DREAMLAND COLLEGE

DISTANCE Program
Hand out for
FUNDAMENTALS OF ACCOUNTING II
(AcFn2012)
(4 Cr. Hrs)

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UNIT ONE
ACCOUNTING FOR INVENTORIES
Introduction
In this unit we are going to discuss the nature of inventories for those enterprises operating in buying and
selling of finished items to consumers.

Section 1: Nature and Importance of Inventories

Overview

Inventories are asset items held for sale in the ordinary course of business or goods that will be used or
consumed in the production of goods to be sold.

They are mainly divided into two major categories:

 Inventories of merchandising businesses; and
 Inventories of manufacturing businesses
1. Inventories of merchandising businesses: are merchandise purchased for resale of business.
2. 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 identified with the completed but unsold units on hand at the
end of each period.
In this unit only the determination of the inventory of merchandise purchased for resale commonly called
merchandise inventory will be discussed.
Merchandise purchased and sold is the most active elements in a merchandising business, i.e. in
wholesale and retail type of businesses. This is due to the following reasons:
 The sale of merchandise is the principal source of revenue for them.
 The cost of merchandise sold is the largest deductions from sales.
 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 following period‟s financial
statements. If inventories are misstated (understated or overstated), the financial statements will be
distorted.

Section 2: The Effects of Inventories on Financial Statements

2.1 Effect of Ending Inventory on Current Period’s Financial Statements

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Ending inventory is the cost of merchandise on hand at the end of the accounting period. Let us see its
effect on current period‟s financial statements.

The effect of ending inventory is reflected in both income statements and balance sheets. First let‟s see its
effect on the income statement:

2.1.1 Income Statement

a. Ending inventory is used in calculating cost of goods sold in the income statement.
Cost of goods (merchandise) sold =Beginning inventory + Net purchase – Ending inventory

As you see, ending inventory is a deduction in calculation cost of merchandise sold. So, it has an indirect
(negative) relationship to cost of merchandise sold, i.e. if ending inventory is understated, the cost of
merchandise sold will be overstated, and if ending inventory is overstated, the cost of merchandise sold
will be understated. This shows us the inverse relationship.

b. The cost of the merchandises sold will then subsequently be used in calculating the gross profit of the
enterprise. Gross Profit = Net sales – Cost of merchandise sold
Here, the cost of merchandise sold had indirect relationship to gross profit. So, the effect of ending
inventory on gross profit is the opposite of the effect on cost of merchandise sold. 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. There exists a direct (positive) relationship between ending inventory and
gross profit.

c. Operating income = Gross Profit – Operating Expenses

Gross profit and operating income have direct relationships. Thus, the effect of ending inventory on net
income is the same as its effect on gross profit. There exists a direct (positive) relationship between
ending inventory and gross profit.

2.1.2 Balance Sheet

A balance sheet is a financial statement that lists all assets, liabilities and capitals of an organization on a
specific date. The ending inventory of an organization affects the two major components of a balance
sheet:
1. Current assets - Ending inventory is part of current assets, even the largest. So, it has a direct
(positive) relationship to current assets. If ending inventory balance is understated (overstated),
the total current assets will be understated (overstated).
2. Liabilities- No effect on liabilities. Inventory misstatement has no effect on liabilities.
3. Owners’ equity – The net income will be transferred to the owners‟ equity at the end of
accounting period. Closing income summary account does this. So, net income has direct
relationship with owners‟ equity at the end of accounting period. The effect-ending inventory on
owners‟ equity is the same as its effect on net income, i.e. if ending inventory is understated
(Overstated), the owners‟ equity will be understated (Overstated).

2.2 Effect of Ending Inventory on the Following Period’s Financial Statement

The ending inventory of the current period will become the beginning inventory for the following period.
So, it will have the same effect as beginning inventory of the current period. Let us summarize it.

2.2.1 Income Statement of the Following Period

a. Ending inventory is used in calculating cost of goods sold in the income statement.

Cost of goods (merchandise) sold =Beginning inventory + Net purchase – Ending inventory
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As you see, ending inventory of the previous period will become beginning inventory of the following
period. Therefore, when ending inventory of the current period increases, it means that beginning
inventory of the next period increases too. Due to this cost of goods sold of the next period increases.
There exists a direct or positive relationship between ending inventory of the previous period and cost of
merchandises.
b. The cost of the merchandises sold of the following period will then subsequently be used in
calculating the gross profit of that period.
Gross Profit = Net sales – Cost of merchandise sold
In this case you have to note that, ending inventory of the previous period has increased cost of goods
sold of the following period. Therefore, gross profit of the following period will decrease as cost of the
goods sold increase.
c. Operating income = Gross Profit – Operating Expenses
The effect of ending inventory on the following period‟s operating income is the same with that of gross
profit.

The Effect of Inventory on the Following the two misstatements will be equal and in
Period’s Statements opposite directions.
The inventory at the end of one period becomes
the inventory for the beginning of the following Therefore, the effect on net income of an
period. Thus, if the inventory is incorrectly incorrectly stated inventory, if not corrected, is
stated at the end of the period, the net income of limited to the period of the error and the
that period will be misstated and so will the net following period. At the end of this following
income for the following period. The amount of period, assuming no additional errors, both
assets and owner‟s equity will be correctly
stated.

In the illustration, the $10,000 understatement of Section 3: Inventory Systems: Periodic Vs

inventory at the end of period 1 resulted in an Perpetual
overstatement of the cost of merchandise sold
and thus an understatement of gross profit by 1.1 Periodic Inventory System
$10,000. On the balance sheet, merchandise
inventory and owner‟s equity would both be There are two principal systems of inventory
understated by $10,000. Because the ending accounting: periodic and perpetual.
inventory of period 1 become the beginning
inventory for period 2, the cost of merchandise Under the periodic inventory system there is no
sold was understated and gross profit was continuous record of merchandise inventory
overstated by $10,000 for period 2. Both account. The inventory balance remains the
merchandise inventory and owner‟s equity will same through out the accounting period, i.e. the
be correct at the end of period 2. beginning inventory balance. This is because
when goods are purchased, they are debited to
2.2.2 Balance sheet of the following the purchases account rather than merchandise
period inventory account.
The ending inventory of the current period will
not have an effect on the following period‟s The revenue from sales is recorded each time a
balance sheet items. This is because the balance sale is made. No entry is made to record for the
sheet of the following period reports only ending cost of goods sold. So, physical inventory must
inventory of that period instead of ending be taken periodically to determine the cost of
inventory of the previous period. inventory on hand and goods sold.

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The periodic inventory system is less costly to This system is often used by retail enterprises
maintain than the perpetual inventory system, that sell many kinds of low unit cost
but it gives management less information about merchandise such as groceries, drugstores,
the current status of merchandise. 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 allowance XX
4. To close beginning inventory
Income Summary XX
Merchandise inventory (beginning) XX
5. To record ending inventory
Merchandise inventory (ending) XX
Income summary XX

1.2 Perpetual Inventory System

Under this system the accounting record Companies that sell items of high unit value,
continuously disclose the amount of inventory. such as appliances or automobiles, tend to use
So, the inventory balance will not remain the the perpetual inventory system.
same in the accounting period. All increases are Given the number and diversity of items
debited to merchandise inventory account and contained in the merchandise inventory of most
all decreases are credited to the same account. businesses, the perpetual inventory system is
There are no purchases and purchase returns and usually more effective for keeping track of
allowances accounts in this system. At the time quantities and ensuring optimal customer
of sale, the cost of goods sold is recorded in service. Management must choose the system or
addition to Journal entry for the sale. So, we can combination of systems that is best for achieving
determine the cost of inventory as well as goods the company's goal.
sold from the accounting record. No need of
physical counting to determine their costs.

Journal entries to be prepared are:

1. At the time of purchase of merchandise
Merchandise inventory XX at cost
Accounts payable/cash XX
2. At the time of sale of merchandise
Accounts receivable or cash XX at retail price
Sales XX
Cost of goods sold XX
Merchandise inventory XX at cost
To record the cost of merchandise sold

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3. To record purchase returns and allowances

Accounts payable or cash XX at cost
Merchandise inventory XX
4. No adjusting entry or closing entry for merchandise inventory is needed at the end of each
accounting period.

1.3 Determining Actual Quantities in There are two main types of shipping terms.
the Inventory FOB shipping point and FOB destination
(1) FOB shipping point- the ownership title
The physical count of inventory is needed under passes to the buyer when the goods are
both inventory systems. Under periodic shipped (when the goods are loaded on
inventory system, it is needed to determine the the means of transportation, i.e. at the
cost of inventory and goods sold. seller‟s point). The purchaser is
responsible for freight charges.
The inventory account under a perpetual (2) FOB destination – the title passes to the
inventory systems is always up to date. Yet buyer when the goods arrive at their
events can occur where the inventory account destination, i.e. at the buyer‟s point.
balance is different from inventory on hand.
Such events include theft, loss, damage, and So, in general, goods in transit purchased on
errors. The physical count (some times called FOB shipping point terms are included in the
“taking an inventory”) is used to adjust the inventories of the buyer and excluded from the
inventory account balance to the actual inventories of the buyer and excluded from the
inventory on hand. inventories of the seller. And goods in transit
purchased on FOB destination terms are
We determine a birr amount for physical count included in the inventories of the seller and
of inventory on hand at the end of a period by: excluded from the inventories of the buyer.
(1) Counting the units of each product on
hand; There are also problems with goods on
(2) Multiplying the count for each product consignment at the time of taking inventory.
by its cost per unit; and
(3) Adding the cost for all products. Consignment sale is a special sales transaction
where owner transfers the products to an agent.
At the time of taking an inventory, all the The ownership of consigned items still belongs
merchandise owned by the business on the to the owner not the agent. Goods on
inventory date, and only such merchandise, consignment to another party (agent) called the
should be included in the inventory. The consignee. A Consignee agrees to sell the goods
merchandise owned by the business may not for the owner usually on commission basis. And
necessarily be in the warehouse. They may be in the consigned items are included in the
transit. consignor‟s inventories and excluded from the
consignee‟s inventories.
The legal title to the merchandise in transit on
the inventory date is known by examining
purchase and sales invoices of the last few days
UNIT TWO
of the current accounting period and the first few DETERMINING THE COST OF
days of the following accounting period. This INVENTORY
legal title depends on shipping terms
(agreements). Introduction
Section 1: Cost of Merchandise Inventories

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Costs included in merchandise inventory are For example, if a company purchases item X in
those expenditures necessary, directly or three different dates, say on January 1, 50 units
indirectly, to bring an item to a salable condition at 12 birr each, on January 10,40 units at 12 birr
and location. In other words, cost of an each and on January 31, at 12 birr each. What is
inventory item includes its invoice price minus the cost of any amount of inventory remaining at
any discount, plus any added or incidental costs hand at the end of the period?
necessary to put it in a place and condition for
sale. Added or incidental costs can include In the above case, it is simple whether it is from
import duties, transportation-in, storage, the January1, 10 or 31 purchase the cost of any
insurance against losses while the goods are in unit remaining at hand or sold during the period
transit, and costs incurred in an aging is 12 birr per unit.
process(for example, aging of wine and cheese).
But when identical items are purchased at
Minor costs that are difficult to allocate to different costs, a question arises as to what
specific inventory items may be excluded from amounts are included in the cost of merchandise
inventory cost and treated as operating expenses sold and what amounts remain in inventory.
of the period. This is based on materiality
principle or the cost-to –benefit constraint. There are four methods commonly used in
assigning costs to inventory and cost of
1.1 Inventory Costing Methods Under merchandise sold. These are:
Periodic Inventory System  Specific identification
One of the most important decisions in  First-in first-out(FIFO)
accounting for inventory is determining the per  Last-in first-out (LIFO)
unit costs assigned to inventory items. When all  Weighted average
units are purchased at the same unit cost, this Let us see these costing methods under periodic
process is simple since the same unit cost is inventory system based on the following
applied to determine the cost of goods sold and illustration
ending inventory.

The ending inventory consists of 300 units, 100 purchase and continue to the next recent.
from each of the last three purchases. Because the first purchased items (old
purchases) are the first to be sold they are used
1.1.1 Specific Identification Method (included) in the computation of cost of goods
When each item in inventory can be directly sold.
identified with a specific purchase and its
invoice, we can use specific identification (also For example, easily spoiled goods such as fruits,
called specific invoice pricing) to assign costs. vegetables etc., must be sold near the time of
This method is appropriate when the variety of their acquisition. So, the inventory on hand will
merchandise carried in stock is small and the be from the recent purchases. As an example,
volume of sales is relatively small. We can consider the previous illustration.
specifically identify the items sold and the items
on hand. The cost of ending inventory under FIFO
method
= Br. 40 x 240 Br. 9,600
1.1.2 First-in, First-out (FIFO) = Br. 46 x 60 2,760
This method of assigning cost to inventory and 300 units Br. 12,360
the goods sold assumes inventory items are sold
in the order acquired. This means the cost flow Cost of Ending inventory Br. 12,360
is in the order in which the expenditures were Cost of merchandise sold=Br.59,520 –Br.12,360
made. So, to determine the cost of ending Br. 47,160
inventory, we have to start from the most recent
1.1.3 Last-in first-out (LIFO)

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This method of assigning cost assumes that the = Br. 44,640
most recent purchases are sold first. Their costs
are charged to cost of goods sold, and the costs 1.2 Comparison of Inventory Costing
of the earliest purchases are assigned to Methods
inventory. The cost flow is in the reverse order If the cost of units and prices at which they are
in which expenditures were made. sold remains stable, all the four methods yield
In calculating the cost of goods sold, we will the same results. But if prices change, the three
start from the earliest purchases. methods usually yield different amounts for:
- Ending inventory
As an example, take the previous illustration - Cost of merchandise sold
The cost-ending inventory under LIFO method - Gross profit or net income
=Br.60 x 80 = Br. 4,800
In periods of rising (increasing) prices: (or if
=Br. 56 x 220 = 12,320
there is inflationary trend):
300 units
Ending inventory cost = Br. 17,120 FIFO yields – Higher ending inventory
Cost of merchandise sold _ Lower cost of merchandise sold
= Br. 59,520 – Br. 17,120 _ Higher gross profit (net
= Br. 42,400 income)
LIFO yields _ Lower ending inventory
1.1.4 Weighted Average Method _ Higher cost of merchandise
This method of assigning cost requires sold
computing the average cost per unit of _ Lower gross profit (net income)
merchandise available for sale. That means the Weighted average yields the results
cost flow is an average of the expenditures. between the two.
To calculate the cost of ending inventory, we In periods of declining (decreasing) prices:
will calculate first the cost per unit of goods FIFO yields _ Lower ending inventory
available for sale _ Higher cost of merchandise sold
Average cost per unit = Lower gross profit or net
Cost of goods available for sale income
Total units available for sale LIFO yields _ higher ending inventory
_ Lower cost of merchandise sold
_ Higher gross profit or net
Then the weighted average unit cost is
income
multiplied by units on hand at the end of the
Weighted average- between the two
period to calculate the cost of ending inventory.
Also, the same average unit cost is applied in the
computation of cost of goods sold. Section 2: Inventory Costing Methods under
As an example, take the previous illustration Perpetual Inventory System
Under perpetual inventory systems we will
59,520
Weighted average unit cost = Br. apply the inventory costing methods each time
1,200 sale of merchandise is made. We calculate the
= Br. 49.60 cost of goods (merchandises) sold and inventory
Ending inventory cost = Br. 49.60x 300 on hand at the time of each sale. This means the
= Br. 14,880 merchandise inventory account is continually
Cost of merchandise sold = Br. 59,520-Br. updated to reflect purchase and sales.
14,880

2.1 First-in First-out Method (FIFO) Because each withdrawal of goods is from the
The assignment of costs to goods sold and oldest stock on hand. The oldest is the same
inventory using FIFO is the same for both the whether we use periodic inventory system or
perpetual and periodic inventory systems. perpetual inventory system.

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Let us calculate the cost of goods sold and system from the above illustration.
ending inventory under perpetual inventory

2.2 Last-in, First-out Method (LIFO) Let us calculate first the cost of goods sold and
Unlike FIFO method, different results may occur ending inventory for the above illustration under
under periodic and perpetual inventory system. perpetual inventory system. Then, we will see
The most recent purchases change when new the results under periodic inventory system.
purchase occurs.

2.3 Weighted Average Cost Method applied on the sales made after the purchases.
The results may be different under periodic and
Under this method, the average unit cost is
perpetual inventory system.
calculated each time purchased is made to be

UNIT THREE In applying LCM, cost is the acquisition price of

ADDITIONAL VALUATION inventory computed using one of the historical
cost methods - specific identification, FIFO,
PROBLEMS FOR INVENTORIES LIFO, and Weighted average. Where as, market
is defined as the current market value (cost) of
Introduction replacing inventory. It is the current cost of
Section 1: Inventory Valuation: Lower of purchasing the same inventory items in the usual
Cost or Market (LCM) Method manner. It is important to know that market is
not defined as the sales prices.
It was explained how costs are assigned to
A decline in market cost reflects a loss of value
ending inventory and cost of goods sold using
in inventory. This is because the recorded cost of
one of the four costing methods (FIFO, LIFO,
inventory is higher than the current market cost.
Weighted average, or specific identification).
When this occurs, a loss is recognized. This is
Yet, the cost of inventory is not necessarily the
done by recognizing the decline in merchandise
amount always reported on a balance sheet.
inventory from recorded cost to market cost at
Accounting principles require that inventory be
the end of the period.
reported at cost. However sometimes it might be
necessary to value inventories at a value other LCM is applied in one of three ways:
than cost. Especially, when there exists a (1) Separately to individual items
significant difference in historical purchasing (2) To major categories of items
price and current market cost of inventories. (3) To the whole of inventory
One alternative technique of inventory valuation The less similar the items that make up
is based on a comparison of the market value of inventory are, the more likely it is that
inventories against their cost and taking which companies apply LCM to individual items.
ever is lower. Merchandise inventory is then Advances in technology further encourage the
said to be reported on the balance sheet at the individual item application.
lower of cost or market (LCM).
Retail Method of Inventory Costing
As the name implies, this method is mostly used
There are two common techniques of inventory by retail businesses. The estimate is made based
cost estimation; retail method and the gross on the relationship between the cost and the
profit method. First let us first see the retail retail price of merchandises available for sale.
method of inventory cost estimation:

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The steps to be followed to apply this method Usually the gross profit rate is calculated as:
are: Sales  cost of goods sold
1. Calculate the cost to retail ratio=
Sales
Cost of merchandise available for sale The steps to be followed in applying the gross
Re tail Pr ice of merchandise available for sale profit method are:
(1) The gross profit rate is estimated and then
This will tell you the proportion of cost from estimated gross profit is calculated in birr
one birr retail price. value.
Estimated gross profit (in birr) = Gross
2. Calculate the ending inventory at retail profit rate X Sales
price
(2) Cost of merchandise sold is estimated
Ending inventory at retail price = retail
Estimated cost of merchandise sold = Sales -
price of merchandise available for sale
Estimated gross profit
– Sales
3. Calculate the estimated cost of ending (3) Calculate the estimated cost of ending
inventory inventory
Estimated cost of ending inventory = Cost to
retail ratio (calculated in step1) X Ending Estimated cost of ending inventory =
inventory at retail (calculated in step) Cost of merchandise available for sale –
Estimated cost of merchandise sold.
Example
Cost Retail Please recall that cost of merchandises available
Sep. 1, beginning Br. 25,000 Br. 40,000 for sale is the sum of cost of beginning inventory
inventory and net cost of purchases.
Purchases in 125,000 160,000
September (net) UNIT FOUR
Sales in 140,000 ACCOUNTING FOR PLANT
September (net) ASSETS AND DEPRECIATION
1. Cost retail ration = Br. 25,000  Br.125,000
Br. 40,000  Br.160,000 Introduction
= 0.75
This implies that for every one birr retail price 0.75 Section 1: Nature and Meaning of Long-Term
birr or 75 cents is the cost of that inventory. Assets
2. Ending inventory at retail = (Br.40,000 +
Br.160,000) – Br. 140,000 = Br. 60,000 Assets that can be used by a business enterprise
3. Estimated ending inventory at cost = 0.75 X for relatively long period (usually more than one
Br. 60,000 year) are called Long-Term Assets.
= Br. 45,000
Long-term assets are divided into tangible and
Gross Profit Method intangible categories.

Gross profit refers to the amount of income that A. Tangible assets (also called plant assets or
an organization earns from selling of items after fixed assets) are assets with physical
deducting their cost. This method uses an substance that can be charged in the
estimate of the gross profit realized during the operations of business for a relatively
period to estimate the cost of inventory. The longer period of time, usually more than
gross profit rate may be estimated based on the one year or one operating cycle whichever
average of previous period‟s gross profit rates. is longer. Examples are land, buildings,
The gross profit rate will tell you the percentage equipments and machineries, trucks, etc.
or ratio of gross profit from every one birr sales.

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B. Intangible assets are assets without a insurance while in transit and installation are
physical feature that can be charged in the included in the cost of the asset because they are
operations of businesses for long period of necessary if the asset is to function. According
time. They generally consist of rights or to the matching principle, therefore, such costs
advantages held such as goodwill, patents, are allocated to the economic life of the asset
copyrights, franchise, trade marks, rather than charged as expenses in the current
organization costs, etc. period.

1.1 Determination of the Acquisition Cost 1.1.1 Cost of Land

of Plant Assets The acquisition cost of land includes the
negotiated cash price plus other costs such as the
The acquisition cost of plant (fixed) assets is the cost of land surveys, legal fees, title fees,
cash or cash-equivalent purchase price, broker‟s commissions, cost of preparing the land
including incidental costs required to complete to build on, and even the demolition costs of old
the purchase, to transport the asset, and to structures that might be torn down to get the
prepare it for use. In general all costs that are land ready for its intended use.
necessary and relevant to make the asset ready
Under the historical cost assumption, land is
for its intended purpose is included as the cost of
reported in the balance sheet at its original cost.
the plant asset.
Land is not subjected to loss in value because
For example, expenditures related to the land does not have a limited useful life.
acquisition of a plant asset such as freight,

Generally, land is part of property, plant and  part of the overhead and other indirect costs
equipment. If the major purpose of acquiring  engineers and architects‟ fees
and holding land is speculative, it is more  insurance during construction
appropriately classified as an investment.  interest incurred on construction loans during
the period of construction
If the land is held on a real estate concern for  lawyers' fees,
resale, it should be classified as inventory. When  building permits, etc..
the land has been purchased for the purpose of If outside contractors are used in the construction,
constructing a building, all costs incurred up to the net contract price plus other expenditures
the excavation for the new building are necessary to put the building in usable condition
considered land costs. are included.
1.1.3 Cost of Equipment
Removal of old buildings clearing, grading and The term “equipment” in accounting includes
filling are considered land costs because these office equipment, store equipment, factory
costs are necessary to get the land in condition equipment, delivery equipment, machinery,
for its intended purpose. Any proceeds obtained furniture and fixtures, and similar fixed assets.
in the process of getting the land ready for its The cost of such assets includes the invoice
intended use, such as salvage receipts on the (purchase) price, transportation and handling
demolition of an old building are treated as charges, insurance on the equipment while in
reductions in the price of the land. transit, assembling and installation costs, and
1.1.2 Cost of Buildings costs of conducting trail runs. As indicated
When an existing building is purchased its cost earlier, all costs of getting an asset ready for its
includes, the purchase price plus all repairs and intended use are costs of that asset.
other expenses required to put it in a usable
conditions. On the other hand, when a business 1.2 Nature and Meaning of Depreciation
constructs a new building, the cost includes all
reasonable and necessary expenditures, such as: As plant assets are used in the operations of a
 Materials business, their value to provide service decreases
 Labor through usage and the passage of time.

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This cost allocation of plant asset, called Estimated economic (useful) life- the estimated
depreciation, is recorded in the accounting economic life of an asset is the total number of
books periodically. service units expected from the asset. Service
units may be measured in terms of years the
Depreciation is frequently misunderstood. The asset is expected to be used, units expected to be
term depreciation, as used in accounting, does produced, miles or kilometers expected to be
not refer to the physical deterioration of an asset driven, or similar measures.
or the decrease in market value of an asset
overtime. In determining the estimated useful life of an
asset, the accountant should consider all relevant
Depreciation means the allocation of the cost of information, including (1) past experience with
a plant asset to the periods that benefit from the similar repair assets, (2) the asset‟s present
services of the asset. condition, (3) the company‟s repairs and
maintenance policy, (4) current technological
The term depreciation is used to describe the and industry trends, and (5) local conditions
gradual conversion of the cost of the asset into such as whether.
an expense.
Section2: Methods of Computing
Depreciation is not a process of valuation. Depreciation
Accounting records are kept in accordance with
the cost principle; they are not indicators of Depreciation methods differ primarily in the
changing price levels. amount of cost allocated to each period. A list of
depreciation amounts for each year of an asset‟s
1.2.1 Factors that Affect the useful life is called depreciation schedule.
Computation of Depreciation
Four factors affect the computation of The most common methods of computing
depreciation. They are: depreciation for plant assets are:
(1) Cost of the plant asset; (1) The straight line method
(2) Residual/salvage value of the plant (2) The units of production method
asset; (3) The double-declining balance method,
(3) Depreciable cost; and and
(4) Estimated economic (useful) life of the (4) The sum-of- the years-digits method.
plant asset.
2.1 Straight-Line Depreciation
Cost- is the net purchase price plus all When this method is used to allocate
reasonable and necessary expenditures to get the depreciation, the depreciable cost of the asset is
asset in place and ready for use. This cost spread evenly (uniformly) over the useful life of
includes all items that we have discussed in the an asset. The straight-line method is based on
above sub-section 1.1. for the respective plant the assumption that depreciation depends only
assets. on the passage of time.
Residual value- also known as salvage value, The depreciation expense for each period is
disposal value, scrape value, or trade-in value computed by dividing the depreciable cost by
represents the estimated market value of the the number of accounting periods in the asset‟s
asset at the time of its retirement. estimated useful life. The depreciation expense
Depreciable cost – represents the difference to be reported is the same in each year. The
between the asset cost and its estimated residual following illustration will help us to understand
value. For example, an item of equipment that the Straight-Line method of computing
costs Br. 25,000 and has a residual value of Br. depreciation.
4,000 would have a depreciable cost of Br.
21,000, (Br. 25,000 – Br. 4,000). The
depreciable costs must be allocated over the
estimated economic life of the asset.

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 DREAMLAND COLLEGE

2.2 Units of Production Method hours, the depreciation cost per hour would be
The production method of depreciation is based determined as follows:
on the assumption that depreciation is mainly the
result of use and that the passage of time plays
no role in the depreciation process. If we assume
that the office equipment from the previous
illustration has an estimated useful life of 10,000

Under the production method, there is a direct The declining-balance method is the most
relation between the amounts of depreciation common accelerated method of depreciation.
each year and the units of output or use. Also, Under this method depreciation is computed by
the accumulated depreciation increases each applying a fixed rate to the book value of the
year indirect relation to units of output or use. asset, resulting in higher depreciation charges
Finally, the carrying amount decreases each year during the early years of the asset‟s life. Though
in direct relation to units of output or use until it any fixed rate might be used under the method,
reaches the estimated residual value. the most common rate is a percentage equal to
twice the straight-line percentage. When twice
Under the production method, the units of output the straight-line rate is used, the method is
is used to measure estimated useful life for some usually called the double-declining balance
assets. For example, for one machine number of method.
units produced may be an appropriate measure,
for another number of hours may be a better Referring to the previous example, the
measure. The production method should be used equipment had an estimated useful life of four
only when the output of an asset over its useful years. Consequently, under the straight-line
life can be estimated with reasonable accuracy. method, the depreciation rate for each year was
25 percent, (¼ years).
2.3 Declining Balance Method
This method of depreciation results in relatively Therefore, under the double-declining balance
large amount of depreciation in the early years method, the fixed rate is 50 percent (2X 25
of an asset life and smaller amounts in later percent). This fixed rate of 50 percent is applied
years. This method is based on the assumption to the remaining carrying book value at the end
of the passage of time. Since most kinds of plant of each year. Estimated residual value is not
assets are most efficient when new, and so they taken into account in computing depreciation
provide more and better service in the early except in the last year of an asset‟s useful life,
years of useful life. It is consistent with the when depreciation is limited to the amount
matching rule to allocate more depreciation to necessary to bring the carrying value down to
the early years than to later years if the benefits the estimated residual value. The depreciation
or services received in the early years are schedule for this method is as follows:
greater.

of the asset's life and a decline depreciation

2.4 The Sum of the Years Digits expense thereafter this is because a successively
Method smaller fraction is applied each year to the
Like the declining balance method, the sum of depreciable cost of the asset.
the years digits method is an accelerated method
of depreciation. It provides a higher amount of Under this method, first we must determine the
periodic depreciation expense in the earlier use denominator of the fraction, which is the sum of

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 DREAMLAND COLLEGE
the digits representing the years of life. While equal to the salvage value. For example, for a
computing depreciation, the denominator of the plant asset with an estimated life of 4 years, the
fraction is unchanged and would remain the denominator of the fraction is 4+3+2+1 = 10.
same. On the other hand the numerator of the The depreciation schedule for this method is as
fraction, decreases year by year follows:
(4/10,3/10/2/10/1/10). At the end of the asset‟s
useful life, the balance remaining should be

asset does not coincide with the beginning of a

NB. The above illustration for the sum of year‟s fiscal year, it is necessary to allocate each full
digit method is based on the assumption that the year‟s depreciation b/n the two fiscal years
first use of the asset coincide with the beginning benefited.
of the fiscal period. When the first use of the

2.5 Comparison of Depreciation Methods and a gradually declining periodic expense

thereafter.
The straight-line depreciation provides a The main justification for this approach is that
uniform or equal depreciation charges to more depreciation should be charged in earlier
expense throughout the service life of the asset. years because the asset suffers its greatest loss of
services in those years.
The production method of depreciation provides
Accelerated depreciation method also recognizes
for periodic charges to depreciation expense that
that changing technologies make some
may vary considerably, depending upon the
equipment lose their capacity to yield services
amount of usage of the asset. The production
rapidly. Thus, it is appropriate to allocate more
method does not generate a regular pattern
to depreciation in the early years, than in later
because of the random fluctuation of the
years.
deprecation from year to year.
Another argument in favor of an accelerated
The major limitation of the production method is
method is that repair (maintenance) expense is
that it is not appropriate in situation in which
likely to be greater in later years than in early
depreciation is a function of time instead of
years. Thus, the reduced amounts of
activity. Another problem in using the
depreciation reported in later years of the asset‟s
production method is that an estimate of units of
life are offset to some extent by increased repair
output or service hours received is often difficult
(maintenance) expense.
to determine.
A visual comparison may provide a better
Both the declining balance and the sum of the
understanding of the three-depreciation methods
years digits methods are referred to as
described above. Figure 4-1 compares the yearly
accelerated depreciation methods, because they
depreciation under the four methods.
provides (report) relatively higher depreciation
expense in the earlier uses of the life of the asset

In the above graph that shows yearly The production method does not generate a
depreciation, straight-line depreciation is regular pattern because of the random
uniform at Birr 1375 per year over the four years fluctuation of the depreciation from year to year.
period. However, the declining balance method In general companies use different methods of
begins at an amount greater than straight line deprecation for goods reason. The straight-line
(Br.3000) and decreases each year to amounts method can be advantageous for financial
that are less than straight line (ultimately, Br. reporting because it can produce the highest net
250). income, and the accelerated depreciation method

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 DREAMLAND COLLEGE
can be beneficial for tax purposes because it can expense is debited and the part of the entry that
result in lower income taxes. records the decrease in the plant asset is credited to
a contra asset account entitled Accumulated
2.6 Recording Depreciation Depreciation or Allowance for Depreciation. The
The amount by which a fixed asset decreases is an use of this contra asset account permits the original
expense of the business. The amount of
depreciation expense should be recorded each 3.1.1 Revision of Depreciation Rates
fiscal period. If depreciation expense is not
recorded, the income statement will not contain all 3.1.2 Revision of Depreciation Rates
the expenses of the business. This will cause the
net income to be reported higher than it should be. cost to remain unchanged in the plant asset
Income tax laws allow a business to deduct account. This facilitates the computation of
depreciation as an expense in determining net periodic depreciation, the listing of both cost and
income. If depreciation expenses are not included accumulated depreciation on the balance sheet, and
on the income tax reports, the business will pay reporting required for property and income tax
more income taxes than it should be. purposes.
Depreciation may be recorded by an entry at the NB. An exception to the general procedure of
end of each month, or the adjustment may be recording depreciation monthly or annually is often
delayed until the end of the year. made when a plant asset is sold, traded-in, or
discarded.
To record the periodic cost expiration (allocation)
of plant asset, the expense account, depreciation
Section 3: Other Topics in Depreciations The group method is frequently used when the
assets are fairly homogeneous and have
3.2 Special Depreciation Methods approximately the same useful lives. The group
Some times each of the four depreciation method more closely approximates a single-unit
methods discussed so far may not be suitable cost procedure because the dispersion from the
because the assets involved have unique average is not as great.
characteristics, or the nature of the industry
requires that a special depreciation method be Composite-rate depreciation - the term
use of these methods, the group and composite “composite” refers to collection of assets that are
methods are discussed below: not similar (or dissimilar) in nature.

3.2.1 Group and Composite Methods The composite method is used when the assets
are heterogeneous and have different lives.
Depreciation methods are usually applied to a
single asset. Under some circumstances, When depreciation is computed on the basis of a
however, a number (group) of asset accounts are composite group of assets of differing life spans,
depreciated using one rate. For example, an a rate based on averages must be developed.
enterprise such as Ethiopian Telecommunication This is done by (1) computing the annual
Corp. might depreciate telephone poles, depreciation for each asset, (2) determining the
microwave systems, or switchboards by groups. annual depreciation, and (3) dividing the sum
thus determined by the total cost of the assets
Group depreciation - the term “group” refers to
a collection of assets that are similar in nature.

3.2.2 Depreciation of Partial Years accounting period. However, business does not
So far, the illustrations of the depreciation often buy assets exactly at the beginning or end
methods have assumed that the plant assets were of the accounting period. In most cases, they
purchased at the beginning or end of the acquire the assets when they are needed and sell

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 DREAMLAND COLLEGE
or discard them when they are no longer useful It is a bare fact that in nature plant assets are
or needed. The time of year is normally not a expected and most of the time actually stays in
factor in the decision. Thus, it is often necessary operation for longer period of time. Therefore, it
to calculate depreciation for partial years. is customary in business world that additional
outlays will be made on them in order to rape
Assume that a piece of equipment is purchased
the best benefit out of them. In accounting these
for Br. 5000 and that it has an estimated useful
subsequent costs incurred on plant assets are
life of five years, and an estimated residual value
categorized in to two major categories, based on
of Br. 500. Assume further that the equipment is
the benefit we expect from those outlays.
purchased on October 2 and that the yearly
accounting period ends on December 31.
A. Capital Expenditures- are expenditures that
Depreciation must be recorded for three months,
improve the operating efficiency (or capacity) or
October through December, or 3/12 of a year.
costs incurred to achieve greater future benefits.
This factor is applied to the calculated
depreciation for the entire year. The three In addition to the acquisition of plant assets,
months‟ depreciation under the straight-line capital expenditures included additions and
method is calculated as follows: betterments.
Solution: An addition is an enlargement to the physical
Annual depreciation = layout of a plant asset. Suppose for example, if a
Original cost - Estimated Salvage value new wing is added to a building, the benefits
Estimated useful life from the expenditure will be received over
Br. 5000  Br.500 several years, and the amount paid for it should
= be debited to the asset account.
5 years
= Birr 900 A betterment, on the other hand, is an
Depreciation for partial year (Oct – Dec. 31) is improvement that does not add to the physical
therefore, Br. 900 x 3/12 = Br. 225 layout of the asset. Installation of an air
conditioning system is an example of
If the company used the double declining betterment, Replacement of a concrete floor for
balance method on the above equipment, the a wooden floor is also betterment that will
depreciation on the asset would be: Br. 5000 x provide benefits over a number of years, so its
40/100 x 3/12, = Br. 500, depr. For three cost should be charged (debited) to an asset
months. account.
If the company used the sum-of-years-digits Another types of capital expenditures include
method, the depreciation on the asset would be: extraordinary repairs. Extraordinary repairs
are repairs of amore significant nature. They
Birr (5000 – 500) x 5/15 x 3/12 = Birr 375, and affect the estimated residual value or estimated
the depreciation for the second year would be: useful life of an asset. For example, a boiler for
(5000 – 500) x 5/15 x 9/12 =Br. 1125 heating a building may be given a complete
(5000 – 500) x 4/15 x 3/12 = 300 overhaul, at a cost of Br. 3000 that will prolong
Therefore, total 2nd year depreciation Br. 1425 its economic life by 5 years.
NB. In this specific example depreciation was Extraordinary repairs are recorded by debiting
recorded from the beginning of October. If the the accumulated depreciation account, under the
equipment had been purchased on October 16, assumption that some of the depreciation
or thereafter, depreciation would be calculated previously recorded has now been eliminated.
beginning November 1, as if the equipment were The effect of this reduction in the accumulated
purchased on that date. depreciation account is to increase the book
3.2.3 Capital and Revenue Expenditures value of the asset by the cost of the
extraordinary repair. As a result, the new book
value of the asset should be depreciated over the
new estimated useful life.
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B. Revenue expenditures A plant asset rarely lasts exactly as long as its

Revenue expenditures are expenditures incurred estimated life. If it lasts longer than its estimated
in order to maintain the normal operating life, it is not depreciated past the point at which
efficiency of the asset. its carrying value equals its residual value. The
purpose of depreciation is to spread the
Among the more usual kinds of revenue depreciable cost of the asset over the economic
expenditures for plant asset are the repairs, life of the asset. Thus, the total accumulated
maintenance, lubrication, Cleaning and depreciation should never exceed the total
inspection necessary to keep an asset in good depreciable cost. If the asset is still used in the
working condition. business beyond the end of its estimated life, its
Ordinary repairs are expenditures that are cost and accumulated depreciation remain in the
necessary to keep an asset in good operating ledger accounts.
conditions. Trucks must have tune-ups, their Proper records will thus be available for
tires and batteries must be replaced regularly, maintaining control over plant assets. If the
and other routine repairs must be made. Offices residual value is zero, the book value of a fully
and halls must be painted regularly, and broken depreciated asset is zero until the asset is
tiles or woodwork must be replaced. Such disposed off. If such an asset is discarded, no
repairs benefits only the current period and gain or loss results. A plant asset may be
therefore must be charged against the revenue in disposed by:
the current fiscal period. (1) Discarding it as worthless;
(2) Selling it; or
(3) Trading it in with a new asset.
UNIT FIVE
DISPOSAL OF PLANT ASSETS 1.1 Recording Discarding of a Plant
Asset
Introduction
If a plant asset is of no further use to the
Plant assets, such as equipment, delivery trucks, business and cannot be sold or traded, then the
or machineries cannot be used forever. The plant asset is discarded. If the asset has no book
assets may wear out or the business may replace value. (i.e., if it is fully depreciated), the plant
them with newer model. When a plant asset is asset account is credited for the amount of the
no longer useful to a business the asset may be original cost of the item being discarded. At the
disposed of either through discarding, sale, or same time, the accumulated depreciation
traded-in with similar) or dissimilar) assets. account is debited for the amount of the total
accumulated depreciation of the item being
Section 1: Disposals of Plant Assets discarded. In this case neither gain nor loss is
realized. On the other hand, if a plant asset has a
Overview book value (if not fully depreciated) at the time
it is discarded, the business incurs a loss.

1.2 Recording the Sale of Plant Asset equipment under three assumptions about the
The entry to record the sale of an asset for cash selling price. In the first case, the Br. 2000 cash
is similar to the one illustrated above except that received is exactly equal to the book value of the
the receipt of cash should also be recorded. The equipment (which is equal to Br. 2000).
following entries show how to record the sale of

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 Depreciation, Equip……...9000.00
Equipment ………………………………..11000.00

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 DREAMLAND COLLEGE
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 of equipment………………….500.00
Accumulated Depreciation……………………… 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 of Br. 1000, cash received through
Sale less book value of the asset (Br. 3000 – Br. 2000)
Year 5
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

1.3 Recording Exchange of Plant Assets received is greater than the carrying book value
Businesses also dispose of plant assets by trading of the assets surrendered, there has been a gain.
them in on the purchase of other plant assets. If the trade-in allowance is less than the
Exchanges may involve similar assets, such as an carrying value, there has been a loss.
old machine traded-in on a newer model, or
dissimilar assets, such as a machine traded-in on a Trade in allowance is a consideration or birr
truck. In either case, the purchase price is reduced value given to the old plant assets.
by the amount of the trade-in allowance.
There are special rules for recognizing these
The basic accounting for exchanges of plant
gains and losses, depending on the nature of the
assets is similar to accounting for sales of plant
assets exchanged.
assets for cash. If the trade-in allowance

Exchange Losses Gains

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

Both Gains and Losses are recognized when a

company exchanges dissimilar assets. Assets are When a company trades-in an older machine on
dissimilar when they perform different a newer machine of the same type, the economic
functions; assets are similar when they perform substance of the transaction is the same as that
the same function. of a major renovation and upgrading of the older
machine.
For financials reporting purposes, gains on
exchanges of similar assets are not recognized Accounting for exchange of similar assets is
because the earning lives of the asset complicated by the fact that neither gains nor
surrendered are not considered to be completed. losses are recognized for income tax purposes.

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1.3.1 Loss Recognized on the Exchange To illustrate the recognition of a loss, assume
A loss is recognized for financial reporting that the business exchange a machine with a cost
purposes on all exchange in which a material of Br. 11,000, and accumulated depreciation of
loss occurs. Br. 9000 for a newer more modern machine on
the following terms:

Price Cost of new machine …………………Birr 12000

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

Solution Br. 500, (Br. 2000–Br. 1500). Therefore, the

journal entry required to record the exchange of
In the illustration above, the trade-in allowance assets would be as follows:
(1500) is less than the carrying value (Br. 2000)
of the old machine. The loss on the exchange is

Year 5.
July 5. Equipment (New)……………………..120,00.00
Accum. Depreciation-Equip…………………...9,000.00
Loss on Exchange of plant assets………………. 500.00
Equipment (old)……………………………………11,000.00
Cash…………………………….…………………. 10,500.00
500 was recognized. If the transaction is for
1.3.2 Loss Not Recognized on the similar assets and is to be recorded for income
Exchange tax purpose, the loss should not be recognized.
As it was discussed in subsection 1.3 for tax In this case, the cost basis of the new asset will
purpose neither the gain nor the loss from reflect the effect of the unrecorded loss. The cost
exchange of plant assets is recognized. In the basis for the new asset, therefore, is computed
previous illustration, in which a loss was by adding the cash payment to the carrying
recognized, the new asset was recorded at the value of the old asset:
purchase price of Br. 12000 and a loss of Br.

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

Cash paid (Boot given)………………………………………… 10,500.00
Cost-basis of new Equipment ……………………………… Birr12,500.00
Note that no loss is recognized in the entry to record this transaction.
Year 5.
July 5. Equipment (New)……………………………….12,500.00
Accumulated Depreciation……………………… 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.

NB. The new equipment is recorded (reported) postponement of the loss. Since depreciation of
at a purchase price of Br. 12000 plus the the new equipment will be computed based on a
unrecognized loss of Br. 500. the post cost of Br. 12500 instead of Br. 12000, the

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 DREAMLAND COLLEGE
“unrecognized” loss results in more depreciation exchanged. To illustrate the recognition of a
each year on a new equipment than the loss had gain, assume the following terms in which the
been recognized. machines being exchanged serve different
1.3.3 Gain Recognized on the Exchange functions:
Gains on exchanges are recognized for financial
reporting purposes when dissimilar assets are

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 allowance (Br. 3000) exceeds the fair mark value of the old machine.
the carrying value (Br. 2000) of the old machine Assuming that this condition is true, the entry to
by Br. 1000. thus, there is a gain on the record the transaction is as follows:
exchange, if the trade-in allowance represents
Years 5
July 5. Equipment (New)……………………………12,000
Accumulated Depreciation…………………….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.

1.3.4 Gain Not Recognized on the equipment must indicate the effect of the
Exchange: unrecorded gain. This cost basis is computed by
A gain on an exchange should not be recognized adding the cash payment to the carrying value of
in the accounting records if the assets perform the old asset:
similar functions. The cost basis for the new

Carrying value of 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 transaction is as follows:
Year 5
July 5. Equipment (New)……………………………..11,000.00
Accumulated Depreciation…………………… 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 recognition of losses, the no recognition of the gain on exchanges is, in effect, a
postponement of the gain. Since depreciation 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.

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Section 2: Accounting for Intangible Assets and Natural Resources

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

Intangible assets include patents, copyrights, trademarks, franchises, organization costs, leaseholds,
leasehold improvements, and goodwill. The allocation of intangible assets to the periods they benefits is
called amortization.
Intangible assets are accounted for at acquisition 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 from another party at a price established in the market place.
The, Accounting Principles Board (APB) has decided that a company should record as assets the costs of
Intangible assets acquired from 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 amortization 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 amortized over a reasonable length of time (not to exceed forty years).
Assume that on Jan 2, 2002 Coca Cola Soft Drink Bottling company purchased a patent on a unique
bottle cap for Br. 54,000.
The entry to record the patent would be as follows:
2002
Jan 2. Patent……………..54,000
Cash………………………..54,000
To record the purchase of Bottle cap patent
Assume that Coca Cola‟s management determines that, although the patent for the bottle cap will last for
seventeen years, the product using the cap will be sold only for the next six years. The entry to record the
annual amortization would be as follows:
Amortization 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 amortization expense. This is in
contrast to other long-term asset accounts in which depreciation or depletion is accumulated in a separate
contra account.
If the patent becomes worthless before it is fully amortized, the remaining carrying value is written off as
a loss. For instance, assume that after the first two years Coca Cola soft Drink Bottling Company‟s chief
competitor‟s offers a bottle with a new type of cap that makes Coca Cola‟s cap obsolete. The entry to
record the loss is:
Loss on patent…………36,000.00
Patent…………………………36,000.00
To record the loss resulting from patents becoming worthless.
2.1 Natural Resources
Depletion is the accounting measure used to allocate the acquisition cost of natural resources. Depletion
differs from depreciation because depletion focuses specifically on the physical use and exhaustion of the

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 DREAMLAND COLLEGE
natural resources, while depreciation focuses more broadly on any reduction of the economic value of a
plant or fixed asset. The costs of natural resources are usually classified as long-terms assets.
Depletion expense is the measure of that portion of long-term assets that is used up in a particular period.
The depletion rate established is computed in the following manner.
Total cost Salvage value
=Depletion cost per unit.
Total estimated units available

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 DREAMLAND COLLEGE
5. Gross Earnings: is the total amount of income
earned by an individual or a company.
UNIT SIX
ACCOUNTING SYSTEMS FOR 6. Payroll Deductions: are deductions from the
PAYROLL AND PAYROLL TAXES gross earnings of an employee such as
employment income taxes & labor union, etc.
Section 1: Importance of Payroll Accounting
7. Net Pay: Net Pay is the earning of an employee
Accounting systems for payroll and payroll taxes after all deductions have been made.
are concerned with the records and reports
associated with the employer-employee Net Pay = Gross Earning - Total Deductions
relationship. Employees of an organization are
entitled to receive their remuneration on time.
8. Pay Check: A business can pay payroll by
Appropriate payroll accounting summarized as:
writing a check or it will be paid in cash at the
organization for each employee or using bank.
1. Payroll often represents the largest expense
that a company incurs;
2. Both federal and state governments require 1.2 Basic Components of a Payroll Register
that detailed payroll records be kept; and 1. Employee Number
3. Employees are sensitive to payroll errors or
Number assigned to employees for identification
irregularities or timely payments. purpose when a relatively large number of
1.1 Definition of Payroll Related Terms employees are involved in a payroll register.
Payroll accounting involves so many generally 2. Name of Employees
accepted and standardized terms. The following are A complete record of employee should include both
the most common terms used in payroll accounting: the name and ID No. of the employee.
3. Earnings
Money earned by an employee from various
1. Salary and Wages: The term wages is used to
sources. This may include.
refer payments to unskilled-manual labor. On
a. Basic Salary- Monthly salary of an employee.
the other hand, salaries refers to payments to
b. Allowances- money paid monthly to an
skilled labor on a monthly or yearly basis.
employee for special reasons, like:
2. The Pay Period: Refers to the length of time -Position allowance- For assuming responsibility.
covered by each payroll payment. -Housing allowance- Monthly housing allowance
-Hardship allowance- To compensate for an
3. The Pay Day: The pay day- is the day on which inconvenient circumstance
wages or salaries are paid to employees. -Desert allowance- For assignment in hot region.
-Transportation (fuel) allowance- To cover cost of
4. A Payroll Register (sheet): is the list of transportation up to the workplace.
employees of a business along with each c. Overtime Earning: for work performed by an
employee‟s gross earnings; deductions and net employee beyond the regular working hours.
pay for a particular pay period.
Income tax proclamation has discussed the
Sources of input for payroll register is the following about how overtime work should be paid
following: to the employee:
 Attendance sheets: is where employees sign i. 1.25 times ordinary hourly rate for extra
at the time of arrival and exit from office. work done before 4 o‟clock in the evening.
 Punched (clock) cards; is an electronically ii. 1.5 times ordinary hourly rate for extra
recorded card used for attendance work done from 4 o‟clock to 12 o‟clock in
recording. Manufacturing plant uses it. the morning.
 Time cards: Similar to punched card except iii. 2 times the ordinary hourly rate for extra
that the time is manually written in hand work done on weekly rest days.
written format by the employee.

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 DREAMLAND COLLEGE
iv. 2.5 times the ordinary hourly rate for
overtime work performed on a public a. Employment Income Tax: Almost in every
holiday. country citizens are required to pay employee
tax to the government. In Ethiopia also, income
Gross Earning = Basic Salary + Allowances +
tax is required to be paid as per schedule A of
Overtime Earning
the income tax proclamation.

4. Deductions: are subtractions made from The tax rates under schedule A are Presented
the earnings of employees required by the below:
law or by the employee. Listed below is the
most common deductions from employee‟s
earning:

Table 1.1: Personal Income Tax Schedule

Employment Income Difference Income

(per month) Tax rate

Over Birr To Birr

0 150 150 Exempt (Free from Tax)
151 650 500 10%
651 1400 750 15%
1401 2350 950 20%
2351 3550 1,200 25%
3551 5000 1,450 30%
Over 5,000 35%
Taxable income includes any payment or gains Practically all incomes of an individual may not
in cash or in kind received from employment by be taxable. Income tax Proclamation designates
an individual, including income from former the following category of income as non-
employment. Listed below is short cut procedure taxable:
to calculate monthly income tax of employees. 1. Income from employment received by
casual employees: do not work for more
Table 1.2: Short-cut to Personal Income Tax than one month for the same employer in
Calculation any twelve months period.
Employment Income Income 2. Pension contribution, provident fund and
(per month) Tax Payable all forms of retirement benefits contributed
Over Birr To Birr by employers not exceed 15% of the
0 150 No tax monthly salary of the employee.
151 650 (10% X TI) – 15 3. Payments made to an employee as a
651 1400 (15% X TI) – 47.5 compensation or gratitude in relation to
1401 2350 (20% X TI) – 117.5 (personal injuries & the death of another
2351 3550 (25% X TI) – 235 person)
3551 5000 (30% X TI) – 412.5 In order to facilitate the tax determination
> 5,000 (35% X TI) – 662.5 process, The Council Of Ministers has issued
regulation to the income tax proclamation and
TI = Taxable income of employees. further exempts the following:
15 = (150  0.1) – 0 1. Amounts paid for medical treatment
2. Transportation allowance.
47.5 = [(150  .15) – 0] + [(500  0.15) – (500  3. Hardship allowance
0.1)] and so forth 4. Reimbursement of traveling expenses
b. Pension Contribution
Fundamental of Accounting II 0982 68 68 68 / 0983 68 68 68 Page 24
 DREAMLAND COLLEGE
Employer and employee expected to contribute 3. Totaling and proving the payroll register -
for the employee pension for permanent The grand total, the sum of total deductions
employees with 4% and 6% of the basic salary and net pay should be equal.
to benefit when employees are retired.
Business and (NGO‟s have a provident fund on 4. The accuracy and authenticity of the
which both the employer and the employee information - summarized in the payroll
contribute monthly. When an employee retains should be verified by a different person.
or leaves employment, a lump sum amount is
paid. 5. The payroll - should be approved by
authorized personnel (individual).
c. Other Deductions
Apart from the above two kinds of deductions, 6. Paying the payroll: finally the payment
employees may individually authorize additional should be made either in cash or by writing
deductions. a check or via Bank.

5. Net Pay 7. The payment of the payroll and income

Net pay represents the excess of gross earnings taxes - withheld from employees should be
over total deductions of an employee. recorded in a journal entry form by the
employer as an agent of the government to
Section 2: Major Activities Involved in
collect the tax and submit to the tax
Accounting for Payroll
authority.
The following activities are the most common
objectives of the payroll accounting process: Illustration on a Payroll Register
1. Gathering the necessary data - Relevant Praise is a government agency recently
information about every employee should be organized to rehabilitate street children. It has
gathered. five employees whose salaries are paid
2. Entering the names of employees according to the Ethiopian calendar month. The
following data relates to the month of Yekatit,
1995.

Serial No. Name of Basic Transp. Overtime Duration of OT

Employee Salary Allowance worked(hr) Work
01 Debabe Shewa Br. 730 200 4 6:00-10:00 P.M
02 Yohannes Chala 1020 ___ 8 Sunday(8:30-5:30)
03 Kedir Modesir 5300 ___ ___ ___
04 Elsa Belay 1470 ___ ___ ___
05 Debela Olango 950 ___ 6 Public Holiday

Additional Information
- The management of the agency usually expects a worker to work 40 hours in a week and during
Yekatit there are four weeks.
- There were no absentees during the month
- All employees are permanent except Elsa and Debela
- Yohannes agreed to contribute monthly Br. 300 from his salary as a monthly saving in the credit
association of the agency.
Required
1. Prepare a payroll register (sheet) for the agency for the month of Yekatit, 1995.
2. Record the payment of salary as of yekatit 30 ,1995 using check stub No. 0123.
3. Record the payment of the claim of the credit Association of their agency on Megabit 1, 1995 use
check stub No. 0124.
4. Record the payment of the withholding taxes and pension contribution to the concerned
government body on Megabit 7,1995.
5. Compute and recognize the total payroll tax expense for the month of Yekatit, 1995.

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 DREAMLAND COLLEGE

Computation of Earnings, Deductions and Net Pay

Gross Earnings = Basic salary + Allowance + Overtime Earning

Overtime Earning
Overtime earning = OT hrs worked X (ordinary hourly rate X relevant OT rate)
1. Debabe:
 Br.730 
-OT = 4 hours   1.25 = Br. 22.81
160 hours 
NB Every employee is expected to work 160 hours per month (i.e. 40 hours x 4 weeks)

-You should compute the regular hourly rate (RHR) first:

Monthly salary (Basic Salary)
RHR =
Total Hours worked in the Month
Br . 730
=
160 hours
-Therefore, the regular Hourly payment = br. 4.56

-The regular hourly payment must be multiplied by the appropriate OT rate as follows: Br. (4.56  1.25)  4
hours-------br. 22.81

2. Yohannes
Br .1020
-OT Earning = 8hrs 2 =Br. 102.00
160 hours
3. Debela
Br . 950
-OT Earnings = 6hrs  2.5=br. 89.06
160 hours
The payroll register (or sheet) for Praise Rehabilitation Agency prepared for the Month of Yekatit, 1995 is shown
below.
Name of the Organization
Payroll Register (sheet)
For the month of Yekatit, 1995
No. Name of Earnings Deductions
Employee Basic Allo- Over Gross Income Pension Other Total Net Sign.
salary wance Time Earning Tax Contr. Deduc. Deduc. Pay
01 Debabe Abebe 730 200 22.81 952.81 65.42 29.2 ___ 94.62 858.19
02 Yohannes Derbie 1020 ___ 102 1122 120.8 40.8 300 461.6 660.4
03 Kedir Shifa 5300 ___ ___ 5300 1192.5 212 ___ 1404.5 3895.5
04 Elsa Gebray 1470 ___ ___ 1470 176.5 ___ ___ 176.5 1293.5
05 Debela Dingamo 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

____________ _______________ _______________

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 DREAMLAND COLLEGE
The going concern concept assumes that the
business enterprise continues its operations (at
UNIT SEVEN profit) for indefinite period of time. A business
ACCOUNTING CONCEPTS AND enterprise purchases and holds assets for use in
its operations
PRINCIPLES
1.3 (Historical) Cost Principle
Introduction All goods and services purchased are recorded at
Section 1: Historical Development of cost, where costs are measured on a cash or
Accounting Concepts and Principles equivalent basis. If the consideration given for
an asset or service is cash, cost is measured at
In the earlier periods, a business enterprise was the entire cash outlay made to secure the asset or
very often managed by its owner, and the the service. If a business paid Birr 15,000 for
accounting records and reports were used mainly land to be used in business operation, the land
by the owner – manager in conducting the should be recorded at a cost of Birr 15,000.
business. Bankers and other lenders often relied Journal entry would be recorded in the buyer‟s
on their personal relationship with the owner book as follows: Land-----------------15,000
rather than on financial statements as the basis Cash---------------15,000
for making loans for business purposes.
1.4 Objectivity Principle
As business organizations grew in size and Entries in the accounting records and data
complexity, “management” and “outsiders” reported on financial statements be based on
became more clearly differentiated. objectively determined evidences which can be
verified. This evidence is not always
The preparation of financial statements became conclusively objective, for there are many cases
more and more complex. With these, the need in accounting in which judgments, estimates,
for guiding concepts and principles for fianncial and other subjective factors must be taken into
statements has came into existence. account.
Accounting concepts and principles include
conventions, axioms, standards, rules, guidelines 1.5 Stable Monetary Unit Concept /Unit
and procedures that are necessary to have of measurement
accounting practice at a particular period of Accounting transactions are measured, recorded
time. and reported in terms of monetary unit.
Responsibility for the development of
accounting principles has rested primarily on The generally accepted use of the monetary unit
practicing accountants and accounting educators. for accounting for and reporting the activities of
an enterprise has got two major limitations:
Section 2: Generally Accepted Accounting
Principles (GAAP) First, it limits the scope of accounting reports.
The scope of the report will be on information
1.1 Business Entity Concept which can be quantifiable and measurable in
The business entity concept assumes that a terms of monetary unit. Secondly, as it is stated
business enterprise is separate and distinct from above, any monetary unit in the world is not
the persons who supply its partial or all assets stable due to economic changes.
and from every other business regardless of legal
entity concept. 1.6 The Periodicity Concept /Accounting
period Concept/
The accounting equation, Assets = Liabilities + A complete and accurate, picture of an
Owners equity, is an expression of the entity enterprise‟s success or failure cannot be
concept: i.e. the business owns the assets and obtained until it discontinues operations.
owes the various claimants. Therefore, it is essential to stop the operation of
the business artificially at frequent intervals so
1.2 Going Concern Concept
as to produce periodic reports on operations,
financial position, and cash flows.
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 DREAMLAND COLLEGE

1.7 The Matching Principle

The matching principle states that, after the UNIT EIGHT
revenues for an accounting period have been ACCOUNTING FOR
determined, the costs associated with those PARTNERSHIPS
revenues must be deducted in order to determine
net income. Introduction
1.1 Revenue Realization Principle Section1: Partnerships and Their
Revenue is recorded on the date of sale, not Characteristics
necessarily when the cash is received.
1.2 Adequate Disclosure Principle A partnership is an association of two or more
All financial statements relevant information persons to carry-on as co-owners of a business
must be disclosed to the users but disclosure for profit. This association is based on a
means all the details. The following are some partnership agreement known as the articles of a
examples: partnership. The contract may be written or
 Summary of accounting policies. unwritten.
 Change in accounting methods
The partnership agreement should specify:
 Contingent liabilities and commitments.
Name, location, and purpose of the business;
 Events subsequent to statements capital contributions and duties of each partner;
 Replacement cost of inventories and methods of income and loss division and rights
plant of each partner upon liquidation of a
1.3 The Consistency Principle partnership.

Consistency principle requires that the same 1.1 Characteristics of a Partnership

generally accepted accounting principles are
used from period to period for the same For purposes of accounting, partnerships are
accounting events. Therefore, once an treated as separate economic entities.
accounting method or principle is adapted, it
should be used for reasonable period of time. A) Voluntary Association
However, consistency principle does not A partnership is a voluntary association of
prohibit switching from one accounting method individuals for sharing of profit and loss rather
to another with proper disclosure. than a legal entity in itself. A partner also has
unlimited liability for the debts of the
1.4 The Materiality Concept partnership.
The concept of materiality is determined by B) Limited Life
comparing the size and nature of an item or Any change on the agreement, admission of new
event with the size and nature of other events or partner and death of the partner will dissolve the
items. For example, small expenditures for plant partnership.
assets may be treated as an expense of the period
rather than as an asset. The saving in clerical C) Unlimited Liability
costs is justified if the practice does not
materially affects the financial statements. Each partner is unlimitedly liable for all the
debts of the partnership. Creditors can take each
1.5 The Conservatisms (Prudence) partner‟s personal assets to satisfy their claims.
Concept
D) Mutual Agency: Mutual agency means that
Accountants follow methods and procedures that partner‟s act to any contract is binding on the
yield the lesser amount of net income or net remaining partners as long as it is within the
asset value. If an accountant is faced with two apparent scope of the business‟ operations.
methods of handling a particular event, he /she
tends to use the method which understate the net E) Co-ownership of partnership property: The
income or net asset. This is done to protect the properties contributed by the partners become
firm from uncertain risk of loss. the property of the partnership.

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 DREAMLAND COLLEGE
Upon dissolution, all will have prorate share
1.3 Recording the Formation of a
based on respective capital.
Partnership
1.2 Advantages and Disadvantages of
Partnership Separate capital account is maintained for each
Advantages: partner in a partnership. Each partner‟s capital
A partnership form of business ownership has account is credited for the value of their
the following advantages: investment upon formation of the partnership
and affected separately.
1. Easy and inexpensive to form
2. Raise a large amount of capital and Illustration
managerial skill Ato.Chala and Ato.Haile decided to form a
3. Not subject to separate taxation partnership business, which would provide
4. Not required to observe restrictive laws medical services. They have been in business
separately before they form the partnership. The
Disadvantages partnership assumed the liabilities of their
Partnership has the following disadvantages: separate business. The assets were valued and
1. Partners assume unlimited liability. recorded at their current fair market value.
2. Disadvantageous if each partner does not
exercise his/her good judgment.t Shown below are the assets contributed and the
3. Limited life. Partnerships are subject to liabilities assumed by the partnership at their fair
possible termination (Death of partner) market value.
4. The transfer of ownership is difficult

Ato. Chala Ato. Haile

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 investment of each partner and the formation 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
Chala‟s Capital 36,800

2002, Jan.1. Cash 3,300

A/R 4,300
Supplies 12,000
Building 150,000
Accounts Payable 3,200
Hailu‟s Capital 166,400

there is no agreement made, the law presumes

Section 2: Operation and Dissolution of the distribution of income and loss to be equal or
Partnerships if the agreement stating the income share and
ignore the loss then the law presumes the share
2.1 Division of Partnerships Income/Loss of the loss to be the same ration as the income.
A partnership‟s income and losses can be
distributed as per the partnership agreement. If

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 DREAMLAND COLLEGE
In this case the capital accounts of each partner
The Income of a partnership normally has three will be credited for Birr. 30,000
components: Income Summary-------------60,000
(1) return to the partners for the use of their Ato.Chala‟s capital---------------30,000
capital (interest) Ato.Hailu‟s capital---------------30,000
(2) Partners‟ salaries, and
(3) Other income B. Net income is divided in ratio of 3:2 to
Ato.Chala and Ato.Hailu respectively.
The breakdown of total income into its three
components helps clarify how much each Income summary----------60,000
partner has contributed to the firm. Ato.Chala‟s capital (3/5X60,000) ----36,000
Ato.Hailu‟s capital (2/5 X 60,000) ---24,000
Income can be shared among the partners in one
of the following ways: C. Net income is divided in a ratio of partners‟
1.Net income divided in a stated ratio such as: capital account balances at the beginning of
A) equally the fiscal period.
B) agreed upon ratio a per contract
C) Based on beginning capital balances The sum of the two partners‟ capital on the date
of formation was: 36,800+166,400 = 203,200
2.Net Income divided by allowing interest on the
capital investments, salaries, or both with the Income summary ------------- 60,000
remaining net income divided in an agreed ratio.
 36800 
Ato Chala‟s capital   60,000 -----10,866
Example 
203200

The following illustration indicates independent  
assumption of distributing income and loss of  166400 
 60,000
the partnership. Ato Hailu‟s capital  203200  --- 49,134
Assume that Ato.Chala, and Ato Hailu,
partnership had a net income of Birr 60,000 D. Net income is divided by allowing 5%
interest on their beginning capital balances,
A. Assume that the articles of a partnership and also a salary of Birr. 5,000 was allowed
provides equal share of Net Income or to Ato Chala and the remainder is divide
Loss. equally.

Net Income Division

Dr. Chala Ato Hailu Total Distribution

Net income 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 –
Income Distribution 29,260 30,740 60,000
* 5% of Ato Chala‟s beginning capital would be 5% * 36,800 =1,840
* 5% of Ato Hailu‟s beginning capital would be 5%*166,400 = 8,320
** Distributable income after interest expense is 60,000 – 10,160 = 49,840
*** The remaining 44,840 birr would be distributed equally among the two partners as 22,420.

Journal entry
Income summary ------------ 60,000
Ato. Chala capital ------------------ 29,260
Ato. Hailu capital ----------------- 30,740

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 DREAMLAND COLLEGE
prepared which summarizes the effect of
transactions on the capital account balances of
each partner. The statement of owners‟ equity
2.2 Financial Statements for a for Ato.Chala and Ato.Hailu using assumed data
Partnership and the income division shown above is
The income statement of a sole proprietorship illustrated below:
and that of a partnership are the same. At the end
of the period a statement of partners‟ capital is

Chala and Hailu

Statement of partners’ Capital
For the year ended Dec, 31, 2002
Ato.Chala Ato.Hailu
Capital Bal. January 1, 2002 Br. 36,800 Br. 166,400
Add: Additional investment 4,200 4,300
Total Br. 41,000 Br. 170,700
Net income distribution 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
9
1.3 Dissolution of a Partnership
2.3.2 Retirement or Withdrawal of a
Dissolution of a partnership occurs whenever
Partner
there is change in the original association of
When an existing partner withdraws he/she can
partners. When a partnership is dissolved, the
sell his/her ownership right or can withdraw
partners lose their authority to continue the
assets from the partnership.
business as a going concern. The remaining
partners can act for the partnership in finishing i.Sale of Ownership Right to the
the affairs of the business or sign new contract to Existing Partner
establish new partnership. When ownership right is sold by a withdrawing
partner to an existing partner, the entry on the
2.3.1 Admission of a New Partner partnership‟s books transfers the retiring
The admission of a new partner dissolves the old partner‟s capital balance to the buyer‟s capital
partnership because a new association has been account.
formed. When a new partner is admitted, a new
partnership agreement should be prepared. ii. Withdrawal of Assets From the
Partnership
A. Admission by Purchase of Ownership When a partner withdraws he/she may be paid
Right above or below the amount shown in his/her
When an individual is admitted to a firm by capital balances.
purchasing ownership right from an old partner,
each partner must agree to the change. A journal Section 3: Liquidation of a Partnership
entry is needed in the partnership to transfer the
Liquidation of a partnership is the process of
ownership right purchased from the capital
ending the business, of selling enough assets to
account of the selling partner to the capital
pay the partnership‟s liabilities and distributing
account of the new partner. The partnership’s
any remaining assets among the partners.
assets and liabilities remain unchanged.
B. Admission by Investing Assets A partnership may be liquidated if:
When admission made by investing in the assets
of the partnership the partnership assets and total A. The objectives sought in forming the
owners‟ equity will increase. partnership has been achieved;

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 DREAMLAND COLLEGE
B. The time period for which the As cash is realized, it must be applied first to
partnership was formed expires (ends); outside creditors. Finally, the remaining cash is
C. The newly enacted laws have made the distributed to the partners in accordance with the
partnerships activities illegal; and or balance of their capital accounts.
D. The partnership becomes bankrupt.
Illustration
The partnership agreement should indicate the The partnership of Resom, Sultan, and Tassew is
procedures to be followed incase of liquidation. liquidated on September 1, 2002. The income
and loss sharing ratio of the partners is: Resom
The sale of the assets at the time of liquidation 40%, Sultan 35%, and Tassew 25%. After
of a partnership is known as realization. discontinuing the ordinary business operations
of their partnership and closing the accounts, the
As the assets of the business are sold, any gain following summary of a trial balance is
or loss should be distributed to the partners prepared:
according to the income and loss sharing ratio.

R, S And T
Trial Balance
Septamber 1, 2002
Debit Credit
Cash 10,000
Other assets 90.000
Liabilities 10,000
R. Capital 30,000
S. Capital 30,000
T. Capital ________ 30,000
Total 100,000 100,000

Based on the information on the trial balance, Tassew in the income and loss sharing ratio of
accounting for liquidation of R, S, and T 40%, 35%, and 25% respectively. Then, the
partnership will be illustrated using different liabilities are paid, and the remaining cash is
selling prices for the non-cash assets. distributed to the partners according to the
Case One: Gain on Realization balances in their capital accounts. The entries to
Assume that Resom, Sultan, and Tassew sell all record the steps in the liquidation of a business
noncash assets for Birr 95,000, realizing a gain are as follows:
of birr 5000, (Birr 95,000 – Birr 90,000). The
gain is divided among Resom, Sultan and

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
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 (This is because gain increases capital).
For illustration purpose the capital of reform, Sultan and Tassew is designated by R, S and T respectively.
To distribute gain on realization

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 DREAMLAND COLLEGE
- Liabilities……………………….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 of 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 Resom, 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-----------------------20,000
Other Assets-------------------------------------90,000
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 Realization -------------------------------- 20,000
To distribute the loss on realization (this is because loss reduces capital)
- Liabilities ---------------------------------- 10,000
Cash -----------------------------------10,000
To record the settlement of partnership liabilities
After the above entries have been posted; the entry to record the cash distribution to the
accounts show cash 70,000 R, cap. Birr22,000 partners would, therefore, be as follows:
S,cap. Birr 23,000 and T, cap. Birr 25,000. The
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 sold for only Birr 10,200, incurring a loss of
Birr 79,800,( Birr 90,000 – Birr 10,200). The entries to record the division 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
- Liabilities ----------------------------------- 10,000
Cash ------------------------------------------------10,000
To record settlement of liabilities

At this stage of the liquidation the capital the amount owed by R to the partnership. This
accounts of the partners have the following amount is called deficiency of capital. And Mr.
balances R is called a deficient partner. This deficiency is
R capital = 30,000 – 31920 = (1,920) the claim of the partnership over the partner.
S capital = 30,000 – 27930 = 2,070
Therefore, either R will have to pay this amount
T capital = 30,000 – 19950 = 10,050
first and the cash will be distributed to S and T,
Only Birr 10,200 cash is available (10,000 +
or S and T will have to share the Birr 1920 loss
10200 – 10,000) for distribution to S and T
in their income and loss-sharing ratio of 35:25.
while the combined balances of their capital
Let‟s assume, the loss was distributed since R
accounts is Birr 12,120. Therefore, additional
couldn‟t pay the amount immediately.
Birr 1,920, (12120 – 10200) is needed which is
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
Cash ----------------------------------------------10,200
To record the final cash distribution to partners.
The various entries in the liquidation of R,S, and T partnership are summarized in the following
statement.
R, S, T partnership
Statement of Partnership Liquidation
For period Sept. 1-15,2002
Cash Non cash Liabilities Capital
Asset R(40%) S(35% T(25%)
Bal. before
realization Br. 10,000 90,000 10,000 30,000 30,000 30,000
Sales of Assets &
Division of loss +10,200 -90,000 --- -31,920 -27,930 19,950
Bal. after realization 20,000 -0- 10,000 (1920) 2,070 10,050
Payment of Liab. – 10,000 --- -10.000 --- --- ---
Bal. After payment 10,200 -0- -0- (1920) 2,070 10,050
Of liab.
Division of
deficiency --- --- --- 1920 (1120) (800)
Bal. After division of
Deficiency – 10,200 -0- -0- -0- 950 9250
Dist.of cash 10,000 --- --- --- -950 -9250

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 DREAMLAND COLLEGE
Balance -0- -0- -0- -0- -0- -0-
b) Difficulties to control: Owners are
UNIT NINE unable to exercise active control over
ACCOUNTING FOR management actions.
c) Greater regulation: The law may
CORPORATIONS provide considerable regulation of the
corporation‟s activities.
Introduction
1.4 Formation of a Corporation
Section 1: Nature of Corporations
A corporation is created by obtaining a corporate
1.1 Corporation: Defined charter. The charter is given from the states in
A corporation is a legal entity having an which the corporation is to be incorporated. To
existence separate and distinct from that of its obtain a corporate charter an application called
owners. In the eyes of the law there are two articles of incorporation are prepared by the
persons. The first is that of natural persons and organizers called incorporators and submitted
a corporation that is an „artificial person‟ having to the state corporation commissioner or other
many of its own rights and responsibilities. designated officials for approval. Detail issue
about the corporation will be included on the
1.2 Characteristics of Corporations
article of incorporation.
Among the characteristics of a corporation are:
1. A corporation is a separate legal entity. 1.4.1 Organization Costs
2. A corporation has a legal status in court. In the process of incorporation, the organizers
3. A corporation has its own charter. must pay for necessary costs such as payment of
4. A corporation pays income taxes on its an incorporation fee to the state, payment of fees
earnings. to attorneys for their services in drawing up the
articles of incorporation, payment to promoters
1.3 Advantages and Disadvantages of the
and variety of other outlays necessary to bring
Corporate form of Business
the corporation into existence.
Organizations
1.4.2 Rights of Stockholders
A corporate entity has many advantages not
available in other forms of organization. Among The stockholders who are the owners of a
the advantages are the following: corporate entity have the following basic rights:
a) Continuous existence: regardless of the a) The rights to vote: to elect the board of
death or retirements of any of its members directors.
corporation has perpetual existence. b) The rights to participate in the
b) No personal liability for owners: Any earnings of a corporation: to get
liability claim will be made against the dividend payment.
assets of the corporation, not the personal c) The rights to share in the distribution
property of the owners. of assets upon liquid action:
c) Separation of managements from d) Pre-emptive rights: existing stockholders
ownership: the owners of a corporation own has the right to purchase shares of the
the corporation but they do not manage it on corporation on a prorate basis when new
a daily basis. stocks are offered for sale.
d) Easily transferable ownership shares:
ownership of a corporation is evidenced by Section 2: Authorization and Issuance of
transferable shares of stocks. Stocks and Accounting for
Retained Earning
Some of the disadvantages of the corporation
The state officials approve the articles of
are:
incorporation, which specify the number of shares
a) Double taxation: corporate earnings are a corporation is authorized to issue. The total
taxed two times. The earnings are taxed number of shares that may be issued is known as
first as a corporate income taxes and the authorized shares. When the corporation
again as personal income taxes.

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receives cash it is exchange for stock certificates, value of the shares issued regardless of whether
which represents the number of shares issued. the issuance price is more or less than par.
The shares subsequently become issued shares. If par value stock is issued for more than par
Shares that are issued and held by the stockholders value (at premium), “paid in capital in excess of
are called outstanding shares. Sometimes a par” account is credited for the excess of selling
corporation re-acquires shares from its own price over par. This paid in capital is excess of
shareholders. These shares are called treasury par does not represent a profit to the corporation
stocks, which reduce the number of outstanding rather it is part of the invested capital. If par
shares. value stock is sold by corporation for less than
1.1 Types of Stocks/Shares par (at discount), a negative stockholders‟ equity
Many corporations issue several classes of accounts, “Discount on common (or preferred)
capital stock, each providing investors with stock”, is debited for the amount of the discount.
different rights and opportunities.
2.2.2 Par Value Stock Issued on a
Common stock possesses the traditional rights Subscription Basis
of ownership such as voting rights, participation During the start-up of a corporation, prospective
residual dividends, and residual claim to assets investors may sign a contract to purchase a
in the event of liquidation. specified number of shares on credits with
Preferred stock are priority claims on payments due at one or more specified future
dividends, cumulative dividend rights, priority dates to attract small investors‟ and to appeal to
as to assets in the event of liquidation of a investors who prefer not to invest cash until the
corporation and no voting power. corporation is ready to start business operations.
Par value: stocks designated dollar amount per A corporation may also sell its capital stock on
share credit after incorporation. When stock is
No-par stocks: stocks without designating dollar subscribed, the company
value  debits “stock subscription receivable” for
the subscription price,
2.1 Issuance of Par-value Stocks
 Credits capital stock subscribed for the par
2.2.1 Par Value Stock Issued for Cash
value of the subscribed shares, and credits
When stocks are issued to various investors, a
“paid in capital in excess of the subscription
stock certificate specifying the number of shares
price over par value”. Later, as cash is
represented is prepared for each investor/or
collected, the entry is a debit to “cash” and a
stockholder.
credit to “stock subscription receivable”.
When par value stock is issued for cash, the
capital stock account is credited with the par

2.2.3 Non Cash Issuance of Capital Stock 2.4 Accounting for Retained Earnings
Corporations sometimes issue capital stock for and Dividends
non-cash assets such as in exchange for real 2.4.1 Nature of Retained Earnings
estate. The current markets value of the stock
issued or the non-cash consideration received, Capital provided to a corporation by
whichever is most reliable, or determinable, is stockholders in exchange for shares of either
used to record the transaction. preferred or common stock is called paid in
capital or contributed capital. The second major
2.3 Issuance of No-par Stock type of stockholders‟ equity is a retained
Some states allow corporations to issue stock earnings. The amount of the retained earnings
without designating a par or stated value. When account at any balance sheet date represents the
this no par stock is issued, the entire issuance accumulated earnings (net income) of the
price is credited to the capital stock account and company since the date of incorporation, less
is viewed as legal capital not subject to any losses and all dividends distributed to
withdrawal. stockholders.
2.4.2 Nature of Dividends

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A dividend is a distribution of earnings to
stockholders in the form of assets or shares of
the issuing company‟s stock.

Type of dividends include the following: 2.5.1 Reasons to acquire Treasury

a) Cash dividend Stocks
In general treasury stocks are reacquired for the
Cash disbursed
following reasons:
b) Property Dividend
a) To increase markets price of the stock
Non cash assets disbursed
b) To increase earnings per share
c) Stock Dividend
c) To reduce dividend payment payments
Corporations own stock disbursed
d) To provide shares for reassurance
d) Liquidating Dividend
e) To use the share for stock dividend
Return of contributed capital
f) To reissue with a higher price
e) Scrip Dividend
Creation of a liability by declaring a 2.5.2 Recording and reporting Treasury
dividend to be paid at a specific future stock Transactions
date. There are several methods of accounting for the
purchase and the resale of treasure stocks. A
A. Relevant dividend dates: Prior to payment,
commonly used method is the cost basis. When
dividends must be declared by the board of
the stock is purchased by the corporation,
directors of the corporation. The important
treasury stock account is debited for the price
dividend dates are:
paid for it. The par and the price at which the
a) Date of Declaration & Date of payment
stock was originally issued are ignored. When
the stock is resold, treasury stock is credited at
2.4.3 Dividend and Characteristics of the price paid for it, and the difference between
preferred stock the price paid and the selling price is debited or
A corporation with both preferred stock and
credited to an account entitled paid in capital
common stock may declare dividends on the
from sale of treasury stock.
common only after it meets the requirements of
the stated dividend on the preferred. 2.6 Equity Per Share
The amount appearing on the balance sheet as
A. Participating and non-participating total stockholders‟ equity can be stated in terms
preferred stock: participating preferred stock of the equity per share (book value per share).
receives a minimum dividend but also receives When there is only one class of stock, the equity
higher dividend when the company pays per share is determined by dividing total
substantial dividends on common shares. stockholders‟ equity by the number of shares
B. Cumulative and Non-cumulative preferred outstanding. For a corporation with both
stock: Cumulative preferred means that if the preferred and common stock, it is necessary first
company fails to pay a preferred dividend, its to allocate the total equity between the two
obligation accumulates and all omitted dividends classes.
must be paid in the future before any common Equity Per Share =
dividends are paid. However, non-cumulative Equity allocated to common stock
will not get any omitted dividends.
Number of o/s shares of common stock
2.5 Accounting for Treasury Stocks
Treasury stock is a corporation‟s own stock
(preferred or common) that has been issued and
required by the issuing corporation. A
corporation may also accept shares of its own
stock in payment of a debits owed by a
stockholder or as a donation from a stockholder.

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