444 AIOU Solved Assignment 2 Spring 2019

AIOU SOLVED ASSIGNMENT 2019

                                         by Shah Rukh

ASSIGNMENT No. 02

Advance Accounting (444) BA/ B.Com

Spring, 2019

Q. 1 (a) What do you know about lease? Describe. Also describe the criteria for identification of finance lease.

A capital lease is a lease in which the lessor only finances the leased asset, and all other rights of
ownership transfer to the lessee. This results in the recordation of the asset as the lessee's
property in its general ledger, as a fixed asset. The lessee can only record the interest portion of a
capital lease payment as expense, as opposed to the amount of the entire lease payment in the
case of the more common operating lease.
Note: The capital lease concept was replaced in Accounting Standards Update 2016-02 (released
in 2016 and in effect as of 2019) with the concept of a finance lease. Consequently, the following
discussion is for historical purposes only.
The criteria for a capital lease can be any one of the following four alternatives:
 Ownership. The ownership of the asset is shifted from the lessor to the lessee by the end of
the lease period; or
 Bargain purchase option. The lessee can buy the asset from the lessor at the end of the
lease term for a below-market price; or
 Lease term. The period of the lease encompasses at least 75% of the useful life of the
asset (and the lease is noncancellable during that time); or
 Present value. The present value of the minimum lease payments required under the lease
is at least 90% of the fair value of the asset at the inception of the lease.
If a lease agreement contains any one of the preceding four criteria, the lessee records it as a
capital lease. Otherwise, the lease is recorded as an operating lease. The recordation of these two
types of leases is as follows:
 Capital lease. The present value of all lease payments is considered to be the cost of the
asset, which is recorded as a fixed asset, with an offsetting credit to a capital lease liability
account. As each monthly lease payment is made to the lessor, the lessee records a combined
reduction in the capital lease liability account and a charge to interest expense. The lessee also
records a periodic depreciation charge to gradually reduce the carrying amount of the fixed asset
in its accounting records.
 Operating lease. Record each lease payment as an expense. There is no other entry.
Given the precise definition of a capital lease, the parties to a lease are usually well aware of the
status of their lease arrangement before a lease is signed, and typically write the lease agreement
so that the arrangement will be clearly defined as either a capital lease or operating lease.

PRESENT VALUE
The aggregate of present value of each periodic rental (or lease payment) over the lease term should
be more than 90% of the market value of the underlying asset at the beginning of the lease. For
example, if the lease rentals of the leased assets whose value is $100,000 are $12,000 every year for
say 10 years, the present value of these lease rentals @ 5% would be $92,660.82. We can see that
the present value is 92.66% which is more than 90% of the current market value of $100,000. This
lease criterion is therefore satisfied for the above lease arrangements.
Therefore, all these listed capital lease criteria are conditions for capital leases and if a lease
agreement has any one of these criteria, then the lessee should record the agreement as a capital
lease. Otherwise, it is known as an operating lease agreement.

EXAMPLE OF CAPITAL LEASE CRITERIA
Suppose you saw a nice machinery that you would love to own for your business, it has everything you
need as an ideal machinery, but the problem is that you don’t have the money to outrightly buy or pay
for it. Having a knowledge of capital lease, you contact the owner of the machinery owner to know if
he would be willing to finance the purchase of the machinery as long as you agree to make the lease
payments. And since you are not willing to return the car after the lease agreement, you can enter
what is called a capital lease agreement (which satisfies the criteria explained above) and you take
charge of all maintenance, repairs while still paying for your monthly payment depending on the lease agreement.

CAPITAL LEASE CRITERIA FASB
Capital lease criteria according to Financial Accounting Standards Board (FASB) amendment of 2016
asked every corporation operating in the US to capitalize all lease above one year with. This
amendment should become effective and fully implemented by December 15, 2018. This capital lease
amendment has a serious effect on most corporations in the US. This issue is as a result of GAAP view
of the capital lease as a purchase of assets if some criteria are met instead of a rental agreement that
it is.

CAPITAL LEASE REQUIREMENT DISCLOSURES
For a lease agreement to take place, the lessor and lessee are required under the GAAP disclosure
form to disclose the following information.
1. The general leasing arrangements should be properly described
2. There should be a gross amount disclosure of assets and it should be recorded under capital
leases.
3. The disclosure should also show a major asset class and accumulated depreciationamount.
4. There should be a separate identification of the asset obligations. This information is found on
the balance sheet of the organization and appropriate classification of the current and noncurrent
assets.
5. There should be a minimum of all future lease payments for the next five years in total.
6. The whole net investment components as of the date of which each balance sheet was
presented should show:
7. The minimum payment to be received in the future. A number of separate deductions should be
made such as representing executor costs, profits that are in the minimum lease payments
8. It also shows the minimum lease payments receivable for uncollectible accumulated allowances.
9. The benefits (unguaranteed) accruing to the lessor should be disclosed
10. Unearned income included offsetting the direct cost that is initially charged against the income
for the different period with respect to the presented income statement.

(b) On January 01, 2012 Mr. Aqeel took possession of a Machine from Mr. Nouman and enters into lease agreement for 10 years. Annual rentals are payable at the beginning ofeach year amounting Rs. 12,000. Useful life of the machine is 15 years and interest rate implicit in the lease was agreed 13%. Fair value of the machine was Rs. 140,000. Required: You are required to identify the type of lease and Pass the necessary journal entries in the books of lesser and lessee both to record the rental payment. 

Q. 2 What do you understand by the terms Amalgamation, Absorption and Reconstruction? How will you distinguish among them? 

Amalgamation is when two or more companies merge. It is the conversion of two companies and two
balance sheets into one company and one (combined) balance sheet. In amalgamation, the identity of
both the companies exist and survive. It is the pooling of assets and liabilities and interest of two
companies. It usually consists of two companies of same size and stature.
Example: Maruti motors(India) and Suzuki(Japan) were amalgamated to form Maruti Suzuki.
Absorption refers to takeover. In absorption, one company is taken over by another and hence it loses
its own core identity. The identity of absorbing company only sustains. Here, it's not pooling of
interest. It is the dominance of absorbing company. Here, it is the taking of a small company by a
comparatively bigger business company.
Example: Takeover of Myntra by Flipkart.

Reconstruction

It includes internal reconstruction and external reconstruction.
Internal reconstruction is carried when when the company faces consistent financial pressure and is
incurring loss since long. Here, there might be some alterations in share capital and waiver of some
debts. The company is neither liquidated nor any new company is formed. “ And reduced” words are to be added in balance sheet . This procedure includes involvement of court and is bit tedious and
lengthy.
External reconstruction refers to forming of a new company to takeover the assets and liabilities of old company. Here, the new company if formed with the deliberate purpose of taking over the old
company. And hence here old company is liquidated and new company is formed. It doesn't require
court’s permission and takes less time as compared to internal reconstruction.

Legal process of amalgamation

An amalgamation is, in fact, a specific subset within a broader group of “business combinations”. There
are three main types of business combinations, which are outlined below in more detail. It’s important
to understand the subtle differences when talking about mergers, acquisitions, and amalgamations.
1. Acquisition (two survivors): The purchasing company acquires more than 50% of the shares
of the acquired company and both companies survive.
2. Merger (one survivor): The purchasing company buys the selling company’s assets. The sale
of the acquired company’s assets leads to the survival of only the purchasing company.
3. Amalgamation (no survivors): This third option creates a new company in which none of the
pre-existing companies survive.
As you can see with the above examples, the difference comes down to the surviving companies. In
an amalgamation, a new company is created and none of the old companies survive.

Why perform an amalgamation?

Amalgamations are often done when competing companies engaged in similar business would achieve
some synergy or cost savings by combining their operations, which can be quantified in a financial
model. By contrast, it can also occur when companies want to enter new markets or get into new
business and mergers and acquisitions as a way to achieve that. Here is a list of reasons why
companies perform consolidations:
 Access to new markets
 Access to new technologies
 Access to new clients / geographies
 Cheaper financing for a bigger company
 Cost savings (synergies) achieved through bargaining power with suppliers and clients
 Eliminating competition

Who is involved in amalgamations?

An amalgamation typically requires investment bankers, lawyers, accountants, and the executives at
each of the combining companies. The bankers will typically perform extensive financial
modeling and valuation to evaluate the potential transaction and advise the individual corporations. In
parallel to this process, the lawyers will work with the bankers and their corporate clients to determine which of the above legal structures is optimal: acquisition, merger, or amalgamation.
The amalgamation of two companies in corporate circles means that the two entities are combined into a single company. In accounting, it means the combination of two or more financial statements. For instance, a group of companies can consolidate the financial statements of each individual company and report their financials as one single entity.

Amalgamation versus Absorption

Amalgamation refers to the joining of multiple companies and should be differentiated from absorption, which is the process by which a more- powerful company takes control of a weaker one. The transferor company is the company that is amalgamated, while the transfer company is the company into which the transferor company is amalgamated into.

Q. 3 Explain the relationship between solvency, liquidity and profitability. 

Liquidity ratios and solvency ratios are tools investors use to make investment decisions. Liquidity
ratios measure a company's ability to convert its assets to cash. On the other hand, solvency ratios
measure a company's ability to meet its financial obligations.
Solvency ratios include financial obligations in both the long and short term, whereas liquidity ratios
focus more on a company's short-term debt obligations and current assets.
Solvency Ratios
The solvency ratio is a comprehensive measure of solvency, as it measures a firm's actual cash flow
rather than net income—by adding back depreciation and other non-cash expenses to assess the
company’s capacity to stay afloat. It measures this cash flow capacity in relation to all liabilities, rather than only short-term debt. This way, the solvency ratio assesses a company's long-term health by evaluating its repayment ability for its long-term debt and the interest on that debt.
The solvency ratio is used often by prospective business lenders to discover whether a company’s cash flow is sufficient to meet its short-and long-term liabilities. The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.
In contrast to liquidity ratios, solvency ratios measure a company's ability to meet its total financial
obligations. The solvency ratio is calculated by dividing a company's net income and depreciation by its short-term and long-term liabilities. This indicates whether a company's net income is able to cover it total liabilities. Generally, a company with a higher solvency ratio is considered to be a more favorable investment.

Liquidity Ratios

Liquidity ratios gauge a company's ability to pay off its short-term debt obligations and convert its
assets to cash. It is important that a company has the ability to convert its short-term assets into cash
so it can meet its short-term debt obligations. A healthy liquidity ratio is also essential when the
company wants to purchase additional assets. For example, internal analysis regarding liquidity ratios
involves using multiple accounting periods that are reported using the same accounting methods.
Comparing previous time periods to current operations allows analysts to track changes in the
business. In general, a higher liquidity ratio shows a company is more liquid and has better coverage
of outstanding debts. One common liquidity ratio is the current ratio. The current ratio measures a
company's ability to meet its short-term debt obligations. It is calculated by dividing its current assets
by its current liabilities. Generally, a higher current ratio indicates that the company is capable of
paying off all of its short-term debt obligations. Another common liquidity ratio is known as the quick ratio. It measures a company's ability to meet its short-term obligations with its most liquid assets and therefore excludes inventories from its current assets. It is also known as the "acid-test ratio"
Liquidity ratio analysis may not be as effective when looking across industries as various businesses
require different financing structures. Liquidity ratio analysis is less effective for comparing businesses
of different sizes in different geographical locations.

The following data is available from the financial statements of XYZ Ltd, you are required to calculate:

(i) Current Ratio
(ii) Inventory Turnover Ratio
(iii) Debtors Turnover Ratio
(iv) Creditors Turnover Ratio (12)
Opening Stock Rs. 47,000 Sundry debtors Rs. 42,000
Closing stock 53,000 Cash 10,000
Sales less returns 2,52,000 Bank 8,000
Provision for bad debts 2,000 Bills Receivable 15,000
Sundry Creditors 32,000 Provision for Taxation 15,000
Loose tools 4,000 Bills Payable29,000
Purchases 1,80,000 Marketable securities 8,000

Ans. 

Q. 4 (a) What do you know about Hire Purchase system? Explain. 

By now you must have been familiar to various aspects of Book-keeping and Accountancy. You must
have understood the concept of double entry system. Now-a-days the books of accounts are
maintained under double entry system by all big business houses and multinationals. You know that
the sales is the Key factor of success of business. The profit of a business always depends on the
volume of its sales. A big business house can effect sales on cash basis as well as on credit basis. The
credit sales are very important and essential for the growth of business. The sale proceeds under such

sales are not immediately collected but are collected under certain arrangements such as Hire-
purchase system or Instalment payment system or collection after a certain period together with

interest on outstanding balances. Hire-purchase system is the most secured and effective tool of
collecting the proceeds of a credit sale.
Hire-puchase system is a special system of purchase and sale of goods. Under this system purchaser
pays the price of the goods in instalments. The instalments may be annual, six monthly, quarterly,
monthly fortnightly etc. Under this system the goods are delivered to the purchaser at the time of
agreement before the payment of instalments but the title on the goods is transferred after the
payment of all instalments as per the hire-purchase agreement. The special feature of a hire-purchase
transaction is that the payment of every instalment is treated as the payment of hire charges by the
purchaser to the hire vendor till the payment of the last instalment.. After the payment of the last
instalment, the amount of various instalments paid is appropriated towards the payment of the price of
the goods sold and the ownership or the goods is transferred to the purchaser. Thus hire-purchase
means a transaction where the goods are sold by vendor to the purchaser under the following
conditions :
 the goods will be delivered to the purchaser at the time of agreement.
 the purchaser has a right to use the goods delivered.
 the price of the goods will be paid in instalments.
 every instalment will be treated to be the hire charges of the goods which is being used by the
purchaser.
 if all instalments are paid as per the terms of agreement , the title of the goods is transferred
by vendor to the purchaser.
 if there is a default in the payment of any of the instalments, the vendor will take away the
goods from the possession of the purchaser without refunding him any amount received earlier in the
form of various instalments.
Characteristics of Hire-purchase system
Before discussing the characteristics of hire-purchase system, we must know what is a hire purchase
agreement and what are the contents of a hire-purchase agreement. Hire-purchase agreement means
a contract between the hire vendor and the hire purchaser regarding the sale of goods under certain
conditions. Usually every hire-purchase agreement shall contain the following terms:
 the cash price of the goods, cash price means the price at which goods may be purchased
against cash payment.
 the hire-purchase price, hire purchase price means the total amount which is payable by the
hire-purchaser under the agreement.
 the date on which the hire-purchase agreement will commence.
 the description of the goods that will be delivered to the hire-purchaser at the commencement
of the agreement.
 the number of instalments to be paid by the hire-purchaser along with the amount of each
instalment and the date of payment of each instalment.
 the down payment if any, the down payment means the amount which is required to be paid by
hire-purchaser to the hire vendor at the time of commencement of hire-purchase agreement.
 the rate interest charged by the hire vendor (optional).
Characteristics of Hire-Purchase System
The characteristics of hire-purchase system are as under
 Hire-purchase is a credit purchase.
 The price under hire-purchase system is paid in instalments.
 The goods are delivered in the possession of the purchaser at the time of commencement of the
agreement.
 Hire vendor continues to be the owner of the goods till the payment of last instalment.
 The hire-purchaser has a right to use the goods as a bailer.
 The hire-purchaser has a right to terminate the agreement at any time in the capacity of a
hirer.
 The hire-purchaser becomes the owner of the goods after the payment of all instalments as per
the agreement.
 If there is a default in the payment of any instalment, the hire vendor will take away the goods
from the possession of the purchaser without refunding him any amount.
(b) Black & White Co., bought a Machine on 1st January, 2012 the cash price being
Rs. 81,900. The purchase is on hire purchase basis, Rs. 18,000 being paid on the singing of
the contract and thereafter Rs. 18,000 being paid annually for four years. Interest was
charged @ 5%. Depreciation was written off at the rate of 10 % p.a on the diminishing
balance method.
Required: Give journal entries and necessary ledger accounts in the books of Black & White
Co., and the Vendor. (10)
Ans. Breakup table
Details Cash Price Installment interest principal Total
On 1st Jan 2012 81900 - - -
Less dawn payment (18000) - - -
Outstanding balance 63900 - - -
Less: 1st installment (14805)
49095

3195 14805 18000

2
nd installment 15545
33550

2455 15545 18000

3
rd Installment (16323)
17227

1677 16323 18000

4
th installment 17227 861 17139 18000



Journal

Black and White Vender

Machinery 81900
Hire Vender A/C 81900
Machinery acquired on HP

Black and White 81900
H.P Sale 81900
Machinery acquired on HP

Hire vender 18000
Bank 18000
(Down payment paid)

Bank 18000
H.P A/C 18000
(Down payment paid)

Interest A/C 3195
Hire vender A/C 3195
(Interest due at the time of installment
3195,2455,1677 and 861)

H.P A/C 3195
Interest 3195
(Interest became due, 3195 , 2455,
,1677 and 861)

Depreciation 8190
Machinery 8190
(Depreciation change on assets : 8190,
7371, 6634, 5970)

Bank 3195
Hire purchase 3195
(Interest & amount receive 3195 , 2455,
1677 and 861)

Profit and Loss A/C 3195
Interest 3195
(Interest transfer to P and L 3195, 2455,
1677 and 861)

Interest 3195
P and L 3195
(Interest transfer to P and L 3195, 2455,
1677 and 861)

P and L 8190
Depreciation 8190
(Depreciation transfer to P and L 8190,
7371, 6634 and 5970)

H.P sale 81900
Transfer A/C 81900
(H.P closing to trading A/C)

Machinery Account

Date Particular Amount Date Particular Amount
1-1-12 Vendor 81900 31-12-12 Dep
Balance c/d

8190
73710
81900 81900



1-1-13 Balance b/d 73710 31-12-13 Dep
Balance c/d

7371
66339
73710 73710

1-1-14 Balance b/d 66339 31-12-13 Dep
Balance c/d

6634
59705
66339 66339

1-1-15 Balance b/d 59705 31-12-13 Dep
Balance c/d

5970
53735
59705 59705

1-1-16 Balance b/d 53735

Interest Account

1-1-12 Vendor 3195 31-12-12 Profit & Loss
A/C

3195

1-1-13 Vendor 2455 31-12-12 Profit & Loss
A/C

2455

1-1-14 Vendor 1677 31-12-14 Profit & Loss
A/C

1677

1-1-15 Vendor 861 31-12-15 Profit & Loss 861

Depreciation Account

1-1-12 Machinery 8190 31-12-12 P & L A/C 8190
1-1-13 Machinery 7371 31-12-13 P & L A/C 7371
1-1-14 Machinery 6634 31-12-14 P & L A/C 6634
1-1-15 Machinery 5970 31-12-15 P & L A/C 5970
Ledger Account in the book of black and white Co.

Date Detail Amount Date Details Amount

Bank (Downpay-
ment)

18000 1-1-12 Machinery 81900

31-12-12 Bank (1st
Installment)
Balance c/d

18000

49095

Interest 3195


85095 85095

31-12-13 Bank
Balance c/d

18000
33550

1-1-13 Balance b/d
Interest

49095
2455
51550 51550

31-12-14 Bank
Balance c/d

18000
17227

1-1-14 Balance b/d
Interest

33550
1677
35227 35227

31-12-15 Bank
Balance c/d

18000
Nil

1-1-15 Balance b/d
Interest

17227
773
18000 18000

Q. 5 (a) What is Profit & Loss Appropriation Account? Which items are usually found on the debit and credit sides of such account, explain each of them.
Profit and loss appropriation accounts are necessary for businesses, especially partnerships, because
they help account for the expenditures and income that are included in profit and loss statements.
These accounts should not be confused with the typical profit and loss account, but rather seen as an
extension of it. Whereas the former is more general in nature, the profit and loss appropriation account is far more specific.

Profit and Loss Account

The profit and loss account serves the purpose of showing how much a company has available, in
terms of surplus funds, at the end of a specific accounting period. These accounts do not necessarily
provide a specific answer as to how funds will be spent. However, they do provide an idea of what
money is available for distribution among partners or for the purpose of being held in a reserve
account until the decision has been made regarding how to spend the surplus. If no surplus exists, the
statement indicates the losses for the accounting period.

Profit and Loss Appropriation Account

The profit and loss appropriation account should be treated as a separate account from the profit and
loss account. The appropriation account is designed to provide an indication of how profit transferred
from the profit and loss account is spent. Appropriations are generally placed into one of four broad
categories: funds designated for removal by partners, capital reserves, reserves earmarked to improve
capital and surplus funds to be carried into the next accounting period.

Debits of Funds

The profit and loss appropriation account is set up like other general ledgers. It usually consists of a
debit column and a credit column. The debits include items such as the funds that are transferred back
to the general profit and loss account at the end of the accounting period. Other debits include money
put in the general company reserve accounts, accounts designated for dividend payments and
payments made on items such as income taxes.

Credits of Funds

When funds are added to the profit and loss appropriation account, these are designated as a credit in
the records. The primary entry in the account comes in the form of the surplus money transferred to
the account from the profit and loss account at the end of the previous accounting period. Net profit at
the end of the current year is also added to this account. Other credits may include money taken from
the general reserve or any other account in which a surplus can be designated for a specific purpose in the profit and loss appropriation account.
Profit and Loss Appropriation account is the part of financial statements of company. It is different from profit and loss appropriation account of partnership firm . When a company makes his profit and loss account, its net profit is transferred to the credit side of profit and loss appropriation account. Profit and loss account shows only the net profit or net loss from operation of business but profit and loss appropriation accounts shows all non- operational adjustment which is needed for proper distribution of net profit between shareholders and company for future growth.
(b) Write notes on:
 (i) Participation Term Certificates
(ii) Deferred expenses on issue of
shares
(c) Proposed Dividend
 (iv) Intangible Assets (10)

(i) Participation Term Certificates

The mode was originally intended for medium- and longterm fixed capital needs of business entities
until these have been largely replaced by term finance certificates (TFCs) which are fundamentally
based on mark-up. TFCs, therefore, do not and have not participated in losses of the investee
companies. It should, however, be appropriate to emphasise that since the financial and economic
relationship envisaged under PTCs is not that of a debtor and a creditor but as partners in business
venture providing capital resources which are usually scarce, a great deal of business judgement on
the part of the financier is imperative in the matter of portfolio selection. I would view this aspect of
interest-free financing not as its weakness but as the fundamental premises on which the hope of the
very success of interest-free participatory financing shall be dependent. The inclination of the financiers to divert the scarce capital resources only to such projects and entities where these can be used profitably and efficiently should have served as a built-in guarantee or at least a safeguard against financial catastrophes but in practice, we observed otherwise. This factor should have assumed greater significance in the context of public-sector undertakings as well, some of which are now being privatised, who according to the then policy of financial reorientation, should have been denied budgetary support for their balancing and modernisation or for new investment.
This aspect of economic policy, if practised objectively both in public and private sectors, shall augur
well in promoting competition for the scarce capital finances and resources available on the market.
This by itself should infuse competition between the nationalised public sector and a healthy private
sector purely on considerations of commercial profits. 1 mention this because it is not uncommon to
hear from public-sector undertakings which are in red that profit is not their business or consideration
and that they are involved in the high-sounding game of achieving social objectives. While there is no
denying the fact that the attainment of social objectives by any enterprise, let alone a public-sector
enterprise, is a commendable pursuit but that should not be a garb to camouflage their inefficiencies
and losses. Another inherent advantage in a profit-sharing arrangement is that it would provide the
much-needed incentive for the mobilisation of savings which would be made possible through efficient
use of capital.

ii) Deferred expenses on issue of shares

Prepaid expenses in accounting are those expenses which are to be incurred in future but the amount
for the same has already been paid in advance. Think of it as expenditure paid in one accounting
period, but for which the related asset will not be consumed until a future period. It is an asset
because the expense has already been incurred however the benefits are yet to be realized.
Importance of Prepaid Expenses Asset
Saving: One good prepaid expense example is rent where the company paid for next 12 months in
advance. In other words, the company will be paying rent at today’s rate regardless of any rent
increase in the coming months. This results in potential savings which can be quite a significant
factoring inflation in next months.
Tax deductions: Many businesses prepay some of their future expenses to have additional business
deductions. The business owner can use these for tax deductions; however, there are various rules to
avail the tax benefits and one of the basic rules is that entity cannot deduct it in the same financial
year. Therefore, if the company paid maintenance for your vehicles for five years, the company can
only deduct a portion of it this year and not the entire deduction.

(iii) Proposed Dividend

A dividend is a distribution made to shareholders that is proportional to the number of shares
owned. A dividend is not an expense to the paying company, but rather a distribution of its
retained earnings.
There are four components of the financial statements. The following table shows how dividends
appear in or impact each one of these statements (if at all):

Type of Financial Statement

Impact of Dividends

Balance sheet Will reduce the balance in the Cash and Retained Earnings accounts once

the dividends have been paid

Income statement Dividends have no impact here, since they are not an expense
Statement of cash flows Reported as a use of cash in the Cash Flow from Financing Activities section
Statement of retained
earnings*

Reported as a reduction in retained earnings

* Also known as the statement of changes in stockholders' equity
A brief narrative description of a dividend issuance may also be included in the notes that
accompany the financial statements, though these notes may not be included if the statements
are only issued for internal use.
Before dividends are paid, there is no impact on the balance sheet. Paying the dividends reduces
the amount of retained earnings stated in the balance sheet. Simply reserving cash for a future
dividend payment has no net impact on the financial statements.
If a dividend is in the form of more company stock, it may result in the shifting of funds within
equity accounts in the balance sheet, but it will not change the overall equity balance.

(iv) Reserves

A reserve is profits that have been appropriated for a particular purpose. Reserves are sometimes set
up to purchase fixed assets, pay an expected legal settlement, pay bonuses, pay off debt, pay for
repairs and maintenance, and so forth. This is done to keep funds from being used for other purposes,
such as paying dividends or buying back shares. The board of directors is authorized to create a
reserve.
A reserve is something of an anachronism, because there are no legal restrictions on the use of funds
that have been designated as being reserved. Thus, funds designated as a reserve can actually be used
for any purpose.
Reserve accounting is quite simple - just debit the retained earnings account for the amount to be
segregated in a reserve account, and credit the reserve account for the same amount. When the
activity has been completed that caused the reserve to be created, just reverse the entry to shift the
balance back to the retained earnings account.
For example, a business wants to reserve funds for a future building construction project, and so
credits a Building Reserve fund for $5 million and debits retained earnings for the same amount. The
building is then constructed at a cost of $4.9 million, which is accounted for as a debit to the fixed
assets account and a credit to cash. Once the building is completed, the original reserve entry is
reversed, with $5 million debited to the Building Reserve fund and $5 million credited to the retained
earnings account.
A reserve line item does not necessarily have to be presented separately in the balance sheet; it may
be aggregated into the retained earnings line item.

(v) Intangible Assets

An intangible asset is a non-physical asset that will be consumed over more than one accounting
period. Examples of intangible assets are copyrights, patents, and licenses. The accounting for an
intangible asset is to record the asset as a long-term asset and amortize the asset over its useful
life, along with regular impairment reviews. The accounting is essentially the same as for other
types of fixed assets. The key differences between the accounting for tangible and intangible fixed
assets are:
 Amortization. If an intangible asset has a useful life, amortize the cost of the asset over
that useful life, less any residual value. Amortization is the same as depreciation, except that
amortization is applied only to intangible assets. In this context, useful life refers to the time
period over which an asset is expected to enhance future cash flows.
 Asset combinations. If several intangible assets are operated as a single asset, combine
them for the purposes of impairment testing. This treatment is probably not suitable if they
independently generate cash flows, would be sold separately, or are used by different asset
groups.
 Residual value. If any residual value is expected following the useful life of an intangible
asset, subtract it from the carrying amount of the asset for the purposes of calculating
amortization. Assume that the residual value will always be zero for intangible assets, unless
there is a commitment from another party to acquire the asset at the end of its useful life, and the
residual value can be determined by reference to transactions in an existing market, and that
market is expected to be in existence when the useful life of the asset ends.
 Useful life. An intangible asset may have an indefinite useful life. If so, do not initially
amortize it, but review the asset at regular intervals to see if a useful life can then be determined.
If so, test the asset for impairment and begin amortizing it. The reverse can also occur, where an
asset with a useful life is judged to now have an indefinite useful life; if so, stop amortizing the
asset and test it for impairment. Examples of intangible assets that have indefinite useful lives are
taxicab licenses, broadcasting rights, and trademarks.
 Useful life revisions. Regularly review the duration of the remaining useful lives of all
intangible assets, and adjust them if circumstances warrant the change. This will require a change
in the remaining amount of amortization recognized per period.
 Life extensions. It is possible that the life of some intangible assets may be extended a
considerable amount, usually based on contract extensions. If so, estimate the useful life of an
asset based on the full duration of expected useful life extensions. These presumed extensions
may result in an asset having an indefinite useful life, which avoids amortization.
 Straight-line amortization. Use the straight-line basis of amortization to reduce the carrying
amount of an intangible asset, unless the pattern of benefit usage associated with the asset
suggests a different form of amortization.
 Impairment testing. An intangible asset is subject to impairment testing in the same
manner as tangible assets. Recognize impairment if the carrying amount of the asset is greater
than its fair value, and the amount is not recoverable. Once recognized, the impairment cannot be
reversed.
 Research and development assets. If intangible assets are acquired through a business
combination for use in research and development activities, initially treat them as having
indefinite useful lives, and regularly test them for impairment. Once the related research and
development activities have been completed or abandoned, charge them to expense.
In general, you should recognize costs as incurred when they are related to internally developing,
maintaining, or restoring intangible assets that have any of the following characteristics:
 There is no specifically identifiable asset
 The useful life is indeterminate
 The cost is inherent in the continuing operation of the business

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