CHAPTER FIVE

TIME VALUE OF MONEY

The timing of the returns on investments has an important effect on the worth of the investment
(asset), and the timing of debt repayments has similarly important effect on the value of the debt
commitment (liability). As a financial expert, you will be expected to make present and future value
measurements and to understand their implications.
The purpose of this chapter is to present the tools and techniques that will help you measure the
present value of future cash inflows and outflows.
Learning Objectives
After you have studied this chapter, you will:
1. Understand the time value of money, which underlines all interest calculations and a wide
range of accounting issues.
2. Understand the difference between simple and compound interest
3. Recognize the difference between future value and present value as these terms apply to both
single payment amounts and annuities
4. Understand the distinction between an ordinary annuity and an annuity due
5. Be able to compute future and present values of both single payments and annuities
6. Be able to solve valuation problems by combining present and future value computations for
a single payments and annuities

5.1 Introduction

It is a concept based on the idea that a dollar received today is worth more than a dollar promised at
some time in the future. In other words, one hundred birr in hand today will be worth more in one
year's time than a second birr one hundred received one year from today. The assumption is that
today's birr can be put to work earning interest.
The time value of money or the cost of using money overtime is called interest. It is the excess of cash
(resources) received or repaid over and above the amount lent or borrowed (principal)
Interest expense is the cost of the excess resources to the borrower for the use of the money.
Interest revenue:- is the benefit of the excess resources ( payments made in excess of the principal) by
the lender of the money over time.

Application in Accounting
Accountants find many situations in which a reliable measurement of transactions depends on the
present value of future cash inflows and outflows. Some of the examples that needs measuring present
or future values of cash flows are listed below.
1. To value long term receivables and payables. For example; at what amount to record a promise to
be received or pay $ 100,000 after 3-yearas
2. For measuring value of assets acquired by issuing long-term debt. Example:- machinery acquired
by issuing a note for $ 80,000 payable after 4-years.
3. Accounting for sinking fund (determining of periodic payments required to provide fund for the
settlement of long-term debt or preferred stock. Example :- What amount should be deposited
yearly at a bank to repay a $ 100,000 loan after 5-years.
4. Accounting for bonds:- to compute interest expense and amortization of premium or discount by
the effective interest method and also to determine present value and interest revenue on
investment in bonds.
Example: How much is the proceeds for 1000 bonds acquired at$100, 8% on January 1, with
interest payable semiannually.
5. Accounting for pensions:- To measure pension costs ( past and current) and funding programs for
pensions . Example!- How much equal annual deposits should I made at the beginning of each 30
years so that, I will have $ 500,000 to acquire a truck at the end of the 30 year.
6. Installment contracts:- measuring periodic payments on long term purchase or sale contracts.
Example :- How much were the purchase price of 2 computers if the buyer was asked to pay
$5,000 each for 5 terms in semi-annual installments starting from today.

5.2 Simple Interest and Compound interest.

Interest, as it is described above, is the growth in a principal amount representing the fee charged for
the use of money for specified time period. The amount of interest involved in any financing
transaction is a function of three variables:-
 Principal: - the amount borrowed or invested
 Interest rate: - a percentage of the outstanding principal charged for using money over time
 Time: - the number of years or fractional portion of a year that the principal is outstanding.
The larger the principal amount, or the higher the interest rate, or the longer the time period, the larger
will be the dollar amount of interest.

Factors that affect the determination of interest rate are:-

 Risk of non payment
- Risk of business or customer's credit worthiness. Usually other factors being equal,
the higher the credit risk of the borrower the higher the interest rate set by lender
 Inflation:- When inflation expectations are high, interest rates are high to avoid the lenders
being paid back with less valuable dollars.

5.2.1. Simple Interest

Simple Interest is the return on principal amount for one time period. When applied to long-term
transactions extending over multiple years, simple interest is based on the principal amount
outstanding at the beginning of each year. Therefore, interest is paid only on the initial principal and
not on interest accumulated but not yet paid.
The equation for computing simple interest is
Interest amount = Px i x n
Where P = Principal
i = Interest rate per period
n = Number of interest periods
Example:- If you deposit 10,000 Birr in Dashen Bank saving account that pays 6% simple interest
annually. What is the amount of your interest income for
i) 1-Year
ii) 3- years.
Given Principal (p) 10,000 Birr
Interest rate (i) = 6%
Number of periods (n) = 1 year, 3 years
Interest amount = PxiXn
For a year = 10,000 x 6 x1
100
= 600 Birr
Year Principal Annual Accumulated Simple Interest
Begining interest Interest
Balance Rate 6%

1 10,000 Br. 600 Br. 600Br. (10,000x6%)......600 Br,

2 10,000 Br. 600 Br. 1200 Br. (10,000x6%)......600 Br,
3 10,000 Br. 600 Br. 1800Br. (10,000x6%)......600 Br,
Total 1,800 Br.
Therefore we can observe from the above summary that the interest income for each year is $ 600 and
the accumulated interest income you will have after 3 years is 1,800 Br (summation of 3 years
income).

5.2.2. Compound Interest

Compound Interest is computed on principal and on any interest earned that has not been paid or
withdrawn. Unlike simple interest, compound interest computes interest for interest earned to date
(accumulated interest) by assuming as part of principle amount.
Example
Assume in the above example your 10,000 Birr deposit in Dashen Bank saving account will earn 6%
annual compound interest. Assume you will not withdraw any interest during the deposit period.

Required :- How much interest income you will have at first year and at the end of 3rd year.
Year Principal Annual Annual Accumulated Accumulated
Begining interest Interest Interest year end
Balance Rate balance

1 10,000 6% 600.00 600.00 10,600.00

2 10,600 6% 636.00 1,236.00 11,236.00
3 11,236 6% 674.16 1,910.16 11,910.16

Activity 1
Dear colleagues to check your understanding, assume all other things being equal, if you are asked to
choose between investing your money in an investment that considers simple interest and compound
interest which one do you prefer? Why?

Feedback
Simply you can take the previous illustrations and when you see the interest accumulated at the end of
second year it is $ 1,236 but $ 1,200 under simple interest. Therefore compound interest produces $
36, more interest than simple interest.

In the above example and generally interest is expressed in terms of annual rate but sometime in
enterprises the compounding period is less than one year.
When the compounding period of interest is less than one year (semi annually, quarterly, monthly)
and interest is expressed in terms of annual rate, the annual interest rate and the number of years
involved must be converted to correspond to the length of the interest consideration period.
Steps to convert:
 Divide the annual rate by the number of compounding periods per year
 Multiply the number of years involved by the number of compounding
periods per year.

Example:- Assume in the above example Birr 10,000 deposited in Dashen Bank for 3-years at 6%
annual interest rate compounded quarterly. Determine the interest rate per compounding Period and
number of Compounding Periods.

Given Annual rate of Interest 6%

Compounding periods = 4 times in a year
Number of deposit Periods = 3 Years
Solution:-
 6%
Interest rate per compounding Period = Annual rate of interest =  1.5%
4
Number of computing
Periods per Year

Number of compounding period = Number of Deposit x Number of compounding

Period periods per year

= 3 years x 4 = 12 Periods

Activity 2
Assume you want to deposit your money in a bank that will give you a high amount interest income
and banks offered the following 3 independent options.
i. Depositing in a saving account, which offers you to earn 12% compound interest per year
ii. Depositing in a saving account, which offer you to earn 12% annual interest compounded
semiannually.
iii. Depositing in a saving account, which offer you to earn 12% annual interest compounded
quarterly.
Required: Which alternative will give you the highest amount of return (interest income) and can
you say that the amount of interest is a function of the interest rate and number of interest periods
(keeping equal principal amounts under each option)?
______________________________________________________________________________
____________________________________________________________
_____________________________________________________________________
 Feedback
Let us take each option by assuming that the deposit amount is $ 1.00 to compute this we can use the
future value interest tables
i. In the first option $ 1.00 deposited at 12% interest compounded annually it would have
interest income of $ 0.12
ii. If $ 1.00 was deposited at 12% interest compounded semiannually then the interest rate
for each interest computation period would be 6%(12%/2) and the interest income for 2
periods would become 0.1236
iii. If $ 1.00 was deposited at 12% interest compounded quarterly the interest income for
each interest computation period would be 3%(12%/4) and the interest income for 4
periods would be 0.12551
Therefore we can infer from the above illustration that the return amount will increase with the
increase in the number of interest computation periods, as well as it also increases with the
increase in interest rate per period.

5.3 Future and present value of a single sum

Q1. If Birr 50,000 is available for investment today and the current annual rate is 12% compounded
semiannually, what total investment amount will result at the end of second year?
Q2. It is known that Birr 100,000 will be needed into two years and the current annual interest rate is
10% compounded semiannually. What total amount must be invested today to produce Birr 100,000
in two years?
Many business and investment decisions involve a single amount of money that either exists now or
will exist in the future.

5.3.1 Future value of a single sum

It is the amount to which a lump sum invested at the beginning of a period will grow at a specified
compound interest for specified periods.
Future Value is computed as follows
FV = P (1+ i) n
Where, FV = Future value
 P = Principle amount
i = Interest rate per single period
n = Number of compounding periods
Take the first question which ask you to compute the accumulated value of Birr 50,000 deposited at
12% interest rate compounded semiannually at the end of the 2 nd year

Principal (p=br 50,000 )is Interest(i) is accumulated Future value

Invested at this time to principal
0 1 2 3 4
Time Periods n = 4
Given P = 50,000 Birr
I = 12% /2 = 6%
n = 2 years x 2= 4 Periods

Solution FV = p (1+ i) n
= 50,000 (1+0.06) 4
= 63,123.85
Therefore it implies that 50,000 Birr invested at 12% interest compounded semiannually will result
63,123.85 Birr after 3-years.
5.3.2 Present value of a single sum
It is the amount that must be invested now to produce the known future value. It is the value today of
receiving a fixed single sum at some time in the future.
The present value is always smaller than the known future value because interest will be accumulated
on the present value to the future date ( Present value + Accumulated interest = Future Value)
We wish to know the present
Value (P) of future Single amount An amount of money (a) is
(a) at this point Interest(i) is accumulated in prospect at this point.
_______________
0 1 2 3 n
Time Periods (n)

In determining the future value we move forward using a process of accumulation, in determining
present value, we move back ward in time using a process of discounting.
Present value = Future value – Discounted amount
FV
Present Value (PV) =
1  i  n
To illustrate present value computation techniques let us take the above question number 2 as on
example.
Given : Future value = 100,000
Interest rate per single Period (i) = 10%/2 = 5%
Number of compounding periods (n) = 2years x 2 =4
100,000
Present Value =  82,270.25 Birr
(1  0.05) 4
This 82,270.25 Birr indicates the sum of money that must be invested now at 10% interest
compounded semiannually to have a deposit balance of 100,000 at the end of 2 nd year.

Activity 3
1. Contrast a future value of $ 1 with the present value of $ 1
2. The future value of birr 1 at 15% interest for 12 years is birr 5.35025: (a) what is the present
value of 1 in this situation?
3. Calculate the future value of $1,800 at 4% interest for five years compounded semiannually?
______________________________________________________________________________
______________________________________________________________________________
 ______________________________________________________________________________
__________________________________________
 Feedback
1. Future values and present values of 1 are the same in one respect: they both relate to a single
payment. The future value looks forward from present dollars to future dollars. The present
value looks back from future dollars to present dollars. To notice this distinction clearly
assume the interest rate is 8% for six periods. Therefore the future value of $1 compounded
each year at 8% interest would be $1.587. The increase of $ 0.587 is the accumulated interest
during the six years.
The present value of a future amount is always less than that future amount. Because the present
value represents the discounted amount (interest excluded) that will accumulate to the future
amount. For the above example $ 1 payment 6 years away discounted at 8% interest for six years
is $0.63
2.We can determine the present value of $1 by using present value interest table or based on the
FV
formula cited above Present Value (PV) =
1  i  n and it will be 0.18691.
3. We can compute using the above mentioned future value formula FV = p (1+ i) n
FV = $1,800 (1+ 0.02) 10
=
$ 2,194.20
5.4. Values of an Annuity
Dear Colleagues in the above discussions we assumed when there is a lump sum (single principal)
investment amount that earns compound interest from the start to the end of the investment time
frame. But in some other situations investment or payments may also occur in a series of uniform
amounts (rent) at uniform intervals over a specified investment time frame, with all amounts earning
compound interest at the same rate. For example; loans or sales to be repaid (collected) on
installments, life insurance contract involving a series of equal payments made at equal intervals of
time
Annuity Amount
An annuity is a series of equal payments (rents) made at specified equal intervals.
It requires:
- The periodic payments or receipts (called rents) always be the same (equal) amount
- The interval between two rents always to be the same
- Equal interest rate per interval
The future value of an annuity is the sum of all the series payments (receipts) plus the accumulated
compound interest in them.
There are two distinct types of annuities: ordinary annuity and annuity due. The distinction is in the
timing of the payments.
i. Ordinary annuity:- is the more common type which, the payments ( or receipts) occur at the
end of each interest compounding period.
ii. Annuity due:- the payments ( or receipts) occur at the beginning of each interest
compounding period
5.4.1 Future Value of an Ordinary Annuity
It is the sum of all periodic payments made at the end of each period plus the interest accumulated on
them. To illustrate how to compute future value for ordinary annuity let us take the following
example.
Mr. Abel works in Bahir Dar University and he is a member of credit and saving association in the
university. Mr Abel is planning to deposit Birr 500 at the end of each month starting from the month
of September 1999. The association considers annual interest rate of 12% compounded monthly. How
much deposit will Mr. Abel have at the end of year 1999 (take Ethiopian calendar year).

Sep.1 Oct. Nov. Dec. Jan Feb. March. April. May June July Augu. Sept 1.
1999 2000
500
First Deposit here i = 12%/12 = 1%
n = 1 year x 12=12

Months Values at the end of the month

September Birr 500(1+0.01) 11

October 500 (1+0.01)12
November 500(1+0.01)10

August 500(1+0.01) 0

The deposits birr 500 rents are made at the end of the period (each month), therefore they will not
earn interest during the month in which they are originally deposited. Let us take the first deposit
made on September; this rent earns interest from the month of October to August. Since it is deposited
at the end of September it will not have interest for the month of September.

Note; In determining the future value of ordinary annuity the number of compounding periods will
always be one less than the number of rents.

Or
we can compute by using the following formula

FVOA  R 

 1  i  n  1 


 i 

Where: FVA = Future value of an ordinary annuity

R = Periodic rent (deposit)
i = rate of interest per period
n = number of computing periods

Given R = 500
n = 12
i = 1%
 1  0.01)12  1 
FVA  500  
 0.01 
 6,341.25 Birr
5.4.2 Future value of Annuity Due
It is the sum of all periodic payments (or receipts) made at the beginning of ach period plus the
interest accumulated on them. Annuity due will accumulate interest during the first period as opposed
to ordinary annuity. Thus, the future value of an annuity due factor can be found by multiplying the
future value of an ordinary annuity factor by 1 plus the interest rate.
 1  i  n  1 
FVAD  R   1  i 
 i 
Where FVAD = Future value of annuity due
r = Periodic rent
i = rate of interest per period
n = number of compounding periods.
For example in the above illustration, Mr. Abel make deposits at the beginning of each month; the
September deposit will earn interest from September to August including the period in which the
deposit is made.
Birr 500 first deposit here
Sep Oct. Nov. Dec. Jan Feb. March. April. May June July Augu. Sept

Months Values at the end of the month

September 500(1+0.01)11
October 500 (1+0.01)10
November 500(1+0.01)9

August 500(1+0.01) 1

Given R = 500 Birr

i = 0.01 or 12%/12
n = 12 periods or 1 year x 12 months
Or
 1  0.0112  1
FVAD  500   1  0.01
 0.01 
 6,404.66 Birr

Activity 4
Assume at the beginning of the current year you open a time deposit account in a bank to deposit
1,000 birr at the beginning of each year at 12% interest compounded semiannually. So that you will
be able to cover your son's University cost when he joins after 5 years.
Required
i. What kind of annuity it represent and how much money you will have at the end of the
fifth year
ii. Assume the deposit is made at the end of each year how much will be the deposit amount.
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
__________________________________________
 Feedback
1. The deposits will be made at the beginning of each period therefore it represents
annuity due. We can determine the future value of each 1,000br to be made at the
beginning of each year for five periods as
 1  i  n  1 
FVAD  R   1  i 
 i 
 1  0.06 10  1
FVAD  1,000
0.06  1  0.06 
 
= 13,971.60 birr
2. If the deposits are made at the end of each period it indicates ordinary annuity and the

 1  i  n  1 
at the end of the fifth year the deposit amount will be FVOA  R  

 i 
  1  0.0610  1 
FVOA  1,000 
 0.06
= 13,180.80 birr

5.4.3 Present Value of an Ordinary Annuity

The present value of an annuity is the single sum that if invested at compound interest now, would
provide for a series of withdrawals (annuity) for a certain number of future periods.
In other words it is the value today of a series of equal payments (receipts) to be made (received) at
the end of each period for some specified number of periods in the future

Present value of Ordinary Annuity

 1 
1  1  i  n 
PVOA = R 
 i 

 


Example
What is the value today of $ 1,000 rent receipts each to be received at the end of the next 5 years
when discounted at 10% interest compounded annually?
PVOA i=10%

0 1 2 3 4 5

n=5
Discount of the 5th year
rent period, the final rent
Year Present Value was discounted back by
1000 the same number of
1
1  0.11 periods that were rents.
1000
2
1  0.1 2
1000
3 3
1  0.1

0r
Given R = $ 1,000
i = 10%
n =5
1
1
PVOA = 1,000 1  0.1 5
0.1
= 3,790.79 Birr
Therefore the present value of the 5 ordinary rental receipts of $ 1,000 each at 10% discount rate is
3,790.79 birr.

5.4.4 Present Value of an Annuity Due

It is the value to day of a series of equal payments (receipts) to be made (received) at the beginning of
each period for some specified number of periods in the future.
Because each cash flow comes exactly one period sooner in the present value of annuity due, the
present value of the cash flows is exactly higher than the present value of ordinary annuity by the
interest amount. There fore the present value of an annuity due factor can be found by multiplying the
present value of an ordinary annuity factor by 1 plus the interest rate.
Example:- assume the same facts as in the above ordinary annuity example except that each $ 1,000
are to be received at the beginning of the next 5 years. What is the present value of each $ 1,000
receipts made at the beginning of the next 5 Years?
PVAD

0 1 2 3 4 5
Rent at beginning of period
No discount (for first withdrawal at period zero-beginning)
Year Present Value
1 $ 1000
1000
2
1  0.11
1000
3
1  0.1 2
1000
4 3
1  0.1

0r
 1 
1  1  i  n 
PVAD = R  1  i 
 i 

 

 1 
1  1  0.1 5 
= 1,000   1  0.1
 0.1 
 
 
= 4,169.87 Birr
We can also determine the present value of annuity due by computing the present value of ordinary
annuity and multiplying it by 1 plus the interest rate per period as follows
PVAD = PVOA (1+i)
= $3,790.79(1.1)
= $4,169.87
Example:- Assume you have just won a lottery totaling $ 1,000,000 and learned that you will be paid
the money by receiving a check in the amount of $ 200,000 at the beginning of each of the next 5-
Years. Suppose an appropriate interest rate is 10% what amount have you really won?
This illustration is asking you that the present value of the $ 200,000 checks you will receive over the
next 5-years.
Given R = $200,000
n = 5 years
i = 10%
Required = PVAD (since the checks will be collected at the beginning of each year)
Solutions
 1 
1  1  i  n 
PVAD = R  1  i 
 i 

 

 1 
1  1  0.1 5 
= 200,000   1  0.1
 0.1 

 

 = $ 833,973.09

Activity 5
Ethiopian Airlines is negotiating to acquire four new Airbus planes. Three alternatives are available:
1. Purchase the air craft for $ 35 million each, payment due immediately.
2. Purchase the air craft by paying $ 20 million immediately and $ 20 million each year for 11
more years.
3. Lease the air craft for $ 21.5 million payable at the end of each year for 12 years.
The relevant market rate of interest (the discount rate) for ventures of this type is 10%.Assuming that
an Ethiopian airline has sufficient resources, which alternative is least expensive? Ignore tax
considerations
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________
 Feedback
Dear colleagues, let us do the following illustration together. To compare each alternative let us
determine the present value for each alternative.
1. $ 35 million X 4 planes =$ 140 million
2. $ 20(PVAD,10%,12) = $ 20(7.49506) = $149.9 million
3. $21.5(PVOA,10%,12) =$ 21.5(6.81369) = $ 146.5 million
Therefore the least expensive option is to buy the aircraft for cash, alternative 1.If the discount
rate is made sufficiently large, and alternative 1 would no longer be the least expensive choice. A
higher discount rate would reflect a lower burden to Ethiopian airline for example for the future
yearly $ 20 million payments :( PVAD, 20%, 12) = 5.32706 with a 20% discount rate, the burden
of the 12 payments $ 20 million is $20(5.32706) = $ 106.5 million

Determination of other values related to the future (present) value of an annuity.

In some situations R, n or i is unknown. If any three of the four variables are given, the fourth can be
computed. The standardized future value and present value tables will help us to compute easily the
fourth variable For example to compute periodic interest rate(i) given a future value of ordinary
annuity of $33,100, a periodic payment of $ 10,000 and three periodic payments (n=3). We can read
from the future value of an ordinary annuity of 1 table like this;

FVOA= R
1  i) n
 1
i
FVOA = 33,1000
R = 10,000
i=?
 1  i  3  1 
33,100= 10,000  
 i 
 1  i  3  1 
  = 3.31
 i 
From the table the interest rate, which has 3.31, read across with n equals 3 is 10%. Thus, the $
10,000 must be invested at 10% at the end of the next 3 periods to accumulate to $ 33,100.

To compute the number of payments (n): given the future value of an ordinary annuity of $ 33,100
with period payment of $ 10,000 and i = 10%

FVOA= R
 (1  i) n

1
i
33,100= 10,000
 (1  i) n

1
i
 (1  i) n
 = 3.31
1
i
By referring to the future value of ordinary annuity table, using the future value factor of 3.31 read
down in the 10% indicates that n is 3

Activity 6
Sara is investing $ 200,000 in a fund that earns 8% interest compounded annually. What equal
amounts can Sara withdraw at the end of each of the next 20 years?
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________
 Feed back
To determine the amount of withdrawals to be collected at the end of each period for the
next 20 years given the value of deposits today is $200,000 and comprises 8% interest
rate per year we will use the present value of ordinary annuity formula
 1 
1  1  0.08 20 
$ 200,000 = R  0.08


 
 
R=$ 20,370.44
5.5 Deferred Annuities
A deferred annuity is an annuity in which the rents begin after a specified number of periods. A
deferred annuity does not begin to produce rents until two or more periods have expired. For example
"an ordinary annuity of six annual rents deferred 4 years" means that no rents will occur during the
first 4 years and that the first of the six rents will occur at the end of the fifth year. "An annuity due of
six annual rents deferred 4 years" means that no rents will occur during the first 4 years, and that the
first of six rents will occur at the beginning of fifth year..
5.5.1 Future value of a deferred annuity
In the case of the future value of a deferred annuity the computations are relatively straight forward.
Because there is no accumulation or investment on which interest may accrue, the future value of a
deferred annuity is the same as the future value of an annuity not deferred. That is, the deferral period
is ignored in computing the future value.
To illustrate, assume you plan to purchase a land site in 6 years for the construction of new business
enterprise. Because of cash flow problem, you are intending to deposit 80,000 birr that are expected to
earn 12% annually only at the end of the fourth, fifth and sixth periods.
Required
What future value will you have accumulated at the end of the sixth year?

R=$ 80,000 80,000 80,000

Future value of ordinary
0 1 2 3 4 5 6 annuity
n =3
(The First 3 periods are ignored)

 1  i  n  1 
R
Future value of ordinary annuity =  
 i 
 1  0.12 3  1
= 80,000  
 0.12 
= 269,952 Birr
5.5.2 Present Value of a Deferred Annuity
In computing the present value of a deferred annuity, the interest that occurs on the original
investment during the deferral period must be recognized. To compute the present value of a deferred
annuity, we compute the present value of an ordinary annuity as if the rents had occurred for the entire
period and then subtract the present value of rents which were not received during the deferral period.
Then it remains with the present value of the rents actually received subsequent to the deferral period.
To illustrate assume in the above example of future value of a deferred annuity, what will be the
present value of the three payments?
Two options are available to solve this problem.

Type 1
Each Periodic rent 80,000 birr
Present value of an ordinary annuity of $1 for
total periods (6)
( number of rents(3) plus number of deferred
periods (3) ) at 12% 4.1114073
Less: Present value of an ordinary annuity of 1
for the number of deferred periods 3 at 12% 2.4018312
Difference 1.7095761
Present value of 3 rents of $ 80,000 deferred 3 136,766.09
periods
(80,000x4.1114073-80,000x2.4018312)

The subtraction of the present value of an annuity of 1 for the deferred periods eliminates the non
existence rents during the deferral period and converts the present value of an ordinary annuity of Birr
1 for 6 periods to the present value of 3 rents of deferred for 3 periods.
Type 2 ; Alternatively, the present value of the 3 rents could be computed:
First by discounting the annuity 3 periods, but because the annuity is deferred for other 3 periods, the
present value of the annuity must then be treated as a future amount to be discounted another
3 periods PV of single sum
4 5 6
PVOA

0 1 2 3 80,000 80,000 80,000

Step 1 compute present value of an ordinary annuity

 1 
1  1  0.12  3 
PVOA = $ 80,000  
 0.12 

 

= 192,146.50 Birr
Step 2. Present value of a single sum = Future Value
(1+i)n
192,146.50
= 1  0.1 3
=
136,766.08

Activity 7
Mr. Abdi wants to create a fund today that will enable him to withdraw $ 20,000 per year for 8 years,
with the first withdrawal to take place at the beginning of five years from today. If the fund earns 8%
interest, how much must Abdi invest today?
__________________________________________________________________________________
__________________________________________________________________________________
____________________________________________________
1 computes present value of an annuity due for four withdrawal periods
 1 
1  1  0.08 4 
PVAD = $ 20,000  
 0.08 

 

= $71,542
Step 2. Discount $ 71,452 for the deferred periods which is four years
Present value of a single sum = Future Value
(1+i)n
71,542
= 1  0.08
4

=
$ 52,585.47
5.6 Valuation of long-term bonds
A long-term bond produces two cash flows:
i. Periodic interest payments during the life of the bond, and
ii. The principal (face value) paid at maturity.
At the date of issue, bond buyers determine the present value of these two cash flows using the market
rate of interest.

Here the periodic interest payments represent an annuity and the principal represents a single sum
problem. The current market value of the bonds is the combined present values of the interest annuity
and the principal amount.

The interest rate written in the terms of the bond indenture is known as the stated (nominal) rate. This
rate is set by the issuer of the bonds and usually expressed as a percentage of the face value (principal
amount).

If the rate employed by the buyers (market rate) differs from the stated rate the present value of the
bonds computed by the buyers will differ from the face value of the bonds.

The difference between the face value and the present value of the bonds is either a discount or
premium.

 If the bonds sell for less than face value, they are sold at a discount.
 If the bonds sell for more than face value they are sold at a premium.

To illustrate, ABC Corporation on January 1, 2002, issues $ 100,000 of 9% bonds due in 5 years with
interest payable annually at year end. The current market rate of interest for bonds of similar risk is
11%. How much is the buyer expected to pay for this bond?
$100,000 Principal
PVOA 9000 9,000 9,000 9,000 9,000 interest

1 2 3 4 5
The present value of the two cash flows is computed by discounting at 11% as follows:
Present value of the Principal $ 59,345.00
 $100,000 
 5
 1  0.11 
Present value of the interest payments
  1 
1  1  0.11 5 
(PVOA = 9,000 1   ) 33,263.10
 0.11 

 

Combined present value (Market value)
Carrying value of bonds 92,608.10

By paying $ 92,608.10 at date of issue, the buyers of the bonds will realize an effective yield of 11%
over the 5 years term of the bonds.
These bonds were sold at a discount of $ 7,391.90 ($100,000-92,608.10). When bonds sell below face
value, it means that investors demand a rate of interest higher than the stated rate because, they can
earn a greater rate on alternative investments of equal risk. Here, the investors receive interest at the
stated rate computed on the face value, but they are earning at an effective rate that is higher than the
stated rate because they paid less than face value for the bonds.
5.6.1 Effective interest method of Amortization of Bond discount or premium
5.6.1.1. Bond Discount
In the above example of ABC Company the bonds were issued at a discount computed as follows:

Maturity value ( face amount) of bonds 100,000.00

Present value of the principal 59,345.00
Present value of the interest 33,263.10
Proceeds ( Present value
and cash received) 92,608.10
Discount on bonds issued 7,391.90

This discount of $ 7,391.90 is amortized (written off) over the life of the bond issued to interest
expense account.

Activity 8
ABC Company issues $ 1 million of 7% bonds due in 10 years with interest payable at year- end. The
current market rate of interest for bonds of similar risk is 8 %. What amount will ABC receive when it
issues the bonds?
__________________________________________________________________________________
__________________________________________________________________________________
____________________________________________________
 Feedback
The bonds are sold below their face value (market rate> stated rate) hence ABC company
will receive $932,895.60 by forgoing $67,104.40 (1,000,000-932,895.60) as a discount.
Present value of the Principal $ 463,190
 $1,000,000 
 10 
 1  0.08 
Present value of the interest payments
 1 
1  1  0.08 10 
(PVOA = 70,000 X 1    ) 469,705.60
 0.08 

 

Combined present value (Market value) $ 932,895.60
Carrying value of bonds

5.6.1.2. Bond Premium

To illustrate bond premium, Nyala Company issued $ 100,000 of 8% term bonds on January 1, 2000
due on January 1, 2006 with interest payable each July 1 and January 1. If the market (investors) were
willing to accept an effective interest rate of 6 % on the bond issued how much would buyers of the
bond would pay.

Note that the bonds are sold for more than face value and hence they would have premium
Maturity Value of bonds $100,000
Present value of the Principal
 $100,000 
 PV     $10,000 x 0.74409 $74,409
 1  0.0310 
Present Value of the interest
(PVOA); R(PVOA 10,3%);
($4,000 x8.53020) 34,121
Proceeds from sale of bonds 108,530
Premium on bonds payable $8,530

5.6.2 Present value amortization (effective interest method)

It is the procedure for amortizing of a discount or premium under this method;
1. Bond interest expense is computed first by multiplying the carrying value of the bonds at the
beginning of the period by the effective interest rate.
Bond interest Carrying value of bonds Effective interest rate
Expense at beginning of period
2. Bond interest paid is then computed as
Bond interest Face Amount Stated interest rate
Paid of bonds

3. The bond discount or premium amortization is then determined by comparing the bond
interest expense with the interest to be paid
Bond interest expense ___ Bond interest paid = Amortization Amount
To illustrate assume in the above example what will be the present value of the three payments?
The effective interest method produces a periodic interest expense equal to a constant percentage of
the carrying value of the bonds. Since the percentage used is the effective rate of interest incurred by
the borrower at the time of issuance, the effective interest method results in matching of expenses
with revenues. Let us take the above illustration to see the effective interest method of amortization.
Schedule of Bond Discount
Amortization 5 year,9% bonds sold to yield 11%

Cash Interest Expense Bond discount carrying value of

Date Interest Amortization bonds.
paid
1/1/2002 92,608.10
12/31/2002 9,000 10,186.89 1,186.89 93,794.99
12/31/2003 9,000 10,317.45 1,317.45 95,112.44
12/31/2004 9,000 10,462.37 1,462.37 96,574.81
12/31/2005 9,000 10,623.23 1,623.23 98,198.04
12/31/2006 9,000 10,801.96 1,801.96 100,000.00

Cash interest paid = $ 100,000 x 0.092 =$9,000

Interest expense such as; on 12/31/2002= 92,608.10X11% = 10,186.89
Bond discount Amortization such as ; 12/31/2002 = $ 10,186.89 -9,000 = $ 1,186.89
Carrying value of bonds such as; 12/31/2002= 92,608.10 + 1,186.89 = $ 93,794.99

Activity 9
After a careful evaluation of the request in Rain Bow Company, the board of directors has decided to
raise funds for the new plant by issuing $2 million of 11% term corporate bonds on March 1, 1997,
due on March 1, 2012, with interest payable each March 1 and September 1. At the time of issuance,
the market interest rate for similar financial instruments is 10% .As the controller of the company;
determine the selling price of the bonds?
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________
SUMMARY
- Interest is the cost of using money over time. Interest is an acknowledgment that there
is a time value to money, meaning that a dollar in hand today is worth more than a
dollar to be collect one year from now.
- Simple interest is computed on the same principal amount each period.
- Compound interest is computed on the principal amount and on all prior period
interest credited and not paid or withdrawn.
- The future value (FV) of a current amount is the amount that will be accumulated at
specified date, given a specific interest rate.
- The present value(PV) of a future amount is the amount today that, with interest at a
specific rate, will accumulate to a given sum at a specified future date.
- An annuity is a stream of constant and regular periodic cash payments over a
specified period of time.
- Ordinary annuities are annuities for which regular payments occur at the end of the
period. An annuity due is an annuity for which payments occur at the beginning of
the period.
- The selection of the appropriate interest rate is not an easy task. The rate selected can
have a significant effect on present and future value calculations if the time period is
long.
- The standard future value and present value tables can be used to solve PV and FV
calculations. When tables are not available or if more precise results are required,
calculator programmed to solve present and future values may be used.
- Breaking them into components and calculating the answer to each component
separately can solve complex interest problems.
 SELF EXAMINATION QUESTIONS
I. True – False. Indicate by filling in the blank spaces provided the appropriate response whether
each of the following statement is true or false.

______ 1. Compound interest is computed on principal and any interest earned regardless
of amount withdrawn.
______ 2. Future value of annuity due is the sum of all periodic payments made at the
end of each period plus the interest accumulated on them
______ 3. In determining future value of ordinary annuity the number of compounding periods will
always be one less than the number of rents.
______ 4. The present value of annuity due cash flows is exactly higher than the present value of
ordinary annuity by the interest amount.
______ 5.When bonds are sold for more than the face value, they are sold at discount
______ 6.In effective interest method of amortization the periodic interest expense is computed by
multiplying the face amount of bonds by the stated interest rate.
II. Discussion Questions
1. Explain what is meant by the time value of money?
2. Assuming that the annual rate of interest is specified as 12 percent, what would simple
interest rates be for the following periods: (a) semiannual, (b) quarterly, (c) monthly?
3. What is the fundamental difference between simple interest and compound interest?
4. Briefly explain each of the following:
1. Future value of $1.
2. Present value of $1.
3. Future value of annuity of n payments of $1 each.
4. Present value of annuity of n payments of $1 each.
5. Explain the difference between (a) future value of an ordinary annuity and (b) future value of
an annuity due.
6. Explain the difference between (a) present value of an ordinary annuity and (b) Present value
of annuity due
 WORK OUT
1. Assume that $10,000 is borrowed on a two-year, 10 percent note payable. Compute
the total amount of interest that would be paid on this note assuming (a) simple
interest and (b) compound interest.
2. Assume that you have a legal contract that specifies that you will receive $200,000
cash in the future. Assuming a 9 percent interest rate, what would be the present value
of the contract if the amount will be received (a) 10 years, (b) 15 years, or (c) 25
years from now?
3. Assume that you deposited $20,000 in a saving account for a three-year period. How
much cash would you receive at the end if 12 percent simple interest per annum is
accumulated in the fund as the end of each quarter?
4. Compute the present value of an annuity of five payments of $9,000 each using a 12
percent interest rate, assuming (a) an ordinary annuity b) annuity due, Explain why
the two amounts are different.
5. Compute the future value of an annuity of six payments of $5,000 each using a 10
percent interest rate, assuming (a) an ordinary annuity and (b) an annuity due. Explain
why the two amounts are different.
6. Mr. Abel wants to withdraw $ 50,000 each year for 4 years from a fund that earns
10% interest, with the first withdrawal to take place after 2 years from today.
Required how much must he invest?
Rainbow Company issues $ 100, 10,000 bonds of 6% due in 5 years with interest payable at year-end.
The current market rate of interest for bonds of similar risk is 8%. What amount will Rainbow receive
when it issues the bonds?

CHAPTER SIX

CASH AND SHORT TERM INVESTMENT

Cash is a medium of exchange that a bank will accept for deposit and immediate credit to the
depositors account. To achieve efficient use of all resources, management of business enterprises
frequently turns unproductive cash balances in to productive resources through the acquisition of
short-term investments.
Learning Objectives
After you have studied this chapter, you will:
 Be familiar with the composition of cash and short term investment
 Know how to construct bank reconciliation and understand other
internal control procedures for cash.
 Be aware of the condition under which short term investments may
be recorded
6.1 Introduction; Cash
Meaning and elements of cash
Cash refers to coin, currency and other items that are;
- A standard medium of exchange or acceptable by knowledgeable parties in exchange
for goods or services
- The basis for measuring and accounting all other items
- Acceptable for deposit at face value by banks
Criteria: - An item to be reported as cash it must be
- Serve as a medium of exchange
- Readily available for the payment of current obligations
- It must be free from any contractual restriction that limits its use in satisfying debts.
Dear students, based on the criteria listed above we can classify negotiable instruments and other
highly liquid items as cash and non cash (cash equivalents).
Cash equivalents are short term, highly liquid investments that are both
i. Readily convertible to known amounts of cash and
ii. So near their maturity that they present insignificant risk of changes in interest rates.
If the item cannot be converted to coin or currency on short notice, it is separately classified as an
investment, as a receivable, or as prepaid expenses. Cash that is not available for payment of currently
maturing liabilities is segregated and classified in the long term assets section.
The following table summarizes the classification of cash related terms.

Item Classification Comment

cash Cash If unrestricted, report as cash.
If restricted, identify as current
and non current assets
Petty cash and change funds Cash Report as cash
short term paper Cash equivalents Investments with maturity of
less than 3 months
Short term paper Temporary investments Investments with maturity of
3 to 12 months
post dated checks and IOUs Receivables Assumed to be collectible
Travel advance Receivables Assume to be collected from
employees or deducted from
their salaries

Postage on hand (as stamps or Prepaid Expenses May also be classified as

in postage meters) office supplies inventory
Bank Overdrafts Current liability if right of offset exists, reduce
cash.
Compensating balances
1. Legally restricted Cash separately classified as a Classify as current or non
 deposit maintained as current in the balance sheet
compensating balance
2. Arrangement without legal Cash with note disclosure Disclose separately in notes
restriction details of the arrangement.

Dear colleagues, based on the above criteria and table 1 items termed as cash like
 Coin and currency
 Negotiable instruments such as money orders, certified checks, personal checks, bank drafts,
saving accounts, (if prior notice is rarely demanded by banks)
are classified as cash because these items are readily available for the payment of current obligations
and free from any contractual restrictions.
In addition petty cash funds, change funds and other funds, even though these funds are intended to
be used for specific purposes they are used to meet current operating expenses and to liquidate
current liabilities so that they are included incurrent assets as cash accounts.
However cash balances deposited and maintained in checking or saving accounts as a minimum
requirements or compensating balances for borrowing are reported as follows. Legally restricted
deposits held as compensating balances against:
- Short term borrowing arrangements to be stated separately among the cash and cash
equivalent items in current assets
- Long term borrowing arrangements should be classified as non current assets in the
investment or other Assets sections. As "cash on Deposit maintained as compensating
balance."
- In cases where compensating balance arrangements exist with out legal restrictions, the
arrangements and the amounts involved should be described in the notes.

Money market funds, money market savings certificates, certificates of deposit, short term papers that
give an opportunity to earn high rates of interest are more appropriately classified as temporary
investments (cash equivalents) than as cash. The reason is that these securities usually contain
restrictions or penalties on their conversion to cash.

Activity 1
Why is the distinction between those items qualifying as cash and other items that are similar to cash
but are not cash?
__________________________________________________________________________________
__________________________________________________________________________________
___________________________________________________
 Feedback
Because for an item to qualify as cash it must fulfill the three basic criteria mentioned at the first page
of this chapter. Hence those items, which are not readily available for the payment of current
obligations and are not free from any contractual restrictions, can not be grouped as cash

6.2 Cash Management and Control

6.2.1 Cash management
In any business enterprise management of cash is very important because cash is a means of acquiring
goods and services and cash can be easily misappropriated or lost. The management of cash is
centered on fore casting and internal controls.

The main objectives and responsibilities of management with respect to cash are
 To maintain liquidity (solvency) that is; to assure that there is sufficient cash to settle
maturing obligations, pay for operating expenses and also to finance unexpected
circumstances
 To invest any idle cash so as to maximize returns
 To prevent loss of cash due to theft, misuse or wastage
6.2.2 Control of cash
In organizations internal control methods, procedures, rules and policies are adopted;
The main purpose of having internal control systems in organizations is
- To assure that assets that belong to business enterprise are received when tendered
- Protected while in the custody of the enterprise and
- Used only for authorized business purposes
Cash controlling consists of administrative control and accounting control
Administrative controls
- Promote operational efficiency ( to ensure no authorized transactions are entered into
by officers or employees)
- Encourage adherence to prescribed managerial policies and achieving the objectives
of the organization
Accounting Controls
- Ensure the protection of assets for it is susceptible to improper diversion and use
- Ensure the accuracy and reliability of accounting data
- To have access to assets only in accordance with management's authorization
- To maintain accountability for assets

6.2.2.1 Internal control procedures

A system of internal control is not designed primarily to detect errors but rather to reduce the
opportunity of errors or dishonesty to occur. Effective system of internal control procedures should
consider the following points:
i. Segregation of duties; like separating one that works on custody with record keeper,
purchaser or receiver of purchased item. Here the separation of duties enables to protect assets
against either fraud or error. In addition the work of one helps to cross check the of the other
ii. Assignment of Responsibilities and Authorities; giving a specific authority to a specific
body helps a company to create responsibility and accountability in the actions of each party,
department or division. For example, to set an internal control procedure for cash payments
on enterprise could set a purchase procedure which gives responsibility to order and acquire
goods to purchase department maintain a record and make payments for invoices to
accounting and finance department and receive the purchased stocks to receiving department.
iii. Using mechanical devices and pre-numbered documents; using cash registers, check
protector holes and pre-numbered business forms are very helpful to ensure the accuracy and
reliability of accounting data.
iv. Maintaining physical safeguarding tools; for example safe boxes, drawers with lockers,
having daily deposits etc.
v. Implementing periodical performance evaluation methods; evaluating helps to take
periodical corrections and to take sure that regulations are properly implemented.
vi. Hiring competent employee and having computer help, creates to have efficient and
accurate record keeping and report preparation function
vii. Planning (budgeting):- forecasting cash necessary for future operations such as through
preparing periodic cash budgets

6.2.2.2 Control over cash receipts

Control over cash is required to safeguard all cash inflows or assure that all cash receivables by the
enterprise is collected and recorded with out loss.
It includes
 Immediate counting
 Daily recording
 Intact deposit
6.2.2.3 Control over cash payments
The main objective of control over cash payments is to ensure no authorized payments are made. It
include;
 Verifying and approving payments for example by using voucher system.
  Making payments by checks
 Periodic preparation of Bank reconciliation
1. Elements of internal control over cash payments.
Cash is safeguarded by keeping it in a safe box, depositing it in banks and through use of special (imp
rest) cash funds

i. Petty cash fund

A petty cash fund refers to a fund of fixed amount used for small expenditures that are most
conveniently paid in cash such as payments for taxi fare, postage stamps, minor amount of supplies
etc.

 Establishment
- Estimate the required amount of payment to meet minor expenditures for specified period.
Journal Entry
Petty Cash fund xx
Cash xx
 Operation
As each cash payment is made from the petty cash fund,prepare a voucher or other receipts
* No Journal entry
 Replenishment: petty cash fund is replenished
- When it reaches a minimum cash balance and
- At the end of the accounting period to recognize the periodic expenses paid from the fund and
to report the year end cash balance correctly.
- The vouchers or receipts will be reviewed and a check will be issued on the total amount of
the vouchers to restore the petty cash fund to its original amount.
Journal Entries at the time of replenishment will be
Various expenses xx
Cash xx
Illustration:
On January 1,2006 ABC company established a petty cash fund to make payments for minor
expenditures, for $ 500. During January the petty cash vouchers indicate payments are made for the
following transactions
Postage Expenses 189.60
Office Supplies 112.75
Minor repair Expenses 60.05
Miscellaneous expense 40.00
On January 28, the custodian requested replenishment for items paid to date and the cash balance in
the petty cash box is $ 95.20
Now let us see the record that ABC Company will have at the establishment of petty cash fund and at
the replenishment of the fund respectively.
Petty cash funds 500
Cash 500
Replenishment Entry

Postage Expenses 189.60

Office Supplies 112.75
Minor repair Expenses 60.05
Miscellaneous expense 40.00
Cash short and over 2.40
Cash ............................................... 404.80
The cash shortage and overage ledger account is classified as revenue when it has credit balance and
as expense when it has a debit balance.

Activity 2
Genesis Company established a petty cash fund of $ 200. The fund is reimbursed when the cash in the
fund is at $17. Petty cash receipts indicate funds were disbursed for office supplies $94 and
miscellaneous expense for $92. Prepare journal entries for the establishment of the fund and the
reimbursement
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________
 Feedback
Here the total amount of petty cash payment receipts is $186 .The amount of cash remained on hand is
$17 and hence the amount of money required to reimburse is $200-17=$183. The difference between
the total petty cash payment receipts and cash reimbursed will show us the overage or shortage taken
place from changes.
Office supplies 94
Miscellaneous Expense 92
Cash 183
Cash short and over 3

ii. Cash Change Fund

A change fund is used to facilitate the collection of cash from customers
 Establishment
- Estimate the required types and amounts denominations.
Journal entry
Cash change fund xx
Cash xx
 Operation
Make the necessary changes and deduct the amount of the change fund from the total cash money on
hand at the close of each business day to determine the daily collections.
* No Journal entry will be required.
iii. Bank checking account (Reconciliation of bank balances)

Activity 3
How does bank reconciliation provide internal control for cash and why are adjusting entries are made
only for reconciling the book balance to the correct cash balance?

__________________________________________________________________________________
__________________________________________________________________________________
____________________________________________________

Enterprises usually open checking account in a bank to have a daily deposits of all cash collections
and to make payments from the bank by issuing checks. Periodically banks prepare bank statement,
which is a summary of cash deposit and out lays made from each checking account of the depositor.
Similarly the depositor will have a ledger account to record daily cash transactions in the bank
account. Usually the cash balance in dictated in a bank statement seldom agrees with cash balance
indicated by the depositors ledger account for the specific period.
Bank reconciliation:- is a schedule that analyzes and explains the difference between the ending
balance of cash in a bank and bank statement.
The possible reasons for the difference between two balances could be
 Delay in recording transactions
For example: Deposit in transit (deposits made after the bank closes it records for the statement
period), out standing checks(checks issued but not presented for payment in the bank), bank service
charges, collections made bank.
 Errors or omissions in recording transactions
Note that, adjustment entries are required for transactions and events that are not included in the
depositor record and for the errors, which are made in recording by the depositor. However for
transactions that are not recorded by bank and for the differences that are self-correcting such as,
deposit in transit, outstanding checks, adjustment entries, will not be required. But for the errors made
by the bank it should be called for correction by writing a memorandum to the bank.

The two commonly used forms of bank reconciliation are:

1. Reconcile both bank balance and depositors balance to correct cash balance (Direct method).
2. Reconcile the bank balance to the balance in the depositor's record (Indirect method)

1. Reconcile both bank balance and depositors balance to correct cash balance.
Illustration:
On August 31, 2006 the cash ledger account in Awash international company shows a debit balance
of Birr 82, 461 while the bank statement provided by Abyssinia bank indicates a balance of birr
110,632. A receipt of August 31, for 12,924 birr was not included in August bank statement. In
addition the checks, which were issued but not paid by, bank during this month totals birr 11,458.
Credit memorandums send by the bank indicated that notes receivable left with the bank for birr
10,200 had been collected and credited for 10,240 birr including interest revnue of birr 40. In addition
the maturing value of treasury bill birr 20,000 collected during this month. The bank acquired for
Awash company at a discount for birr 18,800 and had been recorded at cost in the short term
investment ledger account by Awash company. The bank statement included in debit memorandum
includes birr 28 as a service charge for the month of August. A check for 521 birr drown by ABC
Company (Creditor) returned and marked as NSF. Check number 1334 issued for 328 birr had been
recorded by bank as 382 birr.
Required.
i) Prepare bank recondition schedule for Awash company for the moth of August.
ii) Make the necessary journal entries.
1. Reconciling the bank balance and depositor’s balance to correct cash balances
(direct Method).
Under this method reconciliation will be made to bring both unadjusted balance in a bank and a
depositor’s record to the adjusted or correct balances.
Awash International Company
Bank Reconciliation
August 31,2006
Balance in depositor’s record Br 82,461
Add: Note and interest of Br.40 collected by bank 10,240
: Proceeds from Treasury bill that had been
Acquired for br.18, 800 and interest revenue.br 1,200 20,000 30, 240
Sub total 112,701
Less: NSF checks drown by ABC company 521
: Bank service charges for August 28 549
Correct cash balance 112, 152
Balance in bank statement Br 110,632
Add: Deposit in transit 12,924
Error in recording check number 1334 54 12,978
Sub total 123,610
Less: Out standing checks 11,458
Correct cash balance 112,152
Dear colleagues, preparing the above bank reconciliation will have the following three functions.
1. It helps to determine the correct cash balance to be reported in the balance sheet.
2. To disclose errors made in recording cash transactions, either by the bank or by the depositor,
and
3. To provide information necessary to bring the accounting records up to date.
After bank reconciliation statement is made, all items appearing in the reconciliation as additions to or
deductions from the “balance in the depositor’s record" must be included in the journal entry. The
journal entry on August 31, 2006 to adjust the accounting records of Awash Company is shown
below:

Cash 29,691
Account Receivable 521
Miscellaneous Expenses 28
Interest revenue ( Br 40 + 1,200) 1,240
Notes Receivable 10,200
Short term investments (Treasury bill) 18,800
The cash at bank account in the depositor's record before the above adjustment has a debit balance for
82,461 Birr.

Cash
82,461
Adjustment 29,691
---------------
112, 152

And after the above journal entry is posted it will show the correct balance of 112,152 Birr.
2. Reconcile bank balance to the balance in the depositor’s record (indirect method)
Steps to use this method;
1st Reconcile the bank balance to the unadjusted cash account balance in the general ledger.
- Include all items that are not included in the bank statement
- Add the items that were deducted in the bank statement but not in the depositor’s cash
account record.
- Deduct the items that were added in the bank statement but not in the depositor’s cash
account record.
nd
2 Enter the required adjustments in the bank reconciliation to the cash account in the depositor’s
record.

Awash International Company

Bank reconciliation
August 31, 2006
Balance in Bank statement Br 110,632
Add: Deposit in transit 12,924
: Error in recording check no. 1334 54
: NSF check drown by ABC company 521
: Bank service charges for August 28 13,527
Sub total 124,159
Less: out standing checks 11,458
Note and interest of Br 40 collected 10,240
by bank
: Proceeds from treasury bill that 20,000
had been acquired for br, 18,800
and interest revenue br 1,200 ________ 41,698
Balance in depositor’s records; unadjusted 82,461
Add: Adjustment to cash ledger account (See the above journal entry) 29,691
Correct cash balance (adjusted) 112,152
iv. Reconciliation of Cash Receipts and cash payments (Proof of cash)
A full reconciliation of cash receipts and payments (known as proof of cash) may be made to establish
the accuracy of the cash balance and the effectiveness of internal controls over cash receipts and cash
payment for a selected month or a longer period.

To prepare a proof of cash summary for a specific period:

- Determine the cash receipts and cash payment data for the period from both the company
and the bank.
- Present the bank reconciliation statement for the last period
Step 1 Reconcile cash receipts in bank statement and in depositor's record.

Here the deposit in transit of the lost period is deducted from the deposits recorded by the bank in
current period because it was a receipt of cash of the last period. And the deposit in transit of the
current period that is a receipt of cash of the current period should be included in total cash receipts of
the current period. Besides if there are proceeds on the notes and interest collected by the bank, it
must be deducted from the deposits recorded by the bank because the proceeds had not been entered
in the before adjustment accounting records in the current period.

Step 2. Reconcile cash payment in bank statement and in depositor’s record.

The out standing checks of the last period are included in the bank debits for current period but
because they are payments of the last period they must be deducted from the current period payments.
The out standing checks of the current period are not included in the bank balance and they need to be
included. Similarly the bank service charges and any NSF cheeks are included in the bank’s debits for
current period but not in the unadjusted balance of depositor’s record.

Step 3: Reconciliation of bank and depositor cash balances. The last column of the reconciliation is
identical to the reconciliation of the bank and depositor balances to the correct cash balance and make
the necessary journal entry required to adjust the accounting records the depositor.
Illustration:
The following data were taken from Awash international private company.
- The Bank statement cash balance for May indicated 14,621 birr and 21,406 birr
for June.
- Deposit in transit amounts 12,000 birr for May and 15,000 birr for June.
- Out Standing checks total 208 birr on May and 502 birr on June.
- During May there had been error in recording a check and May bank
reconciliation by adding birr 14 to the bank balance. In addition on June
check number 3280 issued and paid for 766 birr was erroneously recorded
by bank as 668 birr.
- The book balance per depositor record indicated 26,413 birr on May 31 and
35,716 birr on June 30.
- During June cash receipts total 69,236 birr and cash payments total 59,933 birr in the
depositor cash ledger. But the bank statement indicates cash receipts of 66,436 birr and
cash payments for 59,651 birr.
- Note collected by bank were 197 birr and 200 birr on May and June respectively.
- Bank service charges were 7 birr on May and 10 birr on June.
- NSF checks returned 190 birr on May and 100 birr on June
Required:- prepare proof of cash report for the month of June.

A Wash International Company

Proof of Cash
June 30, 2006
Balance Receipts Payments Balance June
 may 30,2006
31,2006
Balances in bank statement 14,621 66,436 59,651 21,406
Deposits in transit
May 31, 2006 12,000 (12,000)
June 30,2006 15,000 15,000
Outstanding checks
May 31,2006 (208) (208)
June 30,2006 502 (502)
Other reconciling items
Bank service charges (7) (10) 10
NSF check drawn 190 (100) 100
Error in recording by bank 14 98 (98)
Note and interest collected by bank (197) (200) (200)
Balances in depositor’s records 26,413 69,236 59,933 35,716
Add: Adjustment of cash 90
ledger account on
June 30,2006 (see the following cash
balance)
Correct Cash Balance 35,806

6.3 Cash Overdraft

Activity 4
1. Can an enterprise report over draft amounts as cash in a balance sheet? In what circumstances, if
any, is it permissible to offset a bank overdraft against positive balance in another account?
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Some times banks allow their good customers to issue a check in excess of the balance on their
deposit and this creates an overdraft in the bank account.
In the rare situation in which a business enterprise maintains only one bank account and that account
is overdrawn on the balance sheet date, the overdraft amount is reported as a current liability.
However, if an enterprise has other accounts in the same bank with larger positive balances, it is
reasonable to present the net balance of cash as a current asset. But an overdraft in an account in one
bank should not be offset against positive balances in other banks because no right of offset exists.
6.3.1 Disclosure of compensating cash balances.
A compensating cash balance is portion of a deposit maintained by a depositor that constitutes support
for existing borrowing arrangements with banks. Disclosure of compensating balance arrangements is
required because such cash balances are not available for discretionary use by management on the
balance sheet date.
6.4 Short term investments
Short-term investments are highly liquid type of temporarily held investments that can be easily
converted in to cash when needed.
Characteristics
- Short-term investments are investments, which are readily marketable
- They are held for sales with in a short period of time
- They are held for earning return on idle cash
The objectives of acquiring short-term investments are
1. To maximize the return on assets and
2.To minimize the risk of loss from price fluctuations.
Investments in securities of other companies acquired by a business enterprise as a means of
exercising influence or control over the operations of such companies are of a quire different character
and should not be considered as short term investment.
Long term bonds and common stocks, occasionally used as a medium for investing idle cash, do not
meet the objective of limited price fluctuation. Long term bond prices fluctuate with changes in the
level of interest rates and the degree of fluctuation is greater for bonds with longer maturities.
6.4.1 Types of short-term investments
1. Debt securities for example
- Treasury bills which are issued at a discount by government units with maturities of
thirteen weeks to fifty two weeks
- Certificates of deposit are promissory notes issued by banks for various periods of time.
- Commercial paper is the term used for short term unsecured promissory notes issued by
corporations and sold at a discount to investors or other companies.
- Bonds: (Short term kinds) are issued to borrow for the short term and it is because the
amount of capital needed is too large for one lender to supply.
 Bond securities include specified interest rates.
2. Equity Securities:- indicate short term investments made in acquiring of other companies
common stock and preferred stocks .
 Dividends are received as compensation for short-term investment.

6.4.2 Recording transactions in short term investments.

i) Acquisition: - Short-term investments are recorded at cost.
The cost includes purchase price, brokerage commission and any costs incident to the
acquisition.
Debt securities acquired between interest dates are traded on the basis of market price plus the interest
accrued since the most recent interest payment. The occurred interest is a separate asset acquired with
the bonds. The cost of these two assets should be separated in the accounting records to see the results
of investment in marketable securities separately.
ii. Sales before maturity
Enterprises may sell short-term investments before maturity and the net proceeds on sales will be
sales price minus any incidental selling costs. When there are several acquisitions of the same
bond or stock at different dates and prices and if a portion of the holding is sold, some procedure
of cost selection must be employed. Among the methods commonly used are specific
identification, first in first out and average cost methods stock and bond certificates generally
have serial numbers that facilitate determination of the cost of specific investments.
Example: - Assume in the previous example of Alpha Company, on April 30, 2006 the company sold
half of the bonds of 110% plus occurred interest. The cash paid for brokerage commission was $ 200.
Required:-
i). Determine the cash received from sale of bonds and
ii). Prepare the necessary journal entry.
Market price of bonds ($100,000 /2 X 110%) 55,000
Less: brokerage commission 200
Net proceeds on sale of bonds 54,800
Add: Accrued interest for 5 months
On & 50,000 of 9% a year
(50,000 x 9/100 x 5/12) 1,875
Total cash received 56, 675
Here half of the short-term investments (bonds) are sold by receiving 54,800 cash. The gain on sale of
short-term investments will be:
Net proceeds on sales 54,800
Minus: original cost ($109,000/2) 54,500
Gain on sale of short term investments 300

The journal entry required at the time of sale (April 30) will be as follows:
2006 Cash 56,675
April 30 Short term investments 54,500
 Interest receivable ($750/2) 375
Interest revenue 1,500
Gain on sale of short term investment 300

Interest Accrued for 5 months indicate interest revenue earned in 2005 for the month of December ($
50,000 x 9/100 x 1/12) and interest revenue accumulated from January 1 up to April 30 ($50, 000 x
9/100 x4/12). Since the December interest revenue is recognized (recorded) and reported in 2005
income statement at the time of cash collection the receivable account will be credited.
iii. Discount or premium on short-term investments (bonds)

Activity 5
Why amortization of premiums or accumulation of discounts will not be made for short-term
investments in bonds?
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Amortization of premiums or accumulation of discounts will not be made for short term investments
in bonds. Because such temporarily held investments generally matures with a short period and any
premium or discount is likely to be negligible
6.4.3 Price fluctuations and valuation of short-term investments.

Activity 6
What are some of the advantages in valuing short-term investment at market prices at the end of
accounting periods?

Normally, an asset is recorded at cost, and this cost is associated with the revenue generated from the
use of the asset. If the asset loses its value without generating revenue, the cost is written off as a loss.
The revenue realization principle usually allows recognition of increases in the value of an asset only
when it is sold. However, Short-term investments are readily salable at quoted market price and hence
the traditional tests of revenue realization should not control the valuation of short-term investments.
The use of market prices to value short-term investments at the end of an accounting period has some
advantages.
1. The income statement will show the results of decision to hold or sell such
investments from period to period
2. Valuation at current market price eliminates the difference of carrying identical
securities at different amounts because they were acquired at different prices.
3. Market value is more meaningful to creditors to judge the debt paying ability of
the business enterprise.
6.4.3.1 Valuation at cost or lower of cost or market method.

Activity 7
1. In marketable equities securities portfolio the net unrealized loss is reported in valuation allowance
account why?
2. What is the difference between unrealized gain or loss and realized gain or loss? How and when
they are reported in financial statements?

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______________________________________________________________
The lower of cost or market method is usually applied on the portfolio of marketable
securities. That is
 If market price is lower than cost, cost should be written down to market
 If market price is greater than cost, cost is maintained as value of the portfolio.
Valuation of lower of cost or market was required when the decline in market value was substantial
and was not “due to a mere temporary condition”

The difference between the aggregate market Value and aggregate costs on any date is called Net
unrealized gain or loss.
Unrealized gain or loss = Market Value of Cost of marketable
Marketable equity - equity security
Securities

In marketable equities securities portfolio the net unrealized loss in that portfolio (excess of cost over
market) would be presented as valuation allowance. The journal entry to establish valuation allowance
for current portfolio of marketable equity securities is

Unrealized loss in value of marketable equity sectaries XX

Allowance to reduce marketable Equity securities to market value XX

The amount at which portfolio of marketable equity securities is reported in the balance sheet known
as carrying amount would be presented as follows:

Cost of marketable equity securities XX

Minus: Valuation allowance XX
Carrying amount XX

Changes in the valuation allowance for marketable equity securities are included in the determination
of net income of the current accounting period in which they occur. Such changes in the valuation
allowance balance result in unrealized gains or losses.

A recovery in the aggregate market Value of securities that had been written down to market value
below cost requires the recognition of unrealized gains however, increases in unrealized gains above
unrealized losses are not recognized in the accounting records.
Allowance to reduce marketable equity
Securities to market Value .......................... xx
Unrealized gain in value of equity securities ................. xx
Unrealized gains and losses on marketable equity securities are not used to compute taxable income.
Such gains and losses result in temporary differences between taxable in come and pretax accounting
income reported in the income statement.
Example
Nas Company began investing idle cash in marketable equity securities in 2002. The cost and
market Value of the securities held in its current port folio at the end of December were as
follows
End of Year Cost Market Value
2001 $ 200,000 210,000
2002 310,000 260,000
2003 280,000 210,000
2004 425,000 400,000
2005 400.000 410.000

Required: - Prepare the journal entries at the end of each year to adjust the valuation allowance if the
lower of cost or market method is used.
In the date of initial application, December 31, 2001 the cost of marketable equity securities included
in current part folio is less than the market value. By considering the objectivity principle and the idea
of lower of cost or market method the gain will not be recorded and hence there will not be valuation
allowance at end the of 2001.
December 31, 2002, a valuation allowance of $50,000 is required for marketable equity securities
included incurrent portfolio to reflect the excess of cost, $310.000, over market value $ 260,000. The
unrealized loss of $ 50,000 is included in net income for year 2002. The journal entry to record
unrealized loss and the valuation allowance is:
Unrealized loss in value of marketable
Equity securities 50,000
Allowance to reduce marketable equity
Securities to market value 50,000
The Unrealized loss of $ 50,000 is included in 2003 net income
On December 31, 2003 there is increase (Change) in valuation allowance amount.

A valuation allowance of $ 70,000 is required for marketable equity securities in the current portfolio
to reflect the excess of total cost $ 280,000 over total market value $210,000. Because the balance in
the valuation allowance account is $ 50,000 an adjustment will be made only for $ 20,000. The
journal entry to record the increase in the valuation allowance is:

Unrealized loss in value of marketable equity 20,000

securities to market value
Allowance to reduce marketable equity
Securities to market value 20,000
There fore, after the above adjustment entry is made the valuation allowance account will have a
balance of $ 70,000 or current required (desired) balance.

In December 31, 2004 there has been recovery and hence we need to reduce the valuation allowance
account, which has a balance of $ 70,000 to $25,000 (Which is the current period excess of cost $
425,000 over $400, 000 market value). The difference of 145,000 (which is $70,000- 25,000) is a
recovery from market value or unrealized gain and is included in net income of year 2005. The
journal entry to record the reduction in the valuation allowance is as follows.

Allowance to reduce marketable equity 45,000

Securities to market value
Unrealized gain in value of marketable equity securities 45,000

In December 31, 2005 the cost of marketable equity securities is lower than the market Value and
hence there is no valuation allowance in 2006. There has been unrealized gain by 10,000 but the
unrealized gain will not be presented in the income statement but a recovery for valuation allowance
account that had a balance of $25,000 will be made as follows:
Allowance to reduce marketable equity
Securities to market value 25,000
Unrealized gain in ralue of marketable
Equity securities 25,000
Realized gain or loss
The net realized gain or loss represents the difference between the net proceeds from the sale of
marketable equity security and its cost.

Realized gain Net proceeds from Cost of marketable

Or loss = Sale of marketable - equity securities.
Equity securities

The realized gains and losses from sale of current or non current marketable equity securities portfolio
are included in the determination of periodic net income.

Example :- Assume in the above example of Nas company the enterprise on January 1,2006 sold one
half of its marketable equity securities for $220,000.
Required:- Determine any gain or loss from sale of marketable equity securities and make the
necessary journal entry.

Proceeds from sale of marketable

Equity securities 220,000
Leas: Cost of marketable equity securities 200,000
($ 400,000 x ½)
Realized gain on sale of marketable
Equity securities 20,000

2006 Cash 220,000

January 1. Short term investments 200,000
Realized gain on sale of marketable
equity securities 20,000

6.4.4. Disclosures required for current portfolio of Marketable

Equity securities

Disclosure is made either in the financial statements or in a note to the financial statements
- To show the gross unrealized gains representing the excess of market value over cost for
all marketable equity securities in the portfolio, and the gross unrealized losses
representing the excess of cost over market value on the balance sheet date
- To show net realized gain or loss included in the determination of net income.
- The basis on which cost was determined in the computation of realized gain or loss.
- To show significant net realized and net unrealized gains and losses arising after the date
of the financial statements, but prior to their issuance, applicable to securities owned on
the date of the most recent balance sheet
6.4.4.1 Balance sheet Presentation of short term Investments

Short-term investments rank next to cash in liquidity and thus are listed below cash in the current
assets section of the balance sheet. Whether short-term investments are reported at cost or at the lower
of cost or market, disclosure of the current market value is required.