warranty bases probably would not be so great

Premiums and Coupons

Numerous companies offer premiums (either on a limited or continuing basis) to customers in return for box tops, certificates, coupons, labels, or wrappers The premium may be silverware, dishes, a small appliance, a toy, or free transportation Also, printed coupons that can be redeemed for a cash discount on items purchased are extremely popular

A more recent marketing innovation is the cash rebate, which the buyer can obtain by returning the store receipt, a rebate coupon, and Universal Product Code (UPC label) or “bar code” to the manufacturer

Companies offer premiums, coupon offers, and rebates to stimulate sales Thus companies should charge the costs of premiums and coupons to expense in the period of the sale that benefits from the plan The period that benefits is not necessarily the period in which the company offered the premium At the end of the accounting period many premium offers may be outstanding and must be redeemed when presented in subsequent periods In order to reflect the existing current liability and to match costs with revenues, the company estimates the number of outstanding premium offers that customers will present for redemption

Accounting Recognition of Asset Retirement Obligations

A company must recognize an asset retirement obligation (ARO) when it has an existing legal obligation associated with the retirement of a long-lived asset and when it can reasonably estimate the amount of the liability Companies should record the ARO at fair value

Obligating Events Examples of existing legal obligations, which require recognition of a liability include, but are not limited to:

Decommissioning nuclear facilities;

Dismantling, restoring, and reclamation of oil and gas properties;

Certain closure, reclamation, and removal costs of mining facilities; and

Closure and post-closure costs of landfills

In order to capture the benefits of these long-lived assets, the company is generally legally obligated for the costs associated with retirement of the asset, whether the company hires another party to perform the retirement activities or performs the activities with its own workforce and equipment AROs give rise to various recognition patterns For example, the obligation may arise at the outset of the asset’s use (e.g., erection of an oil-rig), or it may build over time (e.g., a landfill that expands over time)

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Chapter Three Accounting for Long term Debt 3.1 Introduction

Long term debts are liabilities that do not require the payment of cash, the shipment of goods, or the rendering of services in one year or the operating cycle, whichever is longer, for their liquidation These include bonds, mortgage notes, promissory notes, deposits received for utilities service, obligations under pension and deferred compensation plans, long term lease obligations, deferred income tax credits, and long term deferred revenue items

It is important to note that bonds represent one of the most commonly known types of long term debts Bonds are also a form of interest bearing notes payable issued by various organizations This contract is usually held by trusty such as a bank or trust company who acts as an independent third party to protect the interest of both the issuer and the bond holders

A corporation may use long term financing other than bonds such as notes payable However, these other forms of financing involve one individual company or a financial institution So, money obtained through this instrument is sufficient to finance the funds needed for plant expansion and major projects like new building and factories To obtain large amount of capital, corporate management usually decides whether to issue bonds or to use equity financing

A corporation that issues a long term debt, issuing bonds provide the following advantages as compared with issuing common stocks

i Bond holders do not have voting rights so current owners (stockholders) retain full control of the company

ii Bond interest is deductible for tax purpose but dividend on stock are not

iii Although bond interest expenses reduce net income, earnings per share on common stock are often higher under bond financing because no additional shares of common stocks are issued

As a result of the above advantages, the cost of debt financing remains the cheapest of all capital sources in acquisition

3.2 Types of bonds

Bonds are means of dividing long-term debt into a number of small Chapters By dividing the debt into a smaller Chapter, amounts of money larger than which could be borrowed from a single source may be obtained from a large number of investors Hence, there are various types

of bonds and the most common types are discussed below

A Secured and unsecured bonds

Mortgage bonds are secured by a claim on real estate Collateral trust bonds are secured by stocks and bonds of other corporations A debenture bond is unsecured A “Junk bond” (high-risk bonds issued by companies with a weak financial position) is unsecured and pays a high interest rate These bonds are often used to finance leveraged buyouts

B Term, serial and callable bonds

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Bond issues that mature on a single date are called term bonds, and issues that mature in instalments are called serial bonds Callable bonds give the issuer the right to call and retire the bonds prior to maturity

C Convertible, commodity – backed and deep discount bonds

If bonds are convertible into other securities of the corporation for a specified time after issuance, they are called convertible bonds Commodity–baked bonds (also called “asset linked bonds) are redeemable in measures of a commodity such as barrels of oil and tons of coal Deep discount bonds are bonds that pay exceptionally low rate of interest

D Registered and bearer (coupon) bonds

Bonds issued in the name of the owner are registered bonds and require surrender of the certificate and issuance of a new certificate to complete a sale A bearer or coupon bond, however, is not recorded in the name of the owner and may be transferred from one owner to another by mere delivery

E Income and revenue bonds

Income bonds pay no interest unless the issuing company is profitable Revenue bonds are so called because the interest on them is paid from specified revenue sources These are most frequently issued by airports, school districts, countries, toll-road authorities, and government bodies

3.3 Accounting for issuance of bonds and interest expense

The face value is the amount of principal due at the maturity date The contractual interest rate often referred to as, the stated rate, is the rate used to determine the amount of cash interest the borrower pays and the investor receives Usually the contractual rate is stated as an annual rate and interest is generally paid semi-annually

3.4.1 Issuance of term bonds

In a typical term bond contract, the issuer promises the following two essentially different kinds

of future payments:

i Payment of a fixed amount (face amount or principal) on a specified date and

ii Periodic payment of interest (in an amount expressed as a percentage of the face amount of the bonds)

The principal is the face value of the initial amount at which bonds are issued while interest on bonds expressed as a percentage of the face amount is referred to as the nominal or contract

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rate The interest expense actually incurred on the bond is determined by the price at which the bonds are sold in the market and the rate is called effective rate (yield rate) Effective interest rate is set by money market The effective rate on the bond may be different from the nominal rate set by the company This may result from a change of economic conditions between the date the company set the nominal rate and the date it was issued Once the company set the terms of the bond issue, the selling price and therefore the effective yield of the bonds is determined Three alternatives are possible for a company selling bonds

1 First, if the effective rate is equal to the nominal rate, the purchaser of the bond pays the face value of the bond i.e the bonds are sold at their par value

2 Second, if the effective rate is more than the nominal rate, the purchaser of the bond pays less than face value of the bond, and the bonds are sold at discount

3 Third, if the effective rate is less than the nominal rate, the purchaser of the bond pay more than the face value of the bonds i.e the bonds are sold at premium

The market value (present value) of a bond is, therefore, a function of three factors including,

1 The birr amount to be received at the end of the contract period (face amount)

2 The length of time until the amounts are received

3 The market rate of interest

The market interest rate (effective rate or yield) is the investor’s demand for lending funds

to the company The process of finding the present value is referred to us discounting The following is the formula to compute the present value of a bond with face value of “P” and effective market interest rate “r”

Present value of bond = PV of face amount + PV of periodic Interest payments

r r

I r

P

1 1(

Where: PV= is present value of a bond

P= Principal (face value) of a bond

n = number of discounting periods

I = Interest per period computed using nominal rate

r = effective rate

Bonds may be issued at face value, below face value (at discount) or above face value (at premium) They also are sometimes issued between interest dates The accounting for a bond under these different cases may be illustrated as follows

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Example: Assume that Br 100,000 of five year, 7% term bonds are all authorized by a corporation’s board of directors The bond which promise Br.100, 000 at the end of five years and Br.7, 000 (7% x Br.100, 000) annual interest, then are offered to a group of investment bankers

Required

Based on the above information, determine the proceeds (present value) from issuing the bond and give the appropriate journal entries for the issuer under,

a) the effective market interest rate of 7%

b) the effective market interest rate of 6%

c) the effective market interest rate of 8%

Solution:

a) Effective rate (r) = 7%

r r

Ir

P

11()1

.0

))07.01

1(000,7.)

07.01( .100,000

b)

Effective rate (r) = 6%

213,104.06

.0

))06.01

1(000,7.)

06.01( .100,000

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c) Effective rate (r) = 8%

007,96.08

.0

))08.01

1(000,7.)

08.01

Discount or premium should be reported in the balance sheet as direct addition or deduction from the face amount of the note Because differences between the effective rate and the nominal rate

of interest are reflected in bond prices, the amount of premium or discount affects the periodic interest expense of the issuer This is illustrated by a comparison of the five year interest expense under each of the two assumptions given below

a) Assuming effective rate = 6% b) Assuming effective rate = 8%

Nominal interest (7000x5) ………… 35,000 Nominal interest (7000x5) ………35,000 Less: premium (104,213-100,000) … 4,213 Add: Discount (100,000-96,007) ……3,993 Five years interest expense………….30,787 Five years interest expense ……… 38,993 When the above bonds are issued to yield 8%, the discount amount indicated above (Birr 3,993) represents an additional amount of interest that will be paid by the issuer at maturity Similarly, when the bonds are issued to yield 6%, the premium amount (Birr 4,213) represents advance paid by bond holders for the right to receive larger annual interest The later is viewed as a reduction in the effective interest expense

The present value of the bonds on the date of issuance differs from their face amount because the market rate of interest differs from the periodic interest payment provided in bond contact

3.4.1.1 Reporting bond discount and premium on balance sheet

At the time issuance, the carrying amount of bond payable is equal to the proceeds received because these proceeds are computed as the present value of all future payments at the yield rate set by money market Bond discount and premiums are valuation amounts related tobonds payable The discount or premium should be reported in the balance sheet as a direct addition to

or deduction from the face amount of the bond These are reported on the balance sheet under the classifications of deferred change and deferred credit, respectively Bonds are presented in balance sheet as follows:

Discount on bonds payable 3,993 Bond payable 100,000

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Bonds issued at a discount Bonds issued at a premium

Bond payable (face amount)…… xx Bond payable (face amount)… xx

Less: discount (xx) Add: Premium xx

Carrying amount xx Carrying amount xx

3.4.1.2 Term bond interest expense

Because differences between the effective rate and the nominal rate of interest are reflected in bond prices, the amount of premium or discount affects the periodic interest expense of the issuer

If bonds are issued at a yield rate greater than the nominal rate, the discount represents an additional amount of interest that will be paid by the issuer at maturity Similarly if the bonds are issued at a yield rate less than the nominal rate, the premium represents an advance paid by bond holders for the right to receive layer annual interest checks and is viewed as a reduction in the effective interest expense The premium in effect is returned to bond holders in the form of larger periodic interest payments

The present value of the bonds on the date of issuance differs from their face amount because the market rate of interest differs from the periodic interest payments provided for in the bond contract Therefore, the process of amortizing the bond discount or premium in conjunction with the computation of periodic interest expense is a means of recording the change in the carrying amount of the bonds as they approach maturity In the bond discount case, the increase in the carrying amount of the bonds is caused by the decrease in bond discount through amortization Similarly, in the bond premium case, the decrease in the carrying amount of the bonds is caused

by the decrease in bond premium through amortization

3.4.1.4 Straight line method of amortization

Under this method, the additional interest expense (discount) or reduction of interest expense (premium) may be allocated evenly over the term of the bonds It results in a uniform periodic interest expense The use of straight-line method is acceptable if it is applied to immaterial amounts of discount or premium

1 Compute the amount of annual interest

2 Compute the amount of proceeds from bonds under case 1

3 Compute the amount of discount on bonds under case 1

4 Present the journal entry to record the issuance of the bonds under case 1

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5 Compute the amount of proceeds and premium on bonds under case 2

6 Present the journal entry to record the issuance of the bonds under case 2

7 Compute the amount of effective interest expense over the term of the bonds under

case 1

8 Compute the amount of effective interest expense over the term of the bonds under

case 2

9 Prepare discount amortization table under case 1 using straight line method

10 Present journal entries to record the first two annual interest payments under case 1

using straight line method

11 Prepare premium amortization table under case 2 using straight line method

12 Present journal entries to record the first two annual interest payment under case 2

using straight line method

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%

Present value of ordinary annuity of Br 500,000 interest

every year for 5 years at 12% (Br 500,000 x 3.60478) 1,802,390

Proceeds of bond issue Br 4,639,540

3 Amount of discount under case 1 (12%)

5 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 Br 500,000 interest

payable every year for 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

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6 Journal entry to record issuance under case 1

Premium on bonds payable 399,255

7 Amount of effective interest expense over the term of the bond under case 1

Nominal interest (Br 500,000 x 5) Br 2,500,000

Five year interest expense Br 2,860,460

8 Amount of effective interest expense over the term of bonds under case 2

Nominal interest (Br 500,000 x 5) Br 2,500,000

Five-year interest expense Br 2,100,754

13 Discount amortization table under case 1 using straight-line method

Time Interest paid (10%) Effective interest

expense (8%)

Premium amortization Bond discount

balance

Carrying amount of bonds

4,639,540 End of year 1 Br 500,000 Br 72,092 Br 572,092 288,368 4,711,632

14 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

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15 Premium amortization table under case 2 using straight line method

Time Interest paid (10%) Effective interest

expense (8%)

Premium amortization Bond premium

balance

Carrying amount of bonds

399,255 Br 5, 399,255 End of year 1 Br 500,000 Br 79,851 Br.420, 149 319,404 5,319,404

End of year 1: Bond interest expense 420,149

Premium on bonds payable 79,851

End of year 2: Bond interest expense 420,149

Premium on bonds payable 79,851

3.4.1.5 Accounting for bond issue costs

The issuances of bonds involve engraving and printing costs, legal and accounting fees, commissions, promotion costs, and other similar charges According to GAAP, these items should be debited to a deferred charge account for unamortized bond issue costs and amortized over the life the debt in a manner similar to that used for discount on bonds An alternative procedure advocated by some accountants (but which is not in accordance with GAAPs) is to add bond issue costs to bond discount or deduct them from bond premium This procedure implies that the amount of funds made available to the borrower is equal to the net proceeds of the bond issue after deduction of all costs of borrowing under this procedure, bond issue costs increase the interest expense during the term of the bonds

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Example: Assume that on January 1, 2003, Cheru Corporation sold Br 20,000,000 of 10-year bonds for Br 20,795,000 Costs of issuing the bonds were Br 245,000 The journal entries on January 1 and December 31, 2003 for issuance of the bonds and amortization of the bond issue costs, respectively, would be as follows:

January 1, 2003 (recording issuance of bonds)

Cash (20,795,000 – 245000) 20,550,000

Unamortized bond issue costs 245,000

December 31, 2003 (recording amortization of bond issue costs)

Bond issue expense (245,000/10) 24,500

3.4.2 Issuance of serial bonds

So far, we have considered term bonds having a single fixed maturity date Another type of bond contract known as serial bond provides for payment of the principal in periodic installment As

in the case of the term bonds, serial bonds may be issued at premium or discount Serial bond provides for payment of the principal in periodic installment The proceeds of serial bond issue are the present value of the series of principal payment plus the present value of the interest payments, all the effective interest rate equals the proceeds received for the bonds

Example: Assume that in early January, 2003, a company issued Br 500,000 of ten-year, 10% serial bonds, to be repaid in the amount of Br 50,000 each year Assume that interest payments are made annually and that the bond issue costs were Br 25000 As to the yield rate, assume the following two cases:

Case 1: 9%

Case 2: 11%

Required

1 Present the journal entry to record the bond issue cost

2 Compute the proceeds received on the bonds under case1

3 Compute the amount of bond premium at the time of issuance under case 1

4 Compute the proceeds received on the bonds under case 2

5 Compute the amount of bond discount at the time of issuance under case 2

6 Present the journal entry to record the issuance of the bonds under case 1

7 Present the journal entry to record the issuance of the bonds under case 2

8 Present the journal entry for the amortization of the bond issue cost for 2003

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Solution

1 To record bond issue costs

Unamortized bond issue costs 25,000

2 Proceeds under case 1

End of Interest due

(10% principal left)

Principal due Total amount

due Discounting factor (9%) Present value

4 Proceeds under case 2

End of Total amount due Discounting factor (9%) Present value