UNIT 1.

INVENTORIES

Contents
1.0 Aims and Object ives
1.1 Introduction
1.2 Importance of Inventories
1.3 Effects of Inventories on Financial Statements
1.3.1 Effects of Ending Inventory on Current Period’s Financial Statements
1.3.2 Effects of Beginning Inventory on Current Period’s Financial
Statements
1.3.3 Effects of Ending Inventory on the Fo llowing Period’s Financial
Statements
1.4 Inventory systems
1.4.1 Periodic Inventory System
1.4.2 Perpetual Inventory System
1.5 Determining Actual Quantit ies in the Inventory
1.6 Summary
1.7 Answers to Check Your Progress
1.8 Model Examinat ion Quest ions
1.9 Glossary

1.0 AIMS AND OBJECTIVES

This unit aims at discussing the meaning, importance and effects of inventories. It also
discusses the inventory systems and determining actual quant ities in inventories. After
studying this unit, you will be able to:

- explain the meaning of inventories

- describe the effect of inventory on the financial statements of the current period
and the fo llowing period
- ident ify and describe the two principal inventory systems
- ident ify the procedures for determining the actual quant it ies in inventory.

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1 . 1 IN T R O D U C T IO N
In the last section o f Principles o f Accounting I, you have learned about the principles and
practices of account ing for receivables – one o f the current asset items in the balance sheet of
a retail business. In this unit you will learn and discuss the concepts in account ing for
inventories.

Inventories are asset items held for sale in the ordinary course of business or goods that will
be used or consumed in the production o f goods to be so ld. They are mainly divided into two
major:
 Inventories of merchandising businesses
 Inventories of manufacturing businesses

i. Inventories of merchandising businesses are merchandise purchased for resale in

the normal course of business. These types of inventories are called merchandise
inventories.
ii. Inventories of manufacturing businesses manufacturing businesses are businesses
that produce physical output. They normally have three types of inventories. These
are:

 Raw material inventory

 Work in process inventory
 Finished goods inventory

1. Raw material inventory -is the cost assigned to goods and materials on hand but not yet
placed into production. Raw materials include the wood to make a chair or other office
furniture’s, the steel to make a car etc.
2. Work in process inventory- is the cost of raw material on which production has been
started but not completed, plus the direct labor cost applied specifically to this material and
allocated manufacturing overhead costs.
3. Finished goods inventory- is the cost ident ified with the co mpleted but unso ld units o n
hand at the end of each period.

In this unit only the determinat ion of the inventory of merchandise purchased for resale
commo nly called merchandise inventory will be discussed.

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1 . 2 IM P O R T A N C E O F IN V E N T O R IE S
Merchandise purchased and so ld is the most active elements in merchandising business, i.e. in
who lesale and retail t ype of businesses. This is due to the fo llowing reasons:

1.The sale o f merchandise is the principal source of revenue for them.

2.The cost of merchandise so ld is the largest deductions fro m sales.
3.Inventories (ending inventories) are the largest of the current assets or those firms.

Because of the above reasons inventories, have effects on the current and the fo llowing
period’s financial statements. If inventories are misstated (understated of overstated), the
financial statements will be distorted.

Check Your Progress Exercise -1

1. List the four types of inventories

………………………………………………………
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………………………………………………………
………………………………………………………

2.Why do we consider inventories the most active elements merchandis ing businesses?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

1.3 THE EFFECTS OF INVENTORIES ON CURRENT AND FOLLOWING

PERIOD’S FINANCIAL STATEMENTS.

1.3.1 Effect of ending inventory on current period’s financial statements

Ending inventory is the cost of merchandise on hand at the end o f accounting period. Let us
see its effect on current period’s financial statements.
Inco me statement

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a. Cost of goods (merchandise) sold =Beginning inventory + Net purchase – Ending
inventory
As you see, ending inventory is a deduct ion in calculat ion cost of merchandise so ld. So, it has
an indirect (negat ive) relat ionship to cost of merchandise so ld, i.e. if ending inventory is
understated, the cost of merchandise so ld will be overstated, and if ending inventory is
overstated, the cost of merchandise so ld will be understated.

b. Gross Profit = Net sales – Cost of merchandise sold

Here, the cost of merchandise so ld had indirect relat ionship to gross profit. So, the effect of
ending inventory on gross profit is the opposite of the effect on cost of merchandise so ld. That
is, if ending inventory is understated, the gross profit will be understated and if ending
inventory is overstated, the gross profit will be overstated. This is a direct (posit ive)
relat ionship.

c. Operating income = Gross Profit – Operating Expenses

Gross profit and operating inco me have direct relat ionships. Thus, the effect of ending
inventory on net inco me is the same as its effect on gross profit, i.e. direct (posit ive) effect
(relationship).

Balance Sheet
1. Current assets - Ending inventory is part of current assets, even the largest. So, it has
a direct (posit ive) relationship to current assets. If ending inventory balance is
understated (overstated), the total current assets will be understated (overstated). Since
current assets are part of total assets, ending inventory has direct relationship to total
assets.

2. Liabilities- No effect on liabilit ies. Inventory misstatement has no effect on liabilit ies.

3. Owners’ equity – T he net inco me will be transferred to the owners’ equit y at the end
of account ing period. Closing inco me summary account does this. So, net inco me has
direct relat ionship with owners’ equit y at the end of accounting period. The effect-
ending inventory on owners’ equit y is the same as its effect on net inco me, i.e. if
ending inventory is understated (Overstated), the owners’ equit y will be understated
(Overstated).

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1.3.2 Effects of beginning inventory on current period’s financial statements
Beginning inventory is inventory balance that was left on hand in the previous period and
transferred to the current period. Its effect is summarized below:

Income Statement
1. Cost of merchandise sold= Beginning inventory + Net Purchases – Ending
inventory
As you see, beginning inventory is an addit io n in determining cost of goods sold. It
has direct effect on cost of merchandise so ld. That is, if the beginning inventory is
understated (Overstated), the cost of merchandise sold will be understated
(Overstated)

2. Gross Profit= Net Sales – Cost of merchandise sold

The effect of beginning inventory on gross profit is the opposite of the effect on cost
of merchandise so ld, i.e. indirect (negat ive) relationship. If the beginning inventory is
understated, the gross profit will be overstated and if it is overstated, the gross profit
will be understated.

3. Net income = Gross Profit – Operating expenses

The effect of beginning inventory on net income is the same as it s effect on gross
profit.

Balance sheet
1. Current assets – The inventory included in current assets is the ending inventory. So,
beginning inventory has no effect on current assets.

2. Owners’ equity- If the effect co mes from the previous year, the beginning inventory
will not have an effect on ending owners’ equit y since the posit ive or negat ive effect
of the previous year will be netted off by the negative or posit ive effect of the current
year. But if the error is made in the current period, it will have indirect effect on
ending owners’ equit y.

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1.3.3 Effect of ending inventory on the following period’s financial statements
The ending inventory of the current period will beco me the beginning inventory for the
fo llo wing period. So, it will have the same effect as beginning inventory o f the current period.
Let us summarize it.
Income statement of the following period
Cost of merchandise so ld direct relationship
Gross profit indirect relat ionship
Net inco me indirect relat ionship

Balance sheet of the following period

The ending inventory of the current period will not have an effect on the fo llowing period’s
balance sheet items.

Illustration - 1
The fo llowing amounts were reported in Belay Company’s financial statements for three
consecut ive fiscal year ended December 31.

2000 2001 2002

a) Cost of merchandise so ld Br. 130,000 Br. 154,000 Br. 140,000
b) Net inco me 40,000 50,000 42,000
c) Total Current assets 210,000 230,000 200,000
d) Owner’s equit y 234,000 260,000 224,000

In making the physical counts of inventory, the fo llowing errors were made:
 Inventory on December 31,2000, under stated by Br. 12,000
 Inventory on December 31, 2001, overstated by Br. 6000

Required:
Determine the correct amount of the items listed above.

S ol u t i on
2000 2001 2002
a) Cost of merchandise sold:
Reported Br. 130,000 Br. 154,000 Br. 140,000

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 Adjust ment of
2000 error (12,000) 12,000 _
2001 error _ 6,000 ( 6, 000)

Corrected Br. 118,000 Br. 172,000 Br. 136,000

b) Net income:
Reported Br. 40,000 Br. 50,000 Br. 42,000
Adjust ment of
2000 error 12,000 (12,000) _
2001 error _ (6,000) 6,000
Corrected Br. 52,000 Br. 32,000 Br. 48,000

c) Total current assets:

Reported Br. 210,000 Br. 230,000 Br. 200,000
Adjust ment of
2000 error 12,000 _ _
2001 error _ (6,000) _
Corrected Br. 222,000 Br. 224,000 Br. 200,000

d) Owner’s equity:
Reported Br. 234,000 Br. 260,000 Br. 224,000
Adjust ment of
2000 error 12,000 _ _
2001 error _ (6,000) _
Corrected Br. 246,000 Br. 254,000 Br. 224,000

Check Your Progress Exercise -2

1. Why does an understated ending inventory understate net inco me for the period by the
same amount?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

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2. Why does an error in ending inventory affect two accounting periods?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

1.4 INVENTORY SYSTEMS: PERIODIC VS PERPETUAL

There are two principal systems of inventory account ing periodic and perpetual.

1.4.1 Periodic inventory system

Under this system there is no continuous record of merchandise inventory account. The
inventory balance remains the same through out the accounting period, i.e. the beginning
inventory balance. T his is because when goods are purchased, they are debited to the
purchases account rather than merchandise inventory account.

The revenue fro m sales is recorded each t ime a sale is made. No entry is made for the cost of
goods sold. So, physical inventory must be taken periodically to determine the cost of
inventory on hand and goods sold.

The periodic inventory system is less costly to maintain than the perpetual inventory system,
but it gives management less informat ion about the current status of merchandise.

This system is o ften used by retail enterprises that sell many kinds o f low unit cost
merchandise such as groceries, drugstores, hardware etc.

The journal entries to be prepared are:

1. At the time of purchase of merchandise:
Purchases XX at cost
Accounts payable or cash XX
2. At the time of sale of merchandise:
Accounts receivable or cash XX at retail price
Sales XX
3. To record purchase returns and allowance:
Accounts payable or cash XX
Purchase returns and allo wance XX

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 4. To record adjusting entry or closing entry for merchandise inventory:
Inco me Summary XX
Merchandise inventory (beginning) XX

To close beginning inventory

Merchandise inventory (ending) XX
Income summary XX
To record ending inventory

1.4.2 Perpetual inventory system

Under this system the account ing record continuously disclose the amount of inventory. So,
the inventory balance will not remain the same in the accounting period. All increases are
debited to merchandise inventory account and all decreases are credited to the same account.

There are no purchases and purchase returns and allowances accounts in this system. At the
time o f sale, the cost of goods sold is recorded in addit ion to Journal entry for the sale. So, we
can determine the cost of inventory as well as goods sold fro m the accounting record. No need
of physical count ing to determine their costs.

Companies that sell items o f high unit value, such as appliances or automobiles, tended to use
the perpetual inventory system.

Given the number and diversit y o f items contained in the merchandise inventory of most
businesses, the perpetual inventory system is usually more effect ive for keeping track of
quant it ies and ensuring optimal customer service. Management must choose the system or
combinat ion of systems that is best for achieving the co mpany's goal.

Journal entries to be prepared are:

1. At the time of purchase of merchandise
Merchandise inventory XX at cost
Accounts payable/cash XX
To record cost of goods sold

2. At the time of sale of merchandise

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 Accounts receivable or cash XX at retail price
Sales XX
To record cost of goods sold

To record the sales

Cost of goods sold XX
Merchandise inventory XX at cost
To record the cost of merchandise sold

3. To record purchase returns and allowances

Accounts payable or cash XX
Merchandise inventory XX

4. No adjust ing entry or closing entry for merchandise inventory is needed at the end
of each account ing period.

Illustration – 2
In its beginning inventory on Jan 1, 2002, NINI Company had 120 units of merchandise that
cost Br. 8 Per unit. The fo llowing transact ions were completed during 2002.
February 5 Purchased on credit 150 units of merchandise at Br. 10 per unit.
9 Returned 20 detective units fro m February 5 purchases to the supplier.

June 15 Purchased for cash 230 units o f merchandise at Br 9 per unit.

September 6 Sold 220 units of merchandise for cash at a price of Br. 15 per unit. These
goods are: 120 units from the beginning inventory and 100 units for February
Purchases.
December 31 260 units are left on hand, 30 unit s from February 5 purchases.

Required: Prepare general journal entries for NINI Company to record the above transact ions
and adjust ing or closing entry for merchandise inventory on December 31,
a) Periodic inventory system
b) Perpetual inventory system

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S ol u t i on
a) February 5 Purchases (150 x Br.10) 1, 500
Account payable 1, 500
9 Accounts payable (20 x Br. 10) 200
Purchase returns and allowances 200
June 15 Purchases (230 x Br. 9) 2, 070
Cash 2, 070
September 6 Cash (220 x Br. 15) 3, 300
Sales 3, 300
December 31 To record or close the merchandise inventory account
Inco me summary (120 x Br. 8) 960
Merchandise inventory (beginning) 960
_To close the beginning inventory
Merchandise inventor (ending) 2, 370
Income summary [(30 x Br. 10) + (230 x Br. 9)] 2, 370
_ To record the ending merchandise inventory

b) February 5 Merchandise inventory 1,500

Accounts payable 1, 500
9 Accounts payable 200
Merchandise inventory 200
June 15 Merchandise inventory 2,070
Cash 2, 070
September 6 i) To record the sales
Cash 3,300
Sales 3, 300
ii) To record cost of merchandise sold
= (120 x Br. 8) + (100 x Br. 10)
= Br. 960 + Br. 1,000 = Br. 1,960
Cost of merchandise so ld 1,960

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 Merchandise inventory 1, 960
December 31 No entry is needed to record or close merchandise inventory account.

1.5 DETERMINING ACTUAL QUANTITIES IN THE INVENTORY

The phys ical count of inventory is needed under both inventory systems. Under periodic
inventory system, it is needed to determine the cost of inventory and goods sold.
The inventory account under a perpetual inventory systems is always up to date. Yet events
can occur where the inventory account balance is different fro m inventory on hand. such
events include theft,, loss, damage, and errors. The physical count (some t imes called “taking
an inventory”) is used to adjust the inventory ac count balance to the actual inventory on
hand.

We determine a birr (dollar) amount for physical count of inventory on hand at the end o f a
period by:
(1) Counting the units o f each product on hand
(2) Mult iplying the count for each product by its cost per unit
(3) Adding the cost for all products

At the time of taking an inventory, all the merchandise owned by the business on the
inventory date, and only such merchandise, should be included in the inventory. The
merchandise owned by the business may not necessarily be in the warehouse. They may be in
transit.

The legal t it le to the merchandise in transit on the inventory date is known by examining
purchase and sales invo ices of the last few days of the current accounting period and the first
few days of the fo llowing account ing period. This legal tit le depends on shipping terms
(agreements).

There are two main t ypes of shipping terms. FOB shipping po int and FOB dest inat ion
(1) FOB shipping point- the ownership tit le passes too the buyer when the goods are
shipped (when the goods are loaded on the means of transportation, i.e. at the seller’s
point). The purchaser is responsible for freight charges.
(2) FOB destination – the title passes to the buyer when the goods arrive at their
destination, i.e. at the buyer’s point.

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So, in general, goods in transit purchased on FOB shipping po int terms are included in the
inventories of the buyer and excluded fro m the inventories o f the buyer and excluded fro m the
inventories of the seller. And goods in transit purchased on FOB dest inat ion terms are
included in the inventories of the seller and excluded fro m the inventories of the buyer.

There are also a problem wit h goods on consignment at the time o f taking and inventory.
Goods on consignment to another party (agent) called the consignee. A Consignee is to sell
the goods for the owner usually on co mmissio n are included in the consignor’s inventories
and excluded fro m the consignee’s inventories.

Check Your Progress Exercise -3

ABC Co mpany, found in Addis, purchased goods from XYZ Co mpany, found in Mekele, on
FOB shipping point terms.

1.Who will cover transportation charges? Why?

…………………………………………………………………………………………………
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2. Assume these goods are in transit at the end of accounting period. In which co mpany’s
inventories do we include these goods?
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…………………………………………………………………………………………………

1.6 SUMMARY

Inventories are goods held for sale in the ordinary course of business or goods that will be
used or consumed in the production o f goods to be sold. They are included in the current asset
sect ion of the balance sheet.

Goods purchased and so ld are the most active elements in the merchandising businesses due
to many reasons. Because of this reason, they have significant effects on the current and the
fo llo wing period’s financial statements.

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There are two principal systems o f inventory accounting periodic and perpetual. In the
periodic system, only the revenue from sales is recorded at the time the sale is made no entry
is made until t he end o f the period to record the merchandise inventory and the cost of goods
sold. In the perpetual inventory system, sales and cost of merchandise sold are recorded at the
time each sale is made. In this way, the account ing records continuously disclose the amount
of inventory on hand.

The first step in “taking an inventory” is to count the merchandise on hand. To this count is
added merchandise in transit that is owned. Therefore, it is normally necessary to examine
purchases and sales invo ices o f the last few days of the accounting period and the first few
days of the fo llowing period to determine who has legal tit le to merchandise in transit on the
inventory date.

1.7 ANSWERS TO CHECK YOUR PROGRESS

Check Your Progress Exercise 1

1. - Merchandise inventory
- Raw material inventory
- Work in process inventory
- Finished goods inventory

2. - It is due to many reasons including the fo llowing

- The sale of merchandise is the main source of revenue
- The major deduct ion from sales is cost of merchandise sold
- Inventories are the largest of the current assets.
Check Your Progress Exercise 2
1. Ending inventory has direct effect on net inco me of the current period. So, if ending
inventory is understated, the net inco me will be understated by the same amount. In other
way round, if ending inventory is understated, cost of goods sold will be overstated,
result ing in an understatement of gross margin and net inco me.

2. Because the ending inventory for the current period will beco me beginning inventory for
the fo llowing period.
Check Your Progress Exercise 3

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 1. The buyer (ABC Co mpany). The title to the goods is passed to ABC Co mpany at the
seller’s po int. So, while in transit, they are the properties of ABC company.

2. In ABC Co mpany

1.8 MODEL EXAMINATION QUESTIONS

A. Short answer questions

1. Define inventories
2. From the two inventory systems, which method is better considering internal
controls?
3. If ending inventory is misstated, it will not have an effect in the owners’ equit y of
the fo llowing period. Why?
B. Workout questions
2. Abera Company reported annual net inco me as fo llo ws
2000 Br. 151,400
2001 152,400
2002 128,120

Analys is of its inventories shows that the fo llowing incorrect inventory amounts were used
(the correct amounts are also shown)

Incorrect inventory Correct inventory

Amount Amount
December 31,2001 Br. 24,000 Br. 28,000
December 31,2001 27, 000 23,000

Compute the annual net inco me for each of the three years assuming the correct inventories
had been used.

3. Condensed inco me statement for FANTU Supermarket for two years are shown below:
19 x 4 19 x 3
Sales (net) Br. 126,000 Br. 105,000
Cost of Goods Sold 75, 000 54, 000

Gross Margin Br. 51,000 Br. 51,000

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 Operating Expenses 30, 000 30, 000
Net Income Br. 21,000 Br. 21,000

After the end of 19 x 4 it was discovered that an error had resulted in a Br. 9000
understatement of 19 x 3 ending inventory.

Required: Compute
a) the corrected net inco me for 19 x 3
b) the corrected cost of goods sold for 19 x 4
c) the corrected net inco me for 19 x 4
d) what effect will the error have on net inco me and ending owner's equit y for 19 x 5?

4. MAMO Co. engaged in the following transact ions in Megabit 1995:

Megabit 1- So ld merchandise to Belew Co. on credit, terms n/30, FOB shipping point,
Br. 2100 (cost br. 1260)
3 – Purchased merchandise on credit from Semi Co., terms n/30, FOB shipping
point, Br. 3800
5 – Paid Express Transit for freight charges on merchandise received, Br. 290
6 – Purchased store supplies on credit from Hadiya Trading, terms n/20, Br.
636
8 – Purchase merchandise on credit fro m Semi Co., terms n/30, FOB shipping
point, Br. 3600, which includes Br. 200 freight costs paid by Semi Co.
12 – Returned so me o f the merchandise received on Megabit 3 for credit, Br.
600
Refer to the fo llowing exercise in order to answer questions a – f.

The fo llowing informat ion is related to the business for three consecut ive fiscal years.

19 x 3 19 x 2 19 x 1
Net sales Br. 430,000 Br. 425,000 Br. 400,000
Cost of goods sold 240,000 243,000 240,000
Gross Profit 189,200 182,000 160,000
Operating Expenses 96,800 92,400 86,500

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Assume that you have found everything in order except for the fo llowing:
i. The ending inventory was understated by Br. 15,000 and Br. 3000 at the end of 19 x 1
and 19 x 2 respect ively.

ii. The ending inventory was overstated by Br. 20,200 at the end of 19 x 3

The business enterprise uses the periodic inventory system and the above errors had not been
brought to attention prior to your investigation.

a. What was the correct amount of cost of goods sold for 19 x 1?

b. What was the correct amount of cost of goods sold for 19 x 2?
c. What was the correct amount of cost of goods sold for 19 x 3?
d. What was the correct amount of Net inco me for 19 x 2?
e. What was the correct amount of Net inco me for 19 x 3?
f. Compute the correct gross profit percentage for 19 x 1?

Megabit 15 – Sold merchandise on credit to MERON Trading, terms n/30, FOB shipping
point, Br. 1200 (cost Br. 720)
16 – Returned some of the store supplies purchased in Megabit 6 for credit, Br. 200
17 – Sold merchandise for cash Br. 1000 (cost, Br. 600)
18 – Accepted for full credit a return from Belew Co mpany and returned
merchandised to inventory, Br. 200 (Cost Br. 120)
24 – Paid Semi Co mpany for purchase of Megabit 3 loss return of Megabit 12
25 – Received full payment fro m Belew Co mpany for his Megabit 1 purchase less the
return on Megabit 18

Required:
1. Prepare general journal entries to record the transactions, assuming use of the periodic
inventory system.
2. Prepare general journal entries to record the transactions, assuming use of the periodic
inventory system.
3. Compute the cost of goods sold and net sales during Megabit.
4. Compute the Gross Profit on sale for the month of Megabit.

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1.9 GLOSSARY

1. Cost of merchandise sold- The cost of the merchandise purchased by a merchandise

enterprise and so ld
2. Current asset- Cash or another asset that may reasonably be expected to be realized in
cash or sold or consumed, usually wit hin a year or less, through the normal operations of a
business.
3. Finished goods inventory- The cost of finished products on hand that have not been so ld
4. FOB destination- Terms of agreement between buyer and seller where by ownership
passes when merchandise is received by the buyer, and the seller absorbs the
transportation costs.
5. FOB shipping, point-Terms of agreement between buyer and seller, whereby ownership
passes when merchandise is delivered to the shipper, and the buyer absorbs the
transportation costs.
6. Gross profit- The excess o f net revenue fro m sales over the cost of merchandise sold.
7. Net income- The final figure in the income statement when revenues exceed expenses.
8. Purchases returns and allowances- Reduct ion in purchase, result ing fro m merchandise
returned to the vendor or from the vendor’s reduction in the original purchase price; a
contra account to purchases.
9. Work in process inventory- The direct materials costs, the direct labor costs, and the
factory overhead costs, which have entered into the manufacturing process, but are
associated with products that have not been finished.

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UNIT 2: DETERMINING THE COST OF INVENTORY

Contents
2.0 Aims and Object ives
2.1 Introduction
2.2 Inventory Costing Methods Under Periodic Inventory system
2.2.1 Specific Ident ificat ion Method
2.2.2 First-in First-out Method
2.2.3 Last-in First-out Method
2.2.4 Weighted Average Method
2.3 Comparison o f Inventory Costing Methods
2.4 Inventory Costing Methods Under Perpetual Inventory System
2.4.1 First-in First-out Method
2.4.2 Last-in First-out Method
2.4.3 Weighted Average Method
2.5 Summary
2.6 Answers to Check Your Progress
2.7 Model Examination Questions
2.8 Glossary

2.0 AIMS AND OBJECTIVES

This unit aims at discussing inventory cost determinat ion and inventory costing methods.
After going through this unit, you will be able to:
1. describe the determinat ion of the cost of inventory
2. aware of the most commo n inventory costing methods under a periodic system
3. compare the effect of the methods on operating results
4. describe the accounting for inventory under the perpetual system.

2.1 INTRODUCTION

This chapter is the continuation o f the previous chapter, in which we have discussed the
meaning and concepts of inventory. In this chapter, we will discuss the determination of the
cost of inventory.

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Costs included in merchandise inventory are those expenditures necessary, direct ly or
indirect ly, to bring an item to a salable condit ion and lo cat ion. In other words, cost of a n
inventory item includes its invo ice price minus any discount, plus any added or incidental
costs necessary to put it in a place and condit io n for sale. Added or incidental costs can
include import duties, transportation-in, storage, insurance against losses while the goods are
in transit, and costs incurred in an aging process(for example, aging of wine and cheese).

Minor costs that are difficult to allocate to specific inventory items may be excluded fro m
inventory cost and treated as operating expenses of the period. This is based on materialit y
principle or the cost-to –benefit constraint.

Check Your Progress Exercise -1

1. An art gallery purchases a paint ing for Br. 11,400 on terms FOB shipping po int.
Addit io nal costs in obtaining and o ffering the artwork for sale include. 130 for
transportation-in, Br. 150 for import duties, Br. 100 for insurance during shipment, Br.
180 for advertising, Br. 400 for training, and Br. 800 for sales salaries. For comput ing
inventory, what cost is assigned to the paint ing?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

2.2 INVENTORY COSTING METHODS UNDER PERIODIC INVENTORY SYSTEM

One o f the most important decisio ns in account ing for inventory is determining the per unit
costs assigned to inventory items. When all units are purchased at the same unit cost, this
process is simple since the same unit cost is applied to determine the cost of goods sold and
ending inventory. But when ident ical items are purchased at different costs, a question arises
as to what amounts are included in the cost of merchandise so ld and what amounts remain in
inventory. A periodic inventory system determines cost of merchandise so ld and inventory at
the end o f the period. We must record cost of merchandise so ld and reduct ions in inventory as
sales occur using a perpetual inventory system. How we assign these costs to inventory and
cost of merchandise so ld affects the reported amounts for both systems.

20
There are four methods commo nly used in assigning costs to inventory and cost of
merchandise sold. These are:

 Specific ident ificat ion

 First-in first-out(FIFO)
 Last-in first-out (LIFO)
 Weighted average

Let us see these cost ing methods under periodic inventory system based on the fo llowing
illustration

Illustration:
Beza Co mpany began the year and purchased merchandise as fo llows:
Jan-1 Beginning inventory 80 units@ Br. 60 = Br. 4,800
Feb. 16 Purchase 400 units@ 56 = 22, 400
Sep.2 Purchase 160 units @ 50 = 8, 000
Nov. 26 Purchase 320 units@ 46 = 14, 720
Dec. 4 Purchase 240 units@ 40 = 9, 600
Total 1200 units Br.59, 520

The ending inventory consists of 300 units, 100 from each of the last three purchases.

2.2.1 Specific Identification Method

When each item in inventory can be direct ly ident ified with a specific purchase and its
invo ice, we can use specific ident ification (also called specific invo ice pricing) to assig n
costs. This method is appropriate when the variety o f merchandise carried in stock is small
and the vo lume o f sales is relatively small. We can specifically ident ify the items so ld and the
items on hand.

Example
From the above illustration, the ending inventory consists of 300 unit s, 100 fro m each of the
last purchases. So, the items on hand are specifically known fro m which purchases they are:

21
Cost of ending inventories under specific ident ification method
Br. 40 x 100 = Br. 4,000
Br. 46 x 100 = 4, 600
Br. 50 x 100 = 5, 000
300units Br. 13,600

 Cost of Ending inventory cost = Br. 13,600

 The cost of merchandise so ld = Cost of goods available for sale - Ending inventory
= Br. 59,520 – Br. 13,600
= Br. 45,920

2.2.2 First-in, First-out (FIFO)

This method of assigning cost to inventory and the goods sold assumes inventory items are
sold in the order acquired. This means the cost flo w is in the order in which the expenditures
were made. So, to determine the cost of ending inventory, we have to start from the most
recent purchase and cont inue to the next recent. Because the first purchased items (old
purchases) are the first to be so ld they are used (included) in the co mputation o f cost of goods
sold.

For example, easily spo iled goods such as fruits, vegetables etc., must be so ld near the time o f
their acquis it ion. So, the inventory on hand will be fro m the recent purchases. As an example,
consider the previous illustration on page 21.

The cost of ending inventory under FIFO method

= Br. 40 x 240 Br. 9,600
= Br. 46 x 60 2,760
300 units Br. 12,360

 Cost of Ending inventory Br. 12,360

 Cost of merchandise so ld = Br. 59,520 – Br. 12,360
Br. 47,160

22
2.2.3 Last-in first-out (LIFO)
This method of assigning cost assumes that the most recent purchases are sold first. Their
costs are charged to cost of goods sold, and the costs of the earliest purchases are assigned to
inventory. The cost flow is in the reverse order in which expenditures were made.

In calculating the cost of goods sold, we will start from the earliest purchases.

As an example, take the previous illustration

The cost-ending inventory under FIFO method
=Br.60 x 80 = Br. 4,800
=Br. 56 x 220 = 12, 320
300 units
Ending inventory cost = Br. 17,120
Cost of merchandise so ld = Br. 59,520 – Br. 17,120
= Br. 42,400

2.2.4 Weighted Average Method

This method of assigning cost requires co mput ing the average cost per unit of merchandise
available for sale. That means the cost flow is an average of the expenditures.

To calculate the cost of ending inventory, we will calculate first the cost per unit o f goods
available for sale

Average cost per unit = Cost of goods available for sale

Total units available for sale

Then the weighted average unit cost is mult iplied by unit s on hand at the end of the period to
calculate the cost of ending inventory. Also, the same average unit cost is applied in the
computation of cost of goods sold.

As an example, take the previous illustration

Weighted average unit cost = Br. 59,520 = Br. 49.60
1,200

23
  Ending inventory cost = Br. 49.60x 300
= Br. 14,880

 Cost of merchandise so ld = Br. 59,520-Br. 14,880

= Br. 44,640

2.3 COMPARISON OF INVENTORY COSTING METHODS

If the cost of units and prices at which they are sold remains stable, all the four methods yield
the same results. But if prices change, the three methods usually yield different amounts for:

- Ending inventory
- Cost of merchandise so ld
- Gross profit or net income
In periods of rising (increasing) prices: (or if there is inflat ionary trend):

FIFO yields – higher ending inventory

_ Lower cost of merchandise so ld
_ Higher gross profit (net inco me)

LIFO yields _ Lower ending inventory

_ Higher cost of merchandise so ld
_ Lower gross profit (net inco me)

 Weighted average yields the results between the two.

In periods of declining (decreasing) prices:

FIFO yields _ Lower ending inventory

_ Higher cost of merchandise sold
_ Lower gross profit or net inco me

LIFO yields_ higher ending inventory

_ Lower cost of merchandise so ld
_ Higher gross profit or net inco me
 Weighted average- between the two

24
Check Your Progress Exercise -2

1. Which of the methods of inventory costing will in general yie ld an inventory cost nearly
approximat ing current replacement cost?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

2. Does the terms FIFO and LIFO refer to techniques emplo yed in determining quant ities of
various merchandise on hand?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

2.4 INVENTORY COSTING METHODS UNDER PERPETUAL INVENTORY SYSTEM

Under perpetual inventory systems we will apply the inventory costing methods each time
sale of merchandise is made. We calculate the cost of goods (merchandise) so ld and inventory
on hand at the time o f each sale. This means the merchandise inventory account is cont inually
updated to reflect purchase and sales.

Illustration:
The beginning inventory, purchases and sales of Nesru Company for the month o f Januar y
fare as fo llows:
Units Cost
Jan. 1 Inventory 12 Br. 10.00
6 Sale 5
10 purchase 10 Br. 12.00
20 Sale 8
25 purchase 8 Br. 12.50
27 Sale 10
30 purchase 15 Br. 14.00

25
 2.4.1 First-in first-out Method
The assignment of costs to goods sold and inventory using FIFO is the same for both the
perpetual and periodic inventory systems. Because each wit hdrawal o f goods is fro m the
oldest stock on hand. The o ldest is the same whether we use periodic inventory system or
perpetual inventory system.

Let us calculate the cost of goods sold and ending inventory under perpetual inventory syste m
fro m the above illustration.

Perpetual - FIFO
Date Purchase Cost of merchandise sold Inventory
Qty. Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Jan. 1 15 Br. 10.00 Br. 150.00
6 5 Br. 10.00 Br. 50.00 10 10.00 100.00
10 10.00 100.00
10 10 Br. 12.00 Br.120.00 10 12.00 120.00

20 8 10. 00 80. 00 2 10.00 20.00

10 12.00 120.00
2 10.00 20.00
25 8 12. 50 100. 00 10 12.00 120.00
8 12.50 100.00
27 2 10. 00 20. 00 2 12.00 24.00
8 12. 00 96. 00 8 12.50 100.00
2 12.00 24.00
30 15 14. 00 210. 00 8 12.50 100.00
5 14.00 210.00
23 Br. 246.00 25 Br. 334.00

So, the cost of merchandise so ld and ending inventory under perpetual- FIFO method are Br.
246 and Br. 334 respectively.
Let us see them under periodic - FIFO method:
Units on hand = units available for sale – units sold

26
 = ( 15 + 10 + 8 + 15 ) – ( 5+ 8 + 10 )
= 48 - 23 = 25

Cost of ending inventory = Br. 14 x 15 = Br. 210

Br. 12.50 x 8 = 100
Br. 12 x 2 = 24
Br. 334

Cost of goods available for sale = Br. 120 + Br. 100 + Br. 210 = Br. 580
Cost of goods sold = Br. 580 – Br. 334
Br 246

So, the same results of cost of gods sold and ending inventory under both periodic inventory
systems.

2.4.2 Lasting, First-Out method

Unlike FIFO method, different results may occur under periodic and perpetual inventory
system. The most recent purchases change when new purchase occurs.

Let us calculate first the cost of goods sold and ending inventory for the above illustration
under perpetual inventory system. Then, we will see the results under periodic inventory
system.
Perpetual - LIFO
Date Purchase Cost of merch. Sold Inventory
Qt y Unit cost Total cost Qt y Unit cost Total cost Qt y Unit cost Total cost
Jan. 1 15 Br. 10.00 Br. 150.00
6 5 Br. 10.00 Br. 50.00 10 10. 00 100. 00
10 10 Br. 12.00 Br. 120.00 10 10. 00 100. 00
10 12. 00 120. 00
20 8 Br. 12.00 Br. 96.00 10 10. 00 100. 00
2 12. 00 24. 00
25 8 12. 50 100. 00 10 10. 00 100. 00
2 12. 00 24. 00

27
 8 12. 50 100. 00
27 8 12. 50 100. 00 10 10. 00 100. 00
2 12. 00 24. 00
30 15 14. 00 210. 00 10 10. 00 100. 00
15 24. 00 210. 00
23 Br. 270.00 25 Br. 310.00

So, the cost of merchandise so ld and ending inventory under perpetual inventory system are
Br. 270 and Br. 310 respectively.
The results under periodic inventory system are:
Cost of ending inventory = Br. 10 x 15 = Br. 150
Br. 12 x 10 = 120
25
Br. 270

Cost of merchandise so ld = Br. 580 - 270

= Br. 310
As you see, the results are different under periodic & perpetual inventory systems.

2.4.3 Weighted average cost method.

Under this method, the average unit cost is calculated each t ime purchased is made to be
applied on the sales made after the purchases. The results may be different under periodic and
perpetual inventory system.

Let us calculate the cost of merchandise so ld and ending inventory co mes out from the
previous illustration under perpetual inventory system.

28
 Average Cost Method (Moving Average)
Purchase Cost of merchandise sold Inventory
Date Qty Unit cost Total cost Qt y Unit cost Total cost Qt y Unit cost Total cost

Jan. 15 Br. 10.00 Br. 150.00

1
6 5 Br. 10.00 Br. 50.00 10 10. 00 100. 00
20 11. 00 220. 00
10 10 12.00 Br. 120.00 = 100+120
10+10
20 8 11. 00 88. 00 12 11. 00 132. 00
20 11. 60 + 232. 00
25 8 12. 00 100. 00 132+100
12+8

27 10 11. 60 116. 00 10 11. 60 116. 00

30 15 14. 00 210. 00 15 13. 04 326. 00
116+210
10+15
23 Br. 254.00 25 Br. 13.04 Br 326.00

So, the cost of goods sold and ending inventory under perpetual inventory system are Br.
254.00 and Br. 326.00, respectively.

The results under periodic inventory system are:

Weighted average unit cost = Br. 580 = Br. 12.08
48
Ending inventory cost = Br. 12.08 x 25
= Br. 302
Cost of merchandise so ld = Br. 580 – Br. 302
= Br. 278
So, the result is different under periodic and perpetual inventory systems.

29
Check Your Progress Exercise -3
1. What are the advantages of perpetual inventory system over the periodic inventory system?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………………………….

2. In periods of steadily rising prices, which inventory method will give the highest,
i) inventory cost,
ii) lowest inventory cost
iii) highest net income, and
iv) lowest net inco me?

3. Do the FIFO and LIFO inventory methods result in different quant ities of ending
inventory?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………………………….

2.5 SUMMARY

The cost of merchandise inventory is made up of the purchase price and all expenditure
incurred in acquiring such merchandising including transportation, customs dut ies, and
insurance against losses in transit.

Under periodic inventory system, in determining the cost of merchandise so ld and the
inventory at the end o f the period, it is customary to use an assumpt ion as to the flow of costs
of merchandise through an enterprise. The four methods of costing an inventory are specific
ident ificat ion, FIFO, LIFO and weighted average of which the last three are the cost flow
assumpt ions. The FIFO method of costing inventory is based on the assumpt ion that costs
should be charged against revenue in the order in which they were incurred. The LIFO
method is based on the assumpt ion that the most recent costs incurred should be charged
against revenues. T he weighted average method is based on the assumption that costs should
be charged against revenue according to the weighted average unit costs of the goods sold.

30
If the cost of units and the prices at which they are sold remain stable, all three inventory
costing methods will yie ld the same results. However, during a period o f rising prices, the use
of FIFO method will result in a higher amount of gross profit than the other two methods. In a
period of declining prices, the use of LIFO method will result in a higher amount of gross
profit than the other two methods. The average cost method is o ften viewed as a co mpromise
between the FIFO and LIFO methods.

Under a perpetual inventory system, costs are assigned to the cost of merchandise so ld
account each time a sale occurs. Specific identification assigns a cost to each item so ld by
referring to its actual cost. Weighted average assigned a cost to items so ld by taking the
current balance in the merchandise inventory account and dividing it by the total items to
determine the weighted average cost per unit.

2.6 ANSWERS TO CHECK YOUR PROGRESS

Check Your Progress 1

1. Total c cost is Br. 12,180, computed as: Br. 11,400 + 130 + Br. 150 + Br. 100 + Br.
400.
Br. 180 for advertising and Br. 800 for sales salaries are not added to cost of the
inventory. They are included in operating expenses

Check Your Progress 2

1) First-in, First-out (FIFO) method
2) No, They are the methods of determining cost of the inventory.

Check Your Progress 3

1) For internal c control purpose. This is by co mparing the perpetual inventory record
and inventory amount through physical count; we can determine the inventory
shortage or overage.
For preparation of interim financial statements, there is no need of count ing the
inventory. Frequent comparisons o f balance with predetermined maximum and
minimum levels facilitate the timely recording of merchandise to avoid both excess
inventory and the cost of sales.

31
2.7 MODEL EXAMINATION QUESTIONS

A. Short answer questions

1. When costs and prices are rising, does LIFO or FIFO report higher net inco me?
2. In periods of declining prices, which method are not preferable income tax purposes?

B. Workout question
Tale Co mpany had the fo llowing beginning inventory and purchases during 2002:
Item X
Date Unit’s Unit cost
Jan. 1 Inventory 400 Br. 14
March 10 Purchase 200 15
May 9 Purchase 300 16
Sep. 22 Purchase 250 20
Nov. 28 Purchase 100 21

At December 31, 2002, there were 550 units of X on hand.

Sales of units were as fo llows:
Jan.15 200 units at Br. 30
April 1 200 units at Br. 30
Nov. 1 300 units at Br. 35

Addit io nal data for use in applying the specific ident ification method
(1) Jan. 15 sale - 200 units@ Br. 14
(2) April 1 Sale - 200 units@ Br. 15
(3) Nov. 1 Sale - 200 units@ Br. 20

Required:
a. Calculate the cost of merchandise available for sale
b. Apply the four different methods of inventory costing to calculate ending
inventory & Cost of merchandise so ld under:

i) Periodic inventory system

ii) Perpetual inventory system

32
1. What is the difference between goods flow and cost flow?
2. What are the relat ive advantages and disadvantages of FIFO and LIFO methods o f
inventory costing?
3. Why do you think it is more expensive to maintain a perpetual inventory system?
4. What are the three most important advantages of the perpetual inventory system?
5. A co mpany using a perpetual inventory system sells merchandise to a customer on
account for Br. 1250; the cost of the merchandise was Br. 1000.
a) What entries would be made on the general ledger accounts as a result o f the
transaction?
b) What is the amount of gross profit realized from this specific sale?

II. Choose the best answer fro m the given alternat ives
1. The inventory system that does not attempt to record the cost of goods sold each t ime sale
is made is;
a) FIFO b) Periodic c) Perpetual d) Physical
e) b and d f) c and d

2. If merchandise inventory is being valued at cost and the price level is consistent ly falling,
which method of costing will yield the largest net inco me?
a) LIFO b) FIFO c) Average cost d) a or b
e) None of the above

3. Ident ify the correct statement

a) If the FIFO method of inventory costing is selected by a co mpany the method shall
be used for all inventory items.
b) Under the average cost method, the same unit cost is used to compute both the cost
of goods sold and the cost of inventory.
c) One o f the major drawbacks o f LIFO is that it does not attempt to match current
costs with current revenues.
d) All o f the above
e) None of the above

33
4. Ident ify the wrong statement:
a) The FIFO method in periods of rising prices causes businesses to report more than
their true profit result ing in the payment of excess inco me taxes.
b) Over a period of rising prices a business that use LIFO method may report the value
of inventory at a cost figure far below what it current ly pays for the same item.
c) Pricing the inventory and cost of goods sold using the specific ident ificat ion method
is the same under both periodic and perpetual systems.
d) The FIFO method of inventory costing is not the best measure of the current balance
sheet value o f inventory.
e) None of the above.

5. In which method of inventory costing the flow of cost and inco me determinat ion is given
due considerat ion?
a) Average cost b) FIFO c) LIFO
d) Gross profit e) None of the above

III. Problems
1. E yassu Furniture Co mpany so ld 2200 doors during 19 x 5 at Br. 320 per door. Its
beginning inventory on January 1 was 130 doors at Br. 112. Purchases made during the
year were as fo llows:

February 225 doors @ Br. 124

April 350 doors @ Br. 130
June 700 doors @ Br. 140
August 300 doors @ Br. 132
October 400 doors @ Br. 136
November 250 doors @ Br. 144
The company's selling and administrative expenses for the year were Br. 202,000, and the
company uses the periodic inventory system.

Required:
1. Prepare a schedule to compute the lost of goods available for sale.
2. Prepare an inco me statement under each o f the fo llowing assumpt ions:

34
 (a) costs are assigned to inventory using the average cost method
(b) costs are assigned to inventory using the FIFO method
(c) costs are assigned to inventory using LIFO method

2.8 GLOSSARY

6. Cost-to-benefit constraint- it is a concept that says account ing information is used

disclosed if the cost perceived to be associated with it is balanced against the benefit s
perceived to be associated with it.

7. First-in, First-out (FIFO) method- method of inventory costing based on the assumpt ion
that the costs of merchandise so ld should be charged against revenue in the order in which
the costs were incurred.

8. Last-in, First-out (LIFO) method- a method of inventory costing based on the

assumpt ion that the most recent merchandise costs should be charged against revenue.

35
UNIT 3: ADDITIONAL VALUATION PROB LEMS FOR INVENTORIES

Contents
Aims and Object ives
Introduction
Valuat ion at Lower of Cost or Market
Estimat ing Inventory Cost
Method of Inventory Costing
Retail Gross Profit Method
Summary
Answers to Check Your Progress
Model Examinat ion Quest ions
Glossary

3.0 AIMS AND OBJECTIVES

This chapter aims at discussing various valuat ion methods like lower of cost or market, retail
method and gross profit method.

After studying this chapter, you would be able to:

1. explain the valuation o f inventory at other than cost, including valuat ion at the lower
of cost or market.
2. acquaint yourself with various methods of est imating cost of an inventory, including
retail method and gross profit method.

3.1 INTRODUCTION

an attempt has been made in this unit to explain valuat ion of inventory valuat ion and the
problems such as valuat ion at lower of cost or market, retail method and gross profit method
of est imating an inventory cost.

3.2 VALUATION AT LOWER OF COST OR MARKET (LCM)

It was explained how costs are assigned to ending inventory and cost of goods sold using one
of four costing methods (FIFO, LIFO, Weighted average, or specific ident ificat ion). Yet, the
cost of inventory is not necessarily the amount always reported on a balance sheet.

36
Account ing principles require that inventory be reported at the market value o f replacing
inventory when market is lower than cost. Merchandise inventory is then said to be reported
on the balance sheet at the lower of cost or market (LCM).

In applying LCM, cost is the acquisit ion price of inventory co mputed using one of the
historical cost methods - specific ident ificat ion, FIFO, LIFO, and Weighted average; market is
defined as the current market value (cost) of replacing inventory. It is the current cost of
purchasing the same inventory items in t he usual manner. It is important to know that market
is not defined as the sales prices. A decline in market cost reflects a loss o f value in inventory.
This is because the recorded cost of inventory is higher than the current market cost. When
this occurs, a loss is recognized. This is done by recognizing the decline in merchandise
inventory from recorded cost to market cost at the end of the period.

LCM is applied in one of three ways:

(1) Separately to individual item
(2) To major categories of items
(3) To the whole of inventory

The less similar the items are that make up inventory, the more likely it is that companies
apply LCM to individual items. Advances in technology further encourage the individual ite m
applicat ion.

Illustration
The fo llowing are the inventory of ABC motor sports, retailer.
Inventory u n its per unit
Items on hand cost market
Cycles:
Roadster 50 Br. 15,000 Br. 14,000
Sprint 20 9,000 9,500

Off Road:
Trax-4 10 10,000 11,200
Blaz’m 6 16,000 14,500

37
Let us see LCM computation under the three ways:

(1) Separately to each individual item

Inventory items Total cost Total market LCM

Roadster Br. 750,000 Br. 700,000 Br. 700,000

Sprint 180,000 190,000 180,000
Categories sub total Br. 930,000 Br. 890,000
Trax-4 100,000 112,000 100, 000
Blaz’m 96,000 87,000 87, 000
Categories sub total Br. 196,000 Br. 199,000
Totals Br.1,126,000 Br. 1,089,000 Br. 1,1,067,000

(2) Major categories of items

Inventory Categories Categories LCM

categories total cost total market
Cycles Br. 930,000 Br. 890,000 Br. 890,000
Off. Road 196, 000 199, 000 199,000
Totals Br. 1,126,000 Br. 1089,000 Br. 1,086,000

When LCM is applied to the who le o f inventory, the market cost is Br. 1,089,000. Since this
market cost is Br. 37,000 lower than Br. 1,126,000 recorded cost, it is the amount reported for
inventory on the balance sheet. When LCM is applied to individual items of inventory, the
marked cost is Br. 1,067,000. Since market is again less than Br. 1,126,000 cost, it is the
amount reported for inventory. When LCM is applied to the major categories of inventories,
the market is Br. 1,086,000 which is also lower than cost.

Check Your Progress Exercise -1

1. In the phrase lower of cost or market, what is meant by “market”?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

38
2. Blen Trading value its inventory, shown below, at the lower of cost or market. Compute
Blen's inventory value using (i) item – by – item method, and (ii) the major category
method.
Per Unit
Q u an t i t y Cost Market
Category I
Item A 200 Br. 5.00 Br. 4.00
Item B 300 4.00 4.00
Item C 400 10.00 8.60

Category II
Item X 500 8. 00 9.20
Item Y 300 14. 00 14.50

3.3 ESTIMATING INVENTORY COST

In practice, an inventory amount is est imated for some purposes. When it is impossible to take
a physical inventory or to maintain perpetual inventory records.

Example
1) Monthly inco me statements are needed. It may b e too costly, to take physical inventory.
This is especially the case when periodic inventory system is used.
2) When a catastrophe such as a five has destroyed the inventory. In such case, to ask claims
fro m insurance co mpanies, the is a need of est imated inventory.

To estimate the cost of inventory, two methods are used. These are retail method and gross
profit method.

3.3.1 Retail method of inventory costing

This method is mo stly used by retail business. The estimate is made based on the relat ion ship
between the cost and the retail price of merchandise available for sale.

39
The steps to be fo llowed are:
(1) Calculate the cost to retail rat io = Cost of merchandise available for sale
Retail Price of merchandise available for sale

(2) Calculate the ending inventory at retail price

Ending inventory at retail price = retail price of merchandise available for sale – Sales

(3) Calculate the estimated cost of ending inventory

Estimated cost of ending inventory = Cost to retail ration X Ending inventory at retail

Example
Cost Retail
Sep. 1, beginning inventory Br. 25,000 Br. 40,000
Purchases in September (net) 125,000 160,000
Sales in September (net) 140,000

(1) Cost retail rat ion = Br. 25,000 + Br. 125,000 = 0.75
Br. 40,000 + Br. 160,000
(2) Ending inventory at retail = (Br. 40,000 + Br. 160,000) – Br. 140,000 = Br. 60,000
(3) Estimated ending inventory at cost = 0.75 X Br. 60,000
= Br. 45,000

Check Your Progress Exercise -2

1. Enterprises using the retail method of inventory costing determine the merchandise
inventory at retail is Br. 300,000. If the rat io of cost of retail price is 65%, what is the
estimated cost of inventory?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. Does the retail inventory method mean that inventories are measured at retail value on the
balance sheet? Explain.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

40
3.3.2 Gross profit method
This method uses an estimate of the gross profit realized during the period to estimate the cost
of inventory. The gross profit rate may be est imated based on the average o f previous period’s
gross profit rates.

The steps are as fo llows:

(1) The gross profit rate is est imated and then est imated gross profit is calculated.
Estimated gross profit = Gross profit rate X Sales

(2) Cost of merchandise so ld is est imated

Estimated cost of merchandise so ld = Sales - Estimated gross profit

(3) Calculate the estimated cost of ending inventory

Estimated cost of ending inventory =
Cost of merchandise available for sale – Estimated cost of merchandise so ld.

Example

Oct. 1, beginning inventory (cost) – Br. 36,000

Net purchases during October (cost) 204,000
Net sales during October 220, 000
Estimated gross profit rate is 40%

The ending inventory is est imated as follows:

(1) Estimated gross profit = 0.4 X 220,000
= Br. 88,000

(2) Estimated cost of merchandise so ld

= Br. 220,000 – Br. 88,000
= Br. 132,000

(3) Estimated cost of ending inventory

= (Br. 36,000 + 204,000) – Br. 132,000
= Br. 240,000 – Br. 132,000
= Br. 108,000

41
Check Your Progress Exercise-3
1. Cost of merchandise available for sale is Br. 200,000 and net sales for the period is Br.
180,000. If the cost of merchandise so ld percentage of sales is 60%, what is the est imated
cost of the inventory to be reported on the financial statements?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

2. What are so me o f the reasons that may cause management to use the gross profit method
of est imating inventory?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

3.4 SUMMARY

If the market price of an item o f inventory is lower than its cost, the lower of cost or market
method is used to value inventory. Market, as used in the phrase lower o f cost or market; is
interpreted to mean the cost to replace merchandise on the inventory date. It is possible to
apply the lower of cost or market basis to each item in the inventory, to major classes or
categories, or to the inventory as a who le.

When it is impract ical or impossible to take a physical inventory or to maintain perpetual

inventory records, two commo nly used methods of estimat ing inventory would be applied:
1) the retail method and
2) the gross profit method

The retail method of inventory est imat ion is based on the relation ship of the cost of
merchandise available for sale to the retail prices of the same merchandise. The inventory at
retail is determined by deducting net sales for the period fro m the retail price of the goods that
were available for sale during the period. The inventory at retail is then converted to cost on
the basis o f the ratio of cost to selling price of the merchandise available for sale.

42
The gross profit method of est imating inventory is based upon the historical relat ionship of
the gross profit to the sales. The rate of gross profit is mult iplied by the sales to determine the
gross profit. To determine the cost of merchandise so ld, the gross profit is then subtracted
fro m sales. The est imated cost of ending inventory is co mputed by subtracting the cost of
merchandise sold fro m cost of merchandise available for sale.

3.5 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress Exercise 1

1. The cost to replace merchandise on the inventory date
2. (i) Item – by – item method:

Category I Total Cost Total Market LCM

Item A Br. 1000 Br. 800 Br. 800
Item B 1200 1320 1200
Item C 4000 3440 3440

Category II Total Cost Total Market LCM

Item X Br. 4000 Br. 4600 Br. 4000
Item Y 4200 4350 1200
Inventory of LCM Br. 13,640

(ii) The Major Category Method

Category I Total Cost Total Market LCM
Item A Br. 1000 Br. 800
Item B 1200 1320
Item C 4000 3440
Totals Br. 6200 Br. 5560 Br. 5560

Category II Total Cost Total Market LCM

Item X Br. 4000 Br. 4600
Item Y 4200 4350
Totals Br. 8200 Br. 8950 Br. 8200
Inventory of LCM Br. 13,760

43
Check Your Progress Exercise 2
1. It is Br. 195,000 computed as 0.65 X Br. 300,000
2. No, the inventory at retail is converted to cost on the basis o f the ratio of cost to retail.
Therefore, it is reported on the balance sheet at its estimated cost.

Check Your Progress Exercise 3

1. It is Br. 92,000 computed as fo llows
Cost of merchandise so ld = Br. 180,000 X 0.60 = Br. 108,000
Estimated cost of ending inventory = Br. 200,000 – Br. 108,000
= Br. 92,000

2. To replace the retail method when records of the retail prices o f beginning inventory and
purchases are not kept.
To prepare interim financial statements, and to estimate the inventory lost or destroyed by
theft, fire, or other hazards.

3.6 MODEL EXAMINATION QUESTIONS

A. Short answer questions

1. From three ways o f applying lower of cost or market, which one results in minimu m
value of inventory?
2. When do we use the inventory estimat ion methods to determine the cost of inventory?

B. Work out questions

1. Crystal Corporation’s ending inventory includes the fo llowing items.

Product Units on hand Unit cost Replacement cost per unit

W 40 Br. 30 Br. 34
X 50 48 40
Y 60 26 24
Z 44 20 20

Replacement cost is determined to be the best measure of market. Calculate lower of cost or
market for the inventory
a. As a who le b. Applied separately to each products

44
2. The records of the unlimited provided the following informat ion for the year ended
December 31:
At cost At retail
Jan. 1 beginning inventory Br. 160,450 Br. 264,900
Purchases 1,100,140 1,828,200
Purchases returns 17,600 34, 100
Sales _ 1,570,200
Sales returns _ 15, 600
Transportation in 13,000 _

Required: calculate the estimated cost of ending inventory

a. By retail method
b. By gross profit method if the gross profit rate is 30%

3. Rahel Co mpany's Dress shop had net retail sales of Br. 1,000,000 during the current year.
The fo llowing addit ional informat ion was obtained fro m the accounting records:

At Cost At Retail
Beginning Inventory Br. 160,000 Br. 240,000
Net Purchase 560,000 880,000
Transportation – In 41,600

Required:
a) Estimate the company's ending inventory at cost using the retail method.
b) Assume that a physical inventory taken at year-end revealed an inventory on hand o f
Br. 72,000 at retail value. What is the estimated amount of inventory shrinkage (loss
due to theft, damage, and so forth) at cost?

4. Fantu and his family is a large retail furniture company that operates in two adjacent
warehouses. One warehouse is a showroom, and the other is used to store merchandise.
On the night of March 13, a fire broke out in the storage warehouse and destroyed the
merchandise stored there.

45
 Fortunately, the fire did not reach the showroom, so all the merchandise on displa y was
saved.

Alt hough, the co mpany maintained a perpetual inventory system, its records were rather
had hazard, and the last reliable physical inventory was taken on December 31. In
addit ion, there was not control of the flo w of the goods between the show room and the
warehouse.

Thus, it was impossible to tell what goods should be in eit her place. As a result, the
insurance co mpany required an independent est imate of the amount of loss. The insurance
company examiners were sat isfied when they were provided with the fo llowing
informat ion.

1. Merchandise Inventory on December 31 Br. 1,454,800

2. Purchase, January 1 to March 13 2,412,200
3. Purchase Returns, Jan. 1 to March 13 (10,706)
4. Freight – In, Jan 1 to March 13 53, 100
5. Sales, January to March 13 3,959,050
6. Sales Returns, Jan 1 to March 13 (29,800)
7. Merchandise Inventory in Showroom March 13 402, 906
8. Average gross Margin 44%

Required:
Prepare a schedule that estimates, the amount of the inventory lost in the fire.

5. Sanete Trading Company switched recent ly to the retail inventory method to estimate
the cost-ending inventory. To test this method, the company took a physical inventory one
mo nth after its implementation. Cost, retail, and the phys ical inventory data are as
fo llo ws:

At Cost At Retail
Beginning Inventory, January 1 Br. 472,132 Br. 622,800
Purchase 750,000 1,008,400
Freight – In 8,350

46
Purchases Returns and Allowances (25,200) (34,800)
Sales 1,060,000
Sales Returns and Allowances (28,000)
January 31, Physical Inventory 508, 200

Required:

a) Prepare a schedule to estimate the amount of Sanete Company's January 31 inventory

using the retail method.
b) Use the company's cost ratio to reduce the retail value of the physical inventory to
cost.
c) Calculate the estimated amount of inventory shortage of cost and at retail.

47
UNIT 4: ACCOUNTING FOR PLANT ASSETS AND DEPRECIATION

Content
4.0 Aims and Object ives
4.1 Introduction
4.2 Nature and Meaning of Long-Term Assets
4.3 Determinat ion of The Accusat ion cost of Plant Assets
4.4 Natures and Meaning of Depreciat ion
4.5 Factors That Affect the Computation of Depreciation
4.6 Methods of co mputing Depreciat ion
4.6.1 The Straight-Line Method
4.6.2 Units of Production Method
4.6.3 Double-Declining Balance Method
4.6.4 The Sum-of-The-Years-Digit s Method.
4.7 Comparison of Depreciat ion Methods
4.8 Recording Depreciation
4.9 Special Depreciat ion Methods
4.9.1 Group and Composite-Rate Depreciation Methods
4.10 Revisio n of Depreciat ion Rates
4.11 Capital and Revenue Expenditures
4.12 Summary
4.13 Answer to Check Your Progress
4.14 Model Examinat ion Quest ions
4.15 Reference Books
4.16 Glossary

4.0 AIMS AND OBJECTIVES

This unit aims at discussing the meaning and nature of plant assets, acquisit io n costs, and the
related cost allocation (depreciation) o f plant assets. The units also discuss the different
methods of co mput ing depreciat ion and the account ing procedures invo lved in recording the
transactions relat ing to disposal o f plant assets.

48
After having studied and worked through this unit, you will able to be:
 determine the acquisit ion c cost of tangible assets
 compute depreciat ion for plant assets using various depreciat ion methods
 record depreciat ion expense in the account ing records
 dist inguish expenses fro m expenditures that should be capitalized
 different iate depreciat ion for financial reporting from depreciation for inco me tax

4.1 INTRODUCTION

In the previous chapter you have learnt about the accounting for current assets (i.e. account ing
for cash, receivables and inventories). In this chapter you will learn about the issues of plant
assets and its related depreciat ion.

Most business enterprise ho lds such major assets as land, buildings, equipments, furnitures,
tools, and etc. These assets help produce revenue over many periods by facilit ating the
production and sale o f goods or services to customers. Because these assets are necessary in a
company’s day-to-day operations, companies do not sell them in the ordinary course of
business. Keep in mind, though; one co mpany’s long-term asset might be another company’s
short-term asset. For example, a delivery truck is a long-term asset for most companies, but a
truck dealer would regard a delivery truck as a current asset merchandise inventory.

4.2 NATURE AND MEANING OF LONG-TERM ASSETS

Assets that can be used by a business enterprise for relat ively lo ng period (usually more than
one year) are called Long-Term Assets.

Long-term assets are divided into tangible and intangible categories.

Tangible assets (also called plant assets or fixed assets) are assets with phys ical substance that
can be charged in the operations o f business for a relat ively lo nger period of time, usually
more than one year or one operating cycle whichever is lo nger. Examples are land, buildings,
equipments and machineries, trucks, etc.

49
In contrast, intangible assets are assets without a physical feature that can be charged in the
operations o f business for long period of time. They generally consist of rights or advantages
held such as goodwill, patents, copyrights, franchise, trade marks, organizat ion costs, etc.

4.3 DETERMINATION OF THE ACQUISITION COST OF PLANT ASSETS

The acquis it ion cost of plant (fixed) assets is the cash or cash-equivalent purchase price,
including incidental costs required to complete the purchase, to transport the asset, and to
prepare it for use.

For example, expenditures related to the acquisit io n o f a plant asset such as freight, insurance
while in transit, and installat ion are included in the cost of the asset because they are
necessary if the asset is to funct ion. According to the matching principle, therefore, such costs
are allo cated to the economic life o f the asset rather than charged as expenses in t he current
period.

L an d
The acquisit io n cost of land includes the negotiated cash price plus other costs such as the
cost of land surveys, legal fees, title fees, broker’s commissio ns, co9st of preparing the land to
build on, and even the demo lit ion costs of o ld structures that might be torn down to get the
land ready for its intended use.

Under the historical cost assumpt ion, land is reported in the balance sheet at its original cost.
Land is not subjected to depreciat ion because land does not have a limited useful life.

The fo llowing illustration will help us how to determine the cost of land.

Illustration-1
A business enterprise acquires a piece of land for future site. It pays a cash price of Br.
210,000, pays brokerage fees of Br. 7500 and tit le fees of Br. 3000, pays Br. 5000 to have
unwanted building removed, and pays, Br. 1500 to have the site graded. The business receives

Br. 2000 salvage fro m the old building. The cost of the land is determined as fo llows:
Cash prices (negotiated price)…………………………………………Br. 210,000.00
Tit le Fees……………………………………………………………………..3,000.00

50
 Brokerage Fees………………………………………………………………...7,500.00
Cost of Grading……………………………………………………………..…1,500.00
Cost of removing (demo lit io n) unwanted building Br. 5000
Less: Salvage received……………………………….(2000)…………………3,000.00
Total cost of land…………………………………………………… .….Br. 225,000.00

Generally, land is part of property, plant and equipment. If the major purpose of acquiring and
ho lding land is speculat ive, it is more appropriately classified as an investment. If the land is
held on a real estate concern for resale, it should be classified as inventory. When the land has
been purchased for the purpose of constructing a building, all costs incurred up to the
excavat ion for the new building are considered land costs. Removal o f o ld buildings clearing,
grading and filling are considered land costs because these costs are necessary to get the land
in condit io n for its intended purpose. Any proceeds obtained in the process o f getting the land
ready for its intended use, such as salvage receipts on the demo lit io n of an o ld building are
treated as reductions in the price of the land.

Cost of buildings
When an exist ing building is purchased its cost includes, the purchase price plus all repairs
and other expenses required to put it in a usable condit ions. On the other hand, when a
business constructs a new building, the cost includes all reasonable and necessary
expenditures, such as those for materials, labor, part of the overhead and other indirect costs,
engineers and architects’ fees, insurance during construction, interest incurred on construction
loans during the period o f construction, lawyers' fees, and building permits. If outside
contractors are used in the construction, the net contract price plus other expenditures
necessary to put the building in usable condit io n are included.

Cost of equipment
The term “ equipment” in account ing includes office equipment, store equipment, factory
equipment, delivery equipment, machinery, furnit ures and fixtures, and similar fixed assets.
The cost of such assets includes the invo ice (purchase) price, transportation and handling
charges, insurance on the equipment while in transit, assembling and installat ion costs, and
costs of conducting trail runs. As indicated earlie r, all costs of getting an asset ready for its
intended use are costs of that asset.

51
4.4 NATURE AND MEANING OF DEPRECIATION

As plant assets are used in the operations of a business, their value to provide service
decreases through usage and the passage of time.

This cost allocat ion o f plant asset, called depreciation, is recorded in the account ing books
periodically.

Depreciat ion is frequently misunderstood. The term depreciat ion, as used in accounting, does
not refer to the physical deterioration o f an asset or the decrease in market value of an asset
overtime.

Depreciat ion means the allocat ion o f the cost of a plant asset to the periods that benefit fro m
the services of the asset.
The term depreciat ion is used to describe the gradual conversio n o f the cost of the asset into
an expense.

Depreciat ion is not a process o f valuation. Ac count ing records are kept in accordance wit h
the cost principle; they are not indicators of changing price levels. It is possible that, through
an advantageous buy and specific market condit ions the market value o f a building may rise.
Nevertheless, depreciat ion must continue too be recorded because it is the result of a n
allocat ion, not a valuat ion process.

4.5 FACTORS THAT AFFECT THE COMPUTATION OF DEPRECIATION

Four factors affect the computation of depreciat ion. They are:

(1) Cost
(2) Residual value
(3) Depreciable cost, and
(4) Estimated economic (useful) life.

Cost- is the net purchase price plus all reasonable and necessary expenditures to get the asset
in place and ready for use.

Residual value- also known as salvage value, disposal value, scrape value, or trade-in value
represents the estimated market value of the asset at the time of its retirement.

52
Depreciable cost - represents the difference between the asset cost and its estimated residua l
value. For example, an item o f equipment that costs Br. 5000 and has a residual value o f Br.
500 would have a depreciable cost of Br. 4500, (Br. 5000 - Br. 500). The depreciable costs
must be allo cated over the estimated economic life of the asset.

Estimated economic (useful) life- the estimated economic life o f an asset is the total number
of service unit s expected fro m the asset. Service units may be measured in terms of years the
asset is expected to be used, units expected to be produced, miles or kilo meters expected to be
driven, or similar measures. In determining the estimated useful life of an asset, the
accountant should consider all relevant information, including (1) past experience wit h similar
repair assets, (2) the asset’s present condit ion, (3) the company’s repairs and maintenance
policy, (4) current techno logical and industry trends, and (5) local condit ions such as whether.

4.6 METHODS OF COMPUTING DEPRECIATION

Depreciat ion methods differ primarily in the amount of cost allocated to each period. A list of
depreciat ion amounts for each year of an asset’s useful life is called depreciation schedule.
The most commo n methods of co mputing depreciation for plant assets are:
(1) The straight line method
(2) The units o f production method
(3) The double-declining balance method, and
(4) The sum-o f- the years-digits method.

4.6.1 Straight-Line Depreciation

When this method is used to allocate depreciat ion, the depreciable cost of the asset is spread
evenly (uniformly) over the useful life of an asset. The straight-line method is based on the
assumpt ion that depreciat ion depends only on the passage o f t ime. The depreciat ion expense
for each period is co mputed by dividing the depreciable cost by the number o f accounting
periods in the asset’s est imated useful life. T he depreciat ion expense to be reported is the
same in each year. The fo llowing illustration will help us to understand the Straight-Line
method of co mputing depreciat ion.

53
 Illustration - 2
Suppose, for example a business enterprise acquires a new co mputer (office equipment) at a
cost of Birr 6000. It is est imated that the computer has an est imated residual value o f Birr
1000 at the end of it s est imated useful life o f 4 years. The yearly (annual) depreciation would
be Birr 1250m computed as follows:

Annual depreciat ion = Cost - Salvage value

Estimated useful life

= Birr 6000 – Birr 1000 = Birr 1250

4 years
The depreciation to be reported for each of the four years would be as fo llows:

Depreciation Method- Straight-Line Method

Year Cost Yearly Accumulated Carrying value
Depreciation Depreciation (Book Value)
Beginning of first year Br. 6000 - - Br. 6000.00
End of first year 6000 Br. 1250.00 Br. 1250.00 4750. 00
End of second year 6000 1250. 00 1250. 00 3500. 00
End of third year 6000 1250. 00 3750. 00 2250. 00
End of fourth year 6000 1250. 00 5000. 00 1000. 00

NB. There are three important points to note from the depreciation schedule for the straight-line
depreciation method. First, the depreciation is the same each year. Second, the accumulated
depreciation increases uniformly. Third, the carrying (Book) value decreases uniformly until it
reaches the estimated residual value.

4.6.2 Units of Production Method

The production method of depreciation is based on the assumpt ion that depreciat ion is mainly
the result of use and that the passage o f time plays no role in the depreciat ion process. If we
assume that the office equipment fro m the previous illustration has an estimated useful life o f
10,000 hours, the depreciat ion cost per hour would be determined as fo llows:

Hourly depreciat ion = Cost – Salvage value = Br. 6000.00 – 1000 = Br. 0.50
Rate Estimated units of useful life 10,000 operating hrs.

54
 If we assume that the use o f the equipment was 2800 hours for the first year, 3600 hours for
the second, 2400 hours for the third, and 1200 hours for the fourth, the depreciation schedule
for the office equipment would appear as fo llows:

Depreciation Schedule – Production Method

Year Cost Hours Depreciation Yearly Accum. Carrying value

Per Hour Depr. Depr. (Book value)
Beginning of the Br. 6,000 - Br. 0.50 - - Br. 6,000.00
First year
End of first year 6, 000 2, 800 0. 50 Br. 1,400.00 Br. 1,400.00 4,600.00
End of second year 6, 000 3, 600 0. 50 1,800.00 3,200.00 2,800.00
End of third year 6, 000 2, 400 0. 50 1,200.00 4,400.00 1,600.00
End of fourth year 6, 000 1, 200 0. 50 600. 00 5,000.00 1,000.00

Under the production method, there is a direct relation between the amounts of depreciat ion
each year and the units o f output or use. Also, the accumulated depreciation increases each
year indirect relat ion to units o f output or use. Finally, the carrying amount decreases each
year in direct relat ion to units of output or use until it reaches the estimated residual value.

Under the production method, the unit s o f output or use that is used to measure est imated
useful fife for each asset should be appropriate for that asset. For example, for one machine
number of units produced may be an appropriate measure, for another number of hours ma y
be a better measure. The production method should be used only when the output of an asset
over its useful life can be est imated with reasonable accuracy.

4.6.3 Declining Balance Method

This method of depreciat ion results in relat ively large amount of depreciat ion in the early
years o f an assets life and smaller amounts in later years. This method is based on the
assumpt ion of the passage of t ime. Since most kinds o f plant assets are most effic ient when
new, and so they provide more and better service in the early years o f useful life. It is
consistent with the matching rule to allocate more depreciat ion to the early years than to later
years if the benefit s or services received in the early years are greater.

55
 The declining-balance method is the most commo n accelerated method of depreciat ion. Under
this method depreciat ion is co mputed by applying a fixed rate to the book value o f the asset,
result ing in higher depreciation charges during the early years o f the asset’s life. Though any
fixed rate might be used under the method, the most co mmon rate is a percentage equal to
twice the straight-line percentage. When twice the straight-line rate is used, the method is
usually called the double-declining balance method.

Referring to the previous example, the equipment had an est imated useful life o f four years.
Consequent ly, under the straight-line method, the depreciation rate for each year was 25
percent, (100/ estimated useful life o f the asset for 100/ 4 years).

Therefore, under the double-declining balance method, the fixed rate is 50 percent (2X 25
percent). This fixed rate of 50 percent is applied to the remaining carrying value at the end of
each year. Estimated residual value is not taken into account in comput ing depreciat ion except
in the last year of an asset’s useful life, when depreciat ion is limited to the amount necessar y
to bring the carrying value down to the estimated residual value. The depreciat ion schedule
for this method is as fo llows:

Depreciation Schedule, Double-Declining Balance Method

Year Cost Fixed Depr. Yearly Accumulated Carrying Value

Rate Depreciation Depreciation (BV)
Date of purchase Br. 6000 50% - - Br. 6000
End of first year 6000 50% Br. 3000 Br. 3000 3000
End of Second year 6000 50% 1500 4500 1500
End of third year 6000 50% 750 5250 750
End of fourth year 6000 50% 250 550 500
NB. The fixed rate of 50% is always applied to the Book value at the end of the previous year. The
depreciation is greatest in the first year and declines each year after that. Finally, the depreciation in
the last year is limited to the amount necessary to reduce book value to residual value, Br. 250 = Br.
750 – Br. 500 (i.e. Previous book value minus residual value).

Check Your Progress Exercise -1

1. What is the major justificat ion of using the production method of depreciat ion?

56
 …………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

4.6.4 The Sum of The Years Digits Method

Like the declining balance method, the sum o f the years digit s method provides a higher
amount of periodic depreciat ion expense in the earlier use o f the asset's life and a decline
depreciat ion expense thereafter because a successively smaller fraction is applied each year to
the depreciable cost of the asset. Under this method, first we must determine the deno minator
of the fract ion, which is the sum o f the digit s represent ing the years of life. While co mput ing
depreciat ion, the deno minator of the fract ion is unchanged and would remain the same. On
the other hand the numerator of the fract ion, decreases year by year (4/10,3/10/2/10/1/10). At
the end of the asset’s useful life, the balance remaining should be equal to the salvage value.
For example, for a plant asset with an est imated life o f 4 years, the denominator of the
fraction is 4+3+2+1 = 10. The depreciat ion schedule for this method is as fo llows:

Depreciation Schedule- Sum - of - the - Years - Digits Method

Year Depreciable Rate Yearly Accumulated Book Value
Cost Depreciation Depreciation
Date of purchase Br6000 - - - Br. 6000
End of first year 6000 4/ 10 Br. 2200 Br. 2200 3800
End of second year 6000 3/ 10 1650 3850 2150
End of third year 6000 2/ 10 1100 4950 1050
End of fourth year 6000 1/ 10 550 5500 500

Check Your Progress Exercise -2

1. What happens if the est imated economic life of the asset is, let say, 25 years? How would
you calculate the sum-o f-years-digit s?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

57
NB. The above illustration for the sum of year’s digit method is based on the assumpt ion that
the first use o f the asset concide wit h the beginning of the fiscal period. When the first use o f
the asset does not concide wit h the beginning of a fiscal year, it is necessary to allocate each
full year’s depreciat ion b/n the two fiscal years benefited. Assuming that the asset in the
example was placed in service after four months of the fiscal year had been elapsed, the
depreciat ion for that fiscal year would be Br. 1466.67 computed as fo llows:

First year depreciat ion = 4/10 X (6000 – 500) X 8/12…………………. Br. 1466.67
Therefore, the depreciat ion for the second year would be ….Br. 1833.33
Computed as follows:

= 4/10 X (6000 – 500) X 4/12……………….. Br. 733. 33

= 3/10 X (6000 – 500) X 8/12……………………. 1100.00

Total, second fiscal year depreciat ion…………………………… Br. 1833.33

4.7 COMPARISON OF DEPRECIATION METHODS

The straight-line depreciation provides a uniform or equal depreciat ion charges to expense
throughout the service life of the asset.

The production method of depreciat ion provides for periodic charges to depreciat ion expense
that may vary considerably, depending upon the amount of usage o f the asset. The production
method does not generate a regular pattern because o f the rando m fluctuation o f the
deprecation fro m year to year.

The major limitat ion o f the production method is that it is not appropriate in situat ion in
which depreciation is a function of t ime instead of activit y. Another problem in using the
production method is that an estimate of units of output or service hours received is often
difficult to determine.

Both the declining balance and the sum o f the years digits methods are referred to as
accelerated depreciat ion methods, because they provides (report) relat ively higher
depreciat ion expense in the earlier uses of the life of the asset and a gradually declining
periodic expense thereafter.

58
The main just ificat ion for this approach is that more depreciat ion should be charged in earlier
years because the asset suffers its greatest loss of services in those years.
Accelerated depreciat ion method also recognizes that changing techno logies make so me
equipment lose their capacit y to yield services rapidly. Thus, it is appropriate to allocate more
to depreciation in the early years, than in later years.

Another argument in favor of an accelerated method is that repair (maintenance) expense is

likely to be greater in later years than in early years. Thus, the reduced amounts of
depreciat ion reported in later years of the asset’s life are o ffset to some extent by increased
repair (maintenance) expense.

A visual co mparison may provide a better understanding o f the three-depreciat ion methods
disc ribe above. Figure 4-1 compares the yearly depreciat ion under the four methods.

300
Graphical Co mparison of three methods of
Yearly 2500 determining depreciat ion
Depreciat ion
2000

1500
SLD

1000
SYD
500
DDBD

1 2 3 4

In the above graph that shows yearly depreciat ion, straight-line depreciat ion is uniform at Birr
1375 per year over the four years period. However, the declining balance method begins at an
amount greater than straight line (Br.3000) and decreases each year to amounts that are less
than straight line (ult imately, Br. 250). The production method does not generate a regular

59
pattern because of the rando m fluctuation of the depreciat ion fro m year to year. In genera l
companies use different methods of deprecat ion for goods reason. The straight-line method
can be advantageous for financial reporting because it can produce the highest net inco me,
and the accelerated depreciat ion method can be beneficial for tax purposes because it can
result in lower inco me taxes.

Check Your Progress Exercise -3

1. Under what situation is the production method of depreciat ion appropriate?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

2. State and describe the draw back of the production method of depreciat ion?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

4.8 RECORDING DEPRECIATION

The amount by which a fixed asset decreases is an expense of the business. The amount of
depreciat ion expense should be recorded each fiscal period. If depreciat ion expense is not
recorded, the inco me statement will not contain all the expenses of the business. T his will
cause the net income to be reported higher than it should be. Inco me tax laws allow a business
to deduct depreciat ion as an expense in determining net income. If depreciat ion expenses are
not included on the inco me tax reports, the business will pay more inco me taxes than it should
be.

Depreciat ion may be recorded by an entry a t the end of each mo nth, or the adjust ment may be
delayed unt il the end of the year.

To record the periodic cost expiration (allocation) of plant asset, the expense account,
depreciat ion expense is debited and the part of the entry that records the decrease in the plant
asset is credited to a contra asset account entit led Accumulated Depreciat ion or Allowance for
Depreciat ion. The use of this contra asset account permits the original cost to remain
unchanged in the plant asset account. This facilitates the co mputation of periodic

60
depreciat ion, the list ing o f both cost and accumulated depreciation on the balance sheet, and
reporting required for property and inco me tax purposes.
NB. An exception to the general procedure of recording depreciation monthly or annually is often
made when a plant asset is sold, traded-in, or discarded.

Check Your Progress Exercise -4

1. What would be the journal entry to record the depreciat ion expense of a machine that
costs Br? 3000, with no salvage value and has an estimated economic life o f 10 years if
the straight-line method is applied? Assuming that the machine was placed in service after
two months had been elapsed in the current period
…………………………………………………………………………………………………
…………………………………………………………………………………………………

Illustrative Problem
TORA-BORA Construction Co mpany acquired a new crane for Birr 360,500 at the
beginning of year 1. The crane has an est imated residual value o f Birr 35,000 and an
estimated useful life o f five years. The crane is expected to last 10,000 operating hours. It was
used 1800 hours in year 1, 2000 hours in year 2. and 2500 hours in year 3. Based on the
informat ion given above:

1) Compute the annual depreciat ion and the carrying value for the crane for each o f the
first three years under each of the fo llowing methods:
a) Straight line method,
b) Units of production method,
c) Double-declining-balance method, and
d) Sum-of-the-years-digit s method.

2) Prepare the adjust ing entry that would be made each year to record the depreciat ion
calculated under the straight line method.

S ol u t i on :
1) a) Straight Line Method:
Annual depreciat ion = original cost – estimated salvage value
Estimated Economic life

61
 = Br. 36,500 – Br. 35,000
5 years

= Br. 325,500 = Br. 65,100

5
Therefore, deprecation for the first year, second year, and for the third year, is uniformly
Br. 65,100.

b) Units of Production Method:

Hourly Depreciat ion Rate = Original Cost – Salvage value
Estimated Operating Hours

= Br. 360,500 – 35,000

10,000 operating hours

= Br. 32.55

During the first year the crane has been in operation for 1800 hours. Therefore, the
depreciat ion for the first year is Br. 58,590, computed as follows:

Br. 32,55 X 1800 hours = Br. 58,590

Second year deprecation = Br. 32.55 X 2000 hours = Br. 65,100

Third year depreciat ion = Br. 32.55 X 2500 hours = Br. 81,375

c) Double-declining- balance Method:

To proceed with the double-declining-balance method, first we have to determine the rate.
The double-declining rate for the asset can be obtained by the fo llowing formula:

Rate = 100 X2
Estimated
Life

62
 Rate = 100 2 = 40%
5 years

Unlike the other methods, in the declining-balance method the salvage value is not deducted
in co mputing the depreciat ion base. The declining balance rate is mult iplied by the book value
of the asset at the beginning o f each period. Therefore,

First year depreciat ion = 40/100 X 36,500 = Br. 144,200

Second year deprecation = 40/100 X (360,500 – 144,200)

= 40/100 X 216,300 = Br. 86,520

Third year depreciat ion = 40/ 100 ( 360, 500 – 230, 720)
= 0.4 X 129,780 = Br. 51,912

d) Sum-of-the-years-digits Method
To work with this method, we must determine the deno minator of the fraction,
The deno minator or the fract ion for an asset with an est imated economic life of 5 years is
5+4+3+2+1 = 15

 Depreciat ion for year 1 is therefore, 5/15 x (OC – Salvage value)

 Which is 5/15x (325,500) = Br. 108,500
 Second year depreciat ion = 4/15 x (325,500) = Br. 86,800
 Third year depreciat ion= 3/15 x 325,500 = Br. 65,100

4.9 SPECIAL DEPRECIATION METHODS

Some t imes each of the four depreciat ion methods discussed so far may not b e suitable
because the assets invo lved have unique characterist ics, or the nature of the industry requires
that a special depreciat ion method be use of these methods, the group and composite methods
are discussed below:

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4.9.1 Group And Composite Methods
Depreciat ion methods are usually applied to a single asset. Under some circumstances,
however, a number (group) of asset accounts are depreciated using one rate. For example, an
enterprise such as Ethiopian Teleco mmunicat ion Corp. might depreciate telephone po les,
microwave systems, or switchboards by groups.

Group depreciation - the term “group” refers to a collect ion of assets that are similar in
nature. The group method is frequent ly used when the assets are fairly ho mogeneous and have
approximately the same useful lives. The group method more closely approximates a single-
unit cost procedure because the dispersion fro m the average is not as great.

Composite-rate depreciation - the term “co mposite” refers to collection o f assets that are not
similar (or dissimilar) in nature.

The composite method is used when the assets are heterogeneous and have different lives.
When depreciation is co mputed on the basis of a composite group of assets of differing life
spans, a rate based on averages must be developed. This is done by (1) comput ing the annua l
depreciat ion for each asset, (2) determining the annual depreciat ion, and (3) dividing the su m
thus determined by the total cost of the assets.
Illustration - 3
TANA Transport share Co. depreciates its group of cars, buses, and trucks on the basis o f
composite-depreciat ion method. The co mposite-rate depreciat ion is co mputed in the
fo llo wing manner:
Original Residual Depreciable Estimated Annual Dep.
Asset Cost Value Cost L if e (straight line method)

Cars Br.400,000 Br. 80,000 Br. 320,000 8 years Br. 40,000

Buses 2,400,000 240,000 2,160,000 10 years 216,000
Trucks 1,500,000 150, 000 1,350,000 9 years 150,000
Br. 4,300,000 Br. 470,000 Br. 3,830,000 Br. 406,000
Composite depreciat ion rate = Br. 406,000 = 9. 44%
Br. 4,300,000

64
If no change exists in the asset account, the group of assets will be depreciated to the residual
or salvage value at the rate of Br. 406,000 (Br. 4,300,000 x 9.44%) a year.

The composite depreciation rate may be applied against total asset cost on a monthly basis, or
some reasonable assumption may be made regarding the timing of increases and decreases in
the group. A commo n pract ice is to assume that all addit io ns and ret irements have occurred
uniformly throughout the year. The co mposite rate is then applied to the average o f the
beginning and ending balances o f the account. Another acceptable averaging technique is to
assume that all addit io ns and retirements during the first-half o f the year occurred as of the
first day of the year, and that all addit io nal and retirements during the second half o f the year
occurred on the first day of the fo llowing year.

NB. If an asset within the co mposite group is retired before, or after, the average service life
of the group is reached, the result ing gain or loss should not be recognized. This practice is
just ified because so me assets will be ret ired (disposed) before the average service life of the
group and others after the average life. For this reason, the debit to Accumulated Depreciat ion
is the difference between original costs and cash received.

Illustration - 4
Suppose that TANA Transport share Co. in the previous example, so ld one of the trucks with
the cost of Br. 75,000, at a selling price of Br. 40,000, at the end of the fourth year. Therefore,
the entry to record the disposal would be:

S ol u t i on :
Original cost of the asset………………………………………..Birr 75,000
Less: cash receipts from sale o f asset………………………………..40,000
Accumulated Depreciat ion of the asset…………………………Birr 35,000

Accumulated Depreciat ion……………35,000

Cash…………………………………...40,000
Cars, Buses, and Trucks……………….75,000

65
4.10 REVISION OF DEPRECIATION RATES

When a plant asset is acquired, depreciat ion rates are carefully determined based on past
experience wit h similar assets and other relevant informat ion. The provisio ns for depreciat ion
are only est imates, however, and it may be necessary to revise the est imated econo mic life
and that of salvage value during the life o f the asset. Unexpected physical deterioration or
unforeseen obso lescence may make the useful life of the asset less than originally est imated.
Good maintenance procedures, revisio n of operating procedures, or similar improvements
may prolong the life of the asset beyo nd the original est imate.

Illustration - 5
Assume that a delivery truck originally acquired for Br. 75,000 is est imated to have a 16-year
life wit h a residual value of Br. 3000. However, after 10 years o f intensive use, it is
determined that the delivery truck will last only 4 more years, (instead of 6 years) but its
estimated residual value at the end of the four years will be Br. 6000, (instead of Br. 3000).

S ol u t i on :
Before the revision o f the est imated life and the residual value o f the asset at the beginning o f
the 11th year, the asset account and its related accumulated depreciation account would appear
as shown below:
Delivery Trucks Accumulated Depr- Delivery Truck

Cost 75,000
45,000 Balance at the
end of the 10th Year

After the revisio n, at the beginning o f the 11th year, the remaining depreciable cost and the
revised annual depreciat ion by the straight-line method are computed as fo llows.

Original Cost of the truck…………………………………………….Birr 75,000

Less: Accumulated depreciat ion already taken………………………………… 45,000
Remaining cost of the delivery truck…………………………………Birr 30,000

66
Less: Revised est imated salvage value…………………………………………...6,000
Revised annual depreciat ion 30,000 - 6000
4 years …………………….Birr 6,000

The new annual periodic depreciat ion expense is co mputed by dividing the revised
depreciable cost of Br. 24,000 by the remaining revised useful life of 4 years. Therefore, the
new periodic depreciat ion charge is Br. 6000. The annual adjusting entry for depreciat ion for
the next two years would be as fo llows:

Year 11
Dec. 31, Depreciat ion Expense - Delivery Truck………………..6000
Accumulated Depreciat ion - Delivery Truck………………6000
Year12
Dec. 31 Depr. Expense-Truck…………………………….6000
Accum. Depreciat ion-Truck……………………………60000

Depreciation of partial years

So far, the illustrations of the depreciat ion methods have assumed that the plant assets were
purchased at the beginning or end of the accounting period. However, business does not often
buy assets exact ly at the beginning or end of the account ing period. In most cases, they
acquire the assets when they are needed and sell or discard them when they are no longer
useful or needed. The time o f year is normally not a factor in the decisio n. Thus, it is o ften
necessary to calculate depreciation for partial years.

Illustration - 6
Assume that a piece o f equipment is purchased for Br. 5000 and that it has an estimated usefu l
life o f five years, and an est imated residual value of Br. 500. Assume further that the
equipment is purchased on October 2 and that the yearly account ing period ends on December
31. Depreciat ion must be recorded for three months, October through December, or 3/12 of a
year. This factor is applied to the calculated depreciat ion for the ent ire year. The three
mo nths’ depreciation under the straight-line method is calculated as fo llows:

67
S ol u t i on :
Annual depreciat ion = Original cost – Estimated Salvage value
Estimated useful life

= Br. 5000 – Br. 500 = Birr 900

5 years

Depreciat ion for partial year (Oct – Dec. 31) is therefore, Br. 900 x 3/12 = Br. 225

If the co mpany used the double declining balance method on the above equipment, the
depreciat ion on the asset would be: Br. 5000 x 40/100 x 3/12, = Br. 500, depr. For three
mo nths,

If the company used the sum-of-years-digits method, the depreciat ion on the asset would be:

Birr (5000 – 500) x 5/15 x 3/12 = Birr 375, and the depreciat ion for the second year would be:

( 5000 – 500) x 5/ 15 x 9/ 12 = Br. 1125

( 5000 – 500) x 4/ 15 x 3/ 12 = 300
nd
Therefore, total 2 year depreciat ion Br. 1425

NB. In this specific example depreciat ion was recorded from the beginning of October. If the
equipment had been purchased on October 16, or thereafter, depreciat ion would be calculated
beginning November 1, as if the equipment were purchased on that date.

4.11 CAPITAL AND REVENUE EXPENDITURES

Capital Expenditures- are expenditures that improve the operating efficiency (or capacit y) or
costs incurred to achieve greater future benefits.

In addit io n to the acquisit ion of plant assets, capital expenditures included addit io ns and
betterments.

An addition is an enlargement to the phys ical la yout of a plant asset. Suppose for example, if
a new wing is added to a building, the benefits from the expenditure will be received over
several years, and the amount paid for it should be debited to the asset account.

A betterment, on the other hand, is an improvement that does not add to the physical layout
of the asset. Installat ion of an air condit io ning system is an example o f betterment,

68
Replacement of a concrete floor for a wooden floor is also betterment that will provide
benefits over a number of years, so its cost should be charged (debited) to an asset account.

Another types of capital expenditures include extraordinary repairs. Extraordinary repairs

are repairs o f amore significant nature. They affect the est imated residual value or estimated
useful life o f an asset. For example, a bo iler for heating a building may be given a co mplete
overhaul, at a cost of Br. 3000 that will prolong its economic life by 5 years.

Extraordinary repairs are recorded by debit ing the accumulated depreciat ion account, under
the assumpt ion that some of the depreciat ion previously recorded has now been eliminated.
The effect of this reduct ion in the accumulated depreciat ion account is to increase the book
value of the asset by t he cost of the extraordinary repair. As a result, the new book value o f
the asset should be depreciated over the new est imated useful life.

Illustration - 7
Suppose for example, a machine costing Br. 35,000 had no est imated residual value and an
original est imated useful life of ten years, has been depreciated for 7 years. At the ver y
beginning of the 8th year, the machine was given a major overhaul costing Br. 3000. This
expenditure extended the useful life of the machine 3 years beyo nd the original est imate. The
computation o f the new book value and the entry for the extraordinary repair would be as
fo llo ws:

S ol u t i on
To record extraordinary repair
Jan. 4. Accumulated Depreciat ion – Machinery……………3000.00
Cash …………………………………………………………3000.00
Extraordinary repair to machinery

The revised annual depreciat ion for each o f the six years remaining in the machine’s usefu l
life would be calculated as fo llows:
Cost of Machine……………………………………… Birr 35,000
Accum. Depreciat ion before extraordinary repair Br. 24,500
Less: extraordinary repair (Debited to Accum. Depr.)….3000 21,500
Book value (carrying value) after extraordinary repair… Br.13,500

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Revised Annual periodic depreciat ion= 13500……………………….2,250
6 years

Revenue expenditures
Revenue expenditures are expenditures incurred in order to maintain the normal operating
efficiency o f the asset.

Amo ng the more usual kinds o f revenue expenditures for plant asset are the repairs,
maintenance, lubricat ion, Cleaning and inspect ion necessary to keep an asset in good working
condit ion.

Ordinary repairs are expenditures that are necessary to keep an asset in good operating
condit ions. Trucks must have tune-ups, their t ires and batteries must be replaced regularly,
and other routine repairs must be made. Offices and halls must be painted regularly, and
broken t iles or woodwork must be replaced. Such repairs benefit s only the current period and
therefore must be charged against the revenue in the current fiscal period.

Check Your Progress Exercise -5

1) Discuss the difference between ordinary repairs and extraordinary repairs?
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4.12 SUMMARY

Almost all business enterprises o f any size or activit y use assets of a durable nature. Such
assets, commo nly refereed to as property, plant, and equipment, plant assets, or fixed assets,
support the operating activit ies in every business organizat ion, instead o f being a part of the
operating act ivit ies. Such assets include land, building, and equipments (machinery, furniture,
tools).

The major characterist ics of plant (or fixed) assets are:

1) they are acquired for use in the operations o f a business, they are not intended for
resale purpose. If the business ho lds them for resale they are categorized under the
caption 'Inventories', in the balance sheet.

70
 2) they are long-term in nature and usually subject to depreciat ion long-term assets are
capable of repeated usage in the operating act ivit ies of the business, and
3) they posse’s phys ical features.

One o f the big issues in account ing for plant assets is the determinat ion o f cost. The
acquisit ion cost of a plant asset includes the cash or cash equivalent purchase price o f
obtaining the asset and bringing it to the location and condit ion necessary for its intended use.

Cost of Land: Includes the negotiated cash price plus other costs such as the cost of land
surveys, legal fees, broker’s co mmissions, t itle fees, cost of preparing the land to build on,
and the cost of tearing-down (or razing) old building, and any expenditures associated wit h
the acquisit io n of land that are necessary to get the land ready for its intended use.

Cost of buildings: Includes the purchase price plus all repairs and other expenses requited to
put it in a usable condit io n. When a business constructs a new building, the cost includes all
reasonable and necessary expenditures, such as materials, labor, part of the overhead and
other indirect costs, engineers and architects’ fees, insurance during construction period,
lawyers fees, and building permits.

Cost of Equipments: Includes the invo ice price, transportation and handling costs, insurance
on the equipment while in transit, assembling and installat ion costs, and costs of conduct ing
test (trail) runs.

As plant assets are used in the operation o f a business, their value to provide services
decreases through usage and the passage of t ime. This cost allocat ion o f plant asset through
usage and the passage of time are called depreciation.

Depreciat ion is frequent ly misunderstood. The term doesn’t refer to the decrease in market
value of an asset overtime; no it is a process of valuation. Instead, the term is used to describe
the gradual conversion o f the cost of the asset into an expense account. Four factors affect the
computation of depreciat ion. They are:

(1) cost, (2) residual value, (3) depreciable cost, and (4) est imated useful life of the
asset. Business may be different methods to compute depreciat ion

71
The most commo n methods of co mputing depreciat ion for plant assets are (1) straight line
method, (2) production method, (3) double-declining balance method, and (4) sum-of-years-
digits method.

After the determinat ion o f periodic depreciation, the amount of depreciat ion expense should
be recorded each fiscal period by debit ing the depreciat ion expense and credit ing a contra
asset account called Accumulated Depreciat ion. The use o f this contra asset account permits
the original cost to remain unchanged in the plant asset account.

Somet imes each of the four depreciat ion methods may not be appropriated because the assets
invo lved have unique characterist ics or the nature of the industry requires that a specia l
depreciat ion method be used. Of these methods, the group and composite methods are often
used by business enterprises.

When a plant asset is acquired, deprecat ion rates area carefully determined based on past
experience wit h similar assets and other relevant informat ion, however, it may be necessary to
revise the est imated economic life and that of salvage value during the life o f the asset.
Unexpected physical deterioration or unforeseen obso lescence may make the useful life of the
asset less than originally estimated. Good maintenance procedures, revisio n of operating
procedures, or similar improvements may pro long the life of the asset beyo nd the originals
estimate.

After plant assets are acquired and ready for use, addit ional costs are incurred that range fro m
ordinary repairs to significant additions. The major problem is allocat ing these costs to the
proper time periods. These costs are divided into two major categories: capital, and revenue
expenditures.

Capital expenditures are expenditures that improves the operating capacit y (or efficiency) or
expenditure that increases the useful life o f the asset beyo nd the original est imate. The most
commo n capital expenditures are (1) addit ions, (2) betterments, and (3) extraordinary repairs.

Revenue expenditures, on the other hand, are expenditures incurred in order to maintain the
normal operating efficiency o f the asset. The most usual kinds of revenue expenditures for a
plant asset are the repairs, maintenance, lubricatio n, cleaning, and inspect ion necessary to

72
keep an asset in good working condit io n. Such expenditures benefit s only the current period
and therefore must be charged against the revenue in the current fiscal period.

4.13 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress Exercise - 1

1. The just ificat ion for using the production method is that, it assumes that depreciat ion is a
funct ion of use or productivit y instead o f the passage of t ime. Moreover, under the
production method there is a direct relat ion between the amounts of depreciation each year
and the units o f output or use.

Check Your Progress Exercise - 2

1. There is an easy means of comput ing the deno minate of the fract ion.
It is: n(n + 1) = 25 ( 25 + 1) = 325
2 2

Check Your Progress Exercise - 3

(1) Where loss o f services is a result of act ivit y or productivit y, the production method will be
best match costs and revenues. And, when the units o f output or use that is used to measure
estimated useful life for each asset is reasonably determined.

(2) The major limit ation (or drawback) of the production method is that it is not appropriate in
situations in which depreciat ion is a funct ion of t ime instead of activit y. For example a
building is subject to a great deal o f steady deterioration from the elements (time) regardless
of its use. Another drawback in using the production method is that an est imate of units o f
output or service hours received is often difficult to determine.

Check Your Progress Exercise - 4

1. Annual deprecat ion = original cost - salvage value
Estimated life
Since the asset had been placed in service after two months had been elapsed, only
depreciat ion for 10 months will be recognized.

Therefore, 10 x 300 = Br. 250.00

2

73
 Depreciat ion Expense……….. 250.00
Accumulated Depreciat ion……250.00

Check Your Progress Exercise – 5

1. Ordinary repairs: are expenditures made to maintain plant assets in normal operating
condit ion, they are charged to an expense account in the period in which they are incurred
on the basis that is benefits on one account ing period. Ordinary repairs affect the expenses
of one accounting period only.

Extra ordinary repairs - on the other hand, are repairs of a more significant nature. They
affect the estimated residual value or estimated useful life o f the asset. Extraordinary repairs
increase the life o f the asset beyo nd the original estimate. Hence, it benefits the operating
activit y of the business for several years. Extraordinary repairs should be debited to the
Accumulated Depreciat ion account instead of debiting to an expense account.

4.14 MODEL EXAMINATION QUESTIONS

TYPE A: Answer the following questions:

1. Explain the meaning of deprecat ion
2. Describe in detail the major characterist ics of plant (fixed) assets.
3. Briefly describe the factors that affect the computation of depreciation.
4. Dist inguish between an addit io n to plant assets and a betterment.
5. What account ing treatment is normally given to the fo llowing items in account ing for
plant assets?
a) Addit ions
b) Extraordinary (major) repairs.
c) Betterments.

TYPE B: For each of the following questions choose the best answer from the given
alternatives.
1. Which of the following statements best describe the purpose of accounting for
depreciat ion?
A) Depreciat ion is an attempt to measure the decrease in market value of an asset
during a period of time.

74
 B) Depreciat ion is the allocat ion o f the cost of a natural resource over its usefu l
life as it is used up.
C) Depreciat ion is the allocat ion of an equal amount of cost of a tangible asset to
each year of its econo mic life.
D) Depreciat ion is the allocat ion of the cost of a tangible asset over its useful life.
E) None of the above

1. Which o f the fo llowing expenditures incurred in connect ion wit h the acquisit io n o f
equipment is not a proper charge to the asset account?
A) Freight or transportation costs.
B) Cost of test runs to ready the machine for operation
C) Taxes and tariffs
D) Cost of vandalis m
E) B and D

2. If the Double-declining depreciat ions rate of a plant asset is 50%, then its est imated
life will be:
A) 50 years. B) 10 years C) 5 years D) 4 years E) None of the above

3. Which of the fo llowing methods will yield the highest deprecation expense during the
first year of an asset’s life?
A) Straight line method
B) Sum-of-years-digits method
C) Double-declining balance method
D) All o f the above
E) None of the above

4. If the adjust ing entry to record depreciat ion expense was overlooked, then:
A) Total assets will be understated
B) Liabilit ies would be overstated
C) Owner’s capital would be overstated
D) Net inco me would be overstated
E) C and D

75
TYPE C: Work out the following questions:
On October 5, 2001, NOON C. acquired a new machine at a cost of Birr 250,000. the machine
has a useful life o f 5 years and scrape value o f Br. 10,000. it is est imated that the equipment
will produce 2,000,000 units of products throughout its life. The equipment produced 95,000
units and 300,000 units o f products during the fiscal periods ending December 31, 2001 and
December 31,2001 respect ively. On the basis of the above date, compute deprecation expense
to be recorded on Dec. 31, 2002.

1) Under the units of production method.

2) Under the declining-balance method.
3) Under the sum-o f-years-digit s method
4) Under the straight-line method.

4.15 RECOMMENDED (REFERENCE) BOOKS

1. Fees and Warren : Principles of Account ing, 16th

Edit io n.
2. Horngren, Sundem, and E lliot. : Introduction to Financial Account ing,
8th Edit ion. Pearson Educational Inc.
New Delhi, 2002
3. Roger H. Hermanson, :
Jems D, Edwards and : Account ing principles 4th Edition,
R.F Salmo nson (1989) IRWIN Inc.

4.16 GLOSSARY

1. Accumulated Depreciation: The cumulat ive sum of all depreciat ion recognized since
the date of acquisit io n of the particular assets.
2. Book Value, (net book value): The balance o f an account shown on the book, net of
any contra accounts. For example the book value of equipment is its acquisit io n cost
minus accumulated depreciat ion.
3. Capitalized: A cost that is added to an asset account, as distinguished fro m being
expensed immediately.

76
4. Contra account: A separate but related account that offsets or is a deduct ion fro m a
companio n account. An example is accumulated depreciat ion.
5. Depreciable Value: The amount of the acquis it ion cost to be allocated as depreciat io n
over the total useful life o f an asset. It is the difference between the total acquisit io n
cost and the predicted residual value.

77
UNIT 5. DISPOSAL OF PLANT ASSETS

Contents
5.0 Aims and Object ives
5.1 Introduction
5.2 Disposal o f Plant Assets
5.2.1 Recording Discarding of a plant asset
5.2.2 Recording The Sale of Plant Assets
5.2.3 Recording Exchanges of Plant Assets
Accounting for Intangible Assets and Natural Resources
Summary
Answer to Check Your Progress
Model Examination Questions
Reference Books
Glossary

5.0 AIMS AND OBJECTIVES

This unit aims at discussing the meaning o f disposing o f plant assets, the different ways o f
disposing plant assets, and the account ing procedures invo lved in recording transactions
relat ing to the discarding sale and exchange of plant or (fixed) assets.

After going through this unit, you will be able to;

- understand the concept of disposing of plant assets.
- examine the different ways of disposing of plant assets.
- analyze and record the transact ions invo lving the discarding, sale, and
exchange of plant assets.
- different iate account ing for financial reporting fro m account ing for
inco me tax with respect of exchange of plant assets.

5.1 INTRODUCTION

So far we have seen how to account for property, plant, and equipment assets, from
calculat ing acquisit io ns cost to depreciat ing this cost up to the end of the asset’s useful life.
Plant assets, such as equipment, delivery trucks, or machineries cannot be used forever. The

78
assets may wear out or the business may replace them wit h newer model. When a plant asset
is no longer useful to a business the asset may be disposed of either through discarding, sale,
or traded-in wit h similar) or dissimilar) assets. This chapter therefore, is presented this
concept in detail.

5.2 DISPOSALS OF PLANT ASSETS

A plant asset rarely lasts exactly as lo ng as its estimated life. If it lasts longer than it s
estimated life, it is not depreciated past the point at which its carrying value equals its residua l
value. T he purpose of depreciat ion is to spread the depreciable cost of the asset over the
economic life o f the asset. Thus, the total accumulated depreciation should never exceed the
total depreciable cost. If the asset is st ill used in the business beyo nd the end o f its est imated
life, its cost and accumulated depreciation remain in the ledger accounts. Proper records will
thus be available for maintaining control over plant assets. If the residual value is zero, the
book value o f a fully depreciated asset is zero until the asset is disposed o ff. If such an asset is
discarded, no gain or loss results. A plant asset may be disposed by:
(1) Discarding it as worthless; (2) Selling it; or (3) Trading it in on a new asset

5.2.1 Recording Discarding of a Plant Asset

If a plant asset is of no further use to the business and cannot be so ld or traded, then the plant
asset is discarded. If the asset has no book value. (i.e., if it is fully depreciated), the plant asset
account is credited for the amount of the original cost of the item being discarded. At the
same t ime, the accumulated depreciat ion account is debited for the amount of the total
accumulated depreciat ion of the item being discarded. In this case neit her gain nor loss is
realized. On the other hand, if a plant asset has a book value (if not fully depreciated) at the
time it is discarded, the business incurs a loss.

Illustration - 1
Suppose for example, on July 5, year 5, equipment that was acquired On Jan 10, year 1, at a
cost of Br. 11,000, is discarded as worthless. The discarded equipment has a carrying value o f
Br. 2000 at the time o f disposal. T he carrying value is co mputed as the difference between the
cost of asset Br. 11,000 and accumulated deprecation, Br. 9000. A loss equal to the carrying
value should be recorded when the equipment is discarded.

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S ol u t i on :
The journal entry required to discard the plant asset as of July 5, year 5, is:
Year 5
July 5. Accumulated Deprecation, Equipment …………9000.00
Loss on disposal of plant Asset…………………2000.00
Equipment ……………………………….11000.00
Discarding Equipment no longer used in the business.

5.2.2 Recording the Sale of Plant Asset

The entry to record the sale o f an asset for cash is similar to the one illustrated above except
that the receipt of cash should also be recorded. The fo llowing entries show how to record the
sale o f equipment under three assumpt ions about the selling price. In the first case, the Br.
2000 cash received is exact ly equal to the book value o f the equipment (which is equal to Br.
2000) .

Case 1. Sold at an amount equal to Book value, Br. 2000, no gain or loss results.
Year 5
July 5. Cash ……………………………………2000.00
Accumulated Depreciat ion, Equip……...9000.00
Equipment ………………………………..11000.00
Sale of equipment at an amount equal to book value

Case 2. Sold at Br. 1500 cash; Loss of Br. 500, (BV = Br. 2000)
Year 5
July 5. Loss on sale o f equipment………………….500.00
Accumulated Depreciat ion……………………… 9000.00
Cash ……………………………………………….1500.00
Equipment…………………………………11000.00
Sale of equipment at less than the book value. Loss of Br. 500

Case 3. Sold at Br. 3000 cash; gain o f Br. 1000, cash received through
Sale less book value of the asset (Br. 3000 – Br. 2000)
Year 5

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 July 5.
Cash ……………………………………….3000.00
Accumulated Depr, Equipment……………9000.00
Equipment……………………………………………..11000.00
Gain on sale of plant asset……………………………...1000.00
Sale of equipment at more than the book value; gain of Br. 1000,
(Br. 3000 – Br.2000) recorded

5.2.3 Recording Exchange of Plant Assets

Businesses also dispose of plant assets by trading them in on the purchase of other plant
assets. Exchanges may invo lve similar assets, such as an o ld machine traded-in on a newer
model, or dissimilar assets, such as a machine traded-in on a truck. In either case, the
purchase price is reduced by the amount of the trade-in allowance.

The basic accounting for exchanges of plant assets is similar to accounting for sales o f plant
assets for cash. If the trade-in allowance received is greater than the carrying value of the
assets surrendered, there has been a gain. If the trade-in allo wance is less than the carrying
value, there has been a loss.

There are special rules for recognizing these gains and losses, depending on the nature of the
assets exchanged.
Exchange Losses G ai n s
Recognized Recognized
For Financial Reporting Purposes:

 Of similar assets………………………… Yes……………………………….No

 Of Dissimilar assets……………………….. Yes…………………………….. Yes

For Income Tax purposes:

 Of similar assets…………………………… No………………………….. No

 Of dissimilar assets………………………… Yes……………………… Yes

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Both Gains and Losses are recognized when a company exchanges dissimilar assets. Assets
are dissimilar when they perform different funct ions; assets are similar when they perform the
same funct ion.

For financials reporting purposes, gains on exchanges of similar assets are not recognized
because the earning lives of the asset surrendered are not considered to be completed.

When a co mpany trades-in an o lder machine on a newer machine o f the same t ype, the
economic substance of the transact ion is the same as that of a major renovat ion and upgrading
of the older machine.

Account ing for exchange of similar assets is complicated by the fact that neither gains nor
losses are recognized for inco me tax purposes.

Loss Recognized on the Exchange

A lo ss is recognized for financial reporting purposes on all exchange in which a material lo ss
occurs.

Illustration-2
To illustrate the recognit ion of a loss, assume that the business exchange a machine wit h a
cost of Br. 11,000, and accumulated depreciat ion o f Br. 9000 for a newer more modern
machine on the following terms:

Cost of new machine ………………………Birr 12000.

Trade-in Allo wance for old machine……………(1500)
Cash payment required (Boot)……………..Birr 10500.

S ol u t i on
In the illustration above, the trade-in allowance (1500) is less than the carrying value (Br.
2000) of the old machine. The loss on the exchange is Br. 500, (Br. 2000 – Br. 1500).
Therefore, the journal entry required to record the exchange of assets would be as fo llows:

Year 5.
July 5. Equipment (New)……………………..120,00.00
Accum. Depreciat ion-Equip…………………...9,000.00

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 Loss on Exchange of plant assets………………. 500.00
Equipment (old)……………………………………11,000.00
Cash…………………………….…………………. 10,500.00

Check Your Progress Exercise -1

1. What is the just ificat ion for the non-recognit ion o f gains? T hat results fro m the exchange
of similar assets?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

Loss Not Recognized on the Exchange

In the previous illustration, in which a lo ss was recognized, the new asset was recorded at the
purchase price of Br. 12000 and a loss o f Br. 500 was recognized. If the transaction is for
similar assets and is to be recorded for inco me tax purpose, the loss should not be recognized.
In this case, the cost basis o f the new asset will reflect the effect of the unrecorded loss. T he
cost basis for the new asset, therefore, is co mputed by adding the cash payment to the
carrying value of the old asset:

Carrying (Book) value of o ld Equipment……………………..Birr 2,000.00

Cash paid (Boot given)………………………………………… 10,500.00
Cost-basis of new Equipment ……………………………… Birr 12,500.00

Note that no loss is recognized in the entry to record this transact ion.
Year 5.
July 5. Equipment (New)……………………………….12,500.00
Accumulated Depreciat ion……………………… 9,000.00

Equipment (old)……………………………11,000.00
Cash……………………………………….. 10,500.00
To record exchange of Equipments - cost of old Equipments
and its related Accumulated Depreciation removed from the
accounts; new equipment recorded at amount equal to book
value of old equipment plus boot given.

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NB. The new equipment is recorded (reported) at a purchase price of Br. 12000 plus the
unrecognized loss of Br. 500. the post postponement of the loss. Since depreciat ion of the new
equipment will be computed based on a cost of Br. 12500 instead of Br. 12000, the
“unrecognized” loss results in more depreciat ion each year on a new equipment than the loss
had been recognized.

Gain Recognized on the Exchange

Gains on exchanges are recognized for financial reporting purposes when dissimilar assets are
exchanged. To illustrate the recognit ion of a gain, assume the fo llowing terms in which the
machines being exchanged serve different funct ions:

Price of new machine………………………………Birr 12,000.00

Trade-in Allowance for old machine………………….(3000)
Cash payment required (Boot given)……………….Birr 9,000.00

Here the trade-in allo wance (Br. 3000) exceeds the carrying value (Br. 2000) of the o ld
machine by Br. 1000. thus, there is a gain on the exchange, if the trade-in allowance
represents the fair mark value o f the old machine. Assuming that this condit ion is true, the
entry to record the transact ion is as fo llows:
Years 5
July 5. Equipment (New)……………………………12,000
Accumulated Depreciat ion…………………….9,000
Equipment (old)………………………….11,000
Cash ……………………………………… 9,000
Gain on exchange of Equip………………..1,000
To record the exchange of Equipments to remove
cost of old equipment and the related accumulated
depreciation, new equipment recorded at cost price;
gain recognized.

Gain Not Recognized on the Exchange:

A gain on an exchange should not be recognized in the account ing records if the assets
perform similar funct ions. The cost basis for the new equipment must indicate the effect of

84
the unrecorded gain. This cost basis is co mputed by adding the cash payment to the carrying
value of the old asset:
Carrying value o f old equipment …………………………..Birr 2,000.00
Cash paid (Boot Given)………………………………………… 9,000.00
Cost basis of new Equipment……………………………. Birr 11,000.00

The entry to record the transact ion is as fo llows:

Year 5
July 5. Equipment (New)……………………………..11,000.00
Accumulated Depreciat ion…………………… 9,000.00
Equipment (old)…………………………………..11,000.00
Cash…………………………………………………9,000.00

To record exchange of Equipment to remove the cost of old

equipment and the related accum. depr. of old assets; new
equipment recorded at a cost equal to BV of old asset plus cash paid.

As with the no recognit ion of lo sses, the no recognit io n of the gain on exchanges is, in effect,
a postponement of the gain. Since depreciat ion will be computed on the cost basis of Br.
11,000, the “unrecognized” gain is reflected in less deprecation each year on new equipment
than if the gain had been recognized.

Illustrative Problem:
ABC Corporation acquired machine X for Br. 84,000 on January 10.1999. Machine X had an
estimated useful life o f six years with no salvaged value. The machine was depreciated on the
basis o f Sum-o f-the-years-digits’ method. On May 5, 2002, machine X was exchanged for
another similar machine Y. The new machine had a cash price of Br. 95,000. In addit ion to
Machine X, cash o f Br. 25,000 and three notes for Br. 45,000 was given up in the exchange.
Machine Y has an est imated useful life of seven years and salvage value o f Br. 1000. Machine
Y is to be depreciated using the straight-line method. The corporation had the experience o f
recording the exchange for financial reporting purposes.

Required: Wit h reference to the above informat ion:

1. Compute the cost-basis for Machine Y in line wit h corporation experience.

85
 2. Pass the journal entry made by ABC Corporation to record the exchange of the
machine.
3. Compute the depreciation expense to be made on Machine Y for 2002 fiscal year
ending Dec. 31 for financial reporting purpose.
4. Compute the cost-basis of Machine Y for inco me tax regulation.
5. Pass the journal entry to record the exchange for purposes of inco me tax regulat ion.

Solution to Illustrative Problem:

1. Depreciat ion for the year 1999, on Machine X is:
n(n + 1) = 6( 6 + 1) = 21
2 2
6 X 84,000 = …………………………………………24,000.00
21

 Depreciat ion for 2000, 5/2 X 84,000………………………………. 20,000.00

 Depreciat ion for 2001, 4/21 X 84,000……………………………. 16,000.00
 Depreciat ion for 2002 (for four months only) 3/12 X 84,000 X 4/12 . 4,000.00
 Total Accumulated Depreciat ion as of May 5, 2002, Br. 64,000.00

Old Equipment Traded-In (Machine X)

Cost…………………………………………………………Birr 84,000
Accumulated Depreciat ion, May 5, 2002………………………..64,000
Book Value………………………………………………… Birr 20,000

New Equipment Traded-In (Machine Y)

Purchase (List) price…………………………………….Birr 95,000
 Trade-in Allo wance on old Machine…………………………25,000
Boot Given (cash + Notes)……………………………… Br 70,000

Therefore, the cost-basis of Machine Y can be obtained by adding the Book Value and the
amount of Boot given which is ; Br. 20,000 + 70,000 = Br. 90,000. There is unrecognized
gain on the exchange.

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( 2) 2002
May 5. Machine Y…………………………………..90,000.00
Accumulated Depreciat ion ………………….64,000.00
Machine X……………………………………………...84,000.00
Cash…………………………………………………….25,000.00
Notes payable…………………………………………..45,000.00

3. Depreciat ion Expense on Machine Y for year ending Dec. 31,2002 by the straight line
method is:

Ann. Depr. = Br. 90,000.00 – Br. 1000.00 = Br. 12714.29, since the Machine is emplo yed in
7 Years
service after four months had been elapsed, the depreciat ion for 8 months, (May through
Dec. 31) would be:
Br. 12714.29 X 8/12 = Br. 8476.20

4. The cost-basis for Machine Y for inco me tax regulat ion is:
Since gains and losses result ing fro m the exchange of similar assets are not recognized for
inco me tax purposes, the cost basis of the Machine is the same that is Br. 90,000.

5. Journal entry to record the exchange of machine Y for purposes of inco me tax regulat ion
would be:
2002
May 5. Machine Y………………………………………………90,000
Accumulated Depreciat ion, Machine X…………………64,000
Machine X…………………………………………. 84,000
Cash …………………………………………………25,000
Notes Payable……………………………. …………45,000

5.3 ACCOUNTING FOR INTANGIBLE ASSETS AND NATURAL RESOURCES

Intangible Assets: are lo ng-term assets that do not have physical substance and in mo st cases
relate to legal rights or advantages held.

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Intangible assets include patents, copyrights, trademarks, franchises, organization costs,
leaseho lds, leasehold improvements, and goodwill. T he allocat ion o f intangible assets to the
periods they benefits is called amortization.

Intangible assets are accounted for at acquisit io n cost, that is, the amount paid for them. Some
intangible assets such as goodwill and trademarks may be acquired at little or no cost. Even
though they may have great value and be needed for profitable operations they should not
appear on the balance sheet unless they have been purchased fro m another party at a price
established in the market place.

The, Account ing Principles Board (APB) has decided that a company should record as assets
the costs of Intangible assets acquired fro m others. However, the company should record as
expenses the cost of developing intangible assets. Also, intangible assets that have a
determinable useful life such as patents, copyrights, and leaseholds, should be written off
through periodic amort izat ion over that useful life in much the same way that plant assets are
depreciated.

Even though some intangible assets, such as goodwill and trademarks, have no measurable
limit on their lives, they should also be amort ized over a reasonable length of t ime (not to
exceed forty years).

Illustration - 3
Assume that on Jan 2,2002 MOHA So ft Drink Bottling co mpany purchased a patent on a
unique bottle cap for Br. 54,000.
The entry to record the patent would be as fo llows:

2002
Jan 2. Patent……………………………..54,000
Cash……………………………………..54,000
To record the purchase of Bottle cap patent

Assume that MOHA’s management determines that, although the patent for the bottle cap will
last for seventeen years, the product using the cap will be so ld only for the next six years. The
entry to record the annual amort izat ion would be as follows:

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 Amortizat ion Expense………………………..9,000.00
Patent……………………………………………9,000.00
To record annual amortization of patent (Br. 54000/ 6 years)

Note that the patent account is reduced directly by the amount of the amort izat ion expense.
This is in contrast to other long-term asset accounts in which depreciat ion or deplet ion is
accumulated in a separate contra account.

If the patent beco mes worthless before it is fully amortized, the remaining carrying value is
written o ff as a lo ss. For instance, assume that after the first two years MOHA soft Drink
Bottling Co mpany’s chief co mpet itor’s offers a bottle wit h a new t ype o f cap that makes
MOHA’s cap obso lete. The entry to record the loss is:

Loss on patent……………………………36,000.00
Patent……………………………………36,000.00
To record the loss result ing from patents beco ming worthless.

Depletion of Natural Resources

We now turn our attention to another group of long-lived assets natural resources, such as
minerals, oil, and timber or lumber. These natural resources are extracted from the earth.

Deplet ion is the accounting measure used to allocate the acquisit io n cost of natural resources.
Deplet ion differs fro m depreciation because depletio n focuses specifically on the physical use
and exhaustion o f the natural resources, while depreciat ion focuses more broadly on any
reduction of the econo mic value of a plant or fixed asset. The costs of natural resources are
usually classified as long-terms assets.

Deplet ion expense is the measure o f that portion o f long-term assets that is used up in a
particular period.

Illustration - 4
Suppose for example, MIDROC Construction has acquired the right to use 10,000 acres o f
land in Kibre-Mengist territory to mine for go ld at a total cost of, Br. 10,000.000. The
Company est imated that the mine will; provide approximately 500,000 grams of go ld. The
deplet ion rate established is computed in the fo llowing manner.

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 Total cost – Salvage value = Depletion cost per unit.
Total est imated units available

Br. 10,000,000 = Br. 20 per gram

500,000 units

If 100,000 grams are extracted in the first year, then the depletion for the year is 2000.000
(1000,000 x Br. 20.00). The entry to record the deplet ion is therefore:

Deplet ion Expense…………………..2,000,000

Accumulated Deplet ion……………………….2,000,000

Check Your Progress Exercise - 2

1. Dist inguish between amortizat ion and deplet ion.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

5.4. SUMMARY

Plant assets, such aw equipments, trucks, or machineries, cannot be used forever. The assets
may wear out or the business may replace them wit h newer models. When a fixed asset is no
lo nger useful to a business, the asset may be disposed o f by: (1) discarding it as worthless; (2)
selling it: or (3) trading it in on a new asset.

If a plant asset is of no further use to the business and cannot be so ld or traded, then the plant
asset is discarded. If the asset is fully depreciated, no loss or gain is recognized. Otherwise, if
the asset is not fully depreciated at the time of disposal, the business incurs a loss.

Another means o f disposing o f a plant asset is sale of plant asset. While selling plant assets, if
the selling price exceeds the book (carrying) value of the asset, there is a gain, and the gain
should be reported in the inco me statement for the period under other income sect ion because
it results from no operating activit ies. On the other hand, if the cash received through sales o f
plant asset is less than the book (carrying) value of the asset sold, there is a loss, and this loss
is reported among the other expense section on the inco me statement. If the amount of cash

90
received through sale of a plant assert is exact ly equal to the book value o f the asset, neither
gain nor loss is realized.

Business also dispose of plant assets by trading them in on the purchase o f other plant assets-
Exchanges may invo lve similar assets that serves the same funct ion, or it may invo lve
dissimilar assets that serve different functions.

The basic accounting for exchanges of plant assets is similar to accounting for sales o f plant
assets for cash. If the trade-in allowance received on old asset is greater than the carrying
(book) value o f the asset surrendered, there has been a gain. In contrast, if the trade-in
allowance is less than the carrying (book) value, there has been a loss.

There are special rules for recognizing these gains and losses, depending on the nature of the
assets exchanged.

If the assets exchanged are dissimilar (perform different functions), both gains and lo ses are
recognized. If the assets exchanged are similar (perform the same funct ion), loss on
exchanges is recognized, but if the exchange results in a gain, the gain should not be
recognized for financial reporting purposes.

For inco me tax purposes, neit her gain nor loss is recognized fro m the exchange o f similar
assets. However, inco me tax law allows the recognit io n of both gains and losses fro m the
exchange of dissimilar assets.

The chapter also discussed account ing for intangible assets and natural resources. Intangible
assets are lo ng-term assets wit hout a phys ical substance, and inmost cases related to legal
rights or advantages held. Intangible assets include patents, copyrights, trademarks,
franchising, organizat ion costs, leaseho lds, leasehold improvements, and goodwill. The cost
allocat ion of intangible assets to the periods they benefit is called amortizat ion.

Natural resources are another group of lo ng-term assets that are extracted fro m the earth such
as minerals, o ils, (or petroleum), and t imber (or lumber). The periodic cost allocat ion o f these
natural resources is referred to as depletion.

Unlike plant assets, natural resources are consumed physically over the period of use and do
not maintain their physical characterist ics.

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5.5 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

Check Your Progress Exercise 1

1. Gains on exchanges of similar assets are not recognized for financial reporting
purposes because the earning lives of the asset surrendered are not considered to be
completed.

Check Your Progress Exercise 2

1. Amortizat ion is the periodic cost allo cat ion o f intangible assets to the periods that
benefit from the assets.

Whereas, deplet ion is the process of allo cating the cost of natural resources tot he periods
in which the resources are used.

5.6 MODEL EXAMINATION QUESTIONS

TYPE A – Answer the Following Quest ions:

1. Explain the account ing procedures for discarding of plant assets.
2. Explain the entries required in selling a plant asset for cash.
3. Dist inguish between amortizat ion and deplet ion.
4. What is meant by Intangible Asset?

TYPE B – Choose the best answer for the fo llowing quest ions:
1. If plant asset is retired before it is fully depreciated, and no salvage value or scrap
value is received.
A) a gain on disposal will be recorded
B) Loss on disposal will be recorded
C) Neither gain nor loss on disposal will be recorded
D) All o f the above.

2. One of the fo llowing is not an example of intangible assets.

A) patents B) Franchise C) Trademarks
D) Organizat ion cost E) None

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 3. A plant asset priced at Br. 100,000 is acquired by trade-in a similar asset that has a
book value of Br. 25,000. Assuming that the trade-in allowance is Br. 30,000 and that
Br. 70,000 cash is paid for the new asset. What is the cost basis for the new assets for
financial reporting purpose?
A) Br. 100,000 B) Br. 70,000 C) Br. 30,000
D) Br. 125,000 E) Non

4. Good will in the amount of Br. 60,000 was purchased on January 15, the first month o f
the fiscal year. It is decided to amortize over the maximum period allowable. The
current amortizat ion expense would be:
A) Br. 5000 C) Br. 1,500
B) Br. 6000 D) Br. 10,000 E) None

TYPE C- Work out the fo llowing problem:

1. Sold a truck for Br. 950.00. The truck had been purchased two years ago on January 2
for Br. 2300.00.The amount of depreciat ion is Br. 400.00 a year. Accumulated
depreciat ion for that amount was recorded at the end of the two previous years.
A) Record the depreciation for the current year to June 30.
B) Record the sale of the truck.

2. Discarded office equipments for which there was no further use and which could not
be so ld. The office equipment cost Br. 160.00 and had a book value of Br. 20.00 at the
time was discarded.

5.7 RECOMMENDED (REFERENCE) BOOKS

1. Fees and Warren : Principles of Account ing, 16 Edit ion

2. Horngren, Sundem : Introduction to Financial Account ing and E lliot
8th Edit ion, (2002) Parson Education Inc.
3. Roger H. Hermanson, : Account ing Principles, 4th Edit ion ,1989,
Jems D, Edwards and: IRWIN Inc.
4. R.F. Salmonson : Principles of Account ing , 14th Edition.
5. Kieso and Weygandt : Intermediate Account ing, 9th Edition,
(998) John Wiley & sons ,Inc.

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5.8 GLOSSARY

1. Amortization: When referring to long-lived assets, it usually means the allo cat ion of the
costs of intangible assets to the periods that benefit s from these intangible
assets.

2. APB Opinions: A series of thirt y-one opinio ns of the accounting principles Board, many
of which are st ill the “account ing law of the land.”

3. Depletion: The process of allo cat ing the cost of natural resources to the periods in which
the resources are used.

4. Franchises (Licenses): Privileges granted by a government, manufacturer, or distributor to

sell a product or service in accordance wit h specified condit ions.

5. Goodwill: T he excess o f the cost of an acquired company over the sum o f the fair market
value of its identifiable individual assets less the liabilit y.

6. Leasehold: The right to use a fixed asset for a specified period of time, typically beyo nd
one year.

7. Leasehold Improvement: Invest ments by a lessee in items that are not permitted to be
removed fro m the premises when a lease expires, such as
installat ion o f new fixtures, panels, walls and air-condit ion
equipment.

8. Patents: Granted by the federal government to an invent bestowing (in the united states)
the exclusive right for 17 years to produce and sell the in invention.

9. Trademarks: Dist inct ive ident ificat ion o f a manufactured product or of a service taking
the form of a name, a sign, a slogan, a logo, or an emblem.

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UNIT 6. ACCOUNTING SYSTEMS FOR PAYROLL AND PAYROLL TAXES

Contents
6.0 Aims and Object ives
6.1 Introduction
6.2 Importance of Payro ll Accounting
6.3 Definit ions of Payro ll Related Terms
6.4 Possible Components of A Payro ll Register
6.5 Major Act ivit ies Invo lved In Account ing For Payroll
6.6 Illustration Of A Payro ll Register
6.7 Summary
6.8 Answer to Check Your Progress Questions
6.9 Model Examination Questions
6.10 Glossary

6.0 AIMS AND OBJECTIVES

This unit aims at discussing the account ing for payro ll and payro ll tax liabilit ies. The
techniques and procedures used in co mput ing personal inco me tax, pensio n contribut ions, and
other deductions are discussed in detail. Also, the journal entries and other records necessar y
in account ing for payro ll will be explained and illustrated based on examples. After reading
and covered this unit you would be able to:

 understand the importance of payro ll accounting

 define payro ll related terms
 describe the components of a payroll register
 calculate inco me taxes, pensio n contribut ion and other deductions and net pay
 record journal entries related to payro ll and payroll taxes
 prepare a payro ll register

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6.1 INTRODUCTION

In the previous chapter you have discussed the basic accounting principles and practices that
are useful in accounting for the acquis it ion, use, and disposal o f plant assets, as well as the
accounting for intangible assets and natural resources have also been discussed briefly.

In this chapter you will be acquainted with the basics o f account ing for payro ll and payro ll
taxes. Account ing systems for payro ll and payro ll taxes are concerned wit h the records and
reports associated with the emplo yer-emplo yee relat ionship. It is important that the
accounting system provide safeguard to ensure that payments are in accord with
management’s general plans and its specific authorizat ions.

All emplo yees o f an organizat ion expect and are ent it led to receive their remunerat ion at
regular intervals fo llowing the clo se o f each payro ll period. Regardless o f the number o f
emplo yees and the difficult ies in co mput ing the amounts to be paid, the payro ll system must
be designed to process the necessary data quickly and assure payment of the correct amount to
each emplo yee.

The system must also provide adequate safeguards against unauthorized payments to
emplo yees and other misappropriat ions of funds.

Various federal, state, and local laws requires emplo yers to keep accurate payro ll records and
to prepare reports and submit to the appropriate governmental unit s. The law also require
emplo yers t remit the amounts withheld fro m its emplo yees and for taxes imposed on itself.
These records must be kept for specified periods of time and be available for inspect ion by
those responsible for enforcement of the laws. Besides, payro ll data may be useful in
negotiat ions wit h labor unio ns, in settling emplo yee grievances, and in determining rights to
vacations, sick leaves, and retirement pensio ns.

Here, in this chapter, you are going to learn intensely and worked through the major concepts
that are commo n to most payroll systems such as the emplo yee’s earnings record, payro ll
sheet (or register), and journal entries related to payro ll. Each of these concepts is illustrated
and discussed by taking into account the current tax law of the country. As much as possible
the chapter attempts to give you adequate knowledge about payroll systems in Ethiopia,
however, if you come across any confusio n or difficult ies you can consult the authorities in

96
the Ministry of Finance or Inland Revenue Administration in your localit y, or refer the
various proclamat ions especially; Proclamat ion No. 286 / 2002, the council o f ministers
regulat ion No. 78 / 2002. And Article 33 or proclamat ion No. 64 / 1975

6. 2 IMPORTANCE OF PAYROLL ACCOUNTING

Account ing for payroll is particularly important because:

1- Payro ll o ften represents the largest expense that a company incurs.
2- Both federal and state governments require that detailed payro ll records be kept and
3- Emplo yees are sensit ive to payroll errors or irregularit ies. To maintain good emplo yee
morale payro ll must be paid on a timely and accurate basis.

6. 3 DEFINITION OF PAYROLL RELATED TERMS

1. Salary and Wages: Salary and wages are usually used interchangeably. However, the term
wages is more correctly used to refer to payments to unskilled-manual labor. It is usually paid
based on the number of hours worked or the number of units produced. Therefore, wages are
usually paid when a particular piece o f work is completed or weekly.

On the other hand, salaries refers to payments to emplo yees who render managerial,
administrative or similar services, and they are usually paid to skilled labor on a mo nthly or
yearly basis.

Both wages and salaries related to an ‘emplo yee’ is an individual who works primarily to one
organizat ion and whose activit ies are under the direct supervisio n of emplo yer.

A self-emplo yed person on the other hand works (gives her services) on a fee basis to various
firms.

2. The Pay Period: A pay period refers to the length of time covered by each payro ll
payment.

3 The Pay Day: The pay day- is the day on which wages or salaries are paid to emplo yees.
This is usually on the last day of the pay period.

97
4. A Payroll Register (sheet): is the list o f emplo yees of a business alo ng wit h each
emplo yee’s gross earnings; deduct ions and net pay (take ho me pay) for a part icular pay
period. The payro ll register (sheet) is prepared based on attendance sheets, punched (clock)
cards or time cards.

5. Pay Check: A business can pay payro ll by writ ing a check for the amount of the net pay. A
check is prepared in the name o f each emplo yee and handed to emplo yees. Alternat ively a
check for the total net pay can be prepared for emplo yees to the paid by cash at the
organizat ion.

6. Gross Earnings: are taxes co llected from the earnings of emplo yees by t he emplo yer
organizat ion as per the regulat ions o f the government. These have to be submitted (paid) to
the government because3d emplo yer organizatio n is only act ing as an agent of the
government in co llect ing these taxes fro m emplo yees.

7. Payroll Deductions: are deductions fro m the gross earnings o f an emplo yee such as
emplo yment inco me taxes (wit h ho lding taxes), labor unio n dues, fines, credit associatio n
pays etc.

8. Net Pay: Net Pay is the earning o f an emplo yee after all deduct ions have been deducted.
This is the take home pay amount collected by an emplo yee on the payday.

6.4. POSSIBLE COMPONENTS OF A PAYROLL REGISTER

1. Employee Number
Number assigned to emplo yees for ident ificat ion purpose when a relat ively large number of
emplo yees are invo lved in a payro ll register.

2. Name of Employees

3.6. Earnings
Money earned by an emplo yee fro m various sources,. This may include.
a. Basic Salary- a flat monthly salary of an emplo yee for carrying out the normal work
of emplo yment and subject to change when the emplo yee is promoted.
b. Allowances- money paid monthly to an emplo yee for special reasons, like:

98
 - Position allowance- a mo nthly paid to an emplo yee of earning a particular office
responsibilit y.
- Housing allowance- a mo nthly allowance given to cover housing costs of the
individual emplo yee when the emplo yment contract requires the emplo yer to
provide housing but the emplo yer fails to do so.
- Hardship allowance- a sum o f mo ney given to an emplo yee to compensate for
an inconvenient circumstance caused by the employer. For instance, unexpected
transfer to aw different and distant work area or location.
- Desert allowance- a monthly allowance given to an emplo yee because o f
assignment to a relat ively hot region.
- Transportation (fuel) allowance- a mo nthly allowance to an emplo yee to cover
cost of transportation up to her workplace if the emplo yer has co mmitted itself to
provide transportation service.

C. Overtime Earning: Overtime work is the work performed by an emplo yee beyo nd the
regular working hours.

Overt ime earnings are the amount paid to an employee for overtime work performed.

Art icle 33 of proclamat ion No. 64/1975 discussed the fo llowing about how overtime work
should be paid:

A worker shall be ent it led to the paid at a rate of

i. One and one-quarter (1 ¼) times his ordinary hourly rate for overtime work performed
before 10:00 P.M in the evening.
ii. One and one half (1 ½) times his ordinary hourly rate for overtime work performed
between 10:00 P.M and six (6:00 A.M) in the morning.
iii. two times the ordinary hourly rate for overtime work performed on weekly rest days
iv. two and one half (2 ½ ) times the ordinary hourly rate for overtime work performed on
a public ho liday.

All in all, the gross earnings o f an emplo yee may include the basic salary, allowance and
overtime earnings.

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Check Your Progress Exercise – 1
1. What term is frequent ly used to refer to the total amount paid to emplo yees for a certain
period?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

2. Dist inguish between salaries and wages?

………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

3. An emplo yee earns Br. 50 per hour with one and quarter (1 ¼) times than regular hourly
rate for all hours in excess of 40 per week. If the emplo yee worked 50 hours during the
current week, what was the gross earning for the week?
………………………………………………………………………………………………
………………………………………………………………………………………………
………………………………………………………………………………………………

4 Deduction: are subtractions made fro m the earnings o f emplo yees required by the
government or permitted by the emplo yee himself.

a. Employment Income Tax: E ver y cit izen is required to pay emplo yee tax to the
government in almost all countries. In Ethiopia also, inco me tax is charged on the
gross earnings o f the emplo yee at the rates indicated under schedule A of the
Proclamat ion N. 286/2002- Income tax proclamat ion.

The tax rates under schedule A are Presented below:

100
 Employment Income Income
(per month) Tax rate *In comput ing and wit hho lding
tax, the inco me tax proclamat ion
Over Birr To Birr
0 150 Exempt (Free from dictates that inco me attributable
Tax) to the month of Nehassie and
151 650 10%
651 1400 15% Pagumen shall be aggregated
1401 2350 20% (added) and treated as the inco me
2351 3550 25%
3551 5000 30% of one month.
Over 5,000 35%

Taxable inco me includes any payment or gains in cash or I n kind received fro m emplo yment
by an individual, including inco me fro m former emplo yment or otherwise or from
prospective emplo yment.

Check Your Progress Exercise – 2

1. What is the total amount deducted as inco me tax for an emplo yee who earns a basic
mo nt ly salary of Br. 1800, a monthly non taxable allowance o f Br. 300, and an overtime
earning of Br. 400?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

2. Describe (i) Basic (regular) pay, (ii) Overtime pay

…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

Short cut to Income Tax Calculation

Employment Income Income
(per month) Tax Payable
Over Birr To Birr
0 150 No tax

101
151 650 (10% X EI) – 15
651 1400 (15% X EI) – 47.5
1401 2350 (20% X EI) – 117.5
2351 3550 (25% X EI) – 235
3551 5000 (30% X EI) – 412.5
Over 5,000 (35% X EI) – 662.5

EI = Emplo yment Income or taxable income

15 = (150 X 0.1) – 0
47.5 = [(150 X .15) – 0] + [(500 X 0.15) – (500 X 0.1)]and so forth
Proclamat ion No. 286/2002 states that the fo llowing are not taxable.
1- inco me fro m emplo yment received by casual emplo yees who are not regularly
emplo yed provided that they do not work for more than one month for the same
emplo yer in any twelve months period.
2- Pensio n contribut ion, provident fund and all forms of ret irement benefit s contributed
by emplo yers in an amount that doesn’t exceed 15% of the monthly salary of the
emplo yee.
3- Payments made to---- (an emplo yee) as a compensation or gratitude in relat ion to:
o personal injuries suffered by that person
o the death of another person

The council o f ministers regulation No. 78/2002

Regulations issued pursuant to the inco me tax proclamat ion further exempts the fo llowing
fro m inco me tax.

1- Amounts paid by emplo yers to cover the actual cost of medical treatment of
emplo yees.
2- Allowance in view of means of transportation granted to emplo yees under contract of
emplo yment, i.e., transportation allowance.
3- Hardship allowance
4- Amounts paid by emplo yee in reimbursement of traveling expenses incurred on duty.

102
4.b. Pension Contribution
Permanent emplo yees a governmental organization in Ethiopia is expected to pay or
contribute 4% of their basic salary to the governments’ pensio n trust fund.

This amount is wit hheld by the emplo yer from each emplo yee on every payro ll and later be
paid to the respective government body.

The emplo yer is also expected to contribute towards this same fund 6% of the basic salary o f
every permanent government emplo yee.

Therefore, the total contribution to the pensio n fund o f the Ethiopian government is equal to
10% of the basic salary o f all of its permanent emplo yees.

That is, 4% comes fro m the emplo yees and 6% comes from the emplo yer.

This enables a permanent emplo yee of a government organizat ion to be ent it led to the pensio n
pay when retiring provided the emplo yee satisfie s the minimum requirements to enjo y the
benefits.

Business and non-governmental not-for profit organizat ion (NGO’s) also have this kind o f a
scheme to benefit their emplo yees with so me modificat ions. A fund known as provident fund
is established and both the emplo yer and the employee contribute towards this fund mo nthly.
When an emplo yee retains or leaves emplo yment, a lump sum amount is paid to him/her.

4.c. Other Deductions

Apart fro m the above two kinds of deduct ions, emplo yees may individually authorize
addit ional deduct ions such as deduct ions to pay life insurance premiums, to repay loan fro m
the emplo yer, to pay for donation to charitable organizat ion, contribut ions to "ldir" etc.

Check Your Progress Exercise – 3

1. Ident ify the federal and state taxes that most emplo yers are required to withho ld fro m
emplo yees?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………. .

103
2. What is the emplo yer share of pensio n contribut ions for a government permanent
emplo yee whose regular monthly salary o f Br. 2400?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………. .

5 Net Pay
Net pay represents the excess of gross earnings over total deduct ions of an emplo yee.

Signature

The payro ll sheet should have a co lumn for signature of the emplo yee to be taken when the
emplo yee co llects the net pay.

6.5 MAJOR ACTIVITIES INVOLVED IN ACCOUNTING FOR PAYROLL

1 Gathering the necessary data - All t he relevant information about every emplo yee should
be gathered.

This requires reviewing various documents such as attendance sheets and doing so me
arithmetic work.

2 Entering the names of employees - alo ng with the gathered data such as earnings,
deductions and net pays in the appropriate columns of the payroll register.

3 Totaling and proving the payroll register -the grand total for earnings must be checked if
its equal to the sum of the grand totals of deductions and net pays.

4 The accuracy and authenticity of the information - summarized in the payro ll should be
verified by a different person fro m the one who prepared it.

5 The payroll - should be approved by an authorized personnel (individual)

6 Paying the payroll - either in cash or by writ ing a check.

7 The payment of the payroll and income taxes - withheld fro m emplo yees (wit hho ld do ing
tax liabilit y) should be recorded in journal entry form.

104
8 The withholding tax - must be paid to the relevant government authorit y in t ime (prompt ly)
and this is recorded in journal entry form.

Check Your Progress Exercise – 4

1. How is Net Pay co mputed?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. Assume an emplo yee's regular hourly pay is Br. 16, with a time and a half for every hour
worked in excess of 48 during a week. The fo llowing data are available:
Hours worked during current month Br. 200
Regular monthly salary Br. 3072
Allowance (transportation) Br. 300
Assume that according to company po licy transportation allo wance in excess of Br. 200 is
subject to emplo yment inco me tax.

Based on the above data, compute the amount of the emplo yee's:
i. net pay for the current month;
ii. emplo yment inco me tax,
iii. total deductions, assuming the emplo yee is permanent civil servant.

6.6. ILLUSTRATION OF A PAYROLL REGISTER

Godanaye is a government agency recent ly organized to rehabilitate street children. It has five
emplo yees whose salaries are paid according to the Ethiopian calendar month. The fo llo wing
data relates to the month of Yekatit, 1995.

Serial Name of Employee Basic Transp. Overtime Duration of

No. __________________ Salary Allowance worked(hr) OT Work
01 Aregash Shewa Br. 730 200 4 6: 00- 10: 00 P . M
02 Paulos Chala 1020 ___ 8 Sunday(8:30-5:30)
03 Mohammed Modesir 5300 ___ ___ ___
04 Tensay Belay 1470 ___ ___ ___
05 Haile Olango 950 ___ 6 Public Ho liday

105
Additional Information
- The management of the agency usually expects a worker to work 40 hours in a week
and during Yekat it there are four weeks.
- There were no absentees during the month
- All emplo yees are permanent except Tenssay and Haile
- Paulos agreed to contribute monthly Br. 300 fro m his salary as a mo nthly saving in the
credit association o f the agency.

Required
1. Prepare a payro ll register (sheet) for the agency for the month of Yekat it, 1995.
2. Record the payment of salary as of yekat it 30,1995 using check stub No. 0123.
3. Record the payment of the claim o f the credit Associat ion of their agency on Megabit
1, 1995 use check stub No. 0124.
4. Record the payment of the wit hho lding taxes and pensio n contribut ion to the
concerned government body on Megabit 7,1995.
5. Compute and recognize the total payro ll tax expense for the month of Yekat it, 1995.

Computation of Earnings, Deductions and Net Pay

Gross Earnings = Basic salary + Allowance + Overtime Earning

Overtime Earning
Overt ime earning = OT hrs worked X (ordinary hourly rate X relevant OT rate)

1. AREGASH:
 OT Earning = 4 hours X br. 730 X 1.25 = br. 22.81
160 hours
NB Every emplo yee is expected to work 160 hours per month
(i.e. 40 hours x 4 weeks)
 You should compute the regular hourly rate first:
Regular Hourly Rate = Monthly salary (Basic Salary)
Total Hours worked in the Month
= br. 730
160 Hours

106
  Therefore, the regular Hourly payment = br. 4.56
The regular hourly payment must be mult iplied by the appropriate OT rate as
fo llows:
br. (4.56 x 1.25) x 4 hours-------------------br. 22.81

2. PAULOS
 OT Earning = 8 hours X br. 1020 x 2 ----------------br. 102.00
160 hours

3. HAILE
 OT Earnings = 6 hours X br. 950 x 2.5 -------------br. 89.06
160 hours
GROSS EARNINGS
Gross Earnings = Basic salary + Allowance + OT Earnings

1. AGEGASH
 Gross Earnings = br. 730 + br. 200 + br. 22.81 = br. 952 .81
 Remember taxable inco me in this case is br. 752.81 because the transportation
allowance of br. 200 is not subject to taxation.

2. PAULOS
 Gross Earning = br. 1020 + br. 102 = br. 1122
 The Gross Total Earnings o f Paulos consists o f the br. 1020 basic salary plus
the overtime earnings of br. 102, which is br. 1122.

3. MOHAMMED
 Gross Total Earnings = br. 5300, which include the basic salary alo ne

4. TENSAY
 Gross Total Earnings = br. 1470, which is the basic salary.

5. HAILE
 Gross Total Eanings = br. 950 + 89.06 = br. 1039.06

107
DEDUCTIONS AND NET PAY

1. AREGASH:
 Gross Total Earnings-----------------------------------------br. 952.81
 Gross Taxable Inco me (br. 952.81 – br. 200)-----------------752.81

Employee Income Tax:

Earnings X Income Tax Rate = Income Tax

0 – 150---------150 0 br. 00.00
151 – 650 o n 500 10% 50.00
651 – 752. 81 o n 102. 81 15% 15.42
TOTAL br. 752.81-----------------------------------------------br. 65.42

Pension contribut ion:

Basic salary x 4%
= br. 730 x 0.04-------------------------------------------------29.20
 Total Deduct ion (br. 65.42 + br. 29.20)-----------------br. 94.62

NB. The inco me tax to be deducted fro m the emplo yee could have been co mputed by using
the short-cut method as fo llows:
= (Taxable Inco me x 15%) – br. 47.5
= (br. 752.81 x 0.15) – br. 47.5 = br. 65.42

2. PAULOS:
 Gross Total Earning-----br. 1122.
 Emplo yee Inco me tax

Earning X Income Tax Rate = Income Tax

0 – 150 (150) 0 br. 00.00
151 – 650 o n 500 10% 50.00
651 – 1122 o n 472 15% 70.80
TOTAL br.1122---------------------------------------------br. 120.80
 Pensio n Contribution (br. 1020 x 0.04)---------------------40.80
 Credit Associat ion--------------------------------------------300.00

108
  Total Deduction---------------------------------------------br. 461.60

3. MOHAMMED:
 Gross Total Earnings------------------------------------br. 5300.00
 Employee Income Tax

Earning X Income Tax Rate = Income Tax

0 – 150-------150 0 br. 00.00
151 – 650 o n 500 10% 50. 00
651 – 1400 o n 750 15% 112. 50
1401 – 2350 o n 950 20% 190. 00
2351 – 3550 o n 1200 25% 300. 00
3551 – 5000 o n 1450 30% 435. 00
Over 5000 on 300 35% 105. 00
Total br. 5300.00-----------------------------------------------br. 1192.50
 Pensio n contribut ion (br. 5300 x 0.04)---------------------- 212.00
 Total Deductions------------------------------------------br. 1404.50

4. TENSAY:
 Gross Total Earnings------------------------------------br. 1470.00
 Gross Taxable Inco me--------------------------------------1470.00
Emplo yee Inco me Tax:

Earning X Income Tax Rate = Income Tax

0 – 150-----150 0 br. 00.00
151 – 650 o n 500 10% 50. 00
651 – 1400 o n 750 15% 112. 50
1401 – 1470 o n 70 20% 14. 00
Total br. 1470---------------------------------------------------- br. 176.50

NB. No pension contributions because she is not permanent employee of the organization.
Therefore, total deduction is the same as Employee Income Tax, br. 176.50.

109
5. HAILE:
 Gross Total Earnings--------------------------------------br. 1039.06
Emplo yee Inco me Tax:
Earnings X Income Tax Rate = Income Tax
0 – 150----150 0 br. 00.00
151 – 650 o n 500 10% 50.00
651 – 1039.66 on 389.06 15% 58.36
Total br. 1039.06----------------------------------------------------br. 108.36
 Pensio n contribut ion should not be co mputed for Haile because he is not
permanent emplo yee of the agency. Thus, the only deduct ion fro m Haile’s
earnings is the emplo yee inco me tax.

NB. It is also possible to compute inco me tax by using the short-cut method:
Total Inco me Tax = (Taxable Inco me x 15%) – 47.5
= (br. 1039.06 x 0.15) – 47.5
= br. 108.36
NET PAY:

Net pay = Gross Total Earnings – Total Deductions

1. AREGASH:
Net pay = br. 952.81 – br. (94.62)
Net pay = br. 858.19

2. PAULOS:
Net pay = br. 1122 – br. (461.60)
Net pay = br. 660.40

3. MOHAMMED:
Net pay = br. 5300 – br. (1404.50)
Net pay = br. 3895.50

4. TENSAY:
Net pay = br. 1470 – br. (176.50)

110
 Net pay = br. 1293.50

5. HAILE:
Net pay = br. 1039.06 – br. 108.36
Net pay = br. 930.70

PROVING THE PAYROLL:

Total Earnings:
Basic salary-----------------------------------------------br. 9470.00
Allowances-----------------------------------------------------200.00
Overtime--------------------------------------------------------213.87
Grand Total---------------------------------------br. 9883.87
Deductions:
Emplo yee Inco me Taxes--------------------------------br. 1663.58
Pension Contributions----------------------------------------282.00
Other Deductions----------------------------------------------300.00 =
Total Deduct ions------------------------------br. 2245.58
Net Pay Total------------------------------------------------------br. 7638.29
Total Deductions plus Net pay----------------------------------br. 9883.87

The payro ll register (or sheet) for Godanaye Rehabilitat ion Agency prepared for the Month o f
Yekatit, 1995 is shown below.

6.7 SUMMARY
The term payro ll is used to refer to the total amount paid to emplo yees for a certain period.
Payro ll includes amounts paid for salaries to managerial or administrative emplo yees as well
as wages paid for manual labor.

Account ing systems for payroll and payro ll taxes are concerned wit h the records and reports
associated wit h the emplo yer-emplo yee relat ionship. It is important that the account ing
system provide safeguards to ensure that payments are accord with management’s general
plans and its specific authorizat ions.

111
Various federal, state, and local laws require emplo yers to keep accurate payro ll records and
to prepare reports and submit to the appropriate governmental units. T he law also requires
emplo yees and for taxes imposed on itself. These record must be kept for specified periods o f
time and be available for inspect ion by those responsible for enforcement of the laws.

Payro ll data may also be useful in negotiations with labor unions, in settling emplo yee
grievances, and in determining rights to vacations, sick leaves, and retirement pensio ns.

Salary and wages are usually used interchangeably. However, the term wage is more correctly
used to refer to payments to unskilled manual labor. It is usually paid based on the number of
hours worked or the number of units produced. Therefore, wages are usually paid when a
particular piece of work is co mpleted or on a weekly basis. On the other hand, salaries refer to
payments to emplo yees who render managerial, administrative, or similar services. Salaries
are usually paid to skilled labor on a monthly or yearly basis.

A payro ll register is the list of emplo yees o f a business alo ng wit h each emplo yee’s gross
earnings, deduct ions, and net pay (take-home-pay) for a particular pay period. The payroll
register (sheet) is prepared based on attendance sheets, punched (clock) cards or time cards.

Components of a payro ll register include E mployee number, Emplo yee name, Earnings
(usually Basic or regular salary, Allowances, and overt ime), Deductions, Net pay, and
Signature.

Earnings are mo ney earned by an emplo yee of an organizat ion fro m various sources. It may
include: (1) the basic salary which is a flat monthly salary o f an emplo yee that is paid for
carrying out the normal work or emplo yment, (2) allowances which represents money paid
mo nthly to an emplo yee for special reasons, which may include: posit ion allowance, housing
allowance, hardship allowance, desert allowance, and transportation (or fuel) allowance, etc,
and (3) overtime earnings – the amount payable to emplo yees for overtime work performed.

Deductions are subtractions made fro m the earnings o f emplo yees. Deduct ions are eit her
required by law or permitted by the emplo yee himself. The principal deduct ions in Ethiopia
are: E mplo yee Inco me tax, pensio n contribut ion, and other deductions like deductions to pay

112
 life insurance premiums, to repay loans fro m the emplo yer, for credit association, to pay for
donation to charitable organizat ion, contribut ion to ‘Idir’, etc.

Net pay or take-home-pay represents the excess of gross earnings over total deductions of an
emplo yee.

The payro ll sheet should have a co lumn for signature of the emplo yee to be taken when the
emplo yee co llects the net pay. In general, a payroll register (sheet) should at least show the
total earnings of each emplo yee, deduct ions, and the net pay together with the names and
signatures of emplo yees.

Todanaye
Payroll Register(sheet)
For the month of Yekatit,1995
Ser. Name of Earnings Deductions
No. Employee Basic Allo- Over Gross Income Pension Other Total Net Sign.
salary wance Time Earning Tax Contr. Deduc. Deduc. Pay
01 Aregash Shewa 730 200 22. 81 952. 81 65. 42 29. 2 ___ 94. 62 858. 19
02 Paulos Chala 1020 ___ 102 1122 120. 8 40. 8 300 461. 6 660. 4
03 Mohammed 5300 ___ ___ 5300 1192. 5 212 ___ 1404. 5 3895. 5
Mudesir
04 Tensay Bela y 1470 ___ ___ 1470 176. 5 ___ ___ 176. 5 1293. 5
05 Haile Olango 950 ___ 89. 06 1039.06 108. 35 ___ ___ 108. 35 930. 71

Totals 9470 200 213. 87 9883.87 1663.57 282 300 2245.57 7638. 3

Prepared by_______________Checked by________________Approved by___________

6.8 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

Check Your progress Exercise - 1

1. Payro ll

113
2. (a) Salaries – represent payment for emplo yees who are paid at a monthly or yearly rate.
Salary is usually applied to payment for managerial, administrative, or similar
services.

(b) Wages – represent payment for services of emplo yees at an hourly rate or on a piece
work basis. Wage is usually applied payment for a manual labor.

(c) Gross Earnings = Basic Salary + Overtime earning for the week

Weekly Basic Salary = regular hourly rate x weekly regular working hours.
= br. 50 x 40 hrs. = br. 2000

 Therefore, weekly regular salary of the emplo yee is br. 2000

 Overt ime Earning = Overtime Hours worked x (Regular Hourly rate x OT rate)
OE = 16 x (br. 50 x 1.25)
OE = 16 x (62.50)
Overtime Earning = br. 1000.
 Thus, total earnings of the week = br. 2000 + Br. 1000 = br. 3000

Check Your progress Exercise – 1

1. Gross total Earnings of the emplo yee = Basic Salary + Allowance +
Overtime earning
Gross total Earnings = br. 1800 + br. 300 + br. 400
Gross Total Earnings = br. 2500
Taxable Inco me of the emplo yee = br. 2200, whic h does not include the allowance o f br. 300,
because it is non-taxable.

Earnings X Income Tax Rate = Income Tax

0 – 150 150 0 00. 00
151 – 650 on 500 10% 50.00
651 – 1400 on 750 15% 112.50
1401 – 2200 on 800 20% 160.00
Total br. 2200 322.50
 Total Employee Income Tax is therefore, br. 322.50

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 (b) (i) Basic (Regular) pay – is a flat monthly salary o f an emplo yee that is paid
for carrying out the normal work of emplo yment and subject to change
when the emplo yee is promoted.
(ii) Overtime pay – is the amount payable to an emplo yee for overtime work
done.

Check Your progress Exercise - 3

1. Emplo yee inco me tax
- emplo yee pension contribution (if any)
2. Pensio n contribution is the amount of mo ney that each government permanent emplo yee
contributes towards a fund which up on the emplo yees retirement, will be drawn upon to
finance the participant’s welfare.
 The emplo yer’s share of pension contribut ion is 6% of the regular monthly salary o f
the permanent civil emplo yee. Thus; 0.06 x br. 2400 = br. 144.00

Check your progress Exercise - 4

1. Net pay is co mputed using the fo llowing formula:
Net pay = Gross total Earnings – Total Deductions

2. Gross Total Earnings = Basic Salary + Allowance + Overtime earning

Gross Total Earning = br. 3072 + br. 300 + (8 hrs x (br. 16 x 1.50)
= br. 3072 + br. 300 (8 x br. 24)
= br. 3072 + br. 300 + br. 192
= br. 3564.00

 Net pay = Total Earnings – Total Deduct ions

 Total Deductions = Inco me Tax + pensio n contribution
 Inco me Tax: Taxable Inco me (br. 3564 – br. 200) ---br. 3364.

Earnings X Income Tax Rate = Income Tax

0 – 150 on 150 0 00. 00
151 – 650 on 500 10% 50.00
651 – 1400 on 750 15% 112.00
1401 – 2350 on 950 20% 190.00

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 235 – 3364 on 1014 25% 253.50
Total br. 3364--------------------------------------------------- br. 606.00
 Pensio n contribut ion = 4% of basic salary
Pensio n contribut ion = 0.04 x br. 3072 = br. 122.88
Total Deduct ions -----------------------------br. 728.88
 (i) Net pay = br. 3564 – br. 728,88
Net pay = br. 2835.12
 (ii) E mplo yee Income Tax = br. 606.00
 (iii) Total Deduct ions = br. 606 + br. 122.88 = br. 728.88

6.9 MODEL EXAMINATION QUESTIONS

PROBLEM – 1
CHILALO Retail E nterprise, a government owned business, pays its emplo yees salaries
according to the Ethiopian calendar Month. The following data relate to the month o f
Meskerem, 1995 E.C.

S.No Employee Name Basic Salary

001 Animut Anley birr 2500
002 Nebiyat Girma 1880
003 Erecha Megersa 1790
004 Bekuretsion G/Tensae 1565

A d d itio n a l in f o r m a tio n
 All workers are expected to work 40 hours per week and during Meskerem there are 4
weeks. The workers have done as they have been expected.
 Nebiyat Girma has worked 10 hours of overtime during Meskerem: 3 hours during
‘Meskel’ and the other 7 hours before 10 p.m.
 Erecha Megersa has also worked 5 hours o f overt ime: 2 hours during weekly rest days
and 3 hours between 10 p. m. – 6 a.m.
 Animut and Nebiyat received a mo nthly posit ion allowance o f br. 350 and br 300
respectively which are both taxable.
 Animut Anley agreed to have a monthly deduct ion of br. 250 for credit associat ion.

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  All workers are permanent except Bekuretsion G/Tesnae.

Required:
1. Compute the total deduct ions and net pay for each emplo yee.
2. Compute (calculate) the total:
a) Wit hho lding Taxes
b) Payro ll Tax
c) Record the payment of salary as of Meskerem 30,1995.
3. Pass the entry to pay the withho lding taxes to the appropriate government unit.

PROBLEM – 2
HABESHA Trading co. is a private business enterprise. The company pays the salary o f it s
emplo yees according to the Ethiopian calendar mo nth. The fo llowing data relates to the
mo nth of Hidar, 1995.

Serial No. Name Basic Salary

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

Additional information
 The organizat ion expects every worker to work 48 hours in a week and during Hidar
there are four weeks and all workers have done as they have been expected.
 Ato, Abeje Belew and W/r, Haregua Delelegn are ent itled to get a monthly allowance
of birr 500 and br. 400 respectively.
 All workers are permanent except W/t, Zinash Manahlot, and they are ent itled to a
total of 15% provident fund o f which 10% from the emplo yer and 5% from the
emplo yee.
 Ato Zeleke Belayneh and W/t Zinash Manahlot have worked 12 hours of overtime
each on public ho lidays.
 According to the company rule, any allowance mo re than birr 200 is subject to inco me
tax.

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Required: based on the information given above:
1. Compute the inco me tax for each emplo yee.
2. Compute the total deduct ions for each emplo yee.
3. Determine the net pay (take-home-pay) for each emplo yee.
4. Compute the total wit hholding tax for the month.
5. Compute the total payroll tax expense.
6. Pass the journal entry to record the payment of salary as of Hidar 30,1995.

PROBLEM – 3
The fo llowing data relates to the payro ll o f the emplo yees o f a privately owned business
organizat ion known as”ALAZAR Retail Enterprise”, for the month of Megabit, 1995 E.C.

Serial Name Basic Overtime Worked

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

Additional Information
 The management of the business organizat ion usually expects a woker to work 40
hours in a week.
 There were no absentees during Megabit.

Required:
1. Prepare a payro ll sheet for the month of Megabit
2. Record the payment of salary as of Miazia 1, 1995
3. Record the recognit ion of the payro ll tax expense as of Miazia 1, 1995
4. Record the payment o f wit hho lding taxes to the proper government unit s as o f Miazia
15, 1995

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6. 10 GLOSSARY

Payroll- total amount paid to emplo yees for a certain period.

Salary – amount paid to work performed for skilled labor

Wages – amount paid to a piece of work by unskilled labor

Payroll Register (sheet) – a list of emplo yees of a business alo ng with their earnings,
deductions and net pay.

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UNIT 7. CONCEPTS AND PRINCIPLES

Contents
7.0. Aims and Object ives
7.1. Introduction
7.2. Generally Accepted Account ing Principles (GAAP)
7.3. Summary
7.4. Answers to Check Your Progress Exercises
7.5. Model Examination Questions
7.6. Reference Books
7.7. Glossary

7.0 AIMS AND OBJECTIVES

This unit aims at discussing the basic accounting concepts and procedures used in the
preparation of finical reports. It also discusses in detail the Generally Accepted Accounting
Principles.

After studying this unit, you will be able to:

- describe the development of account ing concepts and principles

- dent ify and illustrate the applicat ion of basic account ing concepts and principle
- sol e exercises and problems.

7.1 INTRODUCTION

The historical development of account ing pract ice has been closely related to economic
developments. In the earlier periods, a business enterprise was very o ften managed by its
owner, and the accounting records and reports were used mainly by the owner – manager in
conducting the business. Bankers and other lenders often relied on their personal relationship
with the owner rather than on financial statements as the basis for making loans for business
purposes. If a large amount was owed to a bank or supplier, the creditor often participated in
management decisio ns.

As business organizations grew in size and complexit y, “management” and “outsiders”

became more clearly different iated. From the later group, which includes owners (stock

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ho lders), creditors, government, labor unio ns, customers and the general public, came the
demand for accurate financial informat ion for use in judging the performance of management.

In addit ion, as the size and complexit y of the business unit increased, the accounting problems
invo lved in the preparation of financial statements became more and more co mplex. Wit h
these developments came an awareness of the need for a framework of concepts and generally
accepted accounting principles to serve as guidelines for the preparation o f the basic financia l
statements.

Account ing concepts and principles include convent ions, axio ms, standards, rules, guidelines
and procedures that are necessary to have accounting practice at a particular period of time.
The word “principles” as used in the context of generally accepted accounting principles does
not have the same authoritativeness as universal principles or natural laws relating to the
study of astronomy, physical or other physical sciences.

Account ing principles have been developed by individuals to help make accounting data more
useful in an ever-changing societ y. They represent the best possible guides, based on reason
observat ion, and experimentation, to the achievement of the desired results. These principles
are continually re examined and revised to keep pace with the increasing co mplexit y of
business operations. General acceptance amo ng the members o f the account ing professio n is
the criterion for determining an accounting principle.

Responsibilit y for the development of account ing principles has rested primarily on pract icing
accountants and account ing educators, working both independently and under the sponsorship
of various account ing organizat ion. T hese principles are also influenced by business pract ice
and customs, ideas and beliefs o f the users o f the financial statements, governmental agencies,
stock exchanges and other business groups.

Check Your Progress Exercise -1

1. Account ing principles and concepts are needed due to different reasons. What are they?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

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7.2 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

1. Business Entity Concept

The business entit y concept assumes that a business enterprise is separate and dist inct fro m
the persons who supply its partial or all assets and from every other business. Businesses are
perceived and treated as a distinct separate ent ities regardless of the legal concept because in
so far as a specific business is concerned, the purpose of account ing is to record its
transactions and periodically report its financial posit ions and pro fitabilit y. Consequent ly, the
records and reports of the business should not include eit her the transact ions o f another
business or the personal assets or transact ions of its owner or owners. To include eit her
would distort the financial posit ion and profitabilit y o f the business.

The account ing equat ion, Assets = Equities, or Assets = Liabilit ies + Owners equit y, is an
expressio n of the ent it y concept: i.e. the business owns the assets and owes the various
claimants. Thus, the accounting process is primarily concerned with the enterprise as a
productive econo mic unit and only secondarily concerned wit h the investor as a claimant to
the assets of the business.

Note: the legal ent it y concept may not go in accordance with the business ent it y concept
depending on the type o f the business enterprise, i.e., whether the business is a so le
proprietorship, partnership or corporate entit y. The two concepts match for corporate entit y
but not for the other two business enterprises.

2. Going Concern Concept

Only in rare cases is a business organized wit h the expectation o f operating for only a certain
period of time. In most cases, it is not possible to determine in advance the length of life of
an enterprise, and so an assumpt ion must be made.

The nature of the assumpt ion will affect the manner of recording so me of the business
transactions, which in turn will affect the data reported in the financial statements.

The go ing concern concept assumes that the business enterprise cont inues its operations (at
profit) for indefinite period of time. A business enterprise purchases and ho lds assets for use
in its operations. The market value of those assets may change over t ime. However, the

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accounting records for those assets are not adjusted to reflect the market value changes. T his
is because o f the going concern concept. As a going concern, the assets used in carrying on
the operation of the business are not for sale. Obviously, they cannot be sold wit hout
disturbing the business operation. Therefore, their market values are not particularly relevant
and need not be shown. That is, the going concern concept provides much of the justificat ion
for recording plant assets at acquisit io n cost and depreciat ing them in an orderly manner
without reference to their current realizable values. If there is no immediate expectation o f
selling them, plants assets should not be reported on the balance sheet at their est imated
realizable values regardless o f whether their current market value is less than or greater than
their book value.

The go ing concern assumpt ion similarly supports the treatment of prepaid expenses as assets,
even though they may not be salable.

Doubt as to the continued existence of a firm may be disclosed in a note to the financia l
statements.

If a business enterprise is to be so ld or liquidated, financial statements should be prepared

fro m the “quitt ing concern” or liquidat ing point of view rather than fro m a “go ing concern”
point of view. That is, in such cases, the cost principle and the going concern would not be
applied in preparing the financial statements. Instead the est imated market values beco me
more useful and informat ive.

3. (Historical) Cost Principle

Under this principle, which is a fundamental principle in account ing, all goods and services
purchased are recorded at cost, where costs are measured on a cash or equivalent basis. If the
consideration given for an asset or service is cash, cost is measured at the ent ire cash outla y
made to secure the asset or the service. Otherwise, cost is measured at the cash equivalent
value o f the considerat ion given or the cash equivalent value o f the thing received whichever
is more clearly evident.

For example, if a business paid Birr 15,000 for a lot of land to be used in business operation,
the land should be recorded at a cost of Birr 15,000. It does not make any difference if the

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buyer or any other competent outside appraiser think that the land worth more or less than
Birr 15,000. Therefore, the journal entry would be recorded in the buyer’s book as follows:

Land-------------------------------------15,000
Cash--------------------------------------15,000

4. Objectivity Principle

This principle requires that entries in the accounting records and data reported on financia l
statements be based on object ively determined evidence. This principle answers the questio n
why assets and services are recorded at cost rather than so me other amount such as est imated
market value. As a rule, costs are object ive since normally are established by buyers and
sellers, each striking the best possible bargain for themselves. If this principle is not
fo llo wed, the confidence o f the many users of the financial statements could not be
maintained. For example, objective evidence such as invo ices and vouchers for purchass,
bank statements for the amount of cash in bank, and physical counts for merchandise on hand
supports much of the account ing. Such evidence is completely object ive and can be verified.

Evidence is not always conclusively object ive, for there are many cases in account ing in
which judgments, estimates, and other subjective factors must be taken into account. In such
situations, the most object ive evidence available should be used. For example, the provisio n
for doubtful accounts is an est imate of the losses expected from failure to collect sales made
on account. The est imat ion o f this amount should be based on such object ive factors as past
experience in co llect ing accounts receivable and reliable forecasts of future business
activit ies. To provide account ing reports that can be accepted wit h confidence, evidence
should be developed that will minimize the possibilit y o f error, intent ional bias, or fraud.

Check Your Progress Exercise – 2

1. What does the objectivit y principle require for informat ion presented in financia l
statement?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

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2. A business shows office stationery on the balance sheet at its cost Birr 430 cost, although it
cannot be sold for more than Birr 10 as scrap paper. Which accounts principle require this
treatment?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………………………….

5. Stable Monetary Unit Concept /Unit of measurement

Account ing transact ions are measured, recorded and reported in terms o f mo netary unit. In
the process of measuring, recording and reporting the monetary unit is treated as a stable unit
of measure like a gallo n, a kilo meter etc. However, the monetary unit is not a stable unit of
measure nevertheless; accountants use a mo netary unit as a standard unit o f measurement in
their reports. Money is both the commo n factor of all business transact ions and the only
feasible unit of measurement that can be used to achieve uniform financial data.

The generally accepted use of the mo netary unit for accounting for and reporting the act ivit ies
of an enterprise has got two major limitat ions: First, it limits the scope of account ing reports.
The scope of the report will be on informat ion which can be quantifiable and measurable
interims o f monetary unit. What so ever the information is useful to the user, unless it is
measurable interims o f mo netary unit, it cannot be reported on the financial statements.
Secondly, as it is stated above, any mo netary unit in the world is not stable due to economic
changes. T herefore, the accountants report could be highly crit icized for not being fully
informat ive.

To consider the above two limit ations, accountants usually prepare reports which acco mpany
the financial statements. These reports try to info rm relevant unquant ifiable informat ion and
reflect the effects of change in purchasing power of the mo netary unit.

6. The Periodicity Concept /Accounting period Concept/

According to this concept, the life o f a business ent it y should be broken into segment periods
for account ing purposes. A co mplete and accurate, picture of an enterprise’s success or
failure cannot be obtained unt il it discont inues operations, converts its assets into cash, and
pays o ff its debts. Then, and only t hen is it possible to determine its true net inco me. But

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many decisio ns regarding the business must be made by management and interested outsiders
during its existence. Therefore, it is essent ial to stop the operation of the business artific ially
at frequent intervals so as to produce periodic reports on operations, financial posit ion, and
cash flows. These reports reduced will help the user how well or bad the business was
operating during those periods. These periods are timely and provide a consistent frame o f
reference to measure the business act ivit ies and compare those measurements with previous
periods and other companies.

Reports may be prepared when a certain jo b or project is co mpleted, but more often they are
prepared at specific t ime intervals. For a number of reasons, including custom and various
legal requirements, the longest interval between reports is one year.

This element of periodicit y creates many of the problems o f accountancy. T he basic proble m
is the determinat ion of periodic net inco me. For example, the need for adjust ing entries,
problems of inventory costing, problems o f recognizing the unco llect ibilt y o f the receivables,
and problem of select ing depreciat ion methods are direct ly related to the periodic
measurement process.

Check Your Progress Exercise - 3

What are the two major limitat ions of stable mo netary unit concept on the accounting reports?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

7. The Matching Principle

How well or bad the co mpany is do ing is reflected to users on the income statement prepared
for a period of t ime. The inco me statement tries to measure the business’s earnings by
comparing the revenue wit h expenses of that period which is covered by the inco me
statement.

The matching principle means that after the revenues for an account ing period have been
determined, the costs associated with those revenues must be deducted in order to determine

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net inco me. The term matching refers to the close relat ionship that exists between certain
costs and the revenue realized as a result of incurring those costs.

Thus, the use o f matching as a pervasive principle in the inco me measurement offers another
practical reason for the widespread use o f cost principle. For example, the expenditure for
advert ising is a cost to be matched against the sales that is promoted. The recognition o f
unco llect ible accounts is also supported by the matching principle. Unco llect ibles arise fro m
credit sales to customers who fails to pay their bills. To match this expense (uncollectible
amount) , it becomes important to estimate what part of the credit sales is to be unco llect ible
in the future. The use of est imate is necessary in order to carry the matching principle.

8. Revenue Realization Principle

States that revenue fro m business transactions is recorded when goods or services are so ld.
Some business sell goods or services on one date but receive payment on a later date. In such
cases, the revenue is recorded on the date of sale, not necessarily when the cash is received.

9. Adequate Disclosure Principle

All financial statements and acco mpanying statements should include the necessary data that
helps to facilitate the user’s understanding. Thus, all relevant informat ion to the users must be
disclosed. However, full disclosure does not mean that everyt hing must be disclosed. That
would be too costly. A balance must be maintained between the cost of disclo sing
informat ion and its relevance to users. Basically, if the informat ion will make a difference in
investors’ or creditors’ decisio ns it should be disclosed. Therefore, the criterion for disclo sure
is based on value judgment rather than objective facts.

Financial statements are made more useful by the use o f headings and subheading, and by
merging items in significant categories. Alt hough all essent ial data should be disclosed wit h
in these categories, judgments must be exercised by excluding non-essent ial informat ion to
avo id clutter. For example, detailed informat ion as to the amount of cash in various special
and general funds, the amount on deposit in each of several banks, and the amount invested in
various marketable government securit ies is not needed by the reader o f financial statements.
Such informat ion displayed on the balance sheet would hinder rather than aid understanding.

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In most cases, all o f the pert inent data needed by the reader cannot be presented in the
financial statements themselves. The statements therefore normally include essential or
explanatory information in acco mpanying notes. Adequate disclo sures are necessary for both
historical facts and subsequent events to the issuance o f financial statements. The fo llowing
are some examples:

 Summary o f significant accounting policies.

 Change in account ing methods used by the business
 Contingent liabilit ies and co mmit ments.
 Events subsequent to the date of statements
 Replacement cost of inventiories and plant assets etc.

10. The Consistency Principle

The amount and direct ion o f change in net income and financial posit ion fro m period to
period is very important to readers and may greatly influence their decisio ns. Therefore,
interested person should be able to assume that successive financial statements of a n
enterprise are based on consistent ly on the same generally accepted accounting principles. If
the principles are not applied consistent ly, the trends indicated could be the result of changes
in the principles used rather than the result o f changes in business condit io ns or managerial
effect iveness.

Consistency principle requires that the same generally accepted accounting principles are used
fro m period to period for the same account ing events. Therefore, once an account ing method
or principle is adapted, it should be used for reasonable period of time. This is because
accounting informat ion is more useful if it can be compared wit h similar informat ion for the
same company fro m time to time. However, consistency principle does not prohibit switching
fro m one account ing method to another. Changes are permissible when it is believed that the
uses o f a different principle will more fairly state net inco me and financial posit ion.
Examples o f change in account ing principles include a change in the method of inventory
pricing, a change in depreciat ion method for previously recorded assets and a change in the
method of accounting for long- term construction contracts. Considerat ion of changes in

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accounting principles must be acco mpanied by consideration o f the general rule for disclosure
of such changes, which is as fo llows:

The nature of and just ificat ion for a change in accounting principle and its effects on inco me
should be disclosed in the financial statements of the period in which the change is made.
The just ificat ion for the change should explain clearly why the newly adopted accounting
principle is preferable.

There are various methods o f reporting the effect of a change in account ing principle on net
inco me. The cumulat ive effect of the change on net inco me may be reported on the inco me
statement of the period in which the change is adopted. In some cases the effect of the change
could be applied retroactively to past periods by present ing revised inco me statements for the
earlier years affected.

The applicat ion of the consistency principle does not require that a specific method be used
uniformly throughout an enterprise. For example, it is not unusual for large enterprises to use
different costing methods and pricing methods for different segments of their inventories.

11. The Materiality Concept

In fo llowing generally accepted account ing principles, the accountant must consider the
relat ive importance o f any event, accounting procedure or change in procedure that affects
items on the financial statements. The concept of materialit y is relat ive. What is material for
one firm may be immaterial for another firm. The determinat ion of what is important and
what is not requires the exercise of judgments. Precise criteria cannot be formulated. Some
factors do help to ident ify events as being material or immaterial. T his is done by co mparing
the size and nature of an item or event with the size and nature of other events or items. For
example, the erroneous classificat ion o f a Birr 10, 000 asset on a balance sheet exhibit ing total
assets of Birr 10,000,000, would probably be immaterial. If the assets total only Birr 100,000,
however, it would certainly be material. If the Birr 10,000 represented a note receivable fro m
an officer of the enterprise, it might well be material even in the first assumpt ion.

The concept of materialit y may be applied to procedures used in recording transact ions. For
example, small expenditures for plant assets may be treated as an expense of the period rather

129
than as an asset. The saving in clerical costs is just ified if the pract ice does not materially
affects the financial statements.

Customs and pract icalit y also influence the criteria of materialit y. For example, corporate
financial statements seldo m report the cents amount or even the hundreds of do llars. A
commo n pract ice is to round to the nearest thousands. For large corporations, there is a n
increasing tendency to report the financial data in terms of millio ns, carrying figures to one
decimal.

12. The conservatisms (prudence) concept

Accountants fo llow methods and procedures that yield the lesser amount of net inco me or net
asset value. Of an accountant faced two methods of handling a particular event, he /she tends
to use the method which understate the net income or net asset. This is done to protect the
firm fro m uncertain risk of loss. Thus, conservatism is usually expressed by the statement
“ant icipate no profit but provide for all losses”. Such an attitude of pessimism has been due
in part to the need for an offset to the optimism of business management.

Current accounting thought has shifted so mewhat from this philo sophy of conservat ism.
Conservat ism is no longer considered to be a dominant factor in select ing among alternat ives.

N.B: the concepts and principles of objectivity disclosure, consistency and materiality are
more important than conservatism and the latter should be a factor only when the others
don’t play a significant role in the decisions to be made by users of financial statements.

7.3 SUMMARY

The account ing professio n is guided by basic account ing concepts and principles. In recording
business transact ions and in preparing financial statements, accountants apply these principles
and concepts.

Account ing principles differ fro m the principles related to the physical sciences. Account ing
principles are developed by individuals to help make account ing data more useful in an ever –
changing societ y. T hese principles are cont inually reexamined and revised to keep pace wit h
the increasing co mplexit y o f business operations.

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7.4 ANSWERS TO CHECK YOUR PROGRESS

1. Account ing principles and concepts are needed because of the fo llowing facts:

i) The development of business firm in size and form.

ii) The complexit y of business transact ions.
iii) The need for separation of management and owners
iv) The demand for accurate, timely and relevant informat ion by users.

2. i) the object ivit y principle requires that accounting records be based on verifiable events
such as business transact ions between independent parties.

ii) the historical cost principle.

3. The two major limitat ions of stable mo netary unit concept are:
a) The scope of the report will be on information, which can be quant ifiable and
measurable in terms of money.
b) Any mo netary unit in the world is not stable due to economic changes.

7.5 MODEL EXAMINATION QUESTIONS.

A) Discussion Questions

1. For accounting purposes, what is the nature of the assumpt ion as to the length of life o f a n
enterprise?

2. Why should the most object ive evidence available be used as the basis for data reported
on financial statements?

3. If a co mplete and accurate picture of an enterprise’s success or failure is desired, what

accounting period must be used to report on operatio ns?

4. Is revenue fro m sales of merchandise on account more co mmonly recognized at the time
of sale or at the time of cash receipt?

5. When there are several acceptable alternat ive accounting methods that could be used, the
method used by an enterprise should be disclo sed in the financial statements. Give
examples of account ing methods that fall in this category.

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6. If significant changes are made in the accounting principle applied from one period to the
next, why the effect of these changes should be disclosed in the financial statements?

7. You have just been emplo yed by a relat ively small merchandising business that records its
revenues only when cash is received and it s expense only when cash is paid you are
aware of the fault that the enterprise should record its revenues and expenses on the
accrual basis. Would changing to the accrual basis vio late the principle o f consistency?
Discuss.

8. The accountant for a large department store charged the acquisit io n of a pencil sharpener
to an expense account, even though the asset had an estimated useful life o f 10 years.
Which account ing concept supports this treatment of the expenditure?

9. Why do the financial statements of a business present its activit ies separate from it s
owner’s act ivit ies?

10. The mo netary principle assumes that money is a useful standard measuring unit for
reporting the effects of business transact ions. State and explain two major crit icism or
limitations of this account ing principle.

B) Exercises

1. Each of the fo llowing statements represents a decisio n made by an accountant. State

whether or not you agree with the decisio n. Support your answer with reference to
generally accepted accounting principles that are applicable in the circumstance.

a) In preparing the balance sheet, detailed information as to the amount due from
hundreds of customers was o mitted. The total amount was presented under the
captain “Accounts Receivable”

b) Used co mputer equipment, with an est imated useful life o f 5 years and no salvage
value, was purchased early in the current fiscal year for Birr 150,000. Since the
company planned to purchase new equipment, costing Birr 250.000, to replace this
equipment at the end o f five years, depreciat ion expense of Birr 50,000 was recorded

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 for the current year. The depreciat ion expense thus provided for one fift h o f the cost
of the replacement.

c) All minor expenditures for office equipment are charged to an expense account.

d) Merchandise transferred to other parties on a consignment basis and not sold was
included in merchandise inventory.

e) Land, used as a parking lot, was purchased 10 ye ars ago for Birr 50,000. Since it s
market value is now Birr 90,000, the land account is debited for Birr 40,000 and a
gain account is credited for a like amount. The gain is presented as an “other
inco me” item in the inco me statement.

f) Thirt y days before the end of the current year, sales catalogs were acquired for birr
45,000. Although the catalogs are not salable the unused portion is included as an asset in
the balance sheet at the end of the year.

g) Merchandise inventory at the end o f the current year was est imated by the genera l
manager, who “eye balled”, the inventory on hand and then determined its cost, based on
the est imate of current costs. The accountant used the general manager’s est imate for
recording the cost of the inventory in the accounts.

h) Financial statements adjusted to eliminate the effects of inflat ion (using the current cost
method) were presented as supplementary financial data.

i) Net inco me for the current year is expected to be larger than normal. T herefore the
accountant used the declining – balance method for determining depreciat ion for the
current year to reduce the net income to a more normal amount. The accountant plans to
return its future years to the use of the straight-line method that has been used in all past
years for determining inco me.

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7.6 REFERENCE BOOKS

1. Fees and Warren : Principles of Accont ing, 16th Edition.

2. Horngren, Sundem, and E lliot : Introduction to Financial Account ing, 8th

Edit ion, (2002) Pearson Education Inc.

3. Roger H. Hermanson, : Accouonting Principles, 4th Education (1989)

Jems D. Edwards and R.F Salmo nson IRWIN Inc.

4. Kieso and Weygandt : Intermediate Accounting, 9th Edit ion, (1998)

John Wiley and Sons, Inc.

7.7 GLOSSARY

1. Adequate disclosure – the concept that financial statements and their accompanying
footnotes should contain all o f the pertinent data believed essent ial to the reader
understands of an enterprises financial status.

2. Business Entity concept – the concept that assumes that account ing applies to individua l
economic unit s and each unit is separate and district from the persons who supply it s
assets.

3. Conservatism – the concept that dictates that in select ing among alternatives, the method
or procedure that yields the lesser amount of net inco me or asset values should be
selected.

4. Consistency – the concept that assumes that the same generally accepted account ing
principles have applied in the preparation of successive financial statements.

5. Cost Principle – the principle that assumes that the mo netary records for properties and
services purchased by a business should be maintained in terms of its cost.

6. Going Concern Concept – the concept that assumes that a business ent it y has a
reasonable expectation of continuing in business at a profit for an indefinite period of
time.

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7. Matching – the principle o f account ing that all revenues should be matched wit h the
expenses incurred in earning those revenues during a period of time.

8. Materiality – the concept that recognizes the pract icalit y o f ignoring small or
insignificant deviations fro m generally accepted accounting principles.

9. Periodicity concept – the concept that states that the life of a business ent it y should be
broken into segment periods for accounting purposes.

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UNIT 8. ACCOUNTING FOR PARTNERSHIPS

Contents
8.0 Aims & Objectives
8.1 Introduction
8.2 Partnership And Their Characterist ics
8.3 Advantages And Disadvantages of A Partnership
8.4 Recording The Format ion of A Partnership
8.5 Divisio n of Partnership Inco me And Losses
8.6 Financial Statements For A Partnership
8.7 Disso lut ion of A Partnership
8.7.1. Admissio n of A New Partner
8.7.2. Withdrawal o f A Partner
8. 8 Liquidat ion of A Partnership
8. 9 Summary
8.10 Answers To Check Your Progress
8.11 Model Examinat ion Quest ions
8.12 Reference Books
8.13 Glossary

8.0 AIMS AND OBJECTIVES

The unit aims at discussing the account ing for partnerships such as recording invest ments,
comput ing each partner’s share of income or losses using different techniques, and recording
them to the respect ive capital accounts. Also, the account ing implicat ions o f disso lut ion and
liquidat ion of a partnership will be described. Having studied and worked through this
chapter you would be able to:

 define partnerships and explain their characterist ics.

 describe the advantages and disadvantages of a partnership
 record the invest ments made by the partners in forming a partnership.
 understand and apply the various methods of dividing the income or lass o f a
partnership.
 Record the admissio n and withdrawal of a partner(s)

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  Understand and apply the steps in the liquidat ion of a partnership.

8.1 INTRODUCTION

In your previous course you have studied the three most dominant forms o f business
organizat ion: so le proprietorship, partnership, and corporation. For accounting purposes, each
form should be viewed as an econo mic unit separate fro m it s owners, though legally only the
corporation is considered separate fro m its owners. In the previous section you have also
studied the basic account ing principles and practices used in account ing for a sole
proprietorship form of business organizat ion. The account ing for corporate form o f
businesses will be explained in the next unit. Therefore, the main focus o f this chapter is to
acquaint the learns wit h the basics o f accounting for partnerships. As will be explained later
in this section, the same accounting principles that are used in account ing for a so le
proprietorship are applied in partnership form o f businesses. However, there are accounting
practices that are unique to partnerships. T hese unique account ing features relate to the
partners’ capital and drawing accounts, division of inco me (or loss), and changes in
ownership of the partnership.

8.2 PARTNERSHIPS AND THEIR CHARACTERSTICS

A partnership is an associat ion of two or more persons to carry-on as co-owners of a business

for profit. This associat ion is based on a partnership agreement or contract known as the
articles of a partnership.

The partnership agreement should specify the name location, and purpose of the business; the
capital contributions and duties of each partner; the methods of inco me and loss divisio n; the
rights of each partner upon liquidat ion (winding up) of a partnership, etc.

The partnership agreement should be in writ ing to avoid any misunderstandings about the
format ion, operation, and liquidat ion of a partnership.

Characteristics of a partnership
For purposes of account ing, partnerships are treated as separate economic ent ities. The next
paragraphs describe so me o f the important features of a partnership.

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A) Voluntary Association
A partnership is a vo luntary association o f individuals rather than a legal ent ity in it self.
Therefore, a partner is responsible under the law for his or her partner’s business act ions wit h
in the scope of the partnership. A partner also has unlimited liabilit y for the debts of the
partnership. Because of these potential liabilit ies, an individual must be allowed to choose the
people who jo in the partnership.

B) Limited Life
Because a partnership is formed by the consent of two or more partners, it has a limited life.
This means that, anything that ends the contract disso lves the partnership.

A partnership can be dissolved when (1) a new partner is admitted; (2) a partner wit hdraws,
retires, dies or becomes bankrupt. At this point, the remaining partners should sign a new
contractual agreement to continue the affairs of the business. In place o f the old partnership a
new partnership is formed. Thus, a partnership is said to have a limited life.

C) Unlimited Liability
Each partner is liable for all the debts of the partnership. When and if the partnership fails to
pay its debts, creditors can seize (take) each partner’s personal assets to satisfy their claims.
Therefore, partnerships creditors claims are not limited to the assets of the business, but is
extends to the personal property o f the partners. Each partner, then, could be required by law
to pay all the obligat ions (debts) of the partnership.

Suppose, for example, the liabilit ies o f ABC company (a partnership business) as of a certain
date is birr 600,000, however, the total properties (assets) of ABC co mpany could only be
sold for birr 450,000. Thus, to settle creditors claims fully, the house or personal assets of the
partners may have to be sold.

D) Mutual Agency
Each partner is an agent of the partnership wit hin the scope of the business. This means that
partner’s act to any contract is binding on the remaining partners as long as it is with in the
apparent scope of the business’ operations.

138
For example, a partner in a public account ing firm can bind the partnership through the
delivery of account ing services. redundent. But this partner cannot bind the partnership to a
contract for delivering (or providing) cars because it is out of the scope of the business.

E) Co ownership of partnership property

Once invested, the properties contributed by the partners beco me the property of the
partnership and is owned jo intly by all the partners. Upon liquidation o f the partnership and
distribut ion o f assets, the partner’s claim on the assets is measured by t he amount of the
balance in his/her capital account.

8.3 ADVANTAGES AND DISADVANTAGES OF PARTNERSHIP

Advantages:
A partnership form of business ownership has the following advantages:

1. Easy and inexpensive to form than a corporation. A partnership is easy to form. It only
requires the consent of two or more parties. Two or more competent persons simply agree
to be partners in so me co mmo n business purpose.

2. Advantageous to raise a large amount of capital and managerial skill (talent) than a so le
proprietorship. Because a partnership is formed by two or more persons, it is possible to
raise a large amount of capital and managerial skill than a single owner.

3. Not subject to separate taxation as a case in a corporation because each partner reports
his/her own share of partnership inco me and is individually taxed, and

4. Not required to observe on many restrict ive laws unlike a corporation.

Disadvantages

Partnership has the following disadvantages:

1. Partners assume unlimited liabilit y. The liabilit y of the partners is not limited to what
they have in the partnership, but it goes to the extent of their personal properties (assets).

2. Disadvantageous if each partner does not exercise his/her good judgment because one
partner’s act can bind a partnership into a contract.

139
3. Limited life. Partnerships are subject to possible termination due to many uncontrollable
circumstances such as the death of a partner.

4. The transfer of ownership fro m one partner to another person is difficult unless the
remaining partners approve of this

8.4 RECORDING THE FORMATION OF A PARTNERSHIP

A separate capital account is maintained for each partner in a partnership. Each partner’s
capital account is credited for the value of their investment upon format ion of the partnership.

Illustration
Dr. Teklay and Dr.Mamo decided to form a partnership business, which would provide
medical services. They have been in business separately before they form the partnership.
The partnership assumed the liabilit ies of their separate business. The assets were valued and
recorded at their current fair market value.

Shown below are the assets contributed and the liabilit ies assumed by the partnership at their
fair market value.

Dr. Teklay Dr. Mamo

Cash Birr 6.500 Cash Birr 3,300
Accounts Receivable 8,600 Accounts Receivable 4, 300
Supplies 21,000 Supplies 12,000
Medical Equipment 3, 000 Medical Equipment 150,000
Accounts Payable (2,300) Accounts Payable (3,200)
The journal entry on January 1, 2002 to record the invest ment of each partner and the
format ion of the partnership would be:

2002, Jan.1. Cash 6,500

A/R 8,600
Supplies 21, 000
Medical Equipment 3,000
A/p 2, 300
Teklay Capital 36,800

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 2002, Jan.1. Cash 3,300
A/R 4,300
Supplies 12, 000
Building 150,000
Accounts Payable 3,200
Mamo, Capital 166, 400

Check Your Progress Exercise - 1

1. On February 2, 2oo2, Dr. Teklay and Dr. Mamo made addit io nal invest ments of cash Birr
4,200 and 4300 respectively. Show the entry to record the invest ments by the owners.
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2. What is the meaning of unlimit ed liabilit y when applied to a partnership?

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3. What characterist ics of a partnership could be interpreted as disadvantages?

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8.5 DIVISION OF PARTNERSHIP INCOME AND LOSSES

A partnership’s inco me and lo sses can be distributed according to whatever method the
partners specifies in the partnership agreement. The agreement should be specific and clear,
to avoid later disputes.

If a partnership agreement does not ment ion the distribut ion of inco me and losses, the law
requires that they be shared equally by all partners. Also, if a partnership agreement specifies

141
only the distribut ion o f inco me, but is silent as to losses, the law requires that losses be
distributed in the same ratio as inco me.

The Inco me of a partnership normally has three components:

(1) return to the partners for the use of their capital – called interest on partners’ capital,
(2) compensat ion for direct services the partners have rendered – called partners’ salaries,
and
(3) other inco me for any special characteristics individual partners may bring to the
partnership or risks they may take.

The breakdown of total inco me into its three components helps clarify how much each partner
has contributed to the firm.

Inco me can be shared among the partners in one of the fo llowing ways:

1. Net inco me divided in a stated ratio such as:

A) equally
B) agreed upon ratio (other than equally)
C) ratio based on beginning capital balances

2. Net Income divided by allowing interest on the capital invest ments, salaries, or both
with the remaining net inco me divided in an agreed ratio.

Example
Assume that Dr. Teklay and Dr. Mamo partnership had a net inco me of Birr 60,000
1. A. Assume that the articles of a partnership provides equal share of Net Income or
Loss.

- In this case the capital accounts of each partner will be credited for Birr. 30,000

Inco me Summary-------------------------------60,000
Dr. Teklay capital-----------------------------------30,000
Dr. Mamo capital------------------------------------30,000

B. Net income is divided in ratio of 3.2 to Dr. teklay and Dr. Mamo respectively.

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 - Income summary-------------------------------------60,000
Dr. Teklay capital (3/5 X 60,000) --------------------------36,000
Dr. Mamo capital (2/5 X 60,000) ---------------------------24,000

C. Net inco me is divided in a ratio of partners’ capital account balances at the beginning
of the fiscal period.

Inco me summary ------------------------------- 60,000

 36800 
  60,000
Dr. Teklay capital 203200 -----------------------------10,860
 
 

 166400 
Dr. Mamo capital   60,000 ------------------------------ 49,134
 203200 

 36800 + 166400 = 203200

2. Net inco me is divided by allowing 5% interest on their beginning capital balances, a

salary o f Birr. 5,000 to Dr. Teklay and the remainder is divide equally.

Net Income Division

Income to be
Dr. Teklay Dr.Mamo Total Distributed

Net inco me Birr, 60,000

Interest (5%) 1,840 8,320 10, 160 49, 840
Salary 5,000 -- 5,000 44, 840
Remainder 22,420 22,420 44, 840 -- 0 –
Distribut ion 29, 260 30, 740 60, 000

Journal entry
Inco me summary ---------------------------- 60,000
Dr. Teklay capital ---------------------------- 29,260
Dr. Mamo capital ---------------------------- 30,740

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Check Your Progress Exercise - 2

1. Assume the same agreement as in number “2” above but the net inco me for the year was
Birr. 10,000. Determine the amount to be distributed to each partner and record the
distribut ion in journal entry form --------------------------------------------------------------------
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8.6 FINANCIAL STATEMENTS FOR A PARTNERSHIP

The inco me statement of a so le proprietorship and that of a partnership are the same. At the
end o f the period a statement of partners’ capital is prepared which summarizes the effect of
transactions on the capital account balances o f each partner. The statement of owners equit y
for Teklay and Mamo using assumed data and the inco me divisio n shown above is illustrated
below:
Dr. Teklay and Dr Mamo
Statement of partners’ Capital
For the year Ended Dec, 31, 2002

Dr. Teklay Dr. Mamo

Capital Bal. January 1, 2002 Br. 36,800 Br. 166,400
Add: Addit ional investment
4,200 4,300
Total Br. 41,000 Br. 170,700
Net inco me distribut ion 29,260 30,740
70,260 201, 440
Deduct: Withdrawals during the year 5, 000 5, 000
Capital Bal. Dec. 31, 2002 Br. 65260 Br. 196,440

NB- The balance sheet of a partnership is different fro m that of a sole proprietorship only
in the owner’s equit y sect ion. In the partnership business since two or more persons
owns the business, there are two or more capital accounts whereas for a sole
proprietorship there will always be one capital account.

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Check Your Progress Exercise - 3

1. Hilina and Meron agreed to form a partnership. Hilina contributed Br. 200,000 in cash ,
and Meron contributed assets with a fair market value o f Br. 400,000. The partnership, in
its init ial year, reported net income of Br. 120,000.

Prepare the journal entry to distribute the first year’s inco me to the partners under each o f the
fo llo wing condit io n.

 Hilina and Meron failed to include stated ratio in the partnership agreement.
 Hilina and Meron agreed to share inco me and losses in a 3:2 ratio.
 Hilina and Meron agreed to share inco me and losses in the ratio of their origina l
investments.
 Hilina and Meron agreed to share inco me and losses by allo wing 10 percent interest
on their original invest ments and sharing any remainder equally

2. What accounts are debited and credited to record the divisio n o f net inco me at the end o f
the fiscal period?
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3. What accounts are debited and credited to record the divisio n of net loss among the
partners’ at the end of the fiscal period?
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8.7 DISSOLUTION OF A PARTNERSHIP

 Disso lut ion of a partnership occurs whenever there is change in the original associat ion o f
partners. When a partnership is disso lved, the partners lose their authorit y to continue the
business as a go ing concern. This does not mean that the business operation necessarily is

145
 ended or interrupted, but it does mean – fro m a legal and account ing standpo int – that the
separate entit y stops to exist.

 The remaining partners can act for the partnership in finishing the affairs o f the business
or in forming a new partnership that will be a new accounting ent it y.

 A partnership is legally disso lved (terminated) when a new partner is admitted or an

exist ing partner withdraws.

8.7.1. Admission of a New Partner:

The admissio n o f a new partner disso lves the o ld partnership because a new associat ion has
been formed.

Disso lving the old partnership and creat ing a new one require the consent of all the o ld
partners and the ratificat ion of a new partnership agreement.

When a new partner is admitted, a new partnership agreement should be prepared.

 A new partner can be admitted into a partnership in one of two ways:

(1) by purchasing ownership right from one or more of the original partners, or

(2) by invest ing assets in the partnership.

1. Admission by Purchase of Ownership Right

When an individual is admitted to a firm by purchasing ownership right fro m an o ld partner,
each partner must agree to the change. A journal entry is needed in the partnership to transfer
the ownership right purchased from the capital account of the selling partner to the capital
account of the new partner. The partnership’s assets and liabilit ies remain unchanged.

Suppose, for example, Sister Helen jo ins the partnership of Dr. Teklay and Dr. Mamo by
buying ownership right of Br. 8000 from Dr. Mamo. The entry to record the admissio n o f
Sister Helen and the transfer of the ownership right from the capital account of Dr. Mamo to
the capital account of Sister Helen in the partnership books shown below

Journal entry

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 Dr. Mamo---------------------------------- 8,000
Sr. Helen --------------------------------------8,000

The price that sister Helen paid to Dr. Momo can be more or less than Br. 8,000 but that is
irrelevant as it wouldn’t be reflected in the record (books) of the partnership.

2. Admission by Investing Assets

Assume that instead of purchasing ownership right fro m the exist ing partners, Sister Helen
invested cash of Br. 80,000 into the partnership. In this case both partnership assets and total
owners’ equit y are increase. T he journal entry must record such an invest ment and the
increase in partnership assets.

Consider the fo llowing scenarios as an example:

1- Sister Helen receives a 50% ownership right in the partnership. Assume also that Dr.
Teklay and Dr. Mamo ’s capital balance were Br. 25,000 and Br. 55,000 respect ively. Dr.
Teklay and Dr. Mamo share inco me in a ratio of 2:1 respectively.

Journal Entry

Sister Helen’s capital account would be credited for Br. 80,000 i.e., (55,000 + 25,000 +
80,000) X ½.
Cash------------------------------------------80,000
Sister Helen, Capital------------------------80,000
2- Sister Helen receives a one –fourth ownership right upon admissio n.
Assume everything else as above. In this case Sister Helen’s capital account would be
credited for birr 40,000 ie, (Birr 25,000 + Birr 80,000) X ¼.

The difference Br. 40,000, (80,000 – 40,000) would be shared between the remaining two
partners with the income-sharing rat io.

Journal entry
Cash----------------------------80,000
Helen capital ------------------------40,000
Dr. Teklay capital --------------------- 26,667
Dr. Mamo capital --------------------- 13,333

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Check Your Progress Exercise - 4
1. Assume the same as above except that sister Helen received ¾ ownership right upon
admissio n as she was thought to bring goodwill to the partnership. Record the admissio n.

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8.7.2. Retirement or Withdrawal of a Partner

When an exist ing partner withdraws he/she can sell his/her ownership right or he/she can
withdraw assets fro m the partnership. Both options are considered below:

1. Sale of Ownership Right to the Existing Partner

When ownership right is so ld by a wit hdrawing partner to an exist ing partner, the entry on the
partnership’s books transfers the retiring partner’s capital balance to the buyer’s capita l
account.
Example:

Dr. Mamo withdraws from the partnership because of a disagreement. He sells his Br. 38,333
ownership right to Dr. Teklay.

Journal entry
Dr. Mamo Capital----------------------------- 38,333
Dr. Teklay Capital ----------------------------- 38,333

The amount paid by Dr. Teklay is not recorded on the partnership books, because the
transaction invo lves no flow of assets to or from the partnership.

2. Withdrawal of Assets From the Partnership

When a partner withdraws he/she may be paid above or below the amount shown in his/her
capital balances.

148
Example:

a. Assume Dr. Mamo was paid Br. 50,000 cash when he withdraws fro m the partnership
of T,M&H. The capital balances of each partner were as fo llows as of that date:

Dr. Teklay capital ---------------------------Br. 100,000

Dr. Mamo capital --------------------------- --- 50,000
Sister Helen capital ----------------------------- 35,000
Total Equit ies Birr 185, 000

Journal entry

Dr,Mamo capital -------------------------------- 50,000

Cash -----------------------------------------------------------50,000

b. Assume Dr. Mamo was paid Br. 56,000 instead of Br. 50,000, the excess amount of Birr
6,000 is charged to the remaining partner’s capit al accounts based on the inco me- sharing
ratio. (Assume a 3:2:1 inco me-sharing ratio between Dr Teklay Dr. Mamo and Sister Helen
respectively).

Journal entry
Dr. Mamo capital ------------------------------50,000
Sister Helen capital ---------------------------- 1,500
Dr. Teklay capital ------------------------------ 4,500
Cash ----------------------------------------------------56,000
 The Birr 6,000 excess is shared on the basis o f a 3:1 ratio, i.e., Dr. Teklay would be
charged for 6,000 X c/4 = birr 4500, and Sister Helan would be charged for
Birr 6000 X ¼= Birr 1500.

Check Your Progress Exercise - 5

1. Assume everything else as in # b above except that Dr. Mamo was paid Br. 45,000 upon
withdrawal. Record the disso lut ion.

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149
Attempt the following questions:

1. The partnership agreement for Kebede and Lema partnership does not disclo se how they
will share income and losses. How would the inco me and losses be shared in this
partnership?

2. In January 19X1, Sisay Hailu and Gelane Jalene agreed to produce and sell Soaps. Sisa y
contributed br. 240,000 in cash to the business. Gelane contributed the building and
equipment, valued at Br. 220,000 and Birr. 140,000, respectively. T he partnership had an
inco me o f Birr 84,000 during 19X1 but was less successful during 19X2, when inco me
was only Br. 40,000.

(a) Prepare the journal entry to record the investment of both partners in the partnership

(b) Determine the share of inco me for each partner in 19X1 under each of the fo llowing
condit ions:

 The partners agreed to share inco me equally.

 The partners failed to agree on an inco me- sharing arrangement.
 The partners agreed to share inco me according to the ratio of their capital invest ments
 The partners agreed to share inco me by allowing interest of 10% on their origina l
investments and dividing the remainder equally.
 The partners agreed to share inco me by allowing salaries o f Birr 40,000 for Sisay and
Br. 28,000 for Gelane, and dividing the remainder equally.

3. Nadew, Tezera, and Wo liyi have equit y in a partnership o f Birr 80,000, Birr 80,000, and
Birr 120,000, respectively, and they share inco me and losses in a ratio of 20%, 20%, and
60%. The partners have agreed to admit Equbay to the partnership.

Instruction: prepare journal entries to record the admissio n of Equbay to the partnership
under the following condit io ns:

150
 (a) Equbay invests Birr 50,000 for 20% interest in the partnership, and a bonus is
recorded for the original partners.

(b) Equbay invests Birr 60,000 for a 40% interest in the partnership, and a bonus is
recorded for Equbay.

8.8 LIQUIDATION OF A PARTNERSHIP

Liquidat ion o f a partnership is the process o f ending the business, of selling enough assets to
pay the partnership’s liabilit ies and distribut ing any remaining assets among the partners.

Liquidat ion is a special form of disso lution. When a partnership is liquidated, the business
will not continue.

 A partnership may be liquidated if:

A. the object ives sought in forming the partnership has been achieved.
B. the time period for which the partnership was formed expires (ends)
C. newly enacted laws have made the partnerships activit ies illegal,
D. the partnership beco mes bankrupt.

The partnership agreement should indicate the procedures to be fo llowed incase o f

liquidat ion. Usually, the books (records) are adjusted and closed, with the inco me or loss
distributed to the partners and the assets are sold.

The sale of the assets at the time of liquidat ion of a partnership is known as realization.

As the assets of the business are so ld, any gain or loss should be distributed to the partners
according to the income and loss sharing ratio.

As cash is realized, it must be applied first to outside creditors. Finally, the remaining cash is
distributed to the partners in accordance with the balance of their capital accounts.

Illustration
The partnership of Reso m, Sultan, and Tassew is liquidated on September 1,2002. The
inco me and loss sharing ratio of the partners is: Reso m 40%, Sultan 35%, and Tassew 25%.

151
After discont inuing the ordinary business operations of their partnership and closing the
accounts, the fo llowing summary o f a trial balance is prepared:

R, S And T
Trial Balance
Septamber 1, 2002

Debit Credit
Cash 10, 000
Other assets 90. 000
Liabilit ies 10, 000
R. Capital 30, 000
S. Capital 30, 000
T. Capital ________ 30, 000
Total 100, 000 100, 000

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

Case One: Gain On Realization

Assume that Reso m, Sultan, and Tassew sell all noncash assets for Birr 95,000, realizing a
gain o f birr 5000, (Birr 95,000 – Birr 90,000). The gain is divided amo ng Reso m, sultan and
Tassew in the inco me and lo ss sharing rat io of 40% 35%, and 25% respectively. Then, the
liabilit ies are paid, and the remaining cash is distributed to the partners according to the
balances in their capital accounts. The entries to record the steps in the liquidat ion of a
business are as fo llows:
Cash………………………………95,000
Other assets………………………….90,000
Gain on sale of assets……………….. 5,000
Entry to record the sale of non cash assets
and the recognition of gain on realization

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 - Gain on sale of assets…………… 5,000
R Cap. (5,000 X 40%)………………… 2.000
S Cap. (5,000 X 35%)…………………. 1,750
T Cap. (5000 X 25%)…………………...1,250

To distribute gain on realization

- Liabilit ies……………………….10,000
Cash………………………………..10,000

To record the settlement of partnership liabilities.

After the above entries are posted, the partners’ capital accounts shows:

R’s Beg Bal. 30,000 + 2,000 = Birr 32,000

S’s Beg Bal. 30,000 + 1,750 = Birr 31,750
T’s Beg Bal. 30,000 + 1,250 = Birr 31,250

The cash account now shows a balance of Birr 95,000 (10,000 + 95,000 – 10,000). The entry
recorded upon distribution o f this cash among the partners would, therefore, be

R, capital……………………… Birr 32,000

S, capital……………………… Birr 31,750
T, capital……………………… Birr 31,250
Cash-------------------------------------95,000

To record the distribution of cash among the partners.

Case two: Loss on Realization: No capital Deficiencies

Assume that Reso m, Sultan, and Tassew sell all non cash assets for Birr 70,000, instead of
Birr 95,000, incurred a loss of birr 20,000,(Birr 90,000 – Birr 70,000)

Journal entry

-Cash --------------------------------------70,000
Loss on realization-----------------------20,00
Other Assets-------------------------------------90,000

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 To record the sale of the assets

-R capital---------------------- (40% X 20,000) -----------------8,000

S capital----------------------- (35,000 X 20,000) --------------7,000
T capital ---------------------- (25% X 20,000) --------------- 5,000
Loss on Realizat ion ------------------------------------- 20,000

To distribute the loss on realization

- Liabilit ies ---------------------------------- 10,000

Cash -----------------------------------10,000
To record the settlement of partnership liabilities

After the above entries have been posted; the accounts show cash 70,000 R, cap. Birr22,000
S,cap. Birr 23,000 and T, cap. Birr 25,000. The entry to record the cash distribution to the
partners would, therefore, be as fo llows:

R cap --------------------------------- 22,000

S cap ----------------------------------23,000
T cap --------------------------------- 25, 000
Cash -------------------------------------- 70,000
Entry to record the distribution of cash to partners.

Case three: Loss on Realization with Deficiency in one Partner Capital

- Assume the non-cash assets of R,S and T partnership are so ld for only Birr 10,200,
incurring a loss o f Birr 79,800,( Birr 90,000 – Birr 10,200). The entries to record the
divisio n of loss among the partners and the liquidation to this point are shown below:

Cash -------------------------------- 10,200

Loss on sale of Assets ----------- 79,800
Other Assets-------------------------- 90,000

To record the sale of assets

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 R capital (79800 X 40%) ----------------------31,920
S capital (79800 X 35%) ---------------------- 27,930
T capital (79800 X 25%) ---------------------- 19,950
Loss on sale of Assets ---------------------------- 79,800

To distribute loss on realization

- Liabilit ies ----------------------------------- 10,000

Cash ------------------------------------------------10,000

To record settlement of liabilities

At this stage of the liquidat ion the capital accounts of the partners have the fo llowing balances

R capital = 30,000 – 31920 = 1,920

S capital = 30,000 – 27930 = 2,070
T capital = 30,000 – 19950 = 10,050

Only Birr 10,200 cash is available (10,000 + 10200 – 10,000) for distribut ion to S and T while
the combined balances o f their capital accounts is Birr 12,120. Therefore, addit ional Birr
1,920, (12120 – 10200) is needed which is the amount owed by R to the partnership.

Therefore, either R will have to pay this amount first and the cash will be distributed to S and
T, or S and T will have to share the Birr 1920 loss in their inco me and loss-sharing ratio of
35: 25.

Let’s assume, the loss was distributed since R couldn’t pay the amount immediately.

Journal Entries
S capital (35/60 X 1920) -------------- 1,120.00
T capital (25/60 X 1920) -------------- --800.00
R capital -------------------------------------1,920
To charge R’s capital deficiency to S and T

S, capital -----------------------------------950.00
T, capital -----------------------------------9,250.00

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 Cash ----------------------------------------------10,200
To record the final cash distribution to partners.

The various entries in the liquidat ion of R,S, and T partnership are summarized in t he
fo llo wing statement.

R, S, T partnership
Statement of Partnership Liquidation
For period Sept. 1-15,2002

Non cash = Liabilit ies + Capital

Cash + Asset
R(40%) S(35% T(25%)

Bal. before realizat ion Birr 10,000 90, 000 10, 000 30,000 30,000 30,000

Sales of Assets &

Divisio n of loss +10,200 - 90, 000 --- -31,920 -27,930 19,950

Bal.after realizat ion 20, 000 - 0- 10, 000 ( 1920) 2,070 10,050

Payment of Liab. – 10, 000 --- - 10. 000 --- --- ---

Bal. After payment

Of liab. 10,200 - 0- - 0- ( 1920) 2,070 10,050

Divisio n of deficiency --- --- --- 1920 (1120) 800

Bal. After divis io n of

Deficiency – 10,200 -0- - 0- - 0- 950 9, 250

Dist.of cash 10,000 --- --- --- - 950 - 9250

Balance - 0- - 0- - 0- - 0- -0- -0 -

8.9 SUMMARY

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A partnership is an associat ion of two or more persons to carry on as co-owners of a business
for profit. This associat ion is based on a partnership agreement or contract known as the
articles of a partnership.

A partnership form o f business ownership has several characteristics. Fro m amo ng them are:
vo luntary association, limited life, unlimited liabilit y, mutual agency, and co- ownership o f
partnership property.

The advantages o f partnerships include: easy o f formation, possible to raise large amount of
capital than a single owner, not subject to separate taxation, and the absence of many
restrict ive laws unlike a corporation, etc.

Partnerships have also the fo llo wing disadvantages: unlimited liabilit y, mutual agency,
limited life, etc.

In account ing for partners’ invest ment, it is necessary to maintain separate capital and
withdrawals accounts for each partner and to divide the inco me and losses of the co mpany
among the partners. When recording the invest ments of the partners, all noncash assets must
be recorded at their fair market value at the time they are transferred to the partnership.

A partnership inco me and losses can be distributed according to whatever method the partner
specifies in the partnership agreement. The agreement should be specific and clear, to avo id
later disputes.

If a partnership agreement does not ment ion the distribut ion of inco me and losses, the law
requires that they be shared equally by all partners. If a partnership agreement specifies only
the distribut ion o f inco me, but is silent as to losses, the law requires that losses be distributed
in the same ratio as inco me.

The inco me of a partnership normally has three components: (1) return to the partners for the
use of their capital, (2) co mpensat ion for direct services the partners have rendered, and (3)
other inco me for any special characterist ics individual partners may bring to the partnership or
risks they may take.

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At the end o f each fiscal period financial statements are prepared for a partnership business.
Most of the financial statements of a partnership are the same as that of a so le proprietorship
with the exception of the owners equit y section o f a balance sheet.

Disso lut ion o f a partnership occurs whenever there is a change in the original associat ion o f
partners. When a partnership is disso lved, the partners lose their authorit y to continue the
business as a go ing concern. This does not mean that the business operation necessarily is
ended or interrupted, but it does mean - fro m a legal and accounting stand point - that the
separate entit y stops to exist. A partnership is legally disso lved when a new partner is
admitted or an exist ing partner withdraws.

Liquidat ion o f a partnership is the process o f ending the business, of selling enough assets to
pay the partnership’s liabilit ies and distribut ing any remaining assets among the partners.
Liquidat ion is a special fro m of disso lution. When a partnership is liquidated, the business
will not continue.

A partnership may be liquidated if: (a) the objectives sought in forming the partnership has
been achieved, (b) the time period for which the partnership was formed expires (or ends), (c)
newly enacted laws have made the partnership’s activit ies illegal, (d) the partnership beco mes
bankrupt.

The partnership agreement should indicate the procedures to be fo llowed incase o f

liquidat ion. Usually, the records are adjusted and closed, wit h the inco me or loss distributed
to the partners, and the assets are so ld. T he sale of the assets at the time o f liquidat ion o f a
partnership is known as realizat ion. As the assets of the business are so ld, any gain or loss
should be distributed to the partners according to the inco me and lo ss sharing ratio. As cash
is realized it must be applied first to outside creditors. Finally, the remaining cash is
distributed to the partners in accordance with the balance of their capital accounts.

8.10 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

Check Your Progress Exercise -1

Journal entry

Cash-----------------------------8500

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 Dr. Teklay capital-------------------------- 4200
Dr. Mamo capital--------------------------- 4300

Check Your Progress Exercise –2

Net inco me divisio n
Inco me to be
Dr. Beklay Dr. Mamo Total Distributed
Net inco me 15, 000
Interest (5%) 1,840 8, 320 10, 160 4,840

8.11 MODEL EXAMINATION QUESTIONS

PART I. Choose The Best Answer:

____________ 1. The term unlimited liabilit y when used in connect ion with a
partnership refers to the fact that:
A) A contract entered into by one partner is binding on all partners.
B) Creditors can look beyond the partnership assets to the individual
assets of the partners for satisfact ion.
C) The partnership has an unlimited obligat ion to provide professional
services.
D) The partnership is liable for all act ions o f the partners even when
conducting personal business.
E) All except D.

____________ 2. A and B agree to form a partnership. A is to contribute birr 60,000 in cash

and to spent one – half t ime to the partnership. Bi is agreed to contribute birr 40,000 and to
devote full t ime to the partnership. How will A and B share in the divisio n o f net inco me or
net loss?
A) 1:2 C) 3:2 E)None of the above

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 B) 2:1 D) 1:1

Refer to the fo llowing informat ion which is related to XYZ partnership and answer questions
3 and 4.

The capital account and inco me sharing rat ios of the three partners after realizat ion of non –
cash assets and settlement of all liabilit ies are as follows:

Partner Balance in Capital Income – Sharing

Account Ratio
X Birr 45,000 2

Y (15,000) 3

Z 36,000 3

________ 3. If partner Y is unable to pay any part of his deficiency to the partnership,
how much cash will be given to partner Z fro m the liquidat ion?

A) Birr 30,375 C) Birr 13,500 E) None of the above.

B) Birr 27,000 D) Birr 30,000

________ 4. If partner Y pays two – third of the deficiency to the partnership, how much
cash will be given to partner X?
A) Birr 33,000 C) Birr 43,000 E) None of the above.
B) Birr 47,000 D) Birr 45,000

_________ 5. Which of the fo llowing is not a characterist ic o f a partnership?

A) each partner can act as an agent of a partnership
B) Unlimited life.
C) Easy of format ion
D) It is not legally separate from its owners.
E) None of the above

PART II – Attempt the Following Questions

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1. What are the disadvantages of the partnership over the corporation as a form o f
organizat ion for a profit making business enterprise?
2. Explain the difference between the admissio n of a new partner to a partnership (a) by
purchase of an interest from another partner and (b) by contribut ion of assets to the
partnership.

3. When a new partner is admitted to a partnership and goodwill is attributable to the old
partnership, how should the amount of the goodwill be allocated to the capital accounts of
the original partners?

4. Why might partnership attribute goodwill to a newly admitted partner?

5. Paulos, Kebede, and Abeje are partners sharing income 3:2:1. After the firm’s lo ss fro m
liquidat ion is distributed, Paulos’s capital account has a debit balance of Birr 30,000. If
Paulos is personally bankrupt and unable to pay any o f the birr 30,000, how will the loss
be divided between Kebede and Abeje?

Exercise
Dagnachew and Firdu formed a partnership. Dagnachew invested Birr 90,000 and Firdu
invested Birr 60,000. Dagnachew is to devote one-half t ime to the business while Firdu is to
devote full time.

The fo llowing plans for the divis io n of inco me are being considered:

1. equally
2. in the rat io of original investments
3. in the rat io of time devoted to the business
4. Interest of 12% on original investments and the reminder equally.
5. Interest of 12% on original invest ments, salaries of Birr 10,000 to Dagnachew and Birr
20,000 to Firdu, and the remainder equally.
6. The same as in #5 except that Dagnachew is also to be allowed a bonus equal to 25% of
the amount by which net inco me exceeds salary allowances.

Required:

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Determine the divisio n of inco me to Dagnachew and Firdu under each plan assuming the
partnership of Danagnachew and Firdu earned a net inco me of:
a) Birr 32,000
b) Birr 150,000

Problem 1
The fo llowing balance sheet is related to YOGA partnership

YOGA Partnership
Balance sheet
Meskerm 10,1995

Assets: Liabilities and Capital

Cash-------------------------Birr 20,000 Liabilit ies--------------Birr 30,000

Other assets--------------------- 80,000 Capital:
Y.capital-------------------- 40,000
G. capital------------------- 21,000
_______ A. capital------------------- 9,000
Total Liabilities and
Total Assets---------------- Birr 100,000 Capital-----------------------100,000

The partners agreed to liquidate the business enterprise by selling other assets and dividing
any remaining cash available in the partnership after settling the debt of the partnership as o f
the date of liquidat ion. All the partners are general partners. Partner Y, G and A share
inco me or loss in the ratio of 20%, 40%, and 40% respectively.

Required:

A. prepare a liquidat ion statement assuming that the other assets were realized for:
i) Birr 80,000
ii) Birr 100,000
iii) Birr 60,000

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 iv) Birr 50,000

B. Journalize the necessary entries for the business enterprise on the basis o f the
liquidat ion statement prepared for each case.

8.12 REFERENCE BOOKS

1. Fees and Warren : principles of Accounting, 16th Edit ion.

2. Horngrn, sundem, : Introduction to Financial Account ing: 8th Edit ion,

(2002) Pearson Education Inc.,

3. Roger H. Hermanson, : Account ing Principles, 4th Edit ion, (1989) IRWIN
Jems D. Edwards INC.
And R.F. Salmo nson

4. Kieso and Weygandt : Intermediate Account ing, 9th Edit ion, (1998) John
wiley and sons, Inc.

8.13 GLOSSARY

Partnership : a business owned by two or more individuals as

co-owners based on a partnership agreement.

Partners : owners of a partnership

Dissolution : format ion of a new partnership because of the

retirement’s admissio n or death of a partner.

Liquidation : the winding up of operation and sale of business

assets.

Realization : sale of business assets for cash

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UNIT 9. ACCOUNTING FOR CORPORATIONS

Contents
9.0 Aims and Object ives
9.1 Introduction
9.2 Definit ion o f Corporation
9.3 Characteristics of Corporation
9.4 Advantages of Corporate form of Organizat ion
9.5 Disadvantages of Corporate form of Organization
9.6 Formation of a Corporation
9.6.1 Organizat ion Costs
9.6.2 Rights of Stockholders
9.7 Authorizat ion and Issuance of Stocks
9.7.1 T ypes of Stocks / Shares
9.7.2 Issuance of Par-value Stocks
9.7.2.1 Authorizat ion
9.7.2.2 Par-value Stock issued for cash
9.7.2.3 Par-value Stock issued on a subscription basis
9.7.2.4 Non cash issuance of Capital Stock
9.7.2.5 Issuance of No-par Stock
9.8 Accounting for Retained earnings and Dividends
9. 8. 1 Nature of Retained Earnings
9. 8. 2 Nature of Dividends
9. 8. 3 Relevant Dividends dates
9. 8. 4 Dividends and Characterist ics of Preferred Stock
9.8.4.1 Participat ing and Non participating preferred stock
9.8.4.2 Cumulat ive and Non cumulative preferred stock
9.9 Accounting for Treasury Stocks

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 9.9.1 Reasons to acquired Treasury Stocks
9.9.2 Recording and Reporting Treasury Stock Transactions
9.10 Equit y Per Share
9.11 Summary
9.12 Answers to Check Your Progress
9.13 Model Exam Quest ions
9.14 Glossary

9.1 AIMS AND OBJECTIVES

This unit aims at discussing different issues related to a corporate form o f organizat ion suc h
as the characteristics of a corporation, accounting and reporting practical for the issuance o f
stocks. Treasures stocks and equit y per share. After studying this chapter, you will be able to:
- describe the characterist ics, advantages and disadvantages o f the corporate form
of business organizat ion
- explain the rights of stockholders and the role of corporate direct ions.
- different iate among authorized, issued and outstanding shares.
- Account for the issuance of capital stock
- understand the nature of retained earnings and dividends
- account for treasury stock transact ions
- know how to calculate earnings per share.

9.1 INTRODUCTION

Assume that you are planning to start a new business. Would you choose a sole
proprietorship, a partnership or a corporation? In principles of accounting 1 and previous
chapter of principles of account ing you have studied about the first two forms of business
organizat ions. In this chapter the importance of corporate form of organizat ion will be
discussed.

9.2 DEFINITION OF CORPORATION

A corporation is a legal ent ity having an existence separate and dist inct from that of its
owners. In the eyes o f the law there are two persons and a corporation is an ‘art ificial person’
having many o f its own rights and responsibilit ies.

165
9.3 CHARACTERISTICS OF CORPORATION

Amo ng the characteristics of a corporation are:

a) A corporation is a separate legal ent it y. According to the law a corporate entit y ma y
own property in its own name, may enter into contract and responsible for its own debts.
b) A corporation has a legal status in court. According to the law a corporation may sue
and be sued as if it were a real person.
c) A corporation has its own charter. A corporation is created by obtaining charter fro m
the state in which the company is to be incorporated.
d) A corporation pays inco me taxes on its earnings. The inco me o f a corporation is
subject to income taxes, which must be paid by the corporation.

9.4 ADVANTAGES OF THE CORPORATE FORM OF ORGANIZATION

A corporate entit y has many advantages not available in other forms o f organizat ion. Amo ng
the advantages are the fo llowing:

a) Continuous existence: A corporation has perpetual existence in that its continuous

existence is not disso lved by the death on retirements of any of its members.

b) No personal liability for owners: Since a corporation is a separate legal ent it y, the
creditors of a corporation have a claim against the assets o f the corporation, not the
personal property of the owners.

c) Separation of managements from ownership: the owners o f a corporation (called stock

ho lders or shareho lders) own the corporation but they do not manage it on a daily basis.
To administer the affairs o f the corporation, president and other officers are hired for it.
Thus, individual stockholder has no rights to participate in the management's activit y o f
the corporation unless the stockholder has been hired as a corporate officer.

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d) Easily transferable ownership shares: ownership o f a corporation is evidenced by
transferable shares o f stocks. These shares of stocks may be so ld by one investor to
another without disso lving or disrupt ing the business organization.

9.5 DISADVANTAGES OF CORPORATE FORM OF ORGANIZATION

Some of the disadvantages of the corporation are:

a) Double taxation: corporate earnings are taxed two times. The earnings are taxed first
as a corporate inco me taxes and again as personal inco me taxes if the corporation.
Distributes its earnings to stockholders.

b) Difficulties to control: since ownership is usually separated from managements,

owners are unable to exercise act ive control over management actions.

c) Greater regulation: since a corporation co mes int o existence according to the law o f
the state, the law may provide for considerable regulat ion o f the corporation’s
activit ies. For example, the withdrawal o f funds fro m a corporation is subjects to
certain limits sets by law.

9.6 FORMATION OF A CORPORATION

A corporation is created by o btaining a corporate charter. The charter is given fro m the states
in which the corporation is to be incorporated. To obtain a corporate charter an applicatio n
called articles o f incorporation are prepared by t he organizers called incorporators and
submitted to the state corporations co mmissio ner or other designated officia ls. These articles
of incorporation specify the purpose of the business, its locat ion, the names o f the organizers,
the classes and numbers of shares o f capital stock authorized, and the consideration to be paid
in by the organizers for their respect ive shares. The article o f incorporation is approved by the
state and charter is issued. Once a charter is obtained a board of directors is elected. The
directors in turn ho ld meet ings at which officers of the corporation are appointed.

9.6.1 Organization costs

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

9.6.2 Rights of Stockholders

The stockholders who are the owners of a corporate ent it y have the fo llowing basic rights:
a) The rights to votes: the commo n stockholders have the right to elect the board of
directors, and thereby to be represented in the management of the business.

b) The rights to participate in the earnings of a corporation: Stockholders in

corporations may not make withdrawal of co mpany assets. However, the earnings of a
profitable corporation may be distributed to stockho lders is the form o f cash dividend.
The payment of a dividend always requires formal authorizat ion by the board of
directors.

c) The rights to share in the distribution of assets upon liquid action: when a
corporation ends its existence, the creditors of the corporation must first be paid is full;
any remaining assets are dividend amo ng stockho lders in proportion to the number of
shares owned.

d) Pre-emptive rights: the current stockholders has the right to purchase the shares o f the
corporation on a prorate basis when new stocks are offered for sale. This preempt ive
rights is designed to provide each stockholder the opportunit y to maintain a
proportional ownership in the corporation.

Check Your Progress Exercise -1

1. When a business is organized as a corporation:
a) Stockholders are liable for the debts of the business
b) Stockholders do not have to pay personal inco me taxes
on dividend received.
c) Each stockholder has the rights to make managerial decisio n.

168
 d) Owners cannot withdraw assets from the business at will.

2. Explain the meaning of the term double taxat ion at it applies to corporate profits.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

9.7 AUTHORIZATION AND ISSUANCE OF STOCKS

The state officials approve the articles o f incorporation, which specify the number of shares a
corporation is authorized to issue. The total number of shares that may be issued is known as
the authorized shares. When the corporation receives cash is exchange for stock certificates,
which represents the number of shares issued, the shares beco me issued shares. Shares that
are issued and held by the stockholders are called outstanding shares. Somet imes a
corporation requires shares fro m its own shareho lders. These shares are called treasury
stocks, which reduce the number of outstanding shares.

A corporation may choose not to issue immediately all the authorized shares even though it is
customary to have a large number of authorized shares than present ly needed. If more capital
is needed, the previously authorized shares will be readily available for issue. A corporation
can apply to the state for permissio n to increase the number of authorized shares.

9.7.1 Types of Stocks/Shares

Many corporations issue several classes of capital stock, each providing investors with
different rights and opportunit ies. The basic types of stock issued by every corporation is
called common stock. Commo n stock possessed the tradit ional rights of ownership such as
voting rights, participation residual dividends, and residual claim to assets in the event of
liquidat ion. When any of these rights is modified, the term preferred stock is used. Preferred
stock specifies different rights that dist inguish it from co mmo n stock. Some o f the dist inctive
features for preferred stocks are priorit y claims on dividends, cumulat ive dividend rights,
priorit y as to assets is the event of liquid act ion of a corporation and no voting power.

Stocks according to their nature are classified into par value and no-par stocks. Par value
stocks with a designated dollar amount per share as stated in the corporate charter and printed

169
on the stock certificates. On the other hand, so me states allow corporations to issue stocks
without designat ing a par value. Such stocks are called no-par stocks. When no par stocks are
issued by a corporation, the ent ire issuance price is viewed as a legal capital, which is subject
to withdrawal. Sometimes some states authorize the issuance o f no-par stock with a stated, or
assigned, value per share that is established permanent ly by t he corporate directors and is in
the laws. Most corporations use a stated value for no par stock.

9.7.2 Issuance of Par-value Stocks

9.7.2.1 Authorization
Authorizat ion of par value stocks, specified in the unit may be recorded as a memo entry in
the general journal and in the ledger accounts. Most states require the total number o f shares
authorized be shown on each stock certificate, in addit ion to the number of shares represented
by that particular stock certificates.

9.7.2.2 Par value stock issued for cash

When stocks are issued to various investors, a stock certificate specifying the number of
shares represented is prepared for each investor/or stockholder. When par value stock is
issued for cash, the capital stock account is credited with the par value o f the shares issued
regardless of whether the issuance price is more or less than par. If par value stock is issued
for more than par value (at premium), paid in capital in excess of par account is credited for
the excess of selling price over par. This paid in capital is excess o f par does not represent a
profit to the corporation rather it is part of the invested capital. If par value stock is so ld by
corporation for less than par (at discount), a negative stockholders’ equit y accounts, Discount
on common (or preferred) stock, is debited for the amount of the discount.

For example, assume that 50,000 shares of Br. 2 par value co mmo n stock have seen
authorized and that 10,000 of these authorized shares are issued at a price o f Br. 10 each. The
entry would be:

Cash………………………………………………………100.000
Commo n Stock…………………………………..20,000
Paid-in-capital is excess of par………………… 80,000

9.7.2.3 Par value stock issued on a subscription basis

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During the start-up of a corporation, prospective investors may sign a contract to purchase a
specified number of shares on credits with payments due at one or more specified future
dates. One reason for this procedure is to attract small investors. Another reason is to appeal
to investors who prefer not to invest cash unt il the corporation is ready to start business
operations. A corporation may also sell it s capital stock on credit after incorporation.

When stock is subscribed, the company debits stock subscript ion receivable for the
subscription price, credits capital stock subscribed for the par value of the subscribed shares,
and credits paid in capital in excess of the subscription price over par value. Later, as cash is
collected, the entry is a debit to cash and a credit to stock subscript ion receivable. When the
ent ire subscript ion price is co llected, the stock certificates are issued for the subscribers. The
issuance of stock is recorded by debit ing capital stock subscribed and credit ing capital stock.
The fo llowing illustration demonstrates the accounting procedures for stock subscriptions.

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

Commo n stock subscript ion Receivable 1, 440, 000

Commo n stock subscribed 1, 200, 000
Paid-in-capital in excess of par 240, 000
To record receipt of subscript ion for 120,000 shares
Cash 480, 000
Commo n stock subscript ion receivable 480, 000
To record receipt of 1st payment
Cash 480, 000
Commo n stock subscript ion Receivable 480, 000
To record receipt of final payment
Cash 480, 000
Commo n stock subscript ion Receivable 480,000
To record receipt of final payment
Commo n stock subscribed 1,200,000

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 Commo n stock 1, 200, 000
To record issuance of stock

9.7.2.4 Non Cash Issuance of Capital Stock

Corporations so met imes issue capital stock for non-cash assets such as in exchange for rea l
estate. The current markets value o f the stock issued or the non-cash consideration received,
whichever is must reliable, determinable, is used to record the transact ion. If the market value
of either capital stock issued or the no cash items are not reliable, the value are established by
the corporation’s board of directors.

9.7.2.5 Issuance of No-par Stock

Some states allow corporations to issue stock without designat ing a par or stated value. When
this no par stock is issued, the ent ire issuance price is credited to the capital stock account and
is viewed as legal capital not subject to withdrawal.

9.8 ACCOUNTING FOR RETAINED EARNINGS AND DIVIDENDS

9.8.1 Nature of Retained Earnings

Capital provided to a corporation by stockholders in exchange for shares o f eit her preferred or
commo n stock is called paid in capital or contributed capital. The second major type o f
stockholders’ equit y is a retained earnings. The amount of the retained earnings account at
any balance sheet date represents the accumulated earnings (net inco me) of the company since
the date of incorporation, less any losses and all dividends distributed to stockholders.

9.8.2 Nature of Dividends

A dividend is a distribut ion of earnings to stockholders is the form o f assets or shares of the
issuing company’s stock. Type of dividends includes the fo llowing.
a) Cash dividend
Cash disbursed
b) Property Dividend
Non cash assets disbursed
c) Stock Dividend
Corporations own stock disbursed
d) Liquidat ing Dividend

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 Return of contributed capital
e) Scrip Dividend
Creation of a liabilit y by declaring a dividend to be paid at a specific future date.

9.8.3 Relevant dividend dates

Prior to payment, dividends must be declared by the board of directors of the corporation. The
important dividend dates are:
a) Date of Declaration: on this date, the corporation’s board of directors formally
approves and announces the dividend to be distributed. The declarat ion is recorded on
this date as a debit to dividends and a credit to dividends payable.

b) Date of payment: this date is determined by the board of directors and is usually stated
is declarat ion. At the date of payment the liabilit y recorded at the date of declarat ion is
debited and the appropriate asset account is credited.

9.8.4 Dividend and Characteristics of preferred stock

A corporation wit h both preferred stock and commo n stock may declare dividends on the
commo n only after it meets the requirements of the stated dividend on the preferred. The
preferred dividend may be stated in mo netary terms or as a percent of par.

9.8.4.1 Participating and non-participating preferred stock

A part icipat ing preferred stock receives a minimum dividend but also receives higher
dividend when the co mpany pays substant ial dividends on commo n shares. The preferred
stockholders’ right may be to receive dividend only a stated amounts. Such stock is said to be
nonparticipating.

To illustrated, assume the fo llowing informat ion

 Commo n stock issued 4, 000

 Preferred stock issued 2,000
 Dividend per share of preferred stock Br. 10

The corporation reported net inco me o f Br. 150,000 for the third year and the BOD declared
both of the net income as dividend. If the preferred stock issued by the corporation is

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participat ing, the preferred stockholders will receive. Br. 30,000 (Br. 20,000 + Br. 10,000),
and the commo n stockholders will receive Br. 60,000 (Br. 40,000 + Br. 20,000).

9.8.4.2 Cumulative and Non-cumulative preferred stock

Cumulat ive preferred means that if the company fails to pay a preferred dividend, its
obligat ion accumulates and all o mitted dividends must be paid in the future before any
commo n dividends are paid. The cumulat ive preferred stockholders would receive all
accumulated unpaid dividends (called dividend in arrears) before the ho lders o f co mmo n
shares receive anything. Preferred stock not having this cumulat ive rights is called no
cumulat ive.

For example, assume the fo llowing information

 Cumulat ive preferred, 10% of Br. 100 par (10,000 shares issued)
 Commo n stock of Br. 90 par (40,000 shares issued)
 The Board of Directors (BOD) did not declare dividend in year 2
 Year 3 dividend declared by the BOD amounts to Br. 320,000.
 Year 1 dividend declared and distributed amounts to Br. 200,000.
If the preferred stock is cumulat ive, the preferred stockholders will receive Br. 200,000 (Br.
100,000 + Br. 100,000), and the commo n stock holders will receive Br. 120,000 (Br. 320,000
– Br. 200,000).

Check Your Progress Exercise –2

1. State the classificat ion (assets, liabilit y, stockholders’ equit y, revenue or expense) o f each
of the fo llowing accounts
a) subscription receivable
b) organizat ion costs
c) paid in capital is excess of par value
d) retained earnings
e) preferred stock

2. If a corporation has outstanding 1,000 shares o f Br. 9 cumulat ive preferred stock of Br.
100 par and dividends have been passed for the preceding three years, what is their

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 amount of preferred dividends that must be declared is the current year before a dividend
can be declared on commo n stock?
a) Br. 9,000 c) Br. 36,000
b) Br. 27,000 d) None

9.9 ACCOUNTING FOR TREASURY STOCKS

Treasury stock is a corporation’s own stock (preferred or commo n) that has been issued and
required by the issuing corporation. A corporation may also accept shares o f its own stock in
payment of a debits owed by a stockholder or as a donation fro m a stockholder.
Treasury stock does not reduce the number o f shares issued, but does reduce the number o f
outstanding shares. The purchase o f treasury stock decreases both assets and stockholders’
equit y. Moreover, treasury stock does not carry voting, dividend, preempt ive, or liquidat ing
rights and is not assets.

9.9.1 Reasons to acquire Treasury Stocks

In general treasury steps are to acquire for the fo llo wing reasons:
a) to support (increase) the markets price of the stock
b) to I increase earnings par share by reducing the number of shares outstanding.
c) To reduce dividend payment payments by reducing the number of shares outstanding.
d) To provide shares for reassurance to emplo yees as a bonus
e) To use the share acquired for stock dividend
f) To reissue with a higher price

9.9.2 Recording and reporting Treasury stock Transactions

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

To illustrate the cost method, assume that Harambe Corporation had 50,000 shares of Br. 10
par commo n stock outstanding at the beginning of the current year. The co mpany purchased

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500 shares for cash and received 500 shares in settlement of a debt from stockholders. The
markets price of stocks was Br. 30/share. The fo llo wing entry is required invo lving the
transactions.

Treasury stock 30, 000

Cash 15, 000
Notes Receivable 15, 000

If the company sells 600 shares of the treasury stock for Br. 31 each, the entry would be:
Cash 18, 600
Treasury stock 18, 000
Paid in capital fro m sale of 600
Treasury stock

Paid in capital fro m sale of treasury stock is reported in the paid in capital sect ion of the
balance sheet. Treasury stock is deducted fro m the total of the paid in capital and Retained
earnings.

9.10 EQUITY PER SHARE

The amount appearing on the balance sheet as total stockholders’ equit y can be stated in terms
of the equit y per share. When there is only one class o f stock, the equit y per share is
determined by dividing total stockholders’ equit y by the number o f shares outstanding. For a
corporation with both preferred and co mmo n stock, it is necessary first to allocate the total
equit y between the two classes. To illustrate, consider the fo llowing statements o f
stockholders’ equit y at December 31, 19x1.

- 9 to preferred stock, Br. 50 par value, authorized 20,000 shares, issued and
Outstanding 12,000 share Br. 600,000

- Commo n stock, no par, stated value Br. 2 per share,

authorized 500,000 shares, issued 400,000 shares of which 25,000
shares are held is the treasury 800, 000

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- Paid in capital is excess of per
-Preferred Br. 50,000
-Commo n 1,000,000 1, 050, 000
- Retained earnings 2, 000, 000
Subtotal Br. 4,450,000

- Less cost of 25,000shares of co mmon stock

Reacquired and held in treasury 250, 000
- Total stockho lders’ equit y Br. 4,200,000
If the preferred stock is entit led to receive Br. 105 per share upon liquidation and if there is no
preferred dividend in arrears, the computation of earnings per share are as fo llows:

Preferred EPS = Equit y allocated to preferred stock

Number of o/s shares of preferred stock
= 105 X 12,000
12, 000
= Br. 105/share

Commo n EPS = Equit y allocated to commo n stock

Number of o/s shares of commo n stock
= 2,940,000
375,000
= Br. 7.84 /share

Check Your Progress Exercise -3

1. A corporation reacquired 1,000 shares of it s own Br. 50 par commo n stock for Br. 75,000
recording it at costs. What effects does it has on stockholders’ equit y?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

2. If the Retained Earnings account has a debit balance, how is it presented in the balance
sheet and what is it called?

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…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

3. How is book value per share o f co mmon stock computed when a co mpany has only o ne
class of stock?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………

9.11 SUMMARY

 A Corporation has the fo llowing most important characterist ics:

 Separate legal existence, limited liabilit y, and transferable units o f stocks.

 The primary advantages o f a corporation are no personal liabilit y o f stockholders for the
debts of the business, the transferabilit y o f ownership shares, cont inuit y of existence and
abilit y to hire professio nal managements.

 Stockholders in a corporation normally have the rights to elect the board of directors, to
share in dividends declared by the directors, to share is the distribut ion o f assets if t he
corporation is liquidated, and to subscribe to addit ional shares if the corporation decides to
increases the number of shares outstanding.

 Commo n stock represents the true residual ownership o f a corporation. These share have
voting rights and cannot be called. Preferred stock has preference over co mmo n stock
with respects to dividends and to distribut ions in the events of liquidat ion.

 When capital stock is issued, appropriate asset accounts are debited for the market price o f
stock. A capital stock account is credited for the par value of the issued shares. The
difference between the market value received and the par value o f the issued shares is
credited or debited to addit ional paid in capital accounts.

 The stockholders; equit y sect ions are classified into two: paid-in-capital and retained
earnings.

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 Any treasury stock held at the end of an account ing period is deducted fro m the total o f
the paid-in-capital and retained earnings of the corporation.

 To determine the equit y per share, the equit y allocated to each class is divided by the
number of shares outstanding of the respect ive class.

9.12 ANSWER TO CHECK YOUR PROGRESS

Check Your Progress Exercise - 1

1. D
2. According to double taxation concept corporate inco me is taxed two times; when
earned to the corporation and then again taxed to the stockholders when distributed as
dividends.

Check Your Progress Exercise - 2

1. a) Assets
b) Assets
c) Stockholders’ equit y
d) Stockholders’ equit y
e) Stockholders’ equit y

2. C

Check Your Progress Exercise - 3

1. The stockholders’eq2uit y decrease for Br. 375,00
2. The debit balance is deducted fro m paid in capital and is called defects.
3. EPS = Total stockholders’ equit y
Number of shares outstanding

9.13 MODEL EXAM QUESTIONS

Part 1. Short answer questions

1. When a corporation issues stock at a premium, does the premium constitute inco me ?
Explain.
2. What type of expenditure is charged to the organization costs accounts?

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3. When stock is issued by a corporation is exchange for assets other than cash, accounts
face the problem o f determining the dollar amounts at which to record the transact ion.
Discuss the factors to be considered and explain their significance?

Part 2. Workout questions

1. Early in the year Yet imwork Demissie and several friends organized a corporation called
mo bile co mmunicat ions, Incorporation. The corporation was authorized to issue 50,000 o f
Br. 100 per value, 10% cumulat ive preferred stock and 400,000 shares of Br, 2 par value
commo n stock. The fo llowing transactions occurred during the year.
Jan. 6 Issued for cash 20,000 shares o f commo n stock at Br. 14 per share. The shares were
issued to Binda and 10 other investors.

Jan. 7 Issued an addit io nal 500 shares of co mmo n stock to Binda is exchange for his services
in organizing the corporation. The stockholders agreed that these services were worth
Br. 11,000.

Jan12 Issued 2,500 shares of preferred stock for cash o f Br. 250,000.

Jan. 4 acquired land as a building site in exchange for 15,000 shares of co mmo n stock. In
view o f the appraised value o f the land, the directors agreed that the co mmo n stock
was to valued for purpose of this transact ion at Br. 15 per share.

Nov15 The first annual dividend of Br. 10 per share was declared on the preferred stock to be
Paid December 20.

Dec20 Paid the cash dividend declared on November 15,

Dec31 After the revenue and expenses were closed into the Income summary account, that
account indicated a net inco me of Br. 106,500.

Instructions
a) Prepare journal entries in general journal form to record the above transactions
b) Prepare stockholders’ equit y sect ion of the Mobile communicat ions, Inc. balance
sheets at December 31.

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2. Belay publicat ions was organized early in 19x1 with authorizat ion to issue 20,000 shares
of Br. 100 par value preferred stock and 1 millio n shares of Br. 1 par value co mmo n stock.
All of the preferred stock was issued at par, and 300,000 shares of co mmo n stock were
sold for Br. 20 per share. The preferred stock pays a 10% cumulat ive dividend and is
callable at Br. 105. During the first five years o f operations, the corporation earned a total
of Br. 4,460,000 and paid dividends o f Br. 1 per share each year on the commo n stock. In
19X6, however, the corporation reported a net loss of Br. 1,600,000 and paid no
dividends.

Instruction
Prepare the stockholders’ equit y sect ion of the balance sheet at December 31, 19X6.

9.14 GLOSSARY

Board of directors: Persons elected by co mmon stockho lders to direct the affairs of a
corporation.

Capital stock: Transferable units of ownership is a corporation. A broad term, which may
refer to commo n stock, preferred stock, or both.

Common stock: A t ype o f capital stock, which possesses the basic rights of ownership
including the rights to vote.

Corporation: A business organized as a legal entity separate fro m its owners.

Legal capital: Equal to the par value or stated value of capital stock issued. This amount
cannot be removed wit hout special legal act ion.

Paid in capital: the amounts invested in a corporation by its stockholders.

Par value (or stated Value): the minimum amount per share to be invested is the corporatio n
by its own owners and cannot be withdrawn except by special
legal act ion.

Preferred stock: a class of capital stock usually having preferences as to dividends and in the
distribut ion of assets inevents of liquid act ion.

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Stock certificate: a document issued by a corporation as evidence of the ownership of the
number of shares stated on the certificate.

Subscriptions to Capital stock: formal promises to buy shares of stock from a corporation
with payment at a later date.

UNIT 10. DEPARTMENTS AND BRANCHES

Contents:
10.0 Aims and Object ives
10.1 Introduction
10.2 Account ing for Departmental Operations.
10.3 Departmental Margin Approach to Income Reporting
10.4 Account ing for Branch Operat ions
10.4.1 Centralized Account ing System
10.4.2 Decentralized Account ing System
10.5 Financial Statements for Home Office and Branch
10.6 Shipments to Branch Billed at Selling Price
10.7 Summary
10.8 Answers to Check Your Progress Exercises
10.9 Model Examination Questions
10.10 Reference books
10.11 Glossary

10.0 AIMS AND OBJECTIVES

After studying this unit, you should be able to:

- discuss the need for departmental informat ion;
- discuss accounting reports for departmental operations;
- explain Depart mental margin Approach to inco me reporting;
- illustrate system of branch account ing;

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 - Centralized Vs Decentralized, and
- explain shipment to branch billed at selling price.

10.1 INTRODUCTION

The act ivit ies of many business enterprises are performed by separate segments such as
departments, divisio ns and branches. These units of an operating ent it y may be organized as
separate corporations, wit h co mmo n ownership of the stock and co mmo n management at the
top. Select ion of the organization structure and the segmentation is o ften affected by size
vo lume o f business, diversit y o f act ivit y and geographic distribut ion of operations. In any
event, the managers o f segmented enterprises need accounting reports which are designed to
aid them in planning, controlling, and evaluat ing the performance of the various segments.

Segmentation may occur in service enterprises as well as in businesses engaged mainly in

merchandising or manufacturing act ivit ies. Segmented accounting reports are useful to
management regardless of the type of act ivit y.

10.2 ACCOUNTING FOR DEPARTMENTAL OPERATIONS

Account ing reports for departmental operations are generally limited to inco me statements.
Alt hough depart mental inco me statements are usually not issued to stockholders or others
outside the management group, the trend is toward providing more informat ion of this type.

Analys is o f operations by depart ments may end with the determinat ion of gross profits or it
may extend through the determinat ion of net income.

Gross Profit by Departments

For a merchandising enterprise, the gross profit is one o f the most significant figures in t he
inco me statement. Since the sales and the cost of merchandise so ld are both, to large extent,
controlled by departmental management, the reporting of gross profit by depart ments is usefu l
in:
 cost analys is and control
 helping management in direct ing its efforts toward obtaining a mix of sales that will
maximize profits. After studying such reports, management may decide to change
sales or purchases policies, cut back or expand operations, or shift personnel to

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 achieve a higher gross pro fit for each depart ment. Caution must be exercised in the
use of such reports to insure that proposed changes affecting gross profit don’t have an
adverse effect on net income,

To compute gross profit by depart ments, it is necessary to determine by departments each

element entering into gross profit. There are two basic methods of doing this

1. Setting up departmental accounts and ident ifying each element by depart ment at the time
of the transact ion. It is usually used unless the t ime required in analyzing each transact ion
is too great, or
2. maintaining only o ne account for the element and then allo cat ing it among the
departments at the time the inco me statement is prepared. This method is likely to yield
less accurate results than the first method but so me degree o f accuracy may be sacrificed
to obtain a saving of time and expense.

The fo llowing are elements that must be departmentalized in order to determine gross profit
by departments:
 Merchandise inventory
 Purchases
 Sales, and
 The related cash discounts, and returns and allowances

Some of the above elements may be identifiable directly to each department and so me are not,
which must be allocated based on different basis (e.g. based on quant it y purchased).

When departmental accounts are maintained for each element, special departmental co lumns
for recording transactions may be provided in the proper columns. For example, in a furniture
store that sells furniture and carpeting, the sales Journal may have a credit column for
Furniture sales and a credit co lumn for Carpet sales. To aid in the journalizing of
departmental transactions, the supporting documents such as sales invo ices, vouchers, and
cash register readings must ident ify the depart ment affected by each transact ion.

An inco me statement showing gross profit by departments for Texas company, which has two
sales departments, appears below.

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185
 Texas Company
Income Statement
For the year ended December 31,2000.

Department X Department Y Total

Revenue from sales:
Sales 630,000 270,000 900,000
Less: Sales returns and allowance 15,300 7,100 22,400
Net sales 614,700 262,900 877,600
Cost of merchandise sold:
Merchandise Inventory
January1,2000 80,150 61,750 141,900
Purchases 334,550 200,350 534,900
Less: Purchase discount 6200 328,350 2400 197,900 8600 526,300
Merchandise available for sale 408,500 259,700 668,200
Less: merchandise Inventory,
Dec. 31,2000 85,150 78,950 164,100
Cost of Merchandise Sold 323,350 180,750 504,100
Gross Profit 291,350 82,150 373,500
Operating expenses:
Selling expenses 113,200
General Expense 110,200
Total operating expenses 223,200
Income from operations
Other expense: 150,300
Interest expenses 2,500
Income befor e income tax 147,800
Income tax 64,444
Net Income 83,350

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N.B. Usually the Operat ing expenses would be listed in detail. But here they are shown in
condensed form for illustrative purpose.

Departmental reporting o f inco me may be extended to the various sect ions of the inco me
statement, such as gross profit less selling expenses (gross selling profit), gross profit less all
operating expenses (operating inco me), inco me before inco me tax, or net inco me. The
underlying principle is the same for all degrees of departmentalizat ion i.e. to assign eac h
department the related revenue and that part of the expenses incurred for its benefit.

Some expenses may be easily ident ifiable wit h the department benefited. For example, if
each sales person is restricted to a certain sales department, the sales salaries may be assigned
to the proper departmental salary accounts each time the payroll is prepared. On the other
hand, the salaries of co mpany o fficers, execut ives, and office personnel are not ident ifiable
with the specific sales depart ments and must therefore be allocated if an equitable and
reasonable basis for allocat ion exists

Many accountants prefer to apportion all operating expenses to the individual department only
at the end o f the account ing period. In this case, there is no need for departmental expense
accounts in the general ledger and fewer postings are needed. The apportionments may be
made on a worksheet, which serves as the basis for preparing the departmental inco me
statement.

When operating expenses are allocated, they should be apportioned to the respective
departments as nearly as possible in accordance with the cost of services rendered to them.
Determining the amount of an expense chargeable to each department requires the exercise of
judgment and considers the cost of collect ing data for use in making an apportionment.

We have different basis o f allocation o f these costs. The fo llowing are commo n basis o f
allocat ion.

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 Expenses Basis of allocation.
 Sales salary Expense……………………………………Payro ll
 Advert ising Expense……………………………………Sales
 Depreciat ion on Store Equipment………………………Average cost of Equipment
 Depreciat ion – on Building………………………….…..Floor space occupied.
 Officers’ Salaries Expense & Office Salaries ……… ….Relative amount of time
expense devoted to each
department
 Rent Expenses, and Heat ing & Light ing Expense……….Floor space occupied.
 Property tax Expense & Insurance Expense……………..Average cost of inventory &
Store Equipment.
 Unco llect ible Accounts Expense…………………………Sales
 Miscellaneous Selling Expense…………………………...Sales
 Miscellaneous General E xpense…………………………..Sales
 Delivery E xpense…………………………………………Quant it y so ld.
 Discounts………………………………………………….Purchase
 Commissio n……………………………………………….Sales

N.B. Basis of allo cations may change whenever more reliable and readily available
informat ion is obtained.

For example, the apportionment of property tax expense and insurance expense for Texas co.
may be done as fo llows:
Total Department X Department Y
Merchandise Inventory:
January 1…………………Birr 141,900 Birr 80,150 Birr 61,750
December 31…………………..164,100 85,150 78, 95

Total…………………………...306,000 165, 300 140,700

Average …………………………...153,000 82, 650 70, 350

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Cost of store Equipment:
January 1………………………..28,300 16,400 11, 900
December 31……………………31,700 19, 600 12, 100
Total…………………………….60,000 36,000 24, 000
Average…………………………...30,000 18,000 12, 000
Total average…………………….183,000 100, 650 82, 350
Percent…………………………... 100% 55% 45%
Property tax expense………………6,800* 3,740 3,060
Insurance expense…………………3,900* 2,145 1,755

*The total Property tax Expense and Insurance Expense are taken fro m the respective
accounts of the company for the year.

The apportionment of Unco llect ible Accounts Expense, Miscellaneous Selling Expense and
Miscellaneous General E xpense are based on sales as indicated above.

The computation of the apportionment is as fo llows:

Total Department X Department Y

Sales Birr 900,000 Birr 630,000 Birr 270,000
Percent 100% 70% 30%
Unco llect ible Account Expense Br.4,600 Br.3,220 Br.1,380
Miscellaneous Selling Expense 4,700 3,290 1, 410
Miscellaneous General E xpense 4,800 3,360 1,440

The other operating expenses will be apportioned in a similar manner. An Inco me Statement
present ing inco me fro m operations by departments for Texas Company appears below.

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190
Check Your Progress Exercise - 1
1. Ford Company apportions depreciat ion expense on equipment on the basis o f the
combined total of average cost of the equipment and average cost of the merchandise
inventories. Depreciat ion expense on equipment amounted to Birr 110,000 and
property tax expense amounted to Birr 26,000 for the year. Determine the
apportionment of the Depreciat ion Expense and the Property tax Expense, based on
the fo llowing data:

Average cost
Departments Equipment Inventories

Service
R…………………………………….Birr 120,000
M………………………………………….60,000
Sales
100……………………………………….240,000………………Birr 160,000
200……………………………………….420,000……………………360,000
300……………………………………….360,000……………………280,000
Total…………………………………… ..Birr.1, 200,000……………...Birr. 800,000

2. What are the uses of account ing reports by departments?

10.3 DEPARTMENTAL MARGIN APPROACH TO INCOME REPORTING

Not all accountants agree as to the merits of the t ype of depart mental analys is discussed in the
preceding section (inco me statement by operating inco me). Many caut ions against complete
reliance on such depart mental inco me statements on the grounds that the use of arbitrar y
based in allocat ing operating expenses is likely to yield in correct amounts of depart mental
operating inco me. In addit ion, objection may be made to the reporting of operating inco me
by departments on the grounds that departments are not independent operating unit s, but
segments of a single business enterprise, and that therefore no single depart ment of a business
can by itself earn an inco me. For these reasons, the format of income statements o f
segmented businesses may fo llow a so mewhat different format than the one illustrated
previously. The alternat ive form emphasizes the contribution o f each department to the

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operating expenses incurred on behalf o f the business as a unified who le. Income statements
prepared in this alternative form are said to fo llo ws the departmental margin or contribut ion
margin approach to inco me reporting. Departmental margin is the term used to describe the
excess of departmental gross profit over direct departmental expenses i.e. Depart mental
margin = Depart mental sales – Departmental cost of goods sold - direct departmental expense.

Prior to the preparation o f an inco me statement in the departmental margin format, it is

necessary to different iate between operating expense that are direct and those that are indirect.

 Direct expense – Operating expenses direct ly traceable to or incurred for the sole
benefit of a specific department and usually subject to the control o f the departmental
manager.
 Indirect expense – operating expenses incurred for the ent ire enterprise as a unit and
hence not subject to the control of individual department managers.

An income statement in the depart mental margin format for Texas Co mpany is presented
below.

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193
Departmental Margin Analysis And Control
The importance o f controlling expenses as an essential element of pro fit maximizat ion has
been emphasized throughout this material. The value of the depart mental margin approach to
inco me reporting derives largely fro m its emphasis on the assignment of responsibilit y for
control. An account ing system that provides the means for such control is so metimes called
responsibility accounting.

Wit h depart mental margin analysis, the manager of each department can be held accountable
for operating expense traceable to the department. A reduction in the direct expenses of a
department will have a favorable effect on that department’s contribut ion to the net inco me o f
the enterprise.

The departmental margin inco me statement may also be useful to management in making
plans for future operations. For example, this type o f analys is can be used when the
discontinuance of a certain operation or department is being considered. If a specific
department yields a departmental margin, it generally should be retained, even though the
allocat ion of the indirect operating expenses would result in a net loss for that department.
This observat ion is based on the assumpt ion that the department in quest ion represents a
relat ively small segment of the enterprise. Its termination, therefore, would not cause any
significant reduction in the amount of indirect expenses.

However, the commo n decisio n criterion for eliminat ion or retention o f a department is to
compare lo st revenue wit h avo idable costs. Lost revenue refers to the revenue lost by the
company if the depart ment is eliminated. Avo idable costs refer to those costs that can be
avo ided if the depart ment is eliminated. Direct expenses are avo idable whereas indirect
expenses may be avo idable or unavo idable.

For example, assume that a company has two departments with the fo llowing data:

Department A Department B Total

Sales……………………………………Birr 900,000 Birr 600,000 Birr 1,500,000
Cost of sales & operating expenses…………810,000 760,000 1,570,000
Operating inco me………………………….. ..90,000 Br.(160,000) (70,000)

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Suppose 40% of total cost and operating expenses are unavo idable, should the co mpany
delete department B?

To answer this quest ion we have to compare avo idable costs with lo st revenues. If lost
revenues greater than avo idable costs, the department should be retained but if lo st revenues
less than avo idable costs, the department should be eliminated. In the above example,
avo idable costs are 60% of Birr 760,000 = 456,000 where as lo st revenues are Birr 600,000.
Lost revenues are greater than avo idable costs, therefore department B should be retained.

In addit ion to the above factors, there are others that may need to be considered. For
example, there may be problems regarding the displacement of sales personnel. Or customers
attracted by the least profitable depart ment may make large purchases in other departments,
so that discont inuance of that department may adversely affect the sales of other departments.

10.4 ACCOUNTING FOR BRANCH OPERATIONS

Branch is a segment of an organization, which is located far geographically. A business

enterprise opens new branches in an effort to increase its sales and inco me. Although
commo nly associated with retailing branch operations are also carried on by banking
inst itutions, service organizations, and many kinds of manufacturing enterprises. Regardless
of the nature of the business, each branch ordinarily has a branch manager. Wit hin the
framework of general policies set by top management, the branch manager may be give n
freedo m in conduct ing the business o f the branch. It is necessary to maintain a record of the
assets at the branch locat ions and of liabilit ies incurred by each branch.

There are various systems o f accounting for branch operations. The system may be highly
centralized or completely decentralized or between these two extremes.

10.4.1 Centralized Accounting System

A system whereby the account ing for the branch is done at the home o ffice (head office). The
branch may prepare only the basic records of its transactions, such as sales invo ices, time
tickets for emplo yees, and vouchers for liabilit ies incurred. Copies of all such documents are
forwarded to the home o ffice, where, they are recorded in proper journals in the usual manner.
When this system is used, the branch has no journals or ledgers. If the operating results o f the

195
branch are to be determined separately, which is normally the case, separate branch accounts
for sales, cost of merchandise so ld, and expenses must be maintained in the home office
ledger. The principles of depart mental account ing will apply in such cases, with the branch
being treated as a department.

One important result of centralizing the bookkeeping act ivit ies at one location may be
substant ial savings in o ffice expense. There is also greater assurance o f uniformit y in
accounting methods used. On the other hand, there is so me likelihood of delays and
inaccuracies in submitt ing data to the ho me o ffice, with the result that periodic reports on the
operations of a branch may not be available when needed.

10.4.2 Decentralized Accounting Systems

A system o f account ing whereby the branch is responsible for the detailed account ing and
only summary accounts carried for the branch by the ho me office. When the account ing for
branches is decentralized, each branch maintains it s own accounting system with journals and
ledgers. T he account classification for assets, liabilit ies, revenues and expenses in the branch
ledger conforms to the classificat ion used by the ho me office. The account ing processes are
like those of an independent business, except that the branch does not have capital accounts.
A special account ent it led Ho me Office takes the place o f the capital accounts. The process
of preparing financial statements and adjusting and closing the accounts is substant ially the
same as for an independent business. In the remainder of this unit, we will discuss this syste m
of branch account ing.

Check Your Progress Exercise – 2

1. What are the dist inction between centralized and decentralized system o f accounting for
branch?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………………………….

Underlying Principles of Decentralized Branch Accounting

When the branch has a ledger wit h a full set of accounts except capital accounts, there must
be so me tie – in between the branch ledger and the general ledger at the ho me o ffice. T he

196
properties at the branch are a part of the assets of the ent ire enterprise, and liabilit ies incurred
at the branch are liabilit ies o f the ent ire enterprise. Although the accounting system at the
branch is much like that of an independent company, the branch is not considered a separate
ent it y but only a segment of the business.

The tie – in between the ho me o ffice and the branch is acco mplished by the subsidiary ledger
technique, with an added modificat ion that makes the branch ledger a self contained unit. The
accounts are Home Office account and Invest ment in branch account. These two accounts
represent the same item except their locat ion. Investment at Branch is an asset account which
is maintained at the head o ffice whereas Ho me Office is a capital account maintained at the
branch. T hese two accounts have always equal but opposite balances and are known as
reciprocal accounts. The ho me o ffice account in the branch ledger replaces the capita l
accounts that would be used if the branch were a separate entity. Actually, the account
represents the portion of the capital o f the ho me office that is invested in the branch.

Transact ions that are usually made between the Home Office and the Branch are:
1. Transfer of assets from head office to branch. The assets may be cash, equipment etc.
2. Transfer of assets from branch to head office.
3. Reporting of operation inco me or loss by branch.

When the ho me office sends assets to the branch, it debits invest ment in branch account for
the total and credits the proper asset accounts. Upon receiving the assets, the branch debit s
the proper asset accounts and credits Home office.
When the branch transfers assets to the ho me o ffice, it debits the Ho me Office account and
credits the proper asset accounts. Upon receiving the assets, the head o ffice, debits the proper
asset accounts and credits Invest ment in branch account.

As the branch incurs expenses and earns revenue, it records the transactions in the usua l
manner. Alt hough such transact ions affect the amount of the ho me o ffice invest ment at the
branch recognit io n of the change is delayed unt il the accounts are closed at the end o f the
accounting period. At that time, the Inco me Summary account in the branch ledger in closed
to the account Ho me Office. If the operations have resulted in an operating income, the
account Home Office will be credited and Inco me Summary will be debited.

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In the Ho me Office, an operating inco me at the branch is recorded by a debit to Invest ment in
Branch and a credit to Branch Operat ing Inco me. For an operating loss, the entries would be
just the reverse.

Illustration:

1. July 1,2002 ABC. Co. (the home office) sent Birr 8000 to Bahir Dar Branch.
2. July 22,2002 the branch sent Birr 5000 to the ho me office.
3. July 31, 2002 the branch reported an operating income of Birr 3000.

Record the above transact ions in the Branch and head Office books.

S ol u t i on :

Head office Book Branch Book

22000022 Invest ment in branch –Bahir Dar…….8000 cash………….8000
JJuulyly11 Cash……………………………..8000 Head office……8000
(Home office)

22000020 Cash………………………………..5000 Head Office…….5000

July 22
July 22 Investment in Branch –Bahir Dar…….5000 Cash……………….5000

22000002 Invest ment in branch –Bahir Dar….3000 Income summary …….3000

July 31
July 31 Branch Operating inco me………..3000 Head office……………3000

In a merchandising business, the branch can get assets eit her fro m transfer of merchandise
fro m head office or purchase fro m local supplier.

When the branch purchase items fro m outside suppliers no journal entry is necessary at head
office and the branch record the purchase as if it is a separate business enterprise.

But when the branch obtains assets fro m head o ffice the journal entries depend on whether
perpetual or periodic inventory system is used.

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When perpetual inventory system is used, a shipment of merchandise fro m the ho me o ffice is
recorded by the ho me o ffice by debit ing Investment in Branch and credit ing Merchandise
Inventory. T he branch records the transact ions by debit ing merchandise inventory and
credit ing Home Office.

When periodic inventory system is used a shipment of merchandise fro m the ho me o ffice is
recorded by the ho me office by debit ing Investment in Branch and credit ing shipments to
Branch. The branch records the transaction by debit ing Shipments from Ho me Office and
credit ing Home Office. The two shipments accounts are also reciprocal accounts.

The account Shipments to Branch is a contra account represent ing a reduction in merchandise
inventory and purchases in the ho me office ledger. A Shipment fro m Home Office, in the
branch ledger, is like a purchase account. Both accounts are temporary in nature and are
periodically clo sed to the respective Inco me Summary accounts.

Illustration of Decentralized Branch Accounting

Home office Entries Branch Entries
Transactions
1. The ho me o ffice established Branch #1 near the end o f the fiscal year, sending Birr
20,000 in cash and Birr 40,000 in merchandise.

Invest ment in Branch #1…..60,000 Cash……………………….20,000

Cash…………………………20,000 Shipments fro m Head Office….40,000
Shipments to Branch #1…….40,000 (Merchandise Inventory)
Head Office……………...60,000

2. The branch purchased on account Birr 20,000 of merchandise, Birr 30,000 of equipments,
and Birr 1,500 of Prepaid Insurance.
Purchases……………….20,000
(Merchandise Inventory)
No need Equipment……………..30,000
Prepaid Insurance…….....1500
Accounts payable……….51,500

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*Only entries and accounts affect ing Branch #1 are presented.

3. The branch so ld merchandise for Birr 36,000 in cash and Birr 21,000 on account

Cash……………..36,000
Account Receivable…21,000
No need Sales…………………..57,000

4. The branch paid operating expenses of Birr 11,300.

Operating expenses………..11,300
No need Cash………………………...11,300

5. The branch co llected Birr 12,000 on accounts receivable.

Cash ………………..12,000
No need Account Receivable……..12,000

6. The branch paid Birr 32,000 on accounts payable.

Account Payable……..12,000
No need Cash ………………..12,000

7. The branch sent Birr 10,000 in cash to the ho me office.

Cash……………10,000 Home Office………..10,000

Invest ment in Branch # 110,000 Cash……………..10,000

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Adjusting Entries.

a) To record the branch ending merchandise inventory

Merchandise Inventory………………22,000
Income Summary…………………..22,000
N.B. if perpetual inventory system is
used no need of adjustment.
b) To record the branch Insurance and Depreciat ion expense.
Operating expenses………700
Prepaid Insurance……...........200
Accumulated Depreciat ion….500
c) to close the branch sales account.
Sales……………………57,000
Income Summary………….57,000
d) To close the branch cost and expense accounts.
Income summary………………..72,000
Shipments from Head office……….40,000
Purchases…………………………..20,000
Operating expenses…………………12,000

e) To close the branch Inco me Summary account and to record the operating inco me o f
the branch in the accounts of the ho me office.

Invest ment in Branch #1……….7,000 Income summary ……7,000

Branch # 1 operating inco me…..7,000 Home office…………7,000

After the foregoing entries have been posted, the Home Office accounts affected and the
Branch ledger accounts appear as shown below.

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 Home office ledger Branch ledger.

Cash Cash
(7) 10,000 (1) 20,000 (1) 20,000 (4) 11,300
(3) 36,000 (6) 32,000
(5) 12,000 (7) 10,000
68, 000 53, 300
Bal. 14,700

Accounts Receivable
(3) 21,000 (5) 12,000

Bal. 9,000

Home office ledger Branch ledger

Merchandise Inventory

(a) 22,000

Prepaid Insurance
(2) 1500 (b) 200
Bal. 1300

Equipment
( 2) 30, 000

Accumulated Depreciat ion

(b) 500

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 Invest ment in Branch #1 Accounts Payable
(1) 60,000 (7) 10,000 (6)32,000 (2) 51,500
(e) 7,000 Bal. 19,500
Bal.57,000
Bal. 15,500
Home Office
(7) 10,000 (1) 60,000
(e) 7,000
Branch #1 operating inco me Bal. 57,000
(e) 7,000
Income Summary
(d) 72,000 (a) 22,000

* Branch operating inco me will (e) 7,000 (c) 57,000

be closed to the Inco me summar y

account. Sales
(c ) 57,000 (3) 57,000
Shipment to Branch#1 _ _
( 1) 40, 000
Shipments fro m Home o ffice
(1) 40,000 (d) 40,000

*Shipments to Branch #1 is deducted _ _

fro m the sum o f the beginning Purchases

inventory and purchases. It will be (d) 20,000 (1) 20,000

closed to the Inco me Summar y _ _

account.
Operating expense
(4) 11,300 (d) 12,000
(b) 700
_ _

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10.5 FINANCIAL STATEMENTS FOR HOME OFFICE AND BRANCH

Branch financial statements differ fro m those of a separate business ent it y in two major
respects. In the Branch Inco me Statement, Shipments fro m the Ho me Office appear in the
cost of merchandise so ld sect ion fo llowing Purchases. In the Branch Balance Sheet, the
account Home Office takes the place of capital accounts.

The Ho me Office Inco me Statement reports details o f sales, cost of merchandise so ld, and
inco me or loss fro m Ho me Office operations in the usual manner. The operating inco me and
loss of each branch is then Listed, and the operating results for the ent ire enterprise are
reported. The asset section o f the balance sheet prepared fro m the Home Office ledger will
include the controlling accounts for the various branches. The various asset and liabilit ies at
the branch locations will not be disclosed.

The ho me o ffice statements, together with financial statements for each individual branch,
serve a useful purpose for management. They are not usually issued to stockholders and
creditors. Accordingly, it is necessary to combine the data on the inco me statements of the
ho me o ffice and the branches to form one overall inco me statement. The data on the balance
sheet of the ho me office and of the various branches are also co mbined to form one balance
sheet for the enterprise. The preparation o f the combined statements is made easier by the use
of worksheets. The worksheets are similar in that each has a co lumn for the ho me office
account balance, a column for the account balances of each branch, a set of co lumns headed
“E liminat ions” and a final co lumn to which the combined figures are extended.

The combined inco me statement and the related worksheet for Kelles Corporation are as
fo llo ws:

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 Keller Corporation
Worksheet for Combined Income statement
For the year ended December 31,2002.
Home Branch Eliminat ions Combined
office #1 Inco me
statement
Debit Credit
Sales 897, 000 57, 000 954, 000
Cost of merchandise so ld:
Merchandise inventory January 1,2002 141, 000 141, 000
Purchases 652, 000 20, 000 672, 000
Shipments fro m Home Office 40, 000 40, 000
Less: shipments to Branch#1 40, 000 _______ 40, 000 ____________
Merchandise available for sale 753, 000 60, 000 813, 000
Less: merchandise Inventory December
31, 2002 150, 000 22, 000 172, 000
Cost of merchandise so ld 603, 000 38, 000 641, 000
Gross Profit 294, 000 19, 000 313, 000
Operating expenses 150, 500 12, 000 162, 500
Inco me before inco me tax 143, 500 7, 000 40, 000 40, 000 150, 500
Income tax 66, 740
Net inco me 83, 700
Keller Corporation
Income Statement
For the Year ended December 31,2002
Sales 54, 000
Cost of merchandise sold:
Merchandise Inventor y, January 1,2002 141, 000
Purchases 672, 000
Merchandise available for sale 813, 000
Less: Merchandise Inventory, December 31,2002 172, 000
Cost of merchandise sold 641, 000
Gross profit 313, 000
Operating expense 162, 500
Income befor e income tax 150, 500
Income tax 66, 740
Net income 83, 760

The account Shipments fro m Ho me Office is canceled by a Credit in the E liminat ion Column,
and the account Shipments to Branch # 1 is canceled by a Debit in the E liminat ion Co lumn.
These eliminat ions are necessary in the preparation of a co mbined statement reporting the

205
 Home Office and the branch as a single operating unit. The two account, merely record a
change in location o f merchandise within the company.

The co mbined balance sheet and the related worksheet for Keller Corporation are presented
below. T he reciprocal account Invest ment in Branch # 1 is canceled by a credit eliminat ion;
the reciprocal accounts Home Office is canceled by a debit eliminat ion.

Killer Corporation
Worksheet for combined Balance Sheet
December 31,2002
Home Office Branch #1 Eliminat ions Combined
Balance sheet
Debit Credit
Debit Balances
Cash 62, 000 14, 700 76, 700
Accounts Receivable 81, 000 9, 000 90, 000
Merchandise Inventory 150, 000 22, 000 172, 000
Prepaid Insurance 8, 200 1300 9, 500
Invest ment in Branch #1 57, 000 57, 000
Equipment 195, 000 30, 000 225, 000
Total 553, 200 77, 000 573, 000
Credit Balance
Accumulated depreciat ion 87, 000 500 87, 500
Accounts Payable 110, 000 19, 500 129, 500
Home Office 57, 000 57, 000
Commo n stock 200, 000 200, 000
Retained Earnings 156, 200 156, 200
Total 553, 200 77, 000 57, 000 57, 000 573, 200

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 Keller Corporation
Balance sheet
December 31,2002
Assets Liability and Capital
Cash……………………………………76,700 Accounts
payable……………………..129,500
Accounts Receivable………….. ……...90,000
Merchandise Inventory……………... 172,000 Capital
Prepaid Insurance……………………….9,500 Commo n stock, Birr 10 per………….208,000
Equipment………………..225,000 Retained earning……………………..156,200
Less: Accumulated depn’….87,500 Total capital…………………………356,200
Total assets………………………… 485,700 Total liabilit ies & capital……………485,700

10.6 SHIPMENTS TO BRANCH BILLED AT SELLING PRIES

In the foregoing discussio n and illustrations, the billing for merchandise shipped to the branc h
has been assumed to be at cost price. When all or most of the merchandise handled by the
branch is supplied by the ho me o ffice, billings are usually made at selling price. An
advantage of this procedure is that it provides a convenient control over inventories at the
branch. The branch merchandise inventory at the beginning of the period (at selling price),
plus shipments during the period (at selling price), less sales for the period yields the ending
inventory (at selling price). Comparison o f the book amount with the physical inventory taken
at selling prices disclo ses any difference. A significant difference between the physical and
book inventories indicates a need for remedial act ion by the management.

When shipments to the branch are billed at selling prices, no gross profit will be reported on
the branch inco me statement. The merchandise inventory on the branch balance sheet will
also be stated at the billed (selling) price o f the merchandise on hand. In co mbining the
branch statements with the home office statements, it is necessary to convert the data back to
cost by eliminat ing the markup form both the Shipments accounts and the Inventory accounts.

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Check Your Process Exercise -3
Area Co mpany has established two branches Branch #1 and Branch #2. The transfer o f
assets(cash) among Ho me Office, Branch 1 and Branch 2 is as indicate below:

Home Office

Movement 1

Branch #1 __________________ Branch #2.

Movement 1: Transfer of cash by the ho me office to branch #1.

Movement 2: Transfer of cash by branch #1 to branch #2.

Required: Record movement 1 and movement 2 in the books of the Home Office, Branch #1
and Branch #2 assuming that Decentralized Account ing system is used (5 journal
entries are necessary)
……………………………………………………………………. ………………………
……………………………………………………………………………………………
……………………………………………………………………………………………

10.7 SUMMARY

Departmental account ing is more likely to be used by a large business than by a small one, but
some degree o f departmentalization may be used by a small enterprise. Accounting reports
for departmental operations are generally limited to inco me statements although departmenta l
inco me statements are not usually issued to external users.

In an effort to increase its sales and inco me a business enterprise ma y also open new branches
(stores). Regardless o f the nature of the business each branch ordinary has a branch manager.
Wit hin the framework of general policies set by top management, the branch manager may be
given freedo m in conduct ing the business of the branch.

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There are various systems o f accounting for branch operations. The system may be highly
centralized, with the account ing for the branch done at the ho me office. Or the system may be
almost completely decentralized, with the branch responsible for the detailed account ing.

10.8 ANSWERS TO CHECK YOUR PROGRESS EXERCISE

Check Your Progress Exercise - 1

i) a) Apportionment of depreciat ion expense:

Total Services Department Sales Department

R S 100 200 300
Average cost of Equipment…1,200,000 120,000 60, 000 240, 000 420,000 360,000
Percent……………………… 100% 10% 5% 20% 35% 30%

Depreciat ion Expense……….110,000 11,000 5,508 22,000 38,500 33,000

b) Apportionment of property tax expense

Total Services Department Sales Department

R S 100 200 300
Average cost of Equipment
& inventory…………Br.2,000,000 120, 000 60,000 400,000 780,000 640,000
Percent………………………….100% 6% 3% 20% 39% 32%

Property tax expense………. 26,000 2,160 1,080 5,200 10, 140 8,320

ii) The uses of Account ing reports by depart ments are

a) for planning and allocat ing of resources.
b) For controlling of operations.
c) For evaluat ing performance

Check Your Progress Exercise - 2

In centralized system of account ing, the accounting for the branch is done at the head o ffice.
The branch is limited to business act ivit ies but in decentralized system of account ing, the
detailed account ing act ivit ies are done by the branch.

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Check Your Progress Exercise - 3
Branch #1 Book Branch #2 Book Home office /Area Co/book

Moment 1. Cash……….XX Invest ment in branch #1…XX

Home Office…XX ___ Cash……………XX

Movement 2 Home Office…XX Cash…………XX Invest ment in

Cash………….XX Home office…XX Branch #2….XX
Invest ment in
Branch #1…..XX

10.9 MODEL EXAMINATION QUESTIONS

Part A. Multiple Choices

1. Which of the following would be the most appropriate basis for allocat ing rent expense
for use in arriving at operating inco me by department?
A. Departmental Sales C. Cost of inventory
B. Physical space occupied D. Time devoted to departments.

2. On the inco me statement departmentalized through departmental margin, sales

commissio n expense would be reported as:
A. a direct expense C. as other expense
B. an indirect expense C. none of the above.

3. In account ing for a firm wit h a co lony west branch, the ho me o ffice and colony west
branch accounts are known as
A. home office ledger accounts C. reciprocal accounts
B. branch ledger accounts D. none of the above.

4. In the worksheet for a combined inco me statement for the Home Office and its North side
Branch what item is eliminated as an offset to Shipments to North side Branch?
A. Home office C. Shipments fro m Home office
B. North side Branch D. None of the above.

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Part B. Exercises
1. Describe the underlying principle of apportionment of operating expenses to departments
for inco me statements departmentalized through income fro m operations.

2. Different iate between a direct and an indirect operating expense.

3. What is the nature of reciprocal accounts emplo yed in branch account ing?

4. a) What Home Office accounts are debited and credited to record the operating inco me o f
the Columbus Branch?
b) What branch accounts are debited and credited to close the Co lumbus Branch Inco me
Summary account

5. Where are the journals and ledgers detailing the operations of a branch maintained in
a) a centralized system for branch accounting?
b) A decentralized system?

6. During the year, the Home Office shipped to the Branch merchandise that had cost Birr
300,000. The branch was billed for Birr 420,000, which was the selling price of the
merchandise. No merchandise was purchased from any outside sources. Branch net sales
for the year totaled Birr 380,500. All sales were made at the billed price. Merchandise on
hand at the beginning of the period totaled Birr 68,300 at the billed price. Merchandise on
hand at the end o f the period as determined by physical count was Birr 101,470 at the
billed price. Determine the amount, at the billed price, of any discrepancy between the
book amount and the physical count of inventory.

10.10 REFERENCE BOOKS

1. Fees and Warren: Principles of Account ing, 16th Edit ion

2. Fees and Warren: Principles of Account ing, 14th Edit ion.

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Part C. Work out
Branch # 1 Book (Area Co.) Home office book

Movement 1. Cash…………..XX Invest ment in Branch #1…XX

Home Office……XX
Cash………………….XX

Movement 2. Home office……XX Invest ment in branch#2…XX

Cash…………..XX Invest ment in branch#1….XX

Branch # 2 book

Movement 1. No need of journal entry.

Movement 2. Cash……………………………..XX
Home office………………………XX

10.11 GLOSSARY

1. Branch: Segment of an organizat ion, which is located far geographically.

2. Centralized accounting system: a system of accounting whereby the accounting for the
branch is done at the head office.

3. Decentralized accounting system: a system of account ing whereby the branch is

responsible for the detailed account ing and only
summary accounts carried for the branch by the home
office.

4. Departmental margin: departmental gross profit less direct departmental expense.

5. Direct expense: an expense direct ly traceable to or incurred for the so le benefit of a

specific department and ordinarily subject to the
control of the department manager.

6. Shipment to branch accounts – a contra account represent ing a reduction in merchandise

inventory and purchases in the ho me o ffice.

212