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Ermi E-Learning Exit Exam Tutorial For

Accounting and Finance students
 Fundamental of Accounting 1
•

• Chapter ONE
• Introduction To Accounting
 1.1. What is Accounting?
Accounting consists of three basic activities—it

◆ identifies,

◆ records, and

◆ communicates

the economic events of an organization to

interested users.
Three Activities
Illustration 1-1
The activities of the accounting process

The accounting process includes

the bookkeeping function.
Who Uses Accounting Data?
o There are two broad groups of users of financial
information: internal users and external users.
1) INTERNAL USERS

o Internal users of accounting information are managers who

plan, organize, and run the business. These include marketing
managers, production supervisors, finance directors, and
company officers.

o Managerial Accounting provides internal reports to help

users make decisions about their companies.

o Examples are financial comparisons of operating alternatives,

projections of income from new sales campaigns, & forecasts
of cash needs for the next year.
 Cont’d

INTERNAL
USERS

Illustration 1-2
Questions that internal
users ask
 Cont’d

EXTERNAL
USERS

Illustration 1-3
Questions that external users ask
Measurement Principles
o IFRS generally uses one of two measurement principles,
the historical cost principle or the fair value principle.
o The selection of which principle to follow generally
relates to trade-offs between relevance & faithful
representation.
o Relevance means that financial information is capable of
making a difference in a decision.
o Faithful representation means that the numbers and
descriptions match what really existed or happened—
they are factual.
 Cont’d
1) HISTORICAL COST PRINCIPLE (or Cost Principle)

o It dictates that companies record assets at their

cost.

o This is true not only at the time the asset is

purchased, but also over the time the asset is
held.

2) FAIR VALUE PRINCIPLE

o It states that assets and liabilities should be

reported at fair value (the price received to sell
an asset or settle a liability).
Assumptions
o Assumptions provide a foundation for the accounting
process.
o Two main assumptions are the monetary unit assumption
and the economic entity assumption.

1) MONETARY UNIT ASSUMPTION

o The monetary unit assumption requires that companies
include in the accounting records only transaction data that
can be expressed in money terms.

o This assumption enables accounting to quantify (measure)

economic events.

o The monetary unit assumption is vital to applying the

historical cost principle.
 Cont’d
2) ECONOMIC ENTITY ASSUMPTION
o It requires that activities of the entity be kept separate
and distinct from the activities of its owner and all
other economic entities.
◆ Proprietorship
◆ Partnership Forms of Business
Ownership
◆ Corporation
 1.4. The Basic Accounting Equation
Basic Accounting Equation
◆ Provides the underlying framework for recording and
summarizing economic events.

◆ Assets must equal the sum of liabilities and equity.

Assets = Liabilities + Equity

1) The main purpose of accounting is

A. to provide financial information to users A

B. to accumulate and determine cost

C. to prove the equality of debits and credit

D. to record and post transactions

2) Which of the following shows the correct sequence of flow of
accounting data in accounting records?
A. Journal-Source document - Occurrence of transaction-Ledger

B. Ledger-Journal - Source document - Occurrence of transaction

C. Source document - Journal - Occurrence of transaction - ledger

D. Occurrence of transaction-Source document - Journal-Ledger

D
3) Which one of the following tasks in NOT part of the
recording process?

A. Posting journal entries

B. Entering transactions in a journal

C. Preparing an income statement

D. Analyzing transactions C
4) The accounting process involves all of the following except
•
a. identifying economic events that are relevant to the business.
•
b. communicating financial information to users by preparing financial
reports.
•
c. recording non quantifiable economic events.
•
d. analyzing and interpreting financial reports.

C
5) The accounting equation shows

A. The equality of net income with net loss

B. The equality of asset with owner's equity

C
C. The equality of resources with sources
Assets = Liabilities. + Owner's Equity.
D. The equality of revenue with expense The right side shows where
the money came from to buy the assets.

The life side show where the money goes

6) If total liabilities increased by ETB 35,000 and equity increased by
ETB 10,000 during a period of time, then total assets must change by
what amount and direction during that same period?

a. ETB 45,000 decrease

b. ETB 45,000 increase

B
c. ETB 60,000 increase A=L+E
A= if L By 35000 + if E 10000
d. ETB 70,000 increase
A= 45000
7) The liabilities of Rain Company equal one-fifth of the total assets. The
owner’s equity is $40,000. What is the amount of the liabilities?
• A. $20,000
• B. $50,000 The accounting equation can be formulated as:

• C. $10,000 Assets = Liabilities + Equity

• D. $100,000 A = 1/5 A – Equity

• E. All (1- 1/5) A = 40000

(1-0.2) A = 40000
• F. None 0.8A= 40000

A= 40000/0.8 = 50000

Liabilities = 1/5 * 50000 = 10000 C

8) The economic entity assumption requires that the activities

a. Activities of different entities can be combined if all the entities are

corporations.

b. Activities must be reported to the Securities and Exchange Commission.

c. Activities of a sole proprietorship cannot be distinguished from the

personal economic events of its owners.

d. Activities of an entity be kept separate from the activities of its owner.

D
9) Bookkeeping differs from accounting in that bookkeeping primarily
involves which part of the accounting process:

a. Recording

• b. analyzing

• c. Summarizing

• d. Communicating
A
10) The accounting process is correctly sequenced as

• a. identification, communication, recording.

• b. recording, communication, identification.

• c. identification, recording, communication.

• d. communication, recording, identification

C
• 11) The proprietorship form of business organization:

• a. must have at least two owners in most states.

• b. generally receives favorable tax treatment relative to a
corporation.
• c. combines the records of the business with the personal records
of the owner.
• d. is classified as a separate legal entity.

The proprietorship refers to the ownership of the person in a business, where the business is
also recorded as the property or the entity owned by the owner along with his or her personal
property. There is no difference made between personal and business obligations when
proprietorship is conducted.
C
12) Which of the following is true regarding the corporate form of
business organization?
• a. Corporations are the most prevalent form of business organization.
• b. Corporate businesses are generally smaller in size than partnerships
and proprietor- ships.
• c. The revenues of corporations are greater than the combined revenues
of partnerships and proprietorships.
• d. Corporations are separate legal entities organized exclusively under
federal law

D
13) Smith is the proprietor (owner) of Smitty's, a retailer of athletic
apparel. When recording the financial transactions, Smith does not record
an entry for a car she purchased for personal use. Smith took out a
personal loan to pay for the car.
What accounting concept guides Deb's behavior in this situation?
• a. Pay back concept
• b. Economic entity assumption
• c. Cash basis concept
• d. Monetary unit assumption B
14) Owner's equity can be described as

• a. creditorship claim on total assets.

• b. ownership claim on total assets.

• c. benefactor's claim on total assets.

• d. debtor claim on total assets

B
15) The basic accounting equation cannot be restated as

• a. Assets – Liabilities = Owner's Equity.

• b. Assets – Owner's Equity = Liabilities.

• c. Owner's Equity + Liabilities = Assets.

• d. Assets + Liabilities = Owner's Equity

D
16) Which one of the following represents the expanded basic accounting
equation?
• a. Assets = Liabilities + Owner's Capital + Owner's Drawings – Revenue –
Expenses.
• b. Assets + Owner's Drawings + Expenses = Liabilities + Owner's Capital +
Revenues.
• c. Assets – Liabilities – Owner's Drawings = Owner's Capital + Revenues –
Expenses.
• d. Assets = Revenues + Expenses – Liabilities.

B
17) If total liabilities increased by $4,000, then

• a. assets must have decreased by $4,000.

• b. owner's equity must have increased by $4,000.

• c. assets must have increased by $4,000, or owner's equity must have

decreased by $4,000.

• d. assets and owner's equity each increased by $2,000.

C
18) Which of the following events is not a business transaction?

• a. Investment of cash by the owner

• b. Hired employees

• c. Incurred utility expenses for the month

• d. Earned revenue for services provided

B
19) If the owner's equity account increases from the beginning of the
year to the end of the year, then
• a. net income is less than owner drawings.
• b. a net loss is less than owner drawings.
• c. additional owner investments are less than net losses.
• d. net income is greater than owner drawings.

D
20) Janzen Company began the year with owner’s equity of $217,000.
During the year, Janzen received additional owner investments of
$294,000, recorded expenses of $840,000, and had owner drawings of
$56,000. If Janzen’s ending owner’s equity was $531,000, what was the
company’s revenue for the year?
• a. $860,000
B.Capital …………….217,000
• b. $916,000
+Additila investment ……..294,000
• c. $1,154,000 +NI……………………………….XXXX
• d. $1,210,000
B _ Drawing ……………………..56,000
E.Capital ………………… 531,000
21) Johnson had the following final balances after the first year of
operations: Assets, $26,000; stockholders' equity, $10,000; dividends,
$2,000; and net income, $6,000.
• What is the amount of Johnson's liabilities?
• A). $36,000.
• B). $20,000.
• C. $16,000.
• D). $10,000 C
22) When preparing financial statements, which one shows how much
money came in and went out of a company during a given time period?

• A) Balance sheet

• B) Statement of cash flow

• C) Income statement
B
• D) Statement of retained earning
 Fundamental of Accounting 1

Chapter Two
Accounting Cycle for
Service-giving Businesses
Double entry accounting
❑ Every transaction must be affect at least
two Account
❑ Debit and credit for every Recording it
must equal
❑ Debit is the left side
❑ Credit is the right side
 Balance sheet accounts
Assets Liabilities
Asset Accounts Liability Accounts
Debit Credit Debit Credit
for Increases for decrease for Decreases for increases

Owner’s Equity Accounts

Debit Credit
for decreases for increases

Income Statement Accounts

In order to make journal entry
Debit for decreases in Credit for Increase in the transaction must be exist
Owner’s Equity Owner’s Equity
Expense Accounts Revenue Accounts Transaction is the exchange of
Debit Credit Debit Credit resource between two parity,
for increases for decrease for decreases for increases
Transaction it may be internal
and external
2.2. Steps in the Recording Process
◆ Although it is possible to enter transaction information
directly into the accounts without using a journal, few
businesses do so.
◆ Practically every business uses three basic steps in the
recording process:
1) Analyze each transaction for its effects on the
accounts.
2) Enter the transaction information in a journal.
3) Transfer the journal information to the appropriate
accounts in the ledger.
◆ The recording process begins with the transaction.
◆ Business documents, such as a sales receipt, a check, or
a bill, provide evidence of the transaction.
Meron Beauty Salon Services was formed on May 1, 2010.
The following transactions took place During the first month. Make the necessary journal
entire.

May 1, Meron invested Birr 50,000 cash in the company, as its sole owner.
Cash ……………..50000 Birr
Meron Capital ,…………………….. 50000 Birr

May 1, Hired two employees to work in the Beauty Salon. They will each be paid a salary of Birr
2,800 per month.
No entry

May 2, Signed a 2-year rental agreement on a Beauty Salon ; paid Birr 24,000 cash in advance for the
first year.

Prepaid rent ………..24000 Birr

Cash ……………………………..24000 Birr
May 4, Purchased furniture and equipment costing Birr 30,000. A cash payment of
$10,000 was made immediately; the remainder will be paid in 6 months.

Furniture and equipment……….30000 Birr

Cash ……..…….10000Birr
Account payable..20000Birr

May 5, Paid Birr 1,800 cash for a one-year insurance policy on the furniture and
equipment
Prepaid insurance…… …1800 Birr
Cash…………..1800 Birr

May 6, Purchased basic office supplies for Birr 500 cash.

Supplies ……..500 Birr
Cash …………..500 Birr
May 7, Purchased more office supplies for Birr 1,500 on account.

Supplies …….1500 Birr

Account payable …..1500 Birr

May 8, Total revenues earned were Birr 20,000, from the total amount Birr
8,000 in cash and Birr 12,000 on account.
Cash ……………….…8000 Birr
Account Receivable…12000 Birr
Sale Revenue………….20000 Birr
May 9 Paid Birr 400 to suppliers for accounts payable due.
Account payable……….400 Birr
Cash ………….……….400 Birr
May 10, Received Birr 3,000 from customers in payment of accounts receivable.

Cash…..….3000
Account Receivable ….3000

May 30,Paid the monthly salaries of the two employees, Birr 5,600
Salary expanse …….5600 Birr
Cash …………………5600 Birr

May 30, Meron was withdraw Birr 500 for her personal use.
Withdraw………500 Birr
Cash……………..500 Birr
May 29, Received utility bills in the amount of Birr 200, to be paid next month.
Utility expense ……..…..200 Birr
Utility payable ……………….200 Birr

May 31, Supplies on hand is 400. ( 500+1500=2000 supplies but at the end of the
supplies on hand is 400, So 2000 - 400 = 1600 supplies expense )

Supplies expanse ………1600 Birr

Supplies…….……1600 Birr
Accrual- Versus Cash-Basis of Accounting

Accrual-Basis of Accounting
◆ Transactions recorded in the periods in which
the events occur.
◆ Companies recognize revenues when they
perform services (rather than when they receive
cash).
◆ Expenses are recognized when incurred (rather
than when paid).
Accrual- Versus Cash-Basis of Accounting

Cash-Basis of Accounting
◆ Revenues are recorded when cash is received.
◆ Expenses are recorded when cash is paid.
◆ Cash-basis of accounting is not in accordance
with International Financial Reporting Standards
(IFRS).
Recognizing Revenues and Expenses
REVENUE RECOGNITION PRINCIPLE
Recognize revenue in the
accounting period in which
the performance obligation
is satisfied.
Recognizing Revenues and Expenses
EXPENSE RECOGNITION PRINCIPLE
Match expenses with
revenues in the period when
the company makes efforts
to generate those revenues.

“Let the expenses follow

the revenues.”
Illustration 3-1
IFRS relationships in
Revenue & Expense
Recognition
 2.6. The Basics of Adjusting Entries
Adjusting Entries
◆ Ensure that the revenue recognition and expense
recognition principles are followed.
◆ Necessary because the trial balance may not
contain up-to-date and complete data.
◆ Required every time a company prepares financial
statements.
◆ Will include one income statement account and
one SoFP account.
Types of Adjusting Entries

Illustration 3-2
Categories of Adjusting Entries
Adjusting Entries for Deferrals
Deferrals are expenses or revenues that are
recognized at a date later than the point when
cash was originally exchanged.
There are two types of deferrals:
◆ Prepaid Expenses and
◆ Unearned Revenues.
PREPAID EXPENSES
Payments of expenses that will benefit more than
one accounting period.

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

◆ Insurance ◆ Rent
◆ Supplies ◆ Buildings and Equipment
◆ Advertising
UNEARNED REVENUES

Receipt of cash that is recorded as a liability because

the service has not been performed.

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

◆ Rent ◆ Magazine subscriptions
◆ Airline tickets ◆ Customer deposits
 Cont’d
Illustration 3-12: Accounting for Unearned Revenues
Adjusting Entries for Accruals
Accruals are made to record
◆ Revenues for services performed but not yet
recorded at the statement date (accrued revenues).

OR

◆ Expenses incurred but not yet paid or recorded at the

statement date (accrued expenses).
ACCRUED REVENUES
Revenues for services performed but not yet received
in cash or recorded.

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

◆ Rent ◆ Services performed

◆ Interest
ACCRUED EXPENSES
Expenses incurred but not yet paid in cash or recorded.

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

◆ Interest
◆ Taxes
◆ Salaries
 Cont’d
Illustration 3-21: Accounting for Accrued Expenses
Summary of Basic Relationships
Illustration 3-22: Summery of Adjusting Entries
23) After the adjusting entries are journalized and posted to the accounts
in the general ledger, the balance of each account should agree with the
balance shown on the
• a. adjusted trial balance.
• b. post-closing trial balance.
• c. the general journal.
• d. adjustments columns of the worksheet.

A
24) If the total debit column exceeds the total credit column of the
income statement columns on a worksheet, then the company has

• a. earned net income for the period.

• b. an error because debits do not equal credits.

• c. suffered a net loss for the period.

• d. to make an adjusting entry.

C
25) A trial balance may balance even when each of the following occurs
except when
• a. a transaction is not journalized.

• b. a journal entry is posted twice.

• c. incorrect accounts are used in journalizing.

• d. a transposition error is made.

D
26) The debit and the credit columns of a trial balance each total
$80,000. Which error may still exist?
• A. A journal entry contains a correct debit amount and an incorrect credit
amount.
• B. A debit entry to the Cash account in the journal is incorrectly posted as
a credit to the Cash account in the ledger.
• C. The credit portion of a journal entry is posted to the ledger twice.
• D. A cash payment on account of $450 is incorrectly recorded as a cash
payment on account of $540.

D
27) Closing entries are made
• a. in order to terminate the business as an operating entity.
• b. so that all assets, liabilities, and owner's capital accounts will have zero
balances when the next accounting period starts.
• c. in order to transfer net income (or loss) and owner's drawing to the
owner's capital account.
• d. so that financial statements can be prepared

C
28) Income Summary has a credit balance of $12,000 in J. Sawyer Co. after
closing revenues and expenses. The entry to close Income Summary is
• a. credit Income Summary $12,000, debit J. Sawyer, Capital $12,000.
• b. credit Income Summary $12,000, debit J. Sawyer, Drawing $12,000.
• c. debit Income Summary $12,000, credit J. Sawyer, Drawing $12,000.
• d. debit Income Summary $12,000, credit J. Sawyer, Capital $12,000.
Net income
D Income summary ………XXXX
Capital …………………XXXX

Net Loss

Capital ……………………XXXX
Income summary …………..XXXX
29) Which of the following steps in the accounting cycle would not
generally be performed daily?

• a. Journalize transactions

• b. Post to ledger accounts

• c. Prepare adjusting entries

• d. Analyze business transactions C

30) Speedy Bike Company received a $940 check from a customer for the
balance due. The transaction was erroneously recorded as a debit to Cash
$490 and a credit to Service Revenue $490.
The correcting entry is
• a. debit Cash, $940; credit Accounts Receivable, $940.
• b. debit Cash, $450 and Accounts Receivable, $490; credit Service Revenue,
$940.
• c. debit Cash, $450 and Service Revenue, $490; credit Accounts Receivable,
$940.
• d. debit Accounts Receivable, $940; credit Cash, $450 and Service Revenue,
$490. Cash ….940
AR………940 C
Error
Cash ….490
Sale revenue 490
31) Powers Corporation received a cash advance of $500 from a customer.
As a result of this event,

• A). assets increased by $500 (Debited).

• B). equity increased by $500 (Credited).

• C. liabilities decreased by $500 (Debited).

• D. Both assets and equity increased by $500

Cash ……….500
A Unearned Revenue 500
32) Grayton Industries purchased supplies for $1,000. They paid $500 in
cash and agreed to pay the balance in 30 days. The journal entry to
record this transaction would include a debit to an asset account for
$1,000, a credit to a liability account for $500.
Which of the following would be the correct way to complete the
recording of the transaction?
• a. Credit an asset account for $500.
• b. Credit another liability account for $500.
• c. Credit the Grayton, Capital account for $500. A
• d. Debit the Grayton, Capital account for $500
33) At December 1, 2008, Marco Company’s accounts receivable balance
was $1,200. During December, Marco had credit revenues of $5,000 and
collected accounts receivable of $4,000. At December 31, 2008, the
accounts receivable balance is
• a. $1,200 debit.
• b. $2,200 debit.
• c. $6,200 debit.
• d. $2,200 credit
B
Fundamental of Accounting 1
Chapter Three
Accounting for
Merchandising Operations
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Identify the differences between service and merchandising
companies.
2. Explain the recording of purchases under a perpetual
inventory system.
3. Explain the recording of sales revenues under a perpetual
inventory system.
4. Explain the steps in the accounting cycle for a merchandising
company.
5. Prepare an income statement for a merchandiser.
 3.1. Merchandising Operations
Merchandising Companies
Buy and Sell Goods

Retailer

Wholesaler Consumer

The primary source of revenues is referred to as sales revenue

or sales.
 Cont’d
Income Measurement

Sales Less
Not used in a Service Illustration 5-1
Business. Income Measurement Process
Revenue for A Merchandising Company

Cost of Equals Gross Less

Goods Sold Profit

Operating Equals
Net Income
Cost of goods sold is the Expenses (Net Loss)
total cost of merchandise
sold during the period.
Operating Cycles
Illustration 5-2
The operating
cycle of a
merchandising
company
ordinarily is
longer than that
of a service
company.

Illustration 5-3
Flow of Costs
Illustration 5-4

Companies use either a Perpetual Inventory System or a

Periodic Inventory System to account for inventory.
34) Cost of goods sold is determined only at the end of the accounting
period in

• a. a perpetual inventory system.

B
• b. a periodic inventory system.

• c. both a perpetual and a periodic inventory system.

• d. neither a perpetual nor a periodic inventory system.

35) Which of the following is a true statement about inventory systems?
• a. Periodic inventory systems require more detailed inventory records.
• b. Perpetual inventory systems require more detailed inventory records.
• c. A periodic system requires cost of goods sold be determined after each
sale.
• d. A perpetual system determines cost of goods sold only at the end of
the accounting period.

B
36) In perpetual inventory system Merchandise Inventory account is used
in each of the following except the entry to record

• a. goods purchased on account.

• b. the return of goods purchased.

• c. payment of freight on goods sold. c

• d. payment within the discount period.
37) Flynn Company purchased merchandise inventory with an invoice
price of $5,000 and credit terms of 2/10, n/30.

What is the net cost of the goods if Flynn Company pays within the
discount period?

• a. $5,000
B
• b. $4,900

• c. $4,500

• d. $4,600
38) Stine Company purchased merchandise with an invoice price of $2,000
and credit terms of 2/10, n/30. Assuming a 360 day year, what is the
implied annual interest rate inherent in the credit terms?

• a. 20%
C Implied inters rate=0.36 = 360 * 40
• b. 24% DISCOUNT = 2000*0.02 = 40
30- 10 2000

• c. 36%

• d. 72%
39) A credit sale of $800 is made on April 25, terms 2/10, n/30, on which a
return of $50 is granted on April 28. What amount is received as payment in
full on May 4?

• a. $735

• b. $784

• c. $800
A

• d $750
40) The respective normal account balances of Sales, Sales Returns and
Allowances, and Sales Discounts are

• a. credit, credit, credit.

• b. debit, credit, debit.

C
• c. credit, debit, debit.

• d. credit, debit, credit

41) At the beginning of the year, Midtown Athletic had an inventory of
$400,000. During the year, the company purchased goods costing
$1,600,000. If Midtown Athletic reported ending inventory of $600,000
and sales of $2,000,000, the company’s cost of goods sold and gross profit
rate must be
• a. $1,000,000 and 50%.
• b. $1,400,000 and 30%. B
• c. $1,000,000 and 30%.
• d. $1,400,000 and 70%
 Fundamental of Accounting 1

Chapter Four and Five

• Accounting for Cash and Receivable
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Define Cash.
2. Distinguish items that are reported as cash.
3. Define fraud and internal control.
4. Identify the principles of internal control activities.
5. Explain the applications of internal control principles to cash
receipts and cash disbursements.
6. Describe the operation of a petty cash fund.
7. Indicate the control features of a bank account.
8. Prepare a bank reconciliation.
9. Explain the reporting of cash.
Items those are included as Cash
◆ Coins and Currencies (Paper money)

◆ Money on deposit in a bank that can be drawn with out any

restriction, i.e. demand deposits

◆ Negotiable instruments, which are documents that can be

transferred from one party to another as money, like money
orders, certified checks or CPO’s, checks issued by third
parties and are available at cashiers, checks written to third
parties but not yet issued, traveler’s checks, etc

◆ Saving accounts

◆ Petty cash funds

◆ Change funds
 Cont’d
◆ Some items, however, may initially appear or seem as Cash;
but do not meet the criteria’s.

◆ For instance, a check received from a third party, as a

payment is not included as cash if the party issuing the
check has not sufficient fund in its bank account.

◆ Such checks are marked as NSF (Not Sufficient Fund)

checks and are reported as receivables.

◆ Similarly, Post dated checks, issued by third parties but

that will be drawn only in the future dates, reported as
receivables.

◆ Postage Stamps are items for which cash has been paid and
are expected to be used in the future.
 4.2. Fraud & Internal Control
Fraud
Dishonest act by an employee that results in personal
benefit to the employee at a cost of the employer.

Three factors that

contribute to
fraudulent activity.

Illustration 7-1
Fraud Triangle
 Cont’d
Internal Control
Internal control is a process, effected by an entity's board of directors, management
and other personnel, designed to provide reasonable assurance

Methods and measures adopted to:

1. Safeguard assets.
2. Enhance accuracy and reliability of accounting records.
3. Increase efficiency of operations.
4. Ensure compliance with laws and regulations.
 Cont’d
Five Primary Components OF internal control
● Control environment.
● Risk assessment.
● Control activities.
● Information and communication.
● Monitoring.

● Note: You will be learn more on those components

on the course of AIS and Auditing
Principles of Internal Control Activities

❖ ESTABLISHMENT OF RESPONSIBILITY

❖ SEGREGATION OF DUTIES
❖ DOCUMENTATION PROCEDURES
❖ PHYSICAL CONTROLS
❖ INDEPENDENT INTERNAL VERIFICATION
❖ HUMAN RESOURCE CONTROLS
 4.4. Control Features: Use of a Bank
Contributes to good internal control over cash.

◆ Minimizes the amount of currency on hand.

◆ Creates a double record of bank transactions.

◆ Bank reconciliation.
Reconciling the Bank Account
Reconcile balance per books and balance per bank to
their adjusted (corrected) cash balances.

Reconciling Items:

1. Deposits in transit.

2. Outstanding checks. Time Lags

3. Bank memoranda.

4. Errors.
Bank Statements Illustration 7-10
Bank Statement
DEBIT
MEMORANDUM
◆ Bank service charge.
◆ NSF (not sufficient
funds).

CREDIT
MEMORANDUM
◆ Collect notes
receivable.
◆ Interest earned.
 Cont’d
RECONCILIATION PROCEDURES Illustration 7-11
Bank Reconciliation
Adjustments

+ Deposit in Transit + Notes collected by bank

- Outstanding Checks - NSF (bounced) checks
+/- Bank Errors - Check printing or other
service charges
+/- Book Errors
CORRECT BALANCE CORRECT BALANCE
5.1. Definition of Receivables
◆ The term receivables refers to amounts due from
individuals and companies. They are claims that are
expected to be collected in cash.

◆ The management of receivables is a very important

activity for any company that sells goods or services on
credit.

◆ Receivables are important because they represent one

of a company’s most liquid assets.

◆ For many companies, receivables are also one of the

largest assets.
 5.2. Types of Receivables

Classifications of Receivables

Amounts customers Written promise Nontrade receivables

owe on account (formal instrument) such as interest, loans
that result from the for amount to be to officers, advances
sale of goods and received. Also called to employees, and
income taxes
services. trade receivables.
refundable.
Accounts Notes Other
Receivable Receivable Receivables
 5.3. Accounts Receivable
Recognizing Accounts Receivable
◆ Service organization records a receivable when it
performs service on account.
◆ Merchandiser records accounts receivable at the
point of sale of merchandise on account.
◆ Seller may offer a discount to encourage early
payment.
Valuing Accounts Receivable
◆ Current asset.
◆ Valuation (net realizable value).

Uncollectible Accounts Receivable

◆ Sales on account raise the possibility of accounts not
being collected.

◆ Seller records losses that result from extending

credit as Bad Debt Expense.
Valuing Accounts Receivable

Methods of Accounting for Uncollectible Accounts

Direct Write-Off Allowance Method

Theoretically undesirable: Losses are estimated:
◆ No matching. ◆ Better matching.
◆ Receivable not stated at ◆ Receivable stated at cash
amount expect to be (net) realizable value.
received. ◆ Required by IFRS.
◆ Not acceptable for
financial reporting.
42) An analysis of the items and amounts that result in the cash balance
reported in the bank statement to differ from the balance of the cash
account in the ledger is

• A. Bank statement

• B. Bank analysis

• C. Bank account D
• D. Bank reconciliation
43) In preparing its bank reconciliation for the month of April 2010, Henke, Inc. has
available the following information.
• Balance per bank statement, 4/30/10 Birr39,140
• NSF check returned with 4/30/10 bank statement 450
• Deposits in transit, 4/30/10 5,000
• Outstanding checks, 4/30/10 5,200
• Bank service charges for April 20

• What should be the correct balance of cash at April 30, 2010?

• a. ETB 39,370 Bank balance ……………………39,140
• b. ETB 38,940 + Deposit in transit ….5000
• c. ETB 38,490 - Outstanding Check …5200
• d. ETB 38,470 Adjusted balance ………………….38940

B
44) On March 31, Bora Company has the following information about cash at bank
Cash balance per bank statement Birr 10,500
Credit memo Birr 4,000
Bank debit memo Birr 300.
Outstanding checks Birr 1,500
Deposits in transit Birr 1,200
Based on the above information, what is the amount of the adjusted cash balance per
bank statement at March 31?
Cash balance per bank statement Birr 10,500
A. Birr 10,800 + Deposits in transit Birr 1,200
- Outstanding checks Birr 1,500
= 10,200
B. Birr 10,200
B
C. Birr 11,700

D. Birr 14 500
45) A Company has cash in bank of Birr 20,000, restricted
cash in a separate account of Birr 6,000, and a bank overdraft
in an account at another bank of Birr 2,000. The company
should report cash of
Cash in Bank 20,000
A. Birr 26,000
Bank Overdraft (2,000)
B. Birr 18,000 Balance To Be Reported 18,000

C. Birr 20,000 B
D. Birr 24,000
46) Accounts and notes receivable are reported in the
current assets section of the statement of financial
position

A. Invoice cost
B
B. Net realizable value

C. Lower-of-cost-or-net realizable value

D. Net book value

47) South Ltd. uses allowance method of accounting for uncollectible.
Analysis of long outstanding balance of Br 500,000 expected from customer Z
reveals the amount will not be collected because of disappearance of the
customer following bankruptcy.
The correct journal entry is
A. Debit Bad debt expense and credit Allowance for uncollectible by Br 500,000
B. Debit Allowance for uncollectible and credit Accounts Receivable by Br
500,000
C. Debit Bad debt expense and credit Accounts Receivable by Br 500,000
D. Debit Allowance for uncollectible and credit Bad debt expense by Br 500,000
Bad debt expense ……….500,000
Allowance for uncollectable account ….500,000 B
Allowance for uncollectable account ….500,000
AR………………………………………….500,000
• 48). At the end of December 2022, Star Company’s management estimates
the uncollectible accounts expense to be 1% of net credit sales of
$2,000,000. Identify the correct journal entry to record the uncollectible
accounts expense, assuming the Allowance for Uncollectible Accounts has a
credit balance of $5,000:
• A. Dr. Uncollectible accounts/bad debt expense…..20,000
Cr. Allowance for Uncollectible Accounts……20,000
• B. Dr. Uncollectible accounts/bad debt expense…..15,000.
Cr. Allowance for Uncollectible Accounts……15,000
• C. Dr. Uncollectible accounts/bad debt expense…..25,000
Cr. Allowance for Uncollectible Accounts……25,000
• D. Dr. Uncollectible accounts/bad debt expense…..20,000
Cr. Accounts Receivable…………………………20,000
• E. All
• F. None A
49) The accounts receivable turnover ratio measures the
• a. number of times the average balance of accounts receivable is collected
during the period.
• b. percentage of accounts receivable turned over to a collection agency
during the period.
• c. percentage of accounts receivable arising during certain seasons.
• d. number of times the average balance of inventory is sold during the
period
A ART=
Credit sale / Average AR
50) Horvath Company has the following items at year-end:
• Cash in bank $20,000
• Petty cash 300
• Short-term paper with maturity of 2 months 5,500
• Postdated checks 1,400
• Horvath should report cash and cash equivalents of
• a. $20,000.
• b. $20,300. C 20,000+ 300+ 5500 = 25,500
• c. $25,800.
• d. $27,200.
51) Lawrence Company has cash in bank of $25,000, restricted cash in a
separate account of $4,000, and a bank overdraft in an account at another
bank of $2,000. Lawrence should report cash of
• A). $23,000.
• B). $25,000.
• C) $28,000.
• D) $29,000. A
52) If a petty cash fund is established in the amount of $250, and contains
$150 in cash and $95 in receipts for disbursements when it is replenished,
the journal entry to record replenishment should include credits to the
following accounts

• a. Petty Cash, $75.

Disbursements $95
• b. Petty Cash, $100. Cash short and over
Cash
$5
$100

• c. Cash, $95; Cash Over and Short, $5.

• d. Cash, $100
D
53) If the month-end bank statement shows a balance of $36,000,
outstanding checks are $12,000, a deposit of $4,000 was in transit at
month end, and a check for $500 was erroneously charged by the bank
against the account, the correct balance in the bank account at month
end is

• a. $27,500. Bank Balance ………...36,000

B + deposit in transit …….4000
- Check outstanding ..12,000
• b. $28,500. - + error ……………………..500
Balance ……………………28,500
• c. $20,500.

• d. $43,500.
54) The cash account shows a balance of $45,000 before reconciliation. The
bank statement does not include a deposit of $2,300 made on the last day
of the month. The bank statement shows a collection by the bank of $940
and a customer's check for $320 was returned because it was NSF. A
customer's check for $450 was recorded on the books as $540, and a check
written for $79 was recorded as $97. The correct balance in the cash
account was
• a. $45,512. Book Balance ………...45,000
• b. $45,548. B + Cash Collection …….940
- NSF …..320
• c. $45,728. - error ……………………..90
• d. $47,848. + error…………………….….18
Balance ……………………45,548
55) The journal entries for a bank reconciliation

• a. are taken from the "balance per bank" section only.

• b. may include a debit to Expense for bank service charges.

• c. may include a credit to Accounts Receivable for an NSF check.

• d. may include a debit to Accounts Payable for an NSF check

B
56) For which of the following errors should the appropriate amount
be added to the balance per bank on a bank reconciliation?

• A). Check for $63 recorded by the company as $36.

• B). Deposit of $600 recorded by the bank as $60.

• C) returned $300 check recorded by the bank as $30.

• D) Check for $75 recorded by the company as $57.

B
57) When the allowance method of accounting for uncollectible
accounts is used, Bad Debt Expense is recorded
• A). in the year after the credit sale is made.
• B). in the same year as the credit sale.
• C). as each credit sale is made.
• D). when an account is written off as uncollectible

B
 Fundamental of Accounting 2

Chapter One
Inventories
Ermi E-learning | YouTube
 1.1. Classification of Inventories
Inventories are asset items held for sale in the ordinary
course of business, or goods to be used in the production
of goods to be sold.
Classifying Inventory
Merchandising Company Manufacturing Company
One Classification: Three Classifications:

◆ Merchandise Inventory ◆ Raw Materials

Helpful Hint: Regardless of ◆ Work in Process

the classification, companies
report all inventories under ◆ Finished Goods
6-119
Current Assets on the SoFP.
 1.2. Determining Inventory Quantities

No matter whether they are using a periodic or perpetual

inventory system, all companies need to determine inventory
quantities at the end of the accounting period.
Physical Inventory taken for two reasons:
Perpetual System

1. Check accuracy of inventory records.

2. Determine amount of inventory lost due to wasted raw

materials, and employee theft.

Periodic System

1. Determine the inventory on hand.

6-120 2. Determine the cost of goods sold for the period.

 Cont’d
Determining inventory quantities involves two steps:
(1) taking a physical inventory of goods on hand and
(2) determining the ownership of goods.

Taking a Physical Inventory

Involves counting, weighing, or measuring each kind of
inventory on hand.

Companies often “take inventory”

◆ when the business is closed

◆ at the end of the accounting period.

6-121
 Cont’d

Determining Ownership of Goods

GOODS IN TRANSIT

◆ Purchased goods not yet received.

◆ Sold goods not yet delivered.

Goods in transit should be included in the inventory

of the company that has legal title to the goods.
Legal title is determined by the terms of sale.
6-122
 Cont’d
Goods In Transit Illustration 6-2 Terms of sale

Ownership of the goods

passes to the buyer when
the public carrier accepts
the goods from the
seller.

Ownership of the goods

remains with the seller
until the goods reach the
buyer.
6-123
 1.3. Inventory Costing Methods
Inventory is accounted for at cost.
◆ Cost includes all expenditures necessary to acquire
goods and place them in a condition ready for sale.
◆ Unit costs are applied to quantities to compute the
total cost of the inventory and the cost of goods
sold using the following costing methods:
► Specific identification
► First-in, first-out (FIFO) Cost Flow
► Average-cost Assumptions

6-124
 1.5. Estimating Inventories

❖ Two circumstances explain why companies sometimes estimate inventories.

First, a casualty such as fire, flood, or earthquake may make it impossible to take a
physical inventory.
Second, managers may want monthly or quarterly financial
statements, but a physical inventory is taken only annually.
❖ The need for estimating inventories occurs primarily with a periodic inventory system
because of the absence of perpetual inventory records.
❖ There are two widely used methods of estimating inventories: (1) the gross profit
method, and (2) the retail inventory

Ermi E-learning | YouTube

 1.5. Estimating Inventories
Gross Profit Method
Estimates the cost of ending inventory by applying a gross profit rate to
net sales.
The gross profit method estimates the value of inventory by applying the
company's historical gross profit percentage to current‐period information
about net sales and the cost of goods available for sale.

Ermi E-learning | YouTube

 Retail Inventory Method
Company applies the cost-to-retail percentage to ending inventory
at retail prices to determine inventory at cost
Retail businesses track both the cost and retail sales price of inventory.
This method can be used by retailers who have their merchandise
records in both cost and retail selling prices.

Ermi E-learning | YouTube

 1.3. Inventory Costing Methods
Inventory is accounted for at cost.
◆ Cost includes all expenditures necessary to acquire
goods and place them in a condition ready for sale.
◆ Unit costs are applied to quantities to compute the
total cost of the inventory and the cost of goods
sold using the following costing methods:
► Specific identification
► First-in, first-out (FIFO)
► Average-cost

6-128
 1.3.4. Lower-of-Cost-or-Net Realizable Value
When the value of inventory is lower than its cost
✓ companies must “write down” the inventory to its
net realizable value.
✓ is the d/c b/n the cost of the inventories and the NRV &
✓ is expensed immediately in profit or loss in the period the
write-down occurs.

Net realizable value: Amount that a company expects to

realize (receive from the sale of inventory).
Inventories are not to be carried
✓ in excess of amounts expected to be realized from their
sale or use!
6-129
 > DO IT!
LC or NRV Basis
LION Company sells three different types of home heating
stoves (wood, gas, and pellet). The cost and net realizable
value of its inventory of stoves are as follows.

Determine the value of the company’s inventory under the

lower-of-cost-or-net realizable value approach.
Total inventory value is the sum of these amounts, NT$430,000.
1.4. Inventory Errors

◆ Unfortunately, errors occasionally occur in

accounting for inventory.
◆ In some cases, errors are caused by failure to
count or price inventory correctly.
◆ In other cases, errors occur because companies
do not properly recognize the transfer of legal
title to goods that are in transit.
◆ When errors occur, they affect both the
Income Statement and SoFP.
Ermi E-learning | YouTube
Income Statement Effects
Inventory errors affect the computation of Cost of Goods Sold
and Net Income in two periods.
Illustration 6-12: Formula for cost of goods sold

Illustration 6-13: Effects of inventory errors on current year’s income statement

Ermi E-learning | YouTube

 1.5. Estimating Inventories
❖ Two circumstances explain why companies sometimes estimate
inventories.
First, a casualty such as fire, flood, or earthquake may make it
impossible to take a physical inventory.
Second, managers may want monthly or quarterly financial
statements, but a physical inventory is taken only annually.
❖ The need for estimating inventories occurs primarily with a
periodic inventory system because of the absence of perpetual
inventory records.
❖ There are two widely used methods of estimating inventories: (1)
the gross profit method, and (2) the retail inventory

Ermi E-learning | YouTube

 1.5. Estimating Inventories
Gross Profit Method
Estimates the cost of ending inventory by applying a gross
profit rate to net sales.
The gross profit method estimates the value of inventory by
applying the company's historical gross profit percentage to
current‐period information about net sales and the cost of
goods available for sale.

Ermi E-learning | YouTube

Retail Inventory Method
Company applies the cost-to-retail percentage to ending
inventory at retail prices to determine inventory at cost
Retail businesses track both the cost and retail sales price of
inventory.
This method can be used by retailers who have their
merchandise records in both cost and retail selling prices.

Ermi E-learning | YouTube

58) Nolan Department Store estimates inventory by using the retail inventory
method. The following information was developed:
• At Cost At Retail
• Beginning inventory $318,000 $ 750,000
• Goods purchased 900,000 1,350,000
• Net sales 1,200,000
• The estimated cost of the ending inventory is
• a. $696,000. Cost Retail
CGAF 1,218,000 2,100,000
• b. $522,000. B Ratio = 1,218,000/2100000 = 0.58
• c. $882,000.
• d. $900,000. EI= 2,100,000-1200000 = 900,000
Estimated EI Cost = 900,000*0.58 = 522,000
59) Sharp Company uses specific identification method to value its inventory it purchases
Coming at different costs as follows:
January 5 : 2 units at a cost of Birr 2,000
February 8: 3 units at a cost of Birr 3,000
June 10 :5 units at a cost of Birr 4,000
On June 25, 6 units are sold at Bir 5,000 each.
From the items sold, 3 units are from February 8's purchase and 3 units from June 10
purchase. The amount of cost of goods sold and ending inventory as of June 30 are
………..and…………. respectively

February 8’s 3 * 3000 = 9000

A. Birr 17,000 and Birr 16,000 June 10 purchase 3 * 4000 = 12000
B. Birr 12,000 and Birr 21.000 C CGS = 21,000
Unsold unit
C. Birr 21,000 and B 12.000 Jan 2*2000 =4000
D. Birr 30000 and Ber 20,000 June 2*4000= 8000
EI= 12000
60) A company uses perpetual inventory system An inventory record card
shows the following details.
• January 1, inventory 5000 at a cost of 10
• January 15,sales 1000 at Birr 25
• February 10,purchase 3000 units at a cost Birrr20
• Sales on June 3 is 6000unit at Birr 25
In a perpetual inventory system, what is the Cost of Goods Sold as of June 3
sales connection if the company used FIFO ?
Purchase Cost of good sold Inventor
5000 *10 = 50,000
A)80,000 1000*10= 10,000 4000*10 = 40,000
B)75,000 A 3000*20= 60,000 4000*10 = 40,000
3000*20 = 60,000
C)60,000 4000*10= 40,000
2000*20= 40,000 1000*20= 20,000
D)90,000 CGS = 90,000
61) Which one of the following is FALSE about perpetual
inventory system?

A. Average costs are computed as a simple average of unit

costs incurred.

B. Inventory records continuously show balances that should be

on hand.

C. Cost of goods sold is determined after each sale

D. FIFO cost of goods sold will be the same as in a periodic

inventory system.
A
62) Which of the following should not be included in the
physical inventory of a company?

A. Goods in transit, bought from another company with FOB shipping

point term

B. Goods held on consignment from another company

C. Goods shipped on consignment to another company

B
D. Goods in process
63) Which of the following is NOT a reason the retail inventory
method is used widely?

A. To defer income tax liability.

B. As a control measure in determining inventory shortages.

C. To permit the computation of net income without a physical count

of inventory

D. For insurance information.

A
64) Western PLC uses periodic inventory system. The following balances were taken from its
accounting record:

Merchandise inventory balance as of March 1, 2023 Birr 400,000

Merchandise inventory balance as of March 31, 2023. Birr 150,000
Purchase during the period. Birr 510,000
Purchase discount.. Birr 10,000
Freight out Birr 5,000

The cost of merchandise sold is:

A. Birr 750,000 A
NP = P – PRA-PD = 510,000 – 10000= 500,000
B. Bir 760,000 CMP = NP + Freight in = 500,000 +0
CGS = BI + CMP – EI = 400,000+500,000 – 150,000
C. Birr 250,000 = 750,000

D. Birr 745,000
65) if goods in transit are shipped FOB destination

• a. the seller has legal title to the goods until they are delivered.

• b. the buyer has legal title to the goods until they are delivered.

• c. the transportation company has legal title to the goods while the
goods are in transit.

• d. no one has legal title to the goods until they are delivered.

A
66) Bell Inc. took a physical inventory at the end of the year and
determined that ETB 650,000 of goods were on hand.
In addition, Bell, Inc. determined that ETB 50,000 of goods that
were in transit that were shipped FOB shipping were actually
received two days after the inventory count and that the
company had ETB 75,000 of goods on consignment.
What amount should Bell report as inventory at the end of the
year?
A. ETB 650,000. C. ETB 725,000.
B. ETB 700,000. D. ETB 775,000
B
67) Which of the following items will increase inventorial costs for the
buyer of goods?

• a. Purchase returns and allowances granted by the seller

• b. Purchase discounts taken by the purchaser

• c. Freight charges paid by the seller

• d. Freight charges paid by the purchaser

D
68) Which of the following statements is correct with respect to
inventories?
• a. The FIFO method assumes that the costs of the earliest goods
acquired are the last to be sold.
• b. It is generally good business management to sell the most recently
acquired goods first.
• c. Under FIFO, the ending inventory is based on the latest units
purchased.
• d. FIFO seldom coincides with the actual physical flow of inventory.

C
69) A company just starting in business purchased three merchandise
inventory items at the following prices. First purchase $80; Second
purchase $95; Third purchase $85. If the company sold two units for a
total of $240 and used FIFO costing, the gross profit for the period would
be
• a. $65.
1) 80
• b. $75. A 2) 95
3) 85
• c. $60.
• d. $50 CGS= 80+95 = 175
EI= 85

GP = Sale – CGS
240 – 175 = 65
70) Hardaway Inc. purchased inventory as follows:
• Jan. 10 200 units at $5.00
• Jan. 20 500 units at $10.00
• Jan. 30 800 units at $15.00
• Hardaway Inc. had no beginning inventory and has 500 units on hand as
of January 31. Assuming the specific identification method is used and
ending inventory consists of 100 units from the Jan. 10 purchase, 300
units from the Jan. 20 purchase, and 100 units from the Jan. 30 purchase,
cost of goods sold would be
100*5= 500
• A). $13,000 200*10= 2000
• B). $4,000 A 700*15= 10500
13,000
• C). $7,500
• D). $5,000
71) Baker Bakery Company just began business and made the following four
inventory purchases in
• June:
• June 1 150 units $ 1,040
• June 10 200 units 1,560
• June 15 200 units 1,680
• June 28 150 units 1,320
• $5,600
• A physical count of merchandise inventory on June 30 reveals that there are 210
units on hand. Using the FIFO periodic inventory method, the amount allocated
to ending inventory for June is
• A). $1,456 June 28 150 Unit birr 1320
• B). $1,508 June 15 60* 8.4 = Birr 504
• C. $1,824 C 1824

• D. $1,848
72) An error in the physical count of goods on hand at the end of a period
resulted in a $10,000 overstatement of the ending inventory. The effect of
this error in the current period is Cost of Goods Sold and Net Income

• a. Understated Understated
CGS= BI+CMP – EI
• b. Overstated Overstated
C
• c. Understated Overstated GP = Sale – CGS

• d. Overstated Understated
NI= GP – Operating expense
73) If beginning inventory is Overstated by $10,000, the effect of
this error in the current period is Cost of Goods Sold Net and
Income
• a. Understated, Understated
• b. Overstated , Overstated CGS= BI+CMP – EI

• c. Understated Overstated
• d. Overstated Understated GP = Sale – CGS

D
NI= GP – Operating expense
74) The following information is available for Knot Company at December
31, 2008: beginning inventory $80,000; ending inventory $120,000; cost
of goods sold $900,000; and sales $1,200,000. Knot’s inventory turnover
in 2008 is
• a. 12 times.
ITO= CGS/ Average inventory
• b. 11.3 times.
Average inventory = B. inventory + E. inventory
2
• c. 9 times.
C
• d. 7.5 times
 Fundamental of Accounting 2

Chapter Two

Accounting for PPE

 2.1. Plant Assets
Plant Assets are resources that have

◆ physical substance (a definite size and shape),

◆ are used in the operations of a business,

◆ are not intended for sale to customers,

◆ are expected to provide service to the company

for a number of years.

Referred to as Property, Plant, and Equipment; Plant

and Equipment; and Fixed Assets.
 2.2. The Initial Cost of Plant Assets
The historical cost principle requires that
companies record plant assets at cost.

Cost consists of all expenditures necessary to

acquire an asset and make it ready for its
intended use.
Example
❖ ABC Co. orders a machine at a list price of Br. 10,000 with terms
of 2/10, 2/30, sales tax of Br. 588 must be paid, as well as fright
charges of Br. 1,250.
❖ Transportation form the rail road station to the factory costs Br. 150
& installation labor amounts, to Br. 400.
❖ Hiring One employee with a salary of Br. 800 operates the machine
and the salary paid for the first month of operation was Br. 800.
❖ Repair cost of Br. 2,000 was paid for damage occurred during
unpacking and installing.
❖ Cost of maintenance materials needed during the first month of
operation was Br.25.
List price of the Machine 10,000
Less cash discount ( 2% x Br. 10,000) 200
Net cash price 9,800
Sales tax 588
Freight 1,250
Transportation 150
Installation labor 400
Cost of machine Br. 12,188.00
The acquisition of the machine is then recorded as follows:
Machinery 12,188
Salary expense. 800
Maintenance expense. 25
Loss due to employee negligence 2,000
Cash 15,013
 2.3. Depreciation
Process of allocating the cost of a plant asset to
expense over its useful (service) life in a rational
and systematic manner.
◆ Process of cost allocation, not asset valuation.
◆ Applies to land improvements, buildings, and
equipment, not land.
◆ Depreciable, because the revenue-producing
ability of asset will decline over the asset’s
useful life.
 Causes of Depreciation
• The two major causes of depreciation are physical
deterioration & obsolescence.
• a. Physical Deterioration – occurs from wear & tear
while in use as well as from the action of the weather
(exposure to sun, wind, and other climatic factors)
• b. Obsolescence (Function Depreciation) - is the process
of becoming out of date before the assets physically wears
out.
Factors In Computing Depreciation
Illustration 9-6 Three Factors in Computing Depreciation.

• HELPFUL HINT
Depreciation expense is reported on the I/S.
Accumulated depreciation is reported on the
SoFP as a deduction from plant assets.
Depreciation Methods
Management selects the method it believes best
measures an asset’s contribution to revenue over
its useful life.
Examples include:
(1) Straight-line method
(2) Units-of-activity method
(3) Declining-balance method
(4) Sum of year digit method
 2.6. Plant Assets Disposals
Companies dispose of plant assets in three ways: Sale,
Retirement, or Exchange.
Illustration 9-19 Methods of Plant Asset Disposal

Record depreciation up to the date of disposal.

Eliminate asset by (1) debiting Accumulated Depreciation, and

(2) crediting the asset account.
 2.8. Extractable Natural Resources

Natural resources is a resource existing naturally,

not constructed by humans.

It consist of standing timber and resources extracted

from the ground, such as oil, gas, and minerals.

IFRS defines extractive industries as those businesses

involved in finding and removing natural resources
located in or near the earth’s crust.
 2.9. Intangible Assets
Intangible assets are rights, privileges, and competitive
advantages that result from ownership of long-lived assets
that do not possess physical substance.

Limited life or indefinite life.

Common types of intangibles:

◆ Patents ◆ Goodwill

◆ Copyrights ◆ Franchises

◆ Trademarks ◆ Leases

◆ Trade Names
75) In an exchange with commercial substance, Huang Company traded equipment with a cost of ¥8,200,000 and book
value of ¥3,120,000 and gave ¥4,698,000 cash. The old machine had a fair value of ¥2,960,000. Which of the following
journal entries would Huang make to record the exchange?
• a. Equipment 7,658,000
• Loss on Exchange 160,000
• Accumulated Depreciation 5,080,000
• Equipment 8,200,000
• Cash 4,698,000
• b. Equipment 8,208,000
• Equipment 8,200,000
• Cash 8,000 A
• c. Accumulated Depreciation 5,080,000
• Equipment 7,398,000
• Equipment 8,200,000
• Cash 4,698,000
• d. Equipment 7,658,000
• Accumulated Depreciation 542,000
• Equipment 8,200,000
76) A machine was purchased at a cost of $70,000. The equipment
had an estimated useful life of 8 years and had a residual value of
$6,000. Assuming the equipment was sold at the end of year 6 for
$14,000, determine the gain or loss on the sale of the equipment.
(Assume the straight-line depreciation method.)
• A) Loss 8,000
• B) Gain 8000
• C) 0
• D) Loss 16,000 A
77) Which of the following is not a necessary characteristic for an item to
be classified as property, plant and equipment?

• A). Have a useful life beyond one year

• B). Subject to depreciation

• C). Not intended for sale in the ordinary course of business

• D). Used in the conduct of business

B
78) On April 1, Mooney Corporation purchased for $855,000 a tract of land on
which was located a warehouse and office building. The following data were
collected concerning the property:
• Current Assessed Valuation Vendor’s Original Cost
• Land $300,000 $280,000
• Warehouse 200,000 D 180,000
• Office building 400,000 340,000
$900,000 $800,000
• What are the appropriate amounts that Mooney should record for the land,
warehouse, and office building, respectively?
• a. Land, $280,000; warehouse, $180,000; office building, $340,000.
• b. Land, $300,000; warehouse, $200,000; office building, $400,000.
• c. Land, $299,250; warehouse, $192,375; office building, $363,375.
• d. Land, $285,000; warehouse, $190,000; office building, $380,000
79) Cotton Hotel Corporation recently purchased Emporia Hotel and the
land on which it is located with the plan to tear down the Emporia Hotel
and build a new luxury hotel on the site. The cost of tear down the
Emporia Hotel should be
• a. depreciated over the period from acquisition to the date the hotel is
scheduled to be
• torn down.
• b. written off as loss in the year the hotel is torn down.
• c. capitalized as part of the cost of the land.
• d. capitalized as part of the cost of the new hotel

C
80) Which of the following assets do not qualify for capitalization of
interest costs incurred during construction of the assets?
• a. Assets under construction for a company's own use.
• b. Assets intended for sale or lease that are produced as discrete projects.
• c. Assets financed through the issuance of long-term debt.
• d. Assets not currently undergoing the activities necessary to prepare
them for their intended use.

D
81) When a plant asset is acquired by issuance of ordinary shares, the cost
of the plant asset is properly measured by the

• a. par value of the shares.

• b. stated value of the shares.

• c. book value of the shares. D

• d. fair value of the shares.
82) An improvement made to a machine increased its fair value and its
production capacity by 25% without extending the machine's useful life.
The cost of the improvement should be
• a. expensed.
• b. debited to accumulated depreciation.
• c. capitalized in the machine account.
• d. allocated between accumulated depreciation and the machine
account.

C
83) A company purchased land for its natural resources at a cost of
$1,640,000. It expects to mine 2,350,000 tons of ore from this land. The
residual value of the land is estimated to be $460,000.
• What is the amount of depletion per ton of ore?
• A). $1.119
Cost – SV
• B). $0.894 Estimated
• C). $0.502
• D). $0.698 1640,000 – 460,000
2,350,000

0.502
C
84) Equipment was purchased for $19400. It is estimated that the
equipment will have a $3000 residual value at the end of its 5-year useful
life. Using the straight-line method, annual depreciation expense will be
• A. $4480.
• B) $3280.
• C) $3880.
• D) $4850.
B
85) Which one of the following statements is FALSE about
property plant and equipment (PPE)?

A. Are acquired for use but not for sale under no normal course
of business

B. Can provide service for more than a year period

C. All items of PPE have unlimited life

D. They are tangible in nature C

86) An entity imported machinery to install in its new factory premises before
year-end. However, due to circumstances beyond its control, the machinery
was delayed by a few months but reached the factory premises before year-
end.
While this was happening, the entity learned from the bank that it was being
charged interest on the loan it had taken to fund the cost of the machinery.

What is the proper treatment of freight and interest expense?

A. Interest may be capitalized but freight should be expensed.
B. Both expenses should be expensed,
C. Freight charges should be capitalized but interest cannot be capitalized
under these circumstances
D. Both expenses should be capitalized.

C
• 87) On February 1, 2007, Morgan Corporation purchased a parcel of land as a
factory site for $200,000. An old building on the property was demolished, and
construction began on a new building which was completed on November 1,
2007. Costs incurred during this period are listed below:
• Demolition of old building $20,000
• Architect's fees 35,000
• Legal fees for title investigation and purchase contract 5,000
Construction costs 1,090,000
• (Salvaged materials resulting from demolition were sold for $10,000.)
• Morgan should record the cost of the land and new building, respectively, as
• a. $225,000 and $1,115,000. D Land cost ……………………Building cost
200,000 1,090,000
• b. $210,000 and $1,130,000. + 20,000 + 35,000
+ 5000 = 1,125,000
• c. $210,000 and $1,125,000. - 10,000
= 215,000
• d. $215,000 and $1,125,000.
88) After using equipment for five years, its major part that is believed to
increase life by 3 years is changed at a cost of Br. 30,000.
Which of the following is a correct about the effect of this cost?

• A. Increasing period costs by Br. 30,000

• B. Increasing revenue expenditure by Br 30,000

• C. Increasing general expense by Br. 30,000

D
• D. Increasing carrying value of the asset by Br. 30,000
89) ABC Company purchased a piece of equipment on January 1, 2012. The
equipment cost Birr 60,000 and has an estimated life of 8 years and a
salvage value of Birr 8,000.
What was the depreciation expense for the asset for 2013 under the
double-declining-balance method

Rate = (1/n ) * 2 = (1/8) *2 = 0.25

• A. Birr 6,562 B. Book value rate dep Ex Acc Dep exp E book value
60,000 0.25 15,000 15,000 45000
• B. Birr 15,000 45000 0.25 11250 26,250 33750

• C. Birr 11,250
C
• D. Birr 6.500
90) Hope Bank purchased a Special Copier machine. The machine, costs Birr
340,000, and was estimated to have useful life of 10 years.
The estimated residual value is Birr 40,000. After two years of service it became
evident that the copier machine's total useful life is 7 years instead of 10 years.
Depreciation was recorded for two years based on straight line method. There is
no change on estimated residual value. Based on this information, what is the
new annual depreciation charge on the basis of the revised estimated useful life?

A. Birr 52,000 Original depreciation expense = [(340,000 − 40,000) ÷ 10] = 30,000

Accumulated depreciation after 2 years = 2 × 30,000 = 60,000
Book value = 340,000 − 60,000 = 280,000
B. Birr 48,000
Book value after 2 years of depreciation 280,000
Less: New salvage value 40000
C. Birr 42,500 B Depreciable cost 240,000
Remaining useful life 5 years
D. Bir 30,000 Revised annual depreciation (280,000 ÷ 5) 48,000
91) Yene Company purchased land containing an estimated
1,000,000 tons of ore for a cost of Birr 10,500,000. The land
without the ore is estimated to be worth Bir 500,000.
During its first year of operation, the company mined and sold
300,000 tons of ore.
What is the amount of depletion expense that Yene Company
should record for the year? Depletion Expense = Cost – SV
Estimated life
D 10,000,000 – 0
1,000,000
A. Birr 7,000,000 10 birr/ton
300,000 * 10 = 3,000,000
B. Birr 3,150,000 Depletion Expense ….. 3,000,00
Acc Depletion expense ….3,000,000
C. Birr 10,000,000
D. Birr 3.000.000
92) On April 1, 2001 La Presa Company sells some equipment for $18,000. The
original cost was $50,000, the estimated salvage value was $8,000, and the
expected useful life was 6 years. On December 31, 2000 the Accumulated
Depreciation account had a balance of $29,400.
The gain or loss on the sale was: (SL depreciation method )
a) $2,600 gain Dec 31 2000 Acc Dep Exp = 29400

b) $300 gain Assets slod on April 1 2001

c) $850 loss Cost – salvage = 50000-8000 = 7000

d) $5,400 gain Estimated life 6

7000/12= 583.33 so 3*583.33= 1750

April 1 2001 Acc Dep Exp = 1750+29400= 31150

Book value = 50000- 31150= 18850
Process value = 18000
So PV < BV BY 850

c
93) Which of the following intangible assets could not be
sold by a business to raise needed cash for a capital project?

A. Copyright.

B. Trade name.

C. Patent.
D
D. Goodwill.
94) At the beginning of the year, a company purchases a patent for Birr 2,400,000. The remaining
legal life of the patent is 12 years but management estimates that the patent will generate additional
revenue for the next 16 years because there are currently no known competitors.

At the end of the first year, management calculates straight-line amortization to be Birr 150,000
Which of the following statements is correct?

A. Management's calculation is correct.

B. Management should not amortize the asset until its useful life becomes more evident.

C. Management should amortize the asset over 20 years.

D
D. Management should amortize the asset over 12 years
Fundamental of Accounting 2

CHAPTER3

CURRENT LIABILITIES
 What is a Liability?

IASB, defines a liability as a present obligation of

a company arising from past events, the settlement
of which is expected to result in an outflow from
the company of resources, embodying economic
benefits. In other words, a liability has three
essential characteristics:
Liability:
1. is a present obligation.
2. arises from past events.
3. results in an outflow of resources (cash,
goods, services).
 What is a Current Liability?

Current liability is reported if one of two conditions exists:

1.Liability is expected to be settled within its normal operating cycle; or

2. Liability is expected to be settled within 12 months after the reporting
date.
The operating cycle is the period of time elapsing between the acquisition
of goods and services and the final cash realization resulting from sales
and subsequent collections.

LO 1 Describe the nature, type, and valuation of current liabilities.

 What is a Current Liability?

Typical Current Liabilities:

◆ Accounts payable. ◆ Customer advances and
deposits.
◆ Notes payable.
◆ Unearned revenues.
◆ Current maturities of long-
term debt. ◆ Sales taxes payable.
◆ Short-term obligations ◆ Income taxes payable.
expected to be refinanced.
◆ Employee-related liabilities.
◆ Dividends payable.

LO 1 Describe the nature, type, and valuation of current liabilities.

 What is a Current Liability?

Accounts Payable (trade accounts payable)

Balances owed to others for goods, supplies, or services

purchased on open account.
◆ Time lag between the receipt of services or
acquisition of title to assets and the payment
for them.

◆ Oral Agreement

◆ Terms of the sale (e.g., 2/10, n/30 or 1/10,

E.O.M.)
LO 1 Describe the nature, type, and valuation of current liabilities.
 What is a Current Liability?

Notes Payable
Written promises to pay a certain sum of money on a
specified future date.

◆ Arise from purchases, financing, or other transactions.

◆ Notes classified as short-term or long-term.

◆ Notes may be interest-bearing or zero-interest-bearing.

 What is a Current Liability?

Interest-Bearing Note Issued

Illustration: Castle National Bank agrees to lend $100,000 on March
1, 2011, to Landscape Co. if Landscape signs a $100,000, 6 percent,
four-month note. Landscape records the cash received on March 1 as
follows:

Cash 100,000
Notes Payable 100,000
 What is a Current Liability?

If Landscape prepares financial statements semiannually, it

makes the following adjusting entry to recognize interest
expense and interest payable at June 30:

Interest calculation = ($100,000 x 6% x 4/12) = $2,000

Interest expense 2,000

Interest payable 2,000
 What is a Current Liability?

At maturity (July 1), Landscape records payment of the note and

accrued interest as follows.

Notes payable 100,000

Interest payable 2,000
Cash 102,000
 What is a Current Liability?

Zero-Bearing Note Issued

Illustration: On March 1, Landscape issues a $102,000, four-
month, zero-interest-bearing note to Castle National Bank. The
present value of the note is $100,000. Landscape records this
transaction as follows.

Cash 100,000
Notes payable 100,000

LO 1 Describe the nature, type, and valuation of current liabilities.

 What is a Current Liability?

If Landscape prepares financial statements semiannually, it

makes the following adjusting entry to recognize interest expense
and the increase in the note payable of $2,000 at June 30.

Interest expense 2,000

Notes payable 2,000

At maturity (July 1), Landscape must pay the note, as follows.

Notes payable 102,000

Cash 102,000

LO 1 Describe the nature, type, and valuation of current liabilities.

95) Liabilities are
A. any accounts having credit balances after closing entries are made.

B. deferred credits that are recognized and measured in conformity with

generally accepted accounting principles.

C. obligations to transfer ownership shares to other entities in the future.

D) present obligations arising from past events resulting in an outflow of

resources.
D
96) Which of the following may be a current liability?
• A. Withheld Income Taxes
• B. Deposits Received from Customers
• C. Unearned Revenue
• D. All of these answers are correct
D
97) Vista newspapers sold 4,000 of annual subscriptions at $125 each
on September 1. How much unearned revenue will exist as of
December 31?
• a. $0.
• b. $333,333. B
• c. $166,667.
• d. $500,000.
98) PPP Retailer made cash sales during the month of October of $132,600. The
sales are subject to a 6% sales tax that was also collected.

• Which of the following would be included in the summary journal entry to

reflect the sale transactions?
Cash ………..139,956
• a. Debit Cash for $132,600. sale ……………….132,600
Sale tax payable .. 7956
• b. Credit Sales Tax Payable for $7,506.

• c. Credit Sales for $125,094. D

• d. Credit Sales Tax Payable for $7,956.
 Fundamental of Accounting 2

Chapter Four
Ethiopian Payroll System
You can get this Topic In Public Finance
Course
Fundamental of Accounting 2
Chapter Five
Accounting for partnership
Partnership: definition
• partnership is defined as:
• an association of two or more persons
• to carry on business
• as co-owners
• for a profit .
• Partnership Act (agreement) is:
• The relationship that ‘ exist between persons carrying on a business in
common, with a view to profit ’
Partnership agreement
• Partnership agreement ( Articles of co-partnership )
• written contract (voluntary) that consists
• Names and capital contributions of the partners.
• Rights and duties of partners.
• Basis for sharing net income or net loss.
• Provision for withdrawals of assets.
• Procedures for submitting disputes to arbitration.
• Procedures for the withdrawal or addition of a partner.
CHARACTERISTICS OF PARTNERSHIPS

• Principal characteristics of a partnership are:

• Ease of formation
• Association of individuals
• Mutual agency : each partner has authorization powers
• Limited life
• Unlimited liability
• Co-ownership of property
• No Double taxability
Advantages of partnership
 Advantages
 Pooling of resources
 Low cost
 Formed at little or no cost
 Subject to little regulation
 No double Taxable
 A partnership combines of the partners capital, talent, experience and
knowledge
Disadvantages of partnership
• The disadvantages are:
• Unlimited liability
• Limited life
• Mutual agency
• Difficulty to raise large amount of money
• Ownership is not easily transferred
• Lack of freedom of action
Accounting for partnership
• Accounting for a Partnership deals with:
• Formation
• Distribution of profits and loss
• Change in partnership members
• Liquidation
99) In a Fire & Water partnership, net income and net loss is shared equally. On the date of
liquidation of their partnership, records showed the following balances.
Cash Birr……………..200,000
Non cash assets……...400,000
Accounts payable…….100,000
Fire's capital…………300,000
Water's capital……….200,000
If non cash assets were sold at Br 500,000, which of the following statement is correct?
A. The amount of distributed to Water equals Br200,000
B. The amount of cash available to partners equal Br700,000
C. The amount of cash distributed to Fire equals Br 350.000
D. The amount of cash distributed to Fire equals Br 300,000
Cash noncash Liability F W
Balance 200000 400,000 100000 300000 200000
Realization + 500000 -400000 +50000 50000
Balance 700000 0 100000 350000 250000
Payment Liability -100,000 -100,000
C Balance 600,000 0 0 350,000 250000
Distribution -600000 -350,000 -250000
0 0 0 0 0
100) Hiwot and Yonas have original investments of ETB 50,000 and ETB
100,000 respectively in a partnership. The articles of partnership include
the following provisions regarding the division of net income: interest on
original investment at 10%, salary allowances of ETB 27,000 and ETB
18,000 respectively, and the remainder equally. How much of the net
income of ETB 40,000 is allocated to Hiwot?
A. ETB 20,000 Hiwot Yonas Total
Salary allowance 27000 18000 45000
B. ETB 22,000 Capital interest
Remaining income
5000*
(10000)
10000*
(10000)
15000
(20000)
Total 22000 18000 40000
C. ETB 32,000
Hiwot capital interest = 50000*0.1 = 5000
D. ETB 0 Yonas Capital interest = 100000*0.1 = 10000

B
101) As part of the initial investment, Omar contributes accounts
receivable that had a balance of ETB 22,500 in the accounts of a sole
proprietorship. Of this amount, ETB 2,000 is completely worthless. For the
remaining accounts, the partnership will establish a provision for possible
future uncollectible accounts of ETB 1,500. The amount debited to
Accounts Receivable for the new partnership is
A. ETB 19,000 D
B. ETB 22,500
C. ETB 21,000
22500-2000 = 20500
D. ETB 20,500
102) In a partnership, mutual agency means
• a. each partner acts on his own behalf when engaging in partnership
business.
• b. the act of any partner is binding on all other partners, only if partners
act within their cope of authority.
• c. an act by a partner is judged as binding on other partners depending on
whether the act appears to be appropriate for the partnership.
• d. that partners must pay taxes on a mutual or combined basis.

A
103) Norton invests personally owned equipment, which originally cost $110,000 and has accumulated
depreciation of $30,000 in the Norton and Kennett partnership. Both partners agree that the fair market
value of the equipment was $60,000. The entry made by the partnership to record Norton's investment
should be
• a. Equipment ............................................................................ 110,000
• Accumulated Depreciation—Equipment...................... 30,000
• Norton, Capital............................................................. 80,000
• b. Equipment ............................................................................ 80,000
• Norton, Capital............................................................. 80,000
• c. Equipment .......................................................................... 60,000
• Loss on Purchase of Equipment .......................................... 20,000
• Accumulated Depreciation—Equipment............................... 30,000 D
• Norton, Capital............................................................. 110,000
• d. Equipment ............................................................................ 60,000
Norton, Capital............................................................. 60,000
104) Partner B is investing in a partnership with Partner A. B contributes
as part of his initial investment, Accounts Receivable of $80,000; an
Allowance for Doubtful Accounts of $12,000; and $8,000 cash. The entry
that the partnership makes to record B's initial contribution includes a
• a. credit to B, Capital for $88,000.
• b. debit to Accounts Receivable for $68,000.
• c. credit to B, Capital for $76,000.
• d. debit to Allowance for Doubtful Accounts for $12,000

AR………..80000
C Cash………..12000
AFDA…………12000
B Capital……76000
105) Partners Jim and Joe have agreed to share profits and losses in an
80:20 ratio respectively, after Jim is allowed a salary allowance of
$140,000 and Joe is allowed a salary allowance of $70,000. If the
partnership had net income of $140,000 for 2008,
• Joe’s share of the income would be
• a. $70,000.
Jim Joe Total
• b. $56,000. salary allowance 140000 70000 210,000
Remaining (56000) (14000) ( 70000)
• c. $84,000. Total 84000 56000 140,000
• d. $14,000
B
106) The partnership of Nott and Reese reports net income of $60,000. The
partners share equally in income and losses. The entry to record the
partners' share of net income will include a
• a. credit to Income Summary for $60,000.
• b. credit to Nott, Capital for $30,000.
B
• c. debit to Reese, Capital for $30,000.
• d. credit to Reese, Drawing for $30,000
107) Tomas and Sara are partners who share income in the ratio of 3:1.
Their capital balances are $80,000 and $120,000 respectively. net come is
$30,000. What is Sara’s capital balance after closing Income Summary to
Capital?
• A. $102,500
3:1
• B. $120,000
• C. $112,500 D Tomas = ¾
Sara= ¼
• D. $127,500 Sara= ¼ * 30,000 = 7500

Total capital = 7500+120,000

= 127,500
108) Samuel and Darci are partners. The partnership capital for Samuel is
$50,000 and for Darci is $60,000. Josh is admitted as a new partner by
investing $50,000 cash. Josh is given a 20% interest in return for his
investment. The amount of the bonus to the old partners is
• A. $0
Total Capital Before Josh = 110,000
• B. $18,000
Josh = 50000
• C. $8,000
Total Capital After Josh = 160,000
• D. $10,000
Josh= 160,000*0.2 = 32,000
B
Bonus To Old Partner = 50000 – 32,000
= 18,000
109) Lowe is admitted to a partnership with a 25% capital interest by a cash
investment of $120,000. If total capital of the partnership is $520,000
before admitting Lowe, the bonus to Lowe is

• a. $40,000.

• b. $20,000.
A
• c. $60,000.

• d. $80,000
110) The liquidation of a partnership may result from each of the
following except the

• a. bankruptcy of the partnership.

• b. death of a partner. C
• c. retirement of a partner.

• d. sale of the business by the partners.

111) Partners A, B, and C have capital account balances of $120,000 each.
The income and loss ratio is 5:2:3, respectively. In the process of
liquidating the partnership, noncash assets with a book value of $100,000
are sold for $40,000. The balance of Partner B’s Capital account after the
sale is
• a. $90,000.
Cash noncash Liability A B C
• b. $102,000. Balance 0 100,000 0 120,000 120,000 120,000
Realization + 40,000 -100,000 - 30000 -12000 -18,000
• c. $108,000. Balance 40,000 0 0 90,000 108,000 102000
• d. $132,000.
C
112) Stine and Watson have partnership capital balances of $320,000 and
$240,000, respectively. Watson negotiates to sell his partnership interest to
Leary for $280,000. Stine agrees to accept Leary as a new partner. The
partnership entry to record this transaction is
• a. Cash.................................................................. 280,000
• Leary, Capital .............................................................. 280,000
• b. Watson, Capital............................................... 280,000
• Leary, Capital .............................................................. 280,000
• c. Cash....................................................................... 40,000
• Watson, Capital......................................................... 240,000
• Leary, Capital .............................................................. 280,000
• d. Watson, Capital....................................................... 240,000
• Leary, Capital .............................................................. 240,000
D
113) The admission of a new partner to an existing partnership

• a. may be accomplished only by investing assets in the partnership.

• b. requires purchasing the interest of one or more existing partners.

• c. causes a legal dissolution of the existing partnership.

• d. is almost always accompanied by the liquidation of the business.

C
 •Chapter six

•Accounting Corporation
 5.1. The Corporate Form of Organization
What is Corporation?
◆ A corporation is an entity separate and distinct from
its owners.
◆ A corporation is created by law, and its continued
existence depends upon the statutes of the jurisdiction
in which it is incorporated.
◆ As a legal entity, a corporation has most of the rights
and privileges of a person.
◆ A corporation is subject to the same duties and
responsibilities as a person. For example, it must abide
by the laws, and it must pay taxes.
 Cont’d
Classified by Purpose
◆ Not-for-Profit
◆ For Profit

Classified by Ownership
◆ Publicly held
◆ Privately held
Characteristics of a Corporation
Characteristics that distinguish corporations from
proprietorships and partnerships.
◆ Separate Legal Existence
◆ Limited Liability of Shareholders
◆ Transferable Ownership Rights
Advantages
◆ Ability to Acquire Capital
◆ Continuous Life
◆ Corporate Management
◆ Government Regulations Disadvantages
◆ Additional Taxes
Corporate Capital

Many companies reporting under IFRS often use the term “reserve” as an all-inclusive
catch-all for items such as retained earnings, share premium, and accumulated other
comprehensive income.
LO 2
114) Which of the following is correct, if MAMA Share
Company issued 1,000 shares of Birr 100 par value ordinary
shares receiving a total amount of Birr 120,000?

A. Retained earnings account is credited for Birr 20,000

B. Ordinary share capital account is credited for Birr 120,000
C. The transaction results in a gain of Birr 20,000
D. Total shareholders equity increases by Birr 120,000

Cash ……………….120,000
Ordinary share(100*1000) …………..100,000 D
Share premium.. …………………………..20000
115 ) Before 3 years, HH Company issued 10,000 shares, Birr 100 par value ordinary shares at Birr
120 per share. The following transactions occurred during the current year.

• October 1: Purchased 2.000 shares for the treasury at Birr 90 per share.
• December 5: Sold 1,000 treasury shares at Birr 95 per share
• December 31: Dividend of Birr 45,000 is declared.
• Based on the above information, which of the following is correct?

A. Treasury stock account is credited for Birr 120,000

Cash (120*10000)…….1,200,000
B. Dividend per share is Birr 4.5 Ordinary share .(100*10000)….1,000,000
Share premium (20*10000) 200,000

C. Dividend per share is Birr 5

C Oct 1= treasury Share (2000*90)………..180,000
Cash …………………………180000
Dec 5) = Cash .(1000*95)…….95000
D. Cash is debited by Bin 120,000. Treasury Share…(1000*90) ….90000
Share premium (1000*5)…….5000
Dec 31 = DPS = Dividend / Numbers of outstanding share
45000/ 9000 = 5
116) Stockholders of a business enterprise are said to be the residual
owners. The term residual owner means that shareholders
• a. are entitled to a dividend every year in which the business earns a
profit.
• b. have the rights to specific assets of the business.
• c. bear the ultimate risks and uncertainties and receive the benefits of
enterprise ownership.
• d. can negotiate individual contracts on behalf of the enterprise.

C
117) Which of the following represents the total number of shares that a
corporation may issue under the terms of its charter?

• a. authorized shares

• b. issued shares A
• c. unissued shares

• d. outstanding shares
118) In January 2010, Finley Corporation, a newly formed company,
issued 10,000 shares of its $10 par common stock for $15 per share. On
July 1, 2010, Finley Corporation reacquired 1,000 shares of its
outstanding stock for $12 per share.
The acquisition of these treasury shares
• a. decreased total stockholders' equity.
• b. increased total stockholders' equity. A
• c. did not change total stockholders' equity.
• d. decreased the number of issued shares.
119) Which of the following features of preferred stock makes the
security more like debt than an equity instrument?

• a. Participating

• b. Voting C
• c. Redeemable

• d. Noncumulative
120) The cumulative feature of preferred stock
• a. limits the amount of cumulative dividends to the par value of the
preferred stock.
• b. requires that dividends not paid in any year must be made up in a later
year before dividends are distributed to common shareholders.
• c. means that the shareholder can accumulate preferred stock until it is
equal to the par value of common stock at which time it can be converted
into common stock.
• d. enables a preferred stockholder to accumulate dividends until they
equal the par value of the stock and receive the stock in place of the cash
dividends.
B
121) On September 1, 2010, Valdez Company reacquired 12,000 shares of
its $10 par value common stock for $15 per share. The journal entry to
record the reacquisition of the stock should debit
• a. Treasury Stock for $120,000.
• b. Common Stock for $120,000.
• c. Common Stock for $120,000 and Paid-in Capital in Excess of Par for
$60,000.
• d. Treasury Stock for $180,000.
Treasury Stock ……180000
Share Ordinary ………120000
D Share Premium …………60000
122) Alt Corp. issues 5,000 shares of $10 par value common stock at $14
per share. When the transaction is recorded, credits are made to:
• A.) Common Stock $50,000 and Paid-in Capital in Excess of Stated Value
$20,000.
• B). Common Stock $70,000.
• C). Common Stock $50,000 and Paid-in Capital in Excess of Par Value
$20,000.
• D). Common Stock $50,000 and Retained Earnings $20,000
Cash ……70,000
Share Ordinary ………50000
Share Premium …………20000
C
123) Outstanding stock of the Bush Corporation included 40,000 shares of
$5 par common stock and 20,000 shares of 5%, $10 par cumulative
preferred stock. In 2011, Bush did not declare or pay any dividends. In
2012, Bush declared and paid dividends of $24,000. How much of the 2012
dividend was distributed to preferred shareholders?
• A. $14,000.
• B. $18,000.
Preferred stock Dividends = 20000*10*0.05
• C. $10,000. = 10000
• D. $20,000 First Year 10000
Second Year 10000
D 20000
 124) Which one of the following will result from a stock repurchase?
• A) Increase in the number of shares outstanding
• B) Decrease in the earnings per share
• C) Decrease in the market price per share
• D) Decrease in the P/E ratio

D
Intermediate Accounting 1

Chapter One

Development of Accounting Principles and Professional

Practice
 Objective of Financial Accounting

Objective: Provide financial information about the reporting

entity that is useful to
present and potential equity investors,
lenders, and
other creditors
in making decisions in their capacity as capital providers.

Slide 1-
240
 Objective of Financial Accounting

General-Purpose Financial Statements

Provide financial reporting information to a wide variety
of users.
Provide the most useful information possible at the
least cost.
Investors are the primary user group.
Special Purpose Financial Reporting Framework, is a financial reporting
framework designed to meet the financial information needs of specific
users or to comply with a specific agreement or regulatory requirement.

Slide 1-
241
 Standard-Setting Organizations

Two Major Organizations:

International Accounting Standards Board (IASB)

➢ Issues International Financial Reporting Standards

(IFRS).

Financial Accounting Standards Board (FASB)

➢ Issues Statements of Financial Accounting

Standards (SFAS).

Slide 1-
242
 Standard-Setting Organizations

International Accounting Standards Board (IASB)

Composed of four organizations—

➢ International Accounting Standards
Committee Foundation (IASCF)

➢ International Accounting Standards

Board (IASB) http://www.iasb.org

➢ Standards Advisory Council

➢ International Financial Reporting

Interpretations Committee (IFRIC)

Slide 1-
243
 Standard-Setting Organizations

Illustration 1-4
International Standard-Setting Structure

Slide 1-
244
 Types of Pronouncements

Hierarchy of IFRS
Companies first look to:

1. International Financial Reporting Standards;(IFRS)

2. International Accounting Standards; and (IAS)

3. Interpretations originated by the International Financial

Reporting Interpretations Committee (IFRIC) or the
former Standing Interpretations Committee (SIC).

Slide 1-
245
 Conceptual Framework

Conceptual Framework establishes the concepts

that underlie financial reporting.

Need for a Conceptual Framework

Rule-making should build on and relate to an
established body of concepts.

Enables IASB to issue more useful and consistent

pronouncements over time.

Slide 1-
246
 Conceptual Framework

Development of a Conceptual Framework

IASB and FASB are working on a joint project to
develop a common conceptual framework

Framework will build on existing IASB and FASB

frameworks.

Project has identified the objective of financial

reporting and the qualitative characteristics of
decision-useful financial reporting information.

Slide 1-
247
 Conceptual Framework

Overview of the Conceptual Framework

Three levels:
First Level = Basic objective

Second Level = Qualitative characteristics and

elements of financial statements

Third Level = Recognition, measurement, and

disclosure concepts

Slide 1-
248
 ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
3. Monetary unit 3. Expense recognition
Third
level
4. Periodicity 4. Full disclosure
5. Accrual

QUALITATIVE
CHARACTERISTICS ELEMENTS
1. Fundamental 1. Assets
qualities 2. Liabilities Second level
2. Enhancing 3. Equity
qualities 4. Income
5. Expenses
Illustration 1-7
Framework for Financial
Reporting OBJECTIVE
Provide information
about the reporting
entity that is useful
to present and potential First level
equity investors,
lenders, and other
creditors in their
capacity as capital
Slide 1- Providers.
249
 Second Level: Fundamental Concepts
Illustration 1-8 Hierarchy of Accounting Qualities

Slide 1-
250
1) A Company issues its annual financial reports within one
month of the end of the year. This is an example of was
enhancing quality of accounting information?

A. Relevance

B. Verifiability

C. Timeliness C

D. Confirmatory value
2) According to the IASB Framework, the two criteria required for
incorporating items into the income statement or statement of
financial position are that:
C
A. It satisfies the criteria of capital maintenance.

B. It meets the requirements of comparability and consistency.

C. It meets the definition of an element and can be measured

reliably.

D. It meets the definition of relevance and faithful representation

3) A soundly developed conceptual framework of concepts and objectives
should
• a. increase financial statement users' understanding of and confidence in
financial reporting.
• b. enhance comparability among companies' financial statements.
• c. allow new and emerging practical problems to be more quickly solved.
• d. All of these answer choices are correct.

D
4) What is a purpose of having a conceptual framework?
• a. To enable the profession to more quickly solve emerging practical problems.
• b. To provide a foundation from which to build more useful standards.
• c. Neither a nor b.
• d. To enable the profession to more quickly solve emerging practical problems
and to provide a foundation from which to build more useful standards.

D
5) The objective of general-purpose financial reporting is to provide
financial information about a reporting entity to each of the following
except
• a. potential equity investors.
• b. potential lenders.
• c. present investors.
• d. Tax Authority

D
6) What is the following is a characteristic describing the primary quality of
relevance?
• a. Predictive value.
• b. Completeness.
• c. Verifiability.
• d. Understandability.

A
7) What is meant by consistency when discussing financial accounting
information?
• a. Information that is measured and reported in a similar fashion across
points in time.
• b. Information is timely.
• c. Information is measured similarly across the industry.
• d. Information is verifiable.

A
8) What is the quality of information that is capable of making a
difference in a decision?
• a. Faithful representation.
• b. Materiality.
• c. Timeliness.
• d. Relevance.

D
9) Which accounting assumption or principle is being violated if a
company provides financial reports only when it introduces a new
product?
• a. Economic entity.
• b. Periodicity.
• c. Revenue recognition.
• d. Full disclosure.

B
10) Which of the following serves as the justification for the periodic
recording of depreciation expense?
• a. Association of efforts (expense) with accomplishments (revenue)
• b. Systematic and rational allocation of cost over the periods benefited
• c. Immediate recognition of an expense
• d. Minimization of income tax liability

B
11) Application of the full disclosure principle
• a. is theoretically desirable but not practical because the costs of complete
disclosure exceed the benefits.
• b. is violated when important financial information is buried in the notes
to the financial statements.
• c. is demonstrated by the use of supplementary information explaining
the effects of financing arrangements.
• d. requires that the financial statements be consistent and comparable.

C
• 12) A conceptual framework for financial reporting is:

A. A set of principles which underpin financial reporting

B. A set of regulations which govern financial reporting

C. A set of financial reporting standards

D. A set of items which make up an entity's financial statements

A
13) The fundamental qualitative characteristics of financial information
are:

A. Relevance and comparability

B. Verifiability and understandability

C. Relevance and faithful representation

D. Faithful representation and comparability C

14) Which of the following is not true concerning a conceptual framework in
accounting:
A) it should be a basis for standard-setting
B) it should allow practical problems to be solved more quickly by reference to it
C) it should be based on fundamental truths that are derived from the laws of
nature
D) all of these answer choices are true

C
 CHAPTER TWO

FAIR VALUE MEASUREMENT(IFRS 13)

265
266
Fair Value: Hierarchy

267
Fair value: Valuation Techniques

268
 Fair value: non-financial asset

Highest and best use

⚫ Fair value assumes a non-financial asset is used by market participants
at its highest and best use
✓ the use of a non-financial asset by market participants that maximises
the value of the asset
– physically possible

– legally permissible

– financially feasible

269
15 Which of the following defines the term ‘fair value’?
A. The price at which an orderly transaction to sell an asset or to
transfer a liability would take place between market participants at
the reporting date under current market conditions
B. The price that would be received to sell an asset or paid to transfer
a liability in an orderly transaction between market participants at
the measurement date
C. The weighted average price at which orderly transactions to sell
assets or to transfer liabilities are taking place between market
participants at the reporting date in the relevant market
D. The entry price at the measurement date from the perspective of a
market participant that holds the asset or owes the liability
B
16) Giaconda, Inc. acquires an asset for which it will measure the fair value by
discounting future cash flows of the asset. Which of the following terms best
describes this fair value measurement approach?

• A. Market.

• B. Income.

• C. Cost. B
• D. Observable inputs.
17) Unobservable inputs for the asset or liability
are an example of:
• a) a Level 1 input
b) a Level 2 input
c) a Level 3 input
d) a Level 4 input
Level 1 assets, such as stocks and bonds, are the easiest to
value,
while Level 3 assets can only be valued based on internal
models or "guesstimates" and have no observable market
prices.
C Level 2 assets must be valued using market data obtained
from external, independent sources.
18) In determining the fair value of an asset or liability, would the fair value
of the asset or the fair value of the liability be determined using an entry
price or an exit price?

Asset Fair Value Liability Fair Value

a) Entry price Entry price
b) Entry price Exit price D
c) Exit price Entry price
d) Exit price Exit price
19) Papa Company acquired land with an office building on it from its subsidiary, Sonny
Company, for $110,000. Prior to the sale, Sonny's carrying value of the land was
$60,000 and its net carrying value of the building was $50,000. At the time of the
transaction, Papa appropriately determined that the land had a fair value of $75,000
and the building had a fair value of $35,000. At what amount should Papa record the
land and building on its books at the date of the transaction?
Land Building
a) $75,000 $35,000
A
b) $55,000 $55,000
c) $60,000 $50,000
d) $50,000 $60,000
20) When the fair value of an asset is determined as the amount that
currently would be required to replace the service capacity of the asset,
which one of the following valuation techniques has been used?

•
A. Income approach.
B. Cost approach.
C. Expense approach. B
D. Market approach.
21) On January 15, 2008, Able Co. made a significant investment in the debt
securities of Baker Co., which it intends to hold until the debt matures.
Able's fiscal year-end is December 31. If Able Co. intends to measure and
report its investment in Baker Co. debt securities at fair on which one of the
following dates must Able elect to implement the fair value option?
•

A. January 15, 2008

B. January 31, 2008
C. March 31, 2008
D. December 31, 2008 A
• Cash and Receivables
• Inventories
• Property, Plant, and Equipment

• You can get this topic on The course of

Fundamental of Accounting 1 & 2
• Impairment Loss (IAS 38)
 DEFINITIONS OF TERMS

Impairment
• A fall in the value of an asset (recoverable amount is less than carrying value).
Carrying amount (CA)
• The net value of the asset (after deducting accumulated depreciation & any
impairment losses).
• If value of the asset is higher than its realistic value (RA) ', the asset is judged to have
suffered an impairment loss.
• It will be reduced in value, by the amount of the imp. loss and the amount should
be written off against profit immediately

279
 THE THREE ACCOUNTING ISSUES
• How is it possible to identify when an imp. loss may have occurred?
• How should the RA of the asset be measured?
• How should an 'impairment loss' be reported in the accounts?
1. Identifying a Potentially Impaired Asset
• Assess at the end of each reporting period whether there are any indications of
impairment to any assets.
• The concept of materiality applies, & only material impairment needs to be
identified.

280
 THE THREE ACCOUNTING ISSUES…

• Suggestions by the standard are based largely on common sense

Source of Information
External Sources Of Information
• A fall in the asset's market value that is more significant than would normally be
expected.
• A significant change in the technological, market, legal or economic environment
of the business.
• An increase in market interest rates or market rates of return on investments
likely to affect the discount rate.

281
 THE THREE ACCOUNTING ISSUES…
• The carrying amount of the entity's net assets being more than its market
capitalization.
Internal Sources Of Information
• Obsolete or physically damaged asset
• Significant changes in the extent or manner in which, an asset is used (idle assets,
plans to dispose, discontinue…
• Internal reporting indicates that the economic performance of an asset is, or will
be, worse than expected
Exceptions:(must always be tested for impairment annually with no indication of
imp. )
• An intangible asset with an indefinite useful life ( 10 yrs renewable Brand right).
• Goodwill acquired in a business combination 282
 THE THREE ACCOUNTING ISSUES…

2. Measuring the Recoverable Amount of the Asset

• The RA should be the higher value of:
✓The asset's fair value less costs to sell; and
✓Its value in use. (IAS 36)
• Fair value less costs to sell is the amount net of selling costs that could be
obtained from the sale of the asset
• If there is an active market in the asset, the net selling price should be based on:
✓ the market value, or on
✓the price of recent transactions in similar assets.

283
 THE THREE ACCOUNTING ISSUES…
• If there is no active market in the assets it might be possible to estimate a net selling
price using
✓best estimates of what 'knowledgeable, willing parties' might pay in an arm's length
transaction.
• Net selling price cannot be reduced, by including within selling costs any
✓restructuring or reorganization expenses, or
✓costs that have already been recognized in the accounts as liabilities.
Value in Use (VU)
• The VU is the PV of estimated future cash flows including its estimated net disposal
value (if any) at the end of its UL.

284
 THE THREE ACCOUNTING ISSUES…

3. Recognition & Measurement Of An Impairment Loss

The Rule for Assets at Historical Cost:
• If the RA is lower than the CA , the CA should be reduced by the d/ce which
should be charged as an expense in p&l.
The Rule for Assets Held At a Revalued Amount (Such as PPE):
• The impairment loss is to be treated as a revaluation decrease under the relevant
IAS.

285
 THE THREE ACCOUNTING ISSUES…
In practice this means:
• If there is a revaluation surplus held in respect of the asset, the imp. loss should
be charged to revaluation surplus.
• Any excess should be charged to profit or loss.
Cash Generating Units (CGUs)
• When it is not possible to calculate the RA of a single asset, then that of its CGU
should be measured instead.
• A CGU is the smallest identifiable group of assets that
✓ can generate cash flows from continuing use and
✓are mainly independent of the cash flows from other assets or groups of assets.

286
 THE THREE ACCOUNTING ISSUES…

Use of Cash-Generating Unit

• As a basic rule, the recoverable amount of an asset should be calculated for the
asset individually.
• when it is not possible to estimate value for an individual asset, we use CGU
Impairment Testing Levels
Inventories (other standards)
• Principle: test inventory for impairment item by item

287
22) An impairment loss is:

A. The amount by which the carrying amount of an asset exceeds its market
value.
B. The amount by which the recoverable amount of an asset exceeds its
written down value.

C. The amount by which the recoverable amount of an asset exceeds its

carrying amount.

D. The amount by which the carrying amount of an asset exceeds its

recoverable amount
D
23) On January 2, 2021, Triple Inc. purchased equipment with a cost of Birr 10,440,000, a
useful life of 10 years and no salvage value. The Company uses straight-line depreciation.
At December 31, 2021 and December 31, 2022, the company determines that
impairment indicators are present. The following information is available for impairment
Testing at each year end.
12/31/2021 12/31/2022
FV less cost to sale 9,315,000 8,350,000
Value in used 9,350,000 8,315,000
There is no change in the asset's useful life or salvage value. The 2022 profit or loss
statement will report: 2022
A. Recovery of impairment Loss of Birr 3,889 C Purchase value 9,350,000.00
B. Impairment loss of Birr 10,000 Depreciation (9 year) 1,038,888.89

C. Recovery of impairment Loss of Birr 38,889. Book Value after

Depreciation 8,311,111.11
D. Impairment Loss of Birr 1,000,000
Fair Value 8,350,000.00
10,440,000/10=1,044,000 dep Ex
10,440,000-1,044,000= 9,396,000 BV Recovery of
Impairment loss = 46,000 Impairment loss 38,888.89
24) Rice Industries owns a manufacturing plant in a foreign country. Political unrest
in the country indicates that face choose investigate for possible impairment. Below
is information related to the plant's assets (Birr in millions)
Book value Birr 190
Undiscounted sum of future estimated cash flows 210
Present value of future cash flows 175
Fair value less cost to sell (determined by appraisal) 180
A
The amount of impairment loss that Rice should recognize is:
A. Birr 10 million impairment loss , If CV > Recoverable amount

Recoverable amount is the height of value in used and Fair value less to cost
B. Birr 20 million
FV Less to cost = 180
Value in used = 175
C. Birr 15 million
Recoverable amount = 180
D. There is no impairment. CV > RV BY 10M so the impairment loss = 10 M
190 > 180
• 25) Hope Ltd has determined that one of its cash-generating units (CGUs) has sustained an impairment
loss of $50 000. The carrying amounts of the assets within the CGU are as follows.
• Asset 1 150,000
• Asset 2 200,000
• Asset 3. 50,000
• Total 400,000
• The estimated fair value less costs of disposal of Asset 2 is $190 000, which is greater than its value in use.
• A number of options are being considered as the amounts of impairment loss to be allocated to the three
assets within the CGU.
• In accordance with IAS 16 Property, Plant and Equipment and IAS 36 Impairment of Assets, which one of
the following options would be the amount of impairment loss allocated to the three assets?
• A. Asset 1: 16,667. Asset 2: 16,667. Asset 3: 16,667. Total: 50,000
• B. Asset 1: 18,750. Asset 2: 25,000. Asset 3: 6,250. Total: 50,000
• C. Asset 1: 20,000. Asset 2: 10,000. Asset 3: 20,000. Total: 50,000
• D. Asset 1: 30,000. Asset 2: 10,000. Asset 3: 10,000 Total: 50,000
• E. All Max impairment to allocated to asset 2 is 10000
b/c CV> RV 200000 > 190000
• F. None
Asset 1 150000 150000/200000 * 40000 = 30000
Asset 3 50000 50000/200000 *40000 = 10000
Total 200000

D
26) On January 1, 2015, W. Poon Inc. purchased equipment with a cost of
$4,668,000 a useful life of 12 years and no salvage value. The company
uses straight-line depreciation. At December 31, 2015, the company
determines that impairment indicators are present. The fair value less cost
to sell the asset is estimated to be $4,620,000. The asset's value-in-use is
estimated to be $4,305,000. There is no change in the asset’s useful life or
salvage value. The 2015 income statement will report Loss on Impairment
of
Dep Ex= 4,668,000 – 0
• A). $0.
A 12

• B). $26,000. = 389,000

• C). $48,000. CV= Cost – Acc Dep Ex
• D). $341,000 = 4,668,000 -389,000
= 4,279,000
RV= 4,620,000
B/C RV> CV No impairment
27) Value in use is...
A) ...the present value of future cash flows expected to arise from
continuing use of asset, and from its disposal at the end of its useful life.

B) ...the discounted future value of future cash flows expected to arise

from continuing use of asset, and from its disposal at the end of its useful
life.

C) ...the present value of historical cash flows expected to arise from

continuing use of asset, and from its disposal at the end of its useful life.

D) ...the undiscounted present value of future cash outflows expected to

arise from continuing use of asset, and from its disposal at the end of its
useful life.
A
28) In the component approach, when components have different useful
life's and have significant cost compared to the total cost of the PPE
asset...

A) ... all components are recognized and depreciated aggregately.

B) ... all components always have the same useful life.
C) ... all components are recognized and depreciated separately.
D) ... all components always have the same cost.
C
• IAS 7
•Statement of cash flow
 Statement of cash flow

• The statement of cash flows reports the cash receipts, cash payments, and
net change in cash resulting from operating, investing, and financing
activities during a period.

• Shows those activities that involve sources or provision (inflow) of cash and
spending cash are called uses (or applications)/outflow of cash.
•
 The objective of PREPARATION OF
STATEMENT OF CASH FLOWS
Primary purpose:
To provide information about a company’s cash receipts and cash payments during a
period.

Secondary objective:
To provide cash-basis information about the company’s operating, investing, and financing
activities.

LO 1
 Usefulness of the Statement of Cash Flows

Provides information to help assess:

1. Entity’s ability to generate future cash flows.

2. Entity’s ability to pay dividends and meet obligations.

3. Reasons for the difference between net income and net cash flow from
operating activities.

4. Cash and noncash investing and financing transactions during the period.

LO 1
 PREPARATION OF STATEMENT

Classification of Cash Flows

Operating Investing Financing

Activities Activities Activities

Changes in Changes in Equity

Income
Investments and Non- and Non-Current
Statement Items Current Asset Items Liability Items

LO 2
• Operating activity: Activity's include the cash effects of transactions
that create revenues and expenses.
• They thus enter into the determination of net income. (Income
statement items)

• Investment activity Activity's include (a) acquiring and disposing of

investments and property, plant, and equipment, and (b) lending money
and collecting the loans. (Cash flows resulting from changes in
investments and long-term / non-current asset items.)

• Financing activity Activity’s include

• (a) obtaining cash from issuing debt and repaying the amounts
borrowed,
(b) obtaining cash from stockholders, repurchasing shares, and paying
dividends. (Cash flows resulting from changes in long-term /non-
current liability and stockholders’ equity items.)
• Simply, a capital structure components.
 Steps in Preparation

Three Sources of Information:

1. Comparative statements of financial position.
2. Current income statement data.
3. Selected transaction data.

Three Major Steps:

Step 1. Determine change in cash. Direct and indirect method

Step 2. Determine net cash flow from operating activities.

Step 3. Determine net cash flows from investing and financing
activities.

23-301 LO 2
 Indirect Method—Additional Adjustments

ILLUSTRATION 23-17
Adjustments Needed to Determine Net Cash
Flow from Operating Activities—Indirect Method

23-302 LO 6
23-303
28) Creditors and investors would generally find the statement
of cash flows least useful for assessing the

A. Financial position at a point in time.

B. Ability to pay dividends.
C. Ability to generate future cash flows.
D. Quality of earnings.
A
29) Wilton Company reported net income of $80,000 for the
year. During the year, accounts receivable decreased by
$7,000, accounts payable increased by $3,000 and
depreciation expense of $5,000 was recorded.
Net cash provided by operating activities for the year is

a. $70,000. B
b. $95,000.
c. $79,000. NI…………………..……….80000
+ Decreased AR ………..7000
d. $75,000. + increased AP……………3000
+ Depreciation ……..…..5000
= 95000
30) XYZ Company reported net income of ETB 200,000 for the year.
During the year, accounts receivable decreased by ETB 10,000, inventory
increased by ETB 8,000, accounts payable increased by ETB 6,000,
depreciation expense of ETB 10,000 was recorded, and land was purchased
for ETB 150,000 in cash. Net cash provided by operating activities for the
year is
a. ETB 218,000. NI ……………………………….….200,000
+AR decreased………………..10000
b. ETB 68,000. - inventory increased …………8000
+ AP increased……………………..6000
c. ETB 214,000. + depreciation expense…….10000
- Total
d. ETB 202,000.
A
31) Transactions related to the primary business activities of the
company, such as selling goods and services to customers, are referred
to as:
• A). Investing activities.
• B). Management activities.
• C). Operating activities.
• D) Financing activities

C
32) S Company reported net profit for 2022 in the amount of $400,000.
The company's financial statements also included the following:
Increase in accounts receivable $80,000
Decrease in inventory 60,000
Increase in accounts payable 200,000
Depreciation expense 104,000
Gain on sale of land 148,000
What is net cash provided by operating activities under the indirect
method?
A. $432,000
NI……………………………400,000
• B. $536,000 Dep Expense……………104,000
- Gain ……………………,...148,000
• C. $580,000 B - AR……………………………..80,000
+ Inventory ……………………60,000
• D. $832,000 + AP……………………………200,000
536,000
33) Which of the following terms does this statement define: “the amount
of cash or cash equivalents paid or the fair value of other consideration
given to acquire an asset at the time of its acquisition or construction”?
• A. Cost
• B. Deemed cost
• C. Fair value
• D. Present value

A
34) A ten-year bond was issued at par for $150,000 cash. This transaction
should be shown on a statement of cash flows under

• A. investing activities

• B. financing activities

• C. noncash investing and financing activities

• D. operating activities B
35) Which one of the following below should be added to net income in
calculating net cash flow from operating activities using the indirect
method?

• A. a gain on the sale of land

• B. a decrease in accounts payable

• C. an increase in accrued liabilities

C
• D. dividends paid on common stock
36) Starting with net income and adjusting it for items that
affected reported net income but which did not affect cash is
called the
a. direct method.
b. indirect method.
c. working capital method.
d. cost-benefit method.

B
37) If a loss of $35,000 is incurred in selling (for cash) office equipment
having a book value of $140,000, the total amount reported in the cash
flows from investing activities section of the statement of cash flows is

• a. $105,000.

• b. $140,000.

• c. $175,000. A
• d. $35,000.
38) If accounts receivable have increased during the period,

• a. revenues on an accrual basis are less than revenues on a cash basis.

• b. revenues on an accrual basis are greater than revenues on a cash basis.

• c. revenues on an accrual basis are the same as revenues on a cash basis.

• d. expenses on an accrual basis are greater than expenses on a cash basis

B
39) Which of the following adjustments to convert net income to net cash
provided by operating activities is incorrect? Add to Net Income Deduct
from Net Income

• a. Accounts Receivable decrease increase

• b. Prepaid Expenses increase decrease

• c. Inventory decrease increase D

• d. Accounts Payable increase decrease
40) Bent Company reports a $20,000 increase in inventory and a $5,000
decrease in accounts payable during the year. Cost of Goods Sold for the
year was $230,000. Using the direct method of reporting cash flows from
operating activities, cash payments made to suppliers were

• a. $230,000.
• b. $245,000.
• c. $255,000.
• d. $215,000 C
41) Marsh Company has other operating expenses of $320,000. There has
been an increase in prepaid expenses of $16,000 during the year, and
accrued liabilities are $24,000 lower than in the prior period. Using the
direct method of reporting cash flows from operating activities, what were
Marsh’s cash payments for operating expenses?

• a. $308,000
• b. $312,000
• c. $280,000
• d. $360,000 D
 INTANGIBLE ASSET ISSUES

Characteristics Coca-Cola Company’s

(USA) success comes
1. Identifiable. from its secret formula
for making Coca-Cola,
2. Lack physical existence. not its plant facilities.

3. Not monetary assets.

Normally classified as non-current asset.

Common types of intangibles:

◆ Patent ◆ Trademark or trade name

◆ Copyright ◆ Customer list
◆ Franchise or license ◆ Goodwill
12-318 LO 1
 INTANGIBLE ASSET ISSUES

Valuation
Purchased Intangibles
◆ Recorded at cost.

◆ Includes all acquisition costs plus expenditures to make the

intangible asset ready for its intended use.

◆ Typical costs include:

► Purchase price.

► Legal fees.

► Other incidental expenses.

12-319 LO 2
 INTANGIBLE ASSET ISSUES

Valuation
Internally Created Intangibles
◆ Companies expense all research phase costs and some
development phase costs.

◆ Certain development costs are capitalized once economic

viability criteria are met.

◆ IFRS identifies several specific

criteria that must be met before
development costs are capitalized.

12-320 LO 2
 INTANGIBLE ASSET ISSUES

Internally Created Intangibles ILLUSTRATION 12-1

Research and
Development Stages

12-321 LO 2
 INTANGIBLE ASSET ISSUES

Amortization of Intangibles
Limited-Life Intangibles
◆ Amortize by systematic charge to expense over useful life.

◆ Credit asset account or accumulated amortization.

◆ Useful life should reflect the periods over which the asset
will contribute to cash flows.

◆ Amortization should be cost less residual value.

◆ Companies must evaluate the limited-life intangibles

annually for impairment.

12-322 LO 3
 INTANGIBLE ASSET ISSUES

Amortization of Intangibles
Indefinite-Life Intangibles
◆ No foreseeable limit on time the asset is expected to provide
cash flows.

◆ Must test indefinite-life intangibles for impairment at least

annually.

◆ No amortization.

12-323 LO 3
 INTANGIBLE ASSET ISSUES

Amortization of Intangibles ILLUSTRATION 12-2

Accounting Treatment
for Intangibles

12-324 LO 3
42) Which of the following does not describe intangible assets?
a. They lack physical existence.
b. They are financial instruments.
c. They provide long-term benefits.
d. They are classified as long-term assets.

B
43) On January 1, 2020, Bumper Corp. acquires a customer list for $400,000.
Bumper estimates that this customer list will generate value for at least 5 years.
At the end of 3 years, Bumper plans to sell the customer list to another company
for $62,500. On Bumper's income statement for the year ended December 31,
2020, how much amortization expense should it report?
A) $67,500
Cost – Sv
• B) $80,000
C Estimated life

• C) 112,500 400,000 – 62,500

3
• D) $133,333 = 112,500
44) Which of the following characteristics do intangible assets possess?
a. Physical existence.
b. Claim to a specific amount of cash in the future.
c. Long-lived.
d. Held for resale.

C
• 45) Current accounting practice, intangible assets are
classified as
a. amortizable or unamortizable.
b. limited-life or indefinite-life.
c. specifically identifiable or goodwill-type.
d. legally restricted or goodwill-type.

B
46) Sheffield Corporation purchases a patent from Oriole Company on January 1, 2020, for
$ 69,000. The patent has a remaining legal life of 15 years. Sheffield feels the patent will be
useful for 10 years. Prepare Sheffield's journal entries to record the purchase of the patent
and 2020 amortization.

• A) Patent ……..69000
• cash…………………69000
• Dr Amortization Expense 6900
Cr Acc Amortization-Patent 6900
• B) Cash ………69000
• Patent …………..69000
Cr Acc Amortization-Patent…….6900
• Dr Amortization Expense 6900
• C) Patent ……………..69000 A
• Goodwill ……………….69000
• D) No Recording
47) The controversy surrounding the policy to expense all research and
development costs associated with internally created intangible assets
results in:

A. overstating assets and understating expenses.

B. understating assets and understating expenses.
C. overstating assets and overstating expenses.
D. understating assets and overstating expenses. D
 Investment Property
➢ Investment Property
➢ is property (land or a building—or part of a building—or both) held
by the owner or by the lessee under a finance lease to earn rentals
or for capital appreciation or both.
The following are examples of investment property:
❑ Land held for long-term capital appreciation rather than for short-
term sale in the ordinary course of business.
❑ Land held for a currently undetermined future use.
✓ If an entity has not determined that
➢ it will use the land as owner-occupied property or
➢ for short-term sale the land is regarded as held for capital
appreciation.
331
 Scope of Investment Property
➢ A building owned by the entity (or held by the entity under a finance lease) &
leased out under one or more operating leases.
➢ A building that is vacant but is held to be leased out under one or more
operating leases.
➢ Property that is being constructed or developed for future use as investment
property.
➢ A building held by a parent and leased to a subsidiary.

332
 Scope of Investment Property….
❑ Some properties comprise a portion that is held to earn rentals or for capital
appreciation and another portion that is held for use.
✓ If these portions could be sold separately an entity accounts for the portions
separately.
✓ If the portions could not be sold separately, the property is investment property
only
❖ if an insignificant portion is held for use in the production or supply of goods or
services or for administrative purposes.

333
 Initial Recognition and Measurement of Investment Property
Recognition
❑ Investment property should be recognized as an asset when two
conditions are met.
✓ It is probable that the future economic benefits that are associated
with will flow to the entity.
✓ The cost of the investment property can be measured reliably.
❑ Initial measurement
✓ An investment property should be measured initially at its cost,
including transaction costs.
✓ Leased investment property is measured according to IFRS 16 Leases
❑ Costs of the day-to-day servicing of investment property are
recognised in profit or loss as incurred.
❑ Replacement cost would be recognised as cost of investment
property.
334
48) Which of the following does not define
investment property?
A. Property held to earn rentals.
B. Property held for capital appreciation.
C. Property used in the production or supply of
goods or services.
D. A and C.

C
49) If a property is partly an investment property, and
partly owner-occupied, the company should account
for the property:
A. As owner-occupied.
B. Each portion should be accounted for separately.
C. As investment property.
D. As inventory

B
50) If the investment property is measured using the fair value model, a gain
arising from a change in the fair value of an investment property must be:

• A. Recognized as other comprehensive income

• B. Recognized in the calculation of profit or loss

B
• C. Ignored

• D. Credit to a revaluation reserve

51) Which of the following statements is true with regards to an investment
property?
A. An investment property generates cash flows largely independently of the other
assets held by an entity.
B. The value in use of investment property is significantly higher than of owner-
occupied property.
C. An investment property unlike owner-occupied property shall not be
depreciated over its useful life.
D. An investment property unlike owner-occupied property shall always be
measured at its historical cost.

A
52) Under IAS 40 Investment Property, which of the following is correct?
• A) Investment property is property held for administrative purposes.
• B) Investment property is property held for use in the supply of services.
• C) Investment property is property held for use in the production of
goods.
• D) Investment property is property held by owner to earn rental income
or for capital appreciation.

D
53) Which TWO of the following statements best describe 'owner-occupied
property', according to IAS40 Investment property ?
• 1. Property held for sale in the ordinary course of business
• 2. Property held for use in the production and supply of goods or services
• 3. Property held to earn rentals
• 4. Property held for administrative purposes

• A) 2,4
• B) 1,4 A
• C) 2,3
• D) 4,4
54) Which TWO of the following properties fall under the definition of
investment property and therefore within the scope of IAS40 Investment
property ?
• 1. Land held for long-term capital appreciation
• 2. Property occupied by an employee paying market rent
• 3. Property being constructed on behalf of third parties
• 4. A building owned by an entity and leased out under an operating lease

• A) 2,4
• B) 1,4 B
• C) 2,3
• D) 4,4
55) IAS40 Investment property gives a choice between two different models
as the accounting policy to be used in relation to investment property.

• Which ONE of the following disclosures should be made when the fair
value model has been adopted?

A. Depreciation methods used

B. The amount of impairment losses recognised
C. Useful lives or depreciation rates used D
D. Net gains or losses from fair value adjustments
56) Why is the building where a manufacturing company's factory is located not
considered investment property?

• a.) The cash flows generated from the factory production as a result of the
building is independent from the cash flows generated as a result of other assets.

• b.) The cash flows generated from the factory production as a result of the
building is not independent from the cash flows generated as a result of other
assets.

• c.) Historically the company has not seen the value of the building appreciate
and does not expect it to in the future.
B
• d.) The company is planning on moving locations in the next 3 years.
57) An ______ is held primarily because it is expected to increase in value
over time (capital appreciation) or it is held to earn rentals. It generates
economic benefits for the entity because it might earn regular stream of
income in the form of rentals or might be sold at a profit.

• A. PPE

• B. Inventory
C
• C. Investment Property

• D. Asset
58) A parent company leases a property to its subsidiary. It may be
classified as an investment property in the:
• A. Parent company’s individual financial statements.
• B. Subsidiary’s accounts.
• C. Consolidated accounts.
• D. Combined financial statements

A
 IAS 8

ACCOUNTING POLICIES,
CHANGES IN ACCOUNTING
ESTIMATES AND ERRORS

346
INTRODUCTION

Objective:
⚫ To prescribe the criteria for selecting and changing
accounting policies, together with the accounting
treatment and disclosure of changes in accounting
policies, changes in accounting estimates and
correction of errors

Scope:
⚫ All financial statements prepared in accordance
with IASs/IFRSs
347
OBJECTIVE OF IAS 8
It prescribes the criteria for:
• How to select and apply our accounting policies;
• How to account for the changes in accounting
policies;
• How to account for changes in accounting estimates;
• How to correct errors made in the previous reporting
periods; and
• How to disclose the changes. 348
ACCOUNTING POLICIES, CHANGES IN
ACCOUNTING ESTIMATES AND ERRORS

349
I. ACCOUNTING POLICIES
1. DEFINITION OF ACCOUNTING POLICIES
Accounting policies are the specific principles, bases,
guidelines, conventions, rules, practices, and similar norms
applied/used by an entity in preparing and presenting
financial statements [IAS 1].
⚫ Examples:
➢ Valuation of inventory using FIFO, Average Cost or other
suitable basis as per IAS 2
➢ Classification, presentation and measurement of financial
assets and liabilities under categories specified under IAS
32/IAS 39/IFRS 9 350
 WHEN
TO
REPORT?

ACOUNTING
WHERE POLICIES WHAT
TO TO
REPORT? USEFULNESS REPORT?
FOR DECISION
MAKING

HOW
TO
REPORT? 351
2. SELECTION OF ACCOUNTING POLICIES
➢2.1 What accounting policy to apply?
IAS 8 HIERARCHY
IAS 8 establishes the hierarchy that firms must follow
when dealing with an accounting issue (transaction or
item). The IFRS ACCOUNTING POLICY HIERARCHY is:
1. Apply specifically relevant standards (IASs, IFRSs,
Interpretations).
2. Refer to other IASB standards.
3. Refer to the IASB Framework for guidance.
4. Consider the most recent pronouncements of other
standard-setting bodies. 352
3. CHANGES IN ACCOUNTING POLICIES

3.1 When to change an accounting policy?

➢ MANDATORY: When it is required by another IFRS. This
will be the case when new IFRS is issued and you HAVE
TO apply it mandatorily.

➢ VOLUNTARY: When new accounting policy provides

better, more faithful and relevant information. In this case,
you apply new accounting policy voluntarily.
353
3. CHANGES IN ACCOUNTING POLICIES
3.2 Examples
−A change from measuring a class of assets at
depreciated historical cost to a policy of regular
revaluation (fair value)
−Changing from writing off to capitalizing interest
relating to the construction of noncurrent assets
−Changing inventory valuation from weighted average
to FIFO
−Changing the way in which an item is presented in the
accounts, i.e. classifying depreciation expenses as cost
of sales instead of administrative
354
3. CHANGES IN ACCOUNTING POLICIES
3.3 Exclusions
−Applying an accounting policy to a new type of
transaction.
−Applying a new accounting policy to a
transaction different in substance to those
undertaken previously.
Subsequent
A CHANGE IN POLICY Transaction
Previous
Transaction
NOT A CHANGE IN POLICY Subsequent
Transaction

355
3. CHANGE IN ACCOUNTING POLICIES
3.4 Accounting treatment [How]
➢If a new IFRS is applied and this IFRS contains some
transitional guidance, then simply follow the rules in that
transition provisions. New IFRS will tell exactly how.
➢If there’s no transitional guidance, change the accounting
policy voluntarily, then apply it retrospectively as if the
new policy had always been in place.

356
3. CHANGES IN ACCOUNTING POLICIES
3.5 Exemptions from Retrospective Treatment
− The effect of retrospective application of a change in accounting policy
is immaterial. Anything that cannot affect the decisions of users of
financial statements is material.
− Retrospective application of a change in accounting policy is
impracticable, then the new accounting policy must be applied
prospectively from the beginning of the earliest period feasible which
may be the current period.
− Initial application of an IFRS where the transitional accounting method
provided allow or require prospective application of a new accounting
357
policy– follow it otherwise retrospective application.
II. ACCOUNTING ESTIMATES

1. DEFINIOTION: Reasons [Why]

When an item of financial statements cannot be measured

precisely, it can only be estimated. This is because of:

➢ Uncertainties inherent in the business;

➢ Where judgments are involved based on information that

best reflects the conditions and circumstances that exist at
the reporting date. By its nature, estimates are subjective
and may require frequent revisions in future. 358
II. ACCOUNTING ESTIMATES
2. Changes In Estimates
•Change in accounting estimate is a change either some amount
of an asset or a liability, or pattern of its consumption in both
current and future reporting periods that result from changes
in the circumstances in which the estimate was based.
➢As a result of a new information, As a result of new

development, More experience

⚫If these changes result from some error, such as incorrect
calculation or wrong application of accounting policies – then
they are NOT changes in accounting estimates, but errors. 359
II. ACCOUNTING ESTIMATES

3. Typical examples of changes in accounting estimates:

− Depreciation rates and useful lives of assets
− Provisions for warranty repairs
− Impairment of non-current assets
− Pattern of economic benefits expected to be received
from non-current assets for calculating depreciation
− Impairment of receivables (bad debt provisions)

360
II.ACCOUNTING ESTIMATES
4. Accounting Treatment
Change in accounting estimates are accounted
prospectively, either:

1. In the current reporting period (e.g. bad debt estimate);

2. In both the current and future reporting periods, if the
change affects both (for example, change in useful lives
affects depreciation charges in both the current and the
future reporting periods).
“Prospectively” means that comparatives and equity NOT
restated. Financial statements in the previous reporting
periods not restated and simply adjust calculations in the
current and future reporting periods. 361
II. ACCOUNTING ESTIMATES
4. Accounting Treatment
➢ Prospective application of changes in estimates prevents
frequent revisions in prior period comparative figures
which might cause unnecessary complications in respect of
financial statement balances.

➢ When it is hard to differentiate between a change in

accounting policy and a change in accounting estimate,
the change is accounted for prospectively as an estimate.
362
II. ACCOUNTING ESTIMATES

5. Example
− ABC LTD has depreciated a machine over its expected useful
life of 5 years. No residual value is expected at the end of the
machine's useful life. The cost of machine was Br100,000 and
annual depreciation charge was therefore Br20,000.
− Three years later, the remaining useful life of the machine was
estimated to be only 1 years.
− ABC LTD should account for the change in estimate
prospectively by allocating the net carrying amount of the
asset over its remaining useful life. No adjustment is required
to restate the depreciation charge in previous accounting
periods.
363
III. CORRECTION OF PRIOR PERIOD ERRORS
[PPE]
1. DEFINITION
Omissions from, and misstatements in, the entity’s FS for
one or more prior periods arising from a failure to use, or
misuse of, reliable information that:
➢was available when FS for those periods were
authorised for issue; and
➢could reasonably be expected to have been obtained
and taken into account in the preparation and
presentation of those FS. 364
PRIOR PERIOD ERRORS
Such errors include the effects of:
− Misapplication of accounting policies: e.g. not recognizing sale
upon transfer of goods to a customer
− Fraud: e.g. overstating sales revenue by issuing fake invoices before
the reporting date
− Misunderstanding/misinterpretations of facts, or failure to notice,
information at the time of preparation of financial statements:
e.g. not writing off a receivable who had been announced as
insolvent before the authorization of financial statements
− Arithmetical/mathematical mistakes
− Oversights: Omission of transactions and events from the financial
statements
365
PRIOR PERIOD ERRORS
3. ACCOUNTING TREATMENT

➢ Accounting Errors discovered after the reporting date but before

the authorization of financial statements are adjusting events after
the reporting date as per IAS 10 and must therefore be corrected
in the current period prior to the issuance of financial statements.
366
49) Which of the following is not treated as a change in accounting
principle?
• a. A change from LIFO to FIFO for inventory valuation
• b. A change to a different method of depreciation for plant assets
• c. A change from full-cost to successful efforts in the extractive
industry
• d. A change from completed-contract to percentage-of-completion
•
B
50) Which of the following is not a retrospective-type accounting
change?
• a. Completed-contract method to the percentage-of-completion
method for long-term contracts
• b. LIFO method to the FIFO method for inventory valuation
• c. Sum-of-the-years'-digits method to the straight-line method
• d. "Full cost" method to another method in the extractive industry

B
• 51. Which of the following is accounted for as a change in accounting
principle?
• a. A change in the estimated useful life of plant assets.
• b. A change from the cash basis of accounting to the accrual basis of
accounting.
• c. A change from expensing immaterial expenditures to deferring and
amortizing them as they become material.
• d. A change in inventory valuation from average cost to FIFO.

D
• 52. Which type of accounting change should always be accounted for in
current and future periods?

• a. Change in accounting principle

• b. Change in reporting entity

• c. Change in accounting estimate

• d. Correction of an error
C
Non-current Assets Held For Sale And
Discontinued Operations (IFRS 5)

371
Learning Objectives

372
⚫ Discontinuing a business operation or deciding to sell a major asset are important
commercial events.
⚫ The impact of these events and the way in which they are reported is therefore of
much interest to investors, analysts, regulators and other financial statement users.
⚫ IFRS 5 can have a significant effect on a company's profit or loss, the carrying values
of its assets and on the presentation of results.

373
Initial classification requirements
⚫ Classify a non-current asset (disposal group) as held for sale if its carrying
amount will be recovered principally through a sale transaction rather than
through continuing use .
⚫ IFRS 5 specifies two main requirements to initially classify asset(s) as held for
sale:
✓ the asset(s) must be available for immediate sale in its (their) present
condition.
– there is no significant reason why the sale could not take place
immediately.
✓ the sale must be highly probable.

374
 Held-for-sale classification
⚫ The trigger for a held for sale classification is often a buyer s firm purchase
commitment
⚫ IFRS 5 sets a few criteria for the sale to be highly probable:
✓ Management must be committed to a plan to sell the asset;

✓ An active program to find a buyer must have been initiated;

✓ The assets are on the market at a price that is reasonable in relation to their

estimated current fair values;

✓ The sale is expected to be completed within 1 year from the date of
classification(with exceptions);
✓ Significant changes to or a withdrawal from the selling plan are unlikely.

⚫ The similar criteria also apply to assets held for distribution to owners.
375
53) IFRS 5 requires

a. assets that meet the criteria to be classified as held for sale to be measured at fair value less
costs to sell

b. depreciation on held for sale assets to cease but amortization should still be provided for

c. assets that meet the criteria to be classified as held for sale to be presented separately on the
face of the statement of financial position and the results of discontinued operations to be
presented separately in the statement of profit or loss and other comprehensive income.

d. assets and liabilities of a disposal group to be off-set and presented as one item on the face of
the statement of financial position
C
54) A non-current asset is an asset that

a. is being depreciated or amortized

b. is not expected to be realized within 12 months
c. is restricted cash
d. does not meet the definition of a current asset.

B
55) Which of the following assets is outside the scope of PFRS 5?

a. Property, plant and equipment

b. Investment property carried under the Cost model
c. Deferred tax assets
d. Intangible assets
C
56) Assets which are previously classified as non-current in accordance
with IAS 1 Presentation of Financial Statements when they meet the
criteria to be classified as held for sale are to be presented separately on
the face of the balance sheet and included as

a. Non-current asset
b. Current asset B
c. Neither current nor noncurrent
d. Any of these
Intermediate accounting II
 CHAPTER1

CURRENT LIABILITIES
Provision
Contingent liability and Asset
 What is a Liability?

IASB, defines a liability as a present obligation of

a company arising from past events, the settlement
of which is expected to result in an outflow from
the company of resources, embodying economic
benefits. In other words, a liability has three
essential characteristics:
Liability:
1. is a present obligation.
2. arises from past events.
3. results in an outflow of resources (cash,
goods, services).
 What is a Current Liability?

Current liability is reported if one of two conditions exists:

1.Liability is expected to be settled within its normal operating cycle; or

2. Liability is expected to be settled within 12 months after the reporting
date.
The operating cycle is the period of time elapsing between the acquisition
of goods and services and the final cash realization resulting from sales
and subsequent collections.

LO 1 Describe the nature, type, and valuation of current liabilities.

 What is a Current Liability?

Typical Current Liabilities:

◆ Accounts payable. ◆ Customer advances and
deposits.
◆ Notes payable.
◆ Unearned revenues.
◆ Current maturities of long-
term debt. ◆ Sales taxes payable.
◆ Short-term obligations ◆ Income taxes payable.
expected to be refinanced.
◆ Employee-related liabilities.
◆ Dividends payable.

LO 1 Describe the nature, type, and valuation of current liabilities.

 Provisions

Provision is a liability of uncertain timing or amount.

Reported either as current or non-current liability.

Common types are

► Obligations related to litigation. Uncertainty about

the timing or
► Warrantees or product guarantees. amount of the
future expenditure
► Business restructurings. required to settle
the obligation.
► Environmental damage.
 Recognition of a Provision

Companies accrue an expense and related liability for a provision only

if the following three conditions are met:

1. Warrantees or product guarantees.

2. Probable that an outflow of resources will be required to settle the

obligation; and

3. A reliable estimate can be made.

LO 4 Explain the accounting for different types

of provisions.
 Measurement of Provisions

How does a company determine the amount to report for a provision?

IFRS:

Amount recognized should be the best estimate of the expenditure required to settle
the present obligation.

Best estimate represents the amount that a company would pay to settle the obligation
at the statement of financial position date.

Management must use judgment, based on past or similar transactions,

discussions with experts, and any other pertinent information.

Measurement of the liability should consider the time value of money.

LO 4 Explain the accounting for different
types of provisions.
 Common Types of Provisions

Common Types:

1. Lawsuits 4. Environmental

2. Warranties 5. Onerous contracts

3. Premiums 6. Restructuring

IFRS requires extensive disclosure related to provisions in the notes to the financial
statements, however companies do not record or report in the notes general risk
contingencies inherent in business operations (e.g., the possibility of war, strike,
uninsurable catastrophes, or a business recession).

LO 4 Explain the accounting for different

types of provisions.
 Contingent Liabilities

Contingent liabilities are a liability of uncertain timing or amount.

Its is the result of a loss contingency.

BUT Contingent liabilities are not recognized in the financial statements

because they are

1. A possible obligation (not yet confirmed),

2. A present obligation for which it is not probable that payment will be

made, or

3. A present obligation for which a reliable estimate of the obligation

cannot be made.
LO 5 Identify the criteria used to account for and
disclose contingent liabilities and assets.
 Contingent Liabilities

Contingent Liabilities Guidelines

Illustration 13-12

LO 5 Identify the criteria used to account for and

disclose contingent liabilities and assets.
 Contingent Assets

A contingent asset is a possible asset that arises from past

events and whose existence will be confirmed by the occurrence
or non-occurrence of uncertain future events not wholly within the
control of the company. Typical contingent assets are:

1. Possible receipts of monies from gifts, donations, bonuses.

2. Possible refunds from the government in tax disputes.

3. Pending court cases with a probable favorable outcome.

Contingent assets are not recognized on the statement of financial position.

LO 5 Identify the criteria used to account for and

disclose contingent liabilities and assets.
 Contingent Assets

Contingent Asset Guidelines

Illustration 13-14

Contingent assets are disclosed when an inflow of economic

benefits is considered more likely than not to occur (greater than 50
percent).

LO 5 Identify the criteria used to account for and

disclose contingent liabilities and assets.
57) A contingent liability

• a. definitely exists as a liability but its amount and due date are
indeterminable.

• b. is accrued even though not reasonably estimated.

• c. is not disclosed in the financial statements.

• d. is the result of a loss contingency. D

58) Which of the following best describes the cash-basis method of
accounting for warranty costs?
a. Expensed based on estimate in year of sale.
b. Expensed when liability is accrued.
c. Expensed when warranty claims are certain.
d. Expensed when incurred. D
•
59) A competitor has sued an entity for unauthorized use of its patented
technology. The amount that the entity may be required pay to the competitor if the
competitor succeeds in the lawsuit is determinable with reliability, and according to
the legal counsel it is less than probable (but more than remote) that an outflow of
the resources would be needed to meet the obligation. The entity that was sued
should at year-end

A. Make no provision or disclosure and wait until the lawsuit is finally decided and
then expense the amount paid on settlement, if any.

B. Set aside as an appropriation, a contingency reserve, an amount based on the

best estimate of the possible ability

C. Recognize a provision for this possible obligation.

D. Make a disclosure of the possible obligation in the footnotes to the financial
statements
D
60) Company purchases a one-year insurance policy on June
1 for Birr 5,520. The adjusting entry on December 31 is
A. debit Prepaid Insurance, Birr 5,520, and credit Cash, Birr
5,520
B. debit insurance Expense, Birr 2,760, and credit Prepaid
Insurance, Birr 2,760
C. debit Insurance Expense, Birr 3,220, and credit Prepaid
Insurance, Birr 3,220
D. debit Insurance Expense, Bin 2,300, and credit Prepaid
Insurance, Birr 2,300 Insurance Expense, Birr 3,220
Prepaid Insurance, Birr 3,220
C 5520/12 = 460 So 460*7 = 3220
61) If accrued Utility expense of Br 5,000 is not recorded,
which of the following is correct?

A. Expense will be overstated

B
B. Liability will be understated
Utility Expense ………….5000
Accrued payable ….5000
C. Owner's equity be will understated

D. Net income will be understated

62) Collier borrowed $175,000 on October 1 and is required to pay $180,000
on March 1.

• What amount is the note payable recorded at on October 1 and how much
interest is recognized from October 1 to December 31?

• a. $175,000 and $0.

• b. $175,000 and $3,000. B

• c. $180,000 and $0.

• d. $175,000 and $5,000.

62) Among the short-term obligations of Lance Company as of December
31, the balance sheet date, are notes payable totaling $250,000 with the
Madison National Bank. These are 90-day notes, renewable for another
90-day period. These notes should be classified on the balance sheet of
Lance Company as
a. current liabilities.
A
b. deferred charges.
c. long-term liabilities.
d. intermediate debt.
63) Pegasus Corp. signed a three-month, 6% note on November 1, 2019 for
the purchase of $260,000 of inventory. If Pegasus makes adjusting entries
only at the end of the year, the adjusting entry made at December 31, 2019
will include a ________.
Dec 31
A) debit to Note Payable for $2,600 Interest Expense ….2,600
B Interest Payable …..2,600
B) debit to Interest Expense for $2,600
C) credit to Note Payable for $15,600
D) debit to Interest Expense for $3,900
64) Which of the following is a current liability?
a. Preferred dividends in arrears
b. A dividend payable in the form of additional shares of stock
c. A cash dividend payable to preferred stockholders
d. All of these
C
65) Why is the liability section of the balance sheet of primary importance
to bankers?
a. To evaluate the entity's credit quality.
b. To assist in understanding the entity's liquidity.
c. To better understand sources of repayment.
d. To evaluate operating efficiency. B
66) Which of the following situations may give rise to unearned
revenue?
a. Providing trade credit to customers.
b. Selling inventory.
c. Selling magazine subscriptions.
d. Providing manufacturer warranties. C
67) Which of the following is an example of a provision liability?
a. Obligations related to product warranties.
b. Possible receipt from a litigation settlement.
c. Pending court case with a probable favorable outcome.
d. Tax loss carryforwards.

A
68) Accrued liabilities are disclosed in financial statements by
a. a footnote to the statements.
b. showing the amount among the liabilities but not extending it to the
liability total.
c. an appropriation of retained earnings.
d. appropriately classifying them as regular liabilities in the balance sheet.

D
69) Of the following items, the only one which should not be classified as
a current liability is
a. current maturities of long-term debt.
b. sales taxes payable.
c. short-term obligations expected to be refinanced on a long-term basis.
d. unearned revenues. C
 2 Non-Current Liabilities

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the formal procedures 5. Explain the accounting for long-term

associated with issuing long- notes payable.
term debt. 6. Describe the accounting for the
extinguishment of non-current liabilities.
2. Identify various types of bond issues.
7. Describe the accounting for the fair
3. Describe the accounting valuation for
value option.
bonds at date of issuance.
8. Explain the reporting of off-balance-
4. Apply the methods of bond discount
sheet financing arrangements.
and premium amortization.
9. Indicate how to present and analyze
14-408 non-current liabilities.
 Non-Current Liabilities
Non-current liabilities (long-term debt) consist of an
expected outflow of resources arising from present obligations
that are not payable within a year or the operating cycle of
the company, whichever is longer.

Examples:
► Bonds payable ► Pension liabilities
► Long-term notes payable ► Lease liabilities
► Mortgages payable
Long-term debt has various
covenants or restrictions.

14-409 LO 1
 Bond Payable

Issuing Bonds
◆ Bond contract known as a bond indenture.
◆ Represents a promise to pay:
(1) sum of money at designated maturity date, plus
(2) periodic interest at a specified rate on the maturity
amount (face value).
◆ Paper certificate, typically a 1,000, 500, face value.
◆ Interest payments usually made semiannually or annually
◆ Used when the amount of capital needed is too large for
one lender to supply.
14-410 LO 1
 Types and Ratings of Bonds

Common types found in practice:

◆ Secured and Unsecured (debenture) bonds.

◆ Term, Serial, and Callable bonds.

◆ Convertible, Commodity-Backed, Deep-Discount bonds.

◆ Registered and Bearer (Coupon) bonds.

◆ Income and Revenue bonds.

14-411 LO 2
 Valuation of Bonds Payable

Issuance and marketing of bonds to the public:

◆ Usually takes weeks or months.

◆ Issuing company must

► Arrange for underwriters.

► Obtain regulatory approval of the bond issue, undergo

audits, and issue a prospectus.

► Have bond certificates printed.

14-412 LO 3
 Valuation of Bonds Payable

Interest Rate
◆ Stated, coupon, or nominal rate = Rate written in the
terms of the bond indenture.

► Bond issuer sets this rate.

► Stated as a percentage of bond face value (par).

◆ Market rate or effective yield = Rate that provides an

acceptable return commensurate with the issuer’s risk.

14-413 LO 3
 Valuation of Bonds Payable
Assume Stated Rate of 8%

Market Interest Bonds Sold At

6% Premium

8% Par Value

10% Discount

14-414 LO 3
 Valuation of Bonds Payable

Investment community values a bond at the present value of

its expected future cash flows, which consist of (1) interest and
(2) principal.

Bond value = PV OA of interest + PV principle bond price

14-415 LO 3
 Valuation of Bonds Payable

How do you calculate the amount of interest that is actually

paid to the bondholder each period?

(Stated rate x Face Value of the bond)

How do you calculate the amount of interest that is actually

recorded as interest expense by the issuer of the bonds?

(Market rate x Carrying Value of the bond)

14-416 LO 3
 ILLUSTRATION 14-7
Bond Discount
Amortization Schedule

14-417
 ILLUSTRATION 14-9
Bond Premium
Amortization Schedule

14-418
70) The term used for bonds that are unsecured as to principal is

• a. junk bonds.

• b. debenture bonds.

• c. indebenture bonds.

• d. callable bonds A
71) The interest rate written in the terms of the bond indenture is known as the

• a. coupon rate.

• b. nominal rate.

• c. stated rate.

• d. coupon rate, nominal rate, or stated rate.

D
72) Under the effective-interest method of bond discount or premium amortization,
the periodic interest expense is equal to

• a. the stated (nominal) rate of interest multiplied by the face value of the bonds.

• b. the market rate of interest multiplied by the face value of the bonds.

• c. the stated rate multiplied by the beginning-of-period carrying amount of the

bonds.

• d. the market rate multiplied by the beginning-of-period carrying amount of the

bonds D
73) On January 1, Gasperson Inc. issued $100,000,000, 7% bonds at 102. The
journal entry to record the issuance of the bonds will Not include

a. dr, Cash 102,000,00

• b. Cr, Bond Payable 100,000,000

• C, Credit Premium on bond payable 2,000,000

• D) Cash credit by 102,000,000

D
74) A company issues $5,000,000, 7.8%, 20-year bonds to yield 8% on
January 1, 2010. Interest is paid on June 30 and December 31. The
proceeds from the bonds are $4,901,036. Using effective-interest
amortization, how much interest expense will be recognized in 2010?

• a. $195,000 Year Cash paid Effective interest rate Amortization Ending caring value
0 4,901,036
June 30 195,000 196,041 1041 4,902,077
• b. $390,000 Dec 31 195,000 196083 1083 4903161
392,124
• c. $392,124 Cash Piad = 5,000,000 *0.078*6/12= 195,000
Effective interest rate = 4901036*0.08*6/12 = 196041
• d. $392,083 B Effective interest rate = 4902077*0.08*6/12= 196083
75) Santos issues R$100,000 in bonds, due in five years with 9 percent interest payable
annually at year-end. At the time of issue, the market rate for such bonds is 11 percent.
What is the bond price

A) 92,608
A
B) 100,000

C) 112,612.49

D) 6756.74
76) In a bond amortization table for bonds issued at Premium. Which
one is incorrect
• A. the interest expense is less than interest payment at the end of each
period
• B. the interest expense is greater than interest payment at the end of
each period
• C. the carrying amount the bonds declines eventually to face value
• D. the reduction in the discount is less with each successive interest
payment
• E. All
B
• 77) In a bond amortization table for bonds issued at discount.
• A. the interest expense is less than interest payment at the end of each period
• B. the interest expense is greater than interest payment at the end of each
period
• C. the carrying amount the bonds declines eventually to face value
• D. the reduction in the discount is less with each successive interest payment
• E. All
• F. None B
78) Refer to the following lease amortization schedule. The five payments are made annually
starting with the beginning of the lease. A Birr 2.000 purchase option is reasonably certain to be
exercised at the end of the five-year leave. The asset has an expected economic life of eight years.

What would be the amount of interest expense recorded with payment 5?

A. Birr 2,000 Interest Rate= Effective Interest/ Outstanding Balance of Previous Month
B. Birr 7,107 2660/ 26600 = 10.%
C. Birr 1,107 Interest payment = Outstanding Amount X Interest Rate
D. Birr 893 D = 8925*0.10
= 893
79) Refer to the following lease amortization schedule. The five payments
are made annually starting with the inception of the lease. A $2,000 bargain
purchase option is exercisable at the end of the five-year lease. The asset has
an expected economic life of eight years.

What is the outstanding balance after payment 5 ?

A. Birr 3818
Interest Rate= Effective Interest/ Outstanding Balance of Previous Month
B. Birr 1818 2660/ 26600 = 10%
C. Birr 2182 Interest payment = Outstanding Amount X Interest Rate
D. Birr 2000 = 8925*0.10 = 893
B Decrease in balance = 8000 – 893 = 7107
Outstanding balance = 8925 -7107= 1818
80)
 3 Investments

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe the accounting 5. Understand the accounting for equity

framework for financial assets. investments at fair value.

2. Understand the accounting for debt 6. Explain the equity method of

investments at amortized cost. accounting and compare it to the fair
value method for equity investments.
3. Understand the accounting for debt
investments at fair value. 7. Discuss the accounting for impairments
of debt investments.
4. Describe the accounting for the fair
value option. 8. Describe the accounting for transfer of
investments between categories.

17-430
 ACCOUNTING FOR FINANCIAL ASSETS

Financial Asset
◆ Equity investment of another company (e.g., ordinary or
preference shares).

◆ Contractual right to receive cash from another party

(e.g., loans, receivables, and bonds).

IASB requires that companies classify financial assets into two

measurement categories—amortized cost and fair value—
depending on the circumstances.

17-431 LO 1
 ACCOUNTING FOR FINANCIAL ASSETS
Measurement Basis
IFRS requires that companies measure their financial assets based
on two criteria:
◆ the asset is held within a business model whose objective is to hold
assets in order to collect contractual cash flows from the financial
asset rather than with a view to selling the asset to realize a profit or
loss.

◆ the contractual terms of the financial asset give rise on specified

dates to cash flows that are solely payments of principal and
interest on the principal amount outstanding.
Only debt investments such as lease receivables, loans, and bond investments
that meet the two criteria above are recorded at amortized cost. All other debt
and quity investments are recorded and reported at fair value.
17-432 LO 1
 ACCOUNTING FOR FINANCIAL ASSETS

Measurement Basis
Equity investments are generally recorded and reported at
fair value.

ILLUSTRATION 17-1
Summary of Investment Accounting Approaches

17-433 LO 1
 DEBT INVESTMENTS

Debt investments are characterized by contractual

payments on specified dates of
◆ principal and
◆ interest on the principal amount outstanding.

Companies measure debt investments at

◆ amortized cost or
◆ fair value.

17-434 LO 2
 EQUITY INVESTMENTS

Equity investment represents ownership of ordinary, preference, or

other capital shares.

◆ Cost includes price of the security.

◆ Broker’s commissions and fees are recorded as expense.

17-435 LO 5
 EQUITY INVESTMENTS

Illustration 17-16
Accounting and Reporting for Equity
Investments by Category

17-436 LO 5
17-437 LO 6
81) The investment category for which the investor's
"positive intent and ability to hold" is important is
A. Securities reported under the equity method.

B. Trading securities.

C. Securities available-for-sale.
D
D. Securities classified as held-to-maturity
82) The amortized cost method of accounting for investments
is not applicable to:

A. Trading debt instruments.

B. Trading equity instruments.

C. Held-to-maturity debt instruments. B

D. Available-for-sale debt instruments.

• 83) Greene Corporation pays Br.500,000 to acquire 40% of the voting stock
of Universal Technologies, Inc. on May 5, 2019. This investment will be
classified as a(n) ________.
• A. trading equity investment
• B. available-for-sale equity investment
• C. significant influence equity investment
• D. held-to-maturity equity investment
• E. All
C
• F. None
84) Unrealized holding gains or losses which are recognized in income
are from securities classified as

• a. held-to-maturity.

• b. available-for-sale.

• c. trading.
C
• d. none of these.
85) Watt Company purchased $300,000 of bonds for $315,000. If Watt intends
to hold the securities to maturity, the entry to record the investment includes

a) a debit to Debt Investments at $300,000.

b) a credit to Premium on Debt Investments of $15,000.

c) a debit to Debt Investments at $315,000.

D) No recording
C
86) Under the equity method of accounting for investments, an investor
recognizes its share of the earnings in the period in which the

• a. investor sells the investment.

• b. investee declares a dividend.

• c. investee pays a dividend.

• d. earnings are reported by the investee in its financial statements

D
87) On December 10, 2015, Republic Corporation purchased 1,000 ordinary shares of
Hawthorne Company for €20.75 per share (total cost €20,750). The entry to record the
investment includes
A. Equity Investments 20,750
Cash 20,750
B. Cash………………….20750
Equity Investment …………..20750 A
C. Debt Investments 20,750
Cash 20,750
D. All of the above are correct.
• 88) If Elston Company acquired a 30% interest in Alley Company on
December 31, 2007 for $202,500 and during 2008 Alley Company had
net income of $75,000 and paid a cash dividend of $30,000, applying the
equity method would give a debit balance in the Investment in Alley
Company Stock account at the end of 2008 of

• a. $202,500. Investment ……..202,500

Cash …………….202,500
• b. $216,000. Investment ……(0.3*75,00).22,500
Investment Income …..22500
• c. $225,000. B Cash …………9000
Investment ………….9000

• d. $217,500.
• 89) On its December 31, 2009, balance sheet, Quinn Co. reported
its investment in trading securities, which had cost $600,000, at
fair value of $550,000. At December 31, 2010, the fair value of
the securities was $585,000. What should Quinn report on its
2010 income statement as a result of the increase in fair value
of the investments in 2010?
• a. $0. Trading Securities 35,000
Unrealized Holding Gain - P/ 35,000
• b. Unrealized loss of $15,000.
• c. Realized gain of $35,000.
• d. Unrealized gain of $35,000
D
90) Wang Corporation sold the Watson bonds on July 1, 2016, for ¥90,000, at which time it had an amortized
cost of ¥94,214. The entry to record the investment includes
A. Cash 90,000

Loss on Sale of Debt Investments 4,214

Debt Investments 94,214

B. Cash 94,000

Loss on Sale of Debt Investments 4,214

Debt Investments 94,214

C. Cash 90,000

Loss on Sale of Debt Investments 4,214

Equity Investments 94,214

D. None of the above is correct.
A
91) The amortized cost method of accounting for investments
is not applicable to:

A. Trading debt instruments.

B. Trading equity instruments.

C. Held-to-maturity debt instruments. B

D. Available-for-sale debt instruments.

• 92) Greene Corporation pays Br.500,000 to acquire 40% of the voting stock
of Universal Technologies, Inc. on May 5, 2019. This investment will be
classified as a(n) ________.
• A. trading equity investment
• B. available-for-sale equity investment
• C. significant influence equity investment
• D. held-to-maturity equity investment
• E. All
C
• F. None
 4 Accounting for Leases

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Explain the nature, economic 5. Describe the lessor’s accounting for
substance, and advantages of lease direct-financing leases.
transactions. 6. Identify special features of lease
2. Describe the accounting criteria and arrangements that cause unique
procedures for capitalizing leases by the accounting problems.
lessee. 7. Describe the effect of residual values,
3. Contrast the operating and capitalization guaranteed and unguaranteed, on lease
methods of recording leases. accounting.
4. Explain the advantages and economics 8. Describe the lessor’s accounting for
of leasing to lessors and identify the sales-type leases.
classifications of leases for the lessor. 9. List the disclosure requirements for
21-450 leases.
 THE LEASING ENVIRONMENT
A lease is a contractual agreement between a lessor and a
lessee, that gives the lessee the right to use specific property,
owned by the lessor, for a specified period of time.

In return for the use of the property, the lessee makes rental
payments over the lease term to the lessor.

Largest group of leased equipment involves:

◆ Information technology equipment
◆ Transportation (trucks, aircraft, rail)
◆ Construction
◆ Agriculture
21-451 LO 1
 THE LEASING ENVIRONMENT
Advantages of Leasing
1. 100% financing at fixed rates. Leases are often signed without requiring
any money down from the lessee.
2. Protection against obsolescence. Leasing equipment reduces risk of
obsolescence to the lessee, and in many cases passes the risk of
residual value to the lessor.
3. Flexibility. Lease agreements may contain less restrictive provisions
than other debt agreements.
4. Less costly financing. one companies find leasing cheaper than other
forms of financing.
5. Tax advantages.
6. Off-balance-sheet financing. Certain leases do not add debt on a
statement of financial position or affect financial ratios.

21-452 LO 1
 THE LEASING ENVIRONMENT

Conceptual Nature of a Lease

A lease is classified as a finance lease if it transfers
substantially all the risks and rewards incidental to ownership.
In order to record a lease as a finance lease, the lease must
be non-cancelable

.
Leases that do not transfer substantially all the benefits
and risks of ownership are operating leases.

21-453 LO 1
 ACCOUNTING BY THE LESSEE

Lease Agreement Leases that DO NOT meet any of

the four criteria are accounted for
as operating leases.

ILLUSTRATION 21-4
Diagram of Lessee’s Criteria for Lease Classification

21-454 LO 2
 Feature Finance Lease Operating Lease

Lessee recognizes leased asset on Lessor recognizes leased asset on

Asset Recognition
its balance sheet its balance sheet

Lessee depreciates asset over its

Depreciation Not depreciated by lessee
useful life

Payments include principal and Payments considered operating

Lease Payments
interest expenses

Increases lessee's assets and No significant impact on lessee's

Balance Sheet Impact
liabilities balance sheet

21-455
 Lessor retains ownership of the
Ownership Transfer Lessee essentially owns the asset
asset

Lessee bears most risks and Lessor bears most risks and
Risks and Rewards
benefits of ownership benefits of ownership

Easier to cancel, usually with

Cancellation Options Limited or no cancellation options
penalties

21-456
 Sale type vs Direct Finance Lease

•The sales type lease, therefore, allows the lessor to recognize more
revenue at lease inception, while the direct financing arrangement
recognizes no revenue up front but then catches up as the lease progresses.
In both cases, the lessee should carry the asset on its balance sheet as a
fixed asset

21-457 LO 5
 ACCOUNTING BY THE LESSEE
Capitalization Criteria
Transfer of Ownership Test
◆ If the lease transfers ownership of the asset to the lessee,
it is a finance lease.
Bargain-Purchase Option Test
◆ At the inception of the lease, the difference between the option
price and the expected fair market value must be large enough to
make exercise of the option reasonably assured.

◆ For example, assume that ABC Delivery Service was to lease a

Truck for $599 per month for 40 months, with an option to purchase
for $100 at the end of the 40-month period. If the estimated fair
value of the Truck is $3,000 at the end of the 40 months, the $100
21-458 option to purchase is clearly a bargain. LO 2
 ACCOUNTING BY THE LESSEE
Capitalization Criteria
Economic Life Test (equal to or more than 75% of the estimated
economic life of the leased property.)
◆ Lease term is generally considered to be the fixed, non-cancelable term
of the lease.

◆ Bargain-renewal option can extend this period.

Illustration: Carrefour (FRA) leases Lenovo (CHN) PCs for two years at a
rental of €100 per month per computer and subsequently can lease them for €10
per month per computer for another two years. The lease clearly offers a
bargain-renewal option; the lease term is considered to be four years.

21-459 LO 2
 ACCOUNTING BY THE LESSEE
Capitalization Criteria
Recovery of Investment Test
If the present value of the minimum lease payments equals or exceeds
substantially all of the fair value of the asset, Why? If the present value of the
minimum lease payments is reasonably close to the fair value of the Asset, it
effectively purchasing the asset.
Minimum Lease Payments:
⚫ Minimum rental payments
⚫ Guaranteed residual value
⚫ Penalty for failure to renew or extend the lease
⚫ Bargain-purchase option
Executory Costs:
Exclude from PV of
⚫ Insurance
Minimum Lease
⚫ Maintenance
Payment Calculation
21-460 ⚫ Taxes LO 2
93) Which of the following is a correct statement of one of the capitalization
criteria?
a. The lease transfers ownership of the property to the lessor.
b. The lease contains a purchase option.
c. The lease term is equal to or more than 75% of the estimated economic life
of the leased property.
d. The minimum lease payments equal or Less than 90% of the fair value of the
leased property.
C
94) Which of the following is an advantage of leasing?

• a. Off-balance-sheet financing

• b. Less costly financing

• c. 100% financing at fixed rates

• d. All of these D
95) Major reasons why a company may become involved in leasing to
other companies is (are)
• a. interest revenue.
• b. high residual values.
• c. tax incentives.
• d. all of these. D
96) Which of the following best describes current practice in
accounting for leases?
a. Leases are not capitalized.
b. Leases similar to installment purchases are capitalized.
c. All long-term leases are capitalized.
d. All leases are capitalized.
B
97) The amount to be recorded as the cost of an asset under capital
lease is equal to the
• a. present value of the minimum lease payments.
• b. present value of the minimum lease payments or the fair value of
the asset, whichever is lower.
• c. present value of the minimum lease payments plus the present
value of any unguaranteed residual value.
• d. carrying value of the asset on the lessor's books.

B
98) In computing the present value of the minimum lease payments,
the lessee should
• a. use its incremental borrowing rate in all cases.
• b. use either its incremental borrowing rate or the implicit rate of the
lessor, whichever is higher, assuming that the implicit rate is known to
the lessee.
• c. use either its incremental borrowing rate or the implicit rate of the
lessor, whichever is lower, assuming that the implicit rate is known to
the lessee.
• d. none of these.
C
99) The primary difference between a direct-financing lease and a sales-type

lease is the

a. manner in which rental receipts are recorded as rental income.

b. amount of the depreciation recorded each year by the lessor.

c. recognition of the profit at the inception of the lease.

d. allocation of initial direct costs by the lessor to periods benefited by the

lease arrangements.

C
100) A lessee with a capital lease containing a bargain purchase option should
depreciate the leased asset over the
a. asset's remaining economic life.
b. term of the lease.
c. life of the asset or the term of the lease, whichever is shorter.
d. life of the asset or the term of the lease, whichever is longer.

A
101) On January 1, 2018, Blossom Corporation signed a 10-year noncancelable lease for certain machinery.
The terms of the lease called for Blossom to make annual payments of $200000 at the end of each year for
10 years with the title passing to Blossom at the end of this period. The machinery has an estimated useful
life of 15 years and no salvage value. Blossom uses the straight-line method of depreciation for all of its fixed
assets. Blossom accordingly accounted for this lease transaction as a capital lease. The lease payments were
determined to have a present value of $1300000 at an effective interest rate of 7%. With respect to this
capitalized lease, Blossom should record for 2018

A: interest expense of $91000 and depreciation expense of $86667. A: interest expense of $91000 and
depreciation expense of $86667.

B: interest expense of $77000 and depreciation expense of $130000. Depr Exp = 1300000/15
Int Exp = 1300000*.07

C: interest expense of $86667 and depreciation expense of $73333.

D: lease expense of $190000. C

102) Which of the following is included in the minimum lease
payment?

A: Unguaranteed residual value.

B: Maintenance costs.

C: Executory costs.

D: Bargain purchase option.

D
 471

IFRS 15
REVENUE FROM CONTRACTS
WITH CUSTOMERS

Ermi E-Learning
 THE OBJECTIVE OF IFRS 15 472

 The objective of IFRS 15:

✓ to establish the principles that :
―an entity shall apply to report useful information to users of financial
statements about the nature, amount, timing and uncertainty of
revenue and cash flows arising from a contract with a customer.
―recognising, measuring and disclosing revenue arising from a contract
with a customer that are not dealt with specifically in another IFRS.
 THE SCOPE OF IFRS 15 473

 IFRS 15 Revenue from Contracts with Customers applies to all

contracts with customers except for:
✓ leases IFRS 16;
✓ insurance contracts IFRS 4;
✓ financial instruments and other contractual rights or
obligations IFRS 9; interest and dividend income IFRS 9;
IFRS 10 Consolidated Financial Statements; IFRS 11 Joint
Arrangements; IAS 27 Separate Financial Statements; IAS
28 Investments in Associates and Joint Ventures;
✓ Nonmonetary exchanges to facilitate sales to customers
✓ Certain transactions may fall partially within the scope of
IFRS 15 and partially within the scope of other standards
Revenue 474

 Revenue is the total amount of income

generated by the sale of goods or services
related to the company's primary operations.
 Revenue, also known as gross sales, is often
referred to as the "top line" because it sits at the
top of the income statement.
 It is one of the measurement of company
performance
 Revenue transaction some time subjected to fraud
and complexity
 REVENUE MEASUREMENT
475

 Revenue is measured as the fair value of the consideration

received or receivable.
 Consideration is a payment made by one party to another in
exchange for the transfer of something of value. Consideration
can include the payment of property, the settlement of an
obligation
 The nature, timing and amount of consideration promised by a
customer affect the estimate of the transaction price.
 Amounts received on behalf of other parties (e.g. VAT, amounts
collected on behalf of the principal in agency arrangements) are
not economic benefits flowing to the entity and do not result in
increases in equity. Therefore, they do not constitute revenue.
 REVENUE RECOGNITION
476

 The primary issue in accounting for revenue is

determining when to recognize revenue.
 Revenue is recognized when it is probable that future
economic benefits will flow to the entity and these
benefits can be measured reliably.
 IFRS 15 identifies the core principle that:
✓ an entityrecognizes revenue to depict the transfer
of promised goods or services to customers in an
amount that reflects the consideration to which
the entity expects to be entitled in exchange for
those goods or services.
 REVENUE RECOGNITION

Revenue Recognition Situations

Sale of asset
Type of Sale of product Performing a Permitting use
other than
Transaction from inventory service of an asset inventory

Revenue from
Description Revenue from Revenue from Gain or loss on
interest, rents,
of Revenue sales fees or services disposition
and royalties

Timing of Services As time passes

Date of sale (date Date of sale
Revenue performed and or assets are
of delivery)
billable used or trade-in
Recognition

8
 The Five-step Model Framework 478

 An entity recognizes revenue in accordance with that core

principle by applying the following steps:

Identify the Recognize

Identify the performanc Allocate the
Determine revenue when (or
contract e transaction
the price to
as) the entity
with a obligations satisfies a
transaction performance
customer in the
price (Step 3) obligations performance
(Step 1) contract
(Step 4) obligation (Step
(Step 2)
5)
 There are five main revenue recognition methods:
 1. Sales-Basis Method: 479
 This is the simplest and most common method. Revenue is recognized at
the point of sale, which is typically when the goods are delivered or the
service is performed. This method is often used for short-term contracts and
for companies that sell products with a high turnover rate.
 2. Completed-Contract Method:
 This method is used for long-term contracts where the performance obligations are not
met at a single point in time. Revenue is recognized only when the entire contract is
completed. This method is often used by construction companies, engineering firms, and
other companies that work on long-term projects.
 3. Percentage-of-Completion Method:
 This method is similar to the completed-contract method, but it recognizes revenue based
on the percentage of work that has been completed. This method is often used when it is
difficult to determine when the entire contract will be completed, or when the
performance obligations are met over a period of time.
 4. Installment Method: 480
 This method is used when a contract is payable in installments. Revenue is
recognized as each installment is received. This method is often used for the sale of
goods that are delivered over a period of time, such as furniture or appliances.

 5. Cost Recovery (or Recoverability) Method:

 This method is used when the costs of fulfilling a contract are significant and there is
a risk that the company will not recover those costs. Revenue is recognized only
when the company is reasonably assured that it will recover its costs. This method is
often used for contracts that involve a lot of upfront costs, such as research and
development contracts.
103) When goods or services are exchanged for cash or claims to cash
(receivables), revenue are
a. earned.
b. realized.
c. recognized.
d. all of these.
A
104) The percentage-of-completion method must be used when certain
conditions exist. Which of the following is not one of those necessary
conditions?
• a. Estimates of progress toward completion, revenues, and costs are
reasonably dependable.
• b. The contractor can be expected to perform the contractual obligation.
• c. The buyer can be expected to satisfy some of the obligations under the
contract.
• d. The contract clearly specifies the enforceable rights of the parties, the
consideration to be exchanged, and the manner and terms of settlement.

C
105) In 2021, Cupid Construction Co. (CCC) began work on a two-year fixed price
contract project. CCC recognizes revenue over time according to percentage of
completion for this contract, and provides the following information (birr in millions)

• Accounts receivable, 12/31/2021 (from construction progress billings) Birr 75

• Actual construction costs incurred in 2021 270
• Cash collected on project during 2021 Birr 210
• Construction in progress 12/31/2021 Birr 414
• Estimated percentage of completion during 2021 60%
• How much cash remains to be collected by CCC on the project?
A. Birr 140 million
B. Birr 405 million
C. Birr 480 million
D. Cannot be determined from the given information.
Cash remains = Contract price - cash collected to date
Cash remains = 690 – 210 = 480
Construction in progress = Actual costs incurred + E. Gross profit
E. Gross profit = 414 – 270 = 144
Total Gross profit = Contract price - Estimated total construction costs
Contract price = T GP + E.T.C = 240+450 = 690
Total Gross profit = Estimated GP/%GP = 144/0.6 = 240
Estimated total construction costs =
• Percentage completion to date = A. Cost / Total Estimated cost
= 60 % = 270
T. E.C
E.T.C= 270/0.6 = 450
106) In 2021, Cupid Construction Co. (CCC) began work on a two-year fixed price
contract project. CCC recognizes revenue over time according to percentage of
completion for this contract, and provides the following information (birr in millions)

• Accounts receivable, 12/31/2021 (from construction progress billings) Birr 75

• Actual construction costs incurred in 2021 270
• Cash collected on project during 2021 Birr 210
• Construction in progress 12/31/2021 Birr 414
• Estimated percentage of completion during 2021 60%
• What is the amount of gross profit recognized by CCC during the period ?
A. Birr 320 million Construction in progress =
B. Birr 144 million B Actual costs incurred + Gross profit Recognized
C. Birr 96 million E. Gross profit = 414 – 270 = 144
D. Cannot be determined from the given information.
107) Export Company had a trade account receivable from a foreign customer
stated in the local currency of the foreign customer.
The trade account receivable for 900, 000 local currency units (LCU) had
been restated to $ 315,000 in Export's June 30, 2005, balance sheet. On July
26/2005, the account receivable was collected in full when the exchange rate
was LCU1= $ 0.33 (1/3.)
The journal entry that Export prepares to record the collection of this
trade account receivable include:
A. Credit to Foreign Currency Translation Adjustments, 15,000.
B. Debit to Foreign Currency Transaction Gains 15,000.
C. Credit to Trade Accounts Receivable 300,000
D. Debit to Cash, 300,000.
Cash 300,000
June 30) 315,000/900,000 = $0.35
July 25) 1/3= $0.3333333 Forex loss 15,000
D Accounts Receivable 315,000
(0.35-0.333333) * 900,000 = 15000 Loss
108) When work to be done and costs to be incurred on a long-term
contract can be estimated dependably, which of the following methods
of revenue recognition is preferable?

• a. Installment-sales method

• b. Percentage-of-completion method

• c. Completed-contract method

• d. None of these B
109) Which of the following is not an accurate representation concerning
revenue recognition?
a. Revenue from selling products is recognized at the date of sale, usually
interpreted to mean the date of delivery to customers.
b. Revenue from services rendered is recognized when cash is received or
when service have been performed.
c. Revenue from permitting others to use enterprise assets is recognized as
time passes or as the assets are used. B
d. Revenue from disposing of assets other than products is recognized at the
date of sale.
110) Under the completed-contract method
• a. revenue, cost, and gross profit are recognized during the production
cycle.
• b. revenue and cost are recognized during the production cycle, but
gross profit recognition is deferred until the contract is completed.
• c. revenue, cost, and gross profit are recognized at the time the contract is
completed.
• d. none of these.
C
111) The principal advantage of the completed-contract method is that

• a. reported revenue is based on final results rather than estimates of

unperformed work. A
• b. it reflects current performance when the period of a contract
extends into more than one accounting period.

• c. it is not necessary to recognize revenue at the point of sale.

• d. a greater amount of gross profit and net income is reported than is

the case when the percentage-of-completion method is used.
112) Winser, Inc. is engaged in extensive exploration for water in Utah. If,
upon discovery of water, Winser does not recognize any revenue from water
sales until the sales exceed the costs of exploration, the basis of revenue
recognition being employed is the

• a. production basis.

• b. cash (or collection) basis.

• c. sales (or accrual) basis.

D
• d. cost recovery basis.
113) Under the cost-recovery method of revenue recognition,

• a. income is recognized on a proportionate basis as the cash is

received on the sale of the product.

• b. income is recognized when the cash received from the sale of

the product is greater than the cost of the product.

• c. income is recognized immediately. B

• d. none of these.
114) In 2021, Cupid Construction Co. (CCC) began work on a two-year fixed price
contract project. CCC recognizes revenue over time according to percentage of
completion for this contract, and provides the following information (dollars in
millions):
• Accounts receivable, 12/31/2021 (from construction progress billings) $ 37.5
• Actual construction costs incurred in 2021 $ 135
• Cash collected on project during 2021 $ 105
• Construction in progress, 12/31/2021 $ 207
• Estimated percentage of completion during 2021 60%
• What is the amount of gross profit on the project recognized by CCC during
2021? Construction in progress = Actual costs incurred + E. Gross profit
• A) $160 million. E. Gross Profit = Construction in progress - Actual costs incurred
• B) $72 million. = 207- 135= 72
• C) $48 million.
• D) None B
 Remaining Construction cost =
Total Estimated Cost – Actual construction cost
Total Estimate construction costs = A. Cost / Percentage completion to date
= 135/0.6= 225

A = 225-135= 90
Advanced Financial
Accounting I and II

Joint arrangements
and
Public Enterprises
International Financial Reporting Standards

IFRS 11
Joint Arrangements

The views expressed in this presentation are those of the presenter,

not necessarily those of the IASB or IFRS Foundation
Introduction 497

• IFRS 11 Joint Arrangements establishes principles for

financial reporting by parties to a joint arrangement.
• The standard must be applied by all entities who are
party to a joint arrangement.
 IFRS 11 JOINT ARRANGEMENTS

• A joint arrangement is an arrangement in which two or more parties have

joint control.

• Joint control is the contractually agreed sharing of control of an

arrangement, which exists only when decisions about the relevant activities
require the unanimous consent of the parties sharing control.

• An entity that is a party to an arrangement must assess whether the

contractual arrangement gives all the parties, or a group of the parties,
control of the arrangement collectively.
Formation
The contractual arrangement is usually in writing, whatever its form,
and it will deal with the following issues surrounding the joint
venture.
• Its activity, duration and reporting obligations
• The appointment of its B.O.Ds(or equivalent) & the voting rights of
the parties
• Capital contributions to it by the parties
• How its output, income, expenses or results are shared between the
parties

499
Introduction 500

• Reasons for:
➢ opportunity to gain new capacity and expertise
➢ enter related businesses or new geographic
markets or gain new technological knowledge
➢ gives access to greater resources, including
specialized staff and technology
➢ shares risks
➢ can be flexible
Figure: Assessing joint control
 Forms of Joint arrangements
Joint operation or Joint venture
• A joint arrangement is classified as either a joint operation or a joint venture.

• A joint operation is a joint arrangement whereby the parties that have joint control of the
arrangement have rights to the assets, and obligations for the liabilities, relating to the
arrangement.

• A joint venture is a joint arrangement whereby the parties that have joint control of the
arrangement have rights to the net assets of the arrangement.
Classification 503

Not structured through a Structured through a

separate vehicle * separate vehicle *
Assessment
Assess the parties’ rights and of the parties’
obligations arising from the rights and
arrangement by considering: obligations
(a) the legal form of the separate
vehicle
(b) the terms of the contractual
arrangement, and, if relevant,
(c) other facts and circumstances
Parties have rights to the assets Parties have rights
and obligations for the liabilities to the net assets

Joint operation Joint venture

Accounting
reflects
Accounting for assets, liabilities, revenues Accounting for an
the parties’
and expenses in accordance with the investment using the rights and
contractual arrangements equity method obligations
 Accounting for a joint operation
• A joint operator shall recognise in relation to its interest in a joint operation:

➢ its assets, including its share of any assets held jointly

➢ its liabilities, including its share of any liabilities incurred jointly

➢ its revenue from the sale of its share of the output arising from the joint operation

➢ its expenses, including its share of any expenses incurred jointly

 Accounting for a joint venture

• A joint venturer should recognise its interest in a joint venture as an investment and

should account for that investment using the equity method in accordance with IAS

28 unless the entity is exempted from applying the equity method

PUBLIC Enterprises

507
 1.2 PUBLIC Enterprises
Defn: are autonomous or semi-autonomous bodies owned by the gov’t &
engaged in providing services and or products.

Background:
• The growth of public enterprises has been partly by nationalization and
partly through creation of new ones.

• Some industries are also reserved for the public sector as a matter of
national policy. EX: Airways, defense industries, railways, tele, energy,
Shipping … .
• Why Public enterprises?
• Limitation of the free price mechanism
• Basic industries need huge investment
• Government’s duty to help in economic dev’t
• Creation of economic surpluses and their utilization
• Final choice of projects are made in the interest of the economy as a whole
• If social benefits exceed social costs in the case of any service, then its production should be
taken up
• Limitation on demand of merit goods on account of price if left in private hands
• The overall economic policy of a country may dictate the use of public
enterprises in some sectors
 Formation Provision:
• Every enterprise shall be established by regulation and the establishment
regulation shall contain:
• The name of the enterprise
• A st. the enterprise shall be governed by the proc.
• The purpose for which the enterprise is established
• The authorized capital
• The amt of initial cap. paid up both in cash & in kind
• Not less than 25% of Auth. Cap.
• A st. that the ent. shall not be liable beyond its T-assets
= Limited Liability St.
• The head office of the enterprise
• A st. that may authorize the enterprise to open branches
• The name of the supervising authority
• The duration for which the enterprise is established
 ORGANIZATION
• Each enterprise shall have:

• A supervising authority
• Designated by the Council of Ministers
• Ex: FDRE Public Financial Enterprises Agency

• A management board (3-12 In number)

• Management

• Necessary staff
 Accounting for Public Enterprises
• Public enterprises are state owned, state controlled business enterprises.

• They are characterized by public purpose, public o/ship & control.

• Their accounting aspect is the same as business accounting with minor

differences in the owners’ equity section as there are no shares and
shareholders in PEs.
1) Joint control exists where:

A. The decisions in areas essential to the goals of the joint arrangement

do not require the consent of the parties.

B. One party alone has power to control the strategic operating decisions
of the joint arrangement.

C. No single party is in a position to control the activity unilaterally.

D. No one party may be appointed as the manager of the joint

arrangement.

C
2) The joint arrangement is not structured through a
separate vehicle, the arrangement is classified as a

A. Joint venture

B. Joint vehicle.

C. Joint structure
D
D. Joint operation.
3) Assume that two parties structure a joint arrangement in an incorporated
entity (entity C) in which each party has a 50 per cent ownership interest.
The purpose of the arrangement is to manufacture materials required by the
parties for their own, individual manufacturing processes.
The arrangement ensures that the parties operate the facility that produces
the materials to the quantity and quality specifications of the parties
Assessment of the relevant facts and circumstances indicate that the
arrangement is a
A. joint operation. D
The legal form of entity C (an incorporated entity) through which the activities
are conducted initially indicates that the assets and liabilities held in entity C
B. Joint vehicle. are the assets and liabilities of entity C.

The contractual arrangement between the parties does not specify that the
C. Joint structure. parties have rights to the assets or obligations for the liabilities of entity C.

Accordingly, the legal form of entity C and the terms of the contractual
arrangement indicate that the arrangement is a joint venture
D. Joint venture.
4) Which of the following is a characteristic of a joint venture?

A. The initial carrying value reported must equal the book value of
resources contributed

B. Debt incurred by the venture is reported on the venturers' statement

of financial position

C. The partners can be individuals, but cannot be businesses.

D. The partners all jointly share in managing and controlling the

venture.
D
5) A joint arrangement in which the assets and liabilities relating
to the arrangement are held in a separate vehicle.
• A. joint operation
• B. joint arrangement
• C. joint venture
• D. can be either a or c
D
6) X control over the composition of Y's board of directors. X
owns 49% of Y and is the largest shareholder. X has an agreement
with Z, which owns 10% of Y, whereby Z will always vote in the
same way as X. Can X exercise control over ?
A. X can exercise control because it controls more than 50% of the voting
power, and it can govern the financial and operating policies of Y.
B. X cannot exercise control because it owns only, 49% of the voting rights.
C. X can exercise control solely because it has an agreement with Z for the
voting rights to be used in whatever manner X wishes.
D. X cannot exercise control because it can control only the makeup of the
board and not necessarily the way the directors
A
7) This is defined as an arrangement in which two or more parties
have joint control
a. Joint operation
b. Joint venture
c. Joint arrangement
d. Joint undertaking
C

519
8) The contractually agreed sharing of control of an
arrangement, which exists only when decisions about the
relevant activities require the unanimous consent of the
parties sharing control.
a. significant influence
b. joint control
c. control
d. contractual control
B
9) It is a type of joint arrangement whereby the parties that have joint control of

the arrangement have right to the total assets and obligations for the total

liabilities relating to the arrangement.

a. Joint venture

b. Jointly controlled asset

C
c. Joint operation

d. Joint business

521
10) It is the joint arrangement that involves the establishment of a
corporation in which each party has an equity interest in the net assets of
the corporation.
• a. Joint venture
• b. Joint operation
• c. Joint undertaking
• d. Joint entity

522
11) Join control is defined as

• A). The power to govern the financial and operating policies of another entity so as to obtain
benefits from its activities

• B). The power to participate in the financial and operating policy decisions of another entity.

• C). The contractually agree sharing of control of an arrangement which exists only when
decisions about relevant activities require majority consent of the parties sharing control

• D). The contractually agree sharing of control of an arrangement which exists only when
decisions about relevant activities require unanimous consent of the parties sharing control

523
D
12) What entities shall apply IFRS 11?

A. Only those entities that have joint control over a joint arrangement

B. Only those entities that have significant influence over a joint

arrangement

C. Only those entities that are a party to a joint arrangement

D. All of the above D

524
13) What is the classification of the joint arrangement when the assets and
liabilities relating to the arrangement are held by a separate vehicle or
when the arrangement is established with separate vehicle?

a. It shall be classified as joint venture

D
b. It shall be classified as joint operation
c. Neither joint venture nor joint operation
d. It can be either a joint operation or joint venture depending on the legal
form of the separate vehicle, terms of the contractual arrangement or other
relevant facts and circumstance.
525
14) Under IFRS 11, how shall the joint venturer account for its
Investment in Joint Venture?
a. Equity method
b. Cost method
c. Fair value method under IFRS 9
d. Proportionate consolidation

526
15) Under IFRS 11, how shall the joint operator account for its interest in a joint
operation?
a. The joint operator shall account for its interest under Equity Method
b. The joint operator shall account for its interest under Cost Method
c. The joint operator shall account for its interest using proportionate consolidation
d. The joint operator shall account for its interest by recognizing its assets, its
liabilities, its revenue, its expenses and its shares in the jointly controlled assets,
jointly incurred liabilities, jointly earned revenue and jointly incurred expenses in
accordance with the contractual arrangement.
D
527
16) According to IFRS 11, it is a separately identifiable financial
structure, including separate legal entities or entities recognized by
statute, regardless of whether those entities have a legal personality.
A) separate vehicle

• B) special purpose vehicle

• C) special purpose entity A

• D) public utility vehicle

528
 Accounting for Income
Taxes
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Identify differences between pretax 6. Describe various temporary and
financial income and taxable income. permanent differences.
2. Describe a temporary difference that results 7. Explain the effect of various tax rates and
in future taxable amounts. tax rate changes on deferred income
taxes.
3. Describe a temporary difference that results
in future deductible amounts. 8. Apply accounting procedures for a loss
carryback and a loss carryforward.
4. Explain the non-recognition of a deferred
tax asset. 9. Describe the presentation of income taxes
in financial statements.
5. Describe the presentation of income tax
expense in the income statement. 10. Indicate the basic principles of the asset-
liability method.
 ACCOUNTING FOR INCOME TAXES

Income tax is a type of tax that governments impose on income

generated by businesses and individuals within their jurisdiction.
Income tax is used to fund public services, pay government
obligations, and provide goods for citizens.

Corporations must file income tax returns following the guidelines

developed by the appropriate tax authority.

Because IFRS and tax regulations differ in a number of ways,

frequently the amounts reported for the following will differ:

◆ Income tax expense (IFRS)

◆ Income taxes payable (Tax Authority)

LO 1
ACCOUNTING FOR INCOME TAXES

Financial Statements Tax Return

vs.

Pretax Financial Income  Taxable Income

IFRS Tax Code
Income Tax Expense  Income Taxes Payable

LO 1
 ACCOUNTING FOR INCOME TAXES
Illustration: Chelsea, Inc. reported revenues of $130,000 and
expenses of $60,000 in each of its first three years of operations.

For tax purposes, Chelsea reported the same expenses to the IRS
in each of the years.

Chelsea reported taxable revenues of $100,000 in 2015, $150,000

in 2016, and $140,000 in 2017.

Tax rate is 40%

What is the effect on the accounts of reporting different amounts of

revenue for IFRS versus tax?

LO 1
 Book vs. Tax Differences ILLUSTRATION 19-2
Financial Reporting
Income

IFRS Reporting 2015 2016 2017 Total

Revenues $130,000 $130,000 $130,000 $390,000

Expenses 60,000 60,000 60,000 180,000
Pretax financial income $70,000 $70,000 $70,000 $210,000

Income tax expense (40%) $28,000 $28,000 $28,000 $84,000

ILLUSTRATION 19-3
Tax Reporting 2015 2016 2017 Total

Revenues $100,000 $150,000 $140,000 $390,000

Expenses 60,000 60,000 60,000 180,000
Taxable income $40,000 $90,000 $80,000 $210,000

Income taxes payable (40%) $16,000 $36,000 $32,000 $84,000

LO 1
 Book vs. Tax Differences ILLUSTRATION 19-4
Comparison of Income
Tax Expense to Income
Taxes Payable

Comparison 2015 2016 2017 Total

Income tax expense (IFRS) $28,000 $28,000 $28,000 $84,000

Income tax payable (TA) 16,000 36,000 32,000 84,000
Difference $12,000 $(8,000) $(4,000) $0

Income tax expense (40%) $28,000 $28,000 $28,000 $84,000

Are the differences accounted for in the financial statements? Yes

Year Reporting Requirement

2015 Deferred tax liability account increased to $12,000
2016 Deferred tax liability account reduced by $8,000
2017 Deferred tax liability account reduced by $4,000

LO 1
 Future Taxable and Deductible Amounts

A temporary difference is the difference between the tax basis of an

asset or liability and its reported (carrying or book) amount in the
financial statements that will result in taxable amounts or deductible
amounts in future years.

Future Taxable Amounts Future Deductible Amounts

Deferred Tax Liability represents Deferred Tax Asset represents the
the increase in taxes payable in increase in taxes refundable (or
future years as a result of taxable saved) in future years as a result of
temporary differences existing at deductible temporary differences
the end of the current year. existing at the end of the current
year.

LO 2
ACCOUNTING FOR INCOME TAXES

Specific Differences
Temporary Differences
◆ Taxable temporary differences - Deferred tax liability
◆ Deductible temporary differences - Deferred tax
Asset

LO 6
Taxable Temporary Differences ILLUSTRATION 19-22
Examples of Temporary
Differences

Revenues or gains are taxable after they are recognized in financial income.

An asset (e.g., accounts receivable or investment) may be recognized for revenues or

gains that will result in taxable amounts in future years when the asset is recovered.
Examples:
1. Sales accounted for on the accrual basis for financial reporting purposes and on the
installment (cash) basis for tax purposes.
2. Contracts accounted for under the percentage-of-completion method for financial
reporting purposes and the cost-recovery method (zero-profit method) for tax
purposes.
3. Investments accounted for under the equity method for financial reporting purposes
and under the cost method for tax purposes.
4. Gain on involuntary conversion of non-monetary asset which is recognized for
financial reporting purposes but deferred for tax purposes.
5. Unrealized holding gains for financial reporting purposes (including use of the fair
value option) but deferred for tax purposes.
LO 6
 Taxable Temporary Differences

Expenses or losses are deductible before they are recognized in financial income.

The cost of an asset may have been deducted for tax purposes faster than it was
expensed for financial reporting purposes. Amounts received upon future recovery of
the amount of the asset for financial reporting (through use or sale) will exceed the
remaining tax basis of the asset and thereby result in taxable amounts in future
years. Examples:
1. Depreciable property, depletable resources, and intangibles.
2. Deductible pension funding exceeding expense.
3. Prepaid expenses that are deducted on the tax return in the period paid.
4. Development costs that are deducted on the tax return in the period paid.

LO 6
Deductible Temporary Differences ILLUSTRATION 19-22
Examples of Temporary
Differences

Revenues or gains are taxable before they are recognized in financial income.

A liability may be recognized for an advance payment for goods or services to be

provided in future years. For tax purposes, the advance payment is included in taxable
income upon the receipt of cash. Future sacrifices to provide goods or services (or
future refunds to those who cancel their orders) that settle the liability will result in
deductible amounts in future years. Examples:
1. Subscriptions received in advance.
2. Advance rental receipts.
3. Sales and leasebacks for financial reporting purposes (income deferral) but reported
as sales for tax purposes.
4. Prepaid contracts and royalties received in advance.

LO 6
Deductible Temporary Differences ILLUSTRATION 19-22
Examples of Temporary
Differences

Expenses or losses are deductible after they are recognized in financial income.

A liability (or contra asset) may be recognized for expenses or losses that will result in
deductible amounts in future years when the liability is settled. Examples:
1. Product warranty liabilities.
2. Estimated liabilities related to discontinued operations or restructurings.
3. Litigation accruals.
4. Bad debt expense recognized using the allowance method for financial reporting
purposes; direct write-off method used for tax purposes.
5. Share-based compensation expense.
6. Unrealized holding losses for financial reporting purposes (including use of the fair
value option), but deferred for tax purposes.

LO 6
 Specific Differences

Permanent differences result from items that (1) enter into

pretax financial income but never into taxable income or (2)
enter into taxable income but never into pretax financial income.

Permanent differences affect only the period in which they occur.

They do not give rise to future taxable or deductible amounts.
There are no deferred tax consequences to be recognized.

LO 6
Permanent Differences ILLUSTRATION 19-24
Examples of Permanent
Differences

Items are recognized for financial reporting purposes but not for tax purposes.

Examples:
1. Interest received on certain types of government obligations.
2. Expenses incurred in obtaining tax-exempt income.
3. Fines and expenses resulting from a violation of law.
4. Charitable donations recognized as expense but sometimes not deductible for tax
purposes.

Items are recognized for tax purposes but not for financial reporting purposes.

Examples:
1. “Percentage depletion” of natural resources in excess of their cost.
2. The deduction for dividends received from other corporations, sometimes considered
tax-exempt.

LO 6
17) A deferred tax asset represents the increase in taxes payable in future
years as a result of taxable temporary differences existing at the end of the
current year.

• A) Ture
• B) False

B
18) The use of accelerated depreciation for tax purposes and straight-line
depreciation for accounting purposes results in:

• a. a larger amount of depreciation expense shown on the tax return than

on the income statement over the asset’s useful life.
• b. the asset being fully depreciated for tax purposes in half the time it
takes to become fully depreciated for accounting purposes.
• c. a larger amount of depreciation expense shown on the income
statement than on the tax return in the last year of the asset’s useful life.
• d. a loss on the sale of the asset in question if it is sold for its book value
before its useful life expires

A
19) A major distinction between temporary and permanent differences is:

A) temporary differences reverse themselves in subsequent accounting

periods, whereas permanent differences do not reverse
B) No difference
C) permanent differences reverse themselves in subsequent accounting
periods, whereas temporary differences do not reverse
D) None

A
20) Sandy Company deducts insurance expense of $21,000 for tax purposes in 2017, but the
expense is not yet recognized for accounting purposes. In 2018, 2019 and 2020 taxable
income will be higher than financial income because no insurance expense will be deducted
for tax purposes, but $7,000 of insurance expense will be reported for accounting purposes
in each of these years. Sandy Company has a tax rate of 45% and income taxes payable of
$18,000 at the end of 2017. There were no deferred taxes at the beginning of 2017.
a. Income Tax Expense 18,000
Income Tax Liability 18,000 Taxable temporary difference = 21000
B. Income Tax Expense 27,450 Deferred tax liability = 21000*0.45= 9450

Income Tax Liability 18,000 Income tax expense = Current paired tax + tax deferred Lability
Deferred Tax Liability 9,450
C. Income Tax Expense 26,100
Income Tax Liability 18,000 B
Deferred Tax Liability 8,100
D. Income Tax Expense 30,450
Income Tax Liability 21,000
Deferred Tax Liability 9,450
21) Annette Company made the following journal entry in late 2017 for rent
on property it leases to Hrubec Corporation. Cash 80,000, Unearned Rent
80,000. The payment represents rent for the years 2018 and 2019, the period
covered by the lease. Annette Company is a cash basis taxpayer. Annette has
income taxes payable of $123,000 at the end of 2017, and its tax rate is 38%.

What amount of income tax expense should Annette Company report at the
end of 2017?
A. $153,400
B. $107,800
Deductible temporary difference = 80,000
C. $ 92,600 Deferred tax Asset = 80000*0.38= 30,400
D. $ 73,400
C Income tax expense = Current paired tax - tax deferred Asset
123,000 -30400= 92600
Income tax expense…….92600
Deferred tax Asset ……….30400
Income tax payable ……….123000
22) A company's receivables have carrying amount of $13 000 and a
tax base of$ 15 000, property, plant and equipment has carrying
amount of $100 000 and a tax base of $80 000. Tax rate for the current
year is 25%, but the tax rate of 30% for the future years has already
been enacted. Calculate a net deferred tax liability.
Receivables there is a deductible temporary difference of $2 000
A. $6600 and it gives rise to a deferred tax asset of $ 600 (at the tax rate of
30%).
D
B. $4500 PPE there is a taxable temporary difference of $20 000 and it
gives rise to a deferred tax liability of $-6 000 (at the tax rate of
30%).
C. $5500
Add it up and you get net deferred tax liability of -5400 (600-6
D. $5400 000). Oh, and why did we use tax rate of 30%? Because the new
tax rate applicable in future periods was substantially enacted at
the reporting date.
23) Which of the following differences between financial reporting tax
reporting creates ordinarily a deferred tax asset?
a. Warranty expenses
b. Depreciation
c. Interest on municipal bonds
d. Fines from violation of law
A
24) Which of the following differences between financial reporting tax
reporting creates ordinarily a deferred tax liability?
a. Warranty expenses
b. Premiums paid for officer's life insurance
c. Fines from violation of law
d. Depreciation
D
25) Viking Corporation reported depreciation of $250,000 on its 2010 tax return.
However, in its 2010 income statement, Viking reported depreciation of
$100,000. The difference in depreciation is a temporary difference that will
reverse over time. Assuming Viking's tax rate is constant at 30 percent, what
amount should be added to the deferred income tax liability in Viking's
December 31, 2010, balance sheet?
Temporary difference = 250,000 -100,000
a. $30,000 150,000
= 150,000*0.3= 45,000
b. $37,500
c. $45,000
C B/C Tax base of Asset Less than the CV
d. $75,000 OR Accounting Income > Taxable Income
26) In 2011, Eric Corporation reported $90,000 net income before income
taxes. The income tax rate for 2011 was 30 percent. Eric had an unused
$60,000 net operating loss carryforward arising in 2010 when the tax rate was
35 percent. The income tax payable Eric would report for 2011 would be
a. $6,000.
b. $9,000.
B
c. $10,500. Income tax expense = (Pre-tax Income - operating loss carryforward ) * Tax Rate
= ($90,000 - $60,000) * 30%
d. $27,000. = $30,000 * 30%
= $9,000
26) Current tax should be measured using tax rates and tax laws that:

A) Have been enacted by the end of the reporting period.

B) Have been enacted or substantively enacted by the end of the

reporting period
C) Have been enacted by the date that the financial statements are
authorized for issue
D) Have been enacted or substantively enacted by the date that the
financial statements are authorized for issue .
Measurement of current tax liabilities (assets) is
very straightforward. We need to use the tax
B rates that have been enacted or substantively
enacted by the end of the reporting period and
apply these rates to the taxable profit (loss).
27) The tax base of an asset is the amount which is
attributable to that asset for tax purposes. If the tax base of
an asset is less than its carrying amount, this is an evidence
of:
C
A. A deductible temporary difference

B. A taxable permanent difference

C. A taxable temporary difference

D. A deductible permanent difference

27) All of the following are examples of temporary
book-tax differences except
A. Depreciation

B. Product warranty costs.

C. Payment of premiums for life insurance

D. Contingent liabilities
D
Accounting For Share-based payment
IFRS 2

558
 IFRS 2 Objective

• The objective of this IFRS is to specify the financial reporting by an entity when
it undertakes a share-based payment transaction.

• In particular, it requires an entity to reflect in its profit or loss and financial

position the effects of share-based payment transactions, including expenses
associated with transactions in which share options are granted to employees
and other.

559
 Share-based payment
❖As the name itself describes, share-based payments refer to “payments made by
a company based on its share price”.

❖Share-based payment occurs when an entity buys goods or services from a

‘counterparty’ and the counterparty could be any supplier or even an employee.

❖It is a transaction in which the entity is obtaining goods or services in exchange

for issuing its shares, or paying in cash where the cash payment is linked to the
value of the entity’s shares.

❖Share-based payment awards are common features of employee compensation

for directors, senior executives and other employees.

560
Scope
⦿ A share-based payment is accounted for under IFRS 2 if it
meets the definition of a share-based payment transaction
and the transaction is not specifically scoped out of the
standard
The following transactions are not in the scope of IFRS 2:
⦿ (a) transactions with counterparties (employees) acting
as shareholders rather than as suppliers of goods or
services;
⦿ (b) transactions in which a share-based payment is made
in exchange for control of a business (I,e., business
combination);
⦿ (c) commodity-based derivative contracts that may be
settled in shares or rights to shares.

564
However, awards made by shareholders; transfers of an entity’s equity
instruments by its shareholders to parties (including employees) that have
supplied goods or services to the entity are share-based payment
transactions within the scope of IFRS 2.
⦿ In addition, equity instruments granted to employees of the acquiree
(target company) in their capacity as employees (eg in return for continued
service) are within the scope of this IFRS 2.
⦿ Similarly, the cancellation, replacement or other modification of share-
based payment arrangements because of a business combination or other
equity restructuring shall be accounted for in accordance with this IFRS.
⦿ In general IFRS 2 does not apply to share based payment transactions for
the purpose other than acquisition of goods and services. Share dividends,
the purchase of treasury shares, and the issuance of additional shares are
therefore outside its scope.

565
⦿ Why does an entity choose to pay in equity instruments or
to pay amounts based on the value of an equity instrument,
rather than a fixed cash amount? There are several reasons,
including those set out below.
➢ Principal-agent conflict of interest : share-based payments
are often granted to employees under the condition that
the employees provide future services and that one or more
specified service or performance targets are met.
Therefore, the employees are motivated to make an effort
to achieve the target in order to benefit from the share-
based payment.
➢ Reward for past services (Awards made by shareholders):
Share-based payments are also granted for past services –
e.g. to acknowledge good services of an employee by giving
them a participation in the entity (e.g. free or discounted
shares). In this case, the share-based payment would be
granted without the condition to provide future services –
i.e. the share-based payment vests immediately.
 Basic concepts
❖ Grant Date: The date on which both the parties (the entity &
counterparty) agreed to SBP arrangement. Employees agree,
shareholders approve, agreement is signed or approval recorded in a
company minutes.
❖Vesting conditions: These are the conditions mentioned in the share-
based payment arrangement which need to be satisfied by the
counterparty to become entitled. A vesting condition is either
a service condition or a performance condition.
❖Vesting period: Refers to the period during which all the specified
vesting conditions of a share-based payment arrangement are to be
satisfied.
❖Exercise date ( options turn in to cash or shares).

567
 Basic concepts
❖Service condition: It is a vesting condition that requires
the counterparty to complete a specified period of service. If the
counterparty ceases to provide service during the vesting period
(regardless of the reason), it has failed to satisfy the condition.
❖A service condition does not require to meet a performance target.
❖Performance condition: A vesting condition that requires
• (a) the counterparty to complete a specified period of service (i.e., a
service condition); the service requirement can be explicit (precisely
communicated) or implicit (Implied); and
• (b) specified performance target should be met while the counterparty
is rendering the services as per point (a) above.
• Examples include – Achieving sales target, Profit target, Market price
target, etc. These targets may be pertaining to the entity or any other
entity in the same group or partly related to entity and remaining
related to another entity in the group.
568
 Basic concepts
• A performance condition is further classified into two categories:
• Non-market related condition; and
• Market related condition.
❖Market related condition includes a performance target with reference to
price of equity instruments (share price/share option price) of the entity or
its group entity;
❖Non-market related condition includes a performance target with
reference to the entity’s own operations (or activities); or its group
entity; like achieving specific percentage growth in profits/EPS;
Completion of Research project, etc.
❖Non-vesting conditions: It can be understood that these
conditions do not have any impact on eligibility to have share based
payments. These are neither service nor performance conditions.

569
 Cont.………
❖5 Basic Principles
#1. Classification

#2. Recognition

#3. Measurement

#4. Vesting Conditions

#5. Changes

570
#1. Classification
• There are three types of share based payment transactions:
• Equity-settled share based payment transactions where a company
receives goods or services in exchange for equity instruments (e.g.
shares or share options).
• Cash-settled share based payment transactions, where a company
receives goods and services in exchange for a cash amount paid
based on its share price. (Share price appreciation )
• Share-based payment transactions with cash alternatives (choice of
settlement). It can be settled either by giving cash/other assets or
issuing equity instruments. This choice can be either with the entity
or the counterparty.

571
#2. Recognition

572
#3. Measurement

573
#4. Vesting conditions

574
Cont.………
#5. Changes

575
28) These are transactions in which the entity acquires goods or services by
incurring liabilities to the supplier of those goods or services for amounts that
are based on the price of the entity’s shares and other equity instruments.

• a. Equity transactions
• b. Cash settled share-based payment transactions
• c. Purchase transactions
• d. Cash payment transactions

B
29) For cash settled share-based payment transactions, until the liability is
settled, the entity is required to remeasure the fair value of the liability of
each reporting date and the date of settlement and any changes in fair value
are

• a. Recognized in profit or loss for the period

• b. Included in retained earnings

• c. Treated as component of equity A

• d. Not recognized
30) It is the date on which the entity and another party agree to a share-
based payment arrangement, being when the entity and the counter party
have shared understanding of the terms and conditions of the arrangement.

• a. Grant date

• b. Measurement date

• c. Exercise date
A
• d. Balance sheet date
31) On January 1, 2011, JP CO. agreed to issue 5000 shares to Rock
Company in exchange for construction of a building. Ownership of the
building was transferred on November 30, 2011. However, the contract
price was settled on January 01, 2012. At which date should JP Co recognize
the acquisition of building?
•
• A. January 01, 2011
• B. November 30, 2011
• C. January 01, 2012
• D. November 30, 2012 B
• 32) On January 1, 2015, Morey Company granted Dean, the president, 20,000
appreciation rights for past services. These rights are exercisable immediately and
expire on January 1, 2017. On exercise, Dean is entitled to receive cash for the
excess of the share fair market price on the exercise date over the fair market
price on the grant date.
• The fair market price on Morey’s share was birr 30 on January 1, 2015 and birr 45
on December 31, 2015. As a result of the share appreciation rights, what amount
should be recognized as compensation expense for 2015?
A). 0
• B). 100,000
• C). 300,000
• D). 600,000
SOLUTION:
Fair Market price, December 31, 2015 45
Predetermined price on January 1, 2015 30
C Fair Value of share appreciation right 15
Compensation for 2015 (20,000 x 15) 300,000
33) On January 1, 2016, Kristen Company established a share appreciation rights plan for the
executives. The plan entitled them to receive cash at any time during the next four years for the
difference between the fair market price of the ordinary share and a pre-established price of Birr
20 on 60,000 share appreciation rights.
Market price
• January 1, 2016 20 per share
• December 31, 2016 28 per share
• December 31, 2017 35 per share
• December 31, 2018 30 per share
• What amount of compensation expense should be recognized for 2016?
• a. 480,000
• b. 120,000
• c. 300,000
• d. 180,000
SOLUTION: Fair Value, December 31, 2016 (28-20) 8
Compensation expense for 2016 (60,000 x 8) 480,000

A
34) On January 1, 2016, Oak Company granted share options to certain key
employees as additional compensation. The options were for 100,000 ordinary
shares of 10 par value at an option price of 15 per share. Market price of this
share on January 1, 2016 was 20. The fair value of each share option on January
1, 2016 is 8. The options were exercisable beginning January 1, 2016 and expire
on December 31, 2016. On April 1, 2016, all share options were exercised.

• What amount of compensation expense should be reported in 2016?

• a. 800,000
• b. 500,000
• c. 200,000 A Fair Value of share options (100,000 x
8) 800,000
• d. 125,000
35) On January 1, 2017, Gliezel company issued options to key employees to
purchase 20,000 ordinary shares of Birr 100 par value at birr 125 per share. On
such date, the market value of ordinary share is birr 150 per share. The fair value
of each share option is birr 30. These options are exercisable starting January 1,
2019 and expire one year after. a. Compute compensation expense for the year
2017
A) 300,000
B) 250,000
C) 350,000
Fair Value of share options (20,000 x 30)*1/2= 300,000
D) 0
A
36) Which of the following statements in relation to a cash settled share-based
payment transaction is true?

I) The fair value of the liability shall be remeasured at the end of each reporting
period.

II) The fair value of the liability shall be remeasured at the date of settlement.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
C
37) A company grants 2,000 share options to each of its three directors on 1
January 2016, subject to the directors being employed on 31 December 2018.
The options vest on 31 December 2018. The fair value of each option on 1
January 2016 is $10, and it is anticipated that on 1 January 2016 all of the share
options will vest on 30 December 2018. It is anticipated that on 31 December
2016 only two directors will be employed on 31 December 2018. How will the
share options be treated in the financial statements for the year ended 31
December 2016?
• A) 13,333
• B) 26,666 2,000 options x 2 directors x $10 x 1 year / 3 years = $13,333

• C) 39,999
A
• D) None
38) Which of the following transactions involving the
issuance of shares does not come within the
definition of a share based payment?
A. Employee share option plans.
B. Employee share purchase plans.
C. Share-based payment relating to an acquisition of a
subsidiary. The following transactions are not in the scope of IFRS 2:
⦿ (a) transactions with counterparties (employees)
D. Share appreciation rights. acting as shareholders rather than as suppliers of
goods or services;
⦿ (b) transactions in which a share-based payment is
C made in exchange for control of a business (I,e., business
combination);
⦿ (c) commodity-based derivative contracts that may be
settled in shares or rights to shares.
39) Entity X has entered into a contract with entity Y. Y will provide a
range of services to X. The payment for those services will be in cash
and based upon the price of the X’s ordinary shares on completion of the
contract.
In accordance with IFRS 2, what type of share-based payment
transaction does this represent?
a. Asset settled share-based payment transactions

b. Liability settled share-based payment transactions

c. Cash settled share-based payment transactions C

d. Equity settled share-based payment transactions

40) An entity grants 1,000 share options to each of its five directors on
January 1, 2015. The options vest on June 30, 2018. The fair value of each
option on July 1, 2014, is Birr 5, and it is anticipated that all of the share
options will vest on December 31, 2018.
What will be the accounting entry in the financial statements for the year
ended December 31, 2015?
1000*5*5*1/4 = 6250

A. Increase equity Birr 6,250, increase in expense statement of comprehensive

income Birr 6,250.
B. Increase equity Birr 5,000, increase in expense statement of comprehensive
income Birr 5,000
C. Increase equity Birr 25,000, increase in expense statement of A
comprehensive income Birr 25,000.
D. Increase equity zero, increase in expense statement of comprehensive
income zero.
41) Elizabeth, a public limited company, has granted 100 share
appreciation rights to each of its 1,000 employees in January 2014.
90% of the awards will vest on December 31, 2016. The fair value
of each share appreciation right on December 31, 2014, is Birr10.
What is the fair value of the liability to be recorded in the financial
statements for the year ended December 31, 2014?

A. Birr 10 million
(100 × 1000 × 90% × Birr 10 × 1/3)
300,000
B. Birr 90,000
C
C. Birr 300,000

D. Birr 100,000
• 42) RR Company granted 10,000 share options to each of its five directors on
January 1,2015. The options vest on December 31 2018. The fair value of
each option on January 1, 2015 is Birr 50 and it is anticipated that all of the
share options will vest on December 31 2018.
• What amount should be reported as increase in expense and equity for the
year ended December 31, 2015?
A. 750,000
B. 500,000 FV of share options (10,000 * 5 directors * 50) 2,500,000
Compensation expense (2,500,00/4) 625,000
C. 625,000 Salaries 625,000
Share options outstanding 625,000
D. 125,000
C
• 43. On 1 June 2011 Bridget Ltd acquired an item of plant for an agreed
consideration of 1,000 of its own shares.
• The plant was received on 1 June 2011 and the obligation to transfer shares
was to be settled on 1 August 2011. The fair value of the plant was$10 000 on
1 June 2011. Bridget’s share price was $8 on 1 June 2011 and $9 on 30 June
2011.
• In accordance with IFRS 2 Share-based Payment Bridget should
• A. remeasure the equity to $9000 on 30 June 2011.
• B. initially recognize the plant and equity at $8000 on 1 June 2011.
• C. make no entry in relation to the transaction until 1 August 2011.
• D. initially recognize the plant and equity at $10 000 on 1 June 2011.
• E. All
• F. None D
Agricultural accounting
And Biological asset
IAS 41

592
 Learning Objectives
At the completion of studying this chapter, you will
be able to:
•Explain key terms in IAS 41 & IAS 16 agriculture activities
•Indicate measurement and recognition of agricultural
activities
•Show the subsequent accounting treatment of agricultural
activities
•Identify the disclosure requirements for agricultural activity

593
Definitions of Key Terms (in accordance with IAS 41)
• Agricultural activity – the transformation of biological assets
(living plants and animals) into agricultural produce or into other
biological asset for the purpose of sale or used in the production.

• Examples of agricultural activity include:

• Raising livestock,
• fish or poultry,
• Stud farms (for example, breeding horses or cattle), Forestry,
• Cultivating vineyards, orchards or plantations,
• Floriculture
 Questions About Agricultural
activity
• Is managing animal-related recreational activities agricultural activity?
• No. Managing recreational activities – for example, game parks and zoos – is
not agricultural activity, as there is no management of the transformation of
the biological assets but simply control of the number of animals.
• Is the natural breeding of animals in zoos and game parks agricultural activity?
• No. The natural breeding that takes place is not a managed activity and is
incidental to the main activity of providing a recreational facility. A managed
breeding programmed carried out to produce animals for sale would be
considered agricultural activity.

595
Is ocean fishing agricultural activity?
No. Harvesting biological assets from unmanaged sources, such as ocean
fishing, is not agricultural activity.

Is fish farming agricultural activity?

Yes. Managing the growth of fish for subsequent slaughter or sale is
agricultural activity within the scope of IAS 41.

Is the growing of plants to be used in the production of drugs an activity

within the scope of IAS 41?
Yes. If a pharmaceutical or biotechnology entity grows plants from which
particular drugs are produced, that activity will fall within IAS 41’s scope

596
•Biological assets. Living plants and animals.
What are biological assets?
• • Sheep, pigs, beef cattle, poultry and fish.
• • Dairy cows.
• • Trees in a forest.
• • Plants for harvest (for example, wheat and vegetables).
• • Trees, plants and bushes from which agricultural produce is harvested (for
example, fruit trees, vines and tea bushes).
• Harvest is the detachment of produce from a biological asset
or the cessation of a biological asset’s life processes.
• Agricultural produce. The product of the entity’s biological
assets, for example, milk and coffee beans.

597
• Biological transformation leads to various different
outcomes.
• Both plants and animals are capable of undergoing
biological transformations.
✓Asset changes:
• Growth: increase in quantity and/or quality
• Degeneration: decrease in quantity and/or quality
✓Creation of new assets:
• Production: producing separable non-living products
• Procreation: producing separable living animals
Types of Biological Assets

Biological assets

Bearer Consumable
biological assets biological assets

Plant Animal
IAS 41
IAS 16 IAS 41
Produce
Types of Biological Assets
• Bearer biological assets:
Bearer plants and Animal are defined in IAS 41as a plant that
meets all the following criteria:
❑It is used in the production or supply of agricultural produce
❑It is expected to bear produce for more than one period
❑It is not intended to be sold as a living plant or harvested as
agricultural produce, except for incidental scrap sales (i.e. for
firewood at the end of the plants productive life).

Example: livestock from which milk is produced, grape

vines, fruit trees and coffee trees
600
Types of Biological Assets (cont’d)
• Consumable biological assets:
• Biological assets which do not meet all of
the above requirements.

Example: livestock intended for the production of

meat, livestock held for sale, fish in farms, crops
such as maize and wheat, and trees being grown
for lumber

601
 Exclusions

IAS 41does not apply to:

✓ Land related to agricultural activity (see IAS 16 Property,
Plant and Equipment and IAS 40 Investment Property).
✓ Bearer plants related to agricultural activity (see IAS
16). However, IAS 41 applies to the produce on those
bearer plants.
✓ Government grants related to bearer plants (see IAS 20
Accounting for Government Grants and Disclosure of
Government Assistance).
✓Intangible assets related to agricultural activity (see IAS
38 Intangible Assets).
✓Harvested agricultural produce (IAS 2, Inventory).
However, it does apply to produce growing on bearer
plants.
Recognition

An entity should recognize a biological asset or agricultural

produce when :
(a) the enterprise controls the asset as a result of past events;
(b) it is probable that the future economic benefits will flow to
the enterprise; and
(c) the fair value or cost can be measured reliably.
Measurement
• Any biological asset should be measured initially and at
each balance sheet date, at its fair value less estimated
point-of-sale costs.
• The only exception to this is where the fair value cannot be
measured reliably.
• Agricultural produce should be measured at fair value less
estimated point-of-sale costs at the point of harvest.
• According to IAS 41, agricultural produce can always be
measured reliably.
• Point-of-sale costs include brokers’ and dealers’
commissions, any levies by regulatory authorities and
commodity exchanges, and any transfer taxes and duties.
• They exclude transport and other costs necessary to get
the assets to a market.
44) IAS 41 apply to the following:
• A. Land related to agricultural activity (IAS 16 and IAS 40).

• B. Bearer plants (IAS 16). However, IAS 41 applies to the produce on those
bearer plants

• C. Intangible assets related to agricultural activity (IAS 38)

• D. None D
45) The Anemone Company owns a number of herds of cattle. Where
should changes in the fair value of a herd of cattle be recognised in the
financial statements, according to IAS41 Agriculture?
A) In profit or loss only
B) In other comprehensive income only
C) In profit or loss or other comprehensive income
A
D) In the statement of cash flows only
46) According to IAS41 Agriculture, which one of the following items would
be classified as biological assets?

A) Oranges
B) Milk
C) Eggs
D) Trees

607
47) Are the following statements about classification according to IAS41
Agriculture true or false?
Statement 1
Sugar should be classified as agricultural produce.
Statement 2
Wool should be classified as agricultural produce.

A) Statement 1: False, Statement 2: False

B) Statement 1: False, Statement 2: True
C) Statement 1: True, Statement 2: False
D) Statement 1: True, Statement 2: True B

608
48) Where there is a long aging or maturation process after harvest, the
accounting for such products should be dealt with by

• a. IAS 41.

• b. IAS 2, Inventories.

• c. IAS 16, Property, Plant, and Equipment.

• d. IAS 40, Investment Property.

B

609
49) It is the management by an entity of the biological transformation and
harvest of biological assets for sale or for conversion into agricultural produce
or into additional biological assets.
A. Agricultural activity
B. Biological activity
C. Development activity
A
D. Economic activity

610
50) Where the fair value of the biological asset cannot be determined
reliably on initial recognition, the biological asset should be measured at
• a. Cost.
• b. Cost less accumulated depreciation.
• c. Cost less accumulated depreciation and accumulated impairment losses.
• d. Net realizable value.

611
51) According to IAS41 Agriculture, which TWO of the following criteria must
be satisfied before a biological asset can be recognised in an entity's financial
statements?

1. The entity controls the asset as a result of past events

2. It is probable that economic benefits relating to the asset will flow to the
entity

3. An active market for the asset exists

4. The asset forms a homogenous biological group

1 and 2

612
52) Which of the following is outside the scope of IAS 41?
A. dairy cattle used in the production of milk
B. chickens used in the production of meat
C. rice plants and other crops that produce agricultural products only once
D. mango trees and other plants that produce agricultural products
repeatedly over a long period of time

D
613
53) A bearer plant is a living plant that:

• a. is used in the production or supply of agricultural produce

• b. has a remote likelihood of being sold as agricultural produce, except

for incidental scrap sales

• c. is used to bear produce for more than one period

• d. must possess all of these characteristics

D
614
Insurance Contact
IFRS 4

615
 Learning Objectives

At the completion of studying this chapter, you will be

able to:
•Explain key terms in IFRS 4 insurance contracts
•Indicate measurement and recognition of insurance contracts
•Show the subsequent accounting treatment of insurance
contacts
•Identify the presentation and disclosure requirements for
insurance contract

616
Overview
• IFRS 4 establishes the principles for the recognition,
measurement, presentation and disclosure of insurance
contracts within the scope of the standard.
• IFRS 4 Insurance Contracts applies, with limited exceptions, to
all insurance contracts (including reinsurance contracts) that an
entity issues and to reinsurance contracts that it holds.

617
Objective
The objective of IFRS 4 is to ensure that an entity
provides relevant information that faithfully represents
insurance contracts.
This information gives a basis for users of financial
statements to assess the effect that insurance contracts
have on the entity's financial position, financial
performance and cash flows.
 Scope

An entity shall apply IFRS 4 Insurance Contracts to the following:

Insurance contracts issued by an entity,
Reinsurance contracts issued by an entity,
Part of the insurance contracts that a company has ceded
(sold/transferred risk) to the reinsurance company (reinsurance
contracts held by an entity),
insurance contracts that are substantially investment-related
service contracts under which an entity promises an investment
return based on underlying items
 key Definitions
• An insurance contract is a contract under which one
party (the issuer) accepts significant insurance risk
from another party the (policyholder).
• If a “specified uncertain future event (the insured
event) adversely affects the policyholder”, then the
policyholder has a right to obtain compensation
from the issuer under the contract.
 Basic concept

• Portfolio of insurance contracts: Insurance contracts subject to similar risks and

managed together.

• Fulfilment cash flows: expected value of the present value of the future cash
outflows less the present value of the future cash inflows that will arise as the
entity fulfils insurance contracts, including a risk adjustment for non-financial risk
and financial risk

• Contractual service margin: A component of the carrying amount of the asset or

liability for a group of insurance contracts representing the unearned profit the
entity will recognize as it provides services under the insurance contracts in the
group.
 Basic concept

• Risk adjustment for non-financial risk:

• The compensation an entity requires for bearing the uncertainty

about the amount and timing of the cash flows arising from non-
financial risk as the entity fulfils insurance contracts.

• Separating components from an insurance contract: An insurance

contract may contain one or more components that would be within
the scope of another standard if they were separate contracts.
623
624
625
Modification

• A contract modification could change the scope of the contract, the

price of the contract, or both. A contract modification exists when the
parties to the contract approve the modification either in writing,
orally, or based on the parties' customary business practices.

• Derecognize the original contract and recognized the modified

contract

626
Presentation
Presentation in the statement of financial position
• An entity shall present separately in the statement of
financial position the carrying amount of groups of:
• (a) insurance contracts issued that are assets;
• (b) insurance contracts issued that are liabilities;
• (c) reinsurance contracts held that are assets; and
• (d) reinsurance contracts held that are liabilities.
 Presentation
Presentation in the statement(s) of Profit or loss
• An entity shall disaggregate the amounts recognized in the
statement(s) of financial performance into:
• (a) an insurance service result, comprising insurance revenue and
insurance service expenses; and
• (b) insurance finance income or expenses.
• Income or expenses from reinsurance contracts held shall be
presented separately from the expenses or income from insurance
contracts issued.
 Disclosure Requirements
• IFRS 4 contains specific disclosure requirements that focus on
information about:
• – amounts recognized in the financial statements;
• – significant judgments and changes in those judgments; and
• – the nature and extent of risks that arise from insurance contracts.
54) Insurance contracts without direct participation features are measured
based on the: •General model: Applicable to contracts without DPFs. It measures the
insurer's liability as the present value of expected future cash outflows
(claims and benefits) discounted by a risk-adjusted discount rate.
• a. General model •Variable fee approach: Applies to contracts with DPFs. It measures the
liability and volatility based on the potential variability of future returns linked
to underlying assets or indices.
• b. Variable fee approach Key Characteristics of the General Model:
•Deterministic assumptions: Utilizes fixed or predetermined estimates for
cash outflows and discount rates.
• c. Premium allocation approach•Explicit recognition of contractual service margin (CSM): The profit arising
from the insurance contract is gradually released into profit or loss as claims
and benefits are paid.
• d. General model or •Straight-line measurement of CSM: Applies a constant proportion of the
• Premium allocation approach initial CSM to revenue in each period, except when significant adverse
changes occur.
Example of a Contract without DPFs:
•Term life insurance: Provides a fixed death benefit upon the policyholder's
death. The benefit payment amount and timing are known upfront, making it
A suitable for the general model.
Additional Notes:
•The Premium allocation approach, mentioned in option (c), is no longer a
standalone measurement method under IFRS 17. However, it can be
embedded within the general model in specific cases.
Asset Valuation for Financial Reporting

631
 Valuation
• Appraisal/Valuation is the act or process of developing an opinion of
value.

 Value is not fact but an opinion of either:

(a) The most probable price to be paid for an asset in an exchange, or

(b) The economic benefits of owning an asset.

❑ A value in exchange is a hypothetical price and the hypothesis on
which the value is estimated is determined by the purpose of the
valuation.
❑ A value to the owner is an estimate of the benefits that would accrue
to a particular party from ownership.
 Asset Valuation

• Asset valuation is the process to determine the value of a specific

property, including stocks, bonds, buildings, machinery, or land,
equipment, brands, goodwill, etc

• Asset valuation is the calculation of the financial value of

an organization’s assets reported at the end of a financial
period.
 Asset Valuation

• Asset valuation is commonly performed prior to the

purchase or sale of an asset or prior to purchasing
insurance for an asset.
• It is a process that uses different scientific techniques in
determining the value of an asset.
• The final output of the process is usually communicated
through a formal media called Valuation Opinion/Report
which is duly to be signed by the professional valuer
undertaken the process.

634
 Purpose of Valuation

The purpose of valuation can be:

Sale purpose
Purchase purpose
Loan purpose
Insurance purpose
Financial statement purpose
Merger & acquisition purpose
Compensation purpose
Tax purpose
Litigation purpose
Etc. F635
 Type of assets
• The assets may be categorized into tangible and intangible assets.
•
• Tangible Assets refer to a company’s assets that have a physical form, which
have been purchased by an organization to produce its products or goods or to
provide the services that it offers.

• Tangible assets can be categorized as either fixed asset, such as structures, land,
and machinery, or as a current asset, such as cash.

• Other examples of assets are company vehicles, IT equipment, investments and

on-hand stocks.

636
• Net tangible asset = Total Asset – intangible asset – total liability
Consider the following simple example:
• Balance sheet total assets: $5 million
• Total intangible assets: $1.5 million
• Total liabilities: $1 million

• Net Tangible asset = 5m- 1.5m -1m = 2.5 m

Asset Valuation – Valuing Intangible Assets

• Intangible Assets are assets that take no physical form, but still
provide a future benefit to the company.

• They may include patents, logos, franchises, and trademarks.

• Say, for example, a multinational company with assets of $15 billion

goes bankrupt one day, and none of its tangible assets are left.

• It can still have value because of its intangible assets, such as its logo
and patents, that many investors and other companies may be
interested in acquiring.
 Do we

Do we need Standards for Asset

Valuation?
• What is a standard?
Generally it is agreed that a standard is a level of quality or achievement,
especially one that people generally consider normal or acceptable.
Standards are essential to determining how well a person follows legal,
professional and ethical norms.
-“A standard is something established by authority, custom or general
consent as a model or example; a criteria”
• Considering the form of appearance a standard may either measure a
quantitative number or amount, or a qualitative level of performance.
• In most professions, standards are developed from best practices through
the accumulation of knowledge and skills over time.
• They are considers as a minimum threshold to judge whether a given activity
is accomplished to an acceptable level.

640
Valuation?
Do we need Standards for Asset

Valuation?

Do we need Standards for Asset Valuation?

❑Since long valuers exist in all cultures, even if they are
not officially recognized as such. Wherever value exists,
an opinion of value also exists.
When valuers are more formally organized, recognized
methods are developed and subsequently valuation
standards arise.
❑These standards could be national or international.
❑Regarding the usefulness of valuation standards there
are four important categories which need valuation
standards:

641
 Do we need Standards for Asset Valuation?
• 1) Valuers which are interested to enhance the reliability of valuations (in
accordance with recognized standards). On the other hand valuation standards
represent a means of advertising of the service quality and also a way for protection
for new entrants.

• 2) Clients initially consider the quality of a valuation report in accordance with owns
objectives: less taxes, finding a good loan etc. At the end they are comfortable and
they agree the valuer’s opinion if they know that valuers follows valuation
standards.

• 3) Authorities are responsible for good economic framework, avoiding frauds (ex
privatizations) etc.. Valuation standards could solve a “hot potato” issue; standards
are good because it’s a chance to blame valuers or the poor standard quality.

• 4) General Public is not so interested in such kind a technical issue. The view is
different when something wrong happened (ex. bank failure); in this case they’ll ask
for the quality of services and create a pressure for valuation standards.

642
 Why should we have International valuation
Standards ?
• The worldwide trend towards globalization of businesses
has pushed the need for International
standards in every sector of business.
IAS/IFRS
ISA (international standard of audit)
• For the Valuation profession it has lead to the introduction
of International Valuation Standards (IVS).
• IVSs are developed by International Valuation Standard
Council (IVSC) it is an independent non profit organization.

643
 Objective of IVS

1. promote consistency and aid the understanding of all types of

valuation by identifying or developing globally accepted
principles and definitions
2. identify and promulgate common principles for the undertaking
of valuation assignments and the reporting of valuations,
3. identify specific matters that require consideration and
methods commonly used when valuing different types of assets
or liabilities,
4. identify the appropriate valuation processes and reporting
disclosures for the major purposes for which valuations are
required,

F644
How Business Valuation is Done
(Methods/Approach)
❑Consideration must be given to the relevant and appropriate valuation
approaches.
❑The three approaches described and defined below are the main
approaches used in valuation.
❑The principal valuation approaches are:
(a) market approach,
(b) income approach, and
(c) cost approach.
 Step in Asset valuation

1. Asset Identification
2. Asset Classification (based on the unit of account)
3. Inspection, field data collection and verification of
property, plant and equipment (the inspection
includes land and site data collection)
4. Data Analysis
5. Preparation of Valuation Report
 Accounting for
sales agencies and
Branch operations
Distinction between agencies and branch
◆ An agency relationship refers a contract under which one or more
persons (the principals) engage another person (the agent) to
carry out some service on their behalf.

◆ The sales agency is not an autonomous operation but acts on behalf

of the home office or principal.

◆ The agency may display and demonstrate sample merchandise, take

orders, and arrange for delivery. The orders typically are filled by
the home office because a sales agency usually does not stock
inventory.
◆ Merchandise selection, advertising, granting of credit, collection
of accounts, and other aspects of operating the business usually are
conducted by the home office or principal.
 Cont”d
◆ As a business enterprise grows, it may establish one or
more branches to market its products over a large
territory.

◆ The term branch is used to describe a business unit

located at some distance from the Home Office.

◆ This business unit carries merchandise obtained from the

H/O, makes sales, approves customers’ credit, and makes
collections from its customers.

◆ A branch may obtain merchandise solely from the H/O,

or a portion may be purchased from outside suppliers.
 Branches & Divisions
• A segment of a business enterprise may be operated as a division, which
generally has more autonomy than a branch.

• Accounting procedures for a division (not organized as a subsidiary

company) are similar to those used for branches.

• Subsidiaries are operated as a separate corporation corporation

• Consolidated FS are required.
 Start-up Costs of Opening New
Branches
• Some businesses would capitalize & amortize such start-up
costs on the grounds that such costs are necessary to
successful operation at a new location. However, it is not
allowed in IFRS.

• In IFRS (IAS 38) start-up cost in connection with the opening

of a branch Is recognized as expenses of the acct period in
which the costs are incurred.
Accounting System for a Branch & Home Office
◆ The accounting system of one business enterprise having
branches may provide for a complete set of accounting
records at each branch.

◆ Policies of another such enterprise may keep all accounting

records in the H/O.

◆ For example, branches of drug and grocery chain stores

submit daily reports and business documents to the H/O,
which enters all transactions by branches in computerized
accounting records kept in a central location.

◆ The H/O may not even conduct operations of its own; it may
serve only as an accounting and control center for the
branches.
C ont’d
◆ A branch may maintain a complete set of accounting
records consisting of journals, ledgers, and chart of
accounts similar to those of an independent business
enterprise.

◆ Financial statements are prepared by the branch

accountant and forwarded to the H/O.

◆ The number and types of ledger accounts, the internal

control structure, the form and content of the financial
statements, and the accounting policies generally are
prescribed by the H/O.
◆ Transactions recorded by a branch should include all
controllable expenses and revenue for which the branch
manager is responsible.

◆ If the branch manager has responsibility over all branch

assets, liabilities, revenue, and expenses, the branch
accounting records should reflect this responsibility.

◆ Expenses such as depreciation often are not subject to

control by a branch manager; therefore, both the branch
plant assets and the related depreciation ledger accounts
generally are maintained by the Home Office.
 Reciprocal Ledger Accounts & Reconciliation
◆ The accounting records maintained by a branch include a
Home Office ledger account.

◆ H/O account is Credited for all merchandise, cash, or

other assets provided by the H/O;
◆ H/O account is Debited for all cash, merchandise, or
other assets sent by the branch to the H/O or to other
branches.

◆ The H/O account is a quasi-ownership equity account

that shows the net investment by the H/O in the branch.
◆ At the end of an accounting period when the branch closes
it accounting records, the Income Summery account is
closed to the H/O account.
 C ont’d
◆ A net income increases the Credit balance of the H/O
account; a net loss decreases this balance.

◆ In the H/O accounting records, a reciprocal ledger account

with a title such as Investment in Branch is maintained.
◆ Investment in Branch is a non-current asset account,
which is debited for cash, merchandise, and services
provided to the branch by the H/O, and for net income
reported by the branch.

◆ Investment in Branch is credited for cash or other assets

received from the branch, and for net losses reported by
the branch.

◆ Thus, the Investment in Branch account reflects the equity

method of accounting.
◆ A separate investment account generally is maintained by the
H/O for each branch.

◆ If there is only one branch, the account title is likely to be

Investment in Branch; if there are numerous branches, each
account title includes a name or number to identify each
branch.

Expenses Incurred by H/O and Allocated to Branches

◆ Some business enterprises follow a policy of notifying each
branch of expenses incurred by the H/O on the branch’s
behalf.

◆ Plant assets located at a branch generally are carried in the

H/O accounting records.
 C ont’
◆
d
If a plant asset is acquired by the H/O for the branch, the journal
entry for the acquisition is a debit to an appropriate asset account
such as Equipment: Branch and a credit to Cash or an
appropriate liability account.

◆ If the branch acquires a plant asset, it debits the H/O ledger

account and credits Cash or an appropriate liability account. The
H/O debits an asset account such as Equipment: Branch and
credits Investment in Branch.

◆ The H/O also usually acquires insurance, pays property and

other taxes, and arranges for advertising that benefits all
branches. Clearly, such expenses as depreciation, property taxes,
insurance, and advertising must be considered in determining the
profitability of a branch.
◆ A policy decision must be made as to whether these
expense data are to be retained at the H/O or are to be
reported to the branches so that the income statement
prepared for each branch will give a complete picture of its
operations.

◆ An expense incurred by the H/O and allocated to a branch

is recorded by the H/O by a debit to Investment in Branch
and a Credit to an appropriate expense ledger account; the
branch debits an expense account and credits Home Office.

◆ If the H/O does not make sales, but functions only as an

accounting and control center, most or all of its expenses
may be allocated to the branches.
C ont’d
◆ To facilitate comparison of the operating results of the
various branches, the H/O may charge each branch
interest on the capital invested in that branch.

◆ Such interest expense recognized by the branches

would be offset by interest revenue recognized by the
Home Office and would not be displayed in the
combined income statement of the business enterprise
as a whole.
 Alternative Methods of Billing Merchandise
Shipments to Branches
◆ Three alternative methods are available to the Home
Office for billing merchandise shipped to its branches.

◆ The shipments may be billed:

1) At Home Office Cost,

2) At a percentage above Home Office Cost, or

3) At the Branch’s Retail Selling Price,

◆ The shipment of merchandise to a branch does not
constitute a sale, because ownership of the merchandise
does not change.
Billing of Merchandise to Branches @ H/O Cost
◆ This is the simplest procedure and is widely used.
◆ It avoids the complication of unrealized gross profit in
inventories and permits the financial statements of
branches to give a meaningful picture of operations.

◆ However, billing merchandise to branches at Home

Office cost attributes all gross profits of the enterprise
to the branches, even though some of the merchandise
may be manufactured by the Home Office.

◆ Under these circumstances, Home Office cost may be

the most realistic basis for billing shipment to branches.
Illustration
◆ Assume BIRHAN TRADING Company bills merchandise to
AGARO Branch @ H/O Cost and that AGARO Branch
maintains complete accounting records and prepares FS’s.

◆ Both the H/O and the branch use the perpetual inventory
system.

◆ Equipment used at the branch is carried in the H/O accounting

records.

◆ Certain expenses, such as advertising, insurance, incurred by the

H/O on behalf of the branch, are billed to the branch.
◆ Transactions and events during the first year (2005) of operations
of AGARO Branch are summarized below (start-up costs are
disregarded)
 Cash of Br 1,000 was forwarded by the Home Office to
C ont’d
1.
AGARO Branch.

2. Merchandise with a Home Office cost of Br 60,000 was

shipped by the Home Office to AGARO Branch.

3. Equipment was acquired by AGARO Branch for Br 500,

to be carried in the Home Office accounting records.
(Other plant assets for AGARO Branch generally are
acquired by the Home Office.)

4. Credit sales by AGARO Branch amounted to Br 80,000;

the branch’s cost of the merchandise sold was Br 45,000.
 C ont’
5. Collections of trade accounts receivable byd AGARO
Branch amounted to Br 62,000.

6. Payments for operating expenses by AGARO Branch

totaled Br 20,000.

7. Cash of Br 37,500 was remitted by AGARO Branch to

the Home Office.

8. Operating expenses incurred by the Home Office and

charged to AGARO Branch totaled Br 3,000.

◆ Required: Record the above transactions and events by

the Home Office and the Branch. (omit explanations for
the journal entries)
Solution
:
Solution
:
 Separate Financial Statements for Branch &
Home Office
• A separate income st. & SoFP helps mgt of the enterprise to review the
operating results & financial position of the branch.

• If the merchandise is billed @ retail selling price then Branch’s income

statement will show loss approximating the operating expenses.
Separate Financial Statements for Branch &
Home Office
• The branch statements of financial position will have H.O Ledger Account instead of
Ownership Equity Account.

• The separate Financial statement prepared by branch will be revised by H.O to

include expenses incurred by the H.O for branch & to show the results of branch
operations after elimination of any intra-company profits on merchandise
shipments.

• Separate FS also may be prepared for the H.O so that the results of its operations
and its financial position can be appraised.
Combined Financial Statements For Home
Office And Branches
• A Combined SoFP prepared for distribution to creditors, stockholders,
and government agencies.

• A starting point : adjusted Trial balance of H.O & of the branch.

• Eliminate reciprocal ledger accounts

• Inv’t/ H.O Accounts
• Intra-company profits/losses are eliminated.
• Intra-Co. receivables and payables b/n branches
• Sum-up all other similar accounts
Reconciliation of
Reciprocal Ledger Accounts
• Balance of the Investment in Branch ledger account on the accounting records of
the home office may not agree with the balance of the H.O on the branch books
• Main reason: Delay in recording &/or Errors

• Prepare reconciliation At the end of each period before combined FS are

prepared.
• Illustration:
Assume that the home office and branch accounting records of
Mercer co. contains the following data on December 31,1999:
Investment in AA branch has a bal. of Br 49,500 while H.O A/c
has a balance of Br 41,500 on the same date.

Reconciling items as shown below:

• Shipment of (Br. 8,000) On December 29 from H.O is in transit

Reconciling Entry by branch:

Dec. 31. Inventories in Transit…………………..8,000
Home office……………………………..8,000
2) Collection of A/R (Br.1,000)of branch, by H.O on Dec. 27
was not recorded by branch
• Branch Entry:
Home office ………………1,000
Accounts receivable….1, 000
3) On December 28, branch acquired equipment (TO BE ACCOUNTED with H.O only) for
Br 3,000; NOT recorded by H.O.
H.O ENTRY:
Equipment: Arvin Branch………………………3,000
Investment in Arvin Branch…………………3,000
4) On December 30, trade accounts receivables of the home office (Br.
2,000) were collected by the AA branch. NOT recorded by H.O.
H.O Entry:
Investment in Arvin branch………..2,000
Accounts receivable………………..2,000
55) If the home office maintains accounts in its general ledger for a branch’s
plant assets, the branch debits its acquisition of office equipment to:

• A. Home Office.

• B. Office Equipment.

• C. Payable to Home office.

• D. Office Equipment Carried by Home office

A
56) A journal entry debiting Cash in Transit and crediting
Investment in Branch is required for.

A. The home office to record the mailing of a check by the branch on

the last day of the accounting period.
B. The home office to record the mailing of a check to the branch
early in the accounting period.
C. The branch to record the mailing of a check to the home office on
the last day of the accounting period.
D. The branch to record the mailing of a check to the home office
early in the accounting period.
A
57) At the end of the year, after adjusting and closing entries,
the Overvaluation of Branch Inventory account on the home
office books will contain

A. The markup on the branch's ending inventory.

B. The markup on the branch's beginning inventory plus the

markup on this year's shipments to the branch.

C. The markup on the branch's ending inventory less the markup

on the branch's beginning inventory.
D. The unrealized profit on branch sales for the year.
A
58) The home office accounts for shipments of merchandise to the branch
as sales. The billed price reflects a mark-up equal to 40% of billed price.
The branch reported beginning and ending inventories at billed prices of
Birr 80,000 and Birr 60,000, respectively.
Which of the following statements is FALSE?

A. Working paper elimination entries will reduce combined cost of goods

sold by Birr 8,000. D
B. Home office beginning retained earnings next year is overstated by Birr
32,000.

C. Unrealized intra-firm profit at the end of the year is Birr 24,000.

D. The Overvaluation of Branch Inventory account balance at the end of

the year is Birr 8,000.
59) A branch journal entry debiting Home office and crediting Cash may be
prepared for:

• A. The branch’s transmittal of cash to the home office only.

• B. The branch’s acquisition for cash of plant to be carried in the home office
accounting records only.

• C. Either A or B.

• D. Neither A nor B
C
60) In accounting for branch transactions, it is improper for the home
office to:

a. Credit cash received from a branch to the Investment in Branch ledger

account.

b. b. Maintain Common Stock and Retained Earnings ledger accounts for

only the home office.

c. c. Debit shipments of merchandise to the branch from the home

office to the Investment in Branch ledger account.

d. d. Credit shipments of merchandise to the branch to the Sales ledger

account.
D
61) When a home office ships merchandise to Branch A which is
later shipped to Branch B, the additional freight charged to ship
the merchandise form Branch A to Branch B should:

a. Treated as an expense on the Home Office books

b. Included as part of the cost of merchandise to Branch A

c. Included as part of the cost of merchandise to Branch B

A
d. Both B and C are correct
62) A Home Office‘s Allowance for Overvaluation of Inventories:
Branch ledger account, which has a credit balance, is

• a. an asset valuation account

• b. an equity account

• c. a liability account
A
• d. a revenue account
63) The appropriate journal entry for the home office to recognize the branch’s
expenditure of Birr 10,000 for equipment to be carried in the home office
accounting records is:
a. Equipment 10,000
Inv in Branch 10,000
b. Home Office 10,000
Equipment 10,000
c. Investment in branch 10,000
Cash 10,000
d. Equipment- Branch 10,000
Inv in Branch 10,000 A
64) The appropriate journal entry in the accounting records of the home office to
record a $10,000 cash remittance in transit from the branch at the end of an
accounting period is:
A). Cash 10,000
Cash in Transit 10,000
B). Cash 10,000
Home Office 10,000
C). Cash in Transit 10,000
Investment in Branch 10,000 C
D). Cash in Transit 10,000
Cash 10,000
65) In preparing the financial statements of the home office and its
various branches:

• a. Nonreciprocal accounts are eliminated but reciprocal accounts are

combines

• b. Both reciprocal and nonreciprocal accounts are eliminated

• c. Both reciprocal and nonreciprocal accounts are combines

• d. Reciprocal accounts are eliminated and nonreciprocal accounts are

combined D
66) In a working paper for combined financial statements of the home office
and the branch of a business enterprise, an elimination that debits Shipments
to Branch and credits Shipments from Home Office is required under:

• a. The periodic inventory system only

• b. The perpetual inventory system only A

• c. Both the perpetual inventory system and the periodic inventory system

• d. Neither the perpetual inventory nor the periodic inventory system

67) The Western Branch of Rivas Company reported a net income of 60,000
for the month of January. The appropriate journal entry for the home office
of Rivas Company is:
A). Income Summary 60,000
Income: Western Branch 60,000
B). Income: Western Branch 60,000
Income Summary 60,000
C) Investment in Western Branch 60,000
Income: Western Branch 60,000
D). Investment in Western Branch 60,000 C
Income Summary 60,000
Business Combination

Based on IFRS 3
 Definition of BC

• Business combinations are events or transactions in which two or more

business enterprises, or their net assets, are brought under common
control in a single accounting entity.
 Identification of BC
A transaction or other event is a business combination if: The
assets acquired and liabilities assumed constitute a business.

❑If the asset acquired are not a business, it must be

accounted for as an asset acquisition.
 Business
• IFRS 3 defines a business as ‘an integrated set of activities and assets
that is capable of being conducted and managed for the purpose of
providing a return in the form of dividends, lower costs or other
economic benefits directly to investors or other owners, members or
participants.

• Business consists of Input, process and output

 Definition of terms under BC
• Combined Enterprise: The accounting entity that results from a business combination.

• Constituent Companies: The business enterprises that enter into a combination.

• Combinor : A constituent company entering into a combination whose owners as a group ends up
with control of the ownership interests in the combined enterprise. The term acquirer, parent and
combinor can be used interchangeably.

• Combinee: a constituent company other than the combinor in a business combination. The term
acquired, acquiree, subsidiary and combinee can be used interchangeably.
 Types of Business Combinations
There are three types of business combinations: Horizontal Combination, Vertical Combination,
and Conglomerate Combination:
1. Horizontal Combination: is a combination involving enterprises in the same industry. E.g.
assume combination of Ethio flour and Sun flour.
2. Vertical Combination: A Combination involving an enterprise and its customers or
suppliers. It is a combination involving companies engaged in different stages of production
or distribution. It is classified into two: Backward Vertical Combination – combination with
supplier and Forward Vertical Combination – combination with customers.
E.g.: A Tannery Company acquiring a Shoes Company - Forward
3. Conglomerate (Mixed) Combination: is a combination involving companies that are
neither horizontally nor vertically integrated. It is a combination between enterprises in
unrelated industries or markets.
 Methods of Business Combinations
• The Three common methods for carrying out a business combination are:
• Statutory Merger
• Statutory Consolidation, and
• Acquisition of Common Stock
 1. Statutory Merger
• The acquired company’s assets and liabilities are transferred
to the acquiring company, and the acquired company is
dissolved, or liquidated.
• The operations of the previously separate companies are
carried on in a single legal entity.

ABC Company
ABC Company

XYZ Company
 2. Statutory Consolidation
Both combining companies are dissolved and the
assets and liabilities of both companies are
transferred to a newly created corporation.

ABC Company
EFG Company
XYZ Company
 3. Acquisition of Common Stock
• One company acquires the voting shares of another company and the two
companies continue to operate as separate, but related, legal entities.
• The acquiring company accounts for its ownership interest in the other
company as an investment.

ABC Company ABC Company

XYZ Company XYZ Company

ABC…….Parent
XYZ…….Subsidiary
4. Classes of Business Combinations

BusinessCombinations

FriendlyTakeover HostileTakeover
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Friendly Takeovers
• BODs of all constituent companies amicably
determine the terms of the business combination.

• Proposal is submitted to share holders of all

constituent Cos. for approval.

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Hostile Takeovers
• Target combinee typically resists the proposed
business combination.

• Target combinee uses one or more of the several

defensive tactics.

3/6/2024 702
 Tactics for Defense Used in Hostile Takeovers
• Pac-man Defense: A tray to undertake a hostile takeover of the prospective combinor.
• White Knight: A search for a candidate to be the combinor in a friendly takeover.
• Scorched Earth: The disposal, by sale or by spin-off to stockholders, of one or more profitable
business segments.
• Shark Repellent: An acquisition of substantial amts of outstanding C/S for the treasury or for
retirement, or the incurring of substantial LTD in exchange for outstanding common stock.
• Poison Pill: An amendment of the articles of incorporation or bylaws to make it more difficult
to obtain s/holder approval for a takeover.
• Green Mail: An acquisition of common stock presently owned by the prospective combinor at
a price substantially in excess of the prospective combinor’s cost, with the stock thus
acquired placed in the treasury or retired.

3/6/2024 703
 Reasons of Business combination
1. Growth: In recent years Growth has been main reason for
business enterprises to enter into a business combination. Firms
can achieve growth through external and internal methods. The
external (e.g. business combination) method of achieving growth
is more rapid than growth through internal methods, as per
advocates of external method.
2. Economies of scale: The economies of scale will occur
as a result of more intensive utilization of production facilities,
distribution network, research and development facilities, etc. The
economies of scale will lead to financial synergies.
 Cont.…

3. Better management: Combinations results in better

management. Combinations result running the large scale
enterprises. A large enterprise can offer to use the service of
expertise. Various managerial functions can be efficiently
managed by those persons who are qualified for such jobs.
4. Monopolistic ambition: One of the important reasons
behind business combination is monopolistic ambitions. The
combined enterprises try to control more and more enterprises
in the same line so that they may be able to detect their terms
(E.g. set their price). But, the antitrust law is against such type of
business combination.
 Cont.…
5. Diversification: When one company involves business
combination, it can diversify risks of operations. A Company involving
business combination can minimize risks as the enterprise is
diversifying operation or line of their activity. Since different companies
are already dealing in their respective lines, there will be risk
diversification.
6. Tax advantage: When an enterprise with accumulated losses
merges with a profit making enterprise, it is able to utilize tax shields
(benefits). An enterprise having losses will not be able to set-off losses
against future profits, because it is not a profit earning unit.
 The acquisition method
• Business combinations are accounted for using the
acquisition method, i.e:
• Identifying the acquirer;
• Determining the acquisition date;
• Recognise & measure the identifiable NAs and any NCI;
and
• Recognise and measure any goodwill or bargain purchase.

3/6/2024 707
68) A company owns 80% of the voting shares of B company, which in turn
owns 70% of the shares of C company. There are no outstanding warrants
or options which would enable holders of other instruments to acquire
additional voting shares of any of these companies. in this scenario,

• A) A has indirect control over C

• B) A has direct control over C
• C) A has no control over C
• D) None
A

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69) Parent company acquires sub company's common shares for cash. On
the date of acquisition, sub had goodwill of $100,000 on it's books. Which
of the following statements regarding sub's goodwill on the date of
acquisition is correct?
A) Sub's goodwill is not considered an identifiable asset and should
therefore be excluded from parent company's acquisition differential
calculation
B) Sub's goodwill is considered an identifiable asset and should therefore
be excluded from parent company's acquisition differential calculation
C) Sub's goodwill is May be considered an identifiable asset and should
therefore be excluded from parent company's acquisition differential
calculation
D) None
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A 709
70) Company A has made an offer to purchase all of the outstanding shares of
Company B for $10 per share. In response to Company A's offer, the
shareholders of Company B were given rights to purchase additional shares at
$8 per share. Which of the following tactics were employed by Company B to
prevent Company A from acquiring control of Company B?
A. Pac-man defense.

• B. Selling the crown jewels.

C
• C. Poison Pill.

• D. Reverse-takeover
3/6/2024 710
71) Under the acquisition method, indirect costs relating to
acquisitions should be

a. included in the investment cost.

b. expensed as incurred.

c. deducted from other contributed capital.

d. none of these.
B
72) Which of the following is a reason why a company
would expand through a combination, rather than by
building new facilities?

a. A combination might provide cost advantages.

b. A combination might provide fewer operating delays.
c. A combination might provide easier access to
intangible assets.
d. All of the above are possible reasons that a company
might choose a combination.
D
73) The defense tactic that involves purchasing shares held by
the would-be acquiring company at a price substantially in
excess of their fair value is called
• a. poison pill.
• b. pac-man defense.
• c. greenmail.
• d. white knight.
C
74) In a Statutory merger, which of the following will
occur?
a. A merger occurs when one corporation takes over the
operations of another business entity, and the acquired
entity is dissolved.
b. None of the business entities will be dissolved.
c. The acquired assets will be recorded at book value by the
acquiring entity.
d. None of the above is correct. A
75) According to the acquisition method of accounting for business
combinations, costs paid to attorneys and accountants for services in
arranging a merger should be:

A. Capitalized as part of the overall fair value acquired in the merger.

B. Recorded as an expense in the period the merger takes place.

C. Included in recognized goodwill.

B
D. Written off over a 5-year maximum useful life.
76) Assume that two companies wish to engage in a Business
Combination involving a share exchange. Once the share exchange is
consummated, each shareholder group will have an equal number of
voting shares.
Which of the following statement best describes the course of action
that must be taken under these circumstances?

A. The Boards of Directors of both companies must enter into discussions to

agree on which party will be the acquirer
B. No acquirer can be identified since no shareholder group has majority voting
control so the share exchange must be annulled...
C. Other factors must be examined to determine which shareholder group is
more dominant
D. The company with the largest net assets (at fair market value) is deemed to be
the acquirer.
C
77) The "excess of the acquirer's interest in the net fair value of
acquiree's identifiable assets, liabilities, and contingent liabilities
over cost" (formerly known as negative goodwill) should be:

A. Carried as a capital reserve indefinitely.

B. Recognized in retained earnings.
C. Recognized immediately in profit or loss.
D. Amortized over the life of the assets acquired.
C
 78)

Assuming that Parent Inc. acquires 100% of Sub Inc. on August 1, 2022 for cash of Birr 135,000, what would be the amount of
goodwill or (a gain from bargain purchase or negative goodwill) appearing on the Consolidated financial statements on the
date of acquisition if the identifiable net assets (INA) or partial goodwill method were used?
Goodwill, IF Consideration payment > NA of the Acquiree
A. Birr 2.000
B. (Birr 2.000)
B gain from bargain purchase IF Consideration payment < NA of the Acquiree

C. Birr 7,000 NA = FV Asset – FV Liability = (36000+40000+27000+93000+15000) - (50000+24000)

D. (Birr 7.000) = 211000 -74000 = 137000
gain from bargain purchase 135000 < 137000 = 2000
79)

Assuming that Parent Inc acquires 80% of Sub Inc on August 1, 2022 for cash of $180,000, what would be the amount of
goodwill appearing on the Consolidated Balance Sheet on the date of acquisition if the proportionate consolidation
method were used?
A) 72,000 FV Net Asset = 137,000
Consideration transfer : 180,000 + (137000*0.2) =207400
B) 88,000
C) 70,400 C Goodwill = 207400 -137000= 70,400
D) Nil
 80) On January 1, 20x1, ABC Co. acquired 75% interest in XYZ, Inc. for Birr
2,500,000 cash. ABC Co. incurred transaction costs of birr 250,000 for legal,
accounting and consultancy fees in negotiating the business combination.
ABC Co. elected to measure NCI at the NCI’s proportionate share in XYZ, Inc.’s
identifiable net assets.
• The carrying amounts and fair values of XYZ’s assets and liabilities at the
acquisition date were as follows:
How much is the goodwill (gain on
a bargain purchase)?
a. 140,000 FV of Net Asset =
3,950,000- 1000,000 = 2,950,000
b. 287,500
NCI= 2950000*0.25= 737,500
c. 278,500
d. 264,500 Consideration transfer
2500,000+737500 =3237,500
B 3,237,500 > 2,950,000 by 287,500
Goodwill = 287500
81) On November 30, year 1, Star, Inc. purchased for cash at Birr 15 per share all 250,000 shares
of the outstanding common stock of Green Co.

At November 30, year 1, Green's statement of financial position showed a carrying amount of net
assets of Bir 3,000,000. At that date, the fair value of Green's property, plant and equipment
exceeded its carrying amount by Bim 400,000 in its November 30, year 1 consolidated statement
of financial position, what amount should Star report as goodwill?

15*250,000 = 3,750,000 Consideration transfer

A. Birr 350,000
Fair value Net asset= 3,000,000+ 400,000 = 3,400,000
B. Birr 400,000

C. Birr 0 A Goodwill = 3,750,000 - 3,400,000 = 350,000

D. Birr 750,000
82) An acquirer should at the acquisition date recognize goodwill acquired
in a business combination as an asset. Goodwill should be accounted for
as follows:
(A) Recognize as an intangible asset and amortize over its useful life.
(B) Write off against retained earnings.
(C) Recognize as an intangible asset and impairment test when a trigger
event occurs.
(D) Recognize as an asset and annually impairment test
D
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83) On April 1, 2016, PP Company paid $950,000 for all the issued and outstanding
stock of Simon Corporation. The recorded assets and liabilities of the Simon
Corporation on April 1, 2016, follow:
• Cash $ 80,000
• Inventory 240,000
• Property and equipment 480,000
• Liabilities (180,000)
• On April 1, 2016, it was determined that the inventory of Simon had a fair value of
$190,000, and the property and equipment (net) had a fair value of $560,000.
• What is the amount of goodwill resulting from the business combination?
• a. $0 NA = FV asset - FV Liabilities
(80000+190000+560000) -180000
• b. $120,000 = 650,000
• c. $300,000 Consideration transfer = 950000
Goodwill = 300000 B/C Consideration transfer C
• d. $230,000 > NA BY 300,000
84) According to IFRS regarding amortization of goodwill, which of the following
statements is true?

A) Goodwill recognized in consolidation must be amortized over 20 years.

B) Goodwill recognized in consolidation must be expensed in the period of
acquisition.
C) Goodwill recognized in consolidation will not be amortized but subject to an
annual test for impairment.
D) Goodwill recognized in consolidation can never be written off.
E) Goodwill recognized in consolidation must be amortized over 40 years.

C
3/6/2024 724
85) Which of the following does not represent a primary motivation for
business combinations?

• A) Combinations as a vehicle for achieving rapid growth and

competitiveness.

• B) Cost savings through elimination of duplicate facilities and staff.

• C) Quick entry for new and existing products into markets.

• D) Larger firms being less likely to fail.

D
3/6/2024 725
86) When does gain recognition accompany a business combination?
a. In a combination created in the middle of a fiscal year.
b. When a bargain purchase occurs.
c. When the amount of a bargain purchase exceeds the value of the applicable
noncurrent assets (other than certain exceptions) held by the acquired
company.
d. In an acquisition when the value of all assets and liabilities cannot be
determined. B
3/6/2024 726
87) The acquisition date is
a. the date on which the acquirer obtains control of the acquiree.
b. the opening date.
c. the date the acquirer transfers to the acquiree the consideration in a
business combination.
d. any of these

A
3/6/2024 727
88) On January 1, 20x1, ABC Co. acquired 60% interest in XYZ, Inc. for Birr
2,000,000 cash. ABC Co. incurred transaction costs of Birr 100,000 in the
business combination. ABC Co. elected to measure NCI at fair value. An
independent valuer assessed the NCI's fair value at Birr 1,080,000. The fair
values of XYZ's identifiable assets and liabilities at the acquisition date were
Birr 6,000,000 and Birr 3,500,000, respectively. How much is the goodwill (gain
on a bargain purchase)?
•
a. 500,000 Consideration Transfer = 2M+ 1,080,000
b. (478,000) = 3,080,000

c. (500,000 Net Asset = 6M -3500,000

d. 580,000 D = 2,500,000

= 3080,000-2500,000 = 580,000 Goodwill

3/6/2024 728
89) If an oil drilling company were to purchase one of the companies listed
below, which purchase would be called a vertical takeover?
A. An oil refinery company

• B. A rival oil drilling company

• C. A travel company
A
• D. A finance company

3/6/2024 729
IAS 21 The Effects of Changes in Foreign Exchange Rates

IAS 21 The Effects of Changes in Foreign

Exchange Rates
 IAS 21 The Effects of Changes in Foreign Exchange Rates
Objective and Scope

• The objective of IAS 21 is to prescribe how to include foreign

currency transactions and foreign operations in the financial
statements of an entity and how to translate financial statements
into a presentation currency.

• The principal issues are which exchange rate(s) to use and how to
report the effects of changes in exchange rates in the financial
statements.
Key definitions
• Functional Currency : The currency of the primary economic environment in which
the enterprise operates.
• Presentation Currency }: The currency in which an enterprise presents its financial
statements.
• Exchange Difference: This is the difference resulting from translating one currency
into another currency at different exchange rates.
• Monetary and Non Monetary Items
• Monetary Unit – an asset or liability carrying a value in dollars that will not change in the
future. These items have a fixed numerical value in dollars, and a dollar is always worth a dollar.
A money value is defined.
• Nonmonetary Unit – an asset or liability that a company holds that does not have a precise
dollar value and is not easily convertible to cash or cash equivalents. Example, includes
prepayments, goodwill, intangible assets, inventory and property).
Key definitions

• Spot Exchange Rate

The exchange rate for immediate delivery.
• Closing Rate
This is the spot exchange rate at the reporting date.

• Foreign operations
a subsidiary, associate, joint venture, or branch whose activities are
based in a country or currency other than that of the reporting
entity.
Foreign exchange concepts
• Exchange rate: It is the ratio between a unit of one currency
and the amount of another currency for which that unit can
be exchanged at a particular time.
• The difference between the rates at which a bank is willing
to buy and sell currency is known as the “spread.”
• The exchange rate can be computed directly or indirectly.
Cont...
• Assume that 54 ETB can be exchanged for 1 USD.

• Direct quotation (ETB per one foreign currency unit): $1 = 54

ETB

• Indirect quotation (the number of foreign currency units per

ETB): 1 ETB = USD 0.01852
 Type s of exchange rate urrency
arrangements
• Floating exchange rates:
• These exchange rates are those that reflect fluctuating
market prices for a currency based on supply and demand
and other factors in the world currency markets.
• Fixed/Official exchange rates: are set by a government and
do not change as a result of changes in world currency
markets.
 Foreign currency trades can be executed on a spot or
forward basis.
Spot• Spot
andrate:
Forward Rates
It is the price at which a foreign currency can be
purchased or sold today. The exchange rate that is available
today. In contrast,
• Forward rate: is the price today at which foreign currency
can be purchased or sold sometime in the future. The
exchange rate that can be locked in today for an expected
future exchange transaction.
• The actual spot rate at the future date may differ from
today’s forward rate
Foreign
• Export currency transactions
sales and import purchases are international
transactions; they are components of what is called trade.
• When two parties from different countries enter into a
transaction, they must decide which of the two countries’
currencies to use to settle the transaction.
• When the purchase or sales is made on credit base, the buyer
or the seller will be exposed to foreign exchange risk
• In short, export sale and import purchase have associated
risks.
Cont’d......Foreign currencyexposure
A)Import purchase: A transaction transactions
exists when the
importer is required to pay in foreign currency and is
allowed to pay sometime after the purchase has been made.
• The importer is exposed to the risk that the foreign currency
might appreciate (increase in price) between the date of
purchase and the date of payment.
Illustration
• Assume that an Ethiopian corporation imports inventory
of $5,000 from a US firm when the spot rate for US dollars
is Br 27. The invoice calls for payment of 5,000 US dollars
in 30 days.
Inventory Br 135,000
Accounts payable 135,000
(Translation: 5,000 US dollars * Br27 spot rate.)
Cont’d...
• If the account payable is paid when the spot rate is Br 26
on payment date, the payment is recorded as follows:
Accounts payable 135,000
Exchange gain 5000
Cash 130,000
(Cash required equals 5000 US dollars * Br 26 spot rate.)
Cont’d...
• If the account payable is paid when the spot rate is Br 30
on payment date, the payment is recorded as follows:
Accounts payable 135,000
Exchange loss 15000
Cash 150,000
(Cash required equals 5000 US dollars * Br 30 spot rate.)
Cont’d...
B) Export sale: A transaction exposure exists when the
exporter allows the buyer to pay in a foreign currency and
allows the buyer to pay sometime after the sale has been
made.
-The exporter is exposed to the risk that the foreign currency
might depreciate (decrease in value) between the date of
sale and the date payment is received thereby decreasing
the Ethiopian birr ultimately collected.
Illustration
• Assume Ethiopian corporation sells merchandise to US
Corporation for $6000, when the exchange rate is Br 27,
• Accounts receivable 162,000
Sales 162,000
• (To record sales to US Corporation when spot rate is Birr 27=
$6000x27)
Cont’d
• If the we received payment when the exchange rate is Br 26.

Cash 156,000
Foreign exchange loss 6,000
Accounts receivables 162,000
• 6000*26 = 156,000
Cont’d
• If the we received payment when the exchange rate is Br 30.

Cash 180,000
Foreign exchange gain 18,000
Accounts receivables 62,000
• 6000*30= 180,000
 Determining the functional currency

• The functional currency is the currency of the

primary economic environment in which the
entity operates and it is normally the currency in
which the entity primarily generates and expends
cash.
• IAS-21 provides primary and secondary indicators
for use in the determination of an entity’s
functional currency.
 6.2 Foreign Currency Transactions
• Initial Recognition
➢ Each transaction should be translated using the ER(Exchange rate) on the
date the transaction occurred, or if stable, an average rate
➢ If certain transactions are to be settled at a specified rate, or are covered by
a matching forward contract, then the use ‘contracted rate’
• Subsequent measurement
➢ A foreign currency transaction may give rise to assets or liabilities that are
denominated in a foreign currency. These assets and liabilities will need to
be translated into the entity’s functional currency at each reporting date.
➢ How they will be translated depends on whether the assets and liabilities
are monetary or non-monetary items.
6.2 Foreign Currency Transactions
• Monetary items: The essential feature of a monetary item, as the definition implies, is the right to
receive(or an obligation to deliver) a fixed or determinable number of units of currency. Examples:
➢ Cash and bank balances
➢ Trade receivables and payables
➢ Loan receivables and payables
➢ Foreign currency bonds held as available for sale
➢ Foreign currency bonds held to maturity
➢ Pensions and other employee benefits to be paid in cash
➢ Provisions that are to be settled in cash
➢ Cash dividends that are recognised as a liability
➢ A contract to receive (or deliver)
6.2 Foreign Currency Transactions
• Non-Monetary items
A Non-monetary item does not give the right to receive(or an obligation to
deliver) a fixed or determinable number of units of currency. Examples:
➢ Amounts prepaid for goods and services
➢ Goodwill
➢ Intangible assets
➢ PPE
➢ Provisions to be settled by the delivery of a non- monetary asset
➢ Equity instruments that are held as available for sale financial assets
➢ Equity instruments in subsidiaries, associates or joint ventures
• Reporting at Subsequent Reporting Dates

➢ Monetary items at closing ER (e.g. trade receivables and payables)

➢ Non-monetary items measured at HC are not re-translated at the

reporting date (e.g. non-current assets and inventory)

➢ Non-monetary items measured at foreign currency fair value are

re-translated at each date of fair value measurement
Recognition of exchange differences
• Those arising on settlement of monetary items should be expensed in the period they
arise
• Where a gain/loss on a non-monetary item is recognised directly in equity any exchange
component of that gain/loss should be recognised directly in equity
• Conversely when a gain/loss on a non-monetary item is recognised in profit or loss, any
exchange component of that gain/loss should be recognised in profit or loss.
• If a transaction is settled before the end of a reporting, then:
(i) record the foreign currency transaction in the functional currency at the spot
exchange rate at the date of the transaction (an average rate for a period may be used if
exchange rates do not fluctuate significantly);
(ii) record the settlement at the exchange rate at the date of settlement;
(iii) recognize the exchange difference
90) Slick Co. had a Swiss franc receivable resulting from exports to Switzerland
and a Mexican peso payable resulting from imports from Mexico.
Slick recorded foreign exchange gains related to both its franc receivable and
peso payable. How did the foreign currencies increase or decrease in Birr value
from the date of the transaction to the settlement date?

A. Increase Franc, Decrease Peso

A

B. Increase Franc, Increase Peso The exporter is exposed to the risk that the foreign currency
might depreciate (decrease in value)

C. Decrease Franc Decrease Peso The importer is exposed to the risk that the foreign currency
might appreciate (increase in price),

D. Decrease Franc Increase Peso

91) On January 1, 2022, Star Ethiopian coffee exporter, shipped $120,000
worth of inventory to its main US distributor, with full payment of these goods
due by February 28, 2022. Star has a January 31 year end.
A list of significant dates and exchange rates is shown below.
Transaction Date: January 1, 2022 US $1 Birr 59.332
Year-End Date: January 31, 2022 US $1 Birr 59.384
Settlement Date: February 28, 2022 US $1- Birr 59.540.
The invoice price billed by Star was US $120.000. What is the amount of Star's
foreign exchange gain or loss at year-end?
A. Birr 6,240 loss AR ----(59.332*120,000) --- 7,119,840
Sale …………………………..7119840
B. Birr 24,960 gain AR (59.384-59.332)*120,000……6240
C. Bir 6,240 gain Gain on FX………………….6240
D. Nil foreign exchange gains or losses are deterred to settlement
C
• 92) Dale Inc., a U.S. company, bought machine parts from a German
company on March 1, 20X1, for €30,000, when the spot rate for euros was
$0.4895. Dale's year-end was March 31, when the spot rate was $0.4845. On
April 20, 20X1, Dale paid the liability with €30,000 acquired at a rate of
$0.4945. Dale's income statements should report a foreign exchange gain or
loss for the years ended March 31, 20X1 and April 20, 20X1 of

a.) $0 $0
1 euro = $0.4895 On transaction date
Machine ….(0.4895*30000)..14685
b.) $0 $150 Loss AP……………………..14685

c.) $150 Loss $0

D 1 euro = $0.4845 on year end
AP ……………150
Gain on FX..150

d.) $150 Gain $300 Loss 1 euro = $0.4945 settlement date

Loss On FX .....300
AP……………300
• 93) On July 1, 20X1, Black Company lent $120,000 to a foreign supplier, evidenced by
an interest-bearing note due on July 1, 20X2. The note is denominated in the
borrower's currency and was equivalent to 840,000 LCUs on the loan date. The note
principal was appropriately included at $140,000 in the receivables section of Black's
December 31, 20X1, balance sheet.
• The note principal was repaid to Black on the July 1, 20X2, due date when the
exchange rate was 8 LCUs to $1. In its income statement for the year ended December
31, 20X2, what amount should Black include as a foreign currency transaction gain or
loss on the note principal?
a.) $0 Transaction date LUC 7= $1
b.) $15,000 loss NR ……..120,000
c.) $15,000 gain cash 120,000
Year end= LUC 6 = $ 1
d.) $35,000 loss NR…….20,000
Gain on Fx …20,000
Settlement date LUC 8 = $ 1
Loss …………..35000
D NR……………35000
Received from borrower 840,000 LCU ÷ 8 LCU for
each $1 = $105,000
• 94) On July 1, 20X4, Bay Company borrowed 1,680,000 local currency units (LCUs) from a foreign lender
evidenced by an interest-bearing note due on July 1, 20X5, which is denominated in the currency of the lender.
The U.S. dollar equivalent of the note principal was as follows:
Date Amount
7/1/X4 (date borrowed) $ 210,000
12/31/X4 (Bay's year-end) $ 240,000
7/1/X5 (date repaid) $ 280,000
In its income statement for 20X5, what amount should Bay include as a foreign exchange gain or loss on the
Transaction date LUC 8= $1
note principal? Cash ……..210,000
a.) $ 70,000 gain NP……. 120,000

b.) $ 70,000 loss

D Year end= LUC 7 = $ 1
Loss…….30,000
NP….…30,000
c.) $ 40,000 gain Settlement date LUC 6 = $ 1
d.) $ 40,000 loss Loss …………40,000
NP……………40,000
95) In April 8, 2013, Trul Corporation purchased merchandise from an unaffiliated
foreign company for 10,000 units of the foreign company's local currency. Trul paid
the bill in full on March 1, 2014, when the spot rate was $0.45. The spot rate was
$0.60 on April 8, 2013, and was $0.55 on December 31, 2013. For the year ended
December 31, 2014, Trul should report a transaction gain of

Transaction date LUC 1= $0.6 in April 8 2013

MI ……..6,000
a.) $1,500. AP……. 6,000
Year end= LUC 1 = $ 0.55 on Dec 2013
b.) $1,000. AP…….500

c.) $500.
B Gain on Fx….…500
Settlement date LUC 1 = $ 0.45 on March 2014
AP …………1000
d.) $0. Gain On Fx……………1000
95) Which of the following terms are defined by the statement:
“The currency of the primary economic environment in which
the entity operates”?
A) Local currency

• B) Operational currency
C) Functional currency C
• D) Presentation currency
• 96) If 1 Canadian dollar can be exchanged for 90 cents of U.S.
currency, what fraction should be used to compute the
indirect quotation of the exchange rate expressed in Canadian
dollars?
A.) 1/.90
• B.) 1.10/1
A

• C.) 1/1.10
• D.) 0.90/1
97) Which of the following factors would not be used in determining the
functional currency of the entity?
A. The currency which is the most internationally used for trading in
that industry
B. The currency in which finance is generated
C. The currency in which the costs of the entity are mainly
denominated
D. The currency in which sales from operating activities are
denominated

A
98) Price in one country in relation to other currencies in the
international exchange market is known is-

A. equilibrium rate

B. fixed exchange rate

C. exchange rate C

D. flexible exchange rate

99) An entity denominated a sale of goods in a currency other than its
functional currency. The sale resulted in a receivable fixed in terms of the
amount of foreign currency to be received. The exchange rate between the
functional currency and the currency in which the transaction was
denominated changed. The effect of the change should be included as a
a.) Separate component of stockholders' equity whether the change results in
a gain or a loss.
b.) Separate component of stockholders' equity if the change results in a gain
and as a component of income if the change results in a loss.
c.) Component of income if the change results in a gain and as a separate
component of stockholders' equity if the change results in a loss.
d.) Component of income whether the change results in a gain or a loss.

D
CONSOLIDATED FINANCIAL STATEMENT
Based on IFRS 10
 2.1. CONSOLIDATED FINANCIAL STATEMENT (CFS)
• Consolidated financial statements are the financial statements of a group in
which the assets, liabilities, equity, income, expenses and cash flows of the parent
and its subsidiaries are presented as those of a single economic entity.

• An entity that is a parent shall present consolidated financial statements (IFRS

10.4).
• A parent is an entity that controls one or more entities
• A subsidiary is an entity that is controlled by another entity (i.e. the parent)
• A group is a parent and its subsidiaries
 INTERACTION OF:
IFRSs 3, 7, 9, 10, 11, 12 and IAS 28
Control alone?
YES NO

Consolidation in accordance with

IFRS 3 and IFRS 10 Joint control?

Disclosures in accordance YES NO

with IFRS 12

Define type of joint arrangement Significant

in accordance with IFRS 11 influence?

Joint Operation Joint Venture YES NO

Account for assets, liabilities, Account for an investment in accordance

with IAS 28 IFRS 9
revenues and expenses
Disclosures in
Disclosures in accordance with Disclosures in accordance with accordance with
IFRS 12 IFRS 12 IFRSs 7
767
 2.2. ADVANTAGES OF CFS
1. Provide good information about the parent company, including the
parent`s shareholders, creditors and other resource providers.
2. The only way to conveniently summarize the vast amount of
information about the individual companies.
3. The parent`s long term creditors also find the CFS of subsidiary
operation on the overall health and future of the parent.
 2.3. DISADVANTAGES OF CFS
1. The masking of poor performance.
2. Lack of detailed disclosures.
3. Non-Controlling Stockholders get little value from CFS.
 2.4. CRITERIA FOR CFS
An investor, regardless of the nature of its involvement with an entity (the investee)
shall determine whether it is a parent by assessing whether it controls the investee.
An investor controls an investee when it is exposed, or has rights, to variable
returns from its involvement with the investee and has the ability to affect those
returns through its power over the investee. Thus, an investor controls an investee if
and only if the investor has all the following:
1. Power over the investee
2. Exposure, or rights, to variable returns from its involvement with
the investee; and
3. The ability to use its power over the investee to affect the amount
of the investor’s returns.
 4.5. ACCOUNTING REQUIREMENT
1. Accounting Policy: A parent shall prepare consolidated financial statements using uniform accounting
policies for like transactions and other events in similar circumstances.

2. Non Controlling Interest: A parent shall present non-controlling interests in the consolidated statement of
financial position within equity, separately from the equity of the owners of the parent.

3. Loss of control : If a parent loses control of a subsidiary, the parent:

(a) Derecognizes the assets and liabilities of the former subsidiary from the consolidated statement of financial
position.

(b) Recognizes any investment retained in the former subsidiary.

(c) Recognizes the gain or loss associated with the loss of control

4. Parent and Subsidiary with different Fiscal period: When the fiscal periods of parents and its subsidiaries
differ, We prepare CFS for and as of the end of the parent`s fiscal period. If the difference in fiscal period is
not in excess of three months, it usually is accepted to use the subsidiary`s statement for its fiscal year for
consolidation.
 4.6. STEPS OF CFS
1. Combine like items of assets, liabilities, income, expenses and cash flows of the parent at Book Value
with those of its subsidiaries at Fair values;
2. Offset (eliminate): the carrying amount of the parent’s investment in subsidiary; and the
subsidiary`s equity account (i.e. Common Stock, Additional Paid in capital and Retained Earning.);
3. Eliminate in full intra-group assets and liabilities, equity, income, expenses and cash flows relating
to transactions between entities of the group (Inter company Receivable and Payables).
4. The elimination is not entered in either the parent company’s or the subsidiary’s accounting
records; it is only a part of the working paper for preparation of the consolidated balance
sheet.
5. The elimination And Adjustment is used to reflect differences between current fair values and
carrying amounts of the subsidiary’s identifiable net assets because the subsidiary did not write up
its assets to current fair values on the date of the business combination.
6. The Elimination and Adjustment column in the working paper for consolidated balance sheet reflects
debits and credits.
7. CFS of Equity includes Parent`s Equity balance and Non Controlling Interest.
 Cont…
Intercompany Accounts to Be Eliminated
Parent’s Accounts Subsidiary’s Accounts
Investment in subsidiary Against Equity accounts
Intercompany receivable (payable) Against Intercompany payable (receivable)

Advances to subsidiary (from subsidiary) Against Advances from parent (to parent)

Interest revenue (interest expense) Against Interest expense (interest revenue)

Dividend revenue (dividends declared) Against Dividends declared (dividend revenue)

Management fee received from subsidiary Against Management fee paid to parent
Sales to subsidiary (purchases of inventory Purchases of inventory from parent (sales
Against
from subsidiary) to parent)
 Cont…
Sample Elimination and Adjustment Entry
Subsidiary`s Common Stock…………………………………………………….xx
Subsidiary`s Additional Paid in capital in excess of Par………..xx Reciprocal ledger account
(Subsidiary`s Equity Account)
Subsidiary`s Retained Earning…………………………………………………xx
Payable to Parent………………………………………………………………………xx Inter company transaction
Increase in Fair Value of Assets………………………………………………..xx Increase in Asset and Decrease in
Decrease in Fair Value of Liabilities………………………………………….xx Liability in terms of FV of Sub.
Goodwill……………………………………………………………………………………….xx Excess of AC (TC) Over FVNIA

Investment in Subsidiary…………………………………………xx
Non Controlling Interest………………………………………….xx
Receivable from Subsidiary……………………………………xx
Increase in Fair Value of Liabilities………………………..xx
Decrease in Fair Value of Assets……………………………xx
100) Which of the following is the best theoretical justification for
consolidated financial statements?

A. In form the companies are one entity; in substance they are

separate.

B. In form and substance, the companies are separate.

C. In form and substance, the companies are one entity.

D. In form the companies are separate, in substance they one entity

D
101) Which of the following adjustments do not occur in the consolidating
process?

A. Allocations of difference between implied and book values.

B. Elimination of the investment account

C. Elimination of intra company balances D

D. Elimination of parents retained earnings
102) A Corporation had net income of Birr 50,000 in 2019 and Birr 60,000 in
2020, excluding any income from its investment in B Company. B Company had
net income of Birr 30,000 in 2019 and Birr 40,000 in 2020.
On January 1, 2020, A Corporation acquired all of the outstanding common
shares of B Company for a cash payment of Birr 300,000. Assume that there was
no acquisition differential on this business combination.
What net income would A Corporation report for 2020 in its comparative
consolidated financial statements at the end of 2020?

A. Birr 40,000
B. Birr 100,000 B
C. Birr 80,000
D. Birr 60,000
103) On March 31, 2022, Meade Company merged into Steele Corporation.
The separate income statements of the two companies for the fiscal year ended March
31, 2022, prior to any journal entries necessary to record the business combination on
that date, showed the following net income: Steele, Birr 500,000; Meade, Birr 100,000.
Steele's post- merger income statement for the year ended March 31, 2022, shows net
income in the amount of

A. Birr 600,000

B. Birr 500,000

C. Birr 470,000

D. Birr 570,000
B
104) These are the financial statements of a group in which the assets,
liabilities, equity, income, expenses and cash flows of the parent and its
subsidiaries are presented as those of a single economic entity.
a. Consolidated financial statements
b. General purpose financial statements
c. Separate financial statements
d. Group financial statements

A
105) Eliminating entries are made to cancel the effects of intercompany
transactions and are made on the
a. books of the parent company.
b. books of the subsidiary company.
c. workpaper only.
d. books of both the parent company and the subsidiary.

C
106) Control exists even the parent owns half or less of the voting
power of an entity under which of the following circumstances?

a. Power over more than half of the voting rights by virtue of a contractual
agreement with other entities
b. Power to govern the financial and operating policies of the entity under
a statute
c. Power to appoint or remove the members of the board of an entity or
the power to cast the majority of votes at meetings of the board of
directors
d. Under all of these circumstances
D
107) How does IFRS 10 define control?
a. An investor controls an investee when the investor is exposed, or has rights, to
variable returns from its involvement with the investee and has the ability to affect
those returns through its power over the investee.
b. An investor controls an investee when it has the power govern the financial and
operating decisions of the investee
c. An investor controls an investee when it owns more than 50% of the ordinary
shares of the investee
d. An investor controls an investee when it has the power to participate in the
financial and operating decisions of the investee. A
108) Which of the following is a limitation of consolidated financial
statements?
a. Consolidated statements provide no benefit for the stockholders and
creditors of the parent company.
b. Consolidated statements of highly diversified companies cannot be
compared with industry standards.
c. Consolidated statements are beneficial only when the consolidated
companies operate within the same industry.
d. Consolidated statements are beneficial only when the consolidated
companies operate in different industries.

B
109) On the consolidated balance sheet, consolidated stockholders'
equity is
a. equal to the sum of the parent and subsidiary stockholders' equity.
b. greater than the parent's stockholders' equity.
c. less than the parent's stockholders' equity.
d. equal to the parent's stockholders' equity.

D
110) Consolidated financial statements are designed to provide:
a. informative information to all shareholders.
b. the results of operations, cash flows and the balance sheet in an
understandable and informative manner for creditors.
c. the results of operations, cash flow, and the balance sheet as if the parent
and subsidiary were a single entity.
d. subsidiary information for the subsidiary shareholders

C
• 111) Princeton Company acquired 75 percent of the common stock of
Sheffield Corporation on December 31, 2011.
• On the date of acquisition, Princeton held land with a book value of
$150,000 and a fair value of $300,000; Sheffield held land with a book
value of $100,000 and fair value of $500,000.
• What amount would land be reported in the consolidated balance sheet
prepared immediately after the combination?
a. $650,000
b. $500,000
c. $550,000 A
Book value the parent + Fair value of the subsidiary
d. $375,000 150,000 + 500,000= 650,000
112) A Inc. purchased 100% of the voting shares of B Inc. on July 1, 2019. Which of the
following statements is TRUE?
A. The Consolidated Income Statement for 2019 will only include income from A Inc.
B. The 2019 Consolidated Income Statement will include income for both A Inc. and B
Inc. for the entire year.
C. The 2018 Income Statement (i.e. the comparative year), will retroactively include
income for both A Inc. and B Inc.
D. The 2019 Consolidated Income Statement will include only the income of A Inc. from
January 1, 2019 to June 30, 2019 and income for both A Inc. and B Inc. from July 1, 2019
to December 31, 2019 D
113) A Corporation had net income of $50,000 in 2019 and $60,000 in 2020, excluding
any income from its investment in B Company. B Company had net income of $30,000
in 2019 and $40,000 in 2020. On January 1, 2020, A Corporation acquired all of the
outstanding common shares of B Company for a cash payment of $300,000. Assume
that there was no acquisition differential on this business combination. What net
income would A Corporation report for 2019 in its comparative consolidated financial
statements
A. $80,000
B. $50,000 B
C. $30,000
D. $100,000
114) Company Y purchases a controlling interest in Company Z on January
1, 2002. Which of the following would appear as the shareholder equity
amount on Company Y's consolidated balance sheet on the date of
acquisition?

A) company Y's shareholder equity

B) company X's shareholder equity

C) company X and Y's shareholder equity

D) None A
3/6/2024 791
115 ) Noncontrolling interest shall be presented
a. Separately from liabilities and the parent shareholder's equity
b. Within equity, separately from the parent shareholder's equity
c. As noncurrent liability
d. As component of the parent shareholders' equity

B
3/6/2024 792
 CONSOLIDATED FINANCIAL STATEMENT:
SUBSEQUENT TO THE DATE OF BUSINESS
COMBINATION
 3.1. INTRODUCTION
• Subsequent to date of a business combination the parent
company accounts for operating results of subsidiary.
• That is it accounts for:
1. Net income or net loss, and
2. Dividends declared and paid by subsidiary
• In addition, a number of intercompany transactions and event
that frequently occur in a Parent- Subsidiary relationship shall
be recorded.
• All the three basic financial statements must be consolidated for
accounting periods subsequent to the date of purchase type
business combination.
 3.2. METHOD OF ACCOUNTING FOR CFS
A parent company may choose the Equity Method or
the Fair Value Method to account for the operating
results of consolidated purchased subsidiaries.
 1. EQUITY METHOD

• The Parent company records its share of subsidiary’s net

income or net loss, adjusted for depreciation and
amortization of differences between current fair values
and carrying amounts of a purchased subsidiary’s net
asset on the date of business combination, as well as its
share of dividends declared by subsidiary.
• Proponents claim that equity method stresses the
economic substance of the parent-subsidiary
relationship.
796
 Cont.…

• Proponents of the method maintain that the method is

consistent with the accrual basis of accounting.
• Dividends declared by a subsidiary do not constitute
revenue to the parent company.
• It recognizes increases or decreases in the carrying
amount of the parent company’s investment in the
subsidiary
• When they are realized by the subsidiary as net income or
net loss, not when they are paid by the subsidiary as
dividends
 SAMPLE EQUITY METHOD

Initial Investment---Investment in S……………………….XX

Cash/other assets………………………….XX

✓Net Income ---------Investment in S………………………...XX

Income from S……………………..….XX

✓Net Loss -------------Loss from S…………………….……...XX

Investment in S………………….…...XX

✓Dividend ------------Dividend receivable/ cash….…...XX

Investment in S…………..…….…...XX
Fair value adjustment------NO JOURNAL ENTRY
798
 2. FAIR VALUE METHOD
• Parent company accounts for the operations of a
subsidiary only to the extent that dividends are declared
by the subsidiary.
• Net income or net loss of the subsidiary is not recognized
by the parent company.
• Supporters of the method contend that the method
appropriately recognizes the legal form of parent –
subsidiary relationship.

799
 Cont.…
• Dividends declared by subsidiary are recognized as
revenue by the parent company.
• The general accounting and reporting rule for these
investments is to value the securities at fair value and
record gains and losses in PROFIT OR LOSS.
 SAMPLE FAIR VALUE METHOD

Initial Investment---Investment in S…………….….XX

Cash/other assets…………….…..XX
✓Net Income --------- NO JOURNAL ENTRY
✓Net Loss ------------ NO JOURNAL ENTRY
✓Dividend ------------Dividend receivable/ cash…..……...XX
Dividend income………….……….…...XX
Fair value adjustment:
Increase In Fair Value: Investment In S………………….Xx
Gain From Fair Value Adjustment…………..Xx
Decrease In Fair Value: Loss From Fair Value Adjustment…….Xx
Investment In S………………….Xx 801
 EXAMPLE
• Arthur Company invested Br 400,000.00 for a 80%
interest in ARBE Company on January 1, 2019. At
December 31, 2019, ARBE reported a Net Income of Br
300,000.00 and also on December 21, 2019 it declared a
dividend of Br 100,000.00. At December 31, 2019, the
Fair Value of Arthur’s 80% Share Was Br 600,000.

802
 3.3. WORKING PAPER ELIMINATIONS AND
ADJUSTMENTS FOR EQUITY METHOD
The items that must be included in the elimination are:
1. Three components of the subsidiary’s
stockholders’ equity are reciprocal to the
parent company’s Investment Ledger Account.
2. The subsidiary’s beginning-of-year retained
earnings amount is eliminated.
Cont..
3. The debits to the subsidiary’s plant assets, patent,
and goodwill bring into the consolidated balance sheet
the un-amortized differences between current fair
values and carrying amounts of the subsidiary’s assets
on the date of the business combination.
4. The amount of the parent company’s inter-company
investment income is an element of the balance of the
parent’s Investment Ledger Account.
 CONT…
5. Subsidiary’s dividends are an offset to the
subsidiary’s retained earnings.
6. The balance of the parent company’s Investment
Ledger Account is net of the dividends received from
the subsidiary.
7. The elimination of the subsidiary’s beginning-of-year
retained earnings makes beginning-of-year
consolidated retained earnings identical to the end-of-
previous-year consolidated retained earnings.
SUMMARY OF ELIMINATION AND ADJUSTMENT ENTRIES
1. The basic elimination entry:
Common Stock (S) XX
Additional Paid-in Capital (S) XX
Retained Earnings, Beginning Balance (S) XX
Income from Sub XX
Investment in Sub BV
Dividends Declared XX

2. The excess value reclassification entry:

Asset 1 XX
Asset 2 XX
Goodwill XX
Investment in Sub Excess
SUMMARY OF ELIMINATION AND ADJUSTMENT ENTRIES
3. The amortized excess value reclassification entry:
Cost of Sales XX
Other Expenses XX
Income from Sub XX
This entry reclassifies the equity method amortization of cost in excess of
book from Income from Sub to the appropriate expense accounts where the
costs would have been had the sub used FMV instead of BV.

4. The accumulated depreciation elimination entry:

Accumulated Depreciation XX
Buildings and Equipment XX
Operating Segments
IFRS 8
Operating Segments
Conceptual base of Segment Reporting
❑Segment reporting is the act of disaggregating financial information of
an enterprise.
Why disaggregation?
❑Different segments of an enterprise have different rates of profitability,
degrees and types of risk, and opportunities for growth,
❑But consolidated financial statements do not provide information about
the contribution of each segment; they provide information about
overall measures of profitability, liquidity and efficiency .
❑Without the ability to understand which of an entity's major
operations were making the most positive contributions to its results,
users would face problem to make intelligent investment decisions.
❑Segment reporting is needed to provide information about the different
business activities in which an enterprise engages

809
Operating Segments
Operating segment
• A component of an entity:
(a) That engages in business activities from which it may earn
revenues and incur expenses (including revenues and
expenses relating to transactions with other components of
the same entity),
(b) Whose operating results are regularly reviewed by the
entity’s chief operating decision maker (CODM) to make
decisions about resources to be allocated to the segment and
assess its performance, and
(c) For which discrete/separate financial information is available
• An operating segment may engage in business activities for which
it has yet to earn revenues
• E.g., start-up operations may be operating segments before
earning revenues
810
 Steps in identifying operating segment

Qualitative identification
• Step 1. Identify the CODM
• Step 2. The component generate revenue and incur expenses from
formation its business activities.
• Step 3. The component’s operating results regularly reviewed by the
CODM.
• Step 4. Discrete financial information available for the component.
Example
• Company A has CEO, COO and an executive
committee comprising the CEO, COO and the heads of
three business units-units X,Y and Z. Every month,
financial information is presented to the executive
committee. Units X,Y and Z each generate revenues
and incur expenses. Unit Y derives its major revenues
from unit Z. Corporate head quarter costs that are not
allocated to units X,Y and Z are also reported
separately each month to the executive committee.
IFRS8-Operating Segments
….Operating Segment
Key points
❑Identifiable/Distinguishable
❑Engage in production of goods/services
❑The operating results must be reviewed by senior management for
resource allocation and performance evaluation (segment managers
report this)
❑Discrete/separate financial information is available
All parts of a company may not be included in an operating segment.
✓Units that incur expenses but do not earn revenues are not operating
segment. Eg. Research and development , Head offices with
incidental revenues, marketing finance, admin
✓The costs of departments not identified as operating segments
are allocated to operating segment

813
IFRS8-Operating Segments
Identifying Reportable Segment
❑Reportable Segments are segments whose operating results are
prepared and disclosed separately
❑The financial information of segments engaged in similar activities can
be combined /aggregated; eg those with similar
❑Products and services,
❑Production process,
❑Class of customer,
❑Method for distributing their products and services,
❑Regulatory environment

Criteria to Identify Reportable Segment

❑The following quantitative thresholds are considered

814
IFRS8-Operating Segments
…Identifying Reportable Segment
Quantitative thresholds
• The entity reports only those operating segments that exceed a size
test. The following are quantitative thresholds:
1. Reported revenue is equal to or greater than 10% of the combined
revenues of all operating segments - Includes intersegment sales
2. Absolute amount of profit or loss is equal to or greater than 10% of
combined profits (for those operating segments reporting profits)
and combined losses (for those operating segments reporting
losses)
3. Assets are equal to or greater than 10% of the combined assets of
all operating segments
• If an operating segment meets any one of the above criteria, it is
reportableExample1 IFRS 8.doc
• Example 2 segment reporting the 75% test.doc

815
IFRS8-Operating Segments
...Quantitative thresholds
• Next steps once management have identified the reporting segments
– Assess whether additional segments shall be reported
The test:
- Reported segments must include 75% of all external revenue. External revenue
excludes intersegment revenue.
– If the total external revenues for the reportable segments are less
than 75% of the entity’s revenues, the entity identifies additional
reportable segments (smaller segments can be aggregated if they
meet some of the aggregation criteria)
• Once the 75% threshold has been met
– Entity has identified sufficient reportable segments
– Rest of the non-reportable segments are added together under
“other operating segments” and disclosed
• The entity presents comparatives, which include all reportable segments
816
 Example
x Y Z Total Head Others total(Co
segment quarter nsolidat
ed)

Revenue 100(80
s 200 earned 400 700 --- 230 850
from Z)

Profit 30(10
/loss 50 earned 100 180 (25) 20 165
from Z)

Asset 800 300 950 2050 250 200 2500

 Cont…
Revenue % of Profit % of total Assets % of total
total
X 29 28 39
Y 14 17 15
Z 57 55 46
 Cont….
• The reportable segment accounts for 75% of consolidated revenue.
• 620/850=0.73=73%
• Therefore, which is below 75% requirement.
IFRS8-Operating Segments
Disclosure
How to present information
• The entity should present the following categories of information:
• General information
• Information about the reported segment’s profit or loss, assets
and liabilities, and bases of measurement
• Reconciliations of segment revenues to reported revenues
General information
• The following general disclosures are required:
▪ Factors used to identify the reportable segments
▪ How did management choose to organize the entity in order to
make key resource allocation decisions and to assess
performance? (its base of categorization: geographically?, by
type of products/services?)
• Types of products/services
820
IFRS8-Operating Segments
.....Disclosure
Information about Segment’s profit or loss, and assets/liabilities
• The entity must present the amount of profit/loss and
General
total assets
for each reportable segment principle: If
Segment
• Information is disclosed include: manager thinks
• Segment liabilities that information
is important for
• Segment revenues (external and intersegment) decision-
• Segment depreciation and amortization making, it
• Segment material items of income and expense should be
presented to the
• Segment income tax expense external users
•Segment material non-cash items other than depreciation and
amortization
• Segment investment in associates/joint ventures accounted for by
the equity method
• additions to non-current assets of the segment
821
IFRS8-Operating Segments
Measurements
• Items should be measured the way they are measured for
presentation to CODM (the manager)
• To understand how these numbers are put together, the
following is relevant and should therefore be disclosed:
• Basis of accounting for intersegment transactions
• Nature of any differences between the segment profit or
loss and the entity profit or loss
• Nature of any differences between the segment
assets/liabilities and the entity assets/liabilities
• Nature of any changes from prior periods
• Nature and effect of asymmetrical allocations to reportable
segments

822
IFRS8-Operating Segments
Reconciliations
• Most users focus on the consolidated numbers
• Required reconciliations between reportable segments and
financial statement numbers:
• Revenues
• Profit and loss
• Assets
• Liabilities (if liabilities are presented for the segments)
• Any other material segments amounts presented

• The entity should identify and describe material reconciling items

823
IFRS8-Operating Segments
Items not disclosed:
❑Immaterial items: immaterial amounts of interest revenue and
expense,
❑An item for which internal financial report is not generated on a
segment basis, (This is consistent with the rationale that segment
reporting should create as little additional cost to an enterprise as
possible).

824
IFRS8-Operating Segments
Entity wide disclosures
• This refers to information about Products and Services
The following enterprises are mainly required to disclose revenues
from external customers on the basis of product or service.
1. Enterprises that are not organized based on products and services; ie those
organized based on geographical location;
2. Enterprises that have only one operating segment but provide a range of
different products and services . However, providing this information is not
required if impracticable; that is, if he information is not available and the cost
to develop it would be excessive.
• The following are required to be disclosed by all entities including those that have
only a single segment:
• Information about products and services
• Information about geographical areas
• Information about major customers
Information about products and services
• External revenues by product/service (or group thereof 825
IFRS8-Operating Segments
Entity wide disclosures
Information about geographical areas
• External revenues attributed to the entity’s
• Domestic operations (entity’s country of domicile)
• Foreign operations in other countries
• If revenues from external customers attributed to a specific country are
material, this should be disclosed also
• Non-current assets (other than financial instruments, deferred tax assets, post-
employment benefit assets, and rights under insurance contracts)
• Domestic (located in country of domicile)
• Foreign (located in foreign countries)
• If non-current assets in certain countries are material, this should also be
disclosed
Information about major customers
• If revenues to a customer amount to 10% or more, this fact should be disclosed
along with the amount

826
 Auditing
principle and
practice 1 and 2

CHAPTER ONE
Overview of Auditing

3/6/2024 827
 Definition of Auditing
• Auditing is the accumulation and evaluation of evidence about information to determine and report
on the degree of correspondence between the information and established criteria.
• Evidence is any information used by the auditor to determine whether the information being audited
is stated in accordance with the established criteria.
• To satisfy the purpose of the audit, auditors must obtain a sufficient quality and volume of evidence.
• Auditors must determine the types and amount of evidence necessary and evaluate whether the
information corresponds to the established criteria.

3/6/2024 828
 Definition of Auditing
• Audit is an independent examination of financial statements of an entity that
enables an auditor to express an opinion whether the financial statements are
prepared (in all material respects) in accordance with an identified and acceptable
financial reporting framework (criteria) (e.g. IFRS, international or the national
standard of a particular country and national legislations).

3/6/2024 829
 Cont.…

❖The phrases used; “to express the auditor’s

opinion” means that the financial statements give a
true and fair view or have been presented fairly in
all material respects.
❖True and fair presentation means that the financial
statement are prepared and presented in
accordance with the requirements of the applicable
International Financial Reporting Standards (IFRS) or
GAAP and local pronouncements/legislations.
3/6/2024 830
 Economic demand for Audit
❖ Control mechanism: audits were important control mechanisms for
accountability.
❖ To resolve conflict of interest between management and the owners: The Agency
relation ship that exists between the owner and manager produces a natural
conflict of interest.
❖ To reduce damaging Consequences: the information provided by accounting or
accountant is must be verified by the audit or auditors.
❖ Regulatory requirements: many business laws, memorandum of
association and government regulation, make requirements’ annual audits.

3/6/2024 831
 Objectives of Audit
• The principal or primary objective of an audit is to enable the auditor to gather
and evaluate audit evidence of sufficient quantity and appropriate quality in
order to form, and communicate to the users of the financial statements an audit
opinion on the truth and fairness of the financial position and operating results as
shown by an organization.

3/6/2024 832
 Objectives of Audit
The secondary objectives of an audit are
generally taken to be as follows:-
❖Detection and prevention of errors and

❖Detection and prevention of frauds

3/6/2024 833
 Advantage and disadvantage of auditing

• Advantages:
• Audit can help in detecting and preventing errors and
frauds.
• Because of the audit, book of accounts are kept,
maintained with accuracy, and up to date
• The auditors will recommend on issues, which need
improvement after completing the audit.
• The shareholders, government tax institutions and other
stakeholders will have confidence on the financial
statements of the audited business since an independent
body proved it.
• Valuation of assets and liabilities becomes easy
• Audited accounts will be more acceptable to banks and
other financial institutions in obtaining funds and extending
financial accommodation.

3/6/2024 834
 Advantage and disadvantage of auditing

❖Disadvantage:
❖ May not get complete or correct information or full explanation: Auditor
has to depend on the explanation and information from the client.
❖ An auditor is not expected to be expert in all the areas
❖ The audit fee!
❖ The audit involves the client’s staff and management in giving time to
providing information to the auditor.

3/6/2024 835
 Accounting and Auditing

Similarities evaluating evidence covering financial

statements
❖Both are concerned with ❖ Objective of accounting is to prepare
accounting information financial statements where as , the
❖Both accountants and auditors objective of auditing is to determine
have to have considerable expertise fairness
with GAAP
of statements in conformity
in accounting mater.
❖ Accounting covers only quantitative
❖Both accounting and auditing data. However, auditing covers both
deliver reports to their users. quantitative and qualitative data.
Difference ❖ Accounting starts where book keeping
ends. Whereas, auditing starts where
❖ Accounting is analyzing, recording accounting ends.
classifying and summarizing events and
transactions to prepare financial
statements. Nevertheless, auditing is
concerned with obtaining and

3/6/2024 836
 Types of Audits
1. Audits of Financial Statements: The goal is to determine whether financial
statements have been prepared in conformity with specified criteria and to provide
assurance for third parties or external users that such statements present a company's
financial condition and results of operations 'fairly'. statement audits.
2. . Compliance Audits: concerned with examining whether government resources
are used properly and in compliance with related government rules and regulations.
3. Internal Audits: Internal auditing is essentially an appraisal activity within an
organization for the review of accounting, financial and other operations as a basis for
service to management.
4. Operational Audits: evaluates the efficiency and effectiveness of any part of an
organization’s operating procedures and methods.

3/6/2024 837
 Types of auditors

❖External Auditor

❖Internal

❖Government
3/6/2024 838
1) Which of the following is FALSE about auditing?

A. at involves the task of recording business transactions

B. It involves the task evaluations of evidences

C. involves checking the information with established criteria

D. It involves communicating results to users A

2) Which of the following is not among the responsibilities of an auditor?

A. Performing an audit with an attitude of professional skepticism

B. Maintaining adequate internal control system

C. Detecting material misstatements in the financial statement

D. Detecting direct-effect illegal acts

B
3) The purpose of an audit of financial statements is to
• a. Obtain an absolute level of assurance that the financial statements as a
whole are free from material misstatement.
• b. Relieve management or those charged with governance of the
responsibility for the preparation and presentation of the financial
statements in accordance with the applicable financial reporting framework.
• c. Enhance the degree of confidence of intended users in the financial
statements.
• d. Assure the future viability of the entity by expressing an opinion on the
entity's financial statements
C
3/6/2024 841
4) In order to provide reasonable assurance the audit must be performed
with an attitude of professional skepticism. Which of the following is
most correct regarding the "attitude" of professional skepticism?
• A) auditors should assume that management is dishonest
• B) auditors should assume that management is neither dishonest nor
honest
• C) auditors should assume that management is honest and mistakes are
unintentional
• D) auditors should assume that management is incumbent in preparing
financial statements

B
5) The basic purpose of a financial statement audit is to
A. Detect fraud.
B. Examine individual transactions so that the auditor may certify as to their
validity.
C. Provide assurance regarding whether the client's financial statements are
fairly stated.
D. Assure the consistent application of correct accounting procedures

3/6/2024 843
6) Assurance services may improve all of the following except
A. Credibility.
B. Reliability.
C. Periodicity.
D. Relevance.
C
3/6/2024 844
7) The definition of auditing refers to auditing as a "systematic
process of objectively obtaining and evaluating evidence regarding
assertions " What is meant by "systematic process"?
•
A. All audits involve obtaining the same evidence.
B. All audits involve evaluating evidence in the same manner.
C. There should be a well-planned approach for obtaining and
evaluating evidence.
D. All assertions are equally important for all audits C

3/6/2024 845
8) In audit should be designed to achieve reasonable assurance of
detecting material misstatements due to:
A) Errors.
B) Errors and fraud.
C) Errors, fraud, and those illegal acts with a direct effect on financial
statement amounts.
D) Errors, fraud and illegal acts.
C
3/6/2024 846
9) The concept of reasonable assurance indicates that the auditor is:
a. not an insurer of the correctness of the financial statements.
b. not responsible for the fairness of the financial statements.
c. responsible only for issuing an opinion on the financial statements.
d. responsible for finding all misstatements
A

3/6/2024 847
7) If the auditor were responsible for making certain that all of
management’s assertions in the financial statements. Which one is
correct
a. bankruptcies could no longer occur.

• b. bankruptcies would be reduced to a very small number.

• c. audits would be much easier to complete.

• d. audits would not be economically feasible.

D
3/6/2024 848
8) The primary difference between operation auditing and financial auditing
is that in operational auditing....
• a.) The operational auditor is not concerned with whether the audited
activity is generating information in compliance with financial accounting
standards
• b.) The operational auditor is seeking to help management use resources in
the most effective manner possible.
• c.) The operational auditor starts with the financial statements of an activity
being audited and works backward to the basic processes involved in
producing them.
• d.) The operation auditor can use analytical skills and tools that are not
necessary in financial auditing.
B
9) The objective of the ordinary examination by the independent auditor
is the expression of an opinion on

• a. The accuracy of the financial statements.

• b. The balance sheet and income statement.

• c. The fairness of the financial statements.

• d. The annual report

C
10) Which is not an attribute of an external auditor?
A. Concern for the public interest.
B. Objectivity.
C. Auditee advocacy.
D. Independence.
C
 CHAPTER TWO

PROFESSIONAL

AUDITING STANDARDS
852
2.1.WHAT IS AUDITING STANDARDS?
❑Auditing standards are general guidelines to aid
auditors in fulfilling their professional responsibilities
in the audit of historical FSs.

❑They include consideration of professional qualities

such as competence (know how)&independence,
reporting requirements, and evidence. 853
 2.2. GENERALLY ACCEPTED AUDITING STANDARDS

❑The broadest guidelines available to auditors are

the 10 generally accepted auditing standards
(GAAS), which were developed by the AICPA.
❑10 (ten) generally accepted auditing standards fall
into three categories:
1. General standards
2. Standards of field work
3. Reporting standards
854
 Cont’d….
Generally Accepted Auditing Standards
2. Field Work 3. Reporting
1. General
performance of the results
qualifications audit
and conduct 1. Whether statements
were prepared in
1. Adequate 1. Adequate & Proper planning accordance with GAAP
technical and supervision
2. Circumstances when
training and 2. Sufficient understanding GAAP not consistently
proficiency of the entity, its followed
2. Independence in environment, and its
3.Adequacy of
mental attitude internal control
informative disclosures
3. Due professional 3. Sufficient competent
4. Expression of
care evidence
opinion on financial
statements 855
 2.3. ERROR AND FRAUD
❑Auditor Responsibilities with Respect to Financial Statements

❑ Expression of an opinion
❑Reasonable assurance (word/ declaration) that material
misstatements are absent:
❑Includes errors (faults/mistakes), fraud/fake and other
irregularities
❑Plan and perform the audit in accordance with IFRS or GAAS
856
 Types of Misstatements:

Some are Difficult to Detect!

❑Error: unintentional/chance misstatement

❑Fraud and other irregularities: intentional

❑Theft of assets, often employee fraud

❑Fraudulent financial reporting, often management fraud
❑Computer fraud and so on….

857
 Special need for ethical conduct in professions

❖The term professional means a responsibility for conduct that extends beyond
satisfying individual responsibilities and beyond the requirements of our
society’s laws and regulations.
❖ A CPA, as a professional, recognizes a responsibility to the public, to the client,
and to fellow practitioners, including honorable behavior, even if that means
regardless of the individual providing it.
❖For the CPA, it is essential that the client and external financial statement users
have confidence in the quality of audits and other services.

3/6/2024 858
 CHARACTERISTICS OF A PROFESSION

❖Responsibility to serve the public: In financial statements audit, the auditor

is the representative of the public in the financial reporting process.
❖Complex and Specialized of Knowledge: A profession has a specialized body
of knowledge that member of the profession should acquire through formal
education.
❖Need for public confidence: A profession will be successful if it gains public
trust and confidence.
❖Standards of conduct of behavior: A professional needs to have standards
of conduct that governs the behavior and activities of the members of the
profession.

3/6/2024 859
 PROFESSIONAL QUALIFICATION REQUIREMENTS
• A professional accountant should perform professional services with due
care, competence and diligence and has a continuing duty to
maintain professional knowledge and skill at a level required to ensure
that a client or employer receives the advantage of competent
professional service based on up-to-date development in practice,
legislation and techniques.

860
 PROFESSIONAL ETHICS
• All recognized professions have developed codes of professional ethics.
Professional ethics refer to the basic principles of right action for the
member of a profession.
• Professional ethics may be regarded as a mixture of moral and practical
concepts.
• Thus the professional ethics of an accountant would signify his
behavior towards his fellows in the profession and other professions
and towards members of the public.
861
- Integrity: - An accountant should be straight forward, honest and sincere
in his approach to his professional work.
- Objectivity: - An accountant should be fair and should not allow bias to
override his objectivity.
- Independence: - When in public practice, an accountant should both be
and appear to be free of any interest which might be regarded,
whatever its actual effect, as being incompatible with integrity and
objectivity.

862
- Confidentiality: - A professional accountant should respect the
confidentiality of information acquired in the course of his work and should
not disclose any such information to a third party without specific authority
or unless there is a legal or professional duty to disclose.
- Technical standards: - An accountant should carry out his professional
work in accordance with the technical and professional standards relevant to
that work.
- Professional competence: - An accountant has a duty to maintain his level
of competence throughout his professional career. He should only undertake
works, which he or his firm can expect to complete with professional
competence.
863
- Ethical behavior: - An accountant should conduct himself with a good
reputation of the profession and refrain from any conduct, which might bring
discredit to the profession.
- Contingent fees: - The AICPA code of professional conduct prohibits a CPA
firm from rendering any professional services on a contingent fee basis.
- Responsibilities to colleagues: - The auditor should promote cooperation and
good relations with other members of the profession.
- Advertising: - The advertising should not be false or misleading,” should not
contravene “professional good taste,” should not make “unfavorable reflection
on the competence or integrity of the profession,” and should not” involve a
statement the contents of which” cannot be substantiated.
864
The principle of integrity imposes an obligation on all professional accountants to be straightforward
and honest in all professional and business relationships. Integrity also implies fair dealing and
truthfulness.
The principle of objectivity imposes an obligation on all professional accountants not to compromise
their professional or business judgment because of bias, conflict of interest or the undue influence of
others.
The principle of professional competence and due care imposes the following obligations on all
professional accountants:
(a) To maintain professional knowledge and skill at the level required to ensure that clients or
employers receive competent professional service; and
(b) To act diligently in accordance with applicable technical and professional
standards when providing professional services.
The principle of professional behavior imposes an obligation on all professional accountants to comply
with relevant laws and regulations and avoid any action that the professional accountant knows or
should know may discredit the profession.
The principle of confidentiality imposes an obligation on all professional accountants to refrain from:
(a) Disclosing outside the firm or employing organization confidential information acquired as a result
of professional and business relationships without proper and specific authority or unless there is a
legal or professional right or duty to disclose; and (b) Using confidential information acquired as a
result of professional and business relationships to their personal advantage or the advantage of third
parties.
 CODE OF PROFESSIONAL CONDUCT

• There are more interpretations for independence than for any of the other rules of conduct.

• Some of the more significant issues and interpretations involving independence are discussed in the following
sections.

❖Financial Interests

❖Former Practitioners:

❖Normal Lending Procedures:

❖Financial Interests and Employment of Immediate and Close Family Members:

❖Joint Investor or Investee Relationship with Client

❖Litigation between CPA Firm and Client:

3/6/2024 866
 Auditors’ Professional Responsibility and Liability

• Many accounting and legal professionals believe that a major cause of lawsuits against
Independent (private) audit firms is the lack of understanding by financial statement users of the
difference between a business failure and Audit failure and between Audit failure and Audit risk.
• Business Failure: this occurs when the business is unable to repay its lenders, or meet the
expectations of its investors.
• Audit Failure: This occurs when the auditor issues an incorrect audit opinion because of an
underlying failure to comply with the requirements of IFRS.
• Audit Risk: it is the risk that the financial statements are materially incorrect, but the audit
opinion states that the financial reports are free of any material misstatements.

3/6/2024 867
 Auditors’ Professional Responsibility and Liability

• Auditor’s Responsibility
➢Better Communication
➢Prudent person concept
➢Detection of Errors and Irregularities
➢Detection of Illegal Client Acts: illegal acts may be evidenced by:
• unauthorized transaction
• failure to file tax returns and etc
➢Doubts as to entity’s going concern assumption: the auditor has a
responsibility to evaluate and disclose whether there is substantial doubt about
the entities ability to continue as going concern for the reasonable period of
time.

3/6/2024 868
 Auditors’ Professional Responsibility and Liability

• Auditors’ Liability to Clients: An auditor may liable to a client for breach of contract or
wrongful act when he/she:
✓Issue a standard audit report when he or she has not made an examination in
accordance with GAAS
✓Doesn’t deliver the audit report by the agreed up on date
✓Violates the client’s confidential responsibility
✓Fails to exercise due care, that is reasonably expected from him/her
✓Intentionally deceits, such as misinterpretation concealment or non disclosure of
material fact, that results damage to another
✓Breaches the contract

3/6/2024 869
 Auditors’ Professional Responsibility and Liability

• Auditors’ Liability to Third Parties (actual and potential users of the audit
information):
• The auditor owns a duty to third parties whose reliance is foreseen by the auditor.
• The third party is a person who is not the member with the parties to a contract.
• Third parties can be classified as primary beneficiaries and other or general third
beneficiaries.
• A primary beneficiary is the one about whom the auditor is informed prior to
conducting audit. The auditor is liable to more general third parties for gross negligence
and fraud.

3/6/2024 870
 Types of Liability and Auditors’ Actions Resulting in Liability

Type of Liability Auditors’ Actions Resulting in Liability

Common law—clients Breach of contract
Negligence
Gross negligence/constructive fraud
Fraud
Common law—third parties Negligence
Gross negligence/constructive fraud
Fraud
Federal statutory law—civil Negligence
liability Gross negligence/constructive fraud
Fraud
Federal statutory law— Willful violation of federal statutes
criminal liability
 Liability
• The client/plaintiff must prove the following:

➢A duty owed by the auditor to the client to conform to a required

standard of care.
➢Failure by the auditor
➢A causal connection between the auditor’s negligence and the
client’s damage.
➢Actual loss or damage to the client.
 Defensive mechanisms
• Auditors’ defenses include the following:
• No duty was owed.
• The client was negligent
• The auditor’s work was performed in accordance with professional
standards.
• The client suffered no loss.
• Any loss was caused by other events.
• The claim is invalid because the statute of limitations has expired
11) Which of the following ethical principles requires
the auditor to be honest and straightforward in all
professional and business relationships?
A. Integrity
A
B. Professional behavior

A. Professional competence and due care

B. Objectivity
12) Auditors are periodically punished for holding an investment in a client.
This violates which ethical rule?

• A. Integrity.

• B. Independence.
B
• C. Noncompliance with IFRS.

• D. Confidentiality.
13) The main purpose for establishing a code of conduct for professionals
is to:
A. Protect members of the profession from being sued for substandard
work
B. Demonstrate acceptance of responsibility to the interests of those
served by the profession
C. Enable users to evaluate by themselves the quality of professional
services
D. Guarantee that all members of the profession perform at the same level
of competence
B
14) Which of the following best describes a portion of the auditors'
responsibility regarding illegal acts by clients?
• A) The auditors have a responsibility to discover all material illegal acts.
• B) If audit procedures reveal illegal acts, the auditors should take
appropriate actions.
• C) If the auditors suspect illegal acts have been performed, they should
conduct a legal audit of the company.
• D) The auditors' responsibility for the detection of all illegal acts is the same
as their responsibility regarding material misstatements due to errors and
fraud.
B
3/6/2024 877
15) If an illegal act is discovered during the audit of a publicly held
company, the auditors should first:
• A) Notify the regulatory authorities.
• B) Determine who was responsible for the illegal act.
• C) Intensify the examination to identify all illegal acts.
• D) Report the act to high level personnel within the client's
organization and to the audit committee.
D

3/6/2024 878
16) The auditors who find that the client has committed an illegal act
would be most likely to withdraw from the engagement when the:
A) Management fails to take appropriate corrective action.
B) Illegal act has material financial statement implications.
C) Illegal act has received widespread publicity.
D) Auditors cannot reasonably estimate the effect of the illegal act on the
financial statements. A

3/6/2024 879
17) Due professional care requires
A. The examination of all available corroborating evidence.
B. The exercise of error-free judgment.
C. A study and review of internal controls that includes tests of
controls.
D skill and care that
D. Auditors to plan and perform their duties with the
is commonly expected of accounting professionals.
3/6/2024 880
18) The General Standards stress the importance of:

a. evidence accumulation.

b. personal qualities the auditor should possess.

c. communicating the auditor's findings to the reader.

d. general supervision of the audit. B

3/6/2024 881
19) Which of the following statements most accurately captures the intent of
the standards of field work?

a. Field work standards are primarily concerned with personal attributes

necessary during the conduct of the audit.
b. Field work standards provide extensive guidance regarding the conduct of
an audit.
c. Field work standards are primarily directed at the auditor's planning,
understanding of internal control, and evidence accumulation.
d. Field work standards are primarily concerned with the conduct of
substantive testing as opposed to testing of internal controls.
C
3/6/2024 882
20) If a CPA performs an audit recklessly, the CPA will be liable to
third parties who were unknown and not foreseeable to the CPA for:
(A) Strict liability for all damages incurred.
(B) Gross negligence.

• (C) Either ordinary or gross negligence. B

(D) Breach of contract.

3/6/2024 883
21) Which of the following elements is most frequently necessary to
hold a CPA liable to a client?
(A) Acted with scienter or guilty knowledge.
(B) Was not independent of the client.
(C) Failed to exercise due care.
(D) Did not use an engagement letter. C
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22) Which of the following ethical principles imposes an obligation on all
professional accountants not to compromise their professional or business
judgment because of bias, conflict of interest or the undue influence of
others.

A. Integrity

B. Professional behavior

C. Professional competence and due care

D
D. Objectivity
23) Which of the following is NOT one of auditors’ responsibilities in
verifying financial statements?
• A. To discharge properly the statutory duty to report on the true and
fair view of financial statements.
• B. To ensure that independence is not impaired.
• C. To comply with the fundamental principles of integrity, objectivity,
professional competence and due care, confidentiality and
professional behaviour.
• D. To prepare audited financial statements for shareholders in
accordance with the applicable financial reporting framework
D
• 24) In cases of breach of contract, plaintiffs generally have to prove
all of the following, except:
(A) The CPAs had a duty.
(B) The CPAs made a false statement.
(C) The client incurred losses related to the CPAs’ performance.
(D) The CPAs breached their duty.
B
 CHAPTER THREE

Planning and conducting the Audit

3/6/2024 888
 3.1. Introductions

❑The auditor must adequately plan the work and must properly
supervise any assistants.
❑There are three main reasons why the auditor should properly plan
engagements:
❑To enable the auditor to obtain sufficient appropriate
evidence for the circumstances,
❑To help keep audit costs reasonable, and
❑To avoid misunderstandings with the client.

3/6/2024 889
 3.2. Reason or Need for audit planning

❑Audit planning is the key to an effective and efficient audit.

❑Effectiveness results in the attainment of the main audit objectives

without undue risk.

❑Efficiency enables the auditor to achieve maximum practical

utilization of not only of his own audit staff and resources but,
wherever practicable, of the client’s accounting and internal audit
staff and resources.
3/6/2024 890
 3.3 Audit planning process

❑The audit planning process begins when the auditor accepts an

audit engagement and continues until the completion of the audit.
❑Generally, the six procedures of audit plan are:
1. Pre – plan
2. Obtaining back ground information
3. Obtaining information about client legal obligations
4. Assess materiality & determine acceptable and inherent risk
5. Understand the ICS & determine control risk
6. Develop overall audit plan & program

3/6/2024 891
 Audit planning process - the pre – plan
procedure
❑An engagement letter includes the following matters:
❑Scope: This is a description of the services to be provided, particularly whether there is
to be an audit in accordance with IFRSs or a more limited accounting services are to be
provided, and whether additional services are to be provided, such as preparation of
tax returns or tax planning.
❑Responsibility: This is an explanation of the relative responsibilities of management
and the auditor for assuring that financial statements are in all material respects in
conformity with IFRSs and other matters that often raise questions of responsibility
such as fraud, illegal acts,
• Procedural Arrangements: This is the specification of the schedules to be prepared by
the client, the method and frequency of billing the auditor’s fee and similar matters.

3/6/2024 892
 Audit planning process - Assess
Materiality and Determine Acceptable &
Inherent Audit Risks
• MATERIALITY: Materiality is defined as the magnitude of an omission or

misstatement of accounting information that is the right of surrounding

circumstances, makes if probable that the judgment of a reasonable

person relying on the information would have been changed or influenced

by the omission or misstatement.

3/6/2024 893
 Audit planning process - Assess
Materiality and Determine Acceptable &
Inherent Audit Risks
• AUDIT RISK: Audit risk is the risk that financial statements are materially incorrect, even though
the audit opinion states that the financial reports are free of any material misstatements.
• The second standard of fieldwork requires the auditor to obtain an understanding of the entity
and its environment, including its internal control, to assess the risk of material misstatements
in the client’s financial statements.
• Risk, in auditing, is defined as some level of uncertainty that an auditor accept in performing
the audit function.
• Audit Risk Model: The audit risk model is used primary for planning purpose in deciding how
much evidence to accumulate in each side. The audit risk model is stated as follows:

AAR = PDR X CR X IR
AAR
PDR =
CR x IR
3/6/2024 894
 Audit planning process - Assess
Materiality and Determine Acceptable &
Inherent Audit Risks
✓ Acceptable Audit Risk (AAR): Acceptable audit risk is a measure of how
willing the auditor is to accept that the financial statements may be
materially misstated after the audit is completed and an unqualified
opinion(good) has been issued.

❑Planned detection risk (PDR) is the risk that audit evidence for a segment will fail
to detect misstatements exceeding tolerable misstatement.
❑ Inherent Risk (IR): Inherent risk measures the auditor’s assessment of the likelihood
that there are material misstatements due to error or fraud in a segment before considering
the effectiveness of internal control.
❑ Control Risk (CR): Control risk measures the auditor’s assessment of whether
misstatements exceeding a tolerable amount in a segment will be prevented or detected
on a timely basis by the client’s internal controls.

3/6/2024 895
 Develop Overall Audit Plan and Program

A. Audit plan: An audit plan is an overview of the engagement, outlining the nature and
characteristics of the client’s business operations and the overall audit strategy.
• The audit plan is normally drafted before starting work at the client’s offices.
Typical audit plan contains the following information.
• Description of the client’s business
• Objectives of the audit
• Nature and extent of other work
• Training and scheduling the audit work
• Work to be done by the client’s staff
• Staffing requirements during engagement
• Target dates for completing major segments of the engagement
• Any special audit risks for the engagement
•
3/6/2024 896
 Develop Overall Audit Plan and Program

1. Procedures to obtain understanding the ICS:

• Experience: Auditor’s previous experience with the client
• Inquires: Study of client personnel
• Inspection: Inspection of documents records
• Reading: Reading client’s policy and system manuals
• Observation: Direct observation of client’s activities and operation
2. Testing of control: Testing of controls is performed to determine the internal control procedures have been
properly designed and operating effectively. To obtain sufficient appropriate evidence to support that assessment,
the auditor performs tests of controls.
3. Substantive tests: are a procedures designed to test for dollar misstatements (often called monetary
misstatements) that directly affect the correctness of financial statement balances.
4. Analytical procedure: Analytical procedure involves comparisons of recorded amount to expectations developed
by the auditors. They involve the calculations of ration by the comparison with previous ratio or related data.
5. Tests of details of balances: Tests of details of balances focus on the ending general ledger accounts both for
income statement and balance sheet accounts.
3/6/2024 897
 Develop Overall Audit Plan and Program

B. Audit program: An audit program is a written scheme of the exact details

of the work to be done by the auditor and his staff in connection with a
particular audit. Before commencing the audit, the auditor outlines the
whole process starting from the beginning (preliminary stage) till its
completion (finalization of audit report (his signature there on).
• Audit programming is, therefore, an outlining of procedures to be followed in
order to arrive at an opinion concerning the financial statement of a company.
• Features of Audit program
• It is a set of procedures related with the works to be done.
• It is the auditor’s plan of action.
• It is a scheme: it enables the auditor to delegate work to the audit staff as per
their capability.

3/6/2024 898
 An audit notebook & working papers

• An audit notebook contains general information in respect of audit and significant matters
observed during the audit, which may be of considerable use at the time of finalization of reports,
as well as during successive audit.

• Audit working papers are work records made by auditors of related audit items in the course of
audit.

• Different from audit evidences which testify the truthfulness of audit items, working papers record
the whole process of audit including the collection, appraisal and utilization of evidence.

3/6/2024 899
 An audit notebook & working papers

• Purposes of Audit working papers

• The overall objective of audit documentation is to aid the auditor in providing
reasonable assurance that an adequate audit was conducted in accordance
with auditing standards.
• More specifically, audit documentation, as it pertains to the current year’s
audit, provides:
• A Basis for Planning the Audit
• A Record of the Evidence Accumulated and the Results of the Tests
• Data for Determining the Proper Type of Audit Report
• A Basis for Review by Supervisors and Partners

3/6/2024 900
 Ownership of Audit Files

• Audit documentation prepared during the engagement, including schedules

prepared by the client for the auditor, is the property of the auditor.

• The only time anyone else, including the client, has a legal right to examine the files
is when they are subpoenaed by a court as legal evidence.

• At the completion of the engagement, audit files are retained on the CPA’s premises
for future reference and to comply with auditing standards related to document
retention.

• Permanent and current file

3/6/2024 901
25) Which of the following procedures is not performed as a part of planning
an audit engagement?

A. Performing analytical procedures

B. Confirmation of all major accounts

C. Designing an audit program

D. Reviewing the working papers of the prior year

B
26. In planning the audit engagement, the auditor should consider each of
the following except

• A. The kind of opinion that will likely be given

• B. Matters relating to the entity’s business and the industry in which it
operates
• C. The entity’s accounting policies and procedures
• D. Anticipated levels of control risk and materiality
• E. All
• F. None
A
27) Which of the following is not one of the three main reasons why
the auditor should properly plan engagements?
a. To enable proper on-the-job training of employees.
b. To enable the auditor to obtain sufficient appropriate evidence.
c. To avoid misunderstandings with the client.
d. To help keep audit costs reasonable.
A

3/6/2024 904
28) A measure of how willing the auditor is to accept that the financial
statements may be materially misstated after the audit is completed and
an unqualified opinion has been issued is the:
• a. inherent risk.
• b. acceptable audit risk.
• c. statistical risk.
B
• d. financial risk.

3/6/2024 905
29) A measure of the auditor’s assessment of the
likelihood that there are material misstatements in an
account before considering the effectiveness of the
client’s internal control is called:
 a. control risk.
 b. acceptable audit risk.
 c. statistical risk. D
 d. inherent risk.
3/6/2024 906
30) When obtaining an understanding of the entity and its environment,
the auditor should obtain an understanding of internal controls primarily
to
A. Identify areas of relatively high risk of misstatement and plan the audit
accordingly.
B. Provide suggestions for improvement to the company.
C. Serve as a basis for setting audit risk and materiality.
D. Decide whether to perform an audit for the company. A
3/6/2024 907
31) When a CPA is approached to perform an audit for the first time, the CPA should make inquiries of the
predecessor auditor. This is a necessary procedure because the predecessor may be able to provide the
successor with information that will assist the successor in determining

• A. Whether, in the predecessor's opinion, the financial statements are materially correct.

• B. Whether the predecessor's work should be utilized.

• C. Whether the engagement should be accepted.

C
• D. Whether, in the predecessor's opinion, the company's internal controls have been satisfactory.

3/6/2024 908
32) Which one of the following statements best describes the concept
of materiality?

A. Materiality is largely a matter of professional judgment.

B. Materiality depends only on the dollar amount of an item relative to
other items in the financial statements.
C. Materiality is determined by reference to specific quantitative
guidelines established by the AICPA.
D. Materiality depends on the nature of an item but not on the dollar
amount of the item.
A
3/6/2024 909
33) Which of the following is most likely to occur at the beginning of an
initial audit engagement?
•
a. Prepare a rough draft of the financial statements and of the auditor’s
report.
•
b. Study and evaluate the system of internal administrative control.
•
c. Determine the client’s reason for an audit.
•
d. Consult with and review the work of the predecessor auditor prior to
discussing the engagement with the client management. C

3/6/2024 910
34) When discussing control risk (CR) and the audit risk model,
which of the following is ? False
a. CR is a measure of the auditor’s assessment of the likelihood that
misstatements will not be prevented or detected by internal control.

b. If the auditor concludes that internal control is completely ineffective to

prevent or detect errors, he/she would assign a low value (e.g., 0%) to CR.

c. The relationship between control risk and detection risk is inverse.

d. The relationship between control risk and evidence needed to support

account balances is direct.
B
3/6/2024 911
35) The predecessor auditor is required to respond to the request of the successor
auditor for information, but the response can be limited to stating that no information
will be provided when:
a. the predecessor auditor has poor relations with the successor auditor.
b. the client is dissatisfied with the predecessor’s work.
c. there are actual or potential legal problems between the client and the predecessor.
d. the predecessor believes that the client lacks integrity.

C
3/6/2024 912
36) Planned detection risk

• I. determines the amount of substantive evidence the auditor plans to

accumulate.

• II. is dependent on inherent risk and business risk.

• A) I only

• B) II only

• C) I and II

• D) neither I nor II
A
• 37) The risk of a material misstatement occurring in an account, assuming
an absence of internal control, is referred to as:
• A. Account risk.
• B. Control risk.
Control risk is the risk that the internal control
• C. Detection risk. arrangements will fail to prevent material deviations, or
to detect and correct them on a timely basis.
• D. Inherent risk.
Inherent risk is the risk of a material misstatement in a
• E. All company's financial statements without considering
internal controls.
• F. None
Detection risk, which is the risk that the auditor will not
D detect a material misstatement
• 38) Audit risk' represents the risk that the auditor will give an inappropriate
opinion on the financial statements when the financial statements are materially
misstated. Which of the following categories of risk can be controlled by the
auditor?
• Category of risk:
• (1) Control risk D
• (2) Detection risk Control risk (together with inherent risk) are components of the risk of material
misstatement, which is governed by the circumstances of the audit client and
• (3) Sampling risk therefore is outside the control of the auditor.
• A. (1) and (2)
Detection risk, which is the risk that the auditor will not detect a material
• B. (2) only misstatement
• C. (1) and (3)
• D. (2) and (3) Sampling risk is the risk that the auditor's conclusions based on a sample may be
different from the conclusion if the entire population were the subject of the same
• E. All audit procedure.
• F. None
Sampling risk is a component of detection risk, which is controlled by the auditor.
39) Which one of the following is FALSE?

A. The risk of material misstatement is a function of inherent and control

risk

B. A financial statement that contain immaterial misstatement is not

considered to show true and fair view

C. Knowledge about the client's industry is an essential factor for a

successful audit
B
D. Audit planning can keep audit costs reasonable
 CHAPTER FOUR
917

INTERNAL CONTROL

By: Tahir D. 3/6/2024

 THE MEANING OF INTERNAL CONTROL
918
➢ Internal control is a process, effected by an entity’s board of
directors, management and other personnel
➢ It is designed to provide reasonable assurance regarding the
achievement of objectives in the following categories:
effectiveness and efficiency of operations;
accuracy, reliability and timely preparation of financial reports;
prevention and detection of fraud and error; compliance with
internal policies and applicable laws and regulations; and
safeguarding of assets against unauthorized acquisition, use or
disposition.
➢ It includes the plans, policies and procedures adopted by the
management of an entity to assist in achieving management’s
objective.
By: Tahir D. 3/6/2024
 OBJECTIVES OF INTERNAL CONTROL
919
➢ There are three broad objectives in designing an effective internal control
system
1. Reliability of financial reporting: Management has both a legal
and professional responsibility to be sure that the information (financial
statement) is fairly presented in accordance with reporting requirements
of accounting frameworks such as GAAP and IFRS.
2. Efficiency and effectiveness of operations: Controls within a
company encourage efficient and effective use of its resources to
optimize the company’s goals.
➢ An important objective of these controls is accurate financial and nonfinancial
information about the company’s operations for decision-making.
3. Compliance with laws and regulations:

By: Tahir D. 3/6/2024

 Management and auditors responsibilities
for internal control
920
 Management is responsible for establishing and maintaining the entity’s
internal controls.
 In contrast, the auditor’s responsibilities include understanding and
testing internal control over financial reporting.
Management’s Responsibilities for Establishing Internal Control
➢ Two key concepts underlie management’s design and implementation of
internal control, reasonable assurance and inherent limitations.
➢ Reasonable Assurance: A company should develop internal controls
that provide reasonable, but not absolute, assurance that the financial
statements are fairly stated.
➢ After considering both the costs and benefits of the controls, management
develops internal controls.
➢ The concept of reasonable assurance allows for only a remote likelihood
that material misstatements will not be prevented or detected on a timely
basis by internal control.
By: Tahir D. 3/6/2024
 Management and auditors responsibilities
for internal control
921
 Inherent Limitations: Internal controls can never be
completely effective, regard less of the care followed in their
design and implementation.
 Even if management can design an ideal system, its
effectiveness depends on the competency and depending on
the ability of the people using it.
 Assume, for example, that a carefully developed procedure for
counting inventory requires two employees to count
independently.
 the employees might decide to overstate the counts to
intentionally cover up a theft of inventory by one or both of
them. An act of two or more employees who conspire
to steal assets or misstate records is called collusion.
By: Tahir D. 3/6/2024
 Management and auditors responsibilities
for internal control
922
 Management’s assessment of internal control over financial
reporting are evaluating the design of internal control over
financial reporting and testing the operating effectiveness of
those controls.
 In Designing of Internal Control management evaluate how
transactions are initiated, authorized, recorded, processed,
and reported to identify points in the flow of transactions
where material misstatements due to error or fraud could
occur.
 The testing objective is to determine whether the controls are
operating as designed and whether the person performing the
control possesses the necessary authority and qualifications to
perform the control effectively.
By: Tahir D. 3/6/2024
 Auditor’s Responsibilities for Understanding
Internal Control
923
 The second GAAS field work standard states “The auditor must obtain a sufficient
understanding of the entity and its environment, including its internal control.
 The auditor obtains the understanding of internal control to assess control risk in
every audit.
 Auditors are primarily concerned about controls over the reliability of
financial reporting and controls over classes of transactions.
 Controls Over the Reliability of Financial Reporting: Financial
statements are not likely to correctly reflect GAAP or IFRS if internal controls over
financial reporting are inadequate.
 Auditors deals with controls affecting internal management information, such as
budgets and internal performance reports.
 This information is used by management to run the business and can be important
sources of evidence that help the auditor decide whether the financial statements
are fairly presented.
 In addition, auditors concerned with a client’s internal control over the
safeguarding of assets and compliance with laws and regulations if they affect the
fairness of the financial statements.
By: Tahir D. 3/6/2024
 Auditor’s Responsibilities for Understanding
Internal Control
924
 Controls over Classes of Transactions: Auditors emphasize internal
control over classes of transactions rather than account balances because
the accuracy of accounting system outputs (account balances) depends
heavily on the accuracy of inputs and processing (transactions).
 For example, if products sold, units shipped, or unit-selling prices are
wrong in billing customers for sales, both sales and accounts receivable
will be misstated.
 Because of the emphasis on classes of transactions, auditors are primarily
concerned with the transaction-related audit objectives.
 Even though auditors emphasize transaction-related controls,
the auditor must also gain an understanding of controls over ending
account balance and presentation and disclosure objectives.

By: Tahir D. 3/6/2024

 COMPONENTS OF INTERNAL CONTROL
925

 A company’s internal control structure consists of

five components:
1. The control environment
2. Risk assessment
3. The accounting information and communication system
4. Control activities, and
5. Monitoring

By: Tahir D. 3/6/2024

 COMPONENTS OF INTERNAL CONTROL -
THE CONTROL ENVIRONMENT
926
 The control environment consists of the actions, policies, and
procedures that reflect the overall attitudes of top management,
directors, and owners of an entity about internal control and its
importance to the entity.
 The control environment serves as the umbrella for the other four
components.
 Without an effective control environment, the other four are
unlikely to result in effective internal control, regardless of their
quality.
 The essence of an effectively controlled organization lies in the
attitude of its management.
 If top management believes that control is important, others in the
organization will sense this commitment and respond by
conscientiously observing the controls established.
By: Tahir D. 3/6/2024
 COMPONENTS OF INTERNAL CONTROL -
THE CONTROL ENVIRONMENT
927
 To understand and assess the control environment, auditors should
consider the most important control subcomponents.
a. Integrity and Ethical Values: Management should establish
behavioral and ethical standards that discourage employees from
engaging in acts that would be considered dishonest, unethical or illegal.
b. Commitment to competence: Management should insure that
employees possess the skills and knowledge to the performance of their
jobs.
c. Board of directors or audit committee: The control environment of
an organization is significantly influenced by the effectiveness of its
board of directors or the audit committee.
d. Management Philosophy and operating style: Managers differ in
both their philosophies towards financial reporting and their attitudes in
taking business risks.

By: Tahir D. 3/6/2024

 COMPONENTS OF INTERNAL CONTROL -
THE CONTROL ENVIRONMENT
928
e. Organizational structure: A well designed organizational structure
provides a basis for planning, directing and controlling operations.
f. Human Resource Policies and Procedures:
Management’s policies and practices for hiring, training,
evaluating, promotion and compensating employees have a
significant effect on the effectiveness of the control
environment.
g. Assignment of authority and responsibility:
Personnel within an organization need to have a clear
understanding of their responsibilities and the rules and
regulations that governs their action.

By: Tahir D. 3/6/2024

 COMPONENTS OF INTERNAL CONTROL -
RISK ASSESSMENT
929
✓ Risk assessment for financial reporting is management’s identification
and analysis of risks relevant to the preparation of financial statements
in conformity with appropriate accounting standards.
✓ Once management identifies a risk, it estimates the significance of that
risk, assesses the likelihood of the risk occurring, and develops specific
actions that need to be taken to reduce the risk to an acceptable level.
✓ Management assesses risks as a part of designing and operating internal
controls to minimize errors and fraud, where as auditors assess risks to
decide the evidence needed in the audit.
✓ If management effectively assesses and responds to risks, the auditor will
typically accumulate less evidence than when management fails to identify
or respond to significant risks.
✓ Auditors obtain knowledge about management’s risk assessment process
using questionnaires and discussions with management

By: Tahir D. 3/6/2024

 COMPONENTS OF INTERNAL CONTROL -
CONTROL ACTIVITIES
930
✓ Control activities are the policies and procedures.
✓ It help to ensure that necessary actions are taken to address risks to the
achievement of the entity’s objectives. The control activities generally fall into
the following five types:
1. Adequate Separation of Duties: Four general guidelines for adequate
separation of duties to prevent both fraud and errors are especially
significant for auditors.
a. Separation of the Custody of Assets from accounting to protect a
company from embezzlement
b. Separation of the Authorization of Transactions from the Custody
of Related Assets
c. Separation of Operational Responsibility from Record-Keeping
Responsibility: For example, if a department or division oversees the
creation of its own records and reports, it might change the results to
improve its reported performance.
d. Separation of IT Duties from User Departments:
By: Tahir D. 3/6/2024
 COMPONENTS OF INTERNAL CONTROL -
CONTROL ACTIVITIES
931
2. Proper Authorization of Transactions and Activities:
Authorization can be either general or specific.
✓ Under general authorization, management establishes policies and
subordinates are instructed to implement these general authorizations by
approving all transactions within the limits set by the policy.
✓ General authorization decisions include the issuance of fixed price lists for
the sale of products, credit limits for customers, and fixed reorder points
for making acquisitions.
✓ Specific authorization applies to individual transactions.
✓ The distinction between authorization and approval is also important.
✓ Authorization is a policy decision for either a general class of
transactions or specific transactions.
✓ Approval is the implementation of management’s general authorization
decisions.

By: Tahir D. 3/6/2024

 COMPONENTS OF INTERNAL CONTROL -
CONTROL ACTIVITIES
932
3. Adequate Documententations and Records: Documents and
records are the records upon which transactions are entered and
summarized.
✓ Pre-numbered consecutively to facilitate control over missing documents
and records and as an aid in locating them when they are needed at a later
date.
4. Physical Control over Assets and Records: If records are not
adequately protected, they can be stolen, damaged, altered, or lost,
which can seriously disrupt the accounting process and business
operations.
5. Independent Checks on Performance: The need for independent
checks arises because internal controls tend to change over time, unless
there is frequent review.

By: Tahir D. 3/6/2024

 COMPONENTS OF INTERNAL CONTROL -
INFORMATION AND COMMUNICATION
✓ The purpose is to initiate, record, process,
933and report the entity’s transactions and to
maintain accountability for the related assets.
 To understand the design of the accounting information system, the auditor
determines:
 The major classes of transactions of the entity;
 How those transactions are initiated and recorded;
 What accounting records exist and their nature;
 How the system captures other events that are significant to the financial
statements, such a declines in asset values; and
 The nature and details of the financial reporting process followed, including
procedures to enter transactions and adjustments in the general ledger.
 COMPONENTS OF INTERNAL CONTROL -
MONITORING
✓ Monitoring activities deal with ongoing or periodic assessment of the quality
of internal control by management to determine that controls are operating
as intended and that they are modified as appropriate for changes in
conditions.
By: Tahir D. 3/6/2024
 THE USE OF INTERNAL CONTROL SYSTEMS BY
AUDITORS
934
 Auditors shall:
 Assess the adequacy of the accounting system as a basis for
preparing the account
 Identify the types of potential misstatements that could
occur in the accounts
 Consider factors that affect the risk of misstatements
 Design appropriate audit procedures

By: Tahir D. 3/6/2024

 INTERNAL CONTROLS AND CONTROL RISK
935
✓ Internal controls are all the policies and procedures that a
company uses to prevent, detect, and correct errors,
irregularities, and frauds that might get in to financial
statements.
✓ Control risk is the probability that a company’s controls will
fail to detect errors, irregularities, and frauds.
✓ The auditor’s task is to assess the control risk associated with
the control procedures designed and implemented for the
period under audit.
✓ The auditor has to see what internal control system exists in
the client and then check whether the system is operating
properly as designed.

By: Tahir D. 3/6/2024

 INTERNAL AUDIT AND INTERNAL CONTROL
936
✓ Internal audit is a means of management control mechanism
established internally and arising out of the need for
verification.
✓ In addition, is part of the internal control system in an
organization, which is responsible for evaluating and
commenting on the effectiveness of the internal control
system.
✓ There are two forms of internal auditing.
✓ These are pre-audit and post-audit.
✓ The pre-audit is the examination of transactions before
payment is affected. It is a more traditional audit function.
✓ Post-audit represents after the fact examination and is a more
recent one.
By: Tahir D. 3/6/2024
 INTERNAL AUDIT AND INTERNAL CONTROL
937
 The purposes of pre-audit are to provide reasonable assurance
that:
 Expenditures are not unreasonable or extravagant,
 Sufficient funds are available to enable payments of the invoice, and
 There has been compliance with government proclamations, regulations,
and directive, procedural and budgetary requirements.
 Post-audit is conducted to achieve the following objectives:
 To verify the accounting records
 To review the internal control system
 To evaluate the efficiency, effectiveness and economy of operations and
 To evaluate if management objectives are achieved.

 The basic limitation of the post-audit is that it concentrates on detection of

fraud and error rather than preventing their occurrence.
By: Tahir D. 3/6/2024
 LIMITATIONS OF INTERNAL CONTROL
938
 All internal control systems are subject to three major
inherent limitations:
 Human factors: An employee through misunderstandings of
instructions, carelessness, fatigue, absenteeism, deliberate
circumvention, or overriding specific controls can impair the
effectiveness specific controls. In short, incompetent and/or
dishonest people can reduce the system to a shamble.
 Scope of controls: Controls may not encompass all transactions,
that is non-routine transactions and extraordinary events may not
be covered.
 Business environment: Changed conditions may necessitate
major modifications in the control structure.
 Thus, there is always some level of control risk but detection risk
can be reduced when there is an effective internal control structure.
By: Tahir D. 3/6/2024
40) Internal controls can never be considered as absolutely effective
because:
• a. their effectiveness is limited by the competency and dependability
of employees.
• b. not all organizations have internal audit departments.
• c. controls are designed to prevent and detect only material
misstatements.
• d. internal controls prevent separation of duties.
A
3/6/2024 939
41) Which of the following activities would be least likely to
strengthen a company’s internal control?
a. Separating accounting from other financial operations.
b. Maintaining insurance for fire and theft.
c. Fixing responsibility for the performance of employee duties.
d. Carefully selecting and training employees.
B
3/6/2024 940
42) To issue a report on internal control over financial reporting for a
public company, an auditor must:
a. evaluate management’s assessment process.
b. independently assess the design and operating effectiveness of
internal control.
c. evaluate management’s assessment process and independently
assess the design and operating effectiveness of internal control.
d. test controls over significant account balances.

C
3/6/2024 941
43) Which of the following statements is correct with respect to
separation of duties?
a. Employees should not have temporary and permanent custody of
assets.
b. Employees who authorize transactions should not have custody of
related assets.
c. It is permissible to allow an employee to open cash receipts and
record those receipts.
d. Employees who authorize transactions should have recording
responsibility for these transactions. B
3/6/2024 942
44) The most important type of protective measure for safeguarding
assets is:
a. adequate separation of duties among personnel.
b. proper authorization of transactions.
c. the use of physical precautions.
d. adequate documentation.
C
3/6/2024 943
45) Which of the following is the correct definition of “control deficiency?”

a. A control deficiency exists if the design or operation of controls does not permit
company
personnel to prevent or detect misstatements on a timely basis.

b. A control deficiency exists if one or more deficiencies exist that adversely affect a
company’s ability to prepare external financial statements reliably.

c. A control deficiency exists if the design or operation of controls results in a more than
remote likelihood that controls will not prevent or detect misstatements.

d. A control deficiency exists if the design or operation of controls results in a more than
probable likelihood that controls will prevent or detect misstatements.
A
3/6/2024 944
46) Which of the following is not one of the subcomponents of the
control environment?
a. Management’s philosophy and operating style.
b. Organizational structure.
c. Adequate separation of duties.
d. Commitment to competence
C
3/6/2024 945
47) After considering a client’s internal controls, an auditor has
concluded that it is well designed and is functioning as intended.
Under these circumstances the auditor would most likely:

a. perform tests of controls to the extent outlined in the audit program.

b. determine the control procedures that should prevent or detect
errors and irregularities.
c. not increase the extent of predetermined substantive tests.
d. determine whether transactions are recorded to permit preparation
of financial statements in conformity with IFRS.

C
3/6/2024 946
48) Which of the following is not one of the three primary objectives
of effective internal control?

• a. Reliability of financial reporting

• b. Efficiency and effectiveness of operations
• c. Compliance with laws and regulations
• d. Assurance of elimination of business risk.
D
3/6/2024 947
49) The use of prenumbered checks in disbursing cash is an
application of the principle of:
• A. establishment of responsibility.
• B. segregation of duties.
• C. physical controls.
• D. documentation procedures.

D
 CHAPTER FIVE
AUDIT EVIDENCE

3/6/2024 949
 Audit evidence
•Audit evidence is any information used by the auditor to determine whether the
quantitative information being audited is stated in accordance with the established
criteria.

• Audit evidence includes all the things that influence the auditor’s judgment in
evaluating whether the financial statements are in conformity with IFRS.

• Audit evidence is any information or document that confirms or rejects a premise (a

statement or hypothesis).

3/6/2024 950
 Audit evidence
• What makes audit evidence competent and sufficient?
• Competency of evidence is related to its quality and
reliability.
• Evidence is said to be competent if it is both valid and
relevant.
• The quality of audit evidence is affected by
1. the source of the audit evidence,
2. the strength of the client’s internal control and
3. the ability of the auditor to gather firsthand
information.

3/6/2024 951
Audit evidence
• Sufficiency of evidence relates to the quantity of evidence auditors
should obtain.
• Though the sufficiency audit evidence is determined by the auditor’s
professional judgment, factors such as
• competence,
• materiality and
• risk are the determinants of the sufficiency of audit evidence.
• In general, more evidences are needed for accounts that are material to
the financial statements than for accounts that are immaterial.
• The amount of evidence that is considered sufficient to support the
auditor’s opinion is a matter of professional judgment.

3/6/2024 952
Audit evidence
• The amount of evidence that is sufficient in
a specific situation varies inversely with the
appropriateness of the available evidence.
• Thus the more appropriate the evidence, the
less the amount of evidence that is needed to
support the auditor’s opinion.
• In short sufficiency and competency of
audit evidences are inversely related.

3/6/2024 953
Audit evidence
One of the factors affecting the reliability of
the audit evidence is its source.
To clarify more, you may classify evidence as
follows:
• Evidence originated by the auditor,
• Evidence created by the third party and
• Evidence created by the management of the
client.
3/6/2024 954
Audit evidence
The seven characteristics of competent evidence include:
1. Relevance--to the audit objective that the auditor is testing;
2. Independence of the provider--information received from outside the entity is
presumed to be more reliable than from inside the entity.
3. Effectiveness of the client's internal controls--evidence from a client whose
internal controls are effective is more trustworthy.
4. Auditor's direct knowledge--data or calculations prepared by someone inside
the organization will not be as reliable as data computed or discovered by the
auditor directly.
5. Qualifications of the individuals providing the information--reliability of
the information is enhanced if the person providing it is qualified to do so.
6. Degree of objectivity--objective evidence is more reliable than evidence that is
subjective.
7. Timeliness--data that are timely for the purpose intended are considered more
reliable.
3/6/2024 955
 Types of audit evidence

1. Physical evidence
2. Documentary evidence
3. Accounting Records
4. Written Representations/Confirmations
5. Mathematical evidence
6. Oral evidence
7. Analytical procedures.

3/6/2024 956
50) Auditors basically accumulate evidence to
A. Reach a conclusion about the fairness of the financial
statements

B. Defend themselves in the event of a court case

C. Satisfy the requirements of code of ethical conduct

D. Determine if the financial statements are correct

A
51) Which of the following is correct?
A. Analytical review is sufficient evidence for a reasonable
assurance audit
B. Limited assurance audit opinion is worded negatively
C. Auditors apply professional judgment only on deciding on
the type of opinion
D. Limited assurance audit is acceptable for organizations of
all size B
52) Which of the following statements is not correct?
a. There are many ways an auditor can accumulate evidence to meet
overall audit objectives.
b. Sufficient appropriate evidence must be accumulated to meet the
auditor’s professional responsibility.
c. It is appropriate to minimize the cost of accumulating evidence.
d. Gathering evidence and minimizing costs are equally important
considerations that affect the approach the auditor selects.

D
3/6/2024 959
53) Which of the following statements is not correct with respect to
analytical procedures?
a. Auditing standards emphasize the need for auditors to develop and
use expectations.
b. Analytical procedures must be performed throughout the audit.
c. Analytical procedures may be performed at any time during the
audit.
d. Analytical procedures use comparisons and relationships to assess
whether account balances appear reasonable.
B
3/6/2024 960
54) Of the following, which is the least persuasive type of audit
evidence?
A. Correspondence between the auditor and third party vendors.
B. Computations made by the auditor.
C. Documents mailed by outsiders to the auditor.D
D. Copies of company sales invoices inspected by the auditor.

3/6/2024 961
55) What type of evidence would provide the highest level of assurance in
an attestation engagement?

A) Evidence secured solely from within the entity

B) Evidence obtained from independent sources
C) Evidence obtained indirectly
D) Evidence obtained from multiple internal inquiries
B
56) Which of the following are ordinarily designed to detect possible
material monetary errors in the financial statements?

A. Tests of controls.

B. Analytical procedures.

C. Computer controls.
B
D. Post-audit review of audit documents.
57) To be considered reliable evidence, confirmations must be
controlled by:

• a. a client employee responsible for accounts receivable.

• b. a financial statement auditor.

• c. a client’s internal audit department.

B
• d. a client’s controller or CFO.
58) Which of the following statements is not a correct use of the
terminology?
• a. Evidence obtained from an independent source outside the client
organization is more reliable than that obtained from within.
• b. Documentary evidence is more reliable when it is received by the
auditor indirectly rather than directly.
• c. Documents that originate outside the company are considered more
reliable than those that originate within the client’s organization.
• d. External evidence, such as communications from banks, is generally
regarded as more reliable than answers obtained from inquiries of the
client.
B
59) Which of the following statements relating to the competence of
evidential matter is always true?
• a. Evidence from outside an enterprise is always reliable.
• b. Accounting data developed under satisfactory conditions of
internal control are more relevant than data developed under
unsatisfactory internal control conditions.
• c. Oral representations made by management are not reliable
evidence.
• d. Evidence must be both reliable and relevant to be considered
appropriate.
D
60) Which of the following is not a characteristic of the reliability of
evidence?
• a. Qualification of individual providing information.
• b. Auditor’s direct knowledge.
• c. Degree of subjectivity.
• d. Degree of objectivity.

C
61) Which of the following forms of evidence would be least persuasive
in forming the auditor’s opinion?
• a. Responses to auditor’s questions by the president and controller
regarding the investments account.
• b. Correspondence with a stockbroker regarding the quantity of client’s
• investments held in street name by the broker.
• c. Minutes of the board of directors authorizing the purchase of stock
as an investment.
• d. The auditor’s count of marketable securities.
A
 CHAPTER SIX

Audit Report
 Audit reports
❑ The audit report is the final step of the audit process.
The financial statements on which you prepare an audit
report are the balance sheet, the income statement, the
statement of retained earnings and the statements of cash
flow.
❑ The auditing profession recognizes the need for
uniformity in reporting as a means of avoiding confusion.
❑ To avoid confusion and misrepresentation of an audit
report there should be uniformity in reporting.
Audit reports
• The profession recognizes the need for uniformity in reporting as a
means of avoiding confusion.
• The professional standards have defined and enumerated the types of
audit reports that should be included with the financial statements.
• The wording of audit reports is reasonably uniform, but different
audit reports are appropriate for different circumstances.
Audit reports
Types of audit report: There are four types of audit reports that might
be issued by the auditors.
These are:
1. An unqualified opinion
2. Unqualified opinion with explanatory paragraph /modified wording
3. Qualified opinion
4. An adverse opinion
5. Disclaimer opinion
Components of audit report
• Auditors issue different types of reports based on
their findings.
• One of the reports auditors issue is the standard
unqualified audit report. The standard audit report
(Unqualified) contains three paragraphs, namely the
introductory paragraph, the scope paragraph, and
the opinion paragraph and it has seven parts.
• Each part of the auditor report is significant in terms
of the information conveyed to the user and the
responsibility assumed by the auditor.
Components of audit report
Standard unqualified report has seven parts.
• 1. Report Title: The auditing standard requires that the
report be titled and that the title include the word
Independent.
• The requirement that the title include the word
“independent” is intended to convey to users that the
audit was unbiased in all aspects of the engagement.
• 2. Address: The report is usually addressed to the company,
its stockholders or the board of directors or combinations
of these. If you are appointed by the stockholders at the
annual meeting, you have to write the audit report
addressing to them.
Components of audit report
3. Introductory paragraph: This is the first paragraph
of the audit report and it does three things:
• It makes the simple statement that the audit firm has
done an audit. This is intended to distinguish the report
from a compilation or review report.
• It lists the financial statements that were audited,
including the balance sheet, income statement, statement
of retained earnings and cash flow statements.
• The introductory paragraph states that the statements are
the responsibility of management and that the
auditor’s responsibility is to express an opinion on the
financial statements based on an audit.
Components of audit report
• 4. Scope paragraph: The scope paragraph describes
what the auditor has performed during the audit.
Specifically, it states whether the audit was conducted in
accordance with IFRS.
• It also states that the GAAS requirement that an audit be
planned to provide reasonable assurance that the
financial statements are free of material misstatement.
• The scope paragraph states that the audit is designed to
obtain reasonable assurance (not guaranty) about
whether the statements are free of material
misstatements.
Components of audit report
• 5. Opinion Paragraph: The final paragraph in the
standard report states the auditor’s conclusions
based on the results of the audit examination.
• This paragraph contains the auditor’s opinion on
whether the financial statements are in conformity
with IFRS.
• This paragraph describes the auditor’s findings.
• These findings are expressed in terms of whether the
financial statements are presented in accordance with
IFRS.
Components of audit report
• 6. Name of the audit firm and signature: The name and
the signature identify the audit firm or practitioner that has
performed the audit.
• Typically, the firm’s name is used, since the entire audit firm
has the legal and professional responsibility to make certain
the quality of the audit meets professional standards.
• 7. Date of audit report: The appropriate date of the audit
report is the one on which the field work has been
completed. This date is important because it represents the
time limit on the auditors’ responsibility.
• The auditor does not have any responsibility to make any
enquiries after this date.
62) Under which of the following set of circumstances might
the auditors disclaim an opinion?

A. The financial statements contain a departure from accepted

accounting principles, with a material effect
B. When the portion of the financial statement audited by the
other audit firm is material in relation to the whole.
C. There are significant scope limitations on the audit
D. The method of application of accounting principles is not
consistent.
C
63) If the phrase "except for" is present in the opinion paragraph of the audit
report, the auditor has issued a(n):

• A) adverse opinion.

• B) disclaimer of opinion.

• C) unqualified opinion.
D
• D) qualified opinion.
64) A CPA may wish to emphasize specific matters regarding the financial statements

even though an unqualified opinion will be issued. Normally, such explanatory

information is:

a. included in the scope paragraph.

b. included in the opinion paragraph.

c. included in a separate paragraph in the report.

C
d. included in the introductory paragraph.
3/6/2024 981
65) Auditing standards require that the audit report must be titled and
that the title must:

• A) include the word "independent."

• B) indicate if the auditor is a CPA.

• C) indicate if the auditor is a proprietorship, partnership, or corporation.

• D) indicate the type of audit opinion issued. A

66) The appropriate audit report date for a standard nonqualified audit
report for a non-public entity should be the:

• A) date the financial statements are given to the Board of Directors.

• B) date of the financial statements.

• C) date the auditor completed the auditing procedures in the field.

• D) 60 days after the date of the financial statements as required by the

SEC.
C
67) If the auditor believes that the financial statements are not fairly stated or is
unable to reach a conclusion because of insufficient evidence, the auditor:

• A) should withdraw from the engagement.

• B) should request an increase in audit fees so that more resources can be used to
conduct the audit.

• C) has the responsibility of notifying financial statement users through the

auditor's report.
C
• D) should notify regulators of the circumstances.
68) An adverse opinion is issued when the auditor believes:

a. some parts of the financial statements are materially misstated or misleading.

b. the financial statements would be found to be materially misstated if an investigation were

performed.

c. the auditor is not independent.

d. the overall financial statements are so materially misstated that they do not present fairly the
financial position or results of operations and cash flows in conformity with IFRS.

D
3/6/2024 985
69) If a misstatement is immaterial to the financial statements of the entity
for the current period, but is expected to have a material effect in future
periods, it is appropriate to issue a(n):
• a. adverse opinion.
b. qualified opinion.
c. unqualified opinion.
d. disclaimer of opinion. C
3/6/2024 986
70) When there is uncertainty about a company's ability to continue as a going
concern, the auditor's concern is the possibility that the client may not be able to
continue its operations or meet its obligations for a "reasonable period of time."
For this purpose, a reasonable period of time is considered not to exceed:
A) six months from the date of the financial statements.
B) one year from the date of the financial statements.
C) six months from the date of the audit report.
D) one year from the date of the audit report.
B
3/6/2024 987
71) If the balance sheet of a company is dated December 31, 2009, the audit
report is dated February 8, 2010, and both are released on February 15, 2010, this
indicates that the auditor has searched for subsequent events that occurred up
to:
a. December 31, 2009.
b. January 1, 2010
c. February 8, 2010
d. February 15, 2010 C
3/6/2024 988
72) A company has changed its method of inventory valuation from
an unacceptable one to one in conformity with IFRS . The auditor’s
report on the financial statements of the year of the change should
include:

a. no reference to consistency.
b. a reference to a prior period adjustment in the opinion paragraph.
c. an explanatory paragraph that justifies the change and explains the
impact of the change on reported net income.
d. an explanatory paragraph explaining the change. D

3/6/2024 989
73) The purpose of the introductory paragraph in the standard
unqualified report is:
a. to identify that the type of opinion issued is unqualified.
b. to identify the financial statements audited and the dates and time
periods covered by the report.
B
c. to indicate the CPA followed applicable audit standards.
d. to indicate all the financial statements are in accordance with IFRS.
3/6/2024 990
 CHAPTER ONE
AUDIT SAMPLING

991
NATURE OF AUDIT SAMPLING
• There is neither sufficient time nor sufficient reason to
test all of the transactions underlying an entity's account
balances or classes of transactions. Far too, it is costly.
• As a result, many if not most of the conclusions auditors
reach about account balances & classes of transactions
are based on testing samples rather than entire
populations.
• Thus, when the auditor decides to select less than 100
percent of the population for testing for the purpose of
making inferences about the population, it is called audit
sampling.
Why do auditors use sampling?
• Auditors use sampling
➢to test controls (compliance tests) for assessing control risk, and
➢to test balances (substantive tests) for determining whether balances are
materially misstated.
SELECTING A REPRESENTATIVE SAMPLE
• A representative Sample is one in which the
characteristics in the sample of audit interests are
approximately the same as those of the population.
• This means that the sampled items are similar to the
items not sampled.
• However, it could be highly representative, reasonably
representative, and non-representative.
• Two things can cause a sample result to be non-
representative:
➢Sampling error, called Sampling Risk and
➢Non-Sampling error called Non- sampling Risk
SELECTING A REPRESENTATIVE SAMPLE
• Sampling risk (sampling error) is an inherent part of
sampling that result from testing less than the entire
population.
• Even with zero non sampling error, there is always a
chance that a sample is not reasonably representative.
• For example, if a population has a 3 percent exception
rate, the auditor could select a sample of 100 items
containing no or many exceptions.
SELECTING A REPRESENTATIVE SAMPLE
• There are two ways to control sampling risk: by
➢adjusting sample size and
➢using an appropriate method of selecting sample items from
the population.
• This does not eliminate sampling risk,
➢but it does allow the auditor to measure the risk associated
with a given sample size in a reliable manner.
SELECTING A REPRESENTATIVE SAMPLE
• The auditor is also concerned about non-sampling error.
Non-sampling error arises from non-sampling risk, which
occurs when:
➢the auditor is not careful in examining the sample and fails to
identify an exception or error in a selected sample item
➢the audit test is not appropriate (for example, the sample was
selected from an inappropriate population for the purposes of the
assertion being tested)
➢the auditor has misjudged the relevant risks (that is, the inherent
risk and/or control risk)
➢the auditor has made an error in the evaluation of the sampling
results
 cont…
❑Audit sampling method can be divided in two broad
categories:

1. Statistical sampling and

2. Non Statistical sampling

998
 cont…
Techniques used in probabilistic sample selection are:

1. Simple Random Selection

2. Systematic sampling selection
3. Stratified Sampling
4. Probabilistic proportion to sample size
5. Cluster sampling

999
 2.2. Non statistical sampling
❑The auditor does not quantify sampling risk.
❑Instead conclusion is reached about
population more on judgmental basis
❑There are three common approaches to select non
probabilistic samples from accounting population.
❑Direct Method
❑Block sampling
❑Haphazard sampling

1000
74) The use of statistical sampling technique enables the auditor to:

A. Eliminate the need for judgmental decisions

B. Quantify sampling risk

C. Select a perfectly representative sample

D. Be more subjective in evaluation of sample results

B
75) When the auditor goes through a population and selects items for the
sample without regard to their size, source, or other distinguishing
characteristics, it is called:

• a. block sample selection.

• b. haphazard selection.

• c. systematic sample selection B

• D. none
76) Which of the following method can help the auditor to
reduce non-sampling risk?

A. Using a representative sample

B. Reducing supervision
C. Careful design of audit procedure
D. Increasing sample size

C
77) Why do auditors generally use a sampling approach to evidence gathering?
•
A. Auditors are experts and do not need to look at much to know whether the
financial statements are correct or not.
B. Auditors must balance the cost of the audit with the need for precision.
C. Auditors must limit their exposure to their client to maintain independence.
D. The auditor's relationship with the client is generally adversarial, so the auditor
will not have access to all of the financial information of the company.
B
3/6/2024 1004
78) Which of the following statements best describes a relationship between sample size and
other elements of auditing?
A. If materiality increases, so will the sample size.
B. If the desired level of assurance increases, sample sizes can be smaller.
C. If materiality decreases, sample size will need to increase.
D. There is no relationship between sample size and materiality or the desired level of
assurance.

C
3/6/2024 1005
• 79) Audit sampling is the application of an audit procedure:
A. using statistical methods to evaluate the propriety of the account balance or
class of transactions.
B. to less than 100 per cent of the items within an account balance or class of
transactions for the purpose of evaluating some characteristics of the balance or
class.
C. applied to items selected randomly.
D. on a test basis. B

3/6/2024 1006
80) In systematic selection, the number of sampling units in the
population is divided by the sample size to determine the

A. Sampling interval
B. Pattern that may exist in the population
C. Sampling risk
A
D. Nonsampling risk
3/6/2024 1007
81) Auditors who prefer statistical to nonstatistical sampling believe that the

principal advantage of statistical sampling flows from its unique ability to:

a. define the precision required to provide audit satisfaction

b. mathematically measure uncertainty

c. establish conclusive audit evidence with decreased audit effort

d. promote a more legally defensible procedural approach

B

3/6/2024 1008
82) One of the ways to eliminate non sampling risk is through:

• a. proper supervision and instruction of the client’s employees.

• b. proper supervision and instruction of the audit team.

• c. the use of attributes sampling rather than variables sampling.

• d. controls which ensure that the sample drawn is random and

representative
B
83) Which of the following combinations Assurance a larger sample size?

A. Decrease the desired confidence level and decrease the tolerable deviation rate.
B. Increase the desired confidence level and decrease the tolerable deviation rate.
C. Decrease the desired confidence level and increase the expected deviation rate.
D. Increase the tolerable deviation rate and increase the expected deviation rate.

B
3/6/2024 1010
84) Which of the following best illustrates the concept of sampling risk?
A. An auditor may fail to recognize errors in the documents examined for the
chosen sample.
B. The documents related to the chosen sample may not be available for
inspection.
C. An auditor may select audit procedures that are not appropriate to achieve the
specific objective.
D. A randomly chosen sample may not be representative of the population as a
whole D
3/6/2024 1011
85) The following are advantages of using statistical sampling, except

A. Statistical sampling provides a means for mathematically measuring the degree

of risk that results from examining only part of a population.
B. Statistical sampling allows the auditor to greatly reduce substantive testing.
C. Statistical sampling allows the auditor to measure the sufficiency of the
evidential matter obtained.
D. Statistical sampling aids in the design of an efficient sample. B
3/6/2024 1012
86) The following are examples of nonsampling risk, except

A. Failure to recognize an error.

B. Obtaining an unrepresentative sample.
C. Use of an audit procedure inappropriate to achieve a given objective.
D. Failing to evaluate results properly.
B
3/6/2024 1013
87) The auditor wants to examine 100 sales invoices from a population of
5,000 sales invoices that starts from sales invoice No. 1.The auditor uses
systematic sampling method. Assume Sales invoice No. 40 is the first sales
invoice that is chosen randomly. The 3rd sales invoice that is included in
the auditors sample is:

• a. Sales invoice No. 140 Kth = N/n

= 5000/100
= 50
• b. Sales invoice No. 150
First sample No. 40
Second sample No. 40+50= 90
• c. Sales invoice No. 120 Third sample No. 90+50= 140
A
• d. Sales invoice No. 130
 Chapter Two
Audit of Cash and Bank Balances
CASH
❖ Cash consists of coins, currency, checks, money orders, money on hand
and deposit in bank.
❖ Cash is a type of asset that is readily convertible to any other type of
asset; it is easily concealed, transported and is therefore highly desired.
❖ Because of these characteristic, cash is the most susceptible asset to
improper use.
❖ Moreover, because of the large volume of transactions, a number of
errors may occur in executing and recording cash transactions.
• Therefore, the internal control over cash should be designed considering the special
nature of cash.

✓ The cash balance of a business organization is affected by both collections and

payments.

✓ To maintain a good cash handling practices, business organizations have to

develop an efficient and effective internal control over cash.
•The following are general guideline for good cash handling practices in all types
of business
Handling cash transaction from beginning to end should have to delegate to
different employees.

Cash handling and recording should have to be separated.

Cash receipts should be recorded immediately.

Costumers should be encouraged to obtain receipts and observe cash register

totals.

Any payment should have to be by check, except small payments which have to
be paid from petty cash fund.

Bank reconciliation statement should have to prepare by employees who not

responsible for check issuance and custody of cash.
 Types of cash accounts
• Before dealing with audit tests of the client’s cash and
bank balance, it is helpful to discuss the types of cash
accounts commonly used by most companies, because
the auditing approach to each varies.

• Auditors are likely to learn about the various types of

cash balances when they obtain an understanding of
the client’s business.
Types of cash accounts

• The following types of bank accounts are typically

used:
1) General cash account
2) Imprest cash accounts
3) Imprest petty cash account and
4) Branch accounts
 Assess Inherent risks
Inherent risk analysis questionnaire: cash

• Does company have significant cash flow problems in meeting its current obligations on a timely
basis?

• Does company use cash budgeting techniques effectively?

• Does company use cash management services offered by its banker? What is their nature?

• Has company made significant changes in its cash processing in the past year?

• Does company have loan or bond covenants that influence use of cash or maintenance of working-
capital ratios?

• Is there any reason to suspect that management may desire to misstate the cash balance?
 Assess Control Risk
Control risk questionnaire: cash

• Have service arrangements been reviewed on a current basis?

• Do management and board periodically review the process?

• Are cash transactions properly authorized?

• Are bank reconciliations performed on a timely basis?

• Does internal audit department conduct timely reviews of the process?

• Is the lockbox used to collect cash receipts?

• Who is authorized to make cash transfers?

• What procedure is used to assure monitoring of authorization process?

• Are there any restrictions in getting access to cash?

Substantive procedures of cash receipts and
payments transactions
Audit Objectives Substantive Procedures
1. Occurrence / Existence ⚫ Select samples of cash receipts from cash book and trace to remittance advices,
pay-in slips, and bank statement.
⚫ Select samples of cash payments from cash book and trace to payment
vouchers (with supporting documents) and bank statements.
⚫ Scan through the entries and trace all the unusual items, like contra items,
stopped payment items and cancelled cheques, to support documents and
authorization.

2. Completeness ⚫ Trace a sample of remittance advices and pay-in slip to cash receipt journal.
⚫ Trace a sample of payment vouchers (with supporting documents) to cash
book.

3. Accuracy ⚫ Agree the total of cash receipts and payments to general ledger.

4. Valuation ⚫ Compare a sample of remittance advices with amount in cash receipts recorded
in the cash book.
⚫ Compare a sample of (cancelled) cheques with amounts in cash recorded in the
cash book.
5. Cut-off ⚫ Compare the dates for recording a sample of cash transactions with the dates
of cash deposited in bank or cheques sent.

6. Classification ⚫ Examine a sample of cash receipts and payments transactions for proper
classification.
Test of details of cash balances
Audit Objectives Substantive Procedures
1. Occurrence, ⚫ Agree balance on bank confirmation with bank reconciliation and
completeness and cash book.
valuation ⚫ Trade deposits in transits, outstanding cheques and other
reconciling items to cut-off bank statements.

2. Accuracy ⚫ Check calculation of bank reconciliation and agree with book

balance on cash book and general ledger.

3. Cut-off ⚫ For cash receipts, observe cash count for the last day of the year
end and trace deposits to cash receipts journal and cut-off banks
statement.
⚫ For cash disbursement, record the last cheque issued at the year
end date and trace to cash payments in the cash book; and trace
outstanding cheques on bank reconciliation and investigate any
cheque clearing after a long delay.
4. Classification, ⚫ Review board of directors’ minutes, bank letter, loan agreement
presentation and or other documents for any restrictions on cash.
disclosure ⚫ Ensure bank loans and overdrafts are not offset against positive
bank balances in the financial statements.
 Fraud-Related Audit Procedures

• When the auditor assesses the client’s control over cash

is weak and suspects that some type of fraud or
defalcation involving cash has occurred,

• the following audit procedures are typically used to

detect fraudulent activities in the cash accounts:

a) Proof of cash

b) Testing for kiting

c) Testing for lapping

CHAPTER THREE

AUDIT OF THE
SALES AND
COLLECTION
CYCLE
OBJECTIVES
 Describe the business
Identify the accounts and
functions and the related

After
the classes of transactions
documents and records in
in the sales and collection
the sales and collection
cycle
cycle

studying Understand internal control

and design and perform
Apply the methodology for
controls over sales

this
tests of controls and transactions to controls
substantive tests of over sales returns and
transactions for sales allowances

chapter, Understand internal control

and design and perform
tests of controls and
Apply the methodology for
controls over the sales and

you should
collection cycle to write-
substantive tests of
offs of uncollectible
transactions for cash
accounts receivable
receipts

be able to Develop an integrated audit

plan for the sales and
collection cycle
 An audit involving extensive reliance on
internal controls in the sales and collection
cycle requires the auditor to expand tests of
controls and substantive tests of transactions.
Whether for public or private companies,
Introduction auditors must understand when to rely on
internal controls and when not to.
This chapter delves into assessing control risk,
designing tests of controls, and substantive
tests of transactions for each class of
transactions in the sales and collection cycle.
 Sales

Cash in bank
Accounts in Accounts receivable
the Sales and Cash discount taken
Collection
Allowance for uncollectible accounts
Cycle
Sales returns and allowances

Bad debt expense

 Sales
Transactions
in the Sales Cash receipts

and Sales returns and allowances

Collection Charge-off of uncollectible accounts
Cycle Estimate of bad debt expense
Business Functions in Sales and Collection Cycle
The sales and collection cycle encompasses the crucial
decisions and processes involved in transferring the
ownership of goods and services to customers. It begins
with a customer's request and end in the conversion of
materials or services into an accounts receivable, and
ultimately into cash.

This section explores the eight business functions

associated with the sales and collection cycle, along with
the typical documents and records for each function.
 1) Customer Order
Processing
Processing customer orders is the
foundational step in the cycle, initiated by a
customer's request for goods. This request,
which can be submitted through various
channels, acts as an offer to purchase goods
under specified terms. Upon receiving the
customer order, a sales order is promptly
created, marking the beginning of the order
fulfillment process.
 2) Credit Approval Process

Credit Approval Authorization Protocol

Prior to processing sales orders, the Ensuring that a properly authorized

credit department plays a pivotal role in individual approves credit for sales on
evaluating the eligibility of customers for account is a critical aspect of the
open account transactions. This involves credit approval process. This step
assessing the creditworthiness and mitigates risks and maintains financial
determining whether goods can be discipline within the organization.
shipped based on the approved credit.
 3) Goods Shipment Handling
2 Customer Notification
1 Shipment Initiation
The shipping process marks the pivotal
The original shipping document is
point where company assets are
dispatched to the customer, while
released. Companies often recognize
copies are retained for internal
sales when goods are shipped. The
records. It additionally serves as a
shipping document is rigorously
trigger to invoice the customer,
prepared to establish the shipment of
ensuring seamless transactional
goods, detailing the merchandise
operations.
description, quantity, and other pertinent
data.
 4) Billing Customers
and Recording Sales
Billing customers and recording sales is a crucial
aspect of the accounting process. It involves the
accurate and timely preparation of sales invoices,
updating of various files, and sending out
statements to customers. The activities involved in
this process have a significant impact on the
financial status of the business. A thorough
understanding of the various components
involved in billing and recording sales is essential
for accounting professionals.
Importance of Sales Invoices

1 Description and Quantity

A sales invoice provides a detailed description of the goods sold, including the
quantity, pricing, and any additional charges such as freight and insurance. It
serves as an official record of the transaction and is crucial for ensuring clarity
between the seller and the customer.

2 Payment Details
The invoice also includes payment terms and the due date, providing the
customer with essential information regarding the amount owed and when it is
expected to be paid. This helps in maintaining transparent and professional
relationships with customers.

3 Customer Communication
As the original sales invoice is sent to the customer, it serves as a formal means of
communication regarding the sale, ensuring that both parties have a clear
understanding of the transaction details.
Sales Transaction File and Journal
Sales Transaction File Sales Journal

The sales transaction file contains This report extracted from the sales
comprehensive records of all sales transaction file offers detailed information
transactions processed within a specific such as customer names, transaction dates,
period. It serves as a data repository for amounts, and classifications. It provides a
generating various reports and analyses, concise overview of sales activities for
providing valuable insights into sales assessment and decision-making purposes.
performance and trends.
Customer Accounts and General
Ledger
Accounts Receivable General Ledger Entries
Every individual customer account The general ledger master file
within the accounts receivable master captures all sales and accounts
file represents a unique financial receivable transactions, providing a
relationship, with detailed records of comprehensive overview of financial
transactions, payments, and activities and enabling accurate
outstanding balances. financial reporting and analysis.
5) Processing and
Recording Cash Receipts
The process of processing and recording cash receipts involves
several crucial steps that ensure the proper handling and
accounting of cash transactions. It encompasses receiving,
depositing, and recording cash, which includes currency and
checks. The most important consideration is the prevention of
theft, which can occur at various stages. The handling of cash
receipts requires more attention to detail, timely deposits, and
accurate record-keeping. One important document in this process
is the remittance advice, which provides essential information
when cash payments are received.
Remittance Advice
1 Key Information 2 Importance of Remittance
The remittance advice is a document
Advice
sent with the sales invoice, outlining By providing essential details, the
crucial details that assist in the remittance advice ensures that the
proper allocation of the received payment received is appropriately
payment. It includes the customer's matched with the corresponding
name, sales invoice number, and the sales invoice, minimizing errors and
amount of the invoice, facilitating streamlining the reconciliation
accurate tracking of payments. process.
Cash Receipts Journal or Listing
Comprehensive Reporting
The cash receipts journal compiles all transactions from the cash receipts
transaction file, providing a detailed listing of cash inflows over a specific
timeframe.

Integration with Master Files

Information from the cash receipts journal is synchronized with the accounts
receivable master file and general ledger, ensuring accurate and up-to-date
financial records.
6) Processing and
Recording Sales
Returns and
Allowances
Handling sales returns and allowances is a crucial aspect
of accounting for companies. It involves processing
customer dissatisfaction, preparing receiving reports,
and promptly recording the transactions to maintain
control and facilitate record-keeping.
Credit Memos: A Vital Tool
1 Definition and Purpose
A credit memo indicates a reduction in the amount due from a customer due to returned
goods or an allowance granted, providing an essential tool for managing accounts
receivable.

2 Format and Content

While resembling a sales invoice, a credit memo supports the reduction in accounts
receivable instead of increases, maintaining clarity in financial records.
Sales Returns and Allowances Journal
1 Journal Characteristics 2 Functionality

Similar to the sales journal, It aids in organizing and documenting

the sales returns and sales returns and allowances, providing
allowances journal records a comprehensive record of these
transactions related to sales crucial transactions.
returns and allowances.
Recording Returns and Allowances
Importance of Accuracy
Credit Memo Issuance
It's crucial to ensure that returns and
Issuing credit memos for returns and
allowances are accurately and promptly
allowances is a fundamental practice
recorded in both the sales returns and
that aids in maintaining financial control
allowances transaction file and the
and transparency.
accounts receivable master file.
 Receiving Reports for Returns
Preparation Process Storage and Control Reflecting in Master
Files

Deep knowledge of the return Properly organizing and

Timely updating of the accounts
process and attention to detail documenting received
receivable master file with the
enable the accurate goods ensures efficient
information from receiving reports
preparation of receiving inventory management
is essential for maintaining
reports for returned goods. and financial tracking.
accurate financial records.
Separate Recording in Sales
Journal
Comprehensive
Efficient Data 2
1 Transaction Tracking
Management

Many companies choose to record The sales journal effectively

sales returns and allowances in the captures sales returns and
sales journal to consolidate all sales- allowances, providing a complete
related transactions for easier record of sales activities and
analysis. associated adjustments.
7) Accounting for
Uncollectible
Accounts Receivable
Charging off uncollectible accounts receivable is
crucial for proper accounting. When customers fail to
pay their bills and a conclusion is reached that the
amount is no longer collectible, it must be charged off.
This often occurs after bankruptcy or the account
being handed over to a collection agency. An
Uncollectible Account Authorization Form is used to
indicate the authority to write an account receivable
off as uncollectible.
Reasons for Charging Off
Uncollectible Accounts
1 Lack of Payment
Some customers do not pay their bills, leading to uncollectible accounts.

2 Bankruptcy Filings
Charging off occurs when a customer files for bankruptcy, making the amount uncollectible.

3 Collection Agency Involvement

Accounts are written off when they are turned over to a collection agency.
8) Provision for Bad Debts
1 Sufficient Provision 2 Residual Provision

The provision for bad debts It represents a residual

must be adequate to cover from management’s end-
the current period sales of-period adjustment of
that the company will be the allowances for
unable to collect. uncollectible accounts.
Managing Uncollectible Accounts
Regular Assessment Reserve for Uncollectible
Accounts
Regularly assess the
Establish and maintain proper
collectibility of accounts to reserves for uncollectible
determine if they should be accounts based on past data
and expected trends.
charged off.
Impact of Bad Debts on Financial
Statements
Income Statement

Recognition of bad debts as an expense reduces the net income on the income statement.

Balance Sheet

Uncollected debts are deducted from the accounts receivable balance, affecting the overall assets.
Communication
Initiate contact with the debtor to negotiate payment terms and resolve the
outstanding debt.

Legal Action
If necessary, consider legal action to recover the debt, involving lawyers or
debt collection agencies.

Write-Off
Eventually, write off the debt if all efforts to recover it prove futile.
Reviewing and Auditing of Bad Debts
Internal Audit Independent Review

Conduct regular internal audits to Engage external auditors for an

ensure the accuracy of the provision independent review of the bad debt
for bad debts and the classification provision and the compliance with
of uncollectible accounts. accounting standards.
Methodology
for Designing
Tests of
Controls and
Substantive
Tests of
Transactions
for Sales
Understanding Internal
Control for Sales
In testing internal controls and substantive tests of
transactions for sales, auditors should obtain a
comprehensive understanding of the internal control
for sales and design a methodology to test it. A
typical approach for sales involves studying the
client’s flowcharts, preparing an internal control
questionnaire, and performing walkthrough tests of
sales.
Assessing Planned Control Risk for Sales
1 Framework for Assessing Control Risk
The auditor requires a framework for assessing control risk, which for all classes of transactions is
transactions is based on the six transaction-related audit objectives.

2 Identifying Key Internal Controls and Deficiencies

The auditor must identify the key internal controls and deficiencies specific to the sales audit.
sales audit. These controls and deficiencies will vary for each audit.

3 Assessing Control Risk for Each Objective

The auditor assesses control risk for each objective by evaluating the controls and deficiencies
deficiencies associated with it. This critical step affects the decisions about tests of controls and
controls and substantive tests.
 Key Control Activities for Sales
2 Proper Authorization 3 Adequate
Adequate
1 Documents and
Separation of Duties
Credit, goods shipment, and prices Records
Proper separation of to prevent prices must be properly authorized Proper record-keeping must exist for most
prevent various types of authorized before a sales takes place.
for most transaction-related audit
place. This helps in maintaining
misstatements, both integrity and accuracy in the sales objectives to be met. For example,
intentional and unintentional, sales process. companies should prepare prenumbered
unintentional, is critical for 4 Monthly statement prenumbered sales invoices at the time a
sales. For example, anyone Sending monthly statements automatically or time a customer order is received and use
responsible for inputting sales automatically or by someone not involved in and use these documents for various
sales and cash receipt involved in handling cash or preparing sales various essential processes.
transaction information into sales and accounts receivable records is
into the computer should be to beneficial. This practice encourages customer
be to cash. customer responses if the balance is
Design Test of Controls for
Sales
Designing tests of controls is a critical step in the audit
the audit process, ensuring that key controls are
effective and that sales transactions are properly
properly recorded, complete, and accurate. The
process involves detail examination of documents,
documents, observation of activities, and discussions
discussions with personnel to verify the integrity of the
integrity of the sales system.
Existence Objective: Ensuring Recorded
Recorded Sales Are Genuine

Key Existing Control Test Control

Credit approved by computer Examine customer order for

for approval

Support by documents Examine sales invoice for

supporting documents

Batch totals comparison Examine file of batch totals for

initials

Monthly statements sent Observe statement dispatch

Completeness Objective: Accounting for All
Sales

Shipping Documents Batch Totals Sales Journal

Compare quantities shipped Trace shipping documents to
Account for a sequence of with billed, looking for sales journal entries for
shipping documents, ensuring discrepancies. inclusion.
completeness of records.
Accuracy Objective: Precise Billing and
Recording

1 Document Support 2 Price Verification 3 Monthly Statements

Examine sales invoices for Check unit selling prices Observe the process of
proper documentation against the approved price sending monthly
and billing accuracy. list for accuracy. statements to customers.
Classification Objective: Proper Sales
Categorization

Internal Verification Account Classifications

Examine document package for evidence of internal

verification and correct classification. Review duplicate sales invoices to ensure
transactions are classified appropriately.
Timing Objective: Recording Sales at the
Right Time

1 Shipping Documents
Account for the sequence of prenumbered shipping documents.

2 Date Comparison
Compare recording dates in sales journal with shipping documents for timeliness.

3 Deficiency Identification
Highlight any lack of control in testing for timely recording.
Posting and Summarization Objective:
Accuracy in Accounts

1 2 3
Reconciliation Monthly Statements Master File
Check reconciliation of accounts Trace sales invoices to the master
receivable master file to the Verify the regular dispatch of file for accuracy in amount, date,
general ledger. monthly statements to and invoice number.
customers.
Observation and Discussion: Verifying
Separation of Duties

Activities Observation
Observe whether the billing clerk has access to cash during critical processes.

Personnel Discussion
Engage in discussions with personnel to understand their responsibilities and any deviations from
normal policy.

Substitute Duties
Investigate circumstances where employees take over duties outside their regular responsibilities,
such as during vacations.
 Substantive Tests of
Transactions for Sales
Understanding the substantive tests of transactions
for sales is crucial in the auditing process.
These tests are designed to uncover any monetary
misstatements within sales transactions and are
influenced by the company's internal controls and
related audit objectives.
The procedures vary depending on the
circumstances and often require careful auditor
judgment, especially when internal controls are
deemed inadequate.
Recorded Sales Existence
No Shipment
Auditors trace sales journal entries to shipping documents to confirm existence and
existence and prevent fictitious records.

Duplicate Recording
Reviewing sales transactions for duplicate numbers and ensuring proper
cancellation of shipping documents.

Nonexistent Customers
Tracing accounts receivable credits to source, looking for cash collection or goods
return as evidence of valid sales.
Completeness of Recorded Sales
1 Unbilled Shipments
Tracing from shipping documents to sales invoices and the sales journal to test for
omitted transactions.

2 Direction of Tests
Understanding the importance of tracing direction, from source documents to
journals for completeness.
Accuracy of Sales Recording
Shipping Amount Billing Amount Recorded Amount

Verify goods ordered Check against price list Compare with sales journal

Proper Classification of Sales

Cash vs. Credit Sales Asset Sales
Ensuring cash sales are not debited to accounts
Verifying that sales of assets like buildings are not misclassified as
receivable and credit sales are recorded correctly.
regular sales transactions.

Correct Dating of Sales

Timeliness Date Comparison
Recording sales soon after shipment to ensure Comparing dates on shipping documents with
accuracy and prevent omissions. sales invoices and journals for proper period
recording.
Master File Inclusion and Summarization

1 2
Accuracy Summarization
Checking the accounts receivable master file for Ensuring sales journals are correctly totaled and
correct transaction inclusion. posted to the general ledger.
Designing Audit Procedures
Existence Objective
Designing procedures to test for the existence of recorded sales, starting with the journal.

Completeness Objective
Creating tests for completeness, starting with shipping documents to ensure no omissions.

Accuracy Objective
Comparing recorded transactions with supporting documents for accurate billing and
recording.
 Sales Returns and Allowance
Year-End
Materiality Objectives Emphasis
Completeness

Sales returns and The primary focus is on At year-end, the

allowances may be testing the existence of completeness objective is
immaterial and can recorded transactions to critical as unrecorded sales

sometimes be ignored in prevent any potential returns and allowances

an audit, depending on diversion of cash or can materially overstate

net income.
their significance to the fictitious sales returns.
overall financial
statements.
Uncollectible Accounts and Write-
Offs
1 Existence Verification
Verifying the existence of recorded write-offs is essential to prevent covering up
defalcations by charging off collected receivables.

2 Control Measures
Proper authorization and thorough investigation are key controls for the write-off
of uncollectible accounts.

3 Documentation Review
Examining approvals and correspondence is a typical procedure to substantiate the
uncollectibility of accounts.
Confirmation of Accounts Receivable

1 2
Objective Control Risk
Confirming accounts receivable addresses Results from tests of controls inform the level
the existence and realizable value of of control risk and the nature of
receivables. confirmations needed.
CHAPTER
Four

AUDIT OF THE
PAYROLL AND
PERSONNEL
CYCLE
 Objectives
• Identify the accounts and transactions in the payroll
and personnel cycle
• Describe the business functions and the related
documents and records in the payroll and personnel
cycle
• Understand internal control and design and perform
tests of controls and substantive tests of
transactions for the payroll and personnel cycle
• Design and perform analytical procedures for the
payroll and personnel cycle
• Design and perform tests of details of balances for
accounts in the payroll and personnel cycle
 Introduction
• The payroll and personnel cycle involves the employment and payment
of all employees.

• Labor is an important consideration in the valuation of inventory in

manufacturing, construction, and other industries. Improper valuation and
allocation of labor can result in a material misstatement of net income.
Payroll is also an area in which large amounts of company resources can
be wasted because of inefficiency or stolen through fraud.

• The audit of the payroll and personnel cycle includes obtaining an

understanding of internal control, assessment of control risk, tests of
controls and substantive tests of transactions, analytical procedures, and
tests of details of balances.
 PAYROLL AND PERSONNEL
CYCLE DIFFER FROM
OTHER CYCLE
• There is only one class of transactions for payroll
• Transactions are far more significant than related
balance sheet accounts
• Internal controls over payroll are effective for
almost all companies, even small ones
Accounts and Transactions in the Cycle
Accounts Transactions

Cash in bank Payroll

Accrued wages and salaries Personnel and employment

Direct labor Timekeeping and payroll preparation

Accrued payroll tax expense Payment of payroll

Withheld income taxes Preparation of payroll tax returns

Payroll tax expense Payment of taxes

Business Functions in the Cycle
and Related Document AND
Records
• The payroll and personnel cycle begins with the hiring of
personnel and ends with payment to the employees for the
services performed and to the government and other
institutions for the withheld and accrued payroll taxes and
benefits

• In between, the cycle involves obtaining services from the

employees consistent with the objectives of the company and
accounting for the services in a proper manner.

• There are Four major business function in payroll and

personnel cycle
1) Personnel and Employment
The human resources department provides an independent source for
interviewing and hiring qualified personnel. The department is also an
independent source of records for the internal verification of wage information,
including additions and deletions from the payroll and changes in wages and
deductions.

• Personnel records: are records that include such data as the

date of employment, personnel investigations, rates of pay,
authorized deductions, performance evaluations and
terminations of employment
• Deduction authorization form: A form authorizing payroll
deductions, including the number of exemptions for withholding
income taxes and other retirement saving plans
• Rate Authorization form: A form authorization the rate of pay
 2) Timekeeping and payroll
preparation
• Time card: A time card is a document indicating the time the
employee started and stopped working each day and the number of
hours the employee worked
• Job Time Ticket: A document indicating jobs on which an employee
worked during a given time period
• Payroll Transaction File: A computer-generated file that includes
all payroll transactions processed by the accounting system for a
period, such as a day, week, or month
• Payroll journal or listing: A report generated from the payroll
transaction file that typically includes the employee’s name, date,
gross and net payroll amounts, withholding amounts, and account
classification or classifications for each transaction
• Payroll master file: A payroll master file is used for recording each
payroll transaction for each employee and maintaining total
employee wages paid for the year to date
 3) Payment
of payroll
• Payroll check: A check
written to the employee for
services performed
• Payroll Bank Account
Reconciliation: An important
control is the independent
reconciliation of the imprest
payroll bank account
 4) Preparation of
payroll tax returns
and payment of tax

• W-2 form: A form issued for each

employee summarizing the
earning record for the calendar
year
• Payroll Tax Returns: Tax forms
submitted to local, state, and
federal units of government for
the payment of withheld taxes and
the employer’s tax
 Methodology for Designing Tests of
Controls and Substantive Tests of
Transactions
• Now that you are familiar with the business functions and related
document and records in the payroll and personnel cycle, we can
discuss the assessment of control risk and the design of tests of
control and substantive tests of transactions for the cycle

• These tests are emphasized because of the lack of

independent third-party evidence, such as confirmation, for
verifying accrued wages, withheld income taxes, accrued
payroll taxes, and other balance sheet accounts
Methodology for Designing Tests
1 Understand Control
Assess the effectiveness of internal control within the payroll cycle.

2 Design Tests
Create tests of controls and substantive tests for transactions.

3 Perform Tests
Execute designed tests to verify the accuracy of payroll transactions.
 Understand internal control-
payroll and personnel cycle
• Internal controls vary from company to company; therefore, the auditor
must identify the controls, significant deficiencies, and material
weaknesses for each organization
• Understanding Controls the auditor intends to use for assessed control
risk and the risk must be tested with tests of controls
• If the client is a public and private company, the level of understanding
controls and extent of tests of controls must be sufficient to issue an
opinion on the effectiveness of internal control over financial reporting
• Even though the tests of controls and substantive tests of transactions are the most
important parts of testing payroll. In many audits, there is a minimal risk of material
misstatements, even though payroll is often a significant part of total expenses.
• There are three reasons for this: Employees are likely to complain to management
if they are underpaid, all payroll transactions are typically uniform and uncomplicated,
and payroll transactions are subject to audit by federal and state government for
income tax withholding, social security, and unemployment taxes.
 Understand internal control-payroll
and personnel cycle
• Adequate separation of duties: separation of duties is important in the
payroll and personnel cycle, especially to prevent overpayments and
payments to nonexistent employees

• Proper Authorization: As noted earlier, the human resources department

should be responsible for the authorization of additions and deletions of
employees from the payroll

• Adequate Documents and Records: The appropriate documents and

records will depend on the nature of the payroll system

• Physical Control over Assets and Records: Access to unsigned payroll

checks should be restricted

• Independent checks on performance: payroll computation should be

independently verified, including a comparison of batch totals to summary
reports
 Payroll tax forms and
payments
• Preparation of Payroll Tax Forms: As a part of understanding
internal control, the auditor should review the preparation of at
least one of each type of payroll tax form that the client is
responsible for filing

• Payment of the Payroll Taxes Withheld and Other Withholdings

on a timely Basis: It is desirable to test whether the client has
fulfilled its legal obligation in submitting payment for all payroll
withholding as a part of the payroll tests even though the payment
are usually made from general cash disbursements
 Inventory and fraudulent
payroll considerations

• Relation between Payroll and Inventory Valuation: In

audits in which payroll is a significant portion of inventory,
a common occurrence for manufacturing and construction
companies, the improper account classification of payroll
can significantly affect asset valuation for accounts such
as work in process, finished goods, or construction in
process

• Tests for Nonexistent Payroll: Because auditors have

significant responsibility for the detection of fraud, they
must extend audit procedures when they become
concerned about the possibility of material fraud
 Methodology for Designing
Tests of Details of Balances
• 1. Identify client business risks affecting payroll

• Significant client business risk affecting payroll are unlikely for most companies.
However, client business risk may exist for complex compensation arrangements,
including bonus and stock option plans and other deferred compensation
arrangements. For example, many technology companies provide extensive stock
options as part of their compensation packages for key employees that significantly
impact compensation expense and shareholder’s equity.

• 2. Set Tolerable misstatement and assess inherent risk

• Except for the potential for fraud, inherent risk is typically low for all balance-
related audit objectives. There is an inherent risk of payroll fraud because most
transactions involve cash. The existence objective is therefore often considered to
be important. Also, for manufacturing companies with significant labor charged to
inventory, there is potential for misclassification between payroll expense and
inventory or among categories of inventory.
 Methodology for Designing Tests of
Details of Balances
• 3. Assess control risk and perform related tests : Assessing controls risk and the related tests of
controls and substantive tests of transactions.

• 4. Perform analytical procedures : The use of analytical procedures is as important in the payroll
and personnel cycle as it is in every other cycle.

• 5. Design & perform tests of details of balances for liability & expense accounts

• The verification of the liability accounts associated with payroll, often termed accrued payroll
expenses, is ordinarily straightforward if internal controls are operating effectively. When the auditor
is satisfied that payroll transactions are being properly recorded in the payroll journal and the related
payroll tax forms are being accurately prepared and promptly paid, the tests of details of balances
should not be time-consuming.

• The two major balance-related audit objectives in testing payroll liabilities are (1) accruals in the
trial balance are stated at the correct amounts (accuracy), and (2) transactions in the payroll and
personnel cycle are recorded in the proper period (cutoff). The primary concern in both objectives is
to make sure that there are no understated or omitted accruals.
CHAPTER
FIVE

Audit of
acquisition and
payment cycle
 Objectives
1 Identify Accounts 2 Business Functions
Recognize the various accounts Understand the business functions,
and transaction classes within the documents, and records related to the
acquisition and payment cycle. cycle.

3 Internal Control 4 Methodology

Comprehend and evaluate internal Learn the methodology for designing

control to design and perform tests of tests of details of balances for
controls and substantive tests of accounts payable using the audit risk
transactions. model.
 Classes of Transactions
Acquisition of Purchase
Purchase returns
Returns and and
Acquisition
goods andof Goods and Cash Disbursements
Cash disbursements
Services
allowances
Allowances
services

Includes all Encompasses all Transactions that

transactions related to transactions where involve the return of

the procurement of cash is paid out, goods or issuance of

necessary items for particularly for allowances post-

business operations. acquired goods and purchase.

services.
Accounts Affect on the ACQUISITION AND PAYMENT CYCLE
 Business Functions in the
Cycle and Related Documents
The acquisition and payment cycle involves the decisions and processes
necessary for obtaining the goods and services for operating a business

The cycle typically begins with the initiation of a purchase requisition by

an authorized employee who needs the goods or services, and it ends
with payments for the benefit received

Observe that the first three business functions are for recording the
acquisition of goods and services on account, and the last process is for
recording the cash disbursements for payments to vendors
1. Processing Purchase Order

Purchase order- is a
Purchase requisition- is a document identifying the
request for goods and description, quantity, and
services by an authorized related information for goods
employee and services the company
intends to purchase
2. Receiving Goods and
Services
The receipt by the company of goods and services from
the vendor is a critical point in the cycle because it is the
point at which companies first recognize the acquisition
and related liability on their records

The receiving report includes a description of the goods,

the quantity received, the date received, and other
relevant data

The receipt of goods and services in the normal course of

business represents the date companies normally
recognize the liability for an acquisition
3) Recognizing the Liability
The proper recognition of the liability for the receipt
of goods and services requires prompt and accurate
recording.
The initial recording has a significant effect on the
recorded financial statements and the actual cash
disbursements; therefore, great care must be taken
to include only existing company acquisitions at the
correct amounts.
Acquisition Transaction File
1 Contents
A computer generated file that includes all acquisition transactions processed by
the accounting system for a period.

2 Information Included
Information for each transaction, such as vendor name, date, amount, account
classification, or classifications, and description and quantity of inventory
purchased.

3 Usage
Used for a variety of records, listing or reports, depending upon the company’s
need.
Vendor's Invoice
Description and Quantity
Specifies such things as the description and quantity of goods and services received, price
(including freight), cash discount terms, and date of the billings.

Importance
It is an essential document because it specifies the amount of money owed to the vendor for
acquisition.

Electronic Transmission
For companies using EDI, the vendor invoice is transmitted electronically rather than in paper
form.
 Voucher
Recording and Controlling
Commonly used by organizations to establish a formal means of recording and controlling acquisitions
Voucher includes a cover sheet or folder for containing documents and a package of relevant documents, such as the
purchase order, copy of the packing slip, receiving report, and vendor’s invoice.
.
Debit Memo
1 Indication of Reduction 2 Similar to Invoice
It often takes the same general form as a vendor’s invoice, but it supports
It is a document indicating a reduction in the
reductions in accounts payable rather than increases.
amount owed to a vendor because of returned
goods or an allowance granted.
Accounts Payable Master File
Vendor's Statement Recording Acquisitions
Beginning balance, acquisitions, returns and Used for recording individual acquisitions, cash disbursements, and acquisition
returns and allowances for each vendor.
allowances, payments to the vendor, and
ending balance.
Compiling Information
It comprises the complete history of transactions with each vendor.
4. Processing and Recording
Cash Disbursements
Check- is the document used to pay for the acquisition when
payment is due

Cash disbursement transaction file- is a computer-generated

file that includes all cash disbursements transactions processed
by the accounting system for a period, such as a day, week, or
month

Cash disbursements journal or listing- is a report generated

from the cash disbursements transaction file that includes all
transactions for any time period
Methodology for Designing Tests of Controls
and Substantive Tests of Transactions

1 2
Understand Internal Control Assess Planned Control Risk

3 4
Extent of Testing of Controls Design Tests of Controls
I. Understand Internal
Control
The auditor gains understanding of internal
control for the acquisition and payment cycle
by studying the client’s flow charts,
preparing internal control questionnaire,
performing walkthrough tests for
acquisitions and cash disbursements
 II. Assess Planned Control Risk

Ø Authorization of purchases-
Ø The separation of custody of
proper authorization for
the received goods from other
acquisition is essential because it
functions- most companies have
ensures that goods and services
the receiving department initiate
acquired are for authorized
a receiving report as evidence of
company purposes and it avoids
the receipt and examination of
the acquisition of excessive or
goods
unnecessary items

Ø The authorization of payments to vendors- the most important controls over

cash disbursements include the signing of checks by an individual with proper
authority, separation of responsibilities for signing the checks and performing the
accounts payable function, and careful examination of the supporting documents
by the check signer at the time the check is signed
III. Determine Extent of
Testing of Controls
After the auditor identifies the key internal
controls and weaknesses and assesses
control risk, it is appropriate to decide
whether substantive tests will be reduced
sufficiently to justify the cost of
performing tests of controls
 IV) Design Tests of Controls
and Substantive Tests of
Transactions for Acquisitions
When conducting audits for acquisitions, it's crucial to
focus on transaction-related audit objectives, key
internal controls, and common tests of controls. This
involves examining the occurrence, completeness,
accuracy, classification, timing, and
posting/summarization of acquisition transactions.
Let's delve into the key internal controls and common
tests of controls for each transaction-related audit
objective in the following sections.
Occurrence of Recorded Acquisitions
Acquisitions
1 Key Internal Control
Existence of purchase requisition, purchase order, receiving report, and vendor’s
vendor’s invoice attached to the voucher/cheque.

2 Common Tests of Control

Examine underlying documents for reasonableness and authenticity.
Completeness of Existing Acquisitions
Acquisitions
1 Key Internal Control
Receiving reports are prenumbered and accounted for.

2 Common Tests of Control

Accounts for a sequence of receiving reports (a block test).
Accuracy of Recorded Acquisitions
1 Key Internal Control
Batch totals are compared with computer summary reports.

2 Common Tests of Control

Examine file of batch totals for initials of data entry clerk; compare totals to
to summary reports.
Classification of Acquisition Transactions
Transactions

1 Key Internal Control

Automatic updates and postings.

2 Common Tests of Control

Enter test transactions or observe entry, and trace to correct file.
Timing of Recorded Acquisition Transactions
Transactions
Common Tests of Control
1 Key Internal Control 2
Observe data entry process.
Transaction date must be system date (today’s
(today’s date) or a reasonable date
Posting and Summarization of Acquisition
Acquisition Transactions
Key Internal Control Common Tests of Control
Comparison of accounts payable master file or Test clerical accuracy by footing the journals and
file or trial balance totals with general ledger tracing postings to general ledger and accounts
ledger balance. payable and inventory master files.
Special Attention to Key Audit Objectives

Existence Completeness
Recorded acquisitions are for goods and services Existing acquisitions are accurately recorded.
received, consistent with the best interests of the recorded.
client.

Accuracy Classification
Acquisitions are properly classified. Acquisitions are correctly classified.
 Design Tests of Controls
and Substantive Tests of
Transactions for Cash
Disbursements

In the audit process, it is vital to design and execute tests of controls

and substantive tests of transactions for cash disbursements.
These tests ensure the accuracy, completeness, and validity of
recorded cash disbursement transactions, providing assurance to
accounting professionals and auditors.
Occurrence of Cash Disbursements
Key Internal Control Common Tests of Control
Approvals of payment on supporting Examine indication of approval.
documents at the time cheques are signed.
Completeness of Cash Disbursements

Prenumbered Cheques Block Test

Ensuring that cheques are prenumbered and Conducting a block test to account for a
accounted for is crucial in verifying the sequence of cheques aids in validating the
completeness of existing cash disbursement completeness of recorded cash disbursement
transactions. transactions.
Accuracy of Cash Disbursements
1 Key Internal Control 2 Common Tests of Control
Monthly preparation of a bank Examine bank reconciliations and observe
reconciliation by an independent person. their preparation.
Classification of Cash Disbursements
Adequate chart of accounts Examine procedures manual and chart of
accounts.
Timing and Posting of Cash Disbursements

1
System Date
Transaction date must align with the system date.

Posting and Summarization Control

Comparing vendor master file or trial balance totals with general ledger balance is essential.
 Methodology for Designing Tests
of Details of Balances of
Accounts Payable
Because all acquisitions and payments cycle transactions typically
follow through accounts payable, this account is critical to any audit of
the acquisition and payment cycle

A. Set tolerable misstatement and assess inherent risk for accounts

payable
B. Assess control risk for accounts payable
C. Design and perform tests of controls and substantive tests of
transactions for the acquisition and payment cycle

D. Design and perform analytical procedures for the acquisition and

payment cycle

E. Design tests of details of accounts payable balance to satisfy balance

related audit objectives
The use of analytical procedures is as important
in the acquisition and payment cycle as it is in
every other cycle, especially for uncovering
misstatements in accounts payable Design and
Perform
Of the most important analytical procedures for
uncovering misstatements of accounts payable Analytical
is comparing current year expense totals with
prior years Procedures
for Accounts
Comparing expenses with prior years is an
effective analytical procedure for accounts
Payable
payable when expenses from year to year are
expected to be relatively stable
Examine Underlying Documentation for Subsequent
Cash Disbursements- The purpose of this audit
procedure is to uncover cash disbursements made in
the subsequent accounting period that represent
liabilities at the balance sheet date

Examine Underlying Documentation for Bills Not Paid

Several Weeks After the Year-End- This procedure is Out-of-Period
Liability Tests
carried out in the same manner as the preceding one
and serves the same purpose

Trace Receiving Reports Issued Before Year-End to

Related Vendor’s Invoice- All merchandise received
before the year-end of the accounting period, indicated
by the issuance of a receiving report, should be
included as accounts payable
Out-of-Period Liability Tests
Trace Vendor’s Statements That Send Confirmations to Vendors with
Show a Balance Due to the Accounts Which the Client Does Business-
Payable Trial Balance- If the client Although the use of confirmations for
maintains a file of vendors’ accounts payable is less common
statements, any statement indicating than for accounts payable, it is
a balance due at the balance sheet sometimes used to test for vendors
date can be traced to the listing to omitted from the accounts payable
make sure that it is included as an list, omitted transactions and
accounts payable misstated account balances

Cutoff Tests- Cutoff tests for accounts payable are intended to determine whether transactions
recorded a few days before and after the balance sheet date are included in the correct period
 Evidence Reliability and Accounts
Payable
Vendors' Statements Confirmations
Vendors' Invoices
While only showing total Considered more reliable than
These documents provide detailed
amounts and lacking
vendors' statements, confirmations
evidence about individual transactions, transaction details, statements
are advantageous for including are requests for itemized statements
including units acquired, price, and
the ending balance according sent directly to the auditor, reducing
freight, making them highly reliable for to the vendor's records.
the risk of client alterations.
verifying transactions.
Verification of Accounts in the
Acquisition Cycle
1 Assets
Assets
Verification of assets like cash, inventory, and property affects various accounts such as
supplies and prepaid expenses.

2 Expenses
Expenses
Expenses like rent, utilities, and insurance are scrutinized to ensure they match revenues
and are not materially misstated.

3 Liabilities
Liabilities
Liabilities such as accounts payable and accrued expenses are evaluated for accuracy
and completeness.
Audit of Property, Plant,
and Equipment
Land, such as acres of property used in the operation of
the business, has the significant characteristic of not being
subject to depreciation

Buildings, machinery, equipment, and land improvements,

such as fences and parking lots, have limited service lives
and are subject to depreciation

Natural resources , such as oil wells, coal mines, and

tracts of timber, are subject to depletion as the natural
resources are extracted or removed
Overview of Equipment
Related Accounts
The accounts commonly used for manufacturing are:
Construction-in-process for property, plant, and equipment

The primary accounting record for manufacturing equipment

and other property, plant, and equipment accounts is
generally a fixed asset master file

The contents of the fixed asset master file must be

understood for a meaningful study of the audit of
manufacturing equipment

The master file is composed of a set of records, one for each

piece of equipment and other types of property owned
There are usually fewer current
period acquisitions of
manufacturing equipment

Contrast with
The amount of any given Audit of
acquisition is often material, and
Current
Assets
The equipment is likely to be kept
and maintained in the accounting
records for several years
 Internal Control over
Manufacturing Equipment
Analytical procedures- As in all audit areas, the nature of Verifying Ending Balance in Accumulated
analytical procedures depends on the nature of the client’s
Depreciation- the debits to accumulated depreciation are
operations
normally tested as part of the audit of disposals of assets,
Verifying Current Year Acquisitions- the proper recording of
whereas the credits are verified as a part of depreciation
current year additions is important because of the long-term effect
expense
the assets have on the financial statements
◦ Accumulated depreciation as stated in the property master file
Verifying Current Year Disposals- transactions involving the
agrees with the general ledger
disposal of manufacturing equipment are often misstated when
◦ Accumulated depreciation in the master file is accurate
company internal controls lack a formal method to inform
management of the sale, trade-in, abandonment, or theft of
recorded machinery and equipment
Internal Control over Manufacturing Equipment
Verifying Ending Balance of Verifying Depreciation
Asset Account- the nature of Expense- the recorded
the internal controls over amounts are determined by
existing assets determines internal allocations rather than
whether it is necessary to verify by exchange transactions with
manufacturing equipment outside parties
acquired in prior years

Determining whether the client

is following a consistent Determine whether the client’s
depreciation policy from period calculations are correct
to period and
Audit of Natural Resources

In the examination of companies

They determine whether
operating properties subject to
depletion has been recorded
depletion , the auditors follow a
consistently and in accordance
pattern similar to that used in
with IFRS, and they test the
evaluating the provision for
mathematical accuracy of the
depreciation expense and
client’s computations
accumulated depreciation
Audit of Intangible Assets
Intangible assets include a variety of assets

All intangible assets are characterized by a lack of

physical substance

Audit expertise in the area is required, or the auditor may

need to engage in an independent expert to value material
intangible assets
Audit of Prepaid
Expenses
Prepaid rent

Organization costs

Prepaid taxes

Patents

Prepaid insurance

Trademarks

Deferred charges

copyrights
 The acquisition and recording of
insurance

Audit of
Prepaid Insurance coverage and
Insurance
Expense
Charge-off of insurance
expense
Audit of Accrued
Liabilities
Examine any contracts or other documents on hand that provide the
basis for the accrual

Appraise the accuracy of the detailed accounting records maintained

for this category of liability

Identify and evaluate the reasonableness of the assumptions made

that underlie the computation of the liability

Test the computations made by the client in setting up the accrual

Determine that accrued liabilities have been treated consistently at

the beginning and end of the period

Consider the need for accrual of other accrued liabilities not presently
considered
Accrued Property Taxes
It is, therefore, feasible for the audit working papers to
include an analysis showing all of the year’s property tax
transactions

Tax payments should be verified by inspection of the

property tax bills issued by local government units and by
reference to the related paid checks

The auditors should verify that property tax bills have

been received on all taxable property or that an estimated
tax has been accrued
Audit of Income and Expense Accounts

The matching of periodic

The consistent application of
income and expense is
accounting principles for
necessary for a proper
different periods is
determination of operating
necessary for comparability
results

Tests of details of account

balancesAnalytical
Tests of controls and procedures should be
Analytical procedures substantive tests of thought of as part of the test
transaction of the fairness of the
presentation of both balance
sheet and income statement
 Tests of Details of Account
Balances- Expense Analysis
The amounts included in certain income statement accounts must
be analyzed even though the previously mentioned tests have
been performed

Expense account analysis is the examination of underlying

documentation of the individual transactions and amounts making
up the detail of the total of an expense account

The underlying documents are of the same nature as those used

for examining transactions as part of tests of acquisition
transactions and include invoices, receiving reports, purchase
orders, and contracts
CHAPTER SIX

AUDIT OF THE
INVENTORY AND
WAREHOUSING
CYCLE
 Describe the business Explain the five parts of Design and Design and perform
functions and the related
documents and records in the audit of the perform audit analytical procedures for
the inventory and
Objectives warehousing cycle inventory and
warehousing cycle
tests of cost
accounting
the accounts in the
inventory and
warehousing cycle

Design and Design and perform audit tests of Explain how the various parts of
perform pricing and compilation for the audit of the inventory and
physical inventory warehousing cycle are integrated
observation
audit tests for
inventory
 Introduction
Inventory is often the largest account on the
balance sheet.
Inventory is often in different locations, making
physical control and counting difficult.
Diverse inventory items such as jewels, chemicals,
and electronic parts are often difficult for auditors
to observe and value.
Inventory valuation is also difficult when
estimation of inventory obsolescence is necessary
and when manufacturing costs must be allocated
to inventory.
 Introduction
The inventory and warehousing cycle is unique because of its
close relationships to other transaction cycles.

For a manufacturing company, raw material enters the

inventory and warehousing cycle from the acquisition and
payment cycle, while direct labor enters it from the payroll and
personnel cycle.

The inventory and warehousing cycle ends with the sale of

goods in the sales and collection cycle.

The audit of inventory, especially tests of the year-end

inventory balance, is often the most complex and time
consuming part of the audit.
 Business Functions in the
Cycle and Related Documents
and Records
Process Purchase Orders: the inventory and
warehousing cycle begins with the acquisition of raw
materials for production

Receive Raw Materials: receipt of the ordered

materials is also part of the acquisition and payment
cycle

Store Raw Materials: when materials are received, they

are stored in the stockroom until needed for production
Business Functions in the Cycle and Related
Documents and Records

Process the Goods: the processing portion of

the inventory and warehousing cycle varies
greatly from company to company
Store Finished Goods: as finished goods are
completed by the production department, they
are placed in the stockroom to await shipment
Ship Finished Goods: shipping of completed
goods is an integral part of the sales and
collection cycle

Review inventory quality & condition: the

auditor should also be alert during the course of
their inventory observation for inventory of
questionable quality for condition
Parts of the Audit of
Inventory
❑Ensuring the correct statement of acquisitions of raw materials and
manufacturing costs is a primary focus during the audit process.
❑ The overall objective in the audit of the inventory and warehousing cycle
is to provide assurance that the financial statements fairly account for raw
materials, work in-process, finished goods inventory, and cost of goods sold.
❑The audit of the inventory and warehousing cycle can be divided into five
activities within the cycle:
1. Acquire and record raw materials, labor, and overhead
2. Internally transfer assets and costs
3. Ship goods and record revenue and costs
4. Physically observe inventory
5. Price and compile inventory
Acquire and Record Raw Materials and
Overhead

1 Process Purchase Orders

Understanding the internal control over the process of purchase orders is essential. This includes
testing as part of performing tests of controls and substantive tests of transactions.

2 Receive Raw Materials

Testing the acquisition and payment cycle to ensure that the received raw materials are correctly
are correctly stated is a crucial part of the audit process.

3 Store Raw Materials

Verifying the proper accounting for costs related to the storage of raw materials is an integral
integral aspect of the audit, especially when manufacturing costs are involved.
Transfer Assets and Costs
1 Processing the Goods 2 Storing Finished Goods
Studying and testing the activities related to Understanding and testing the accounting
related to processing and storing the goods accounting records concerned with the storage
goods is crucial, as these two activities are storage of finished goods is a vital part of the
are not related to any other transaction the inventory and warehousing cycle audit.
transaction cycles. audit.
Ship Goods and Record Revenue and
and Costs
Recording of Shipments and Related Costs
Understanding and testing the internal controls over the recording of shipments and
shipments and related costs is a significant part of auditing the sales and collection
collection cycle.

Accuracy of Perpetual Inventory Master Files

Verification procedures should include ensuring the accuracy of the perpetual
inventory master files during tests of controls and substantive tests of transactions.
Physically Observe Inventory
Determine Inventory Existence Verification of Inventory Balance
Observing the client taking physical Physical examination is an essential type
inventory count is necessary to determine type of evidence used to verify the
whether recorded inventory actually exists balance in an account, and this process
at the balance sheet date. process must be studied thoroughly
during the audit.
Price and Compile Inventory
Costs Used to Value Physical Inventory Verification of Inventory Quantities and
Prices
The audit procedures used to verify
It's essential to verify whether the physical
these costs are called price tests and
counts were correctly summarized, the inventory
play a critical role in ensuring accurate
inventory quantities and prices were extended,
inventory valuation.
extended, and the extended inventory was
correctly footed.
 Audit of Cost
Accounting
Cost accounting is a critical aspect of a company's financial health,
reflecting the sophistication of management and the complexity of
inventory items. The systems and controls vary significantly across
organizations, influenced by factors such as the industry sector,
company size, and the level of management's involvement in the
manufacturing process. An audit of these systems ensures that the
physical inventory and related costs are accurately accounted for,
from raw material requisition to the final product storage.
 Cost Accounting Controls
Physical Inventory Related Costs

Physical control over inventory is essential Controls over costs are crucial from the point raw
materials are requisitioned to the point the finished
to prevent loss from misuse and theft.
product is completed and stored, ensuring accurate
Segregated storage areas and the cost tracking.

assignment of custody to responsible

individuals are key controls.

Physical Controls Audit
1 Observation
An auditor's test of physical controls is limited to observation, such as
examining storage areas for proper security measures.

2 Inquiry
Inquiry involves assessing the competence of custodians and the orderly
storage of inventory.

3 Expansion
If physical controls are inadequate, auditors expand their observation to
ensure a comprehensive inventory count.
 Perpetual Inventory Master Files

1 Record Keeping 2 Obsolete Items 3 Responsibility

These files provide a detailed These help in reviewing These are instrumental in
record of items on hand, usage inventory for obsolete or pinpointing responsibility for
of raw materials, and sales of low-moving items, ensuring inventory, crucial for
finished goods, aiding in efficient stock investigating discrepancies
production and inventory management. between physical counts and
management. records.
Documents and Records for Inventory
Transfer Audit
Existence Ensure recorded transfers actually occurred.

Accuracy Verify the quantity, description, and date of

transfers.

Approval Check for proper authorization on requisitions.

Unit Cost Records
Raw Materials
Accurate cost data for raw materials is vital for inventory valuation and
management.

Labor & Overhead

Direct labor and manufacturing overhead must be integrated with production records
for precise product costing. Special attention should be given to verifying the proper
accounting for costs when labor is a significant part of the inventory.

Cost Allocations
Evaluating the reasonableness of cost allocations is crucial for fair inventory
valuation and compliance with IFRS.
Review Inventory Quality &
Condition Audit
Quality Indicators
Observation for signs of obsolescence or infrequent use, such as excessive dust or rust,
is part of the audit process.

Perpetual Records
Reviewing perpetual inventory records for slow-moving items helps in identifying
potentially obsolete stock.

Specialist Advice
Specialists may be consulted to assess the quality and condition of specialized
inventory, ensuring accurate valuation.
Integrating Cost Accounting Records Audit

1 2
Integration Valuation
Cost accounting records must
The valuation of ending
be integrated with other
inventory relies on the proper
financial records for accurate
design and use of cost
product costing.
accounting records.
 Analytical Procedures in Auditing
Inventory and Warehousing
Analytical procedures are a critical aspect of auditing inventory and
warehousing. They are designed to uncover material errors in
counting, pricing, and calculating physical inventory, as well as
fictitious or obsolete inventory.

Auditors must obtain or prepare a comparative summary of

inventories classified by major types and obtain explanations for
major increases or decreases from the prior year's amounts. such
as raw materials, goods in process, finished goods, and supplies

Additionally, the auditors should ensure that aggregate or unit

inventories do not exceed the capacity of the client's production or
storage facilities.
Analytical Procedures in Auditing
Inventory and Warehousing

Gross Margin Percentage Turnover Rates Unit Costs Examination Manufacturing Costs Comparison
Comparison
Compare the gross margin
percentage with that of previous Compare unit costs of inventory Compare current year
Compare turnover rates with
years for any overstatement or with those of previous years to manufacturing costs with those
those of previous years to
understatement of inventory identify any overstatement or of previous years, considering
identify any overstatement or
and cost of goods sold. understatement, which affect changes in volume.
understatement of inventory.
inventory and cost of goods sold.
Identify any obsolescence or
unnecessary large inventories
through turnover rates
comparison.
Non-Financial Information Analysis
1 Inventory Products Details 2 Consistency Assessment
Consider the size and weight of Determine whether recorded inventory
inventory products, as well as their is consistent with available inventory
methods of storage and the capacity of storage using non-financial information.
storage facilities.
 Inventory Audit
Methodology Overview
The methodology for designing tests of details of balances for inventory is a
inventory is a critical aspect of auditing. It involves a series of steps that
that ensure the accuracy and reliability of inventory records. This process is
process is similar across various balance sheet accounts, including accounts
accounts receivable and payable. A deep understanding of the client's
client's business and industry is essential, particularly when it comes to
comes to inventory due to its significant variation across companies.
companies.
Methodology for Designing Test of Controls and
Substantive Tests
Understand internal control –
cost accounting system

Assess planned control risk –

cost accounting system

Determine extent of testing controls

Design tests of controls and Audit procedures

substantive tests of transactions Sample size
for the cost accounting system
to meet transaction-related Items to select
audit objectives Timing
1167
Understanding Client's Business
1 Business Familiarity
Obtaining a thorough understanding of the client's business is crucial for an accurate
inventory audit.

2 Facility Tour
Auditors should tour the client's facilities to gain insights into inventory management and
management and ask critical questions about production changes.

3 Risk Assessment
Assess significant sources of business risk related to inventory, such as product cycles and
supply-chain management techniques.
Setting the Audit Framework
1 Materiality
Set materiality and assess acceptable audit risk and inherent risk for inventory, considering
the unique aspects of the client's operations.

2 Control Risk
Assess control risk across various cycles to ensure comprehensive coverage of potential risk
areas.

3 Test Design
Design and perform tests of controls and analytical procedures tailored to the inventory and
warehousing cycles.
Inventory Risk Factors
Multiple Locations Pricing Complexity Obsolescence

Inventory stored in various The complexity of inventory Concerns about inventory

locations increases concerns pricing raises the risk of obsolescence relate to the
about existence and potential misstatement for accuracy net realizable value objective.
theft. objectives.

Other
➢reliance on a few key suppliers, and
➢use of sophisticated inventory management technology.
Physical Inventory Observation

Planning Evaluation Counting Process Documentation

Auditors should evaluate the Observing the counting Proper documentation and
client's planning of physical process and ensuring communication of
inventory before adherence to procedures is inventory-taking instructions
observation to ensure key to a reliable inventory are vital for a well-controlled
accuracy and control. count. count.
Inventory Counting Procedures In planning the physical inventory,
the client should consider many
factors, such as
Client's Role (1) selection of the best date or
dates,
The client is responsible for setting up accurate procedures for taking physical inventory and
(2) suspending production in certain
recording counts. departments of the plant,
(3) segregating obsolete and
defective goods,
Auditor's Role (4) establishing control over the
The auditor's role is to observe and evaluate the client's procedures, obtaining evidence for
counting process through the
use of inventory tags or sheets,
inventory existence and completeness.
(5) achieving proper cutoff of sales
and purchase transactions,
(6) arranging for services of
Instruction Sets engineers or other specialists to
Companies often prepare two sets of instructions for inventory: one for supervisors and one determine the quality or
for employees conducting the count. quantity of certain goods or
materials.
Special Inventory Considerations
Public Warehouse Inventory Direct confirmation from outside custodians

Consigned Goods Review contracts and communicate with

consignees for inventory verification.

Subcontracted Materials Confirm quantities with subcontractors for client-

owned materials in their possession.

If the amounts are quite material, or if any reason for doubt exists, the auditors may
decide to visit the warehouses and observe a physical inventory of the client’s
merchandise stored at all the warehouses
Audit Decisions
• The auditor-in- charge should determine the dates of the counts, the extent of
the test counts, the number of auditors needed at each location, and the
estimated time required.

• The senior should then assign auditors to specific locations and provide them
with a written statement of their duties.

• The senior may also wish to arrange for the cooperation of the clients internal
auditing staff during count, and possibly for the assistance of the company’s
engineers or independent specialists.

1174
Balance-related Audit Objectives
1. Existence:
• Inventory as recorded on tags exist.
2. Completeness:
• Existing inventory is counted and tagged
3. Accuracy:
• Inventory is counted accurately
4. Classification:
• Inventory is classified correctly on the tags.

1175
Balance-related Audit Objectives
5. Cutoff:
• Transactions are recorded in the proper period.

6. Realizable value:
• Obsolete and unusable inventory items are excluded or

noted.
7. Rights:
• The client has rights to inventory recorded on tags

1176
 Audit of Pricing and
Compilation
An audit of inventory is a major process that ensures the accuracy of
physical counts and perpetual record quantities. It involves a series
of tests to verify that inventory is priced and compiled correctly to
IFRS

This detailed examination includes inventory price tests to confirm

unit prices and inventory compilation tests to ensure accurate
summarization and extension of price times quantity.

The auditors' responsibility extends to evaluating the consistency and

accuracy of the inventory pricing methods used by the client.
Evaluation of Inventory Pricing
Methods
1 Pricing Methodology
What method of pricing does the client use? A range of methods includes cost,
market value, retail method, and quoted market prices for commodities.

2 Consistency Over Time

Is the method of pricing the same as that used in prior years? Consistency is key for
accurate financial reporting.

3 Application in Practice
Has the method been applied consistently and accurately in practice? Auditors must
verify this through representative inventory item tests.
Inventory Pricing and Compilation
Controls
Standard Cost Records Obsolete Inventory Compilation Controls
Review
Standard cost records are Proper summarization and
crucial for indicating A formal review of obsolete verification of physical
variances and evaluating and slow-moving items helps counts are essential for
production, ensuring prevent overstatement of accurate inventory
reasonable costs for inventory, maintaining compilation and general
inventory valuation. accuracy in records. ledger inclusion.
 Inventory Valuation and Reporting
Proper Valuation
Ensuring inventory is valued using the correct method and is accurately reported in financial statements.
cost; cost or market, which ever is lower; the retail method; and quoted market price(as for metals and
staple commodities traded on organized exchanges). The cost method, such as last-in, first-out (LIFO);
first-in, first-out (FIFO); specific identification; weighted average; and standard.

Disclosure
Inventory costing methods and any changes must be clearly disclosed, including the impact on financials.
For example, let us say that client has changed from FIFO method to the LIFO method. The nature and justification of the
change in method of valuing inventory and its effect on income should be disclosed. In addition, the auditors must insert
in the audit report an explanatory paragraph concerning the lack of consistency between the two years.

Commitments

Review of significant sales and purchase commitments that may affect inventory valuation and reporting.
 Balance-Related Objectives: Inventory Pricing and
Compilation
1. Detail tie-in
➢ Inventory in the inventory listing schedule agrees with the physical inventory
➢ counts, the extensions are correct, and the total is correctly added and
➢ agrees with the general ledger
2. Existence
➢ Inventory items in the inventory listing schedule exist
3. Completeness
• Existing inventory items are included in the inventory listing schedule.
4. Accuracy
• Inventory items in the inventory listing schedule are accurate.
5. Classification
• Inventory items in the inventory listing schedule are correctly classified. 1181
Balance-Related Objectives: Inventory Pricing and
Compilation
6. Realizable value
• Inventory items in the inventory listing schedule are stated at

realizable value
7. Rights
• The client has rights to inventory items in the inventory listing

schedule.

1182
Integration of Audit Tests
Acquisition & Payment Cycle
Verifying acquisitions provides evidence for raw materials and manufacturing
overhead costs, influencing inventory and cost of goods sold.

Payroll & Personnel Cycle

Labor costs, both direct and indirect, are verified within this cycle, impacting
the cost accounting records.

Sales & Collection Cycle

Testing in this cycle relates to the storage and shipment of finished goods,
affecting inventory records.
58) Which of the following is not one of the five classes of
transactions included in the sales and collection cycle?

A. Interest income

B. Write-off of uncollectible accounts

C. Bad debt expense A

D. Sales returns and allowances
59) Which of the following is an account that is not affected by the sales
and collection cycle?

• A) cash

• B) accounts receivable

• C) allowance for doubtful accounts

• D) accounts payable
D
60) As used in auditing which of the following statement best
describes "Assertion” ?
A. Assertions are the representations of management as to
the reliability of the information system.
B. Assertions are the auditor's findings to be communicated in
the audit report.
C. Assertions are the representations of management as to
the fairness of the financial statements.
D. Assertions are found only in the footnotes to the financial
statements.
C
61) All of the following are part of tests of control for the
occurrence assertion in the acquisition & payment cycle Except

A. Tracing a sample of goods receiving note to entries on purchases

journal

B. Examine payment documents for approval

C. Inspection of purchase order evidencing authorization

D. Observation of existence of proper segregation of duties D

62) The main reason for the auditor to trace shipping
documents to pre-numbered sales invoices is to
determine that:

A. All goods ordered by customers were shipped

B. Shipments to customers were properly billed

C. All pre-numbered sales invoices were recorded

D. Recorded sales invoices are not fictitious D

• 63) Which of the following is least likely to be considered a financial
statement audit risk factor?

• A. Management operating and financing decisions are dominated by top

management.
• B. A new client with no prior audit history.
• C. Rate of change in the entity's industry is rapid.
• D. Profitability of the entity relative to its industry is inconsistent.
• E. All
B
• F. None
64) Which of the following is not a fraud factor for the revenue recognition
process?

• A. Creating of fictitious invoices

• B. Recognition of revenue on shipments that never occurred

• C. Recording advance collections as revenue

• D. Not recording consignment sales revenue

A
65) Which of the following is least likely to cause uncertainty
about the ability of an entity to continue as a going concern ?

A. The entity has working capital deficiencies

B. The entity has lost a major customer
C. The entity has significant recurring operating losses
D. The entity has a court case with competitor for a minor patent
infringement
D
66) The auditor wants to examine whether shipping documents are
properly billed. He selected 100 shipping documents from a population of
1,000 shipping documents and performed examination. 5 unbilled shipping
documents were found if the tolerable deviation rate is 4%, which one of
the following is FALSE?

A. The auditor needs to test alternative controls to achieve the objective"

B. The auditor needs to extend sample size

C. The auditor needs to modify audit opinion

C
D. The auditor needs to extend substantive procedures
67) Which of the following principle may reduce or entirely eliminate
auditor liability to a client?

A. Auditor ordinary negligence

B. Client contributory negligence

C. Auditor gross negligence

B
D. Client constructive negligence
68) An auditor know that the purpose of her audit was to render reasonable
assurance on financial statements that were to be used for the application for a
loan; the auditor did not know the identity of the bank that would eventually give
the loan. Under the foreseeable third party approach the auditor is generally
liable to the bank which subsequently grants the loan for:

• A. Lack of due diligence.

D
• B. Lack of good faith.

• C. Gross negligence, but not ordinary negligence.

• D. Either ordinary or gross negligence.

69) Assume that $500,000 in damages are awarded to a plaintiff, and the CPA's
percentage of responsibility established at 10%, while others are responsible for the
other 90%. Assume the others have no financial resources. The CPA has been
required to pay $50,000. The auditor's liability is most likely based upon which
approach to assessing liability?

• A. Absolute liability.

• B. Contributory negligence.
D
• C. Joint and several liability.

• D. Proportional liability.
Assertions for balances Substantive procedures of transactions
Audit Objectives
Assertions 1. Occurrence / Existence
1. Existence

2. Completeness
2. Completeness
3. Accuracy
3. Accuracy
4. Cut-off 4. Valuation

5. Presentation and
disclosure 5. Cut-off

6. Classification

6. Detail tie-in
70) Substantive procedures to examine the cut-off assertion
for accounts payable include
A. Re-computing the mathematical accuracy of a sample of vendor
invoices
B. Selecting a sample of receiving reports around year-end and
comparing dates on related vouchers to date the purchases journal
C. Selecting a sample of vouchers and agreeing them to authorized
purchase orders
D. Selecting a sample of vouchers and agreeing them to the
purchases journal
The cut-off assertion is used to determine
B whether the transactions recorded have been
recorded in the appropriate accounting period.
• 71) Tracing from source documents forward to ledgers is most likely to
address which assertion related to posted entries:

• A. Completeness. Existence or occurrence – Assets or liabilities of the

company exist at a given date, and recorded
• B. Existence. transactions have occurred during a given period.

• C. Rights. Completeness – All transactions and accounts that

should be presented in the financial statements are
• D. Valuation. so included.

• E. All Rights and obligations assertions are used to

determine that the assets, liabilities, and equity
• F. None represented in the financial statements are the
A property of the business being audited.

The valuation assertion is used to determine that

the financial statements presented have all been
recorded at the proper valuation.
• 72). Determining that receivables are presented at net-realizable value is
most directly related to which management assertion?
Existence or occurrence – Assets or liabilities of the company
• A. Presentation and disclosure. exist at a given date, and recorded transactions have occurred
during a given period.
• B. Existence.
• C. Rights. Rights and obligations assertions are used to determine that
the assets, liabilities, and equity represented in the financial
• D. Valuation. statements are the property of the business being audited.

• E. All The valuation assertion is used to determine that the financial

statements presented have all been recorded at the proper
• F. None D valuation.

This is the assertion that all appropriate information and

disclosures are included in a company's statements and all the
information presented in the statements is fair and easy to
understand.
73) The auditor tests entity's policy of obtaining credit
approval before shipping goods to customers to support
which of the following management assertions?

A. Completeness
B. Valuation or allocation
C. Existence or occurrence B
D. Rights and obligations
Testing credit approval before shipping goods to
customers tests the valuation assertion.
This test addresses the collectability of accounts
receivable.
74) An auditor reviews aged accounts receivable to assess likelihood of
collection to support​ management's assertion about account balances of
A. rights and obligations.

B. valuation and allocation.

C. existence.

D. completeness.

B
3/6/2024 1201
75) In the audit of accounts​ payable, an​ auditor's procedures will most likely
focus primarily on​ management's assertion about account balances of

A. classification and understandability.

B. completeness.

C. valuation and allocation.

D. existence.
B
3/6/2024 1202
76) Which of the following statements about the existence and
completeness assertions is not true?
• a. The existence and completeness assertions emphasize different
audit concerns.
b. Existence deals with overstatements and completeness deals with
understatements.
c. Existence deals with understatements and completeness deals with
overstatements.
d. The completeness assertion deals with unrecorded transactions.
•
C
3/6/2024 1203
77) Which of the following management assertions is not associated
with transaction-related audit objectives?
a. Occurrence
b. Valuation

c. Accuracy
d. Completeness
B
3/6/2024 1204
78) In testing for cutoff, the objective is to determine:
a. whether all of the current period’s transactions are recorded.
b. whether transactions are recorded in the correct accounting period.
c. the proper cutoff between capitalizing and expensing expenditures.
d. the proper cutoff between disclosing items in footnotes or in
account balances.
B
3/6/2024 1205
79) Which of the following is least likely an example of fraudulent
financial reporting?
• A. An employee steals inventory, and the shortage is covered up by
included it as part of the cost of goods sold.
• B. Company management falsifies inventory count tags for the purpose of
overstatement of inventory closing balance.
• C. An employee borrows tools from the store of the company and
subsequently forgets to return it.
• D. A staff diverts customer payments to his personal use and the
concealing is by writing off the related accounts receivable
C
80) During an audit of an entity's stockholders' equity accounts, the auditor
determines whether there are restrictions on retained earnings resulting
from loans, agreements or state law.

• This audit procedure more likely is intended to verify management's

assertion of

• A) existence or occurrence

• B) completeness

• C) valuation or allocation D
• D) presentation and disclosure
81) Which of the following will generally be considered a significant risk?

• A) a sale to a customer

• B) the determination of the amount of bad debt expense

• C) the purchase of inventory

• D) obtaining a loan from the bank

B
82) An auditor traces a sample of purchase orders and the related
receiving reports to the purchases journal. The purpose of this substantive
audit procedure most likely was to

• a) verify that cash disbursements were for goods actually received.

• b) determine that purchases were properly recorded.

• c) test whether payments were for goods actually ordered. B

• d) identify usually large purchases that should be investigated further.

83) To determine whether accounts payable are complete, an auditor

performs a test to verify that all merchandise received is recorded. The

population of documents for this test consists of all:

A) payment vouchers.

B) receiving reports.

C) purchase requisitions.
B
D) vendors' invoices.
84) Which of the following procedures would an auditor least likely
perform before the balance sheet date?

• a) Confirmation of accounts payable.

• b) Observation of merchandise inventory.

• c) Assessment of the risk of material misstatement.

• d) Identification of related parties.

A
85) An auditor normally obtains an understanding of transaction-level
controls by:

A. - performing a system walkthrough.

B. - conducting an interview with senior management.

C. - reading the prior year's management letter.

D. - testing the entity's risk assessment process.

A
86) When an auditor identifies internal control deficiencies, what levels of

internal control deficiencies must be reported to those charged with

governance of the entity?

A. - Material weaknesses only.

B. - Significant deficiencies only.

C. - Significant deficiencies and material weaknesses in internal control.

D. - Deficiencies and significant deficiencies in internal control.

C
87) Which of the following audit techniques most likely would provide an
auditor with the most assurance about the effectiveness of the operation
of an internal control procedure?

A. - Precomputation of account balance amounts.

B. - Confirmation with outside parties.

C. - Observation of client personnel.

C
D. - Inquiry of client personnel.
88) Confirmations of accounts receivable provide the most evidence for
which of the following assertions?

• A) Existence.

• B) Valuation or allocation.

• C) Rights

• D) Completeness. C
89) The sum of customers' unpaid balances that is compared to the
general ledger balance comes from
A) A total of sales invoices
B) A total of shipping orders.
C) The sales journal.
D) The accounts receivable trial balance.

D
90) Tests for unrecorded assets typically involve tracing from:

• A. Source documents to recorded journal entries.

• B. Source documents to observations.

• C. Recorded journal entries to documents.

• D. Recorded journal entries to observations.

A
91) Which of the following procedures would an auditor most likely
perform in searching for unrecorded liabilities?

• A. Trace a sample of accounts payable entries recorded just before year

end to the unmatched receiving report file.
• B. Compare a sample of purchase orders issued just after year end with
the year-end accounts payable trial balance.
• C. See a sample of cash disbursements recorded just after year end to
receiving reports and vendor invoices.
• D. Scan the cash disbursements entries recorded just before year end for
indications of unusual transactions.
C
92) An auditor would most likely analyze inventory turnover rates to
obtain evidence concerning management's assertion about...

• a. existence or occurrence

• b. presentation and disclosure

• c. rights and obligations

• d. valuation or allocation

D
93) What event initiates a transaction in the sales and collection cycle?

• A) receipt of cash

• B) delivery of product to a customer

• C) identification of a new customer

• D) customer request for goods or services

D
94) When designing audit procedures, tracing of source documents to the
customers subsidiary ledger and subsequently to the general ledger is
done to satisfy what assertion?

• A) valuation

• B) cutoff
C
• C) completeness

• D) classification
95) The accurate recording of sales transactions concerns all of the
following except for

• A) proper credit authorization.

• B) shipping the amount of goods ordered.

• C) accurately billing for the amount of goods shipped.

• D) accurately recording the amount billed in the accounting records

A
96) In assessing control risk for purchases, an auditor vouches a sample of
entries in the voucher register to the supporting documents. Which
assertion would this test of controls most likely support?

• A) Completeness.

• B) Occurrence.

• C) Accuracy.

• D) Classification. B
97) Which of the following accounts is not affected by cash disbursement
transactions?

A) Cash.

B) Accounts payable.

C) Purchase discounts.

D) Purchase returns.
D
98) Identify the three broad categories of management assertions.
A. (1) Assertions about account balances at period​ end; (2) Assertions about existence or​
occurrence; (3) Assertions about presentation and disclosure.
B. ​(1) Assertions about classes of transactions and events for the period under​ audit; (2)
Assertions about account balances at period​ end; (3) Assertions about rights and
obligations.
C. (1) Assertions about classes of transactions and events for the period under​ audit; (2)
Assertions about account balances at period​ end; (3) Assertions about presentation and
disclosure.
D. (1) Assertions about valuation or​ allocation; (2) Assertions about​ completeness; (3)
Assertions about presentation and disclosure.
C
99) Which of the following relatively small misstatements most likely
would have a material effect on an entity's financial statements?
A. An uncollectible account receivable that was not written-off.
B. A petty cash fund disbursement that was not properly authorized.
C. A piece of obsolete office equipment that was not retired.
D. An illegal payment to a foreign official that was not recorded.

D
100) Which of the following is not an audit procedure that is commonly
used in performing tests of controls?

A. Inquiring.

B. Observing.

C. Confirming.

A. Inspecting
C
101) Which of the following would not necessarily be a related party
transaction?

• A. Sales to another corporation with a similar name.

• B. Loan from the corporation to a major stockholder.

• C. Purchases from another corporation that is controlled by the

corporation's chief stockholder. A
• D. Sale of land to the corporation by the spouse of a director.
102) Which of the following would not likely be classified as a related-party
transaction?

• a. An advance of one week’s salary to an employee.

b. Sales of merchandise between affiliated companies.
c. Loans or credit sales to the principal owner of the client company.
d. Exchanges of equipment between two companies owned by the same
person
A
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103) Which of the following is a factual misstatement?
A. A management estimate that is outside the range of reasonable
outcomes determined by the auditor.
B. A projected misstatement resulting from errors found during sampling.
C. A fixed asset being recorded at the incorrect cost.
D. Difference in judgment between the auditor and management.

C
104) The auditor is most likely to presume that a high risk of a fraud
exists if
A. The entity is a multinational company that does business in numerous
foreign countries.
B. The entity does business with several related parties.
C. Inadequate segregation of duties places an employee in a position to
Prevent theft.
D. Inadequate employee training results in lengthy EDP exception reports
each month C
105) An abnormal fluctuation in gross profit that might suggest the
need for extended audit procedures for sales and inventories would
most likely be identified in the planning phase of the audit by the use
of

• A. Tests of transactions and balances.

B. Specialized audit programs.
C. A preliminary review of internal controls. D
D. Analytical procedures.
106) An organizational structure is important for all of the following
reasons except:
A. Defining areas of authority.
B. Ensuring proper accountability.
C. Ensuring a proper commitment to controls.
D. Creating clear lines of reporting.
C
107) Which of the following audit procedures is least likely to detect an
unrecorded liability?
• A) Analysis and recomputation of interest expense.
• B) Analysis and recomputation of depreciation expense.
• C) Mailing of standard bank confirmation forms.
• D) Reading of the minutes of meetings of the board of directors.

B
108) An entity's internal control requires that for every check request
there be an approved voucher, supported by a prenumbered
purchase order and a prenumbered receiving report. To determine
whether checks are being issued for unauthorized expenditures, an
auditor most likely would select items for testing from the population
of all:
• A) purchase orders.
• B) canceled checks.
• C) receiving reports.
• D) approved vouchers. B
Accounting for Public and Civil Society (ACFN-
3070)

Chapter 1
Introduction to Accounting and Financial
Reporting for Governmental and Not-for-
Profit Entities

1236
 Chapter 1 outlines
• Introduction

• Meaning of Governmental Organizations

• Meaning of Not-for-Profit Organizations

• Similarities and Difference among Governmental, NGOs and

Business Organizations

• Source of reporting standards

• Objective of reporting Financial reporting
 Accounting for Governmental and Not-
for-Profit Organizations
• Why are accounting practices for these organizations very
different from those of business organizations?
• It provides different purposes for society

• Financed by resource providers who do not expect benefits proportional

to the resources they provide

• Management has a special duty to be accountable for how resources are

used in providing services
 What are Governmental
Organizations?
• General purpose governments
• Provide a broad array of services
• Examples: Federal government, state governments, cities, towns,
counties (police and fire protection; sanitation; construction and
maintenance of streets, roads, and bridges; and health and welfare)
• Special purpose governments
• Usually provide only a single or just a few/limited services
• Examples: Independent school systems, public colleges and universities,
public hospitals, fire protection districts, sewer districts, transportation
authorities, and many others
 What are Not-for-Profit
Organizations?
• Legally separate organizations
• Usually exempt from federal, state, and local
taxation
• Religious, community service, private educational
and health care, museums, and fraternal and social
organizations, among many other kinds of
organizations.
• Currently, there are nearly 1000 not-for-profit
organizations in Ethiopia.
 How Do Governmental and Not-For-Profit
Organizations Differ from Business
Organizations?

• Resource providers do not expect to receive proportional benefits

• Lack of a profit motive

• Absence of transferable ownership rights

 How Do Governmental Entities Differ From
Not-For-Profit Organizations?
• Power ultimately rests in the hands of the people
• People delegate power to public officials through the election
process
• Officials are empowered by and accountable to a higher level
government
• Taxation powers
 Sources of GAAP/IFRS and
Financial Reporting Standards
FASB( IAS Now)
❑ FASB abbreviated as Financial Accounting Standards Board .
❑ IAS abbreviated as International Accounting Standard
Used by….Business organizations
Nongovernmental not-for-profits
GASB ( IPSAS now)
❑ GASB …Governmental accounting standard board
❑ IPSAS…International Public Sector Accounting Standards
Used by…State and local governmental organizations
Governmental not-for-profits
FASAB=Federal Accounting Standards Advisory Board
Federal government and its agencies and departments
 Why Governmental Financial Reporting Must
Differ from Business Financial Reporting?

• Different financial report users with different needs

➔necessitating the use of fund-based accounting.

• Governmental financial reporting focuses on stewardship

and accountability for how public resources are raised and
used to provide services
 Objectives of Financial Reporting—
SLG (Cont’d)

“ACCOUNTABILITY is the cornerstone of all financial reporting in

government” (GASB Concepts Statement No. 1, par. 56)

❑Accountability arises from citizens’ “right to know.”

❑It imposes a duty on public officials to be accountable to citizens for raising

public monies and how they are spent.
 1.3 Objectives of Financial Reporting—State
and Local Governments (SLG)

Governmental financial reports are used primarily to:

❑ Compare actual financial results with legally adopted budget
❑ Assist in determining compliance with finance-related laws, rules,
and regulations
❑ Assess financial condition and results of operations
❑ Assist in evaluating efficiency and effectiveness
 Objectives of Financial Reporting—
Federal Government (Cont’d)
Federal government financial reporting should assist report
users in evaluating:
❖Budgetary integrity :- public funds are spent properly
and according to the interests of the citizens.
❖ Operating performance :- evaluating actual performance
❖ Stewardship :- responsible for planning and management of
resources.
❖Adequacy of systems and controls :- focus on internal
control
 Objectives of Financial Reporting—
Not-for-Profit (NFP) Organizations

NFP financial reporting should provide information useful in:

❖ Making resource allocation decisions
❖ Assessing services and ability to provide services
❖ Assessing management stewardship and performance
❖ Assessing economic resources, obligations, net resources,
 Minimum Requirement for General Purpose
External Financial Reporting

Management’s discussion and analysis

Government-wide Fund financial

financial statements statements

Notes to the financial statements

Required supplementary information

(other than MD&A)
 Government-wide Financial
Statements
• Provide an aggregated overview of the government’s net position and
change in net position, reported for the government as a whole.
• Assist in assessing operational accountability—whether government has
used its resources efficiently and effectively in meeting service
objectives
• Focused on flow of economic resources, recognized on the accrual
basis—similar to business organizations.
• Information is reported separately for the primary government and
discretely presented component units.
• Within the primary government, information is reported separately for
governmental and business-type activities
 Fund Financial Statements

• A fund is a separate set of accounts used to account for

resources segregated for a particular purpose.

• Funds that focus on the flow of current financial resources

are called governmental funds
 Fund Financial Statements

• Fund accounting reports financial information for separate self-

balancing sets of accounts, segregated for separate purposes or to
account for resources restricted as to use by donors or grantors

• Funds are separate accounting and fiscal entities

• Fund categories
1. Governmental ( Modified Accrual basis )
2. Proprietary (Accrual Basis)
3. Fiduciary ( Accrual and cash Basis)
 Comprehensive Annual Financial Report
(CAFR)
❑A Comprehensive Annual Financial Report is a set of
government financial statements comprising the financial
report of a state, local or other governmental entity that
complies with the accounting requirements promulgated by
the Governmental Accounting Standards Board (GASB).
❑ has three parts
1. Introductory section
2. Financial section
3. Statistical section
CAFR - Introductory Section

• Title page
• Contents page
• Letter of transmittal
• Other(as desired by
management)
 CAFR - Financial Section

❖ Auditor’s report
❖ Management’s discussion and analysis (MD&A)
❖ Basic financial statements
❖ Required supplementary information (RSI)(other
than MD&A)
❖ Combined and individual fund statements and
schedules
CAFR - Statistical Section

Tables and charts showing multiple-

year trends in financial and socio-
economic information.
 Chapter 2:
Principles of accounting
&
Financial reporting
of
Governmental Entities

3/6/2024 1257
 2.1. Activities of government

There are three major activity categories of a state and local

governments –
1. Governmental Activities,
2. Business-Type Activities
3. Fiduciary Activities.

3/6/2024 1258
 1. Governmental Activities
The government provides certain core services called General
Activities. General Activities provided by most general purpose
governments are related to:

❖Protection of life and property, police and fire protection,

❖A Public works (streets and highways, bridges, and public building),

❖A Parks and recreation facilities and programs,

❖A Cultural and social services

❖costs for general administrative support such as data processing,

finance, and personnel.

3/6/2024 1259
 2. Business-type Activities
• Governments engage in
business type activities. G. a Parking garages and lots;
These include: H. a Liquor stores;
A. a Public utilities (electric, water, gas
I. a Swimming pools;
and sewer utilities)
J. a Stadiums and arenas
B. a Transportation system;
• Many of these activities are
C. a Toll roads and toll bridges;
intended to be self supporting by
D. a Airports;
charging users for the services
E. a Hospitals; they
F. a Parking garages and lots
• receive. Operating subsidies from
general revenues are not
uncommon, particularly for
transportation systems.
3/6/2024 1260
 3. Fiduciary Activities
❖Governments often act in a fiduciary capacity, either as an
agent or trustee, for parties outside the government.

❖A government may serve as agent for other governments in the

administering and collecting of taxes.

❖ Governments serve also as trustees for amounts placed in trust

from private citizens for parks and other purposes, for escheat
properties that revert to the government when there are no legal
claimants or heirs to a deceased individual’s estate, and for
assets being held for employee pension plans.
3/6/2024 1261
 2.2 Summary statement of principles

Accounting & Reporting Capabilities (Principle #1)

• A government accounting system must make it possible both:

A. To present fairly & with full disclosure the financial operation of the

funds & account groups of the governmental unit in conformity with

International public sectors Accounting standards

B. To determine & demonstrate compliance with finance-related legal and

contractual provisions

3/6/2024 1262
 Cont.……….
• In some governmental units however Under such
circumstances where the laws require to follow
practices not consistent with accounting principles.

• Governmental units may prepare two sets of

financial statements.

1. One set in compliance with legal requirements,

2. One set in conformity with Accounting principles

3/6/2024 1263
 Fund Accounting System (Fund defined) (principle # 2)
Reporting Diverse Governmental
Activities - Fund Accounting
⚫ Governmental units Examples include:
have many different ⚫ Public Safety
types of activities. ⚫ Sanitation

⚫ No common motivation ⚫ Health & Welfare

links these activities. ⚫ Education

⚫ Parks & Recreation
⚫ Therefore, each activity
⚫ Judicial System
operates quasi-
⚫ Water and Sewer
independent, self-
⚫ Employee Pensions
balancing sets of
accounts called funds.
3/6/2024 1264
 • Fund is self-balancing set of accounts, Special money separated
for special purpose under the custody of special person
❖A fiscal and accounting entity with a self balancing set of account (double entry
system).
❖Accounting Entity refers to anything that uses a double entry
accounting entity to balance the resources with claims to
resources.
❖Each fund has its own accounts' ‘’entities’’.
❖In other words, a fund is an entity with its own set of books (i.e.
chart of account, general journals , general ledgers, TB, and
financial reports.
❖Fiscal Entity refers to any entity that is concerned with some assets set a
side for a specific purpose.
3/6/2024 1265
 Types of Funds (Principle # 3)
All funds fall into one of three
broad classifications.
Governmental Proprietary Fiduciary
Funds Funds Funds

Accounting Accounting for

Accounting for for business- financial
activities related
type activities. resources held
to serving the
for others in a
public.
trustee capacity.

3/6/2024 1266
 • There are 11 types of funds, which are subdivided into 3

categories:

I. GOVERNMENTAL FUNDS:

❖ Account for activities of a government that are carried out

primarily to provide services to citizens and that are financed

primarily through taxes.

❖ Governmental Funds are classified into five: 1.General Fund,

2.special revenue funds, 3.capital projects funds, 4. debt service

3/6/2024
funds, 5.permanent funds, which are discussed as follows: 1267
 1. The General Fund-

❖to account for all financial resources except those required to be accounted

for in another funds.

❖ It is used to account for resources required to provide most of the basic

services provided by the governmental unit such as public safety, public

works, education, etc.

❖Only one GF is used per government and most financial transactions related

to general government operating activities are recorded in the GF.

3/6/2024 1268
 2. Special Revenue Funds- to accounts for the proceeds of specific
revenue sources that are legally restricted to expenditure for
specific purposes.

➢An example of a special revenue fund might be “The Unity

and safety of the motherland tax” that was collected
during the Derg regime. It was raised specifically for the
armed forces.

➢earmarked 25% of current year revenue from value

added tax for draught affected people, special revenue
fund may be established to account for this revenue.
3/6/2024 1269
 3. Capital Project Fund-

❖to account for financial resources to be used for the acquisition or

construction of major capital facilities (other then those financed by

proprietary & trusts funds) .

❖An example of Capital Projects Funds could be the construction of

new building for the city government Administration, the

construction of bridge, buildings, road, dams, railway, hydroelectric

power etc.
3/6/2024 1270
 4. Debt Service Funds

❖It is for the accumulation of resources for & the payment

of general long term debt principal & interest.

❖It is referred to as a cash reserve that is maintained by the

organization in order to pay its dues and obligations on

time.

❖These dues and obligations mainly take the form of

principal and interest payments on certain types of debt.

3/6/2024 1271
 5. Permanent fund
❖To account for legally restricted resources provided by trust in which
the earnings but not the principal may be used for purposes that
support the primary government’s programs

❖A permanent fund is used to account for permanent endowments

created when a donor stipulates that the principal amount of a
contribution must be invested and preserved but earnings on amounts
so invested can be used for some public purpose.

❖Public purposes include activities such as maintenance of a

cemetery or aesthetic enhancements to public buildings.
3/6/2024 1272
 II. Proprietary Funds
❖It account for a government’s ongoing organizations and
activities that are similar to those operated by for- profit
organizations.

❖ This fund type normally encompasses operations where a

user charge is assessed so that determining operating
income or cost-recovery is important.

❖For example: a Toll Road would be reported within the

proprietary funds.

3/6/2024 ❖funds used by governments as proprietary funds:- 1273

 6. Enterprise Funds (EFs) – to account for operations:

A. That are financed and operated in a manner similar to private

business enterprises–where the intent of the governing body is that
the costs (expenses, including depreciation) of providing goods or
services to the general public on a continuing basis be financed or
recovered primarily through user changes.

B. where the governing body have decided that periodic

determination of revenues earned, expenses incurred,
and/or net income is appropriate for capital maintenance,
public policy, management control, accountability or other
purposes.
3/6/2024 1274
 ➢This funds are used when resources are provided primarily through
the use of sales and service charges to parties external to the
government and accrual basis of accounting is used.

• Examples of activities that can be accounted through enterprise

funds include water fund, airports fund, swimming pools and transit
systems, Natural gas fund and other utilities.

3/6/2024 1275
7. Internal Service Funds- to account for the financing of goods or services
provided by one department or agency to the another department or
agency of the governmental unit, or to the other governmental units on a
cost reimbursement basis.
Examples of activities that can be accounted through enterprises: Central data
processing facility (information services fund)
➢Centralized vehicle maintenance or Garage (Fleet services fund)
➢ Photo Copy service activities (copy service fund).
❖A shared garage is a common example of an Internal Service Fund in
government ministry offices. the garage would repair all the
ministries` vehicles regardless of which project, offices or funds uses
them

➢Providing several type of insurance programs (Insurance revolving fund).

➢Centralized supply stores (Warehouse revolving fund).

3/6/2024 1276
 III. Fiduciary Funds

❖These are trust and agency funds that are used to account for assets

held by a governmental unit in a trustee capacity or as an agent for

individuals, private organizations, and other governmental unit.

❖ For these funds the government is acting as a collecting/disbursing

agent or as a trustee

3/6/2024 1277
 8. Agency Funds

✓Are used to account for situations in which the government is

acting as a collecting/disbursing agent for governmental unit in a

trustee capacity or as an agent for individual, private

organizations, other governmental units.

✓An example would be a State tax agency fund, where the State
collects property taxes for other taxing unit, such as Federal
Government.

✓The accounting is simple: assets = liabilities and no revenue and

3/6/2024
expense accounts used since there are no net assets 1278
 9. Pension (and Other Employee Benefit) Funds
❖Are used to account for pension and employee benefit funds for which the
governmental unit is the trustee.
10. Investment Trust Funds
❖ account for external investment pools in which the assets are held for other
(external) governments, along with funds of the sponsoring government.
Assets, liabilities, net assets, and changes in net assets related to the equity of
the external participants are reported in this fiduciary fund.
11. Private Purpose Trust Funds
➢ report all other trust arrangements under which principal and income benefit
individuals, private organization or other governments.

3/6/2024 1279
 Number of Funds (Principle # 4)
• Governmental units should establishes and maintain those
funds require by law & sound financial administration.

• only the minimum number of funds in consistent with legal

and operating requirements should be established, however
since unnecessary funds result in inflexibility, undue
complexity & inefficient financial administration.

• The 11 fund types are to be used if needed by Governmental

unit to demonstrate compliance with legal requirements or if
needed to facilitate sound financial administration.

3/6/2024 1280
 Accounting for fixed assets & long-term liabilities (Principle #5)
❖A clear distinction should be made between Fund fixed assets , general fixed assets &
Fund long-term liabilities & General long-term debt.
❖ A. Fixed assets that related to specific proprietor funds & trust funds should be
accounted for through those funds.
❖ All other fixed assets of governmental units should be accounted for through the
general fixed asset account group.
❖General fixed assets include land, office buildings, improvements others buildings, car &
equipment's used by activities accounted by the five fund types classified as
“governmental funds”.
B. Long term liabilities of proprietary funds & trusts fund should be accounted for through
those funds.
All other unmatured general long-term liabilities of governmental unit including special
assessments debt for which the government is obligated in some manner should be
accounted for through the general long-term debt account group.
3/6/2024 1281
 Valuation of Fixed Assets (PRINCIPLE # 6)

• Fixed assets should be accounted for at cost, or if the cost is not

practically determinable at estimated cost, donated fixed assets

should be recorded at their estimated fair value at the time received.

3/6/2024 1282
 Depreciation of Fixed Assets (PRINCIPLE # 7)
• Capital assets should be depreciated over their
estimated useful lives, except land
• Report depreciation expense for general capital
assets only in the government-wide financial
statements

3/6/2024 1283
 Basis of Accounting (PRINCIPLE # 8)
• The Modified Accrual or accrual basis of accounting as appropriate
should be utilized in measuring financial position & operating
results.
a. Governmental fund revenues & expenditures should be
recognized on the modified accrual basis. Revenues should be
recognized in the accounting in which they become available &
measurable. expenditures should be recognized in the accounting
period in which the fund liability is incurred, if measurable.
b. Proprietary fund revenues & expenses should be recognized on the
accrual basis.
c. Fiduciary funds revenue and expenses or expenditures (as
appropriate) should be recognized on the basis consistent with the
fund’s accounting measurement objective.
d. Transfers of financial resources among funds should be recognized
in all funds affected in the period in which the inter-fund
receivables & payable(s) arise
3/6/2024 1284
 Budget and Budgetary Accounting (Principle # 9)
• Budgeting is the process of allocating of resource to meet unlimited
demands and it is key elements of legislative control over
governmental units.

1. Annual budget (s) should be adapted by every governmental units.

2. The accounting system should provide the basis for appropriate

budgetary control.

3. Budgetary comparisons should be included in the appropriate

financial statement & schedules for governmental units funds,

3/6/2024 1285
 Importance of budget
• Budget is importance for the government because of:

1. Reallocation of Resources: Through the budgetary policy, Government

aims to reallocate resources in accordance with the economic (profit
maximization) and social (public welfare) priorities of the country.

2. Reducing inequalities in income and wealth:. It will reduce income of

the rich and raise standard of living of the poor, thus reducing
inequalities in the distribution of income.

3. Economic Stability: Government budget is used to prevent business

fluctuations of inflation or deflation to achieve the objective of
economic stability

3/6/2024 1286
 4. Management of Public Enterprises: Budget is prepared
with the objective of making various provisions for
managing such enterprises and providing those financial
help.

5. Economic Growth: It helps to mobilize sufficient

resources for investment in the public sector.

6. Reducing regional disparities: The government budget

aims to reduce regional disparities through its taxation and
expenditure policy for encouraging setting up of production
units in economically backward regions.
3/6/2024 1287
 Classification of budget
• A government budget is an annual financial statement which

outlines the estimated government expenditure and expected

government receipts or revenues for the forthcoming fiscal year.

Depending on the feasibility of these estimates, budgets are of

three types

❖Balanced budget

❖Surplus budget and

3/6/2024 ❖Deficit budget. 1288

 Approaches to budgeting
• Various budgeting models continue to be commonly used
and fall predominantly into the following categories:
(1) line-item, or "traditional," budgeting;
(2) performance budgeting;
(3) program and planning ("program") budgeting;
(4) zero-based budgeting (ZBB);
(5) site-based budgeting; and
(6) outcome-focused budgeting.
3/6/2024 1289
 Financial Reporting (Principal # 10)
1. Appropriate interim financial statements & reports of financial
position, operating results & other pertinent information should
be prepared to facilitate management control of financial
operations, legislative oversight & where necessary or desired for
external reporting purpose.

2. A comprehensive annual financial report covering all funds &

account grops of the governmental unit including appropriate
combined, combining & individual fund statements, notes to the
F.S, schedules, narrative explanations & statistical tables should
be prepared & published.
3/6/2024 1290
Assets Accounts

✓ Taxes Receivables–Current: is used to accrue taxes which are due in the current Year. Taxes which
are expected to be collected within the current year are to be recorded in this account.
✓ Taxes Receivable–Delinquent: is used to record any taxes which are past due. Taxes which
have been expected to be collected in the current year, but fail to do so are to be recorded in this
account.
✓ Tax Lien-Receivable: is used to record taking possession of goods on which an owed tax has
not been paid. This account is used to record the total amount of tax liability that a tax payer fails to
pay on the due date, including penalty and interest, for which the taxing agency seized his/her/it‘s
property.
✓ Interest and Penalties Receivable on Delinquent Taxes: is used, obviously, to record interest and
penalties due on unpaid taxes.

3/6/2024 1291
Liability Accounts
✓ Deferred Taxes: account of credited for taxes which are paid in a year
before they may legally be used for expenditure.
✓ Trust for Property Owners: If those possessed goods are sold in
an attempt to cover the tax any additional cost incurred in
collecting it, the Trust for Property Owners account is used to
record any balance remaining from the selling price after the tax and
collection cost are deducted.
• Contra Asset Account
• Allowance for Uncollectible Taxes: is used for recording the
estimate of taxes which the government will not be able to collect.

3/6/2024 1292
 Intra Fund Transfer
1) Inter fund loans and advances
• On the books of the general fund
• Due from the special Revenue fund 50,000
• Cash 50,000

• On the books of the special revenue fund

• Cash 50,000
• Due to the General fund 50,000

3/6/2024 1293
 2) Reimbursements
3) Quasi-external transactions
• On the books of the AA Clinic
• On the books of the General Fund
• Expenditure 3,000
• Cash 3,000 • Expenditures 1,000
•
• (To record payment of bill on behalf of south Omo Due to Internal service Fund 1,000
clinic)
• Cash 3,000
• On the books of the Internal service fund
• Expenditure 3,000
•
• (To record reimbursement from south Omo clinic) Due from the General fund 1,000
• On the books of the South Omo Clinic • Revenues 1,000
• Expenditure 3,000
• Cash 3,000

3/6/2024 1294
4) (Residual) Equity Transfers
5) Operating Transfers

• On the books of the General Fund

• On the books of the General Fund
• Operating Transfers Out 8,000
• Equity Transfers Out 10,000
• Due to Debt Service fund 8,000
• Due to Internal Service fund 10,000
• On the books of the Debit service fund
• On the books of the Internal Service Fund
• Due from General fund 8,000
• Due from the General Fund 10,000
• Operating Transfers In 8,000
• Equity transfers In 10,000

3/6/2024 1295
1) Which of the following statements regarding primary sources of accounting
and financial reporting standards are false?

• a. The GASB sets standards for all state and local governments

• b. The FASB sets standards for all business and not-for-profit entities

• c. The FASB and GASB are administered by the Financial Accounting

Foundation

• d. The FASAB sets standards for the federal government and its agencies and
departments

B
2) Which of the following characteristics best distinguishes a government entity
from a business entity?
• A. Governments operate in a very small section of the economy while businesses
operate globally.
• B. Cost analysis and other control and evaluation techniques are essential to
ensure that resources are used economically and efficiently.
• C. Those contributing resources to the entity do not necessarily receive a direct
or proportionate share the services.

C while governments can

• D. Businesses must acquire and convert scarce resources
demand whatever they need.
3) A primary characteristic that distinguishes government from not-for-profits is

• a. The need to generate revenues equal to or more than expenditures/expenses.

• b. The ability to levy taxes.

• c. The need to provide goods or services.

• d. The correlation between revenues generated and demand for goods or services.

B
4) Which of the following characteristics distinguishes a government or
not-for profit entity from a business?

• a. There is always a direct link between revenues generated and

expenditures/expenses incurred.

• b. Capital assets are used to produce revenues and save costs.

• c. Revenues are always indicative of demand for goods and services.

D
• d. The mission of the entity may include goals other than maximizing profit
5) A primary tool of both governments and not-for-profit to acquire
funds to finance long-term projects is

• a. Levy of special purpose tax.

• b. Printing Money.

• c. Obtain line of credit on current assets. D

• d. Issue bonds to individuals and institutional investors.
6) Which of the following is an objective of financial reporting by
nongovernmental not-for-profit entities as established by the FASB?

• a. Assessing the types of services provided and the need for those
services.

• b. Assessing the services provided and the entity’s ability to earn a profit.

• c. Making rational decisions about the allocation of resources to those

organizations.
C
• d. Assessing how managers have managed personnel.
7) Which of the following activities would most likely be accounted for as

a business-type activity?

• A. Fire protection.

• B. Recreation.

• C. Water operations. C
• D. Street maintenance
8) Which of the following is not an operational accountability measure for a
government?
• A. Economic cost of providing services.
• B. Net income.
• C. Assessment whether a government raised sufficient revenues each period
to cover the
• cost of providing services.
Band
• D. Assessment whether services are being provided economically
efficiently.
9) Which of the following is not a primary financial reporting objective of state and
local government (SLG) reporting?
• A. Provide information necessary to assess the level of LG services and its ability to
• continue to finance its activities and meet its obligations.
• B. Provide information necessary for investment and credit decisions.
• C. Provide a means of demonstrating the SLG’s accountability that enables users to
assess
• that accountability.

B
• D. Provide information necessary to evaluate the SLG’s operating results for the
period.
10) Which of the following is not a characteristic used to determine if an
organization is a government?

• A. The majority of governing board members are appointed by government

entities.

• B. An entity that has the power to enact and enforce a property tax levy.

• C. An entity receives over half of its resources from other governmental

C
entities.

• D. All of the above

11) Which of the following is not a characteristic of a fund?

• A. Fiscal entity.

• B. Separate legal entity.

B
• C. Accounting entity.

• D. Contains self-balancing set of accounts.

12) The City of San Jose built a new city hall and financed construction by
issuing bonds due in installments over the next 30 years. The bond principal and
interest will be paid by a special tax levied on property in the city. The revenue
received from this special tax should be accounted for in which of the following
funds?

• a) General fund.

• b) Internal service fund. D

• c) Capital projects fund.

• d) Debt service fund.

13) The state collects a gasoline tax that must be used to support highway

construction and maintenance. The gasoline tax revenue should be

accounted for in which of the following funds?

• a) General fund.

• b) Special revenue fund.

B
• c) Debt service fund.

• d) Internal service fund

14) Riverside Golf Course is a city-owned golf course that collects greens fees in
amounts sufficient to cover its expenses. Riverside Golf Course should be
accounted for in which of the following funds?

• a) Internal service fund.

• b) Enterprise fund.

• c) General fund.

• d) Special revenue fund.

B
15) To fulfill the printing needs of its various departments and agencies, the City
has established a Central Print Shop, which bills the various departments and
agencies of the city for printing services rendered. The Central Print Shop should
be accounted for in which of the following funds.

• a) Internal service fund.

• b) Enterprise fund.

• c) General fund.
A
• d) Special revenue fund
16) Which of the following funds is accounted for on the modified accrual
basis of accounting?

• a) General fund.

• b) Internal service fund.

• c) Proprietary fund.

• d) Pension trust fund. A

17) Which of the following funds of Addis Ababa City would be
consolidated to form the governmental activities column in the City's
government-wide financial statements?

• a) Its general fund, special revenue fund, and agency fund.

• b) Its general fund, debt service fund, and capital projects fund.

• c) Its general fund, enterprise fund, and fiduciary fund. B

• d) Its enterprise fund and internal service fund.
18) Which of the following activities would be least likely to be operated as
and accounted for in an Enterprise Fund?

• A. Town planning department

• B. Sports stadium

• C. Parking garage

• D. Mass transit authority A

19) Which of the following items would typically not need an
encumbrance?

• A) New Building

• B) Regular Salaries

• C) New Computer B
• D) Office Equipment
20) Encumbrance accounting is not typically used for:

• A. General Funds.

• B. Debt Service Funds.

• C. Capital Projects Funds.

B
• D. Special Revenue Funds.
21) In a budgetary entry, if Estimated Revenues Control exceeds

Appropriations Control, the excess would be:

• A) credited to Fund Balance-Unreserved.

Estimated Revenue ……XXX

• B) debited to Fund Balance-Unreserved. Appropriation …XXX
Fund Balance ..XXX

• C) debited to Budgetary Fund Balance.

D
• D) credited to Budgetary Fund Balance.
22) A certain government passed its budget for the fiscal year ended December
31, 2015. Estimated Revenues amounted to $13,000,000; Appropriations
amounted to $12,000,000; Estimated Other Financing Uses amounted to
$700,000; and Estimated Other Financing Sources amounted to $200,000. In the
budgetary entry (combining entry):

• A) Budgetary Fund Balance would be credited for $500,000.

• B) Budgetary Fund Balance would be debited for $500,000.

Estimated Revenue …….…13,000,000
• C) Budgetary Fund Balance would be debited for $1,000,000.
Other Financing Sources…200,000
Appropriation …………..12,000,000
• A
D) Budgetary Fund Balance would be credited for $1,500,000
Other Financing Uses..700,000
Fund Balance ……………...500.000
23) In closing budgetary and expenditure accounts at year-end a

government should

• a. Debit appropriations and credit expenditures

• b. Credit appropriations and debit expenditures

Appropriation …….XXXX
Expenditures….XXX

• c. Debit expenditures andAcredit fund balance

• d. Credit appropriations and debit fund balance

24) A government places an order for a particular item of equipment and encumbers
$5,500. The item arrives accompanied by an invoice for $5,200. The entries that the
government should make should include

• a. A debit to expenditures for $5,200, debit Reserved for encumbrance 5200 , a debit to
fund balance for $300, and a credit to reserve for encumbrances for $5,500
• b. A debit to expenditures for $5,200, debit Reserved for encumbrance 5200 , a credit
to encumbrances for $5,200, and a credit to accounts payable for $5,200
• c. A debit to expenditures for $5,200, a credit to encumbrances for $5,500, debit
Reserved for encumbrance 5200 and a credit to accounts payable for $5,200
• d. A debit to expenditures for $5,200, debit Reserved for encumbrance 5200 , a credit
Purchase order
to reserve for encumbrances for $5,200, and a credit to accounts payable for $5,200
Encumbrance ……………….5500
Reserved for encumbrance….5500
Received the product
Reserved for encumbrance….5200
Encumbrance ……………….5200 C
Expenditure ……………………..5200
Account Payable ……………5200
25) Purchase orders for items ordered by the General Fund totaled $
205,000. Upon receipt, invoices for these items totaled $200,000. Which of
the following will take place on the date the goods are received.

• A) An encumbrance is debited for $205,000.

• B) Budgetary Fund Balance -- Reserve for Encumbrances

Purchase order is credited for
Encumbrance ……………….205,000
Reserved for encumbrance….205000
$200,000. Received the product
Reserved for encumbrance….200,000
• C) An expenditure
D is credited for $205,000. Encumbrance ……………….200,000
Expenditure ……………………..200,000
Account Payable ……………200,000
• D) A liability is credited for $200,000
26) The Revenues account of a government is credited when:

• A) the budget is recorded in the accounts.

• B) property taxes are collected.

• C) property taxes are levied.

C
• D) budgetary accounts are closed at the end of the year
27) Which of the following is true with respect to Special revenue funds?

• A) Special revenue funds are used when it is desirable to provide separate

reporting of resources that are restricted or committed as to expenditure for
special purposes other than debt service or capital projects.

• B) Special revenue funds are used when it is desirable to provide separate

reporting of resources that are designated for specific purposes.

• C) Special revenue funds are used when it is desirable to provide separate

Asupport capital projects.
reporting for funds provided by other governments to

• D) Both B and C
28) The Town of Little River expects to collect $90,000 in sales tax from the state government
within 30 days of the end of fiscal year 2015 for retail sales taking place in fiscal year 2015. What
entry, if any, would Little River make at the end of 2015?

• A) Taxes receivable – current 90,000

• Deferred Inflows 90,000

• B) Taxes receivable – deferred 90,000

• Revenues control 90,000

• C) Taxes receivable – current 90,000

• Due from state government 90,000

• D) Due from state government 90,000

• Revenues control 90,000 D

29) General Fund resources were expended in the amount of $185,000 to
purchase a new fire truck. The General Fund would debit:
A
• A) Expenditures Control.

• B) Capital assets -Motor Vehicles.

• C) Both (a) and (b) above.

• D) None of the above; no entry is made in the General Fund when a motor
vehicle is purchased because only current financial resources are recorded
in the General Fund.
30) During the current fiscal year, Mountain View City’s water utility, an enterprise

fund, rendered billings for water supplied to the general fund. Which of the following

accounts should be debited by the general fund?

• a) Transfer-out to enterprise fund

• b) Due to water utility enterprise fund

D
• c) Appropriations

• d) Expenditures
31) Which of the following is a source of funding for capital projects

fund?

• A. Gifts from individuals and corporations.

• B. Proceeds from issuance of Long-term debt.

• C. Grants. D

• D. All of the answer choices.

32) In its governmental fund statements a government should recognize
revenue from special assessments

• a. Entirely in the year in which the assessment is imposed

• b. In the years in which the assessments are paid

• c. In the years in which the assessments are due

• d. In the years in which the assessments become availableDfor expenditure

33) During the current fiscal year, the Gateway City government recorded a $15,000 transfer from
the General Fund to an internal service fund, a $25,000 transfer from the General Fund to an
enterprise fund, a $10,000 transfer from an enterprise fund to an internal service fund, and a
$5,000 transfer from an enterprise fund to the General Fund. In the Business-type Activities
column of the government-wide financial statements, Gateway City should report:

A. Net transfers out of $5,000.

Enterprise fund
B. Net transfers in of $10,000.
+25000 -10000-5000
C. Net transfers in of $25,000. = 10000
D. Net transfers in of $35,000.
B
34) During the year an enterprise fund purchased $232,000 worth of equipment.
The equipment was acquired with a cash down payment of $30,500 and a
$201,500 loan. A partial year of depreciation on the equipment was taken in the
A
amount of $22,500. What is the net effect of this transaction on the net position
accounts of the enterprise fund?

A. Net investment in capital assets is increased by $8,000.

B. Net investment in capital assets is increased by $30,500.

Net assets = (Total Fixed Assets) + (Total Current Assets) - (Total Long-term Liabilities) - (Total Short-
C. Net
terminvestment
Liabilities). in capital assets is increased by $209,500.
Net assets of the enterprise shows what will be left for the owners in case of liquidation.
D. Net
Giveninvestment in capital
that the equipment assets
costs $232,000 andisloan
increased by $232,000.
is of $201,500

The increase in capital assets, net of related debt is of $8,000 ($232,000-22,500 - $201,500)
35) Wages that have been earned by the employees of a governmental unit, but not paid

at year-end, should be recorded in the General Fund by a debit to which of the following

accounts?

• A) Appropriations. Expenditure ………..XXX

Wage Payable ……………..XXX

• B) Encumbrances.

• C) Expenses.
D
• D) Expenditures.
36) Which of the following is true with respect to long-term debt?
• A) Term bonds mature in equal installments over the term of the bond.
• B) Resources transferred to the debt service fund from the General Fund
would typically be classified as Other Financing use by the debt service fund.
• C) Resources transferred to the debt service fund from the General Fund
would typically be classified as Other Financing Sources by the debt service
fund.
• D) Resources transferred to the debt service fund from the General Fund
C
would typically be classified as Other Financing Sources by the general fund.
37) When a payment is due to a contractor from capital projects fund

resources, the debit would be to:

• A) A capital asset account.

C
• B) Encumbrances Control.

• C) Expenditures-Capital Outlay.

• D) None of the above, no entry is made until payment.

38) An internal service fund provided services to a General Fund
department. At the time of billing, the credit entry in the internal service
fund would be:

• A) Other Financing Sources—Transfers In.

• B) Operating Revenues—Charges for Services.

• C) Other Financing Sources—Charges for Services.

B
• D) Due from General Fund.
39) Which of the following is an example of the function of an Agency Fund?

not

• A) Payment of pension benefits to retired government employees

• B) Collection of local government sales taxes by the state government

• C) Collection of property taxes for the school district by an elected county

government official.
A
• D) Periodic distribution by the state government of county sales taxes
40) Lakeside Art Center, a nongovernmental not-for-profit entity, receives a
contribution of $5 million. The donor stipulates that the contribution must
be used to acquire paintings by local artists. Lakeside should classify the
contribution as

• a) Permanently restricted
B
• b) Temporarily restricted

• c) Committed

• d) Unrestricted
41) A civic ballet company sells 100 “Benefactor” status memberships for $1,000 each. The Benefactors each receive a season ticket
valued at $350, and a listing in the company’s program. How would the ballet company record the sale of these 100 memberships
at the beginning of the season?
• A) Cash $100,000
Deferred Revenue $100,000
• B) Cash – Restricted $ 65,000
• Cash – Unrestricted 35,000
• Contributions – Restricted $ 65,000
Revenue 35,000
• C) Cash $100,000
Revenue $ 35,000
Contributions – Restricted 65,000
• D) Cash $100,000
Deferred Revenue $ 35,000
Contributions – Unrestricted 65,000

D
42) A donor gave $60,000 to a nongovernmental, not-for-profit charity with instructions that

the funds be transferred to Sam Smith, an individual who lost his home in a fire. The not for-profit

would:

• A) Record the $60,000 cash and credit a liability.

• B) Record the $60,000 cash and credit temporarily restricted revenue.

A
• C) Do either (a) or (b), depending upon the policy of the not-for-profit.

• D) Not record the transaction, because the money is going directly to the intended recipient
43) For its fiscal year ending September 30, 2011, Twin City levied $500 million in property taxes. It
collected taxes applicable to fiscal 2011 as follows (in millions):
• June 1 2010, through September 30, 2010 $20
• October 1 2010 through September 30 2011 $440
• October 1 2011 through November 30, 2011 $15
• December 2011 $4
• The city estimates that $10 million of the outstanding balance will be uncollectable. For the fiscal
year ending September 30, 2011, how much should Twin City recognize in property tax revenue in
millions in its general fund?
• A) 475
• B) 490
• C) 540 A
• D) 430
43) Which of the following statements is true for both
governmental organizations and for-profit organizations?

A. Revenue may be earned through exchange transactions.

B. Absence of owners.
C. Lack of a profit motive.
D. Resources are provided by individuals and entities that may
not directly benefit from the use of the resources

A
44) Which of the following would not be considered a
government or nonprofit organization?

A. A software company that sells software exclusively to state

and local governments.
B. A public elementary school.
C. A church.
D. A private trust organized for charitable purposes.

A
45) Which of the following is FALSE about public debt

A. Public debt may be raised to meet the normal current expenditure,

exigencies like war, finance productive government enterprise, finance
public social welfare and economic development.
B. It is one source of financing budget deficit.
C. It can only be used to promote economic development not to finance
wars.
D. Public debt raised for productive purpose will not be a burden on the
economy,
C
46) Which of the following statement is FALSE regarding the objective
of financial reporting by public sector
A. The objectives of financial reporting by public sector entities are to provide
information about the entity that is useful to users of GPFRS for decision-
making purposes.
B. The objectives of financial reporting by public sector entities are to provide
information about the entity that is useful to users of GPFRS for accountability
purposes.
C. The identification of accountability as an objective of financial reporting
reflects that most governments and public sector entities have a profit seeking
rather than service delivery objective
D. The identification of accountability as an objective of financial reporting
reflects the fact that most governments and public sector entities have their
funding mainly through taxation, but also transfers from other tiers of
government. C
47) For which of the following funds, would a government be least likely to
record its annual budget and thereby integrate to accounting system?

A. Enterprise fund
B. Special revenue fund
C. General fund A
D. Capital project fund
48) Which of the following is true regarding capital projects funds?
A) Capital projects funds are considered to be governmental funds.
B) Capital projects funds use the economic resources measurement focus
and accrual basis of accounting.
C) Encumbrance accounting is not used.
D) Fixed assets are depreciated in capital projects funds.

A
• 49). Which of the following types of funds recognize its long-term debt as a
liability and settles it?
• A. Debt Service Fund
• B. Capital Projects Fund
• C. Enterprise Fund A
• D. Special Revenue Fund
• E. All
• F. None
50) A fund that is used to account for assets held by a government
temporarily for one or more other governments units or for individuals or
private organizations is a(n):
• A) Agency fund
• B) Private-Purpose Trust Fund
• C) Investment Trust Fund
• D) Pension Trust Fund
A
51) Which of the following accounts typically would be used by
an Agency Fund?

A. Revenue
C
B. Bonds payable Agency funds are used to account for assets held by
C. Cash the government as an agent for individuals, private
organizations, other governments, and/or other
funds.
D. Notes receivable
52) Central City was awarded two state grants during its fiscal year ending September 30, 2020: a
Birr 2 million block grant that can be used to cover any operating expenses incurred during fiscal
2021, and a Birr 1 million grant that can be used any time to acquire equipment for its police
department.

For the year ending September 30, 2020, Central City should recognize in grant revenue in its fund
financial statements (in millions):

A. Birr 2 million

B. Bir 1 million B
C. Birr 0

D. Birr 3 million
53) Bonds are sold to finance the construction of a new public
safety station. Bond proceeds equal to the face value of the
bonds are reported in a Capital Projects Fund as:

A. other financing source

B. deferred inflow of resources

C. other financing use

D. a revenue A
54) The repayment of bond principal should be reported in the
fund statements of a debt service fund as

A. A reduction of bonds payable

B. An expenditure

C. A direct charge to fund balance B

D. An "other financing use

55) As a general rule, debt service expenditures in a Debt
Service Fund are recognized

A. when the debt service payment is due

B. when resources to be used for the repayment are made

available to a Debt Service Fund

C. in accordance with the requirements of the original bond

order that specifies the basis of expenditure recognition

D. when due for principal repayments but on an accrual basis for

interest
A
56) The City of Turkana arranged for a 10- year, Birr 40 million loan to finance
construction of a toll bridge.

If the toll bridge is accounted for as an Enterprise Fund activity and a certain portion
of the tolls collected is required to be set aside for maintaining the bridge, these
resources should be accounted for in

A. the Toll Bridge Enterprise Fund

B. the General Fund A

C. a Capital Projects Fund

D. a Debt Service Fund

57) Which of the following statements is FALSE regarding the
definition of a fund?

A. A fund is an accounting entity that is used for one year only and each
year a new set of funds must be established.

B. A fund is a fiscal entity used to account for a subset of an

organization's resources that is to be used for a specific purpose.

C. A fund has a self-encompassing, self-balancing accounting equation.

D. A fund is an accounting entity for which financial statements can be

prepared.
A
58) During the year an enterprise fund purchased $230,000 worth of
equipment. The equipment was acquired with a cash down payment of
$30,000 and a $200,000 loan. A partial year of depreciation on the
equipment was taken in the amount of $23,000. What is the net effect of this
transaction on the net position accounts of the enterprise fund?
A. Net investment in capital assets is increased by $7,000.
B. Net investment in capital assets is increased by $30,000.
C. Net investment in capital assets is increased by $207,000.
D. Net investment in capital assets is increased by $230,000.

A
59) During the year an enterprise fund purchased Birr 230,000 worth of
equipment. The equipment was acquired with a cash down payment of Birr
23,000 and a Birr 207,000 loan.
What is the net effect of this transaction on the net asset accounts of the
enterprise fund?
A. Invested in capital assets, net of related debt is increased by Birr 23,000.
B. Invested in capital assets, net of related debt is increased by Birr 230,000.
C. Invested in capital assets, net of related debt is increased by Birr 207,000.
D. Invested in capital assets, net of related debt is decreased by Birr 207,000.
Net assets = (Total Fixed Assets) + (Total Current Assets) - (Total Long-term Liabilities) -
(Total Short-term Liabilities).

Net assets of the enterprise shows what will be left for the owners in case of liquidation. A
Given that the equipment costs $230,000 and loan is of $207,000

The increase in capital assets, net of related debt is of $23,000 ($230,000 - $207,000)
• 60). The General Fund acquired items through purchase on account. Which
one of the following entries is made to close purchase orders for which
goods and services are NOT fully received at the end of the fiscal period?

• A. DEBIT Encumbrance
• B. DEBIT Reserve for Encumbrance
• C. CREDIT Fund Balance D
• D. CREDIT Encumbrance In order to close the encumbrance at the end of the year:
The journal entry is made below:

General Journal Debit Credit

• E. All Fund balance $XX
• F. None Encumbrances $XX
• 62). International Public Sector Accounting Standard 17 deals with

• A. Presentation of general purpose financial statement

• B. Accounting policies, changes in accounting estimates and errors
• C. Property, plant and equipment
• D. Revenues from non-exchange transactions
• E. All
C
• F. None
 Chapter 3:
International Public Sector
Accounting Standards [IPSAS]
 Activities of Government
• The following matters are some of the activity of the government.

1. Enacting and Enforcing Laws: it is the prime responsibility of the

Government of each country. This is because laws and regulations
only enable the businesses to function smoothly.

2. Maintaining Law and Order: protecting persons and property is

another responsibility of the Government of the country. It would
be impossible to carry on business in the absence of a peaceful
atmosphere.

3. Providing Monetary System: The Government has to provide

monetary system so that business transactions can be effected.
 Cont….
Further, it is also the responsibility of the Government to regulate
money and credit, and protect the money value of the currency in
terms of other currencies.

4.Balanced Regional Development and Growth: It is the

responsibility of the Government to make sure that there are
balanced regional developments and growth.

5. Provision of Basic Infrastructure: Government should provide basic

infrastructural facilities such as transportation, power, finance,
trained personnel and civic amenities, which are indispensable for
the effective functioning of business concerns.
 Cont….
6. Supply of Information: Governments is responsible to provide
information, which is useful to businessmen which relates to
economic and business activity, specific lines of business, scientific
and technological developments.

7. Assistance to Small-scale Industries: Government provide the

required facilities and encourage the development of small-scale
industries to overcome the problem faced by them.

8. Transfer of Technology: Government is responsible to transfer to

private industries whatever discoveries are made by the
Government – owned Research Institutions so that they can be used
for commercial production.
 Cont….
9. Conducting Inspections: Government responsible to
inspect the private business concerns in order to make
sure that they produce quality products, and also to
prevent the production and sale of sub-standard goods.

10. Incentives to Home Industries: It is the

responsibility of the Government to encourage the
development of home industries by providing them
various incentives and subsidies.
 Summary statement of principles
• IPSAS 1—PRESENTATION OF FINANCIAL STATEMENTS

• Objectives: The objective of this Standard is to prescribe

the manner in which general purpose financial statements
should be presented to ensure comparability both with the
entity’s financial statements of previous periods and with
the financial statements of other entities.

• Scope: This Standard shall be applied to all general purpose

financial statements prepared and presented under the
accrual basis of accounting in accordance with IPSASs.
 Definitions
• Accrual basis: means a basis of accounting under which
transactions and other events are recognized when they occur (and
not only when cash or its equivalent is received or paid).

• Assets: are resources controlled by an entity as a result of past

events and from which future economic benefits or service
potential are expected to flow to the entity.

• Contributions from owners: means future economic benefits or

service potential that has been contributed to the entity by parties
external to the entity, other than those that result in liabilities of
the entity
 Cont….
• Distributions to owners means future economic benefits or
service potential distributed by the entity to all or some of its
owners,
• An economic entity is a controlling entity & its controlled
entities.
• Expenses: are decreases in economic benefits or service
potential during the reporting period in the form of outflows
or consumption of assets or incurrences of liabilities that
result in decreases in net assets/equity, other than those
relating to distributions to owners.
• Revenue: is the gross inflow of economic benefits or service
potential during the reporting period when those inflows
result in an increase in net assets/equity, other than
increases relating to contributions from owners.
 Cont….
• Liabilities: are present obligations of the entity arising from past events,
the settlement of which is expected to result in an outflow from the entity
of resources embodying economic benefits or service potential.

• Material: Omissions or misstatements of items are material if they could,

individually or collectively, influence the decisions or assessments of users
made on the basis of the financial statements.

• Net assets/equity: is the residual interest in the assets of the entity after
deducting all its liabilities.

• Impracticable: It is when the entity cannot apply it after making every

reasonable effort to do so.
 Purpose of Financial Statements
❖The objectives of general purpose financial reporting in the public
sector should be to provide information useful for decision
making, and to demonstrate the accountability of the entity for
the resources entrusted to it, by:

❖Providing information about the sources, allocation, & uses of

resources.

❖Providing information about how the entity financed its activities

❖Providing information that is useful in evaluating the entity’s

ability to finance its activities and to meet its liabilities
 Components of Financial Statements
A complete set of financial statements comprises:
1. A statement of financial position.

2. A statement of financial performance.

3. A statement of changes in net assets/equity.

4. A cash flow statement.

5. When the entity makes publicly available its approved budget, a

comparison of budget and actual amounts.

6. Notes, comprising a summary of significant accounting policies.

7. Comparative information in respect of the preceding period.

• Reporting date means the date of the last day of the reporting
period to which the financial statements relate.
 IPSAS 2—CASH FLOW STATEMENTS
• Objective: The cash flow statement identifies (a)
the sources of cash inflows, (b) the items on which
cash was expended during the reporting period, and
(c) the cash balance as at the reporting date.

• Scope: An entity that prepares and presents

financial statements under the accrual basis of
accounting.
 Benefits of Cash Flow Information
✓ It is useful in assisting users to predict (a) the future cash
requirements of the entity, (b) its ability to generate cash flows in
the future, and (c) its ability to fund changes in the scope and nature
of its activities.

✓A cash flow statement, when used in conjunction with other

financial statements, provides information that enables users to
evaluate the changes in net assets/equity of an entity, its financial
structure (including its liquidity and solvency), and its ability to
affect the amounts and timing of cash flows in order to adapt to
changing circumstances and opportunities.
 Definitions
• Cash comprises cash on hand and demand deposits.

• Cash equivalents: are short-term, highly liquid investments that

are readily convertible to known amounts of cash and which are
subject to an insignificant risk of changes in value.

• Cash flows are inflows and outflows of cash and cash equivalents.

• Control: An entity controls another entity when the entity is

exposed, or has rights, to variable benefits from its involvement
with the other entity and has the ability to affect the nature or
amount of those benefits through its power over the other entity.
 Operating Activities
• Operating activities are the activities of the entity that are not
investing or financing activities.

• Cash flows from operating activities are primarily derived from the
principal cash-generating activities of the entity. Examples are:

A. Cash receipts from taxes, levies, and fines.

B. Cash receipts from charges for goods and services provided by the entity

C. Cash receipts from grants or transfers.

D. Cash receipts from royalties, fees, commissions, & other revenue

❖Cash payments to beneficiaries of social benefit schemes.

➢ Cash payments to other public sector entities to finance their operations.
 Operating Activities…………..
❖Cash receipts or payments from discontinuing operations.

❖ Cash receipts or payments in relation to litigation settlements.

❖Cash payments to suppliers for goods and services.

❖Cash payments to and on behalf of employees.

I. Cash payments of local property taxes or income taxes in

normal activity.

II. Cash receipts and payments from contracts held for dealing

or trading purposes.
 Investing Activities
➢ Investing activities are the acquisition and disposal of long-term assets and
other investments not included in cash equivalents.

A. Cash payments to acquire property, plant, and equipment, intangibles, and other
long-term assets. These payments include those relating to capitalized
development costs and self-constructed property, plant, and equipment.

B. Cash receipts from sales of property, plant, and equipment, intangibles, and
other long-term assets.

C. cash payments to acquire equity or debt instruments of other entities and

interests in joint ventures (other than payments or trading purposes.

D. Cash receipts from sales of equity or debt instruments of other entities and
interests in joint ventures (other than receipts those held for dealing or trading
purposes.
 Investing activities ………
A. Cash advances and loans made to other parties.

B. Cash receipts from the repayment of advances and loans made to

other parties.

❖ Cash payments for futures contracts, forward contracts, option

contracts, and swap contracts, except held for dealing or trading
purposes, or the payments are classified as financing activities.

❖Cash receipts from futures contracts, forward contracts, option

contracts, and swap contracts, except when the contracts are held
for dealing or trading purposes, or the receipts are classified as
financing activities.
 Financing Activities
• Financing activities are activities that result in changes in the size and
composition of the contributed capital and borrowings of the entity.

• The separate disclosure of cash flows arising from financing

activities is important, because it is useful in predicting claims on
future cash flows by providers of capital to the entity.
❖Examples of cash flows arising from financing activities are:

A. Cash proceeds from issuing debentures, loans, notes, bonds,

mortgages, and other short or long-term borrowings.

B. Cash repayments of amounts borrowed.

C. Cash payments by a lessee for the reduction of the outstanding

liability relating to a finance lease.
 IPSAS 3—ACCOUNTING POLICIES, CHANGES IN ACCOUNTING
ESTIMATES AND ERRORS

• Accounting estimates are required for the following:

• Bad debts
• Inventory obsolescence
• Useful life, residual valve, expected pattern of consumption of benefit
depreciable asset
• Warranty cost
• Fair value of financial asset and financial liability
 Accounting policies
• Accounting policies can be chosen by a company’s management in which the company is
expected to record its day to day transactions, value its assets and liabilities, and report its
financial results. This policies should be in compliance with the GAAP or IFRS depending
upon the country of operation.
• Valuation of Inventory: For example, a company may adopt the
FIFO method, or average cost method.
• Depreciation: For depreciation accounting company chooses
different methods of calculating depreciation like straight-line
method, double declining method, sum of year’s digits, unit of
production, etc. Accounting policy for depreciation would include
expenses that can be capitalized, depreciation rate, disposal
process, and so on.

• Revenue and Expenses: Accounting policy for revenue recognition

and measurement could include that revenue can only be
recognized once goods or services are received by the customers
• Accounting policies are the specific principles, bases, conventions,
rules, and practices applied by an entity in preparing and presenting
financial statements.

• A change in accounting estimate is an adjustment of the carrying

amount of an asset or a liability, that results from the assessment of
the present status of, and expected future benefits and obligations
associated with, assets and liabilities.

• Prior period errors are omissions from, and misstatements in, the
entity’s financial statements for one or more prior periods arising
from a failure to use, or misuse of, faithfully representative
information
• Retrospective restatement is correcting the recognition,
measurement, & disclosure of amounts of elements of financial
statements as if a prior period error had never occurred.

• For a particular prior period, it is impracticable to apply a

change in an accounting policy retrospectively or to make
a retrospective restatement to correct an error.
• Consistency of Accounting Policies: An entity shall select and apply
its accounting policies consistently for similar transactions, other
events, and conditions, unless an IPSAS specifically requires or
permits categorization of items for which different policies may
be appropriate.
◆Accounted for in the period of change and future periods
(change in estimate).

◆No restatement of prior years’ depreciation expense.

• assume that a delivery truck was purchased @ cost of Birr 75,000,

with a SV of Birr 5000.

• At the time of the purchase, the truck was expected to 14 years, and
it was deprecated on the straight line basis. However, after 8 years
of intensive use, it is determined that the delivery truck will last only
4 more years, but that the estimated residual value of the end of the
two years will still be Birr 5000.
• Objective: The objective of this Standard is to prescribe the criteria
for selecting and changing accounting policies, together with the:

A. accounting treatment and disclosure of changes

in accounting policies
B. changes in accounting estimates,
C. the corrections of errors.

• Scope: This Standard shall be applied in selecting and

applying accounting policies, and accounting for changes
in accounting policies, changes in accounting estimates,
and corrections of prior period errors.
 IPSAS 4―The Effects Of Changes In Foreign Exchange Rates

❖Objective. An entity may carry on foreign activities in two ways. It

may have transactions in foreign currencies or it may have foreign
operations. In addition, an entity may present its financial
statements in a foreign currency.

❖The objective of this Standard is to prescribe how to include foreign

currency transactions and foreign operations in the financial
statements of an entity, and how to translate financial statements
into a presentation currency.

❖The principal issues are (a) which exchange rate(s) to use, and (b)
how to report the effects of changes in exchange rates in the
financial statements.
 IPSAS 5—BORROWING COSTS
• Borrowing costs are interest and other expenses incurred by an
entity in connection with the borrowing of funds.

• Qualifying asset is an asset that necessarily takes a substantial period

of time to get ready for its intended use or sale.

{{{Borrowing costs may include}}}

(a). Interest expense calculated using the effective interest method as
described in IPSAS 41, Financial Instruments;

(b). Finance charges in respect of finance leases and service

concession arrangements.

(e). Exchange differences arising from foreign currency borrowings, to

the extent that they are regarded as an adjustment to interest costs.
❖Objective: This Standard prescribes the accounting
treatment for borrowing costs.

❖This Standard generally requires the immediate expensing of

borrowing costs.
❖However, the Standard permits, as an allowed
alternative treatment, the capitalization of borrowing
costs that are directly attributable to the acquisition,
construction, or production of a qualifying asset.

❖Scope: This Standard shall be applied in accounting for

borrowing costs.
 IPSAS 21—IMPAIRMENT OF NON-CASH-GENERATING ASSETS
• Objective: The objective of this Standard is to prescribe the procedures
that an entity applies to determine whether a non-cash-generating asset
is impaired, and to ensure that impairment losses are recognized.

• Impairment: A non-cash-generating asset is impaired when the carrying

amount of the asset exceeds its recoverable service amount (the higher
of an asset’s fair value, less costs to sell, and its value in use).

• This Standard also specifies when an entity would reverse an impairment

loss, and prescribes disclosures

• Scope: An entity that prepares and presents financial statements under

the accrual basis of accounting shall apply this Standard in accounting for
impairment of non-cash-generating assets, except:
 Cont….
(a) Inventories (see IPSAS 12, Inventories);

(b) Assets arising from construction contracts (see

IPSAS-11,Construction Contracts);

(c) Financial assets that are included in the scope of IPSAS

41,Financial Instruments;

(d) Investment property that is measured using the fair

value model (see IPSAS 16, Investment Property);
 IPSAS 22—disclosure Of Financial Information About The General
Government Sector
• Objective: The objective of this Standard is to prescribe disclosure
requirements for governments that elect to present information
about the general government sector (GGS) in their consolidated
financial statements.

• The disclosure of appropriate information about the GGS of a

government can enhance the transparency of financial reports,
and provide for a better understanding of the relationship
between the market and non-market activities of the government,
and between financial statements and statistical bases of financial
reporting.
 IPSAS 23—Revenue From Non-exchange Transactions (Taxes And
Transfers)
• Objective: The objective of this Standard is to prescribe requirements for
the financial reporting of revenue arising from non-exchange
transactions, other than non-exchange transactions that give rise to a
public sector combination. This Standard deals with issues that need to
be considered in recognizing and measuring revenue from non-exchange
transactions.

• Scope: An entity that prepares and presents financial statements under

the accrual basis of accounting shall apply this Standard in accounting for
revenue from non-exchange transactions such as: Taxes; and Transfers
(whether cash or noncash), including grants, debt forgiveness, fines,
bequests, gifts, donations, goods and services in-kind.
 Definitions
• Conditions on transferred assets are stipulations that specify that
the future economic benefits or service potential embodied in the
asset is required to be consumed by the recipient as specified or
future economic benefits or service potential must be returned to
the transferor.

• Control of an asset arises when the entity can use or otherwise

benefit from the asset in pursuit of its objectives, and can exclude
or otherwise regulate the access of others to that benefit.

• Expenses paid through the tax system are amounts that are
available to beneficiaries regardless of whether or not they pay
taxes.
 Cont….
• Fines are economic benefits or service potential received
or receivable by public sector entities, as determined by a
court or other law enforcement body, as a consequence
of the breach of laws or regulations.
• Transfers are inflows of future economic benefits or service
potential from non-exchange transactions, other than taxes.

• Taxes are economic benefits or service potential

compulsorily paid or payable to public sector entities, in
accordance with laws and/or regulations
 IPSAS 24—PRESENTATION OF BUDGET INFORMATION IN
FINANCIAL STATEMENTS

• Objective: This Standard requires a comparison of budget

amounts and the actual amounts arising from execution
of the budget to be included in the financial statements
of entities that are required to, or elect to, make publicly
available their approved budget(s), and for which they
are, therefore, held publicly accountable.

• This Standard also requires disclosure of an explanation

of the reasons for material differences between the
budget and actual amounts.
 Cont….
• Compliance with the requirements of this Standard will ensure that
public sector entities discharge their accountability obligations and
enhance the transparency of their financial statements by
demonstrating

(a) compliance with the approved budget(s) for which they are held
publicly accountable and

(b) where the budget(s) and the financial statements are prepared on
the same basis, their financial performance in achieving the
budgeted results.
 IPSAS 27―AGRICULTURE
• Objective: The objective of this Standard is to prescribe the
accounting treatment and disclosures for agricultural activity.

• Scope: An entity that prepares and presents financial statements

under the accrual basis of accounting shall apply this Standard for
the following when they relate to agricultural activity:

• (a) Biological assets, except for bearer plants; and

• (b) Agricultural produce at the point of harvest.

 Cont….
• This Standard does not apply to:
(a) Land related to agricultural activity (see IPSAS
16, Investment Property and IPSAS 17, Property, Plant, and
Equipment);
(b) Bearer plants related to agricultural activity (see IPSAS 17).
However, this Standard applies to the produce on those bearer
plants.
(c) Intangible assets related to agricultural activity (see
IPSAS 31, Intangible Assets); and
(d) Biological assets held for the provision or supply of services.
 Definitions
• Agricultural activity is the management by an entity of
the biological transformation and harvest of biological
assets for:
1. Sale;
2. Distribution at no charge or for a nominal charge; or
3. Conversion into agricultural produce or into additional
biological assets
• Agricultural produce is the harvested produce of the
entity’s biological assets.
• A biological asset is a living animal or plant.
 Cont….
• Biological transformation comprises the processes of growth,
degeneration, production, and procreation that cause qualitative or
quantitative changes in a biological asset.

• A group of biological assets is an aggregation of similar living animals or

plants.

• Harvest is the detachment of produce from a biological asset or the

cessation of a biological asset’s life processes.
 Cont….
• A bearer plant is a living plant that:
(a) Is used in the production and supply of agricultural
produce;
(b) Is expected to bear produce for more than one period;
(c) Has a remote likelihood of being sold as agricultural
produce, except for incidental scrap sales.
 IPSAS 39—EMPLOYEE BENEFITS

Objective: The objective of this Standard is to prescribe the

accounting and disclosure for employee benefits. The standard
requires an entity to recognize:
(a) A liability when an employee has provided service in exchange
for employee benefits to be paid in the future; and
(b) An expense when the entity consumes the economic benefits or
service potential arising from service provided by an
employee in exchange for employee benefits.
• Scope: This Standard shall be applied by an employer in
accounting for all employee benefits, except share-based
transactions .
• Employee benefits are all forms of consideration given by an entity
in exchange for service rendered by employees or for the
termination of employment.

• Short-term employee benefits are employee benefits (other

than termination benefits) that are due to be settled wholly before
twelve months after the end of the reporting period in which the
employees render the related service.
• Example: Wages, salaries and social security contributions; Paid annual leave
and paid sick leave; Profit-sharing and bonuses; and Non-monetary benefits
(such as medical care, housing, cars and free or subsidized goods or services)
for current employees.
Cont’d
• Post-employment benefits are employee benefits (other
than termination benefits and short-term employee
benefits) that are payable after the completion of
employment.
• Example: Retirement benefits (e.g., pensions and lump sum payments on
retirement); and Other post-employment benefits, such as post-employment
life insurance and post-employment medical care.

• Other long-term employee benefits are all employee

benefits other than short-term employee benefits, post-
employment benefits and termination benefits
• Example: Long-term paid absences such as long-service leave or sabbatical
leave; Jubilee or other long-service benefits; and Long-term disability benefits).
Cost and Mgt Accounting 1 and Two

Chapter 1
Introduction
To management accounting
 1.4 Financial Accounting, Cost
Accounting and Management Accounting
Management accounting.
It measures and reports financial and nonfinancial information that helps
managers make decisions to fulfill the goals of an organization.

Financial Accounting
Its focus is on reporting to external parties.

It measures and records business transactions.

It provides financial statements based on

generally accepted accounting principles Or IFRS .
 Major Differences Between
Financial & Managerial Accounting

Managerial Accounting Financial Accounting

Communicate financial position to

Purpose Decision making
outsiders

Primary Users Internal managers External users

Focus/Emphasis Future-oriented Past-oriented

Do not have to follow GAAP/IFRS; cost vs. GAAP/IFRS compliant;

Rules
benefit CPA audited

Indirect effects on
Behavioral Issues Designed to influence employee behavior
employee behavior
 Cost Accounting
Cost Accounting: concerned with cost determination and cost control
Cost accounting can be viewed as the intersection between financial and management
accounting

Cost accounting addresses the informational demands of both financial

and management accounting by providing product cost information to
external parties and internal managers for planning, controlling, decision
making, and evaluating performance. 1410
1.6 Key Success Factors
• The dimensions of performance that customers expect, and that are
key to the success of a company include:
• Cost and efficiency
• Quality
• Time
• Innovation

Cost – organizations Quality – customers

are under continuous are expecting higher
pressure to reduce costs. levels of quality.
1) Management accounting:
• A) focuses on estimating future revenues, costs, and other measures to forecast
activities and their results
• B) provides information about the company as a whole
• C) reports information that has occurred in the past that is verifiable and reliable
• D) provides information that is generally available only on a quarterly or annual
basis

A
1412
2) Financial accounting:

• A) focuses on the future and includes activities such as preparing next year's
operating budget

• B) must comply with IFRS

• C) reports include detailed information on the various operating segments of

the business such as product lines or departments

• D) is prepared for the use of department heads and other employees

B
1413
3) Managers use management accounting information to ________.
• A) help external users such as investors, banks, regulators, and suppliers
• B) communicate, develop, and implement strategies
• C) communicate a firm's financial position to investors, banks, regulators, and
other outside parties
• D) ensure that financial statements are consistent with the tax rules and
regulation

B
1414
4) The person most likely to use ONLY financial accounting information is a:

• A) factory shift supervisor

• B) vice president of operations

• C) current shareholder

• D) department manager
C
1415
5) Which of the following statements refers to management accounting
information?

• A) There are no regulations governing the reports.

• B) The reports are generally delayed and historical.

• C) The audience tends to be stockholders, creditors, and tax authorities.

• D) It primarily measures manager's compensation on reported financial results.

A
1416
6) Cost accounting ________.
• A) measures the costs of acquiring or using resources in an organization
• B) helps managers to develop, communicate, and implement strategies
• C) coordinates product design, production, and marketing decisions and evaluate a
company's performance
• D) communicates information to investors, banks, regulators, and other outside
parties
A
1417
7) Which of the following differentiates cost accounting and financial
accounting?
• A) The primary users of cost accounting are the investors, whereas the
primary users of financial accounting are the managers.
• B) Cost accounting deals with product design, production, and marketing
strategies, whereas financial accounting deals mainly with pricing of the
products.
• C) Cost accounting measures only the financial information related to the
costs of acquiring fixed assets in an organization, whereas financial
accounting measures financial and nonfinancial information of a company's
business transactions. D
• D) Cost accounting measures information related to the costs of acquiring or
using resources in an organization, whereas financial accounting measures a
financial position of a company to investors, banks, and external parties.
1418
8) Which of the following statements concerning an organization's strategy is true?
• A) Strategy specifies how an organization matches its own capabilities with the
opportunities in the marketplace to accomplish its objectives.
• B) Cost accountants formulate strategy in an organization since they have more
inputs about costs.
• C) A good strategy will always overcome poor implementation.
• D) Businesses usually follow one of two broad strategies: offering a quality product
at a high price, or offering a unique product or service priced lower than the
competition.
A
1419
 CHAPTER 2
Cost determination and
Introduction to Cost
Terminologies and Classification

© 2009 Pearson Prentice Hall. All rights reserved.

 Basic Cost Terminology
Cost
• a resource sacrificed or foregone to achieve a specific
objective (eg. Recording acquisition of a long-term
resources as fixed assets; or inventory).

Cost Object
• Anything for which a separate measurement of cost is
made.
example: product, number of classes/students,
machine, service or process, project, order, and
program

Page 32
• Cost accumulation – a collection of cost data in
an organized manner for each cost object

• Cost assignment – a general term that includes

tracing and allocating the accumulated costs to a
cost object. This includes:
• Tracing: assigning direct costs (costs with a
direct relationship to the cost object)
• Allocating: assigning indirect costs (costs with
an indirect relationship to a cost object
 Direct & Indirect Costs
• Direct costs – can be conveniently and economically
traced (tracked) to a cost object
• Direct Costs for 3F furniture for example includes
• Cost of timber and metals, (DMC)
• salary of carpenter /woodworker (DLC)
• Indirect costs – cannot be conveniently or economically
traced (tracked) to a cost object.
• Instead of being traced, these costs are allocated to a cost
object in a rational and systematic manner (usually subjective).
• Indirect Costs for 3F furniture for example includes
• Electricity/utility,
• Rental cost and Property taxes,
Factors Affecting Direct / Indirect Cost Classification

• Cost Materiality/significance of the cost

• Availability of information
• Sometimes we may not have information about
whether the costs are specifically related to the
object.
• Operational Design/relation to the product or
operations.
Cost Behavior
• Total Variable costs – changes in total in proportion to
changes in the related level of activity or volume
• Total Fixed costs – remain unchanged in total regardless of
changes in the related level of activity or volume
• Costs are fixed or variable only with respect to a specific
activity or a given time period
 Cost Behavior, continued
• Variable costs per unit – are constant on a per-unit basis. If a product takes
5 pounds of materials each, it stays the same per unit regardless of one, ten
or a thousand units are produced
• Fixed costs per unit – change inversely with the level of production. As
more units are produced, the same fixed cost is spread over more and more
units, reducing the cost per unit
• Semi Variable (Mixed) Costs: Costs that vary with changes in volume
but, unlike variable costs, do not vary in direct proportion. In other
words, these costs contain both a variable component and a fixed
component.
Expense is an expired cost resulted from a productive
usage of an asset. It is the cost which has been matched
against revenue of a particular accounting period.
Example: salary, utility, depreciation, and supplies expense

Loss is a reduction in firms’ equity other than from

withdrawals of capital for which no compensating value
has been received.

Example: Obsolescence or destruction of stock by fire.

• Cost Driver
• A cost driver (also called a cost generator or cost
determinant) is a variable, such as the level of activity or
volume that causally affects costs over a given time span.
An activity: is an event, task, or unit of work with a
specified purpose.
 Different Types of Firms

• Manufacturing-sector companies – create and sell their own

products
• Merchandising-sector companies – product resellers
• Service-sector companies – provide services (intangible
products)
Types of Manufacturing Inventories
• Raw Materials – resources in-stock and
available for use to make product

• Work-in-Process (or progress) – products

started but not yet completed.

• Finished Goods – products completed and

ready for sale
Accounting Distinction Between Costs
Period Costs/ non manufacturing costs
• have no future value and are expensed as incurred.
• are expensed on the income statement as they are
incurred
• also called operating costs (excluding cost of goods
sold)
• Examples: selling, general and administrative costs

Product Costs/ manufacturing costs

• Are capitalized as assets (inventory) until they are sold
and transferred to Cost of Goods Sold
• Expensed only when the product or service is sold
• Examples: materials and labour (manufacturing)
Pages 40 - 41
Types of Product Costs
• Also known as Inventorable Costs
• Direct Materials
• Direct Labor
• Indirect Manufacturing – factory costs that
are not traceable to the product. Other
common names for this type of cost include
Manufacturing Overhead costs or Factory
Overhead costs.
Other Cost Considerations
• Prime cost is a term referring to all direct manufacturing
costs (labor and materials)
• PC= DM cost + DL Cost
• Conversion cost is a term referring to direct labor and factory
overhead costs, collectively
• CC= DL + MOH
9) Which of the following statements about the direct/indirect cost
classification is NOT true?

• A) Indirect costs are always traced.

• B) Indirect costs are always allocated.

• C) The design of operations affects the direct/indirect classification.

• D) The direct/indirect classification depends on the choice of cost object

A
10) A manufacturing plant produces two product lines: golf equipment and
soccer equipment. An example of direct costs for the golf equipment line are:

• A) beverages provided daily in the plant break room

• B) monthly lease payments for a specialized piece of equipment needed to

manufacture the golf driver

• C) salaries of the clerical staff that work in the company administrative offices

• D) utilities paid for the manufacturing plant

B
11) If each motorcycle requires a belt that costs $20 and 2,000 motorcycles
are produced for the month, the total cost for belts is:

• A) considered to be a direct fixed cost

• B) considered to be a direct variable cost

• C) considered to be an indirect fixed cost

• D) considered to be an indirect variable cost

B
12) Within the relevant range, if there is a change in the level of the cost
driver, then:

• A) total fixed costs and total variable costs will change

• B) total fixed costs and total variable costs will remain the same

• C) total fixed costs will remain the same and total variable costs will
change

• D) total fixed costs will change and total variable costs will remain the
same C
• The East Company manufactures several different products. Unit costs associated
with Product ORD203 are as follows:
• Direct materials $50
• Direct manufacturing labor 8
• Variable manufacturing overhead 10
• Fixed manufacturing overhead 23
• Sales commissions (2% of sales) 5
• Administrative salaries 9
• Total $105
13) What are the variable costs per unit associated with Product ORD203?
• A) $60
• B) $82 $50 + $8 + $10 + $5 = $73
• C) $73 C
• D) $105
Amber Manufacturing provided the following information for last month:
• Sales $20,000
• Variable costs 6,000
• Fixed costs 9,000
• Operating income $5,000
14) If sales double next month, what is the projected operating income?
• A) $10,000
• B) $25,000 ($20,000 × 2) - ($6,000 × 2) - $9,000 = $19,000
• C) $19,000
• D) $12,000
C
15) XIAN Manufacturing produces a unique valve, and has the capacity to
produce 50,000 valves annually. Currently XIAN produces 40,000 valves and
is thinking about increasing production to 45,000 valves next year. What is
the most likely behavior of total manufacturing costs and unit
manufacturing costs given this change?
• A) Total manufacturing costs will increase and unit manufacturing costs will
stay the same.
• B) Total manufacturing costs will increase and unit manufacturing costs will
decrease.
• C) Total manufacturing costs will stay the same and unit manufacturing costs
will stay the same.
• D) Total manufacturing costs will stay the same and unit manufacturing
costs will decrease.
B
16) The following information pertains to Alleigh's Mannequins:
• Manufacturing costs $1,500,000
• Units manufactured 30,000
• Units sold 29,500 units sold for $85 per unit
• Beginning inventory 0 units
• What is the amount of gross margin?
• A) $1,475,000
• B) $1,500,000 = 2,507,00 – (29500*50) = 1,032,000
29,500 × ($85 - ($1,500,000 / $30,000)) =
• C) $2,507,500
• D) $1,032,500 D $1,032,500
17) The following cost information about direct material-chemical, is taken from
Kokeb textile firm:
Chemicals on hand as of January 1, 2020, ……….Birr 100,000
Chemicals on hand as of January 31, 2020... ………..80,000
Cost of Chemicals issued to factory during January ….400,000
Excess Chemicals returned from factory
shop to store during January…………………………….. 30,000
What is the cost of direct materials purchased during the period?

A. Birr 400,000
C DMU= BDM +DMP –EDM
B. Birr 230,000
DMP= DMU+EDM-BDM
C. Birr 350,000
= 370,000 + 80,000 – 100,000
D. Birr 500.000 = 350,000
18)Which of the following is a fixed cost for an automobile
manufacturing plant?
A) administrative salaries
B) electricity used by assembly-line machines
C) sales commissions
D) windows for each car produced

A
19) The following cost information is taken from Chereka textile firm:
Cost of Cotton used in production during the period. ………….....600,000
Factory supervisors salary…………………………………………………………100,000
Cost incurred for factory labor converting cotton in to tape....... 300,000
Factory overhead cost other than indirect labor……………………….. 80,000

Based on the above information, what is the amount of prime cost?

A. Birr 600,000 Prime cost = Direct material cost + Direct Manufacturing labor cost
= 600,000 + 300,000
B. Bir 900,000 = 900,000

C. Birr 480,000
B

D. Birr 400,000
 Chapter 3
Product Cost
Job Costing System
and Process
Costing

1
Job-order Costing
System of accounting for separate cost objects
called Jobs.
 Each job may be different from the next, and
consumes different resources
• Aircraft, advertising, furniture, building

Process-Costing
System of accounting for mass production of
identical or similar products
• Oil refining, cement factory, soft drink, beer
factory
 Differences between Job-Order & Process Costing
Job-Order Costing Process Costing
1. Many different jobs are 1. A single product is produced on a
worked on during each period, with continuous basis for long periods
each job having different production of time. All units of product are
requirements. identical.
2. Costs are accumulated by 2. Costs are accumulated by
identical job. department.
3. Job Cost Sheet is the key 3. Department Production Report
document controlling the is the key document showing the
accumulation of costs by a job. accumulation & disposition of costs by a
department.
4. Unit Costs are computed by job 4. Unit Costs are computed
on the job cost sheet. by department on the department
production report.
 Similarities between Job-Order and Process Costing
1. The same basic purposes exist in both systems, which are
✓ To assign material, labor, and overhead cost to products &
✓ To provide a mechanism for computing unit costs.

2. Both systems maintain and use the same basic Mfg. Accounts,
including:
✓ MOH,
✓ Raw Materials,
✓ Work In Process, &
✓ Finished Goods.
3. The flow of costs through the manufacturing accounts is
✓ basically the same in both systems.
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 1-3
Overview of Product Costing Systems
Different kinds of product costing systems:
1. Cost Accumulation methods: The two basic
cost accumulation methods are:
a) Job costing system: Costs are accumulated
by jobs or batches of goods or services
b) Process costing systems: Costs are
accumulated by production process or
department

3
Overview of Product Costing Systems
2. Cost measurement methods:
a) Actual costing system: It uses actual amounts of costs
(DM,DL & FOH) incurred for all products
• Rarely used in practice as it dose not provide timely cost
information
b) Normal costing system: It uses actual costs for DM and
DL but normal costs for FOH based predetermined rate
• Generates timely cost information for management
decisions
c) Standard costing system: It uses standard rates (costs)
and quantities for all three types of Mfg costs.
• Provides good cost control, performance evaluation, and
process improvement

1
4
Overview of Product Costing Systems
3. Overhead assignment methods:
a) Traditional costing system often allocates overhead to
products of jobs on a volume-based cost driver, such as
DL costs, DL hours or machine hours.
• May cause serious product cost distortion, over costing or
under costing, as FOH costs are not volume-based
– E.g. machine setup cost is batch-based and product
design cost is product-based.
b) Activity based costing system allocates overhead
costs to products using cause-and-effect criteria with
multiple cost drivers: both volume-based and nonvolume-
based cost drivers.

1
4
Overview of Product Costing Systems
4. Treatment of fixed overhead costs:
a) Variable costing system treats only variable
manufacturing costs as product costs; fixed FOH
costs Consider as period Cost
• Useful for management planning and control
decisions
b) Absorption costing system includes all
manufacturing costs as product costs
• Acceptable for financial and tax reporting

1
4
 Job Costing in a Manufacturing Firm

o Job costing is used in firms that produce distinct

products that require varying attention and skill.

o A job costing system is supported by a job cost

sheet maintained for each job

o The job cost sheets serve as subsidiary ledger

accounts to Work-in-process control account.

o Each job cost sheet is separately identified by

product name and a unique number assigned.

1
4
Characteristics of job order costing
• Each job has different cost sheet
• Cost object is job
• Production started when customer is order the
product
• Each Job has it own characteristics
• Short duration of production
• DM and DL easy traced to the cost object
• MOH allocated to the cost object by using
predetermined rate
 Job Costing in a Manufacturing Firm

• A job cost sheet records all manufacturing

costs of a job. It shows:
1) the amount of each type of cost (DM, DL,
and FOH) charged by each department on
the job, and date of entry,
2) quantity,
3) start and completion date, and
4) total and unit cost
1
4
 General Steps in Job Costing
Step 1: Identify the job-the chosen cost
object.
Step 2: Identify the direct cost of the job.
Step 3: Select the cost allocation bases to
use for allocating indirect costs to the
job.
Step 4: Identify the indirect costs
associated with each cost-allocation
base.
1
4
 Gen. Steps in Job Costing Cont’d
Step 5:Compute the OH application or allocation
rate per unit of each cost-allocation base

Actual Costing:
Actual Indirect = Actual total costs in indirect cost pool
Cost Rate Actual total quantity of cost-allocation base

Normal Costing:
Budgeted Indirect = Budgeted total costs in indirect cost pool
Cost Rate Budgeted total quantity of cost-allocation base

1458
 Gen. Steps in Job Costing Cont’d
Step 6: Compute the indirect costs to be
allocated to the Job
Actual Costing:
Actual quantity of allocation base Χ Actual indirect cost rate

Normal Costing:
Actual quantity of allocation base Χ Budgeted indirect cost rate

Step 7: Compute the total cost of the job;

– This requires adding all direct and indirect costs
assigned to the job.

1459
 Journal Entries with Normal Job Costs

Journal Entries for Basic Transactions of

ABC Manufacturing during January ,2021.
1. Purchased materials (Direct & indirect)
on credit, Birr 40,000
Materials Control 40,000
Accounts payable control 40,000

1460
Journal Entries with Normal Job Costs Cont’d

2. Issued materials to manufacturing plant

floor: direct materials, Br 24,000 and indirect
materials Br 10,000.
Work- in Process Control 24,000
Manufacturing OH-control 10,000
Materials Control 34,000

1461
Journal Entries with Normal Job Costs Cont’d

3. Total manufacturing payroll for January:

Direct Br 20,500; indirect Br 6,000.
Work in Process Control 20,500
Manufacturing Overhead Control 6,000
Wages Payable Control 26,500

4. Payment of total manufacturing payroll for January

Birr 26,500. (Ignore Applicable Taxes for simplicity).
Wages Payable Control 26,500
Cash Control 26,500

1462
Journal Entries with Normal Job Costs Cont’d

5. Additional manufacturing overhead costs

incurred during January totaled Birr 4,800.
The detail includes:
Plant manager & supervisors’ payroll Br 3,000
Utilities Accrued 600
Plant Depreciation 800
Prepaid Insurance Expired (plant) 400

1463
Journal Entries with Normal Job Costs Cont’d
Manufacturing Overhead Control 4,800
Salaries Payable Control 3,000
Accounts Payable Control 600
Accumulated Depreciation Control 800
Prepaid Insurance Control 400
6. Allocation of manufacturing overhead to jobs, Birr
17,500
– It was made based on actual DML hrs of 500 at
budgeted overhead rate of Birr 35 computed at the
beginning of 2021.
Work in Process Control 17,500
Manufacturing OH Allocated (Control) 17,500
1464
 Journal Entries with Normal Job Costs Cont’d
7. Cost of goods completed and transferred to finished
goods warehouse Birr 54,000.
Finished Goods Control 54,000
Work in Process Control 54,000

8. Sales revenues all on account, Br 80,000 Cost of goods

sold for the month of January Birr 45,000.

Accounts Receivable 80,000

Revenues (Sales) 80,000
Cost of Goods Sold 45,000
Finished Goods Control 45,000
1465
Journal Entries with Normal Job Costs Cont’d

9. Marketing and customer service payroll and

advertising costs accrued for January 2021:
– Marketing & adverting costs 15,000 (of which
advertising accounts for Br 3,000)
– Customer service costs Br 5,000

Marketing & Advertising Costs 15,000

Customer-Service Costs 5,000
Salaries Payable Control (12+5) 17,000
Accounts Payable Control 3,000

1466
Process Costing
 Process-Costing
Process costing is a costing system in which the product
cost is obtained by assigning costs to masses of identical
units.
Each unit receives the same or similar amounts of direct
materials costs, direct labor costs, and manufacturing
overhead
Unit costs are computed by dividing total costs incurred by
the number of units of output from the production process
Generally, Process costing system is applied:
 To similar products
 That are mass-produced
 In a continuous fashion
Example

•Chemicals,
•Petroleum,
•Textile,
•Steel
•Beer
 The characteristics of process costing
1. The cost of production report is used to collect, summarize and compute total
and unit costs
2. Production is accumulated & reported by departments
3. Costs are posted to departmental work in process account
4. Production in process at the end of a period is restated in terms of completed
units
5. Total cost charged by a department is divided by total production units of the
department to determine the unit cost for a specific period.
6. Cost of completed units of a department is transferred to the next processing
department in order to arrive at the total costs of the finished products
during a period.
Procedures of process costing

1. Accumulate Materials, labor and factory overhead costs

by departments.
2. Determine unit costs for each department
3. Transfer costs from one department to the next and to
Finished Goods
4. Assign costs to the inventory of work still in process.
 Department costing
• Each department is responsible to perform a specific operation or
process towards the completions of production.
• While processing each department will consume (charge) a certain
amount of materials, labor and FOH for the accomplishment of its
tasks.
• When units are transferred from one department to the other the
associated cost incurred in each department will also be transferred
along with the physical flow products.
• Finally the cost of completed units is determined by dividing the
total cost of a period by the total units produced during the same
period.
• Departmental total and unit costs are determined by the use of the cost
of production report.
 journal entry
• The possible journal entry to be maintained when materials are
charged for production is as follows
• WIP-Blending department ………………xxx
• MOH……………………………………….XXX
• Materials ……………………………………xxx
• Labor costs are identified by and charged to department
• WIP-Blending department ………………xxx
• WIP-Testing department ………………..xxx
• WIP-Terminal department ……………...xxx
• MoH……………………………………….XXX
• Payroll ………………………………….……xxx
• If we use actual FOH for other manufacturing cost incurred during production,
we would able to determine the accurate /perfect/ cost of production of a certain
product.
• This method is best suitable if production is held at constant rate, but if the
reverse is happen (production varies) the predetermined FOH is used.
•
• Prior to charging of the balance of FOH to production, we should record the
balance of each expense (cost) categories entitled under it. This can be done as
follows:
• FOH control --------------------------------------xxx
• Accounts payable ----------------------------------xx
• Accumulated Depreciation- Machinery ------xx
• Prepaid insurance ---------------------------------xx
• Materials --------------------------------------------xx
• Payroll -----------------------------------------------xx
• When FOH is charged to production:
• WIP-Blending department---------xxx
• WIP – testing department ---------xxx
• WIP- terminal department ---------xxx
• MOH Control ------------------------xxx
• When good transferred from On department to Next
• WIP – terminal department ---------xxx
• WIP- testing department ---------xxx
• Goods complied
• FG…………….XXX
• WIP ………………….XXXX
• Goods sold
• AR………………XXX
• SALE …………………….XXX
• CGS……………………..XXX
• FG………………………..xxx
Product Flow Methods
A product can flow through a factory in many ways. Three product flow formats associated with
process costing are depicted below.
a) Sequential product flow

WIP. Blending dept WIP. Testing dept WIP. Terminal F.G.

Materials Labor Labor
Labor FOH FOH
FOH
b) Parallel product flow

WIP Cutting Dep. WIP-planning & sanding WIP-Assembly WIP- Painting

Materials Labor
Labor FOH Materials Materials
FOH Labor Labor
FOH FOH
WIP-Melting Dept. WIP-casting Finished Goods
Materials
Labor Labor
FOH FOH
c) Selective product flow
WIP-Butchering dept. WIP_ Packing dept. Finished Goods

Materials
Labor Materials
FOH Labor
FOH
WIP-Smoking dept.

Labor
FOH

WIP- Grinding dept.

Labor
FOH
The Cost of Production Report

• The departmental cost of production report shows all

costs chargeable to a department.
• It would help being a source for year end (Month end)
journal entries, & presenting and disposing of costs
accumulated during the month.
• The cost of production report of one department shows:
1. The total and unit costs of goods transferred (received) from the
preceding department(s)
2. Materials, labor & factory overhead added by the department
3. Unit costs for each cost categories added by the department
4. Total & unit costs accumulated to the end operation in the
department
5. The cost of beginning & ending WIP inventories and
6. Cost transferred to the succeeding department or FG store
room
Equivalent Units – The Basic Idea

Two half completed products are

equivalent to one completed product.

+ = 1

So, 10,000 units 70% complete

are equivalent to 7,000 complete units.
Five-Step Process-Costing systems

1. Summarize the flow of physical units of

output
2. Compute output in terms of equivalent units
3. Summarize total costs to account
4. Compute cost per equivalent unit
5. Assign total costs to units completed and to
units in ending Work-in-Process
Process Costing- Three Cases
I) Zero beginning and zero ending WIP inventory

II) Zero beginning and some ending WIP inventory

III) Both some beginning and ending WIP inventory

20) Under a job-order costing system, the dollar
amount transferred from Work in Process to
Finished Goods is the sum of the costs charged to
all jobs:
A. started in process during the period.
B. in process during the period.
C. completed and sold during the period.
D.completed during the period. D FG….XXX
WIP…..XXX
21) ABC furniture produces items based on customer's order. It uses job order system
with normal costing. In March 2022, the cost sheet for Job No. 125 showed the
following data:

Predetermined overhead rate... Birr 25 per machine hour.

Direct materials used………………………..8000 Birr
Direct labour rate per hour...............................19 birr
Machine time used.. …………………………30 hours.
Direct labour hours worked…………………20 H
What is the total cost of Job No. 125 for March under normal costing?
A. Birr 2,380
DM Cost ………………………………8,000
B. Birr 9,130 DL Cost (19*20)……………………380
B Machine cost (30*25)……………..750
Total cost 9130
C. Birr 8,750

D. Birr 10,275
22) Which of the following is FALSE in connection to job order
costing system?

A. Work in process is credited for the transfer of completed items to

Finished Goods Inventory

B. Finished goods is debited for goods completed & sold during the
period

C. In normal costing method, work in process is debited factory

overhead applied B

D. Finished goods is credited for cost of goods shipped to customers

23) Which of the following companies is most likely to use a process
costing system.

• A) a manufacturer of breakfast cereal

• B) a manufacturer of large commercial aircraft

• C) a custom jewelry manufacturer

• D) a law firm
A
24) In a job-order costing system, indirect labor cost is usually recorded
as a debit to:

• A) Manufacturing Overhead

• B) Work in process Inventory

• C) completed during the period

• D) in process during the period

A
25) job-order costing and process costing have which of the following
characteristics? job-order Costing and Process Costing
• a. homogeneous products, heterogeneous products and large quantities and
small quantities
• b. homogeneous products, heterogeneous products and small quantities
and large quantities
• c. heterogeneous products, homogeneous products and large quantities and
small quantities
• d. heterogeneous products, homogeneous products and small quantities
and large quantities

D
26) Which of the following statements is true?

A. A process costing system will have a separate Work in Process Inventory

account for each job.
B. A process costing system will have a single Work in Process Inventory
account.
C. A process costing system will have a separate Work in Process Inventory
account for each of the major processes (departments).
D. A process costing system will have a separate Raw Materials Inventory
account for each of the major processes (departments).
C
27) Quest Co. is a print shop that produces jobs to customer specifications.
During January 20X6, Job #3051was worked on and the following information is
available:
• Direct material used $2,500
• Direct labor hours worked 15
• Machine time used 6H
• Direct labor rate per hour $7
• Overhead application rate per hour of machine time $18
• What was the total cost of Job #3051 for January?
• A). $2,713
• B). $2,770 A 2500+ (15*7)+(18*6)
• C). $2,812
• D). $3,05
= 2713
28) O'Reilly Enterprises manufactures digital video equipment. For each unit
$2,950 of direct material is used and there is $2,000 of direct manufacturing labor
at $20 per hour. Manufacturing overhead is applied at $35 per direct
manufacturing labor hour. Calculate the cost of each unit.

• A) $4,950

• B) $9,950
2,950+2,000+((2,000/20)*35) = 8450
• C) $8,450

• D) $11,950
C
29) A journal entry includes a debit to Work in Process Inventory and a credit
to Raw Material Inventory. The explanation for this would be that

• a. indirect material was placed into production.

• b. raw material was purchased on account.

• c. direct material was placed into production.

• d. direct labor was used for production.

C
30) Which of the following journal entries records the accrual of the cost
of indirect labor used in production?

• a. debit Work in Process Inventory, credit Wages Payable

• b. debit Work in Process Inventory, credit Manufacturing Overhead

• c. debit Manufacturing Overhead, credit Work in Process Inventory

• d. debit Manufacturing Overhead, credit Wages Payable

D
31) A credit to the Manufacturing Overhead control account represents
the

• a. actual cost of overhead incurred.

• b. actual cost of overhead paid this period.

• c. amount of overhead applied to production.

• d. amount of indirect material and labor used during the period.

C
32) Which of the following formulas is correct?

A. Beginning units in inventory + units started = units completed + ending

units in inventory
B. Units started = beginning units in inventory + units completed + ending
units in inventory
C. Units started − beginning units in inventory = units completed + ending
units in inventory
D. Ending units in inventory + beginning units in inventory = units started
− units completed
A
33) An equivalent unit is calculated by:

A. multiplying the number of physical units by the percentage of

completion.

B. dividing the number of physical units by the percentage of completion.

C. subtracting the number of physical units in ending Work in Process

Inventory from the total number of physical units.

D. dividing the number of physical units into direct materials and

conversion costs. A
35) If beginning work in process is 2,000 units, ending work in process is
1,000 units, and the units accounted for equals 5,000 units, what are the
units completed and transferred out?

• A) 7,000 BI= 2000

Unit accounted = 5000 so unit started 3000
• B) 6,000
EI= 1000
• C) 4,000
UNIT completed = 2000+ 3000-1000
• D) 2,000 = 4000
C
• 36) S Company had the following department information about
physical units and percentage of completion:
• Physical Units
• Work in process, May 1 (60%) 36,000
• Completed and transferred out 90,000
• Work in process, May 31 (40%) 30,000
• If materials are 100% complete at the beginning of the production
process, what is the total number of equivalent units for materials
during May? Weighted Average Method
• A) 66,000
• B) 120,000
• C) 156,000
• D) 102,000 B
37) JJ manufacturing uses process costing system with two departments:
Department A and Department B. It uses weighted average method.

Which of the following is correct to compute cost per equivalent unit for a
given cost component?

A. Current period cost less the cost of beginning inventory divided by EUP

B. Current period cost plus the cost of ending inventory divided by ELIP

C. Current period cost plus the cost of beginning inventory divided by EUP

D. Current period cost divided by FUP

C
38) HH Company uses process costing system in weighted average method. Record for
department 1 the following for March 2022:
• Beginning Work in process, 80% complete as to cost 5000 units
• Units stared in March. 25,000
• Ending work in process, 25% complete as to Conversion cost. 8,000 unit
• Beginning work in process inventory cost:
• Material... Birr 20,000
• Conversion cost. 60,000
• Costs in March:
• Material Birr 34,000
• Conversion cost 72.000
• All material is added at the start of the process and all finished products are transferred out. What
is cost equivalent unit of production for material and conversion cost?

A. Birr 1.70 and 5.30 respectively

B. Birr 1.80 and Br 5.50 respectively
C. Birr 2.70 and 6.6 respectively B
D. Birr 2.20 and 5.40 respectively
BWIP 5000
Unit started 25000
Total 30000
Unit Completed 22,000 22,000 22000
EWIP 8000 8000 2000
(8000*0.25)
Total 30000 30000unit 24000 unit
Beginning cost 20000 60000
Cost add current 34000 72000
Total 54,000 Birr 132000 Birr
Unit cost 54000 132000
30000 24000
1.8 birr/unit 5.5Birr/ unit
BWIP 36000
Unit started 84000
Total 120,000
Unit Completed 90,000 90,000 90000
EWIP 30000 30000 12000
(30000*0.4)
Total 120000 120000unit 102000unit
39) On July 1, Premiere Paints' Mixing Department had 80,000 units in Beginning Work-in-
Process that were 80% complete. Between July 1 and July 31, the department transferred
150,000 units to the Packaging Department. At the end of the month, on July 31, the
Mixing Department had 40,000 units in Work-in-Process that were 80% complete.
Materials are added at the beginning of the process, while conversion costs are incurred
uniformly throughout the process. For July, using the FIFO method, the Mixing
Department's equivalent units of production for conversion costs were:

• A) 110,000

• B) 129000
D
• C) 112,000

• D) 180,000
BWIP 80000
Unit started 110,000
Total 190,000
B WIP 80000 - 80,000*0.2
16000
Unit Completed 70000 70000 70000
EWIP 40000 40000 32000
(40000*0.8)
Total 190000 110000unit 118,000 unit
COSTAND MANAGEMENT
ACCOUNTING I

CHAPTER-Four

COST
ALLOCATION
5.1. Cost Allocation & Cost Object
Cost Allocation
✓ is the process of assigning costs in a Cost
Pool to the appropriate Cost Objects!
✓

A Cost Pool is a collection of costs that are to

be allocated to Cost Objects!
C o s t O b j e c t is a n y t h i n g f o r w h i c h c o s t
data are desired.
Example:
✓ Products, ✓ Jobs,
✓ Product Lines, ✓ Departments,
✓ Customers, ✓ S u b - units
 5.2. Purposes of Cost Allocation
1. To provide information for economic decisions!
2. To motivate managers and other employees!
3. To justify costs or compute reimbursement!
4. To measure income & assets for reporting to
external parties!
 Operating and Supporting Departments

• Operating departments (also called a production department in manufacturing

companies) are departments which involved in changing the shape or size of an item
and add value to a product or service that is observable by the customer.
• Supporting departments (also called a service department) are departments that
provide services that maintain other internal departments (operating and other
supporting departments) in the organization. Such as information systems and plant
maintenance.
• Managers face two questions The first one is when allocating the costs of a support
department to operating departments or divisions.
• The second question, Which approach to use? two approaches to allocating support-
department costs: the single-rate cost-allocation method and the dual-rate cost-
allocation method.

• :
 5.3 Cost Allocation Methods
▓ Single-Rate and Dual-Rate Methods
1. The Single-Rate Allocation Method
Pools all costs in one cost pool &
Allocates theses costs to cost objects using the
same rate per unit of the single allocation base!
❖ There is no distinction between costs in a
cost pool in terms of cost behavior, such
as fixed costs versus variable costs!

Sunday, January 8, Cost & Management Accounting - I

2023 Instructor: Kassaye Tuji
 Cost Allocation Methods…
▓ Single-Rate and Dual-Rate Methods…
2. The Dual-Rate Cost Allocation Method
Classifies costs in each cost pool into sub
cost pools:
✓ a variable cost pool &
✓ a fixed cost pool.
❖ Each of these pools uses a different cost
allocation base!
Sunday, January 8, Cost & Management Accounting - I
2023 Instructor: Kassaye Tuji
 Example:
• Assume that XYZ Company has a computer department which serves Testing and Terminal departments only.
The following data apply to the next budget year.

• Fixed cost of operating the facility …………………………..$ 300,000 per year

• Budgeted hours
• Testing department ……………………………………………………….. 800
• Terminal department …………………………………………...………… 400
• Total ………………..……………………………………………… 1,200
• Budgeted variable cost per hour $200/hour used.

• Assume further that Testing department actually uses 900 hours and Terminal 300 only.

• Required: use the budgeted rate and budgeted usage as a base and allocate the XYZ Company’s computer
department cost under:
Single rate method and Dual rate method
 Allocation Based on the Demand for (or Usage of)
Computer Services Under Single rate

• Total cost pool [$300,000 + (1,200hrs * $200)] ………..…… $540,000 per year
• Budgeted usage ………………………………...…………………. 1,200 hours
• Budgeted total rate per hour ($540,000/1,200 hrs)……………….... $450/hr used
• Cost allocated to:
• Testing department ………………………..……………$450*900Ah = $405,000
• Terminal department ……………………..………….…$450*300Ah = $135,000
 Allocation Based on the Demand for (or Usage of)
Computer Services Under Dual rate

• Cost allocated to testing department:

• Fixed cost function ($300,000* 800/1,200)……………..………… $200,000
• Variable cost function ………………………...……………….…….. $200/hour used
• Allocated cost $200,000 + (900*200)……….………………….…. $380,000
• Cost allocated to terminal department:
• Fixed cost function ($300,000* 400/1,200)………………………… $100,000
• Variable cost function …………………….……………..………… $200/hour used
• Allocated cost $100,000 + (300*200)…………. ………….………. $160,000
Operating and Support Departments
Operating Department (Production Department) adds value
to a product or service that is observable by a customer.

Support Departments (Service Department) provide the

service that assists other internal departments.

Methods of Support Department Cost Allocation:

1. Direct Allocation Method
2. Step-Down Allocation Method
3. Reciprocal Allocation Method
Sunday, January 8,
2023
Sunday, January 8,
2023
 Allocating Common Costs
• A common cost is a cost of operating a facility, activity, or like cost object that
is shared by two or more users.

• Common costs exist because each user obtains a lower cost by sharing than
the separate cost that would result if such a user were an independent entity.

• The goal is to allocate common costs to each user in a reasonable way.

7-1517
 Common Costs in Business
• The problem with creating a list of common costs is that they differ for
various businesses. However, you can consider the following
expenditures to be the common costs in most cases:
• rent;
• phone and utilities;
• licenses and tax deposits;
• professional services;
• insurance;
• travel expenses;
• office and other administrative supplies;
• marketing budgets. 7-1518
•Three methods of allocating
this common cost between the
prospective Departments are
the
•stand-alone method
•incremental method and
•the shapely value
7-1519
50) Which of the following is FALSE about cost allocation methods?

A. The dual-rate method provides better information for making decisions

B. The single-rate method aggregates fixed and variable costs and allocates
them to objects using a single allocation base and rate

C. The dual-rate method, groups costs into separate variable cost and fixed
cost pools and use a single cost- allocation base and rate.

D. The single-rate method is relatively simple to apply

C
51) Which of the following may be used by managers to
discourage unnecessary use of service of a support department
by user departments?
A. Allocate support department costs based upon user department
usage
B. Prohibiting user departments from using service of support
departments
C. Allocate a fixed amount of support department costs to each
department regardless of use
D. Not allocate any support department costs to user departments
A
52) Which of the following illustrates a purpose for allocating costs to cost
objects?

• A) to provide information for economic decisions

• B) to reduce competition

• C) to determine employee benefit costs

• D) to defer income and reduce taxes payable A

• E) to evaluate managers and employees
7-1522
53) The method that allocates costs in each cost pool using the same rate
per unit is known as the

• A) incremental cost allocation method.

• B) reciprocal cost allocation method.

• C) single-rate cost allocation method.

• D) dual-rate cost allocation method.

C
• E) homogeneous cost allocation method.

7-1523
54) Under which of the following methods of cost allocation is there no
distinction between fixed and variable costs?

• A) fixed method

• B) dual-rate method

• C) homogeneous method

• D) standard cost method

E
• E) single-rate method

7-1524
55) Which of the following methods of allocating support department costs
is both simple and intuitive?

• A) linear equation method

• B) step-down method

• C) hybrid method

• D) reciprocal method

• E) direct allocation method

E
7-1525
56) What is conceptually the most defensible method for allocating​ support-
department costs?​ Why?
• A. The reciprocal method is theoretically the most defensible method because it fully recognizes the mutual
services provided among all​ departments, irrespective of whether those departments are operating or
support departments.

• B. The​ step-down method is theoretically the most defensible method because it allocates​ support-
department costs to other support departments and to operating departments in a sequential manner.

• C. The direct method is theoretically the most defensible method because it allocates each support​
department's costs to operating departments only. The direct method does not allocate​ support-department
costs to other support departments.

• D. None of the above are correct.

A 7-1526
57) Which method allows for partial recognition of the services rendered by
support departments to other support departments?

• A) the direct allocation method

• B) the single-step allocation method

• C) the reciprocal allocation method

• D) the dual-rate method

• E) the step-down allocation method

E
7-1527
58) Which of the following terms describes a cost of operating a facility, operation,
activity area, or like cost object that is shared by two or more users?

• A) common cost

• B) direct cost

• C) fixed cost

• D) varying cost

• E) sunk cost
A
7-1528
COST AND MANAGEMENT ACCOUNTING I
Chapter 5
ACTIVITY-BASED

COSTING

AND

MANAGEMENT
 Cost classification
Appear on the income
• Product Costs statement when
goods are sold, prior
• Direct labor to that time they are
• Direct materials stored on the balance
sheet as inventory.
• Factory Overhead
• Period Costs Appear on the income
statement in the
• Administrative expense period incurred.
• Sales expense
Cost classification
• Product Costs Direct labor and direct
materials are easy to
• Direct labor trace to products.
• Direct materials
The problem comes
• Factory Overhead with factory
• Period Costs overhead.

• Administrative expense
• Sales expense
Traditional Costing Systems
• Typically used one rate to allocate overhead to products.
• This rate was often based on direct labor dollars or direct labor hours.
• This made sense, as direct labor was a major cost driver in early
manufacturing plants.
Problems with Traditional Costing Systems
• Manufacturing processes and the products they produce are now
more complex.
• This results in over-costing or under-costing.
• Complex products are not allocated an adequate amount of overhead costs.
• Simple products get too much.
Today’s Manufacturing Plants
• Are more complex
• Are often automated
• Often make more than one product
• Use proportionately smaller amount of direct labor
making direct labor a poor allocation base for factory
overhead.
• Then multiple allocation bases should be used to
allocate overhead expense.
• In such situations, managers need to consider using
activity based costing (ABC).
 Activity–Based Costing (ABC)
ABC is a
ABC is designed to good supplement
provide managers with to our traditional
cost information for cost system
I agree!
strategic and other
decisions that potentially
affect capacity, and
therefore, affect “fixed”
as well as variable
costs.
ABC
• Activity based costing is an approach for allocating overhead costs.
• An activity is an event that incurs costs.
• A cost driver is any factor or activity that has a direct cause and effect
relationship with the resources consumed.
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.

Manufacturing Nonmanufacturing
costs costs

Traditional ABC
product costing product costing

 ABC assigns both types of costs to products.

How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.

Manufacturing Nonmanufacturing
costs costs

Some
All

Traditional ABC
product costing product costing

 ABC does not assign all manufacturing costs to products.

How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.

Each ABC cost pool has its

own unique measure of activity.

Traditional cost systems usually rely

on volume measures such as direct labor
hours and/or machine hours to allocate
all overhead costs to products.

 ABC uses more cost pools.

How Costs are Treated Under
Activity–Based Costing
An event that causes the
Activity consumption of overhead
resources.

A “cost bucket” in which

Activity costs related to a single
Cost Pool activity measure are
accumulated.
$ $
$
$ $
$
How Costs are Treated Under
Activity–Based Costing
The term cost driver is
Activity
also used to refer to
Measure
an activity measure.

An allocation base
in an activity-based
costing system.
How Costs are Treated Under
Activity–Based Costing
Two common types of activity measures:

Transaction Duration
driver driver

Simple count A measure

of the number of of the amount
times an activity of time needed
occurs. for an activity.
How Costs are Treated Under
Activity–Based Costing
ABC defines
five levels of activity
that largely do not relate
to the volume of units
produced.

Traditional cost systems usually rely on volume

measures such as direct labor hours and/or machine
hours to allocate all overhead costs to products.
How Costs are Treated Under
Activity–Based Costing
Unit-Level Batch-Level
Activity Activity

Manufacturing
companies typically combine
their activities into five
classifications.

Product-Level Customer-Level
Activity Organization- Activity
sustaining
Activity
1. Unit-level activities are performed each time a unit is produced.
For example, providing power to run processing equipment would be a
unit-level activity.
2. Batch-level activities are performed each time a batch is handled or
processed, regardless of how many units are in the batch. For example,
setting up equipment and shipping customer orders are batch-level
activities.
3. Product-level activities relate to specific products and must be carried
out regardless of how many batches are run or units are produced or sold.
For example, designing or advertising a product would be product-level
activities.
4. Customer-level activities relate to specific customers and are not tied to
any specific product. For example, sales calls and catalog mailings would
be customer-level activities.
5. Organization-sustaining activities are carried out regardless of which
customers are served, which products are produced, how many batches
are run, or how many units are made. For example, heating a factory and
cleaning executive offices are organization-sustaining activities.
Possible Activity measures or Cost Drivers
• Machine hours
• Direct labor hours
• Number of setups
• Number of products
• Number of purchase orders
• Number of employees
• Number of square feet
When do we use ABC costing?
• When one or more of the following conditions are present:
• Product lines differ in volume and manufacturing complexity.
• Product lines are numerous and diverse, and they require different
degrees of support services.
• Overhead costs constitute a significant portion of total costs.
 Activity-Based Management (ABM)
▓What is ABM?

❖ ABM is an extension of ABC from a product costing system to a

management function that focuses on:
✓ Reducing costs &
✓ Improving processes and decision making.

Value-Added Activities
▓ Activities
Non–Value-Added Activities
Saturday, January 21,
2023
 Activity-Based Management (ABM)…
Value-Added Activities
▼ Value-Added Activities are activities
that increases the worth of a product
or service such as:

❑ In Manufacturing Company ❑ In Service Company

→ Assembly →Performing surgery
→ Painting → Legal research
→ Packaging → Delivering packages

Saturday, January 21,

2023
 Activity-Based Management (ABM)…
Non-Value-Added Activities
❖ An activity that:
✓ Adds cost to, or
✓ Increases the time spent on, a product/service;
Without increasing its market value such as:
❑ In Manufacturing Company ❑ In Service Company
→ Repair of machines → Taking appointments
→Storage of inventory →Reception
→ Moving of inventory → Bookkeeping and billing
→ Building maintenance → Traveling
→Inspections → Ordering supplies
→ Inventory control → Advertising

* Keynote – Focusing on value adding activities!

Saturday, January 21, Cost & Management Accounting - I
2023 Instructor: Kassaye Tuji
59) Activity-based costing (ABC) can eliminate cost
distortions because ABC systems _____.
A. establish a cause-and-effect relationship with the activities
performed
B. use single cost pool for all overhead costs, thereby enabling
simplicity
C. use a broad average to allocate all overhead costs
D. never consider interactions between different departments
in assigning support costs
A
60) Which of the following is correct about activity based costing?

A. It tends to allocate too great a proportion of overheads to high volume

products
B. Assign costs to a product on the basis of the product's consumption of
the activities
C. It assume that all products consume all resources in proportion to their
production volumes
D. It allocates equal amount of overheads to all products

B
61) Activity-based costing (ABC) is a costing technique that uses a two-
stage allocation process. Which of the following statements best describes
these two stages?

A. The costs are assigned to departments, and then to the products based
upon their use of activity resources.
B. The costs are assigned to activities, and then to the products based upon
their use of the activities.
C. Indirect costs are assigned to activities, and then to the products using a
plant-wide rate.
D. Service department costs are allocated to the production departments,
and then to the products based upon their use of the activities.

B
• 62) Which of the following statements is true of activity-based costing?
A) In activity-based costing, direct labor-hours is always the best
allocation base to allocate all non-manufacturing indirect costs.

• B) Activity based costing is more suited to companies with high product

diversity than companies with single product line.

• C) Activity based costing broadly averages or spreads the cost of

resources uniformly to cost objects such as products or services.
B
• D) The main advantage of activity-based costing over peanut-butter
costing is the accurate distribution of all direct costs to the products.
• 63) Which of the following statements is true of ABC systems?

• A) ABC systems are time-driven cost systems.

• B) ABC systems classify some direct costs as indirect costs and some indirect
costs as direct costs.

• C) ABC systems provide valuable information to managers beyond accurate

product costs.

• D) ABC systems assume all costs are variable costs. C

• 64) ABC systems create ________.
• A) one large cost pool
• B) homogeneous activity-related cost pools
• C) activity-cost pools with a broad focus
• D) activity-cost pools containing many direct costs
B
• 65) Activity based costing system differs from
traditional costing systems in the treatment of
________.
• A) direct labor costs
• B) direct material costs
• C) prime costs
• D) indirect costs D
• 66) The term cost driver refers to
• a. any activity that can be used to predict cost changes.
• b. the attempt to control expenditures at a reasonable level.
• c. the person who gathers and transfers cost data to the management
accountant.
• d. any activity that causes costs to be incurred.
D
 CHAPTER ONE
COST- VOLUME- PROFIT ANALYSIS (CVP-ANALYSIS)
 INTRODUCTION
❑ CVP analysis is one of most powerful tool that help managers as they make decisions by facilitating quick
estimation of net income at different levels of activity.
❑ It helps them to understand interrelationship between cost, volume & profit in organization by focusing
on interactions between:
✓ Prices of products,
✓ Volume or level of activity
✓ Per unit variable costs
✓ Total fixed costs
✓ Mix of products sold.

❑ CVP analysis helps managers as a vital tool in many business decisions like:
✓ What products to manufacture or sell,
✓ What pricing policy to follow,
✓ What marketing strategy to employ, and
✓ What type of productive facilities to acquire.
Managers use the following assumptions during CVP analysis
to make business decisions, :
1) The number of units sold is the only revenue & cost driver.
2) Total costs can be separated into two components: Fixed
Cost and Variable Cost.
3) The behaviors of total revenues and total costs are linear (
a straight line ) in relation to units sold within a relevant
range (and time period).
4) SP/U, VC/U, and FC (within a relevant range & time period)
are known and constant.
5) In multi-product/service companies, sales mix is constant;
❑CM represents amount remaining from sales revenue after variable expenses have
been deducted.
❑It is amount available to cover fixed expenses & then to provide profit for period.
❑CMPU- indicates by how much Birr contribution margin is increased for each unit
sold.
➢ Example: Sample Merchandising Company’s contribution margin of Br.3.00 per
unit indicates that each unit sold contributes Br.3.00 to covering fixed expenses
and providing for a profit.
 Break Even Analysis Uses and Techniques
❑ Study of CVP analysis is usually referred as break-even analysis.
❑ CVP analysis can be used to examine how various alternatives that decision maker is considering affect
operating income.
❑ The BEP is frequently one point of interest in CVP analysis.
❑ BEP is
✓ The point where total sales revenue equals total expenses, i.e., total variable cost plus total fixed costs.
✓ It is a point where total contribution margin equals to total fixed expenses.
✓ It is a point where operating income is zero.
❑ Approaches to determine break-even point:
 Equation technique
 Contribution margin technique
 Graphical method.
 Target Net Profit Analysis
A. Compute Tantu’s breakeven point (BEP) in sales birrs for the year.

BEP (in birrs) = Fixed Expenses + Target Profit

CM –ratio

B. Compute the number of sales units required to earn a net income

BEP (in birrs) = Fixed Expenses + Target Profit
CM –unit
 Margin of Safety
➢ It is the excess of budgeted (or actual) sales over breakeven volume of sales.
➢ It states the amount by which sales can drop before losses begin to be incurred.
➢ It is the amount of sales revenue that could be lost before the company’s profit
would be reduced to zero.
➢ The formula for its calculations follows:
✓ Total sales - Break even Sales = Margin of safety
✓ The margin of safety can also be expressed in percentage form.
Margin of Safety Ratio= Margin of safety in birrs
Total sales
 Impact of Income Taxes on CVP Analysis
➢ Thus far we have ignored income taxes.
➢ But, profit-seeking enterprises must pay income taxes on their profits.
➢ This fact is expressed in the following formula:

NIAT = NIBT (1 – Tax rate)

Where NIAT = net income after taxes
NIBT=net income before taxes
 Applying CVP Analysis

❑ Sensitivity “What If” Analysis

❑ Sensitivity analysis is a “what if” technique that examine how a result will change if
original predicted data are not achieved or if underlying assumption changes.
❑ In context of CVP, sensitivity analysis answers such questions as:
✓ What will operating income be if output level decreases by given percentage
from original reduction?
✓ What will be operating income if variable costs per unit increase?
❑ Sensitivity analysis to various possible outcomes broadens managers’ perspectives
as to what might actually occur despite their well-laid plans.
 CVP Analysis with Multiple Products
1) Definition of Sales Mix
➢ Term sales mix (also called revenue mix) is relative proportions or
combinations of quantities of products that comprise total sales.

➢ If the proportions of the mix change, CVP relationships also change.

➢ Thus, managers try to achieve combination, or mix, that will yield greatest amount
of profit.
➢ In a multi-product firm, break-even analysis is somewhat more complex.
➢ The reason is that different products will have:
✓ Different selling prices
✓ Different costs
✓ Different contribution margins.

➢ Using contribution margin approach, computation of (BEP) in multi-product firm follows:

BEP (in units) = Total fixed expenses
Weighted average CM per uint
BEP (in birrs) = Total Fixed Expenses
Weighted average CM ratio
➢ Weighted average unit contribution margin is average of several products’ unit contribution
margins, weighted by relative sales proportion of each product.
• WACM Per unit = CMPU1*N1+ CMPU2*N2+ CMPU3*N3
CMPU = Contribution margin per unit
N= Sale mix based on sale unit
• N1= sale unit 1/ total sale unit
• N2= sale unit 2/ total sale unit
N3= sale unit 3/ total sale unit

WACM Ratio = CMR1*n1+ CMR2*n2+ CMR3*n3

CMR= Contribution margin ratio
n = sale mix based on sale birr
n1= Sale birr 1/ total sale birr
n2= Sale birr 2/ total sale birr
n3 = Sale birr 3/ total sale birr
66) The contribution margin ratio always increases when the:

A. Break-even point increases.

B. Variable expenses as a percentage of net sales decrease.

C. Break-even point decreases.

D. Variable expenses as a percentage of net sales increase.

B
CM Ratio = 1 – Vc Ratio
67) When a multi-product factory operates at full capacity, decisions
must be made about which products to emphasize in making such
decisions, products should be ranked based on:

A. contribution margin per unit of the constraining resource

B. selling price per unit

C. Contribution margin per unit

D. unit sales volume A

68) ABC Company has only 25,000 hours of machine time each month to manufacture
its two products. Product X has a unit contribution margin of Birr 50, and Product Y has
a unit contribution margin of Birr 64.

Product X requires 5 hour of machine time, and Product Y requires 8 hours of machine
time.

If ABC Company wants to dedicate 80% of machine time to the product that will provide
the most income, the company will have a total contribution marge
Product X Product Y
CM Birr 50 Birr 64
A. Birr 210,000 Hour 5 8
B. Birr 200,000 CM/H (50/5) 10Birr/h (64/8) 8 Birr/h
C. Birr 240,000
25000*0.8= 20000 h
D. Birr 250,000
X= 20000H*10Birr = 200,000
C Y= 5000*8Birr = 4000
Total CM 240,000
69) Which of the following statements about determining the breakeven
point is FALSE?

• A) Operating income is equal to zero.

• B) Contribution margin - fixed costs is equal to zero.

• C) Revenues equal fixed costs plus variable costs.

• D) Breakeven revenues equal fixed costs divided by the variable cost per
unit
D
70) Once the break-even point is reached, which of the following
statements is true?

• A). the total contribution margin changes from negative to positive.

• B). net income will increase by the unit contribution margin for each
additional item sold.

• C). variable expenses will remain constant in total.

• D). the contribution margin ratio begins to decrease. B

71) Which of the following items is NOT an assumption of CVP analysis?

• A) Costs may be separated into separate fixed and variable components.

• B) Total revenues and total costs are linear in relation to output units.

• C) Unit selling price, unit variable costs, and unit fixed costs are known
and remain constant.

• D) Proportion of different products will remain constant when multiple

products are sold.
C
72) SC Lighting manufactures small flashlights and is considering raising the price
by 50 cents a unit for the coming year. With a 50-cent price increase, demand is
expected to fall by 6,000 units.
• Currently Projected
• Demand 40,000 units 34,000 units
• Selling price $4.50 $5.00
• Variable cost per unit $3.00 $3.00
If the price increase is implemented, operating profit is projected to:
A) increase by ETB 8,000
A
B) decrease by ETB 8,000
C) increase by ETB 12,000 Operating profit = CM * Unit slod
D) decrease by ETB 9,000
[34,000 × ($5 - $3)] - [40,000 × ($4.50 - $3.00)] = increase of $8,000
= 68000 – 60000 = 8000
73) Companies should only produce and sell units as long
as:
• A) there is customer demand for the product
• B) the competition allows it
• C) the revenue from an additional unit exceeds the cost of
producing it
• D) there is a generous supply of low-cost direct materials

C
74) Assume that a company sells a single product. If Q equals the level of
output, P is the selling price per unit, V is the variable expense per unit,
and F is the fixed expense, then the break-even point in sales dollars is:

• A F/[Q(P-V)]

• B F/[(P-V)/P]

• C F/[Q(P-V)/P]

• D F/(P-V)
B
75) Garth Corp sells a single product. if the selling price per unit and the
variable expense per unit both increase by 10% and the fixed expenses do
not change then: CM/unit, CM Ratio, Break-even units

• A Increase, Increase, Decrease

• B No Change, No Change, No Change

• C No Change, Increase, No Change

• D Increases, No Change, Decreases D

76) CVP analysis can be used to study the effect of:

• A. changes in selling prices on a company's profitability.

• B. changes in variable costs on a company's profitability.

• C. changes in fixed costs on a company's profitability.

• D. changes in product sales mix on a company's profitability.

• E. all of the above

E
77) Which of the following would produce the largest increase in the
contribution margin per unit?

• A. A 7% increase in selling price.

• B. A 15% decrease in selling price.

• C. A 14% increase in variable cost.

• D. A 17% decrease in fixed cost.

• E. A 23% increase in the number of units sold. A

78) A recent income statement of Banks Corporation reported the following
data: Sales revenue Birr 8,000,000, Variable costs 5,000,000, Fixed costs
2,200,000. If these data are based on the sale of 20,000 units, the
contribution margin per unit would be:

• A. Birr 40.

• B. Birr 150. CM/unit = CM/Unit sale

= 3,000,000/20,000
• C. Birr 290. B
• D. Birr 360
Chapter 2
Relevant Information
and Decision Making:
 Decision-making is one of the basic functions of a manager.
The purpose of management accounting is:

To provide information that enables

managers to make sound decisions.
Accountants have an important role in the
decision making process, not as a decision
makers but as a collectors and reporters of
relevant information.

The accountant's role in decision making is

primarily that of a technical expert on financial
analysis who helps managers focus on relevant
data, information that will lead to the best
decisions.
Relevance defined
Relevant information is the predicted
future costs and revenues that will
differ among the alternatives
Note that:
➢ Relevant information is a prediction of the future, not a
summary of the past.
➢ Historical (past) data are irrelevant to the decision itself,
because the decision cannot affect past data. Decisions affect
the future. Nothing can alter what has already happened.
➢ Of the expected future data, only those that differ from
alternative to alternative are relevant to decision.
➢ Any item that will remain the same regardless of the alternative
selected is irrelevant.
 Relevant cost and revenue
• Relevant costs are expected future costs, and
• relevant revenues are expected future revenues that differ
among the alternative courses of action being considered.
Revenues and costs that are not relevant are said to be
irrelevant.
• It is important to recognize that to be relevant costs and
relevant revenues they must:
Occur in the future—every decision deals with selecting a
course of action based on its expected future results.
Differ among the alternative courses of action—costs and
revenues that do not differ will not matter and, hence, will
have no bearing on the decision being made.
 Let us now move on to consider an example in a
business environment.
A company is considering the alternative of either purchasing a component
from an outside supplier or producing the component itself. The supper offer the
product by 500 birr
The estimated costs to the company of producing the component are as
follows:

Direct material 300

Direct labor 100
Variable overheads 50
Fixed overheads 100
550
7-1589
 We can therefore represent the cost statements
for the two alternatives using only relevant cots as
follows:

Company To Company
Manufacture To Purchase
Component Component
$ $
Direct material 300 -
Direct labor 100 -
Variable overheads 50 -
Fixed overheads - -
Supplier's purchase price - 500
450 500
 Quantitative and Qualitative Factors
Quantitative factors are outcomes that are measured in
numerical terms. Some quantitative factors are financial; they can be
expressed in monetary terms.

Examples include the cost of direct materials, direct manufacturing

labor, and marketing.

Other quantitative factors are nonfinancial; they can be measured

numerically, but they are not expressed in monetary terms.

Reduction in new product-development time and the percentage of

on-time flight arrivals are examples of quantitative nonfinancial
factors.
Quantitative and Qualitative Factors

Qualitative factors are outcomes that

are difficult to measure accurately in
numerical terms.

Employee morale, customer satisfaction

 Accuracy and Relevance

In the best, information used for decision making

would be perfectly relevant and accurate. However in reality,
the cost of such information often exceeds its benefits.

Accountants often trade off relevance versus

accuracy. Of course, relevance information must
be reasonably accurate but not precisely so.

Precise but irrelevant information is worthless

for decision making. On the other hand, imprecise
but relevant information can be useful. For example,
sales predictions for a new product may be subject
to great error, but they still are helpful to the
decision of whether to manufacture the product.
 Concept of Differential Costs and
Revenues

Differential Cost

Is a cost that would be different if one alternative,

rather than another alternative, were selected.

Differential costs are also called relevant

costs. The term refers both to certain items of cost
and to amounts of cost. Thus in many situations,
direct labor is an item of differential cost; also, if
the amount of cost that differs in a certain problem
is $1000, the $1000 is said to be the amount of
differential cost.
Opportunity Costs

A Special type of relevant costs is an opportunity cost.

An Opportunity Cost

Represent a potential benefit that is given up

because one course of action is chosen over
anther.

For example, the XYZ company owns a piece of land

acquired at a total cost of $100,000. The company has the
opportunity to sell the land for $ 500,000. The company’s
managers decide to keep the land and use it as the location
for the company’s new headquarter. The opportunity cost
of this is $500,000 - the benefit foregone by choosing the
alternative of keeping the land rather than selling it. The
historical cost of $ 100,000 is not relevant to the decision; it
is a sunk cost.
Out – Of – Pocket Costs
The term out-of-pocket costs refer to

cost items that will cause the company

to pay money out of its “pocket” if the
alternative under consideration is
adopted.
Out-of-pocket costs therefore are the same
thing as differential costs in many situations.
Opportunity costs however, often are not out-of-
pocket costs, so the out-of-pocket costs is not
always relevant.
 Sunk Costs

Is a cost that has already been incurred and,

therefore, is irrelevant to the decision making
process.

Sunk cost should have the same meaning of past cost

or historical cost.
Depreciation is ordinarily a sunk cost
because depreciation is a write-off of the cost of
fixed asset, and the cost of the asset was
incurred when the asset was acquired.
Similarly, the book value of a fixed asset is a sunk
cost, it represents that portion of the acquisition
cost that has not yet been written off as
depreciation expense.
 Alternative Choice Decisions
• Alternative choice decisions are situations with two or more courses of action
from which the decision maker must select the best alternative.
The variety of alternative choice decisions is limitless. Some business example
follows:
 Should we accept a special order for a product below our normal selling price?
 Should we raise the price of a product or maintain the current price?
 Should we make or buy a component part?
 Should we sell a joint product at the split off point or process it further?
 Should we keep our copying machine or acquire a faster one?
79) A business has acquired a special purpose machine at a cost of Birr 100,000.
After it is purchased it known that it was unwise is to buy this item. No amount of
regret can relieve the firm from this decision and there is no any future decision that
can avoid this cost.

What is the appropriate classification for this cost?

A. Sunk cost

B. Uncontrollable cost

C. Management cost A
D. Period cost
80) Relevant costs of a make-or-buy decision include all of the
following EXCEPT

A. Fixed salaries that will not be incurred if the part is outsourced

B. Current direct material costs of the part

C. Material-handling costs that can be eliminated.

D. Special machinery for the part that has no resale value.

D
81)

A. Birr 37,000 in favor of keeping the old machine OLD NEW

Cost … 35000
B. Birr 37,000 in favor of replacing the old machine C Dis value
Operations cost
….
35000 (5*7000)
-8000
20000 (5*4000)
C. Birr 12,000 in favor of keeping the old machine Total 35000 47000

D. Birr 12,000 in favor of replacing the old machine So 12000 Birr Favor For Keping the old Machine
82) In a sell or process further decision, which of the following costs are relevant?

I. A variable production cost incurred after split-off

II. A fixed production cost incurred prior to split-off

A. Only I
B. Only II
C. Both I and II
A
D. Neither I or II

1603
83) The cost to produce Part A was $20 per unit in 2013 and in 2014 it has
increased to $22 per unit. In 2014, Supplier ABC has offered to supply Part
A for $18 per unit. For the make-or-buy decision:
A) incremental revenues are $4 per unit

B) incremental costs are $2 per unit

C) net relevant costs are $2 per unit D
D) differential costs are $4 per unit

1604
84) Which of the following would NOT be considered in a make-or-buy

decision?
A) fixed costs that will no longer be incurred

B) variable costs of production

C) potential rental income from space occupied by the production area

D) unchanged supervisory costs D

1605
85) Which of the following is true in a decision to
keep or replace existing​ equipment?
A. The book value of the old equipment is relevant.
B. The disposal value of the old equipment is
relevant.
C. Depreciation on the new equipment is relevant.
D. Old equipment Property taxes is relevant
B
1606
86) A recent college graduate has the choice of buying a new auto for
$20,000 or investing the money for four years with a 6% expected
annual rate of return. If the graduate decides to purchase the auto, the
BEST estimate of the opportunity cost of that decision is:
a. $1,200
b. $4,800 B
c. $20,000
d. zero since there is no opportunity cost for this decision

1607
87) Ratzlaff Company has a current production level of 20,000 units per month.
Unit costs at this level are:
Direct materials $0.25, Direct labor 0.40, Variable overhead 0.15
Fixed overhead 0.20, Marketing - fixed 0.20, Marketing/distribution - variable 0.40
Current monthly sales are 18,000 units. Jim Company has contacted Ratzlaff
Company about purchasing 1,500 units at $2.00 each. Current sales would not be
affected by the one-time-only special order, and variable marketing/distribution
costs would not be incurred on the special order.
What is Ratzlaff Company's change in operating profits if the special order is
accepted?
a. $400 increase in operating profits
C 1500*2= 3000 Sale
b. $400 decrease in operating profits
(0.25+0.4+0.15)*1500 Variable cost
c. $1,800 increase in operating profits Operating Income = 1800 increase
d. $1,800 decrease in operating profits 1608
88) The managers of a firm are in the process of deciding
whether to accept or reject a special order for one of its
products. Which cost is not relevant to this decision?

A) common fixed overhead that will continue if the

special offer is not accepted
B) direct materials
C) Fixed overhead that will be avoided if the special offer
is accepted A
D) Variance overhead 1609
89) When deciding to lease a new cutting machine or
continue using the old machine, the following costs are
relevant EXCEPT the:
a. $50,000 cost of the old machine
b. $20,000 cost of the new machine
c. $10,000 selling price of the old machine
d. $3,000 annual savings in operating costs if the new
machine is purchased
A 1610
90) Ruttles Circuit Company manufactures circuit boards for other firms. Management is
attempting to search for ways to reduce manufacturing labor costs and has received a proposal from
a consulting company to rearrange the production floor next year. Using the information below
regarding current operations and the new proposal, which of the following decisions should
management accept?
Currently Proposed
Required machine operators 4 3
Materials-handling workers 1.50 1.50
B
Employee average pay $10 per hour $12 per hour
Hours worked per employee 2,100 2,000
A) Do not change the production floor.
B) Rearrange the production floor.
C) Either, because it makes no difference
Current to the4employees.
operations: workers × 2,100 hours × $10.00 = $84,000
Proposal:
D) It doesn't matter because 3 workers
the costs incurred × 2,000
will hours
remain × $12.00 = $72,000
the same
1611
 Chapter -Three

BUDGETS AND BUDGETARY CONTROL

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Fundamental concepts of budgeting
Budget is:
➢A written statement of management’s plans for a specified future
time period, expressed in financial terms.
➢It is a predetermined detailed plan of action developed and
distributed as a guide to current operations and as a partial basis for
the subsequent evaluation of performance
➢Is a short- term financial plan which acts as a guide to achieve
the pre -determined targets.
➢Budgeting: is the act of preparing a budget

1613
 Fundamental concepts of budgeting
• Meaning of budget and budgeting:
• CIMA (UK) defined a budget as “A plan quantified in monetary terms prepared and
approved prior to a defined period of time, usually showing planned income to be
generated and, expenditure to be incurred during the period and the capital to be
employed to attain a given objective.”

• Other definitions of budget include:

• “a budget is a plan of action to achieve stated objectives based on predetermined series of
related assumptions.” (Keller & Ferrara )
• “a budget is a written plan covering projected activities of a firm for a definite time
period.” (G.A.Welsh)
 FUNDAMENTAL CONCEPTS OF BUDGETING
Features of a budget
• It is mainly a forecasting and controlling device.
• It is prepared in advance before the actual operation of the
company or project.
• It is in connection with a definite future period.
• Needs approval by management before implementation.
• It shows capital to be employed during the period.
Essentials(considerations) of Effective Budgeting
• Depends on a sound organizational structure with
authority and responsibility for all phases of operations
clearly defined

• Based on research and analysis with realistic goals

• Accepted by all levels of management

1616
 Budgeting-Length of the Budget Period
• Budget may be prepared for any period of time
▪ Most common - one year
▪ Supplement with monthly and quarterly budgets
▪ Different budgets may cover different time periods
• Long enough to provide an attainable goal and minimize
seasonal or cyclical fluctuations
• Short enough for reliable estimates

1617
Flow of budget data under participative budgeting

1620
The part of master budget for Merchandise company
1. Operating Budget
(a) Sales budget
(b) Cash collection Budget
(c) Inventory Purchases budget
(d) Disbursement budget for inventory purchase
(e) Operating expenses budget
(f) disbursement budget for Operating budget
(g) Budgeted income statement
2. Financial Budget
(a) Capital budget
(b) Cash budget
(c) Budgeted balance sheet
(d)Budgeted statement of cash flows
Preparing Budget For Manufacturing

1623
91) A master budget:

A) includes only financial aspects of a plan and excludes nonfinancial aspects

B) is an aid to coordinating what needs to be done to implement a plan

C) includes broad expectations and visionary results

D) should not be altered after it has been agreed upon

B
Copyright ©2018 John Wiley & Sons, Inc. 1624
92) Budgeting provides all of the following EXCEPT:

A) a means to communicate the organization's short-term goals to its members

B) support for the management functions of planning and coordination

C) a means to anticipate problems

D) an ethical framework for decision making

D

Copyright ©2018 John Wiley & Sons, Inc. 1625

93) The expected cash collection pattern is 60% in the month of sale and 25% in
the following month,10% in the second following month. Given the sales budget
presented below, how much cash is expected to be collected in January if
uncollectible amount is 5% of monthly sales?

A)41,000 January = 0.6 jan sale + 0.25 Dec sale + 0.1 Nov Sale
B)35000 (0.6*35000) + (0.25*60000) + (0.1*50000)
C)33250 = 41,000
D)21,000 A
94) Hubo Company manufactures card tables. The company has a policy of
maintaining a finished goods inventory equal to 40% of the next month's planned
sales. Each card table requires 3 hours of labor.
• The budgeted labor rate for the coming year is Birr 13 per hour,
• Planned sales for the months of April, May, and June are respectively 4,000;
5,000, and 3,000 units. The budgeted direct labor cost for June for Hubo
Company is Birr 136,500.
• What are budgeted sales for July for Hubo Company? Direct Labor 136,500
A. 3.500 units Divide: Cost per Hour 13
April, May, June Direct Labor Hours 10,500 hours
4,000; 5,000, 3,000 unit
Divide: Hours per Unit 3
EI 0.4*5000 0.4*3000 0.4* July sale
B. 4,000 units 2000 1200 ----- Total Units 3,500
C. 3,750 units BI - Feb EI 2000 1200 Add: Beginning Inventory 1,200
(3,000 units x 40%)
EI = BI+ Unit Produced – unit sold
Less: June Sales 3,000
D. 4,250 units D EI = 0.4*July sale Ending Inventory 1,700
1700= 0.4*July sale Divide: Pecentage 40%
July sale = 1700/0.4= 4250 unit
Budgeted Sales - July 4,250 units
95) Production of Product B has been budgeted at 200,000 units for
November. One unit of Product B requires 2 kg of raw material. The projected
beginning and ending materials inventory for November
are:
Beg. Inventory = 2,000 kg
End. Inventory = 10,000 kg
How many kg of materials should be purchased during November?
A) 408,000
200,000*2kg = 400,000kg
B) 410,000
DMP= DMU +EDM- BDM
C) 380,000 A = 400,000+10000-2000
D) None = 408,000
Copyright ©2018 John Wiley & Sons, Inc. 1628
96) The revenues budget identifies:

A) expected cash flows for each product

B) actual sales from last year for each product

C) the expected level of sales for the company

D) the variance of sales from actual for each product

C
Copyright ©2018 John Wiley & Sons, Inc. 1629
97) F Company has forecast purchases on account to be $210,000 in March,
$270,000 in April, $320,000 in May, and $390,000 in June. Seventy percent of
purchases are paid for in the month of purchase, the remaining thirty percent
are paid in the following month. What are budgeted cash payments for April?

A) $252,000
April Payment = 0.7*270,000 + March
B) B) $285,000 0.3*210,000
C) C) $159,000
A = 252, 000
D) D) $126,000

Copyright ©2018 John Wiley & Sons, Inc. 1630

98) B Company has forecast production for the next three months as
follows: July 5,000 units, August 6,600 units, September 7,500 units.
Monthly manufacturing overhead is budgeted to be $17,000 plus $5 per
unit produced. What is budgeted manufacturing overhead for July?
A) $24,500
July MOH= (5*5000) +17000= 42000
B) $41,500
C) $42,000
D) $47,000
C
Copyright ©2018 John Wiley & Sons, Inc. 1631
99) Budgeted production equals:
A) beginning finished goods inventory + budgeted unit sales - targeted ending
finished goods inventory
B) targeted ending finished goods inventory + beginning finished goods
inventory - budgeted unit sales

C) budgeted unit sales + targeted ending finished goods inventory - beginning

finished goods inventory
C
D) budgeted unit sales + targeted ending finished goods inventory + beginning
finished goods inventory

Copyright ©2018 John Wiley & Sons, Inc. 1632

100) ACEM Hardware purchased 5,000 gallons of paint in March. The
store had 1,500 gallons on hand at the beginning of March, and expects to
have 1,000 gallons on hand at the end of March. What is the budgeted
number of gallons to be sold during March?

A) 5,500 Unit
Budgeted sales (units) = Beginning inventory (units) + Purchases
B) 3200 Unit during the month (units) − Expected ending inventory (units)=
1,500 units + 5,000 units − 1,000 units = 5,500 units
C) 1500 unit
A
D) 3000 unit

Copyright ©2018 John Wiley & Sons, Inc. 1633

101) Joe's Mart policy is to have 20% of the next month's sales on hand at
the end of the current month. Projected sales for August, September, and
October are 25,000 units, 20,000 units, and 30,000 units, respectively. How
many units must be purchased in September?

A) 55,500 Unit
Required purchases (units) = Budgeted sales (units) + desired
B) 22,000 Unit ending inventory (units) − beginning inventory (units)
= 20,000 + (30,000 × 0.2) − (20,000 × 0.2)
C) 11500 unit = 20,000 units + 6,000 units − 4,000 units= 22,000 units

D) 33000 unit
B
Copyright ©2018 John Wiley & Sons, Inc. 1634
102) Salich Manufacturing Corporation has provided the following sales
budget information:
July - $45,000
August - $55,000
September - $60,000
Cash sales are normally 40% of total sales; credit sales are expected to be
collected in their entirety in the month following the month of sale. The
amount of cash expected to be received from customers in September is:
A) 57,000 August credit sales = [$55,000 × (1 − 0.4)] = $33,000
B) 29090 2. September cash sales = ($60,000 × 0.4) = $24,000
C) 29000 3. Total cash expected to be received from customers
in September = $33,000 + $24,000 = $57,000
D) 30000 A
Copyright ©2018 John Wiley & Sons, Inc. 1635
103) Hubo Company has budgeted sales for the year as follows:
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Sales in units 10,000 12,000 14,000 16,000

The ending inventory of finished goods for each quarter should equal 25% of the next quarter's
budgeted sales in units. The finished goods inventory at the start of the year is 2,500 units. Four
pounds of raw materials are required for each unit produced. Raw materials on hand at the start of
the year total 4,200 pounds. The raw materials inventory at the end of each quarter should equal
10% of the next quarter's production needs in material. Scheduled production for the third quarter
EI= BI+ Unit producing – unit sale
be: B/C of EI = 0.25 * next quarter sale
a. 13,500 units 3 quarter EI = 16000*0.25= 4000 Unit
b. 14,500 units
c. 15,500 units
d. 18,500 units
B BI of 3 quarter is EI of 2 quarter, So 2 quarter EI = 14000*0.25 = 3500

4000= 3500+UP- 14000

UP = 4000+14000-3500 = 14500
Scheduled Prod
in Q3 is 58000
Units
Statement
showing Budget
Particulars Q1 Q2 Q3 Q4
Sales $10,000.00 $12,000.00 $14,000.00 $16,000.00
Ending inventory
$3,000.00 $3,500.00 $4,000.00
@25%
Opening Inv=
Ending of prev 3,000.00 3,500.00 4,000.00
Quarter
Production
$12,500.00 $14,500.00
=Sales+End -Op
Pound reqd per
4.00 4.00 4.00 4.00
unit
Total pounds
50,000.00 58,000.00
reqd for prod
Raw Mat at end
5,000.00 5,800.00
@10%
Opening raw Mat 4,200.00 5,000.00 5,800.00
Purchases =
$50,800.00
Prod+cl-op
 Chapter 4
Standard Cost and Variance
Static Budget, Flexible Budgets and
Variance Analysis

15-1638
 Standard Costs
Standards are:
➢ Benchmarks or “norms” for measuring performance.
➢ Standard Cost has two component :

Quantity standards specify Rate (price) standards

how much of an input specify how much
should be used to make a should be paid for each
product or provide a unit of the input.
service.
 Setting Standard Costs
Cost Standards are set by:
➢ Accountants,
➢Engineers,
➢Purchasing agents, and
➢Production managers combined efforts to
encourage efficient future production.

Engineer Managerial Accountant

Example: Standard Cost of Variable Product Cost
A standard cost for one unit of product(FG) may look
like this:
A B AxB
Standard Standard Standard
Quantity Price or Rate Cost per
Inputs or Hours Unit

Direct materials 3 unit $ 4.00 per unit $ 12.00

Direct labor 2.5 hours 14.00 per hour 35.00
Variable mfg. overhead 2.5 hours 3.00 per hour 7.50

$ 54.50
Standard unit cost
Standards vs. Budgets
•Are standards the same as budgets?
❖A budget is set for total costs and a standard is
a per unit cost.
❖Standards are often used when preparing
budgets
❖Therefore, when variance analysis is made
actual result is compared against budget
prepared using standard cost.
 Price and Quantity Standards

Price and quantity standards are

determined separately for two reasons:

 The purchasing manager is responsible for raw material

purchase prices and the production manager is
responsible for the quantity of raw material used.

 The buying and using activities occur at different times.

Raw material purchases may be held in inventory for a
period of time before being used in production.
A General Model for Variance Analysis
Variance Analysis

Price Variance Quantity/efficiency) Variance

Difference between actual Difference between actual

price and standard quantity and standard
price(budgeted price) quantity(budgeted quantity )

Materials price variance Materials quantity variance

Labor rate variance Labor efficiency variance
VOH spending variance VOH efficiency variance
A General Model for Variance Analysis
Actual Quantity Actual Quantity Standard Quantity
× × ×
Actual Price Standard Price Standard Price

Material Price Material Quantity

Variance Variance
(AQ × AP) – (AQ × SP) (AQ × SP) – (SQ × SP)
(AP-SP)*AQ (AQ-SQ)*SP
AQ = Actual Quantity SP = Standard Price
AP = Actual Price SQ = Standard Quantity
 A General Model for Variance Analysis
Actual Hour Actual Hour Standard Hour
× × ×
Actual Rate Standard Rate Standard Rate

Labor rate Variance Labor Efficiency

Variance
(AH × AR) – (AH × SR) (AH × SR) – (SH × SH)
(AR-SR)*AH (AH-SH)*SR
AH = Actual Hour SR = Standard Rate
AR = Actual Rate SH = Standard Hour
Static budget and Static-Budget Variance
• Static budget – a budget prepared for only one level of
activity
• It is based on the level of output planned at the start of
the budget period.
• The master budget is a static budget.

• Static-Budget Variance (Level 1 variance )

• The difference between the actual operating income and
the static budget operating income amount
• This Variance can be Favorable or Unfavorable variance
• Answers a question of “How much were we off?”
 Static-Budget Variance cont…
• Favorable (F) variance exists if an actual operating income is
greater than budgeted operating income:
• Actual revenue > Budgeted revenue
• Actual expense < Budgeted expense
• Unfavorable (U) variance exists if an actual operating income is less
than budgeted operating income :
• Actual revenue < Budgeted revenue
• Actual expense > Budgeted expense

23-1653
Purpose of Flexible Budgets
Show revenues and expenses that
should have occurred at the actual
level of activity.

May be prepared for any activity

level in the relevant range.

Reveal variances due to rate( price )

and due to volume (quantity)

Improve performance evaluation

(gives more detail variance analysis)

1
 Preparing Flexible Budgets
• Flexible budget

➢Is prepared for several different volume levels within a

relevant range(within firms capacity)
➢A flexible budget is prepared at the end of the period when
the actual output is known
➢shifts budgeted revenues and costs up and down based on
actual operating results (activities)
➢Represents a combination of actual activities(units) and
budgeted dollar amounts(rate)
➢Will allow analysis of Levels 2 and 3 variances
➢Answers the question: “Why were we off?”

23-1655
Level(detail) of Variance Analysis

23-1657
104) A products standard cost card specifies that a unit of the product requires
4 direct labor-hours. During September, 3350 units were made, which was 150
units less than budgeted.
The total budgeted direct labor cost for September was Bir 117,600.
The Budgeted direct labor hour 13400 and Actual 13,450 direct labor-hours
were worked.
The direct labor efficiency variance for the month was:
A. Birr 415.80 Favourable Labor efficiency variance= (Actual hours - Standard hours)*Standard rate

B. Bir 415.80 Unfavourable Standard units= 3350+150= 3500 units

Standard rate= 117600/(3500*4)= 8.40
C. Birr 420.00 Unfavourable Labor efficiency variance= (Actual hours - Standard hours)*Standard rate
D. Birr 420.00 Favourable = (13450-13400)*8.4= 420 U
It is favorable if the actual hours worked is lower than the
standard hours and unfavorable if the actual hours worked is
higher than the standard hours.
C
105) Robba Corporation manufactured 30,000 ice chests during
September. The overhead cost-allocation base is Birr per
machine-hour. The following variable overhead data pertain to
September Actual Budgeted
30,000 unit 24,000 unit
Machine hour 15,000 h 10,800 h
Variable overhead /mh Birr 11.00 Birr 11.25

What is the variable overhead spending variance?

Variable Overhead Spending Variance is essentially the
A. Birr 16.875 unfavourable difference between what the variable production
B. Birr 13,125 unfavourable overheads actually cost and what they should have
cost given the level of activity during a period.
C. Birr 3,750 favourable
D. Birr 30,375-unfavourable variable overhead spending variance
= (Budgeted. rate – Actual rate) AH
C = (11.25- 11) *15000
= 3750 F
106) A flexible-budget variance is $600 favorable for unit-related costs. This
indicates that costs were:

A) $600 more than the master budget

B) $600 less than for the planned level of activity

C) $600 more than standard for the achieved level of activity

D) $600 less than standard for the achieved level of activity

D
23-1660
107) Hoppy Corp compares monthly operating results to a static budget
prepared at the beginning of the month. When the actual level of activity is
less than budgeted, which of the following would be true?

• A. Variable costs would show favorable variance

• B. Variable costs would show unfavorable variance

• C. Fixed costs would show favorable variance

• D. Fixed costs would show unfavorable variance A

23-1661
108) A purpose of standard costing is to

A. Eliminate the need to account for year-end under-applied or over-

applied manufacturing overhead.
B. Simplify costing procedures.
C. Eliminate the need for actual costing for external reporting purposes.
D. Replace budgets and budgeting.
Standard costing is the practice of estimating
the expense of a production process.
B To achieve maximum efficiency and cost
control.
109) An unfavorable sales-volume variance could result from:

a. decreased demand for the product

b. competitors taking market share

c. customer dissatisfaction with the product

d. All of these answers are correct. D

23-1663
110) Regier Company had planned for operating income of $10 million in
the master budget but actually achieved operating income of only $7
million.
A) The static-budget variance for operating income is $3 million favorable.
B) The static-budget variance for operating income is $3 million
unfavorable.
C) The flexible-budget variance for operating income is $3 million
favorable.
D) The flexible-budget variance for operating income is $3 million
unfavorable.
B
111) A favorable price variance for direct materials indicates that:

A) a lower price than planned was paid for materials

B) a higher price than planned was paid for materials

C) less material was used during production than planned for actual output

D) more material was used during production than planned for actual output

23-1665
112) A favorable efficiency variance for direct manufacturing labor indicates
that:

a. lower wage rate than planned was paid for direct labor

b. a higher wage rate than planned was paid for direct labor

c. less direct manufacturing labor-hours were used during production than

planned for actual output

d. more direct manufacturing labor-hours were used during production than

planned for actual output
C
23-1666
114) The standard cost card for a product indicates that one unit of the
product requires 8 kilograms of a raw material at $0.80 per kilogram.
• The production of the product in April was 870 units, but production had
been budgeted for 850 units. During April, 8,200 kilograms of the raw
material were purchased for $6,888 and 7,150 kilograms of the raw material
were used in production. The material variances for April were:

• A) 480 U Material variance = (MPV+MQV)

• B) 480 F MPV= (AP –SP ) * AQ = (0.84-0.80)*8200= 328 U
• C) 328 U MQV= (AQ-SQ)* SP= (6960 -7150)*0.8=152 U
• D) 152 U Material variance = 152 U+ 328U = 480U
A Note SQ= 8*870= 6960
23-1667
115) Last month 75,000 pounds of direct materials were purchased and
71,000 pounds were used. If the actual purchase per pound was $.50 more
than the standard purchase price per pound, then the MPV was:

• A) 48,000 U MPV= (AP-SP)AQ

• B) 37,500 U B MPV= ( 0.5)*75000= 37500 U
• C) 37,500 F

• D) 15,2000 U
23-1668
116) Magno Cereal Corporation uses a standard cost system for its
"crunchy pickle" cereal. The materials standard for each batch of cereal
produced is 1.4 pounds of pickles at a standard cost of $3.00 per pound.
• During the month of August, Magno purchased 78,000 pounds of pickles
at a total cost of $253,500.
• Magno used all of these pickles to produce 60,000 batches of cereal.
•
• What is Magno's materials quantity variance for August?
• A) $1,500 Unfavorable
• B) $18,000 Favorable MQV= (AQ-SQ)* SP
• C) $19,500 Unfavorable = (78,000 – 84000) *3
• D) $54,000 Unfavorable = 18000 F
B 1.4*60000 = 84000
23-1669
117) The standard cost card of a particular product specifies that ir requires
4.5 direct labor hours at $12.80 per direct labor hour. During March, 2300
units of the product were produced and direct labor wages of $128,300 were
incurred. A total of 11,700 direct labor hours were worked. The direct labor
variances for the month were:
Labor variance = LRV + LFV =
• A) 38740 U LRV= (AR-SR)* AH
LEV= (AH-SH)* SR
• B) 38740 F

• C) 4180 U LRV= (128300/11700 -12.8)*11700 =21460 F

LEV= (11700- 2300*4.5)* 12.8 = 17280 U
• D) 4180 F Labor variance = 21460F + 17280 U = 4180F
23-1670
118) Roberson Corporation manufactured 30,000 ice chests during September.
The overhead cost-allocation base is $11.25 per machine-hour. The following
variable overhead data pertain to September:
• Actual Budgeted
• Production 30,000 units 24,000 units
• Machine-hours 15,000 hours 10,800 H
• V/ overhead cost per machine-Hour : $11.00 $25
• What is the Actual variable overhead cost ?
• A) 165000 U
Actual overhead cost
• B) 165000 F
= (Actual rate* AH)
• C) 165000 C = 11 *15000 = 165,000
• D) none

23-1671
119) Bowden Corporation used the following data to evaluate their current
operating system. The company
• sells items for $20 each and used a budgeted selling price of $20 per unit.
• Actual Budgeted
• Units sold 46,000 units 45,000 units
• Variable costs $225,400 $216,000
• Fixed costs $47,500 $50,000
• What is the static-budget variance of revenues?
• A) $20,000 favorable
• B) $20,000 unfavorable (46,000 units × $20) - (45,000 units × $20)
• C) $2,000 favorable = $20,000 F
• D) $2,000 unfavorable A
23-1672
120) Typically, managers have the LEAST control over:

• a. the direct material price variance

• b. the direct material efficiency variance

• c. machine maintenance

• d. the scheduling of production

A
 Financial Mgt I and II

CHAPTER ONE
An overview of financial management

3/6/2024 1674
 Meaning of finance
• Finance is the application of economic principles and
concepts to business decision-making and problem solving
• It is concerned with the nature, creation, behavior,
regulation and problems of money.
• It focuses on how the individuals, businessmen, investors,
government and financial institutions deal.

3/6/2024 1675
Classification of finance
➢Personal finance:- deals with the mobilization of funds from own sources
➢Public finance:- deals with the mobilization or administration of public funds.
➢It includes the aspects relating to the securing the funds by the government from
public through various methods viz. taxes, borrowings from public and foreign
markets
➢Business finance is that business activity which is concerned with the acquisition
and conservation of capital funds in meeting financial needs and overall objectives
of a business enterprise.
• It is broadly defined as activity concerned with planning, raising, controlling and
administering of the funds used in the business

3/6/2024 1676
 AN OVERVIEW OF THE FINANCIAL ENVIRONMENT
1. Financial Institutions: financial intermediaries, which are specialized
financial firms that facilitate the transfer of funds from savers to
demanders of capital.
2. Financial Instruments: Financial instruments are written and formal
documents of transferring funds between and among individuals,
businesses, and governments.
❖ They include loans and borrowing contracts, promissory notes,
commercial papers, treasury bills, bonds, and stocks
❖ 3. Financial market: are markets in which financial instruments are
bought and sold by suppliers and demanders of funds.
❖ Unlike financial institutions, financial markets are places in which
suppliers and demanders of funds meet directly to transact business.

3/6/2024 1677
Meaning of financial management
❖Financial management is concerned with managerial
decisions that result in the acquisition and financial of long-
term and short-term credits for the firm.
❖Financial management actually concerned with business
finance
❖Also called corporate finance, focuses on decisions relating
to how much and what types of assets to acquire, how to
raise the capital needed to buy assets, and how to run the
firm so as to maximize its value.

3/6/2024 1678
Meaning of financial management
• It is a managerial activity which is concerned with the
planning and controlling of firm’s financial resources.
• It is also the process of making optimal use of a firm’s
financial resources for the purpose of maximizing the
owner’s wealth.
• Known as business finance.

3/6/2024 1679
Cont….
• Financial management encompasses many different types of
decisions.
• We can classify these decisions into three groups:
❖ investment decisions,
❖financing decisions, and
❖Dividend decisions

3/6/2024 1680
Investment decisions
➢Investment decisions concerned with the use of funds the buying, holding, or
selling of all types of assets:
✓ Should we buy a new die stamping machine?
✓Should we introduce a new product line?
✓ Sell the old production facility?
✓Buy an existing company?
✓ Keep our cash in the bank?

3/6/2024 1681
Financing decisions
➢concerned with the acquisition of funds to be used for investing and
financing day-to-day operations:
• Should managers use the money raised through the firms’
revenues?
• Should they seek money from outside of the business?

3/6/2024 1682
The Objective of Financial Management

➢The primary objective of FM is the maximization of the economic

wellbeing, or wealth maximizations.
➢ The secondary objective is profit maximization for a firm.
➢Whenever a decision is to be made, management should choose the
alternative that most increases the wealth of the owners of the
business.

3/6/2024 1684
IMPORTANCE OF FINANCIAL MANAGEMENT
✓Financial Planning
✓Acquisition of Funds
✓Proper Use of Funds
✓Financial Decision
✓Improve Profitability
✓Increase the Value of the Firm
✓Promoting Savings

3/6/2024 1689
THE AGENCY RELATIONSHIP
➢The relationship between stockholders and management is called an agency
relationship
➢Such a relationship exists whenever someone (the principal) hires another (the
agent) to represent his/her interests.
➢An agent is a person who acts for—and exerts powers of— another person or
group of persons.
➢The person (or group of persons) the agent represents is referred to as the
principal.

3/6/2024 1690
Conflict of goals between management and
owners and agency problem
➢There is a conflict of goals between managers and owners of a
corporation and mangers may act to maximize their interest instead
of maximizing the wealth of owners.
➢ Managers are interested to maximize their personal wealth, job
security, life style and fringe benefits.
➢The natural conflict of interest between stockholders and
managerial interest create agency problems.
➢Agency problems are the likelihood that mangers may place their
personal goals a head of corporate goals.

3/6/2024 1691
1) What is the primary goal of the corporation?
• A: Maximize the pay and compensation of employees and
managers of the firm.
• B: Maximize the value of the stockholders as they are the owners
of the corporation.
• C:Minimize the wealth of the shareholders and maximize the
wealth of managers.
• D: Maximize the societal value to minimize governmental
interference.

3/6/2024
B
1692
2) What does the agency problem refer to?
• A) The conflict that exists between the board of directors and the
employees of the firm.
• B) The problem associated with financial managers and Internal Revenue
agents.
• C) The conflict that exists between stockbrokers and investors.
• D) The problem that results from potential conflicts of interest between the
manager of a business and the stockholders.

3/6/2024
D
1693
3) Agency costs as the sum costs of:
• A: monitoring costs of the shareholders and the residual loss of wealth
due to divergent management behavior.
• B: the costs of implementing control devices and the monitoring costs
of the shareholders.
• C: the costs of implementing control devices and the residual loss of
wealth due to divergent management behavior.
• D: the set-of-contracts needed to structure the firm and residual wealth.

3/6/2024
B
1694
4) The principle of diversification tells us that:
• A. concentrating an investment in two or three large stocks will eliminate all
of your risk.
• B. concentrating an investment in three companies all within the same
industry will greatly reduce your overall risk.
• C. spreading an investment across five diverse companies will not lower
your overall risk at all.
• D. spreading an investment across many diverse assets will eliminate all of
the risk.
• E. spreading an investment across many diverse assets will eliminate some
of the risk.

E
3/6/2024 1695
5) Which of the following statements best represents what finance is
about?

• A) How political, social, and economic forces affect corporations

• B) Maximizing profits

• C) Creation and maintenance of economic wealth

• D) Reducing risk

3/6/2024
C
1696
6) Which of the following is not a function of financial system?
• A. It provides convenient mode of payments.

• B. It reduces the borrowing capacity of firms

• C. It helps in transferring risks to others

• D. It helps government in influencing macro-economic variables

• E. All

• F. None
B
7) Which of the following can be described as direct finance?

(a) You take out a mortgage from your local bank.

(b) You borrow $2500 from a friend.

(c) A pension fund lends money to General Motors.

(d) You buy shares in a mutual fund.

B
8) Which of the following reasons is most likely correct statement ?

• A) Corporations have limited life.

• B) Stockholders have unlimited liability.

• C) Corporations are subject to less government regulation than the other forms of
business organization.

• D) Corporations have the ability to raise larger sums of capital than the other
forms of business organization.

• E) Corporations are subjected to less taxation than the other forms of business
organization. D
9) Which of the following is not considered as one of the basic
questions of corporate finance?
A. How much inventory should the firm sale in a period?
B. How can the firm raise cash for required capital
expenditures?
C. What long-lived assets should the firm invest in?
D. How should the short-term operating cash flows be
managed?
Three main questions in corporate
finance are capital budgeting,
A capital structure, and working
capital management.
10) If you have a portfolio of two risky stocks which turns out
to have no diversification. The reason you have no
diversification is:

• A. The returns move perfectly with one another.

• B. The returns move perfectly opposite of one another.
• C. The returns are too small.
• D. The returns are completely unrelated to one another.
Diversification means the distribution of investment amounts into
different types and classes of assets to bring down the overall risk.
A Investors diversify their portfolio to bring down the overall risk of the
investments.

The advantage of diversification will increase when the returns on two securities
move in different directions.
11) Beginning with an investment in one company's
securities, as we add securities of other companies,
which type of risk declines?
A. Non-diversified risk
Systematic risk is a market-wide risk or
non-diversifiable risk that affects the
securities of all the firms whereas
B. Market risk unsystematic risk is a diversifiable or
firm-specific risk that affects only a
particular company's securities.
C. Unsystematic risk.
Thus, as we add securities of other
companies to a given portfolio, the
D. Systematic risk. unsystematic risk declines.
C
 Chapter Two:
Financial statement analysis

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• Financial statement analysis: is a process of evaluating
relationships between component parts of financial
statements to obtain a better understanding of the firm’s
financial condition and performance.

• It used to determine the weakness and strength of the

company

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• Internal users
• Used financial statement analysis to improve strategic
information to make effective and efficient decision
• External users
• Used financial statement analysis to make better
decision on investment, landing, Merger and acquisition
and other decision

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 Major steps in financial analysis
1. Preparation
✓ Setting Objectives and gathering data
• Shareholders – Current and future risk and return
• Creditors – Short term liquidity of the firm and profitability
• Management –Planning and controlling decisions
2. Computation
• Ratio analysis
• Common size statements: express individual statement accounts as a
percentage of a base amount
3. Evaluation and interpretation
• Determination of the meaningfulness of the analysis to develop
conclusions and recommendations about the firm’s financial
performance and status.

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 Common size Balance Sheet
Accounts 2013 % Accounts 2013 %

Cash 696 12.9 A/P 307 5.7

A/R 956 17.7 N/P 26 0.5
Inventory 301 5.6 Other CL 1662 30.8
Other CA 303 5.6 Total CL 1995 37
Total CA 2256 41.8 L-T Debt 843 15.6
Net Fixed 3138 58.2 Common Stock 2556 47.6

Asset Total 5394 100 Tot Liab&Equity 5394 100

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 Common size Income Statement
Accounts 2013 %
Revenues 5,000 100
Cost of Goods Sold (2,006) 40
Expenses (1,740) 34.8
Depreciation (116) 2.3
EBIT 1,138 22.8
Interest Expense (7) 0.0
Taxable Income 1,131 22.6
Taxes (442) 8.8
Net Income 689 13.8
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 RATIO ANALYSIS
• Calculating and interpreting financial ratios to assess financial
performance and status.
• A ratio expresses a mathematical relation between two
quantities. It can be expressed as a percent, rate or
proportion
• Ratios are among the more widely used tools of financial analysis
because they provide clues to & symptoms of underlying
conditions
• Ratios standardize numbers and facilitate comparisons.
• Ratios are used to highlight weaknesses and strengths.
• Ratios are not very helpful by themselves; they need to be
compared to something

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Type of ratio ( Basic Approach )
1. Time-series analysis : Identify financial trends
over time for a single company. It is used to see
how the firm’s performance is changing over time.
2. Cross-sectional analysis (Peer group analysis):
Compare to similar companies or within
industries at a single moment in time.
3. Benchmark comparison: measures a company’s
performance against some predetermined
standard.

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Information Sources
◼ Financial statements
◼ Notes to financial statements
◼ Letters to stockholders
◼ Auditor’s report
◼Reports filed with the government
◼Newspapers
◼Other publications

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Types• Liquidity
of ratiosratio
• Activity ratio (efficiency ratio)
• Debt ratio
• Profitability ratio
• Valuation ratios ( Market value ratio)
• Coverage ratio

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Market Valuation Ratio

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Advantages of ratio analysis
• Ratios are easy to compute.
• Ratios provide a standard of comparison at a point
in time and allow comparisons to be made with
industry averages.
• Ratios can be used to analyze a corporation’s financial
time series in order to discover trends, shifts in trends,
and data outliers.
• Ratios are useful in identifying problem area of firm.

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Limitations of ratio analysis
• Many large firms operate different divisions in different industries, and
for such companies it is difficult to develop a meaningful set of
industry averages.
• To set goals for high-level performance, it is best to benchmark on the
industry leaders’ ratios rather than the industry average ratios.
• Inflation may have badly distorted firms’ balance sheets—reported
values are often substantially different from “true” values.
• Firms can employ “window dressing” techniques to make their
financial statements look stronger.
• Companies’ choices of different accounting practices can distort
comparisons.

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12) Assume General hospital has a current ratio of 0.5.
Which of the following actions would improve (increase) this
ratio
A. Use cash to pay off current liabilities
B. Collect some of the current accounts receivable
C. Use cash to pay off some long term debt
D. Purchase additional inventory on credit (i.e., accounts
payable).
E. Sell some of the existing inventory at cost (book value).
F. None D
13) Company A and Company B have the same gross profit
margin and the same total asset turnover, but company A has a
higher return on equity. This may result from:

A. Company B has more common stock.

B. Company A has a lower debt ratio.
C. Company A has lower selling and administrative expenses,
resulting in a higher net profit margin.
D. Company A has lower cost of goods sold, resulting in a higher net
profit margin.
ROE= NI/Total Equity
C
14) ZEMENAY Company reported the following data for 2022:
• Net Profit Margin 10%
• Total Asset Turnover 4
• Total Debt Ratio 60%
• Credit sales Birr 2,920,000
• Average Accounts Receivable Birr 160,000
• Cost of Goods Sold Rate 40%
• Day’s sales in inventory 15 days
• What is the return on asset (ROA)?
ROA = NI/Total Asset
• A. 24% ROA = NET profit margin * total asset turnover
• B. 40% 0.1*4= 0.4
• C. 60%
• D. 120% B
• E. All
• F. None
15) Last year a small-firm had sales of Birr 205,000, assets of Birr 127,500, a
profit margin of 5.3%, and an equity multiplier of 12.
The finance manager believes that the company could reduce its assets by Birr
21,000 without affecting its profit margin.
Had reduced its assets in this amount, and had the debt ratio, sales, and profit
margin remained constant, by how much would the ROE have changed?
When asset = 127,500
A. 2.22%
ROE = Net Profits/Equity Capital
ROE = PM * AT  EM = 0.053* 1.6078 *12 = 0.1023 Or 10.23%
B. 2.02% AT = Sale/ Asset = 205,000/ 127,500 = 1.6078
Assets reduced by $21,000 No effect in sales and cost
B Assets = 127,500 - 21,000 = 106,500
C. 1.81% When asset = 106,500
ROE = PM * AT  EM = 0.053*1.9248*12 = 0.1224 or 12.24%
AT = Sale/ Asset = 205,000/ 106,500 = 1.9248
D. 2.44% So, 12.24 – 10.23 = 2.02 %
16) Cutler Enterprises has current assets equal to $4.5 million. The company's
current ratio is 1.25. What is the firm's level of current liabilities (in millions)?

• a. $3.6

• b. $0.8
CR= CA/CL
• c. $2.9 1.25= 4.5M/CL
• d. $2.4
A CL1.25= 4.5M
• e. $1.8
CL = 4.5/1.25= 3.6M
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17) Lewis Inc. has sales of $2 million per year, all of which are credit sales. Its
days sales outstanding is 42 days. What is its average accounts receivable
balance? Assume a 365-day year.
• a. $266,667
• b. $366,750 DSO = Average Account Receivable * 365
• c. $333,333 credit sale
42 day= AAR * 365
• d. $230,137
D 2M
• e. $350,000 42 * 2M= AAR*365
84,000,000= AAR*365

AAR= 84,000,000/365= 230,137

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18) Info Technics Inc. has total assets equal to $1,000,000. Its total current
liabilities equal $200,000. The firm's total equity equals $500,000. What is the
firm's total debt to total capital ratio?
• a. 42.75%

• b. 37.50% Total debt = Total assets – Total equity – Current liabilities

Total debt = $1,000,000 - $500,000 - $200,000 = $300,000
• c. 25.00% Total capital = Total debt + Total equity = $300,000 + $500,000
= $800,000
• d. 45.00% Total debt to total capital ratio = $300,000/$800,000 = 0.375
Hence, correct answer is d. 37.50%
• e. 30.33%

B
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19) Chang Corp. has $375,000 of assets, and it uses only common equity capital (zero debt). Its sales for the
last year were $595,000, and its net income was $25,000. Stockholders recently voted in a new management
team that has promised to lower costs and get the return on equity up to 15.0%. What profit margin would
the firm need in order to achieve the 15% ROE, holding everything else constant?

• a. 10.94%
ROE= NI/Total Equity
• b. 9.93% 0.15= NI/375000
NI= 56250
• c. 10.42%
PM= NI/SALE = 56250/ 595,000 = 0.0945
• d. 11.49%

• e. 9.45%
E
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20) Which one is the most conservative measure of firm’s
short-term solvency:

• A. Current ratio

• B. Inventory Turnover Ratio

• C. Receivable Turnover Ratio

• D. Quick ratio
D
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21) Last year Harrington Inc. had sales of $325,000 and a net income of $19,000, and its year-end assets
were $250,000. The firm's total-debt-to-total-capital ratio was 15.0%. The firm finances using only debt
and common equity and its total assets equal total invested capital. what was the ROE? Do not round your
intermediate calculations.

• a. 11.09%
Debt to capital = Debt /Total capital
• b. 8.85% 0.15= Debt/ 250, 000
Debt = 250000*0.15= 37500
• c. 8.94%
Total Equity =Total Capital - Debt
• d. 7.42% 250000-37500 = 212,500
ROE = Net Income/Total Equity = 19000/212500 = 0.0894
• e. 9.03%

C
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22) A firm's inventory turnover (IT) is 5 times on a cost of goods sold (COGS)
of $800,000. If the IT is improved to 8 times while the COGS remains the
same, a substantial amount of funds is released from or additionally invested
in inventory. In fact,
• A) $160,000 is released.
• B) $100,000 is additionally invested. ITO = CGS/Average Inventory
• C) $60,000 is additionally invested. 5= 800,000/ Average Inventory
Average Inventory=
• D) $60,000 is released 800,000 /5 = 160000

ITO = CGS/Average Inventory

8= 800,000/ Average Inventory
Average Inventory=
D 800,000 /8 = 100000

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 AFN = Change in Asset – Change in liability – change in retained earning
For payout ratio = 10%:
Change in Asset = 500*0.4=200
Change in liability = (50+20)*0.4= 28
change in retained earning
Increase in Retained earnings = forecasted sale * PM * b
= (300*1.4) * 20%*(1-0.1) = 75.6

AFN = 200 – 28 – 75.6 = 96.4 million

• For payout ratio = 50%:
Increase in Retained earnings = forecasted sale * PM * b
• (300*1.4) * 20%*(1-0.5) = 42
AFN = 200 – 28 – 42 =130 million
•
AFN change = 130 - 96.4 = 33.6
23) Clayton Industries is planning its operations for next year, and Ronnie
Clayton, the CEO, wants you to forecast the firm's additional funds needed
(AFN). The firm is operating at full capacity. Data for use in your forecast are
shown below. Based on the AFN equation, what is the AFN for the coming
year? All Birrs are in millions.
Last year's sales (S) Birr 350.0 Last year's accounts payable Birr 40.0
Sales growth rate (g) 30% Last year's notes payable Br 50.0
Last year's total assets (A) Birr 500.0 Last year's accruals Birr 30.0
Last year's profit margin (PM) 5.0% Initial pay out ratio 60%
AFN = Change in Asset – Change in liability – change in RE
For payout ratio = 60%:
A. Birr 102.8 Change in Asset = 500*0.3=150
B. Bir 108.2 D Change in liability = (40+30)*0.3= 21
C. Bir 113.9 change in retained earning
D. Birr 119.9 Increase in Retained earnings = forecasted sale * PM * b
= (350*1.3) * 5%*(1-0.6) = 9.1
AFN = 150 – 21 – 9.1 = 119.9 million
24) Clayton Industries is planning its operations for next year. Ronnie Clayton, the CEO, wants you to forecast
the firm's additional funds needed (AFN). Data for use in your forecast are shown below.
• Based on the AFN equation, what is the AFN for the coming year?
• Last year's sales = $350
• Last yr's accounts payable $40
• Sales growth rate = g 30%
• Last yr's notes payable $50
• Last year's total assets = $360 AFN = Change in Asset – Change in liability – change in RE
• Last yr's accruals $30 For payout ratio = 60%:
• Last year's prof margin = PM 5% Change in Asset = 360*0.3=108
• Target payout ratio 60%. Change in liability = (40+30)*0.3= 21
• A). $67.0
change in retained earning
Increase in Retained earnings = forecasted sale * PM * b
• B). $78.7 = (350*1.3) * 5%*(1-0.6) = 9.1
• C). $63.9 AFN = 108 – 21 – 9.1 = 77.9 million

• D). $77.9 D
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25) For 2015, Hoyle Company reports total assets of $1,100,000, net sales of
$1,250,000, and net income of $250,000. Hoyle’s 2015 asset turnover is

• A). .23 times.

• B). .25 times. ATO= Sale/TA

• C). 1.14 times. =1250,000/ 1100,000
= 0.23
• D). 1.25 times
C

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26) The rate of return on assets for Hoyle in 2015 is

• A). 20.0%.

• B). 22.7%.
ROA= NI/TA
• C). 25.0%. = 250,000/ 1100,000
= 0.227
• D). 27.8%. B

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27) When is a firm insolvent from an accounting perspective?

• A. When the firm is unable to meet its financial obligations in a timely manner

• B. When the firm's debt exceeds the value of the firm's equity

• C. When the firm has a negative net worth

• D. When the firm's revenues cease

• E. When the market value of the firm's equity equals zero

C

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28) EMBC Company's current ratio is 0.5. Considered alone, which of the
following actions would increase the company's current ratio?
Assume CA= 50 Birr AND CL 100
So CR= CA/CL= 50/100= 0.5
• a. Use cash to reduce accruals.
IF CA AND CL increased By equal
amount 50 birr

• b. Use cash to reduce short-term notes payable. CA= 100 CL = 150

SO CR= CA/CL = 100/150 = 0.6667

• c. Use cash to reduce accounts payable.
SO the answer is D
• d. Borrow using short-term notes payable and use the cash to increase
inventories.
29) The most recent financial statements for ABC company shows: Income
Statement Sales, 7,100; Costs 4,370: on Balance sheet:
• Assets 21,900, Debt, 9,400 and Equity 12,500: Assets and costs are
proportional to sales. Debt and equity are not. No dividends are
• paid. Next year’s sales are expected to grow by 19%. What is the external
financing needed? (Assuming no income taxes)
The current sales level = $7,100
• a. 3,248.7 Increased sales level = $8,449
The percentage increase in sales = (8,449 - 7,100) / 7,100 = 0.19 or 19%
• b. 2,730 The current level of cost = $4,370
• c. 912.7 Increased level of cost = $4,370 x 1.19 = $5,200.3
New net income = $8,449 - $5,200.3 = $3,248.7
• d. 4,161 The External Financing Needed = Increase in assets - Increase in debt - Increase in
equity or retained earning
Increase in assets = 21,900 x 0.19 = $4,161
Increase in equity or retained earnings = Increase in net income as no dividend was
C paid during the year i.e. $3,248.7
Increase in debt = NIL
The External Financing Needed = $4,161 - 0 - $3,248.7 = $912.3.
The Time Value of Money
Chapter 3
What is Time Value?
• We say that money has a time value because that money can be
invested with the expectation of earning a positive rate of return
• A birr that you have today is worth more than the promise or
expectation that you will receive a birr in the future.
• That is because today’s Birr can be invested so that we have
more than one Birr tomorrow
• A single sum of money or a series of equal, evenly-spaced
payments or receipts promised in the future can be converted to
an equivalent value today.
• Conversely, you can determine the value to which a single sum or
a series of future payments will grow to at some future date.
The Terminology of Time Value
• (PV) Present Value - An amount of money today, or the current value of a future
cash flow
• (FV) Future Value - An amount of money at some future time period
• (n) Period - A length of time (often a year, but can be a month, week, day, hour,
etc.)
• (i )Interest Rate - The compensation paid to a lender (or saver) for the use of
funds expressed as a percentage for a period (normally expressed as an annual
rate)

FV= PV(1+I)
 Market Interest rate is composed of
• The Real Rate of Interest compensates lenders for
postponing their own spending during the term of the loan.
• An Inflation Premium to offset the possibility that inflation
may erode the value of the money during the term of the
loan.
• Various Risk Premiums to compensate the lender for risky
loans such as those that are:
✓Unsecured
✓illiquid loans that the lender may not be able to readily resell.
 Type of interest
Simple interest is computed only on the original
amount borrowed.
Simple Interest = p * i * n
where:
p = principal (original amount borrowed or loaned)
i = interest rate for one period
n = number of periods
Example 1: You borrow $10,000 for 3 years at 5% simple annual
interest.
Interest = p x i x n = 10,000 x 0.05 x 3
= 1,500
Example 2: You borrow $10,000 for 60 days at 5% simple interest per
year (assume a 365 day year).
Interest = p xi x n = 10,000 x 0.05 x (60/365) = 82.1917
 Compound Interest
Compound interest is calculated each period on the original amount borrowed
plus all unpaid interest accumulated to date.
• The interest earned in each period is added to the principal of the previous
period to become the principal for the next period.
• The reason for the increase is that each year you are earning interest on the
interest that was earned in previous years in addition to the interest on the
original principle amount
Example
You borrow $10,000 for three years at 5% annual interest compounded annually:
interest year 1 = p x i x n = 10,000 x 0.05 x 1 = 500
interest year 2 = (p2 = p1 + i1) x i x n = (10,000 + 500) x 0.05 x 1 = 525
interest year 3 = (p3 = p2 + i2) x i x n = (10,500 + 525) x 0.05 x 1 = 551.25

• Total interest earned over the three years = 500 + 525 + 551.25 = 1,576.25.
Annuities
• An annuity is a series of nominally equal payments equally spaced in
time
• The payments or receipts occur at the end of each period for an
ordinary annuity while they occur at the beginning of each period for
an annuity due.
• Annuities are very common:
• Rent
• Mortgage payments
• Car payment
• Pension income
• The timeline shows an example of a 5-year, $100 annuity

100 100 100 100 100

0 1 2 3 4 5
 Present Value of an Ordinary Annuity
(cont.)
• Actually, there is no need to take the present value
of each cash flow separately
• We can use a closed-form of the PVA equation
instead:  
1 1−
N
 (1 + i) N

 (1 + i)
Pmt t
PVA = t
= Pmt  
t =1  i 
 
1 − 1 
Annuity due N
 (1 + i) 
N

 (1 + i)
Pmt t
PVA = = Pmt   * 1+i
PV =
t
t =1  i 
 
 The Future Value of an Ordinary Annuity (cont.)

• Just as we did for the PVA equation, we could

instead use a closed-form of the FVA equation:

N
 (1 + i) N − 1 
 Pmt (1 + i)
N−t
FVA = t = Pmt  
t =1  i 

 (1 + i) N − 1 
Annuity due
N

 Pmt (1 + i)
N−t
FVA = t = Pmt   * 1+i
FV = t =1  i 
30) You want to go to USA 5 years from now for your MSc degree, and
you can save Birr 3,100 per year, beginning one year from today.
You plan to deposit the funds in one of the commercial banks that you
think will pay 8.5% interest per year.
Under these conditions, how much would you have just after you make
the 5th deposit, 5 years from now?
Ordinary Annuity
N
 (1 + i) N − 1 
A. Birr 19,287
DFVA =  Pmt t (1 + i) N−t
= Pmt  
t =1  i 
B. Birr 21,264

C. Birr 20,251

D. Birr 18,369 = 18,369

31) You own two annuities that will each pay Birr 500 a month for the
next 12 years. One payment is received at beginning of each month
while the other is received at the end of each month. At a discount rate
of 7.25% compounded monthly what is difference in the present values
of these annuities? PV of ordinarily 1 − 1 
N
 (1 + i) N

 (1 + i)
Pmt t
=
PVAannuity = Pmt  
t =1
t
 i 
500 = 47996.69
 
A. Birr 308.00

B. Birr 265:42 PV of annuity due = PV ordinary annuity (1+i)

= 47996.69 [1+ (0.0725/12)]
= 48286.59
C. Birr 289.98
C difference in the present values of these annuities = 48286.59 - 47996.69
= 289.9
D. Birr 299.01
32) Your father invested a lump sum 26 years ago at 4.25
percent interest. Today, he gave you the proceeds of that
investment which totaled ETB 51,480.79.
How much did your father originally invest?
A. ETB 15,929.47
B. ETB 16,500.00
C. ETB 17,444.86 C
D. ETB 17,500.00
E. ETB 17,999.45
= 51480.79
(1+0.0425)
= 17,444.86
33) You are investing $100 today in a savings account at your local bank.
Which one of the following terms refers to the value of this investment one
year from now?
• A. future value
• B. present value
• C. principal amounts
• D. discounted value A
• E. invested principal
34) Tracy invested $1,000 five years ago and earns 4 percent interest on her
investment. By leaving her interest earnings in her account, she increases the
amount of interest she earns each year. The way she is handling her interest
income is referred to as which one of the following?
• A. simplifying
• B. compounding
• C. aggregation
• D. accumulation B
• E. discounting
35) This afternoon, you deposited $1,000 into a retirement savings account. The
account will compound interest at 6 percent annually. You will not withdraw any
principal or interest until you retire in forty years. Which one of the following
statements is correct?
• A. The interest you earn six years from now will equal the interest you earn ten years
from now.
• B. The interest amount you earn will double in value every year.
• C. The total amount of interest you will earn will equal $1,000(1.06)^ 40.
• D. The present value of this investment is equal to $1,000.
• E. The future value of this amount is equal to $1,000 (1 + 40) .
D
36) Gerold invested $6,200 in an account that pays 5 percent simple
interest. How much money will he have at the end of ten years?

• A. $8,710
I=P* rate *Time =
• B. $9,000 = 6200*0.05*10= 3100

• C. $9,300 MV= P+I

C =6200+3100
• D. $9,678 = 9300

• E. $10,099
37) Suppose an investor wants to have $10 million to retire 45 years from
now. How much would she have to invest today with an annual rate of
return equal to 15 percent?
A). $18,561
• B). $17,844
10M
• C). $20,003 A (1+0.15)^45
• D). $21,345
38) Travis invested $9,250 in an account that pays 6 percent simple interest.
How much more could he have earned over a 7-year period if the interest
had compounded annually?
• A. $741.41
• B. $773.58 Simple interest = 9250*0.06*7= 3885
• C. $802.16 Mv = 9250+3885= 13135
• D. $833.33 Compound interest =
• E. $858.09 FV= 9250(1+0.06)^7= 13908.58
B Difference = 13908.58-13135= 773.58
39) Suppose you are committed to owning a $140,000 Ferrari. You believe your
mutual fund can achieve an annual rate of return of 9 percent and you want to
buy the car in 7 years. How much must you invest today to fund this purchase
assuming the price of the car remains constant?
• A. $74,208.16
• B. $76,584.79
PV = $140,000 [1/(1 + .09)^7
• C. $77,911.08
PV = $76,584.79
• D. $78,019.82
• E. $79,446.60 B
40) Your grandmother is gifting you $150 at the end of each month for four years while you attend
college to earn your bachelor's degree. At a 4.8 percent discount rate, it compounded monthly,
what are these payments worth to you on the day you enter college?

• A) 6539.14

• B)5396.14
1 − 1 
N
 (1 + i) 
N

 (1 + i)
• C)3964.14 Pmt t
PVA = t
= Pmt  
t =1  i 
• D) 9346.14  

A
41) You need some money today and the only friend you have that has any is
your miserly friend. He agrees to loan you the money you need, if you make
payments of $30 for the next six year. In keeping with his reputation, he
requires that the first payment be paid today. He also charges you 2 percent
interest per year. How much money are you borrowing?
• A) 171.4  
1 − 1
N
 (1 + i) 
N
• B) 717.14

Pmt t
Annuity due PV = PVA = = Pmt   * 1+i
t =1 (1 + i )
t
• C) 625.14  i 
 
• D) 124.2
A
42) Stephanie is going to contribute $250 on the first of each month,
starting today, to her retirement account. Her employer will provide a 50
percent match. If both Stephanie and her employer continue to do this
and she can earn a monthly interest rate of 0.5 percent, how much will she
have in her retirement account 25 years from now?
• A) 261.172
Annuity N
 (1 + i) − 1 
N
• B) 612.172

due FV = FVA = Pmt t (1 + i) = Pmt 
N−t
 * 1+i
• C) 126.172 t =1  i 
• D) None
A
43) All of the above Sefa Chartered Accountants has developed and
copyrighted an accounting software program. He agreed to sell the
copyright to Steel company for 6 annual payments of Br. 5,000
each. The payments are to begin 5 years from today. If the annual
interest rate is 8%, what is the present value of the six payments?
• 1 − 1 
• A) 16,989 Annuity due PV =
N
 (1 + i)  *
N
1+i

Pmt t
PVA = = Pmt  
t =1 (1 + i )
• B) 16,000 t
 i 
• C) 10,900  
• D) 18000
Present value of a Deferred Annuityis computed two or more periods
before the first payment is made. B/c of its differed annuity after
determine the PVAdue at 5 year then converted to the PV current
PVAn (Deferred annuity)
= PMT(1 + i)-x= PMT (PVIFAi, n) (1 + i) ^ -X
Chapter Four
Cost of capital
 Cost of capital
The minimum rate of return that a firm
must earn on its investments to
compensate its investors for the use of
their capital.
The appropriate discount rate for cost of
capital may be called opportunity cost of
capital, required rate of return or
weighted average cost of capital.
Importance
For capital budgeting decisions:
to minimized, the cost capital, and to boost
the value of the firm.
For capital structure decisions: mix of
debt and equity
For other decisions: leasing (or
purchasing), to bond refunding, and to
working capital management
To regulate utilities: regulators determine
the cost of capital investors
 Cost of capital components
The cost of capital must reflect the
average cost of the various sources of
long term funds used- the weighted
average cost of capital
Capital component is one of the types
of capital used by firms to raise money.
Capital components are sources of
funding that come from investors
E.g. debt, preferred stock, new common equity, and
retained earnings.
But Accounts payable, accruals, and deferred taxes are
not sources of funding that come from investors
cost of capital relates to cost of new funds needed to
finance the project, not the cost of funds raised in the
past.
It is used primarily to make decisions which involve
raising and investing new capital.
Generally the cost of capital should include the specific
cost of each source of financing today, not the historically
based cost reflected by the existing financing on the
firm’s books.
Cost of long term debt (kd(1-T))
 The after-tax cost today of raising long-term funds through
borrowing.
 Since interest is tax-deductible, the pretax rate should be
adjusted.
 After-tax cost of debt (Ki) = interest rate – tax savings
 = Kd – KdT = Kd(1-T)

Where,
T = tax rate
Kd = the before tax cost of debt, the interest rate net of floatation
costs.
• The explicit cost of debt tends to be the least
expensive of the other forms of financing
sources for two reasons:
➢Bond holders have greater security than
preferred or common stockholders
➢Interest is tax deductible.
 Cost o f preferred stock (Kp)
• Today’s cost of using preferred stock to raise funds.
• Tax adjustment is unnecessary.
Firms often pay dividend on preferred stock because if
they fail to do so:
• a) they can not pay dividends on their common stock,
• b) they will find it difficult to raise additional funds in
the capital markets, and
• c) in some cases, preferred stockholders have the right
to assume control of the firm.
 3. The cost of common stock
The cost of common stock is the minimum
return the firm must earn on common equity
capital to maintain its share price.
A firm can raise common equity capital in two
ways:
1) by retained earnings, and
2) by issuing new common stock.
 In determining the component cost of
common equity, the costs of these two
different types of equity must be considered
Cost of Retained Earnings
• The return on dividends foregone by equity
shareholders.
• The firm should retain earnings only if it can earn
at least as much as its stockholders could earn on
alternative investments of equivalent risk.
• This rate of return stockholders expect to earn on
other investments of equivalent risk is the required
rate return on common stock.
• Estimating the cost of common equity is more
difficult than estimating the cost of debt or
preferred stock because there is no stated interest or
dividend rate.

However, three methods can be used.

a) the discounted cash flow (constant
growth valuation) model, also called the
Gordon model
b) the capital asset pricing model
c) the bond-yield plus risk premium
approach (ad hoc method)
a) The Gordon model (the DCF
approach)
• Since common stock dividends are paid from after-tax
income, no tax adjustment is required.
• Intrinsic value (theoretical value) is the value of an asset
today based on a particular investor’s estimate of the asset’s
expected cash flow and the riskiness of that flow.
• Intrinsic value may be different from the asset’s current
market price, book value, or both.
• next year’s annual dividend per share can be estimated
relatively easily.
• It is not easy to estimate the growth rate expected, but the
following two approaches could be used.
b. The CAPM approach
• The CAPM describes the relationship between the required return and
the non-diversifiable risk of the firm as measured by the beta
coefficient.
• Ks is the return required by investors as compensation for the firm’s
non-diversifiable risk.
• Steps:
• ► estimate the risk free rate taken to be the government Treasury
bond rate or the short term Treasury bill rate.
• ► estimate the stock’s beta coefficient (obtained from investment
advisor services or financial surveyors).
• ► estimate the expected return on the market.
 WEIGHTED AVERAGE COST OF
CAPITAL
• Also called hurdle rate, opportunity cost of capital,
composite cost of capital.
• The WACC is the weighted average cost of each
new dollar of capital raised.
• Reflects, on the average, the firm’s cost of long-term
financing
Weight estimation
Suppose the stock price for Duchess Co. is $50, there are 2.5
million share of stock, the firm has $25 million of preferred
stock, and $100 million of debt.
Value of common equity
= $50 x 2.5 million = $125 million

Value of preferred stock = $25 million

Value of debt = $100 million

Total value of the firm = 125 + 25+ 100 = 250

44) Which one of the following statements is correct for a firm that uses debt in its capital structure?
• A. The WACC should decrease as the firms debt-equity ratio increases.

• B. When computing the WACC, the weight assigned to the preferred stock is based on the coupon rate
multiplied by the par value of the preferred.

• C. The firms WACC will decrease as the corporate tax rate decreases.

• D. The weight of the common stock used in the computation of the WACC is based on the number of
shares outstanding multiplied by the book value per share.

A
45) Cost of capital is
a. The amount the company must pay for its plant assets.
b. The dividends a company must pay on its equity
securities.
c. The cost the company must incur to obtain its capital
resources.
d. The cost the company is charged by investment bankers
who handle the issuance of equity or long-term debt
securities.

C
46) The term "capital structure" refers to:
a. a mix of Long-term debt, preferred stock, and common
stock equity.
b. Current assets and current liabilities.
c. Total assets minus liabilities.
d. Shareholders' equity.

A
47) The weighted average cost of capital for a firm is the:
• a. discount rate which the firm should apply to all of the projects it
undertakes.
• b. overall rate which the firm must earn on its existing assets to maintain
the value of its stock.
• c. rate the firm should expect to pay on its next bond issue.
• d. maximum rate which the firm should require on any projects it
undertakes.
• e. rate of return that the firm’s preferred stockholders should expect to
earn over the long term
48) Central Systems, Inc. desires a weighted average cost of capital of 8 percent.
The firm has an after-tax cost of debt of 4.8 percent and a cost of equity of 15.2
percent.
What debt-equity ratio is needed for the firm to achieve its targeted weighted
average cost of capital?
• WACC = 0.08 = [We * 0.152] + [(1 - We) * 0.048)]
A. 0.38 0.08= 0.152We + 0.048 - 0.048We
B. 0.44
C. 1.02 0.08-0.048= 0.152-0.048We
D. 2.25
E. 2.63
0.032=0.104We
D We= 0.032/0.104

We = 0.3077;
Wd = 1 - We = 0.6923
Debt-equity ratio = 0.6923/0.3077 = 2.25
59) For a typical firm, which of the following sequences is correct?
All rates are after taxes, and assume that the firm operates at its
target capital structure. Note: Re is cost of new equity while Rs is
cost of retained earnings.

A. Rs > Re > Rd > WACC

B. WACC > Rd > Rs > Re.

C. Re > Rs > WACC > Rd.

D. Rd > Re > Rs > WACC C

50) Which one of the following is minimized when the value of a firm is
maximized?

• A. Return on equity

• B. WACC

• C. Debt B
• D. Taxes

• E. Bankruptcy costs
51) Central Systems, Inc. desires a weighted average cost of
capital of 8 percent. The firm has an after-tax cost of debt of 5
percent and a cost of equity of 10 percent. What debt-equity
ratio is needed for the firm to achieve its targeted weighted
average cost of capital?
• A). .77
WACC = 0.08 = [We * 0.1] + [(1 - We) * 0.05)]
• B). .67 0.08= 0.1We + 0.05 - 0.05We
• C). .84
• D). .57 B 0.08-0.05= 0.1-0.05We
0.03=0.05We
• E). .50 We= 0.03/0.05
We = 0.6;
Wd = 1 - We = 0.4
Debt-equity ratio = 0.4/0.6 = 0.66667
52) R.S. Green has 250,000 shares of common stock outstanding at a market
price of $28 a share. Next year's annual dividend is expected to be $1.55 a
share. The dividend growth rate is 2 percent. The firm also has 7,500 bonds
outstanding with a face value of $1,000 per bond. The bonds carry a 7
percent coupon, pay interest semiannually, and mature in 7.5 years. The
bonds are selling at 98 percent of face value. The company's tax rate is 34
percent. What is the firm's weighted average cost of capital?
A. 5.4 percent
B. 6.2 percent
C. 7.5 percent
D. 8.5 percent
E. 9.6 percent

B
• Step 1:
• The market values (MV) of the stock and bond capital are computed below.
• MV Stock = 250,000 shares * $28 per share = $7,000,000
• MV Bond = 7,500 bonds * $1,000 face * .98 discount = $7,350,000
• Equity Weight = $7,000,000 / ($7,000,000 + $7,350,000) = .4878
• Debt Weight = $7,350,000 / ($7,000,000 + $7,350,000) = .5122
• Step 2:
• The cost of equity and the cost of debt are computed below.
• Equity Cost = Next Dividend / Price + Growth Rate
• Equity Cost = $1.55 / $28.00 + .02 = .0754
• After-tax Debt Cost = Coupon Rate / Market Value Discount Factor * (1-Tax Rate)
• After-tax Debt Cost = .07 / .98 * (1-.34) = .0471
• Step 3:
• The WACC is computed as follows:
• WACC = Equity Weight * Equity Cost + Debt Weight * After-tax Debt Cost
• WACC = .4878 * .0754 + .5122 * .0471 = .0609 of 6.09%
53) The dividend growth model:
• A. is only as reliable as the estimated rate of growth.
• B. can only be used if historical dividend information is available.
• C. considers the risk that future dividends may vary from their
estimated values.
• D. applies only when a firm is currently paying dividends.
• E. uses beta to measure the systematic risk of a firm.

A
54) O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and
b = 1.05. What is the firm's cost of equity from retained earnings
based on the CAPM?

A. 11.64% rRf = 5%
B. 12.72% RPM = 6%
C. 11.30% b = 1.05
D. 12.35% C
rs=rRF+b(RPM)
E. 11.99%
=0.05 + 1.05(0.06)
=11.30
55) What is the expected market return if the expected
return on asset X is 20 percent, its beta is 1.5, and the risk
free rate is 5 percent? CAPM Model:
The formula used in this model is:
(a) 5.0% Expected return =
(b) 7.5% Risk-free rate + {Beta * (Market return - Risk-free rat
(c) 15.0% 0.2 = 0.05+(1.5*(MR-0.05)
0.2= 0.05+ 1.5MR- 0.075
0.2+0.075= 0.05+1.5MR
(d) 22.5% 0.275= 0.05+1.5MR
0.275-0.05 = 1.5MR
0.225= 1.5MR
0.225 = 1.5MR
C
1.5 1.5
MR= 0.15 Or 15%
• 56) Which of the following statements is correct?
• a. WACC exceeds the cost of equity.
• b. The cost of equity is greater than the cost of debt.
• c. The cost of reinvested earnings typically exceeds the
cost of new common stock.
• d. The WACC is calculated on a before-tax basis.

B
 Chapter 4
What is Capital Budgeting?
✓ The process of identifying, analyzing, and selecting investment
projects whose returns (cash flows) are expected to extend beyond
one year.
✓Capital budgeting is the process of planning for purchases of assets
whose returns are expected to continue beyond one year (beyond one
operating period). A capital expenditure is a cash outlay that is
expected to generate a flow of future cash benefits lasting longer than
one year.
✓Capital budgeting is a decision-making process for investment in fixed
assets.
✓It involves large cash outlay at the outset and commits the firm to a
particular course of action over a relatively long period.
 Types of capital budgeting decisions/long-
term investments

1. Revenue expansions investments

• Involve expansion of present operations or
• development of new product line are intended to
increase revenue
• Introducing a new product ( R& D department may show
the feasibility of a new product)
 Types of capital budgeting decisions/long-
term investments

2. Cost- reduction investments

• add no revenue to the firm
• Help reduce costs such as cost of materials, cost of labor, etc.
• are usually replacement decisions:-
Replacement of worn-out and damaged fixed assets.
Replacement of obsolete fixed asset
• Mechanization or automation of a process
• Modernizing a process
3. Non-Revenue generating and non-cost saving investments
Are intended to comply with government orders, labor agreements, or
insurance policy terms.
 The Capital Budgeting Process

1. Generate investment proposals

2. Review and Analysis
3. Decision making
4. Implementation (Execution)
5. Follow up
 Capital Budgeting Techniques
Non-Discounted methods (cash flow/traditional
methods: do not consider time value of money.
❑Payback period/PBP/
❑Accounting (Average) rate of Return
Discounted Methods: Consider time value of money
• Net Present value method/NPV?
• Profitability Index/PI/
• Internal rate of return
 Payback Period (PBP)
The payback period is the number of years needed to recover the initial
investment of a project. It is the number of years required for an investment’s
cumulative cash flows to equal its net investment.

Decision rule: Based on the payback rule, an investment is acceptable if its

calculated payback period is less than some pre specified number of years,
maximum desired payback period.

When cash flow of an investment is in annuity form, payback period is computed

by dividing the net investment by the annuity.
Payback Period (PBP)
 b) Accounting Rate of Return
The percentage rate of return expected on an investment or
asset, compared to the initial investment's cost.
The accounting rate of return compares the average after-tax
profits with the average size of investment.

It is computed by dividing a project's expected average net

income by the average investment.
b) Accounting Rate of Return
2. Discounted Methods

• A) Net Present Value

• B) Internal Rate of Return
• C) Profitability Index
 a) Net Present Value (NPV)
NPV is the present value of an investment project’s net
cash flows minus the project’s initial investment. The
discount rate is the opportunity cost of capital

For annuity
NPV = CF (1+r) –n -- I Invt
CF
CF1 CF2 CFn
NPV = + +...+ - I Invt
(1+k)1 (1+k)2 (1+k) n
a) Net Present Value (NPV)
 b) Internal Rate of Return (IRR)

IRR is the discount rate that equates the present value of the future
net cash flows from an investment project with the project’s initial
investment. I.e. NPV at IRR = 0
IRR is the actual rate of return that a project earns when profits and
the time value of money are taken into account.
Note that the IRR is stated as a percentage return.

CF1 CF2 CFn

IINVt = + +...+
(1+IRR)1 (1+IRR)2 (1+IRR)n
b) Internal Rate of Return (IRR)
 Profitability Index (PI)
PI is the ratio of the present value of a project’s future net
cash flows to the project’s initial investment.

CF1 CF2 CFn

PI = + +...+ IInVT
(1+k)1 (1+k)2 (1+k)n

PI = PV
Intial I
Profitability Index (PI)
57) Feb 7, 2023 — Project B requires an investment of birr 750000 which
will give a return of first year birr 250000, 2nd year through fourth year birr
300000, and fifth year birr 100000. if RRR 12%
• WHAT IS THE NPV?

A)866,561.96
B)534331.23
C)324,533.20
D)173304.6
D
 58) Assume you invested 70,000 in project A with 13% discount
rate , the project will have the following cash flow for next six year

What is the Pay back period and NPV of

the project A ?
A)3.5 Year and 11770
B)3.66 Year and 1768.98
C)2.66 year and 12770
PBP = 3 Year+ 10000
D)3 year and -11770 15000
PBP = 3.66 Year

- 70000 = 1768.98
NPV =
59) Your firm is considering investing in one of two mutually exclusive projects.
Project A requires an initial outlay of birr 3,500 with expected future cash flows of Birr
2,000 per year for the next three years.
Project B requires an initial outlay of birr 2,500 with expected future cash flows of Birr
1,500 per year for the next two years. The appropriate discount rate for your fam is
12% .
Assuming both projects can be replaced with a similar investment at the end of their
respective lives, compute the NPV of the two chain cycle for Project A and three chain
cycle for Project B Project A Project B
Cash outflows -3500 -2500
A. Birr 3.528 and Birr 136
C Cash inflows: 2000
2000
1500
-1000 (1500)
B. Birr 5,000 and Birr 1,500
-1500 (2000) 1500
C. Birr 2.232 and Birr 85 2000 -1000 (1500)
2000 1500
D. Birr 2,865 and Bim 94 2000 1500
NPV 2,232 85
60) A capital investment decision is essentially a decision to:
A. exchange current assets for current liabilities.
B. exchange current cash outflows for the promise of receiving future cash
inflows
C. exchange current cash flow from operating activities for future cash
inflows from investing activities.
D. exchange current cash inflows for future cash outflows.
B
61) The long-term planning process for making and financing investments
that affect a company's financial results over a number of years is referred
to as

• A. capital budgeting

• B. strategic planning A
• C. master budgeting

• D. long-range planning
62) In connection with a capital budgeting project, an investment in working capital is
normally recovered

• A. at the end of the project's life

• B. in the first year of the project's life

• C. evenly through the project's life

A
• D. when the company goes out of business
63) If an investment project has a profitability index of 1.15, then the
a. Project’s internal rate of return is 15%.
b. Project’s cost of capital is greater than its internal rate of return.
c. Project’s internal rate of return exceeds its net present value.
d. Net present value of the project is positive

D
64) A project that when accepted or rejected will not affect the cash
flows of another project.

• A. Independent projects
• C. Mutually exclusive projects
• B. Dependent projects
• D. Both b and c
A
• 65) Marian Plunket owns her own business and is considering an
investment. If she undertakes the investment, it will pay $4000 at the end
of each of the next three years. The opportunity requires an initial
investment of $1000 plus an additional investment at the end of the second
year of $5000. What is the NPV of this opportunity if the interest rate is 2%
per year? Should Marian take it? Project A
• A) 5729.69 Cash outflows -1000
• B) 5279.59 Cash inflows: 4000
-1000(4000)
• C)4351.25 A 4000
• D) 2957.29 NPV 5729.69
• 66) Your firm is considering investing in one of two mutually exclusive projects.
• Project A requires an initial outlay of $2,800 with expected future cash flows of $1,000 per year for the next
three years.
• Project B requires an initial outlay of $5,500 with expected future cash flows of $3,000 per year for the next
two years. The appropriate discount rate for your firm is 12% and it is not subject to capital rationing.
• Assuming both projects can be replaced with a similar investment at the end of their respective lives,
compute the NPV of the two chain cycle for Project A and three chain cycle for Project B.
• A) (681.58) and (1,045.69)
• B) 681.58 And 1045.69 Project A Project B
Cash outflows -2800 -5500
• C) 618.58 and 1054.69 Cash inflows: 1000 3000
• D) (618.8) and 1054.69) 1000 -2500 (3000)
A -1800 (1000)
1000
3000
-2500 (3000)
1000 3000
1000 3000
NPV (681.58) (1045.69)
67) An asset costs $210,000 with a $30,000 salvage value at the end of its ten-
year life. If annual cash inflows are $30,000, the cash payback period is
• a) 8 years.
• b) 7 years.
= 210,000/30,000
• c) 6 years.
• d) 5 years. = 7 Year

B
68) If project A has a lower payback period than project B, this may indicate
that project A may have a
a. lower NPV and be less profitable.
b. higher NPV and be less profitable.
c. higher NPV and be more profitable. C
d. lower NPV and be more profitable.
 Chapter Five
Risk and Return
 FINANCIAL
MANAGEMENT II
Capital Structure
Policy and
Leverage

Chapter 1
Capital structuring
• The most crucial component of starting a business is
capital.
• It acts as the foundation of the company.
• Debt and Equity are the two primary types of capital
sources for a business.
• Capital structure is defined as the combination of
equity and debt that is put into use by a company in
order to finance the overall operations of the company
and for its growth.
Capital structuring

How should a firm go about choosing its debt–equity ratio?

• What is the primary goal of financial managers?
Maximize stockholder wealth
• We want to choose the capital structure that will
maximize stockholder wealth
• We can maximize stockholder wealth by maximizing
the value of the firm or minimizing the WACC
Factors that influence capital structure
decisions

• 1. EBIT-EPS Analysis
• 2. Cost of capital
• 3. Cash flow analysis
• 4. Control
• 5. Timing and flexibility
• 6. Nature and Size of the Firm
• 7. Industry Standard
Business and Financial risk
• Business risk is defined as the equity risk that comes
from the nature of the firm’s operating activities.
• Business risk depends on the systematic risk of the
firm’s asset.
• Systematic risk of the assets, (Business risk)
• The greater a firm’s business risk, all other things the
same, the greater the will be its cost of equity.
• The basic risk inherent in the operations of a firm is
called business risk.
• Business risk can be viewed as the variability of a
firm’s Earnings Before Interest and Taxes (EBIT).
Business and Financial risk
• Financial Risk is the risk arising due to the use of debt
financing in the capital structure.
• Financial risk is a debt causes financial risk because it
imposes a fixed cost in the form of interest payments.
• It can be defined as the risk of not being able to pay off the
debt.
• Level of leverage, D/E, (Financial risk)

• The extent to which a firm relies on debt

• The more debt financing a firm uses in its capital structure,

the more financial leverage it employs
Financial leverage and Capital structure
• Optimal capital structure is the capital structure that minimizes the
firm’s weighted average cost of capital and maximizes the value of the
firm to its investors.
• Obviously, the profits of a business with a high degree of both kinds of
leverage vary more, everything else remaining the same, than do those
of businesses with less operating and financial leverage.
• Greater variability of profits, of course, means risk is higher.
• Therefore, in deciding what the optimum level of leverage is, what is
an acceptable risk/return tradeoff must be determined
• If the firm currently has an optimal capital structure, it will finance new
investments by a financing mix approximately like the current mix.
• If the current capital structure is not optima, the firm should finance
new asset in such a manner that the capital structure will be moved
toward the optimal position.
The theory of capital structure
• Capital Structure
• A firm's capital structure is the proportion of debt and equity used to finance the firm's assets.
We can write the value of the firm as `V = D + S` where `V` is the firm's value, and `D` and `S`
are the market values of the firm's debt and equity(share) respectively.
• The idea of an optimal capital structure, is that there is some proportion of debt versus equity
financing which maximizes `V`.

Major theories of Capital structure

• 1. Net income (NI) theory
• 2. Net operating income (NPI) theory
• 3. Traditional theory
• 4. Modigliani-Miller (M-M) Theory
• pecking order theory, trade-off theory
• MM Proposition I (with taxes): The value of the company with debt is greater than
that of the all equity company by an amount equal to the tax rate multiplied by the
value of the debt.
• MM Proposition I (without taxes): The market value of the company is not affected
by the capital structure of the company.
• MM Proposition II (with taxes): The cost of equity is a linear function of the
company's debt/equity ratio. The cost of equity increases as the company increases
the amount of debt in its capital structure, but the cost of equity does not rise as
fast as it does in the no tax case.
• MM Proposition II (No Taxes)
• What MM II says is that if you increase borrowing to get the cheaper rate, you will
also increase the amount you will have to pay on your equity. In fact, the two will
exactly offset leaving your (overall) weighted-average cost of capital the same.
• Static Theory : that the firm's capital structure is determined by a trade-off of the
value of tax shields against the costs of bankruptcy.
69) M&M Proposition I with taxes is based on the concept that:

A. The value of the firm increases as total debt increases because of

the interest tax shield.
B. The capital structure of the firm does not matter because
investors can use homemade leverage.
C. The optimal capital structure is the one that is totally financed with
equity.
D. The weighted average cost of capital increases as the debt-equity
ratio of a firm increases
A
60) Which one of the following is the theory that a firm should borrow up
to the point where the additional tax benefit from an extra dollar of debt
equals the additional costs associated with financial distress from that
additional debt?

A. M&M Proposition II, with taxes Theory that the firm's capital
B structure is determined by a trade-
off of the value of tax shields
B. Static theory of capital structure against the costs of bankruptcy.

C. M&M Proposition I, without taxes

D. M&M Proposition I, with taxes

1) Which one of the following states that a firm's cost of equity capital is a
positive linear function of the firm's capital structure?
A. Static theory of capital structure
B. M&M Proposition I without taxes
C. M&M Proposition II with taxes C
D. Homemade leverage theory
E. M&M Proposition I with taxes
2) Which one of the following statements is the core principle of M&M
Proposition I, without taxes?

• A. A firm's cost of equity is directly related to the firm's debt-equity ratio.

• B. A firm's WACC is directly related to the firm's debt-equity ratio.

• C. The interest tax shield increases the value of a firm.

• D. The capital structure of a firm is totally irrelevant.

D
• E. Levered firms have greater value than unlevered firms
3) The use of borrowing by an individual to adjust his or her overall
exposure to financial leverage is referred to as:

• A. M&M Proposition I.

• B. capital restructuring.
C
• C. homemade leverage.

• D. M&M Proposition II.

• E. financial risk management.

4) Which one of the following supports the theory that the value of a firm
increases as the firm's level of debt increases?

• A. M&M Proposition I, without taxes

• B. M&M Proposition II, without taxes

• C. M&M Proposition I, with taxes

• D. Static theory of capital structure

C
• E. No theory suggests this.
5) Which one of the following is the equity risk arising from the daily
operations of a firm?

• A. Strategic risk

• B. Financial risk

• C. Liquidity risk

• D. Industry risk E
• E. Business risk
6) Which one of the following is the equity risk arising from the capital
structure selected by a firm?

• A. Strategic risk

• B. Financial risk

• C. Liquidity risk

• D. Industry risk

• E. Business risk
B
7) Assume you are comparing two firms that are identical in every aspect,
except one is levered and one is unlevered. Which one of the following
statements is correct regarding these two firms?
• A. The levered firm has higher EPS than the unlevered firm at the break-even
point.
• B. The levered firm will have higher EPS than the unlevered firm at all levels
of EBIT.
• C. The unlevered firm will have higher EPS than the levered firm at relatively
high levels of EBIT.
• D. The EPS for the unlevered firm will always exceed those of the levered
firm.
• E. The unlevered firm will have higher EPS at relatively low levels of EBIT.
E
8) Which one of the following statements concerning financial leverage is
correct?
• A. The benefits of leverage are unaffected by the amount of a firm's
earnings.
• B. The use of leverage will always increase a firm's earnings per share.
• C. The shareholders of a firm are exposed to less risk anytime a firm uses
financial leverage.
• D. Changes in the capital structure of a firm will generally change the firm's
earnings per share.
• E. Financial leverage is beneficial to a firm only when the firm has negative
earnings.
D
9) Which of the following statements best describes the optimal capital structure?

A. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the
company’s earnings per share (EPS).

B. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the
company’s stock price.

C. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the
company’s cost of equity.

D. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the
company’s cost of debt.

E. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the
company’s cost of preferred stock. B
 CHAPTER Two
Dividend Policy: Theory and
Practice
 Dividends
What are Dividends?
Dividends refer to the portion of a firm’s net earning which are paid
out to the shareholders.
Since preference shares are entitled to a stipulated rate of dividend,
the major emphasis of dividend policy decision is concerned with
the ordinary shareholders.
• Firms are not obligated to pay dividends or maintain a consistent
policy with regard to dividends for Ordinary shareholder
• The retained earning constitutes an easily accessible important
source of financing the for investment fund requirement of firms.
Dividends
• A major decision of financial management is the dividend decision in the
sense that the firm has to choose between distributing the profit to the
shareholders and plough them back to the business.
• The choice would hinge on the effect of the decision on the maximization
of shareholders’ wealth.
• That is the firm would be well advised to use the net profits for paying
dividends to the shareholders if the payment will lead to the maximization
of wealth of the owners.
• Dividend decision of the business is one of the crucial parts of the
financial manager, because it determines the amount of profit to be
distributed among shareholders and amount of profit to be treated as
retained earnings for financing its long term growth.
 Theories of Dividend Policy
• There are TWO basic views with regard to the impact of
dividend policy on share prices:
• Dividend policy is irrelevant
Dividends are irrelevant so the amount of dividends paid has no
effect on the valuation of the firm.
• Dividend policy is relevant
The dividend decision as relevant to the value of the firm measured in terms
of the market price of the shares.
• High dividends will increase share prices
• Low dividends will increase share prices
Dividend Irrelevant Theories
• If dividend policy is strictly a financing decision, whether dividends
are paid out of profits or earnings are retained, will depend upon the
available investment opportunities and it is not affect the value of the
firm
• It implies that when a firm has sufficient investment opportunities, it
will retain the earnings to finance them. Conversely, if acceptable
investment opportunities are inadequate, the implication is that the
earnings would be distributed to the shareholders.
• The amount of dividend will fluctuate from year to year depending
upon the availability of acceptable investment opportunities.
• The theory of dividends are irrelevant is based on the investors are
indifferent between dividends and capital gains.
 Miller and Modigliani (MM)
• The most comprehensive argument in support of the irrelevance of
dividends is provided by the Miller and Modigliani (MM) hypothesis.
• MM maintains that dividend policy has no effect on the share price
of the firm, and is therefore, of no consequence.
Assumptions of MM approach
• The MM hypothesis of irrelevant of dividends is based on the
following critical assumptions:
1.Perfect capital market.
2. Investors are rational.
3.There are no tax.
4.The firm has fixed investment policy.
5. No risk or uncertainty.
 Relevance of Dividend decision

• According to this concept, dividend policy is

considered to affect the value of the firm.
• Dividend relevance implies that shareholders prefer
current dividend has direct relationship between
dividend policy and value of the firm.
• Relevance of dividend concept is supported by two
eminent persons like Walter and Gordon.
 Walter’s Model

• The choice of dividend policy affects the value of the firm.

• The key argument in support of the relevant proposition of Walter’s
model is the relationship between the return of the firm’s
investment or its internal rate of return(r) and its cost of capital or
the required rate of return (k).
• if the return on investments (r) exceeds the cost of capital (k), the
firm should retain the earnings; whereas it should distribute the
earnings to the shareholders in case the required rate of return
exceed the expected return on the firm’s investments.
Assumptions
1) The firm uses only internal finance- All financing is done through
retained earnings; external sources of funds like debt or new equity
capital are not used.
2) The firm has constant return and cost of capital- With additional
investments undertaken, the firm’s business risk does not change. It
implies that internal rate of return and required rate of return are
constant.
3) The firm has constant EPS and dividend- There is no change in the
key variables, namely, beginning earnings per share, and dividend
per share.
4) The firm has perpetual or a very long life.

13-1865
Tax preference theory

• Low dividend increases stock values

• current dividends are taxed immediately while the tax on capital
gains can be deferred until the stock is actually sold.
• Thus, capital gains have definite financial advantage for
shareholders.
• Stocks that allow tax deferral (i.e. low dividends and high capital
gains) will possibly sell at a premium relative to stocks that
require current taxation (i.e. high dividends and low capital
gains).

1866
Optimal Dividend Policy
• Optimal Dividend Policy is the dividend policy that strikes a balance between
current dividends and future growth and maximizes the firm’s stock price.

• When deciding how much cash to distribute to stockholders, financial managers

must keep in mind that the firm’s objective is to maximize shareholder value.
• Consequently, the target payout ratio defined as the percentage of net income to be
paid out as cash dividends should be based in large part on investors’ preferences for
dividends versus capital gains:

• Do investors prefer (1) to have the firm distribute income as cash dividends or (2)
to have it either repurchase stock or else plow the earnings back into the business,
both of which should result in capital gains?

13-1867
Optimal Dividend Policy
• This preference can be considered in terms of the constant growth
stock valuation model:
• P0= D1
K-g
• If the company increases the payout ratio, this raises D1. This
increase in the numerator, taken alone, would cause the stock price to
rise.
• However, if D1 is raised, then less money will be available for
reinvestment, that will cause the expected growth rate to decline, and
that will tend to lower the stock’s price.
• Thus, any change in payout policy will have two opposing effects.
13-1868
 Factors Determine Dividend
Policy Decisions
❖Profitable Position of the Firm
❖Uncertainty of Future Income
❖Legal, Contractual and Internal Constraints
❖Liquidity Position:
❖Sources of Finance:
❖Growth Rate of the Firm
❖Tax Policy
❖Market Conditions:
❖Economic Conditions

13-1869
Type of Dividend Policy
• Residual dividend policy
• Regular (stable-dollar) dividend policy
• Low Regular plus Extra dividend policy
• Constant payout ratio – pay a constant percent of
earnings each year
• Irregular dividend policy
• No dividend policy

1870
Alternate forms of Dividends

1. Cash Dividend
2. Stock Dividend
3. Bond Dividend
4. Property Dividend

1871
Stock Repurchases (Stock Buyback)
• Stock repurchase is when a firm uses its cash to
repurchase some of its own stock. (Builds treasury stock)
• This results in a reduction in the firm’s cash balance
(assets) as well as the number of shares of stock
outstanding (stockholder’s equity).

1876
 Repurchase methods

1. Open market purchase: the firm acquires the stock on

the market, often buying a relatively small number of
shares everyday. This is the most widely used method
for stock repurchase.
2. Tender Offer– a company will make a tender offer to
repurchase a specific number of shares, typically at a
premium to the market price
3. Direct negotiation – a company negotiates with one
or more major shareholders to buy back its shares.
This method is not used frequently.
18
77
Stock Splits
• Stock splits – essentially the same as a stock dividend
except expressed as a ratio.
• The company takes fewer old shares and in return issues
larger number of new shares.
• Stock price is reduced when the stock splits
• Common explanation for split is to return price to a “more
desirable trading range”

18
78
81) Which of the following is correct?

A. Declaration of all types of dividend reduces cash balance.

B. As compared to other form of businesses it is difficult to raise
funds in share companies.
C. Shareholders equity account is credited by authorized shares
multiplied by par value.
D. Dividend payable is recorded on the date of declaration of
dividend.
D
82) Which one of the following would tend to favor a low-
dividend pay-out?

A. Elimination of the tax deferral on capital gains

B. Investors' desire for a high-dividend yield

C. Higher tax rates on capital gains than on dividend income

D. High flotation cost for equity issues D

83) High Dividend may increase stock values due
to all of the following reasons except:
A. higher dividends allow companies to increase their
proportion of external equity financing
B. dividends are used as a tool to minimize agency
costs
C. higher dividends are used to signal higher
expected future earnings
D. dividends are more certain than capital gains
Paying higher dividends will decrease the cash
available to firm. It will not help in anyway to firm to
A
increase external equity financing.
84) Which one of the following is NOT the duty of the Board
of Directors of a Share Company?

A. Controlling the day to day activities of the operations

B. Authorizing contracts & setting executive salaries

C. Declaration of dividend
A
D. Arranging major loans with banks
85) All of the following are likely to result in a lower dividend, other things
the same, Except:

• A. Statutory restrictions
D
• B. Liquidity constraints

• C. Debt covenants

• D. Highly diverse ownership

10) A cash payment made by a firm to its owners in the normal course of
business is called a:
A. share repurchase.
B. liquidating dividend.
C. regular cash dividend.
D. special dividend.
E. extra cash dividend C

13-1884
11) If both dividends and capital gains are currently taxed at the same
ordinary income tax rate, the effect of the tax is different because:
a-capital gains are actually taxed, while dividends are taxed on paper only.
b-dividends are actually taxed, while capital gains are taxed on paper only.
c-dividends are taxable when distributed while capital gains are deferred until
the stock is sold.
e-capital gains are taxable when distributed while dividends are deferred until
the stock is sold. C
12) Ignoring capital gains as an alternative, the tax law changes in 2015 tend to
favor a:
A. lower dividend policy.
B. constant dividend policy.
C. zero-dividend policy.
D. higher dividend policy.
E. restrictive dividend policy. D
13-1886
13) The “bird-in-the-hand” dividend theory suggests that:

• A. high dividends increase stock value because shareholders believe they

can earn a higher return than the company
• B. high dividends increase stock value because shareholders are more
certain of the dividend yield than of potential future capital gains
• C. high dividends increase stock value because capital markets are
inefficient, and dividends are the only sure way to get money from an
equity investment
• D. high dividends decrease stock value because dividend payments take
money out of the corporate “nest” and reduce the ability of the
corporation to function effectively
B
14) In a reverse stock split:
A. the number of shares outstanding increases and owners' equity decreases.
B. the firm buys back existing shares of stock on the open market.
C. the firm sells new shares of stock on the open market.
D. the number of shares outstanding decreases but owners' equity is unchanged.
E. shareholders make a cash payment to the firm.

D
13-1888
15) Which one of the following is an argument in favor of a low dividend policy?
A. The tax on capital gains is deferred until the gain is realized.

B. Few, if any, positive net present value projects are available to the firm.

C. A majority of stockholders have other investment opportunities that offer higher

rewards with similar risk characteristics.
D. ALL

A
13-1889
16) From a tax-paying investor's point of view, a stock dividend:
• A. is equivalent to a cash dividend.
• B. is more desirable than a cash dividend.
• C. has the same tax effects as a cash dividend. B
• D. is more highly taxed than a cash dividend.
• E. creates a tax liability even if the investor does not sell any of the shares he owns.

13-1890
17) Which one of the following lists dividend events in the correct
chronological order from earliest to latest?
A. date of record, declaration date, ex-dividend date
B. date of record, ex-dividend date, declaration date
C. declaration date, date of record, ex-dividend date
D. declaration date, ex-dividend date, date of record
E. ex-dividend date, date of record, declaration date

D
13-1891
18) An increase in flotation costs will most likely result in which of the following?
• A. smaller dividend payments so that less external equity financing is needed
• B. larger dividend payments so shareholders are able to earn their required returns
• C. larger dividend payments to offset higher taxes paid by investors
• D. no change in dividend policies because flotation costs are paid by purchasers of
common stock

A
13-1892
• Of the following factors, which one is considered to be the primary factor
affecting a firm's dividend decision?
• A. considering the personal taxes of company stockholders
• B. maintaining a consistent dividend policy
• C. attracting retail investors
• D. attracting institutional investors
• E. avoiding flotation costs

B
13-1893
Financial Managements II

Working Capital
Management

Ermi E- learning
Definition
• Working capital management refers to a company's
managerial accounting strategy designed to monitor
and utilize the two components of working capital,
current assets and current liabilities, to ensure the
most financially efficient operation of the company.
• The primary purpose of working capital
management is to make sure the company always
maintains sufficient cash flow to meet its short-
term operating costs and short-term debt
obligations.
•
 TYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF BASIS OF
CONCEPT TIME

Gross Net Permanent Temporary

Working Working / Fixed / Variable
Capital Capital WC WC
Basic Definitions
• Gross working capital:
Total current assets.

• Net working capital:

Current assets - Current liabilities.
• Net operating working capital (NOWC):
Operating CA – Operating CL =
(Cash + Inv. + A/R) – (Accruals + A/P)

1897
 Permanent Working
Capital
Permanent working capital refers to a level of current assets which
is to be maintained and vital for the firm to carry its business
DOLLAR AMOUNT regardless of the operation levels.

Permanent current assets

TIME
 Temporary Working
Capital
Temporary working capital refers to the working capital which is
over and above the permanent working capital.

Temporary current assets

DOLLAR AMOUNT

Permanent current assets

TIME
 Working capital management
• WCM is a business strategy designed to ensure that a company
operates efficiently by monitoring and using its current assets and
liabilities to their most effective use.

• Working capital management is an act of planning, organizing and

controlling the components of working capital like cash, bank balance
inventory, receivables, payables, overdraft and short-term loans.

The Includes both establishing working capital policy and then the day-
to-day control of cash, inventories, receivables, accruals, and
accounts payable.
• Working capital policy:
• The level of each current asset.
• How current assets are financed.
1900
 Characteristics of Working Capital
• a) Circulating Capital: Working capital, once invested, is
constantly circulating from one component to other component of
working capital.

1901
 Characteristics of Working Capital
• b) Liquidity: Each component of working capital has different
degrees of liquidity. Cash is the most liquid asset. Next is the
marketable security (it is sometimes called near cash asset). A/R is
more liquid than inventories in the sense that inventories may first be
converted to receivables before it is converted to cash.
• c) Risk : Each component of working capital has its own risk. For
example, accounts receivable may be uncollectible or becomes bad
debt. The raw materials may be damaged, finished goods may be
unsalable.
• d) Profitability : Generally, excess working capital may reduce profit
as the money is tied up in current assets, entailing high cost (interest or
opportunity cost).
1902
 Determinants of Working Capital
a)Nature of Business
• The working capital requirement of a firm is closely related to the nature of its
business. A service firm, like electricity undertaking or a transport corporation,
which has a short operating cycle and which sells predominantly on cash basis,
has modest (low) working capital requirement. On the other hand, a
manufacturing concern likes a machine tools unit, which has long operating
cycle and which sells largely on credit, has a very substantial working capital
requirement.
b) Length of Operating Cycle
• The longer the operating cycle the more the working capital requirement, The
more time the inventories (RMs or FGs) are stocked.
➢ The more the manufacturing cycle (i.e. the more the time it takes to convert the
raw materials to final output).
➢ The more time it takes to collect receivables (liberal credit policy).
 Determinants of Working Capital
c) Seasonality of Operations
• Firms which have marked seasonality in their operations usually have highly fluctuating
working capital requirements. To illustrate, consider a firm manufacturing rain coats.
The sale of rain coats reaches a peak during the rainy season and drops sharply during the
winter period, and almost no sales in summer season.
d) Production Policy
• For example, a manufacturer of rain coats may maintain a steady production throughout
the year rather than intensify the production activity during the peak business. Such a
production policy may dampen the fluctuations in working capital requirements.
e) Market Conditions
• The degree of competition prevailing in the market place has an important bearing on
working capital needs.
f) Inflation
• Inflation affects the value of cash and other elements of cash. More WC is required
during high inflation rate affecting price of inputs
 Working Capital Financing Policies
• 1. Conservative working capital policy: Conservative working
capital policy refers to minimize risk by maintaining a higher level
of working capital. This type of working capital policy is suitable
to meet the seasonal fluctuation of the manufacturing operation.
•
2. Aggressive working capital policy: Aggressive working capital
policy is one of the high risky and profitability policies which
maintains low level of working capital against the high level of
sales, in the business during a particular period.
•
3. Moderate working capital policy: Moderate working capital
policy refers to a balance between risk and return is maintained in
order to benefit more by more effective use of the funds..

1905
Causes and effects of excessive working capital.
i. Excessive working capital leads to unnecessary
accumulation of raw materials, components and
spares.

ii. Excessive working capital results in locking up of

excess working capital.

iii. It creates bad debts Expense

iv. It leads to reduce the profits

Causes and effects of inadequate working capital
i. Inadequate working capital cannot buy its
requirements in bulk order.

ii. It becomes difficult to implement operating plans and

activate the firm’s profit target

iii. It becomes impossible to utilize efficiently the fixed

assets.

iv. The rate of return on investments also falls with the

shortage of working capital.

v. It reduces the overall operation of the business.

 Sources of Financing Working Capital
a) Spontaneous current liabilities: this source of working capital
financing mainly from operational activities between a credit
customer and a supplier. The customer finances purchases
through a credit that they obtains from the supplier. Other
spontaneous liabilities include accrued wages, accrued taxes, etc.
b) Short – term financing sources: the sources include bank loans,
private loans, commercial papers (N/P).
c) Long-term loans: this usually involves bank loans on long term
basis. In Ethiopia, for example, loans for working capital
investment can be obtained from DBE, CBE, and private banks.
d) Equity Capital: this is usually the major source of initial WC
investment. It is the money put in the firm by the owner or
investor.
19) Which of the following will cause an increase in net working
capital, other things held constant?
A). A cash dividend is declared and paid.
B). Merchandise is sold at a profit, but the sale is on credit.
C). Long-term bonds are retired with the proceeds of a preferred
stock issue.
D). Missing inventory is written off against retained earnings.
E). Cash is used to buy marketable securities
B
20) The need to manage net working capital arises
because:
A: financial management is naturally broken into those
areas.
B: shareholders want to ensure they receive dividend
payments.
C: there is a mismatch between the timing of cash
inflows and cash outflows.
D: the sum of current assets and current liabilities usually
is zero. C
21) Zap Company follows an aggressive financing policy in its working capital
management while Zing Corporation follows a conservative financing policy. Which one of
the following statements is correct?
A. Zap has low ratio of short-term debt to total debt while Zing has a high ratio of short-
term debt to total debt.
B. Zap has a low current ratio while Zing has a high current ratio.
C. Zap has less liquidity risk while Zing has more liquidity risk.
D. Zap finances short-term assets with long-term debt while Zing finances short-term assets
with short-term debt

B
© Tata McGraw-Hill
Publishing Company Limited, 14-1913
Financial Management
Motives For Holding Cash

Cash management is one of the key areas of

working capital management. There are four
motives for holding cash:
1) Transaction motive,
2) Precautionary motive,
3) Speculative motive, and
4) Compensating motive.
© Tata McGraw-Hill
Publishing Company Limited, 14-1914
Financial Management
 Cash Management: Basic Strategies

The broad cash management strategies are essentially related to the cash
turnover process, that is, the cash cycle together with the cash turnover.
The cash cycle refers to the process by which cash is used to purchase
materials from which are produced goods, which are then sold to
customers, who later pay the bills. The firm receives cash from customers
and the cycle repeats itself.

The cash turnover means the number of times cash is used during each
year. The cash cycle involves several steps along the way as funds flow
© Tata McGraw-Hill Publishing
from Company
theManagement
firm’s accounts. 356/ccc
Limited, Financial 14-1915
68) Which of the following statements is most consistent with efficient
inventory management? The firm has

A. Relatively low days sales outstanding (DSO).

B. Relatively high current ratio

C. Below average inventory turnover ratio,

D. Low incidence of production schedule

Efficient inventory management would result in low wastage of raw
materials and will also ensure sufficient stock of inventory at the right D
time for use in production.
This would in turn reduce the possibility of production schedule
disruptions.
69) Which of the following actions would be likely to shorten the cash
conversion cycle?

A. Change the credit terms offered to customers from 3/10 net 30 to 1/10
net 50.
B. Adopt a new manufacturing process that speeds up the conversion of raw
materials to finished goods from 20 days to 10 days
C. Adopt a new manufacturing process that saves some labor costs but
slows down the conversion of raw materials to finished goods from 10
days to 20 days.
D. Begin to take discounts on inventory purchases; we buy on terms of 2/10
net 30.
B
Cash Conversion Cycle = DIO + DSO – DPO
• 70) A firm has an average age of inventory of 101 days, an average
collection period of 49 days, and an average payment period of 60 days.
The firm's cash conversion cycle is
• A) 150 days.
• B) 90 days.
• C) 112 days. Cash Conversion Cycle = DIO + DSO – DPO
• D) 8 days.
= 101+49- 60
= 90Day

B
22) Which of the following actions should Reece Windows take
if it wants to reduce its cash conversion cycle?
a. Take steps to reduce the DSO.
b. Start paying its bills sooner, which would reduce the average
accounts payable but not affect sales.
c. Sell common stock to retire long-term bonds.
d. Sell an issue of long-term bonds and use the proceeds to buy
back some of its common stock.
A
e. Increase average inventory without increasing sales
23) Other things held constant, which of the following
would tend to reduce the cash conversion cycle?

a. Maintain the same level of receivables as sales decline.

b. Place larger orders for raw materials to take advantage
of price breaks.
c. Take all discounts that are offered.
d. Not take all discounts that are offered to get more trade
credit.
e. Offer longer payment terms to customers
C
24) Suppose a firm changes its credit policy from 2/10
net 30 to 3/10 net 30. The change is meant to meet
competition, so no increase in sales is expected. The
average accounts receivable balance will probably
decline as a result of this change.

a. True A
b. False
25) Thornton Universal Sales's cost of goods sold
(COGS) average $2,000,000 per month, and it keeps
inventory equal to 50% of its monthly COGS on hand
at all times. Using a 365-day year, what is its inventory
conversion period? Monthly Cost Of Goods Sold = $2,000,000
Annual COGS = $2,000,000 × 12 = $24,000,000
Average Inventory = $2,000,000 × 50% =$1,000,000
a. 11.7 days
Inventory Conversion Period =
b. 13.0 days = Inventory/(Annual COGS/365)

c. 14.4 days = $1,000,000/($24,000,000/365)

d. 15.2 days D = 15.208

e. 16.7 days = 15.21 days

26) Brothers Breads has the following data. What is the firm's
cash conversion cycle?
Inventory conversion period = 50 days
Average collection period = 17 days
Payables deferral period = 25 days
A). 31 days
B). 34 days Cash Conversion Cycle = DIO + DSO – DPO
C). 42 days = 50+17-25
= 42Day
D.) 46 days
27) A system of inventory management that discourages the use of safety
stock and that requires coordination between a firm and its suppliers to
ensure delivery of the right quality material at the right time is called:

• A. Computerized system

• B Economic Order Quantity

• C. Just-in-time
C
• D. Material Requirement Planning
28) If EOQ = 360 units, order costs are $5 per order, and carrying costs
are $0.20 per unit, what is the usage in units?

L
• A. 129,600 units EOQ = √ 2*D*O
• B. 2,592 units 360
H
= √2*D*5
• C. 25,920 units 0.2
360 = √50D
• D. 18,720 units
360 = √50D

129600 = 50D
50 50

D = 2592 Unit

B
 Receivable
management
tax
1957
 Introduction
❑ The participation of the government in the economic
activities is essential to accomplish the goals of any
welfare state***
❑ Depending on the level of development of each country
the roles of government sector differ.
❑ The governments of advanced countries are committed
to stability and full employment.
❑ In case of under developed countries the government
aims at accelerated economic development
*** Social safety net and types of government support provided to people at
any level of income to ensure peoples to meet their basic human needs.
➢ Gov’t sector can play a decisive role in shaping
and charting the path of any economy.

➢ However, in all cases the aim is to attain:

✓ Full employment

✓Economic development through the dev’t of:

➢ Agriculture
➢Industry
➢Service sector
1959
 Private and Public Goods
A. Private goods
❑ It refers to all those goods and services, which are
consumed by people to satisfy their personal and
private wants*** or needs***
❑ They relate to articles of food, clothing, shelter,
recreation, etc.
❑ These goods are priced in the market on the basis of
their cost of production and the nature of demand on
the other.
***Wants = Choice w/c person may/may not able to get
***Needs = Necessary for survival
1960
❑ All those who want them &are willing to pay market price will buy
them.
❑ Those who do not want them or who are not in a position to pay
for them will be excluded from the consumption of these goods.
❑ In other words there is no compulsion that everyone will have to
buy them.
❑ Thus, private goods are divisible or subject to the principle of
exclusion.
❑ In the sense that, price mechanism divides people in to two
groups, those who want to consume them and those do not.
❑ Hence, price mechanism excludes the group of people who are
not willing to consume a particular good.

1961
 B. Public Goods

➢ It refers to Goods & Service produced to satisfy collective wants.

➢ Collective wants are those which are demanded by all members of
the community in equal or more or less equal measures.
➢ Example:
✓ Defense
✓ Education
✓ Public Health
✓ Infrastructure Facilities like power, transportation & communication, etc.

➢ These goods are supplied and financed by the country to all its
citizens.

1962
 Features of Public Goods
✓ They cannot be divided and their benefits cannot be shared b/n
people on basis of each individual’s requirements.
➢ Unlike private goods, public goods are not divisible but have to be
collectively consumed.
✓ The principle of exclusion is not applicable since they are
consumed collectively.
➢ Since, public goods are supplied to all people irrespective of their
ability and willingness to pay for them, the pricing system is useless.
➢ Therefore, method of compulsory payment will have to be designed to
finance their cost of production.

1963
 Summary…
Public Goods Private Goods
❑ Open for all to use -Not open for all to use

❑ Consumption by one part does

not deter another party’s ability to use it -Rival

❑ Not excludable -Excludable/ rejectable

❑ Many of them Consumed at no cost - At cost

1964
 Generally:
Basis Public goods Private goods
❖ Provider Nature/Gov.t -Manufacture
❖ Consumer equality Rich/poor equally -Preference to rich

❖ Quality Remains constant -Varies with ability to buy

❖ Traded in free market No -Yes

❖ Opportunity cost No -Yes

❖ Free riders problem Yes -No

❖ Rivalry No -Yes

❖ Excludability/ Rejectable No -Yes

❖ Decision Social Choice -Consumer Decision

❖ Objective Over all growth & dev’t -Profit Earning

A free rider is a person who benefits from something without expending effort
or paying for it. In other words, free riders are those who utilize goods without
paying for their use.
1965
 Function of modern Gov’t and Fiscal Operation***
❑ Government of a modern state undertakes the following functions:
1. Allocation Function:
➢ Government has got to provide public goods that individuals or
private businesses would not provide
➢ Gov’t taxes public & uses amount in providing certain facilities &
services considered essential by people & community.
➢ These facilities are provided at a high cost such as education and
Medicare.
***Fiscal Operation: are actions taken by gov’t to implement budgetary
policies, such as revenue and expenditure measures, as well as issuance of
public debt instrument and public debt management.

1966
Cont’d
➢ Fiscal operations of taxation and public expenditure
have effect of transferring resources from private
goods to produce public goods which would satisfy
collective wants.
➢ Objectives of fiscal operations is provide proper
allocation of resources between private and public
goods so as to maximize social welfare.

➢ In general, of fiscal operations is to maximize social

welfare.
1967
 2. Distribution Function:
➢ In free enterprise economy

✓Distribution of income & wealth is unequal

✓Many times it is grossly unequal resulting in

exploitation of lower income groups.

➢ Inequality of income & concentration of economic

power in hands of a few are responsible for:

✓ Distorting production in favor of rich

✓Reducing social welfare of community.

1968
❑Fiscal Operations have been used to:
➢ Reduce incomes & wealth of rich through
progressive taxation

➢ Raise income & standard of living of lower income

group through public expenditure.

➢ Use of fiscal policy to reduce inequality of incomes

and wealth has been quite common in many
countries.

1969
 3. Stabilization Function
❖ Modern economies are subject to fluctuations:
➢Business boom & inflations on one side
➢Business recessions & depressions on other.
❖ Such fluctuations are not in interest of country.

❑ Fiscal operations have been used to moderate these

fluctuations & if possible to eliminate them altogether.
 For example:
➢ Business booms & inflations can be controlled through heavier
taxation.
➢ Business recession can be checked through public expenditure.
1970
 Public Finance
➢ Financing of gov’t is a matter of universal concern.
➢ Gov’ts, all over world are conducting many public projects such as:
✓ Social security
✓Protection
✓Other services of public utilities like:
➢Water supply -Automatic energy
➢Railways -Heavy electrical projects
❑ To provide social amenities** gov’t requires adequate revenue.
❑ TEs & TR of gov’t > TRs & TEs of single man within country.

** Social Service

1971
➢ Public finance is field of economics & therefore concerned
with:
✓ How government raise money
✓How that money is spent
✓Effects of these activities on economy & society.
❑ Public finance studies:
✓ How governments at all levels:
➢ National
➢ State
➢ Local provide desired services

✓How they secure financial resources to pay for these services.

1972
 Definition of public finance

➢ According to Hugh Dalton’s: PF is concerned with income &

expenditure of public authorities & with adjustment of one to other.

➢ According to Prof. Lutz: PF deals with provision of custody &

disbursement of resources needed for conducting of gov’t or public

functions.

➢ According to Prof. Findlay Shirras: PF is study of principles

underlying spending & raising of funds by public authorities.

❖ Above definitions, frames same definitions, which study of income &

expenditure of gov’t.
1973
 Scope of Public Finance
❑PF is classifies under four broad categories:

1. Public revenue
2. Public Expenditure
3. Public debt
4. Financial administration

1974
 1. Public Revenue
➢ Public revenue is means for public expenditure.
➢ Sources of public revenue:
A. Tax revenue
B. Non-tax revenue
➢ Increasing activities of gov’t are cause of increasing
public expenditure.
➢ Methods of public revenue & their volumes have
significant impact on production & distribution of
wealth & income in country.
1975
 A. Tax Revenue
➢ Taxes are compulsory payments to gov’t without
expectation of direct return or benefit to tax payers.
➢ It imposes a personal obligation on taxpayer.
➢ Taxation is powerful instrument in hands of gov’t for
transferring purchasing power from individuals to
government.
➢ Therefore, taxation is:
✓ A compulsory contribution

✓ Aimed at welfare of community

✓ Benefit may not be proportional to tax paid

✓ A legal collection
1976
 B. Non-tax Revenue
❑ This includes revenue from:

✓ Government or public undertakings

✓Revenue from social services like education &
hospitals
✓Revenue from loans or debt service
❑ To sum up, non-tax revenue consists of:
❑ Interest receipts
❑ Dividends & profits
❑ Fiscal services & others
1977
 2. Public Expenditure
➢ Public Expenditure is used to designate expenditure
of gov’t central, state & local bodies.
➢ It differs from private expenditure in that gov’ts need
not pay for themselves or yield a pecuniary profit.
➢ Gov’t of country has to use its expenditure & revenue
programs to produce desirable effects on:
✓ National income
✓Production
✓Employment

1978
➢ Public expenditure plays dual role of administration
and economic achievement of a nation.

➢ Wise spending is essential for stability of gov’t &

proper earnings

➢ Hence, planned expenditure & accurate foresight of

earnings are important aspects of sound gov’t
finance.

1979
 Public expenditure

❑ Done under two broad heads viz.,

❖ Developmental expenditure
❖ Non-developmental expenditure
➢Developmental expenditure: Incurred on dev’t activities
➢Example: Social & community services, economic services,
and grants in aid.
❖ Non-developmental expenditure: Incurred on non-dev’t

activities Example: interest payments, administrative

services, & defense expenses.

1980
 Plan and Non-plan Expenditure

❑ Plan expenditure: refers to estimated expenditure w/c is provided to

in budget to be incurred during year on implementing various
projects and programs included in plan.
✓ Two types w/c is Revenue and Capital expenditure
✓ Public expenditure w/c represents current dev’t and investment
outlay .
❑ Non-planned expenditure: refers to estimated expenditure provided
in budget for spending during year on routine functioning of gov’t.
These are non-productive expenditures and obligatory in nature.
Example: Expenditure for protecting country from foreign attack.

19
81
 A. Non-plan Expenditure
❑ Non-plan expenditure of central government is divided into non-

plan revenue and non-plan capital expenditure.

❑ Non-plan revenue expenditure: Include interest payment, defense

expenditure, major subsidies, interest & other subsidies, debt relief to

farmers, postal deficit, police, pensions, other general services, social

services, grants to states and union territories.

❑ Non-plan capital expenses: Include defense expenses, loans to states

and union territories, foreign governments etc.

1982
 B Plan Expenditure
❑ The second major expenditure of central

government is plan expenditure. This is to finance the

following activities;

i) Central plans such as agriculture, rural development,

irrigation and flood control, energy, industry, and minerals,

communication service and technology, environment, social

service and others.

ii) Central assistance for plans of states & union territories.

1983
 Revenue & Capital expenditure
❑ Revenue expenditure
✓ Do not create any addition to assets & covers
activities of government departments’ services,
subsidiaries & interest charges.
❑ Capital expenditure
✓ Involves that expenditure, which results in creation
of assets.
✓ Finance ministry is responsible for plan expenditure.
✓ This includes grants to state
1984
 3. Public debt
❖Public Debt is the loans raised by governments
➢Purpose of Borrowing:
 Economic Development
 To repair damages resulting from natural calamities
 During times of wars
 Fighting Depression
 Controlling inflation
 Covering temporary budget deficits
Sources
• Borrowings from individuals;
• Borrowing from commercial banks
• Borrowing from non-banking financial institutions
• Borrowing from central bank
• Borrowing abroad
1985
 4. Financial Administration

❑ This category includes :

✓ Preparation of financial budget

✓ Control & administrations of budget

✓ Auditing etc…

❑ Budget includes ‘Annual Financial Statements’ which incorporates all annual

statements of receipts & expenditures of government.

❑ Financial Administration is properly regarded as the fourth division of

the subject, because it is as necessary to know not only how a State

gets its revenues but when it gets them and for what it spends them.

1986
 Fiscal Federalism
 Fiscal Federalism is
◦ an area of study in Public Finance
◦ that focuses on the allocation of fiscal rights and
responsibilities
◦ across different levels of government in a
federal government system.
 Issues of Fiscal Federalism:
➢How much should go to the central and how
much to the states in order to improve the
efficiency of governing by improving the allocation
of funding and expenditures.
➢Issues of taxation
Role of Fiscal Policy in Economic Development

➢ Fiscal policy*** is also called as budgetary policy.

➢ Fiscal policy refers that segment of national economic policy, which
is primarily concerned with:
➢ Receipts & Expenditures
 It relates to those activities of state that are concerned with raising
financial resources and spending them.
✓ Resources are obtained via taxation & borrowing both within country &
from abroad.
✓ Budget can act as an important tool of economic policy.

***Fiscal policy: Use of government spending & tax policies to influence

economic conditions.
1988
❑ Fiscal Policy relates to government’s decision making
with respect to following:
✓Taxation
✓Government spending
✓Government borrowing
✓Management of government debt.
❑ In both developed & developing countries main objectives are:

➢Rapid economic development

➢An equitable distribution of income.
❑ Fiscal Policy can be important instrument for attaining
these objectives. 1989
The Role of Fiscal Policy
 What is the Role of fiscal policy?
 Fiscal policy is a powerful instrument for influencing the
economy. By adjusting spending levels and taxes,
governments can achieve such desired policy objectives
as increased growth and employment, macroeconomic
stability, income distribution, allocative efficiency and
operational efficiency.

1990
 Major Roles of Fiscal Policy in Economy

1.Primary task of fiscal policy in under developed

and developing countries:
✓ To allocate more resources for investment & to
restrain consumption.

1991
2. Fiscal policy should reduce economic inequalities

of income & wealth.

➢ This can be achieved by taxation & public
distribution measures.
➢ Private section is not interested in investing in
social & economic overheads.
➢ Investments in social & economic overheads are
very essential to accelerate rate of economic
growth. 1992
3. Fiscal policy has to be used progressively for raising level

of investments & savings rather than keeping consumption

level.

Fiscal Policy is used as instrument of resource

mobilization.

In order to attain growth with stability goal of fiscal policy

should be promotion of highest possible rate of capital

formation & should reduce actual & potential

consumption.
1993
 FP should encourage private investment & attract
foreign funds for development projects.

4. Existing pattern of investment may differ from

optimum pattern of investment.

✓ Thus becomes responsibility of gov’t to
undertake investments in such a way that it is
most beneficial for people of country.
5. Fiscal policy should control inflation within

tolerable levels since inflation mostly affects poor.

1994
 Federal Finance
❑ Where govt's functions are divided b/n two sets of authorities i.e.

Central gov’t & state gov’ts, it is called a federal system.

❑ Federal finance refers to system of assigning source of revenue to

central & state gov’ts for efficient discharge of their respective

functions i.e.

➢ Clear-cut division is made regarding allocation of resources of revenue

b/n central & state authorities.

1995
 Principles of Federal Finance
❑ The Following are Main Principles Must Be Applied:

1. Principle of Independence
❑ Under system of federal finance:
➢ Gov’t should be autonomous & free about internal financial matters
concerned.
❑ It means that each Government should have:
✓ Separate sources of revenue,
✓ Authority to levy(charge) taxes,
✓ To borrow money
✓ To meet expenditure.
❑ Gov’t should normally enjoy autonomy in fiscal matters.

1996
 2. Principle of Equity
❑ From point of view of equity:

➢ Resources should be distributed among d/t states

✓So that each state receives a fair share of revenue.

➢ Allocation of resources should be made to give:

✓Equitable treatment to individuals & business firms in

d/t places.

1997
 3. Principle of Uniformity

❑ In federal system, each state should pay equal tax

payments for federal finance.

❑ But, this principle cannot be followed in practice

b/c taxable capacity of each unit is not of same.

❑ Equality of contribution imposes heavy burden on

backward states.
1998
 4. Principle of Adequacy of Resources
❑ The resources of each Gov’t (Central & State)

➢ Should be adequate to carry out its functions effectively

❑ Adequacy must be decided with reference to both current

as well as future needs.

❑ The resources should be elastic to:

➢ Meet growing needs

➢Unforeseen expenditure like war, floods etc.

1999
 5. Principle of Fiscal Access
❑ In a federal system:

➢ There should be possibility for Central & State

Gov’ts to:

✓Develop new source of revenue within their

prescribed fields to meet growing financial needs.

➢ Resources should grow with increase in responsibilities

of government.
2000
6. Principle of Integration & Co-ordination
❑ The whole financial system of federation should be well

integrated.

❑ There should be perfect co-ordination among d/t layers of

financial system of country.

❑ This should be done in such a way to:

➢ Promote overall economic development of country.

2001
 7. Principle of Efficiency

❑ The financial system should be well organized &

efficiently administered.

❑ There should be no scope for evasion & fraud.

❑ No one should be taxed more than once in a year.

❑ Double taxation should be avoided.

2002
 8. Principle of Administrative Economy

➢ Cost of collection should be at minimum level

➢ Major portion of revenue should be made available for

other expenditure outlays of gov’ts.

9. Principle of Accountability
➢ Each Gov’t should be accountable to its own legislature
for its financial decisions

2003
 Difference between Social and Merit wants

Social wants(collective wants)

❑ Social or collective wants requires goods
✓ Demanded by all members of society equally whether people have
capacity to pay, or not. Example:
➢ Defense
➢ Education
➢ Public health
➢ Flood control provision
➢ Social overhead capital like roads, bridge

➢ Collective wants which must be available to all people whether they

can afford to have them or not.

2004
 Merit wants
❖ Certain types of collective wants such as educational facilities
have been called as merit wants
❖ Essential private wants Eg.
❖Food
❖Clothing
❖Housing
❖ Satisfied by government at low price for poor due their low
level of income.

2005
 Public versus Private Finance

➢ Public Finance deals with income & expenditure of public

authorities.

➢ Public means Gov’t that is Central, state & local authorities.

➢ Private finance deals with wants & satisfaction of households &

firms.

➢ But, public finance deals with collective wants & their

satisfaction.

2006
 Similarities b/n PF and Private Finance
1. Satisfaction of Human Wants
❑ Individual is concerned with personal wants
❑ Government is concerned with social wants
❑ Both private & public finance have same objective (i.e. satisfaction of
human wants).
2. Balancing of Income & Expenditure:
❖ Both individual & Government have incomes & expenditures & trying to
balance each other.
3. Maximum Satisfaction:
❑ Both private & public finance aim at maximum satisfaction.
2007
4. Borrowing as Common Feature
❑ As & when current incomes becomes insufficient to
meet current expenditure, individuals & Governments
rely upon borrowings.
❑ Both of them are having loan repayment plans
5. Economic Choice a Common Problem:
❑ Both individual & Government face problem of
economic choice (i.e. Sources of revenue are limited,
comparing with their expenditure.
❑ Hence, they have to satisfy unlimited ends with limited
means. 2008
 Dissimilarities between PF & Private Finance

1. Adjustment of Income & Expenditure:

❑ In private finance, individual first considers his income & then

decides about his expenditure.

❑ But in PF, gov’t first estimates volume of expenditure & then

tries to find out methods of raising necessary income. i.e.

➢Private finance tries to adjust its income to expenditure

➢Public finance tries to meet expenditure by raising income.

2009
 2. Nature of Benefit
❑ Private Finance aims at individual benefit i.e. benefit of
individual household.
❑ PF aims at collective benefit, i.e. benefit of nation as a whole.
3. Postponement of Expenditure:
❑ In Private Finance, individual can postpone or even avoid
certain expenditure, as they likes.
❑ In PF, Gov’t cannot avoid certain commitments like social
welfare measures
➢ Thus cannot postpone certain expenses like relief measures, defense,
etc.

2010
4. Allocation of Resources:
❑ In Private Finance, individual can allocate his income to
various expenditure to get maximum satisfaction.
❑ In PF, Gov’t cannot aim at maximum satisfaction on
expenditures made.
5. Motive of expenditure:
❑ In Private Finance, individual expects return in benefit from
expenditure made.
❑ Gov’t cannot expect return in benefit from various
expenditures made. i.e.
➢ Profit or benefit is motive of private finance
➢Social welfare & economic dev’t is motive of PF
2011
 6. Influence on expenditure:

❑ Expenditure pattern of private finance is influenced by

various factors such as,

✓Customs

✓Habits culture religion

✓Business conditions etc.

❑ But, pattern of expenditure of public finance is influenced &

controlled by economic policy of Government.

2012
 7. Nature of Perspective
❑ In private finance, individual strives for immediate &
quick return.
❑ Since, his life span is definite & limited he gives
importance to present or current needs & allots only a little
portion of income for future.
❑ Gov’t is a lasting organization & caretaker of present &
future.
❑ Thus, Government allots a considerable amount of its
income for promotion of future interests.
❖ Private finance has a short-term perspective
❖ Public finance has a long term perspective. 2013
 8. Nature of Budget
❑ In private finance individuals prefer:

❖ Surplus budget as virtue

❖ Deficit budget is undesirable to them

❑ But, Government does not prefer a surplus budget.

❑ If Government bring surplus budget, it will create negative

opinion on Government because surplus budget is:

✓Result of high level of taxation or

✓Low level of public expenditure

✓Both may affect Government adversely. How?

2014
 10. Coercion:
❑ In private finance individuals & business units cannot

use force to get their income.

❑ But, in public finance governments can use force in

form of imposing taxes to get income i.e. taxes are

compulsory in nature.

❑ It is an obligation on part of tax payer.

❑ No one can refuse to pay taxes if he is liable to pay

them.
2015
 11. Publicity
❑ Individuals do not like to disclose their financial

transactions to others.

❑ They want to keep them secret.

❑ But, Government gives greatest publicity to its budget

proposals & allocation of resources to different heads.

❑ Publicity strengthens confidence of people in Government.

2016
 12. Audit

❑ In case of private finance:

✓ Auditing of financial transactions of individuals is not

always necessary.

❑ But, accounts of public authorities are subject to audit

& inspection.

2017
 Chapter 2
Taxation: An Overview
Contents
▪ What is tax?
▪ Tax accounting
▪ Interdisciplinary Nature of Taxation
▪ Objectives of taxation
▪ Basic Elements of Tax Systems
▪ Tax Related Terms
▪ Basic characteristics of tax
✓ Types of Tax Rates
✓ Taxation Systems (Tax Rate Structures)
✓ Principles /Canons of taxation
▪ Effects of Taxation
▪ Classification of taxes
What is Tax?
 Tax is
 a compulsory charge or payment
 imposed by government on individuals or corporations.

 A tax is
 an involuntary fee or more precisely "unrequited payment"
made by individuals or businesses to a government without
quid pro quo (something done in exchange)
 The persons who are taxed have to pay the taxes
irrespective of any corresponding return from the
goods or services by the government.
 It is the most important source of revenue for a
government.
 Taxation is used as a system of raising the lion share
of public revenue in modern economic system.
Tax Accounting
➢ Tax Accounting is one of the specialized fields of
accounting that encompasses activities such as:
 Recording of tax related transactions;
 Continuous follow-up of tax laws affecting a
taxpayer;
 Analyzing the consequences of tax on alternative
business transactions/courses of actions
 Determination of tax bases and tax liabilities;
 Preparation of tax returns or tax reports; and
 Providing tax related information to assist decision
makers
Objectives of Taxation
 To Raise public revenue
 To Remove inequalities of income and wealth
 To Ensure economic stability
 To Reduce regional imbalances
 To Create employment opportunities
 To Prevent harmful consumption
 To Divert resources beneficially
 To Encourage exports
 To Enhance standard of Living
Basic Elements of a Tax System

 The FIVE pillars or basic elements of tax system are:

 Taxpayer refers to any individual or organization that is
obligated to pay tax
 Tax Base is the value of everything which is subject to
taxation
 Tax Rate is the amount of taxes expresses as a percentage
of the tax base
 Tax Period is the period for tax assessment. It can be a
year (tax year), month, week, etc
 Tax Administration refers to any government office mainly
with a responsibility of tax collection and other related
activities
TAX RELATED TERMS

 Delinquent Tax: refers to taxes remaining unpaid on and

after due date
 Tax Assessment: refers to the determination of the
amount subjected to tax
 Tax Avoidance: refers to the practice of paying as little
tax as possible
 Tax Evasion: refers to an illegal activity in which a
taxpayers seek to hide taxable income by overstating
expenses or understating revenue
 Tax Bracket : refers to a range of income subject to tax
at the same tax rate. It is the band of taxation in which a
taxpayer is in.
Basic Characteristics of Tax

 Tax is a compulsory payment (obligatory payment)

 Benefits are not the basic condition in tax payment
 It is a personal obligation
 It is used for common interest
 It is a Legal collection
 It is a periodic and regular payment
 It has Wide Scope
 No discrimination exists in tax payment
Types of Tax Rates
 There are four different types of tax rates:
 Statutory Tax Rates (STRs): all legally imposed tax rates on a
taxpayer (those percentages appearing in the tax law).
 Marginal Tax Rate (MTR): is the tax rate you pay on any
additional income you earn.
 Average Tax Rate (ATR): is the total amount of tax you pay
divided by your total taxable income.
 Effective Tax Rate (ETR): is the total amount of tax you pay
divided by your total income.
Principles/Canons of Taxation
 What is a good tax system?
 These principles are called Canons of Taxation.
 Adam Smith’s four canons of taxation are:
▪ Canon of Equality
▪ Canon of Certainty
▪ Canon of Convenience
▪ Canon of Economy
 Principles/Cannons of Taxation

A) Canon of Equity and Fairness

 The tax burden should be fair and equal.
 Similarly situated taxpayers should be taxed similarly.
Two Principles of Equity
 Benefit Received Principle: taxpayers should contribute to
government in proportion to the benefits that they receive
from public expenditures.
 Ability - to - Pay Principle: citizens should bear tax
burdens in line with their ability to pay taxes.
 Two Equities include:
▪ Horizontal equity: those with equal ability to pay
should bear equal tax burdens.
▪ Vertical equity: those with greater ability to pay should
pay more.
Principles/cannons of Taxation

B) Canon of Convenience
▪ Mode and timings of tax payment should be convenient
to the taxpayer
▪ Taxes should be imposed in such a manner and at the
time which is most convenient for the tax payer
C) Canon of Certainty
▪ The tax which each individual is required to pay should
be certain and not arbitrary.
▪ The time of payment, the manner of payment and the
way of computing the amount to be paid should be
clear to every tax payer.
Principles/cannons of Taxation

D) Canon of Economy (Efficiency)

❑ Minimum cost of administration
❑ Minimum cost of compliance
❑ Neutral with regard to effect on tax payers decision making
(to work, to consume, to save, etc) (neutrality)
Additional Principles:
 Productivity
 Elasticity
 Diversity
 Simplicity
 Expediency
 Buoyancy
 Coordination
Principles/Cannons of Taxation

E) Canon of Productivity (Canon of Adequacy)

❑ The Tax System should enable the government to collect
sufficient tax revenue for the provision of essential
public services.
F) Canon of Elasticity (Canon of Flexibility)
❑ Taxes should be flexible enough to be increased or
decreased according to the needs of the government.
G) Canon of Diversity (Broad Basing)
❑ Taxes should be spread over as wide as possible
section of the population, or sectors of economy,
to minimize the individual tax burden.
Principles/Cannons of Taxation

H) Canon of Simplicity
❑ A tax system should be easily understood by the average taxpayer
I) Canon of Expediency
❑ Taxes should be levied after considering all favorable and unfavorable
factors from different angles. I.e. it should require the least possible
resistance.
J) Canon of Buoyancy
❑ The tax revenue should have an inherent tendency to increase along
with an increase in national income
K) Canon of Co-ordination
❑ There should be a proper co-ordination between various authorities while
imposing taxes.
Tax Rate Structures (Tax Systems)

 Tax Rate Structure expresses

 the relationship between
 the tax rate and tax base in a country

A. Proportional Tax
 The rate of taxation remains constant as the income
of the tax payer increases
 All incomes are taxed at a single uniform rate,
irrespective of whether tax payer’s income is high or
low.
 The tax liability increases in absolute terms, but the
proportion of income taxed remains the same.
1. Proportional Tax
Tax Payable = Tax Base X Tax Rate
Tax Rate

Tax Rate Structure

10%

Tax Base in Birr

1500 6500 14000 23500 35500 50000
Tax Rate Structures (Tax Systems)

B. Progressive Tax
 The rate of taxation increases as the tax payer’s
income increases
 The tax rate progresses from low to high income
 The marginal tax rates are generally higher than
average rates.
 The burden of taxation is heavier upon the rich than
on the poor.
 Progressive Tax
Tax Payable = Tax Base X Tax Rate

Tax Rate
35%
Tax Rate Structure

30%

25%

20%

15%

10%
Tax Base in Birr
150 650 1400 2350 3550 5000
C. Regressive Taxation

 The amount of tax is smaller as a percentage of

income for people with larger incomes.
 The rate of tax declines with the increase in the
income or value of property.
 It places more burden on those with lower incomes.
 Its disadvantages is that the tax burden falls more
heavily on the poor and it violates the principles of
equity and social justice.
Regressive Taxation
Tax Payable = Tax Base X Tax Rate
Tax Rate

20%

15%

10%

5% Tax Rate Structure

4000 6000 12000 15000 Tax Base in Birr

 Classification of Taxes

I. Based on the Tax Bases

 Income Taxes: are taxes levied on income of
persons or businesses
 Property Taxes: are levied on a property of
Persons or businesses. Eg. Property tax, land
use tax, estate tax, capital gain tax…
 Commodity Taxes: are taxes levied on
commodities and services. Eg. VAT, TOT,
excise tax,…
II. Based on Tax Determinant
1. Specific
 A tax based on quantity of an item
◼ Example: excise taxes on wines, cigars,
gasoline
2. Ad valorem
 Tax based on value of an item
◼ Example: real estate tax, value-added tax
 Tax Impact vs Tax Incidence
Tax Impact
❑ The initial burden of tax
❑ Felt by the person from whom the tax is collected
❑ Impact of the tax is always on the person who is
responsible by law to pay the tax amount to the
government
Tax Incidence
❑ The ultimate burden of tax
❑ Felt by the person who actually bears the burden of the
tax
❑ Impact of a tax can be shifted, but the incidence of a tax
cannot be shifted.
 III. Based on who Bears the Burden

1. Direct
 Tax which is demanded from the person who also shoulders the
burden of the tax; or tax which the taxpayer cannot shift to
another
 The impact and incidence of which fall on the same person
Example: income tax
2. Indirect
 Tax which is demanded from one person in the expectation and
intention that he should indemnify himself at the expense of
another
 The impact and incidence of which fall on different persons
◼ Example: VAT
 Effects of Taxation

A) Effects of Taxation on Production

Production is affected by taxes in two ways:
1. By affecting the ability to save and invest
2. By affecting the desire to work, save and invest
◼ A heavy tax on income tends to reduce the
ability and willingness to save and invest on part
of individuals.
◼ If saving and investment are affected, the
production will automatically be affected
 Effects of Taxation
B) Effects of Taxation on Distribution of Income and
wealth
 Taxation is used in most countries to distribute fairly
the income generated in a country.
 The effects of taxes on income distribution depends on
the type of taxes and rates of taxes
◼ Regressive tax structure redistributes incomes in
favour of rich.
◼ Progressive tax structure redistributes incomes in
favour of the poor.
 Effects of Taxation

C) Effects of Taxation on Stabilization of Economy

 Inflation is a result of either demand pull or cost push.
 In demand pull inflation, the government should
increase the tax so as to reduce the capacity of the
people to purchase.
 In cost push inflation, the government uses taxation
to minimize and control cost of production so as to
reduce the price of goods and services
 Conclusions
❑ To conclude, we can say that the instrument of taxation is
of great significance.
• Increasing the level of economic activity - Regressive
taxation
• Reducing income inequalities - progressive taxation
• Promoting economic growth – Funds could be
reinvested
• Social-Welfare Objective - Tax payment helps
reduce the gap between the haves and have-nots. As
it helps in mobilizing the surplus income from the haves
and reinvesting them for public welfare, it helps these
surplus funds to reach the have-nots.
 CHAPTER THREE

PUBLIC FINANCE AND FISCAL

FEDERALISM IN ETHIOPIA: AN
OVERVIEW
 Learning Objectives:
➢ After the completion of this chapter, students should be able to:
➢ Explain the meaning of budget and its function

➢ Describe the budget classification, public budget procedures and

approaches
➢ Understand and explain the concept of Fiscal Federalism

➢ Explain the meaning and concepts of budget deficit and deficit financing

➢ Describe the relationship between deficit financing and inflation

3.1 Features of Ethiopian fiscal federalism

 Federalism referred to as federal government, a national or

international political system in which two levels of government control
the same territory and citizens.
 Federalism involves the transfer of political, fiscal and administrative
powers form central government to sub national units of government.
 In federal system of government there are two sets of authorities:
a. central government: top level of government
b. state governments
THE INTERGOVERNMENTAL FISCAL RELATIONS

 Fiscal decentralization is the process of shifting the responsibilities of

revenue collection and expenditure execution from the central to
subnational authorities.
 is one aspect of intergovernmental fiscal relations.
 Intergovernmental relations (IGR) are, at their most basic level, the
relationships between different governments within a single country,
 It is the currently fashionable term; the alternative descriptions "central-local
financial relations","fiscal federalism" and “federal finance” are often used.
 Intergovernmental financial relation covers two interrelated issues.
1. The first is the division of spending responsibilities and revenue sources
between levels of government (national, regional, local etc).
2. The second is the amount of discretion given to regional and local
governments to determine their expenditures and revenues (both in
aggregate and detail).
3.2 The Principles of Federal Finance
fundamental principles of federal finance:
I. Clear assignments of functional responsibilities between the
levels of governments
II. Proper decentralization of revenues to sub governments
III. Tax collection and other revenue raising responsibilities should
be assigned in such a way that considers:
◼ Efficiency of the internal common market (free movements of goods and
services from one sub-nationals to the other…)
◼ The overall national equity where fair distribution of wealth and income
is maintained
◼ Administration and compliance costs( issues such as capacity of states to
tackle tax evasion, auditing and financial administration capacities of
states, etc…) has to be taken in to account
IV. Fiscal accountability has to carefully considered ( i.e access
to revenue sources should matched as close as possible to
revenue needs)
3.3 Fiscal Federalism in Ethiopia
3.3.1 Assignment of Expenditure Responsibilities Between Central
Government and States
 The distribution of expenditure responsibilities (called powers and duties)
between the centre and states is followed based on "Constitution of
Ethiopia” and Proclamation No. 33/1992-Proclamation.
 To define expenditure responsibilities, Ethiopian constitution adopted the
model of “residual approach”.
 The powers and duties of the central or federal government are
exhaustively listed and all other remaining government activities are left as
the discretionary power of states.
3.3.2 Distribution of Revenues between Central and States

 The objectives of revenue sharing are explained as:

a) To enable the central government and national/regional governments
efficiently carry out their respective duties and responsibilities
b) To assist national/regional governments develop their regions on their own
initiatives,
c) To narrow the existing gap in development and economic growth between
regions, and
d) To encourage activities that have common interest to regions
3.3.3 Fiscal Transfers In Ethiopia – Correcting The Imbalances

 National/Regional Governments, where deemed appropriate,

shall receive subsidies from the Central Government.
 The issues of intergovernmental fiscal transfers are designed to
address the vertical fiscal imbalance and horizontal fiscal
imbalance.
Intergovernmental budget grants in Ethiopia are provided as:
1. The rendering of proportional distribution of public services for
residents of different states (equity).
2. Making the grant effort neutral. This means, the grant will not take in
to consideration the revenue added by a region using cost effective
administrations and the increase in tax revenue. This may geared to
encourage states by giving incentives. However, the disregard of
difference in tax bases may have effect of equity consideration.
3. regions that typically require more money than usual to cover their
expenses will be given more attention when allocating funds from a
budget grant.
Cont’d
 The amount of subsidy to be granted shall be based on
Budget Formula specified by MoF and endorsed by the
house of federation and councils of people’s
representative. This then expected to help the
realization of a common minimum standard of public
service.
 All regional governments, including, Dire Dawa
administrative council, but with the exception of Addis
Ababa administration, are unable to fully cover their
recurrent budget needs or implement their development
programs and projects from their own revenue sources.
Assessments in the determination of the grant formula

A. Expenditure Need Assessment

 The assessment takes in to account the recurrent and
capital expenditure of the preceding five years is
categorized in to six major sectors.
i. expenditure for education,
ii. agricultural sector expenditures,
iii. rural safe drinking water expenditures,
iv. expenditure for rural road construction,
v. health sector expenditure and
vi. recurrent expenditures.
❑ These sectors are indicated as having constituted over
90% of the share of expenditure responsibilities.
 B. Revenue Capacity Assessment
 Tax rate is not considered in the grant formula. The reason as
indicated is that the grant formula is effort neutral.
 In the revenue capacity assessment, tax bases which cover over
90% of the revenue are taken.
 Equalization of revenue capacity is taken instead of equalization
of tax collection effort.
 The variables included in the grant formula are population and
disability factors in both revenue raising and expenditure needs.
 The question of performance incentives is ignored from the grant
formula. The case is that if an incentive is to be granted, it shall
not be part of the grant share; rather part of conditional or
specific purpose grant.
 Budget grant will not be given for failure or success of the
financial policies of the respective.
3.4. Public budgeting in Ethiopia

3.4.1. THE MEANING AND FUNCTION OF BUDGET

 Budget is a comprehensive plan of action, which
brings together in one consolidated statement all
financial requirements of the government.
 The budget has become the powerful instrument for
fulfilling the basic objectives of government. The
budget covers all the transactions of the central
government.
 Budget is a time bound financial program
systematically worked out and ready for execution
in the ensuing fiscal year.
FUNCTIONS OF A BUDGET
The functions of budget include the following:
 It reflects government stated policies and set national priorities
 Evaluate public programs and review the activities of government
departments
 A system of accountability and controls over government officials,
ministries and departments, setting expenditure limits and safeguard
against abuse of public funds
 A tool for development management and economic growth
 As a political tool, budget is value ridden signaling the government's
ideological commitment, political philosophy and policy plat form
 As an economic tool, budget shapes economic priorities and accelerates
economic growth (development)
 Influence the direction of investment
 Promotes employment
 Influence the redistribution of income (can be pro poor or non-caring)
Cont’d
In addition to the above points budget has also the following
functions:
➢ Proper allocation of resources: - to relate expenditure decisions to specified
policy objectives and to existing and future resources to relate all major
decisions to the state of the national economy
➢ Long-term economic growth: to ensure efficiency and effectiveness in the
implementation of government programs
➢ To facilitate legislative control over the various phases of the budgetary
process
➢ Equitable distribution of income and wealth and Securing economic stability
and full employment
3.4.2. THE BUDGET STRUCTURE IN ETHIOPIA

 The government budget represents a plan/forecast by

government of its expenditures and revenues for a
specified period.
 Commonly government budget is prepared for a year,
known as a financial year or fiscal year (Hamle 1- Sene
30 in Ethiopian calendar).
 Budget structures are the formats that organize budget
data.
Classification of Budget
1. Revenue budget
 It represents the annual forecast of revenues to be raised
by government through taxation and other discretionary
measures.
 It is usually structured into three major headings:
❖ Ordinary revenue: include both tax and non-tax revenues.
❖ External assistance: includes cash grants; these are grants from
multilateral and bilateral donors for different structural
adjustment programs; and technical assistance in cash and
material form.
❖ Capital revenue: could be from domestic (sales of movable
properties and collection of loans), external loan from
multilateral and bilateral creditors mostly for capital projects,
and grants in the form of counterpart fund.
2. Expenditures Budget
 Expenditures are categorized into recurrent and
capital expenditures.
 Definition of recurrent and capital budgets, follow some
combination of the ff criteria:
❖ Recurrent budget is to be covered by domestic revenue from
tax and non-tax sources. But the economy could borrow to
meet its capital budget.
❖ The financial Proclamation 57/1996 and financial
Regulations 17/1997 defined capital budget based on the
object of expenditure. Accordingly, capital budget equals
capital expenditure which equals fixed assets and
consultancy services.
❖ Short-term activities that are project in nature are included
in capital budget while those activities that are recurring
and continuous in nature are put in the recurrent budget.
Recurrent Budget

 Financial Proclamation 57/1996 and Financial

Regulation 17/1997 defined only the capital
budget, implicitly defining the recurrent one as a
residual.
 The recurrent budget is structured by implementing
agencies (public bodies) under four functional
categories:
❖ administrative and general services,
❖ economic services,
❖ social services, and
❖ other expenditures.
Capital Budget
 Capital budget is budget for capital expenditures.
 Detailed definition of capital expenditures to mean:
❖ The acquisition, reclamation, enhancement as laying out of land
exclusive of roads, buildings or other structures;
❖ The acquisition, construction, preparation enhancement or
replacement of roads, buildings and other structures;
❖ The acquisition, installation or replacement of movable plant,
machinery and apparatus, vehicles and vessels;
❖ The making of advances, grants or other financial assistance to
any person towards him/her on the matters mentioned in (a) to
(c) above or in the acquisition of investments; and
❖ The acquisition of share of capital or loan capital in any body
corporate;
❖ Any associated consultancy costs of the above.
3.4.3.Ethiopian budgetary process
 Budgeting from the initial stage of forecasting the
annual revenues and expenditures, to the final stage of
approval of the annual budget by the Council of
Peoples Representatives, passes through a sequential
and an iteractive process.
 The budget calendar is the major instrument to manage
the budgetary process.
 Financial Proclamation 57/1996 states that “the budget
appropriation shall be approved by the Council of
Peoples Representatives by Sene 30th (July 6) and all
public bodies shall be notified by Hamle 7 (July 13).”
Federal Level Budgetary Process
Supplementary Budget
 In the course of the budget year supplementary (additional) budget
will be proclaimed when necessary, following almost the same process
as the initial budget preparation.
 Likewise budget reallocation will be made mainly based on
performance.
The Budgetary Process at the Regional Level

 It is quite difficult to present the budget process at the Regional level

in the way discussed for Federal Budgeting. At present the budget
process followed by regions is not uniform.
 The process is more or less a mirror image of the Federal budget
process.
 The regional budget process starts at the woreda level and goes up to
Zone and Region levels
Cont’d
Pre-ceiling Budgeting
 It is the budgeting practice at the woreda and zone levels before the

region receives its subsidy/grant from the Federal government.

Post-ceiling Budgeting
 Following the notification of the subsidy from the Federal government,

the regional public expenditure envelope will be determined based on

the Federal subsidy, local revenue and local borrowing.
 Once the expenditure envelope is set, then it will be split up between
recurrent and capital expenditures.
3.5. BUDGET DEFICIT
 A budget is considered as surplus or deficit according to
the position of the revenue accounts of the government.
 A surplus budget is one in which revenue receipts exceed
expenditure charged to revenue account regardless of the
gap in capital accounts.
 Deficit budget is one in which expenditure is greater than
current revenue receipts.
 The deficit financing denotes the direct addition to gross
national expenditure through budget deficits whether the
deficits are on revenue or capital accounts.
 Deficit financing can be defined as “the financing of a
deliberately created gap between public revenue and public
expenditure.”
3.5.1. Methods of Financing Deficit

Four important techniques:

❖ Borrowing from central bank
❖ The running down of accumulated cash balances
❖ The government may issue new currency
❖ Borrowing from market or from external sources
3.5.2 Objectives of Deficit Financing

➢ Deficit financing has generally been used as a method of meeting the

financial needs of the government in times of war, when it is considered
difficult to mobilize adequate resources.
➢ Deficit financing used as an instrument of economic policy to overcome
conditions of depression and to raise the level of output and employment.
➢ The use of deficit financing has also been considered essential for financing
economic development especially in under developed countries.
➢ Deficit financing is also advocated for the mobilization of surplus idle and
unutilized resources in the economy.
2.5.3 Effects of Deficit Financing

Deficit financing has both positive and negative effects in the economy
as under:
 Inflationary rise in prices: Deficit financing increases the total volume
of money supply. Unless there is proportional increase in production
this can lead to inflation.
 Effects on distribution of wealth and income: The real income of
wage earners gets reduced and that of entrepreneurs/ businessmen
increased, leading to distribution of wealth in favor of business class.
Cont’d
 Faster growth: Country is able to implement the developmental plans
through deficit financing there by attaining faster growth.
 Credit creation in banks: Inflationary forces created by deficit
financing are reinforced by increase credit creation by banks.
 Change in pattern of Investment: Deficit financing leads to
encouragement for investment in certain fields like construction, luxury
consumption inventory holding and speculation. This may lead to
investment in undesirable fields.
3.5.4. Deficit Financing in Ethiopia

 Deficit financing in Ethiopia was mainly resorted to enable the

Government of Ethiopia to obtain necessary resources for the plans.
The levels of outlay laid down were of an order, which could not be
met only by taxation or through a revenue surplus.
 The gap in resources is made up partly through external assistance.
But when external assistance is not enough to fill the gap, deficit
financing has to be undertaken.
 CHAPTER FOUR

ETHIOPIAN TAX SYSTEM

ACCOUNTING FOR DIRECT TAXES

PART ONE
EMPLOYMENT INCOME TAX
 Employment Income
❑Employment Income is taxed under schedule “A” .

 The EIT is deductible at source on system known as PAYE (Pay

As You Earn) in almost all the countries through the world.
 In EIT, the taxpayers are employees of:

✓ Private,
✓ Non-governmental or

✓ Governmental organizations.

 Employee: is any individual, other than a contractor, engaged to

perform services under direction and control of employer either
on a permanent or temporary basis.
➢ EIT is applied on residential status of 183 days.
➢ A person who is employed and generating EI, whether he/she is an Ethiopian
or foreign citizen living in Ethiopia for more 183 days must pay EIT.
➢ As per Art. 12 of ITP No. 979/2016, employment income shall include:

✓ Any payments or gains in cash or in kind received from

employment by an individual from all employers.
➢ EI include:
✓ Basic salary or wages
✓ Overtime (OT) Income
✓ Allowances
✓ Bonus
✓ Employment Termination Payment
 1. Basic salary or wages.
❑ The term wages is more correctly used to refer to payments for
manual labor that are paid based on the number of hours worked
or the number of units produced.
❑ Salary is regular payment to which worker is entitled in return for performance
of work that he/she performs under contract of employment, its is
compensations to employees on monthly or annual basis
❑ That is payment is received by employee for regular or normal working hours.

❑ The regular working hours may vary:

✓ From country to country and
✓ From organization to organization even within the same country.

❑ In Ethiopia, NWHs shall not exceed:

➢ 8 hrs per day or 48 hrs per week.

❑Normal working hours: is time during which a worker
actually performs work or avails himself for work in
accordance with :

✓The Law

✓Collective Agreement

✓Work Rules
2. Overtime (OT) Income

❑OT income is payment made to employee for overtime work

during a specific payroll period. i.e.

✓ Payment made for work done in addition to one’s NWHs

❑ In accordance with Art. No. 66(1) of Labor Proc. No.

377/2003:

➢ Work done in excess of normal daily hours of work

fixed in Art. No. 61(1) i.e. 8 hrs per day or 48 hrs a
week shall be deemed to over time.
 ❑Overtime shall be worked only in cases of:
➢ Actual or threatened accident

➢ Force majeure

➢ Urgent work

➢ Substitution of absent workers

➢ OT income depends on the duration OT work done.

➢ To determine the OT income:

✓ First determine Regular Hourly Rate

➢ RHR is payment per hour for regular or NWHs.

➢ It is determined as follows:

RHR = Basic Salary

NWHs
➢ In Ethiopia, there are four over time payment durations.
❑Ordinary hours

✓ For OT jobs b/n 6:00 AM to 10:00 PM, OHR=RHR @ 1.5

❑Late hours
✓ For OT jobs b/n 10:00 PM to 6:00 AM, OHR=RHR @ 1.75

❑Rest day
✓ For OT jobs on weekly rest day, OHR=RHR @ 2.0

❑Holiday
✓ For OT jobs on public holiday, OHR=RHR @ 2.5
Cont..
Overtime Earning = OT Hrs Worked @ (Ordinary Hourly

Rate @ OT Rate)

OHR = Basic Salary/normal working hours in a month

Where: RHWR = Regular Hourly Wage Rate

OHR = Ordinary Hourly Rate

3. Allowances
 Allowances are special payments made or benefits accrue to
employees for various reasons.
 These are:
✓ Position Allowance Housing Allowance
Medical Allowance
✓ Board Allowance
Per-diem Allowance
✓ Cash Indemnity Allowance Transportation Allowance

✓ Educational Allowance Entertainment allowance (guest

accommodation expenses)
✓ Desert Allowance
Representation allowance
✓ Disturbance (hardship) Allowance Meal allowance (lunch allowance)
 4. Bonus:
 It is payment made to employees of businesses for generating
attractive profit as a result of best performance of the employees.
 Bonus allowed only once a year.
5. Employment Termination Payment
 Under Art. No. 36 to 41 any case of termination provokes
payment obligations.
➢ Upon termination of employment contract, the ff. payments are
made to employees:
✓ Severance Payment
✓ Job Search Payment
✓ Compensation Payment
✓ Annual Leave Payment
✓ Job Termination Bonus
 A. Severance Pay:
❑ It is payment made to an employee whose:
✓ Contract of employment is terminated as compensation of service years.

❑ A worker who has completed his probation:

✓ Shall have right to get severance pay from employer in Ethiopia (Art. 39 of Labor
Proclamation 377/2003).

❑ Severance pay shall be:

➢ 30 times his/her daily wages of last week of service for first year of service

➢ For service < 1 yr, severance pay shall be calculated in proportion to period of
service.

❑ If worker has served for >1 yr:

➢ Payment shall be increased by 1/3rd of previous sum for every additional year of
service, within limit of a total amount of twelve months salary
 B. Job Search Payment:

❑When a contract of employment is terminated for reason that:

✓ Ceases of operation permanently due to bankruptcy/ other cause

✓Reduction of work force by undertaking

➢The worker is entitled to be paid additional severance pay .

 It is equal to 60 multiplied by his average daily wage of last

week of service (2 months basic salary).

C. Compensation Payment:

❑ A worker who terminates a contract of his employment on

ground that there is good cause to terminate a contract such as:

✓ Act committed by employer against dignity & morals of

employees

✓ Imminent danger threatening worker’s safety or health &

✓ Failure to fulfill obligations towards employee

➢ Shall be paid a compensation 30 times his/her daily

wages of last week of service (one month Basic Salary).
 D. Annual Leave Payment

❑ It is prohibited to pay wages in lieu of annual leave.

❑But, a worker whose contract of employment is terminated is

entitled to pay for leave he has not taken.

E. Job Termination Bonus

❑Sometimes organizations w/c are reducing work forces may give

additional bonus to employees whose contact is terminated.

 Basic Legal Provisions of EIT

❑The legal provisions are taken from ITP No. 979/2016 &

Ethiopian Council of Minister Regulation No. 78/2002.

❖Employment Income Tax Rates

❑Employment income tax rate is applied progressively to different

tax brackets.

❑Ethiopian EIT(Schedule “A”) has seven tax brackets.

 Schedule “A”
Employment Income Tax per Month Tax Liability

TB Over Birr To Birr Tax Rate

1st 0 600 Exempt
2nd 601 1,650 10%
3rd 1651 3,200 15%

4th 3,201 5,250 20%

5th 5,251 7,800 25%
6th 7,801 10,900 30%
7th 10,900 XXXX 35%
 Employment Income Tax Exemptions
❑ Art 13 of Proc. No 979/2016 exempts the following EI from taxation:

➢ Income from employment received by casual employees.

➢ PC, PF contributions and all forms of retirement benefits not more

15% of basic salary

➢ Income from employment received by diplomatic & consular

representatives & other persons employed in any Embassy

➢ Income specifically exempted from income tax by any law in Ethiopia

➢ Payments made to a person as compensation or gratitude in r/n to

personal injuries suffered by that person; or the death of another
person.
❑The following payments are excluded from computation of
income taxable under Schedule “A” (Art. No.3 ECMR No.
78/2002):

➢ Medical Allowance:

✓ Amounts paid by employers to cover actual cost of medical

treatment of employees.
 ➢Transportation Allowance
❑ Allowances in lieu of means of transportation

➢ It is exempted from tax payable for employee only up to 1/4th

(25%) of total salary of employee.
➢ In any circumstances amount of transportation allowance
exempted from tax must not be > 2,200 Br.
➢ Transportation allowance is only for:
➢ The task which is carried out by moving from place to place
due to nature of work and
➢ If it is clearly stated in contractual agreement b/n employer &
employee.
 ➢ Hardship Allowance/Disturbance Allowance

❑ Payment made to employee for change in work place

❑ Only for approved location

➢ Per-diem Allowance (Daily Allowance) (its far 25km from normal working
area)
✓ To cover travelling expenses incurred on duty.

✓ These include expenditures on food, bed, transportation & others.

✓ Max Br 500 or 4% of salary

➢ Traveling Expenses:
✓ Amounts paid to employees resulted from:
▪ Elsewhere than place of employment on joining and completion of
employment or
▪ In case of foreign travelling expenses from or to their country.
 ➢Board Allowances
❑Allowances paid to:

✓ Members & secretaries of boards of PEs &public bodies

➢Income of persons employed for domestic duties

❑For example: monthly salary of House guards and house servants.

Other Exemptions
❑The provision of mobile phone by an employer for use by
an employee.
❑The payment by the employer of the cost of mobile phone
calls by the employee
 Tuition fees paid by the employer for the benefit of the employee
for attendance at a course offered by a university, college, or other
institution providing education courses.
 A cash indemnity allowance paid by an employer to an employee
but only to cover actual shortages;
 The provision of uniforms and related work materials.
3/6/2024
 Computation of Taxable Employment Income (TEI)
 The entire employment income of an individual is not taxable
as some of the employment benefits are non taxable.
 Taxable income is the sum of all taxable employment benefits.
 Tax Exemptions – are employment incomes exempted from
EIT.
 Employers have an obligation to:
✓ Withhold tax from each payment to an employee and

✓ To remit amount of tax withheld to tax authority during each

calendar month.
❑ Income attributable to months of Nehassie & Pagumen shall be aggregated
and treated as income of one month (Art. No. 10 of EITP No. 979/2016)
❑ It is determined as follows:
TEI = Gross Employment Income – Tax Exemption -– Tax Allowance
1. Gross Employment Income:
❑Refers to any income earned from employment sources
regardless of way it is earned.
2. Taxable Income is sum of all taxable employment benefits
3. Tax Exemptions
❖ Are employment incomes exempted from EIT.
❖ It is classified as:
I. Direct/Special Tax Exemptions
➢ Are income directly exempted by ITP in Ethiopia for special
reason
➢ For example: Hardship allowance, transportation allowance,
medical allowance, etc
 Cont..
II. Personal Exemption
➢Non-taxable income for each employee under
Schedule “A” per month
➢Example: Br. 600 per month.
3. Tax Allowances
❑ Are amounts which are allowed to be deducted from Gross EI for d/t
reasons.
❑ For example:
✓ Mortgage allowance (deductible mortgage interest) to encourage home
ownership
✓ Child Care Allowance (investment made on children) to encourage
childcare
✓ Charitable allowance (Charitable contributions) to encourage giving, and
others.

❑ However, there is no such type of tax allowance in Ethiopia.

➢ So that formula for calculating TEI can be modified as:

TEI= Gross EI– Tax Exemptions

 Computation of Taxable Employment Income (TEI) (Cont’d…)
2108

When all payments are made at the end of the month

Determination of Taxable Employment Income

Basic salary …………………………………......... XXXXX
Overtime Pay …………………………………..... XXXXX
Transport allowance ……………………………... XXXXX
Other allowances ………………………………... XXXXX
Gross Employment Income ……………………….. XXXXX
Less: Special Tax Exemptions …………………… (XXXXX)
Taxable Employment Income …………………….. XXXXX
 Activity 1 (14 Minutes)
2109

Example 1
 Ato Daniel is a loan officer at Awash International Bank.
Ato Daniel earns monthly salary of Br 12,800 for 160
Normal Working Hours and the Employer’s Contribution to
Provident Fund is 20% of Daniel’s basic salary. He has
worked for 20 overtime hours in weekly rest days during the
month.
Required
Determine his Taxable Employment Income
 Solution
2110

Example 1
Determination of Taxable Employment Income
Basic salary …………………………………......... 12,800.00
Overtime Pay (20 *12,800/160 * 2……………… 3,200.00
Provident Fund (12,800*20%) .…………………... 2,560.00
Gross Employment Income ……………………….. 18,560.00
Less: Provident Fund (12,800*15%) ……………… (1,920.00)
Taxable Employment Income (TEI) ………………….. 16,640.00
2111

 Example 2
 Ato Samuel is head of Human resource department of Yene PLc. Assume
the following
 He gets a monthly salary of Br 15,280 for 176 normal working hours;
 He worked 10 hours during the month of Sene 2006 and all overtime work
was done on weekly rest days.
 He has position allowance of Br 1000
 He is entitled to receive a Transportation Allowance of Br 2,000.
 Required
 Determine the Taxable Employment Income of Ato Samuel
 Solution (Cont’d…)
2112

Example 2
Determination of Taxable Employment Income
Basic salary …………………………………......... 15,280.00
Overtime Pay (10 *15,280/176 * 2)…………… 1,736.37
Transportation Allowance ………………………. 2,000.00
Position Allowance……………………………… 1,000.00
Gross Employment Income ……………………….. 20,016.37
Less: Transportation Allowance ………………… (2,000.00)
Taxable Employment Income (TEI) …………………. 18,016.37
2113

 Example
 Ato Samuel is head of Human resource department of Yene PLc. Assume
the following
 He gets a monthly salary of Br 15,280 for 176 normal working hours;
 He worked 10 hours during the month of Sene 2006 and all overtime work
was done on weekly rest days.
 He has position allowance of Br 1000
 He is entitled to receive a Transportation Allowance of Br 3,000.
 Required
 Determine the Taxable Employment Income of Ato Samuel
 Solution (Cont’d…)
2114

Example 3
Determination of Taxable Employment Income
Basic salary …………………………………......... 15,280.00
Overtime Pay (10 *15,280/176 * 2)…………… 1,736.37
Transportation Allowance ………………………. 3,000.00
Position Allowance……………………………… 1,000.00
Gross Employment Income ……………………….. 21,016.37
Less: Transportation Allowance ………………… (2200.00)
Taxable Employment Income (TEI) …………………. 18,816.37
Q1
• Case 1) Assume that B.s of Hana 5000 Br
• Transpiration allowance is 4000 Br
• How much amount is taxable from the transportation allowance?
• B.s * 0.25 =
• 5000*0.25 = 1250 Non taxable
• Taxable transportation allowance = 4000 -1250 = 2750 Br

• Case2) Assume that B.s of Hana 9000 Br

• Transpiration allowance is 4000 Br
• How much amount is taxable from the transportation allowance?
• B.s * 0.25 =
• 9000*0.25 = 2250 only 2200 is non taxable
• Taxable transportation allowance = 4000 -2200 = 1800 Br
 Adding Tax on Income

❑If tax on income from employment instead of being

deducted from salary or wage of employee is:

✓ Paid by employer in whole or in part, amount so paid

shall be added to taxable income & shall be

considered as part thereof (Art 4, Regulation No

78/2002).
❑Example 4: The employment contract between Mr. X and his
employer stated that Mr. X will receive a basic salary of Br 1,200
net of tax (after the tax is deducted) and employer agreed to pay

Br 310 tax to tax authority on the basic salary amount. The

normal working hours are 160

❑Determine the TEI for the month of Nehassie and Pagumen

assuming that Mr. X worked 190 Hours and all overtime

work was done on employee rest day and transportation

allowance of 2,800
 Solution (Cont’d…)
2118

Example 4
Determination of Taxable Employment Income
Basic salary …………………………………......... 1200.00
Overtime Pay (30 *1200/160 * 2)…………… 450.00
Transportation Allowance ………………………. 2800.00
Taxpaid by employer …………………………… 310.00
Gross Employment Income ……………………….. 4760
Less: Transportation Allowance ………(1200*0.25) (300.00)
Taxable Employment Income (TEI) …………………. 4,460
 Accounting For Employment Income Tax
❑ Concerned with:
✓Determination EIT
✓Preparation of EIT Declaration/Return
✓ Recording EIT Related Transactions
 Computing Employment Income Tax
2122

1. Progression Method:
 the EIT is computed progressively applying the tax rates in Schedule “A”
2. Addition Method
 EIT = Addition + [(TEI – Lower Tax Bracket) @ Marginal Tax Rate]
3. Deduction Method
 EIT = Taxable Employment Income @ Marginal Tax Rate – Deduction
TB Range of TEI TR Addition EIT Calculation

No Tax Payment
1st 0-600 Ex. 0.00

EIT = 0.00 + (TEI – 600) @ 10%=105

2nd 600-1650 10% 0.00

EIT = 105.00 + (TEI – 1,650) @ 15%=337.50

3rd 1650-3,200 15% 105.00

EIT = 337.50+ (TEI – 3,200) @ 20%=747.50

4th 3,200-5,250 20% 337.50

EIT = 747.50 + (TEI – 5,250) @ 25%=1,385

5th 5250 -7800 25% 747.50

7800 -10,900 EIT = 1,385+ (TEI – 7,800) @ 30%=2,315

6th 30% 1,385

EIT = 2,315 + (TEI –10,900) @ 35%=XXX

7th Over 10,900 35% 2,315
 Computing Employment Income Tax
2124

3. Deduction Method
TB Rate Deduction EIT Calculation
1 0-600 0% 0.00 No Tax Payment
2 601-1,650 10% 60.00 EIT = TEI @ 10% – 60.00
3 1,651-3,200 15% 142.50 EIT = TEI @ 15% – 142.50
4 3,201-5,250 20% 302.50 EIT = TEI @ 20% – 302.50
5 5,251-7,800 25% 565.00 EIT = TEI @ 25%n – 565.00
6 7,801-10,900 30% 955.00 EIT = TEI @ 30% – 955.00
7 10,901 and above 35% 1,500.00 EIT = TEI @ 35% – 1,500.00

60= .1*1650-.1*1050
142.5 = .15*3200-.15*1550-0.1*1050
302.5 = 0.2*5250-0.2*2050-0.15*1550-0.1*1050
565= 0.25*7800-0.25*2550-2050*0.2-1550*0.15-1050*0.1
955= 0.3*10900-3100*0.3-0.25*2550-2050*0.2-1550*0.15-1050*0.1
1500= 0.35*10900-3100*0.3-0.25*2550-2050*0.2-1550*0.15-1050*0.1
Example 1: Assuming an Income of Br 2,000,
determine employment income tax under:
✓ Progression,
✓ Deduction, and
✓ Addition Method

Example 2: Determine the EIT to be paid by Ato Girma

for income of Br 3,600 for the month of Hamle, 2015
under the three Employment Income Tax calculation
methods
 Example 1
 Deduction
 2000*0.15-142.5 = 157.5
 Addition
 105+(2000-1650)*0.15= 157.5
 Progression
 (1650-600)*0.1+ (2000-1650)*0.15= 157.5

 Example 2
 Deduction
 3600*0.2-302.5 = 417.5
 Addition
 337.5+(3600-3200)*0.2= 417.5
 Progression
 (1650-600)*0.1+ (3200-1650)*0.15+ (3600-3200)*0.2= 417.5
Severance Pay
 Compensation received by an employee from the employer in connection
with the termination of his/her employment is taxable on receipt bases.
 There are two types of severance pay:
a) Normal Severance Pay
b) Extraordinary Severance Pay
a) Normal Severance Pay
 If an employee has given service to the employer from the minimum of
five years and his/her contract of employment is terminated
because of his/her initiation provided that (s)he has no contractual
obligation, relating to training, to serve more with the employer, then
the employee is entitled to the normal severance pay.
b) Extraordinary Severance Pay
o Compensation for Termination of Contract of Employment without
Notice = normal severance + 1 month salary ,
o However, where the termination is based on Article 32 (1) (b) the worker
shall, in addition to severance pay, be entitled to compensation of his
daily wage multiplied by ninety

2127
 Employment Income Tax on Job Termination
Payments
2128

 The EIT on Severance Pay is computed as follows:

1. Determine the total Severance Pay
2. Determine number of months with severance pay
- the total Severance Pay is divided by the basic
salary of the employee at the time the
Employment Contract is terminated
3. Determine the EIT on Severance Pay per month
using Schedule “A”
4. Determine the EIT on the total Severance Pay
 Activity 3
Employment Income Tax on Job Termination Payments facts
 Assume that the contract of employment is terminated when the basic
salary of an employee is Br 12,000.
Required
 Compute the tax on the severance payment if the employee left the
organization after serving for:
a) 7 years
b) 7 years and 9 months
c) 7 Years and 18 days
d) 35 years
 Solution
2130

Severance Payment
A) 12000+(12000*6 *1/3)=12000+12400=36000
Amount of tax = 36000/12000= 3 time
12000*0.35-1500= 2700*3 = 8100
Net Pay = 36000-8100= 37900
B)12000+(12000*6*1/3)+(12000*9/12*1/3)
=12000+24000+3000
=39000
Amount of tax = 39000/12000 = 3.25
= 12000*0.35-1500= 2700 *3= 8100
0.25*12000= 3000 so 3000*0.15-142.5= 307.5
Net pay =39000-8407.5= 30592.5
2131

 C)12000+(12000*6*1/3)+(12000*18/365*1/3)
 =12000+24000+197.26 =36197.26
 Amount of tax= 36197.26/12000 = 3.0164
 12000*0.35-1500=2700*3= 8100
 0.0164*12000= 196.8 Tax free
 Net pay = 36197.26 -8100 = 28097.26
 D) 12000+(12000*34*1/3)=12000+136000=148000
 MAX= 12000*12= 144,000
 Amount of tax= 144000/12000=12
 12000*0.35-1500= 2700 *12= 32400
 Net pay = 144000-32400= 111600
 Example
 Alemayehu was the employee of one private company in Arba Minch.
When he leaved the company after serving for 10 years, he was
reached at the monthly salary of Br 8,500.
A) If he terminated by his will, what would be his normal severance pay?
B) If the company terminated without notice the will of Alemayehu, what
amount of extra ordinary severance pay entitled for him?
C) What is the amount of total severance payment entitled to
Alemayehu?
 A) Normal Severance Pay :
 8500 + (8500*9*1/3) = 34000
 B) Extraordinary Severance Pay
 8500 =
 C) Total Severance
 34000 + 8500 = 42,500
Annual leave payment
 If the Bs = 11,000
 Used annual leave day = 30day
 Annual leave payment = 11,000 but is Annual benefit So 11,000/12=
916.66
 Taxable income = 11000+916.66= 11916.66
 11916.66*0.35-1500= 2670.883
 Previses tax payment
 11000*0.35-1500= 2350

 The difference is 2670.833-2350 = 320.833

 So to total tax on annual leave payment = 320.833*12 =3849.996

 Net pay of annual leave payment = 11,000-3849.996= 7150.004

Annual leave payment
 If the Bs = 11,000
 Used annual leave day = 34day
 Annual leave payment = 11,000 but is Annual benefit So 11,000/12=
916.66 so Daly = 916.66/30= 30.55
 34*30.55= 1038.88
 Tax = 11000+1038.88= 12038.88
 12038.88 *0.35-1500= 2713.608
 Previses tax payment
 11000*0.35-1500= 2350

 The difference is 2713.608 - 2350 = 363.608

 So to total tax on annual leave payment = 363.608*12 =4363.296

 Net pay of annual leave payment = 12038.88-4363.296= 7675.584

Preparation of Employment Income Tax Declaration
 ERCA introduced EIT Declaration (Form 1103) as of July 2006.

 The Employer is required to file Form 1103.

 Form 1103 has five sections:

✓ Taxpayer Information

✓ Declaration Details

✓ Calculation of Tax Due

✓ Employees Removed From Payroll

✓ Taxpayer Certification
Recording EIT Related Transactions
❑At time of payment of Employment Income,
appropriate income tax liability should be recorded.
❑Withheld EIT should be credited to liability account.

❑This Withheld EIT should be submitted to tax

authority within time frame set in income tax
proclamation.
❑At time of submission related liability account should
debited.
 Cont’d
Record the payment of salary

Record the payroll tax expense

 Cont’d
Record the payment of the claim

Record the payment of the payable

2142
 Contents
2143

 Overview of Business profit Tax

 Legal form of businesses and taxable entities
 Categories of Business taxpayers in Ethiopia
 Tax accounting methods
 Tax rates and other legal provisions on Business Profit Tax
 Deductible Expenses
 Non-Deductible Expenses
 Exemptions from Business Profit Tax
 Accounting for business income tax
 Overview
2144

 Business or Trade: means any industrial, commercial,

professional or vocational activity or any other
activity recognized as trade by the Commercial Code
of Ethiopia and carried on by any person for profit.
Two Types of Businesses:
 Bodies (Organizations):
 Others: includes all non-body entities that carry out
businesses for profit.
 Body
2145

 any company;
 any registered partnership;
 any entity formed under foreign law resembling a
company or registered partnership
 any public enterprise or public financial agency that
carries out business activities
 Any body of persons, corporate or unincorporated
whether created or recognized under a law in force in
Ethiopia or elsewhere.
 Any foreign body’s business agent doing business in
Ethiopia on behalf of the principle.
 Legal Forms of Businesses and Taxable Entities
2146

 Sole Proprietorship: The simplest, one-person show. Easy setup, full control, but personal
assets are on the line. Ideal for freelancers and small, low-risk ventures.
 General Partnership: Two or more owners sharing profits and liabilities equally. Flexible
and affordable, but unlimited liability exposes personal wealth. Best for trusted partners
managing a shared passion.
 Limited Partnership (LP): Combines general and limited partners. General partners
manage and have unlimited liability, while limited partners invest with capped risk.
Attractive for attracting funding while protecting some assets.
 Share Company: A separate legal entity owned by shareholders who hold limited liability.
Complex setup but offers access to capital through share sales. Ideal for larger businesses
seeking growth and investor participation.
 Private Limited Company (PLC): Similar to a share company, but with stricter rules and a
maximum of 50 shareholders. Suitable for smaller businesses wanting limited liability
benefits without a full public listing.
 Joint Venture: A temporary collaboration between two or more businesses for a specific
project. Shares profits and risks according to agreement. Useful for combining resources
and expertise for focused undertakings.
 Cooperative: Member-owned business focused on shared values and benefits. Members
contribute and share profits based on participation or patronage. Ideal for communities
seeking economic empowerment through collaboration.
 Legal Forms of Businesses and Taxable Entities
2147

According to Commercial Code of Ethiopia, there are

seven forms of business organizations in Ethiopia:
 Sole Proprietorship – It is a taxable entity but not legal
entity
 General Partnership – it is both taxable and legal
entity
 Limited Partnership – it is both taxable and legal entity

 Joint Venture - It is a taxable entity but not legal entity

 Private Limited Company - it is both taxable and legal

entity
 Share Company - it is both taxable and legal entity

 Co-operative - it is a legal entity but it may or may not

be a taxable entity
 Scope of Business Profit Tax
2148

 Ethiopian Income Tax System is based on the principle

of residence (worldwide income) as opposed to
Territorial (local income) and citizenship.
 Any business or individual which is a resident in
Ethiopia pays tax on its World Wide Income.
 Any non-resident business or individual that derives
income in Ethiopia shall pay income tax only on its
Ethiopian Income Source (local income).
 Residency
2149

 An individual shall be resident in Ethiopia, if (s)he::

 has a domicile (permanent residence address) within
Ethiopia;
 has a habitual residence (a place that he frequently
resides) in Ethiopia; and/ or
 is a citizen of Ethiopia and lives abroad for a consular,
diplomatic or similar purposes of the government of
Ethiopia.
 lives in Ethiopia for more than 183 days in a period of
twelve calendar months, whether continuously or
intermittently.
 Special Notes
2150

 Residential Status is determined at the end of a tax

period.
 The Residential Status of a taxpayer in Ethiopia is
determined not for a particular source of income but
for all sources.
 A resident in Ethiopia is considered as such even
though that person has a residency in other countries
at the same time.
 Scope of Business Profit Tax
2151

 A body shall be resident in Ethiopia, if it:

 has its principal office in Ethiopia;
 has its place of effective management in
Ethiopia; and/or
 is registered in the trade register of the
Ministry of Trade and Industry or Trade bureau
of the Regional Governments as appropriate.
 Categories of Taxpayers
2152

 The categorization of taxpayers depends upon

the following
i. Annual turnover or annual sales
ii. Maintenance of accounting records
iii. Requirements for registered vouchers

iv. Number and types of financial statements to be

prepared for tax purposes
v. Declaration of Income and time of payment of
tax liability
 Category ‘A’ Taxpayers
2153

 Category ‘A’ Taxpayers shall include:

 Any business having an annual turnover of Br 1,000,000 or
more;
 Any company incorporated under the laws of Ethiopia or in a
foreign country
 Legal requirements:
◼ Maintain accounting records
◼ Use registered vouchers
◼ Submit Balance sheet and a profit & loss statement
◼ The tax year is the fiscal year of the government.
◼ They shall submit the Tax Declaration Form within 4
months
 Category ‘B’ Taxpayers
2154

 Category ‘B’ Taxpayers shall include any business having an

annual turnover of over Br 500,000 and less than 1,000,000
 Legal requirements:
Maintain accounting records
Use registered vouchers
Submit only a profit and loss statement
They shall submit the Tax Declaration Form to the Tax
Authority within 2 months from the end of the tax
year
 Category ‘C’ Taxpayers
2155

 Category “C” Taxpayers include, unless already

classified in Categories “A” and “B”, a taxpayers
whose annual turnover is estimated by the Tax
Authority as being up to Birr 500,000.
 Maintaining books of accounts is encouraged but not
mandatory
 Not required to use registered vouchers and to

submit any financial statement

 The tax year is the government fiscal year and tax
shall be declared with in one month from the end
of the tax year.
 ❑ Note:

❖ It does not necessarily mean that all the three

categories remain constant at their position.
❖ If annual sales or revenue is increasing:
➢ Category ‘C’ taxpayers may shift to category ‘B’ taxpayer and
even to category ‘A’
➢ If their sales or revenue decreases the opposite become true.

❑ Share companies are always in category ‘A’ taxpayers

regardless of:
➢ The revenue amount or annual sales volume.
 Tax Accounting Methods
2157

 A taxpayer shall account for its activities either on a Cash or

Accrual Basis for the purpose of financial reporting .
 However, a company shall account for tax purposes only on
cash basis.
 Taxable business income shall be determined on the basis of
the income statement prepared as per GAAP or IFRS, subject
to the provisions of applicable Proclamations and the
directives issued by the Tax Authority.
 Business Profit Tax Rate
2158

 Taxable Business Profit of a body is taxable at the

rate of 30 % (Art9, pro.no. 979/2016).
 Taxable business income of other taxpayers which
are unincorporated shall be taxed in accordance
with Schedule “C” of Proclamation 979/2016
 Presumptive Tax – is a predetermined amount of
tax paid by small businesses whose annual sales is
Br 500,000 or less.
 The tax is estimated by estimating annual sales (daily
sales) as per Art3, pro.no. 979/2016.
 Business Profit
Business Profit Tax RateTax Rate
2159

Schedule “C”
Taxable Business Income per Business
Year Income Tax
TB Over Birr To Birr Tax Rate Deductions
1st 0 7,200 Exempt (0%) 0
2nd 7,201 19,800 10 720
3rd 19,801 38,400 15 1,710
4th 38,401 63,000 20 3,630
5th 63,001 93,600 25 6,780
6th 93,601 130,800 30 11,460
7th 130,801 ***** 35 18,000
 Activities
 Alpha Plc earned taxable profit of Br 300,000 for the tax year of
2008. what is the income tax liability of the organization?
 300,000*0.3= 90,000

 Ato Alemu earned a taxable profit of Br 300,000 for the tax year
ended on Sene 30, 2016. What is the tax liability of Ato Alemu.
 300000*.35-18000= 87,000
 Deductible Expenses (Allowable Deductions)
2161

❑ Generally, any Direct Costs and Expenses of producing

the Income shall be deductible.
❑ It includes:

◼ Insurance Expense
◼ Promotional Expense
◼ Commissions Expense
◼ Payment to Holding or Parent Company for services
provided
◼ General and administrative expenses
◼ Salaries expense
 Deductible Expenses (Cont’d…)
2162

 Interest Expense but not exceeding Inter-Bank Rate + 2%

 Donations and Gift Expense not exceeding 10% of the
Unadjusted Taxable Income
 Maintenance and Improvement Expense (i.e. if it is
immaterial or incidental)
 Bad Debts Expense (Uncollectible Accounts Expense) – Direct
write-off method (if failed to collect legally)
 Participation deduction (Deduction for Reinvestment of
Profit) not exceeding 5% of the Unadjusted Taxable
Income. The investor must have at least 25% ownership in the
new business unit by value or by number in the voting right.
 Deductible Expenses (Cont’d…)
2163

 Special (technical) reserves for financial institutions

 Transportation Allowance paid to Employees not
exceeding the limit (Br 2200)
 Retirement Benefits – less or equal to 15% of the
basic salary of the employee
 Representation Expense – 10% of basic salary of
employee
 Trading Stock (inventory) Disposed (Cost of Goods
Sold) - determined on the basis of the Average Cost
Method
 Activity 1(10 Minutes)
2164

BIRTY Share Company has the following beginning and purchase

of merchandise Inventory during the Tax Year 2014 (Assume a
tax year from Hamle 1 to Sene 30)
Date Particulars Quantity Unit Cost/Br
Hamle 1, 2013 Beg Bal. 2,000 10
Tikmet 16, 2014 Purchase 2,600 11
Megabit 22, 2014 Purchase 3,000 10.5
Sene 13, 2014 Purchase 2,500 10.6

Required
Determine the cost of trading stock disposed during the tax
year assuming that 2,700 units were on hand as of the end of
the tax year. (Average Cost Method)
 Solution
2165

Cost of Trading Stock Disposed

Beginning Inventory(2000@10)............................. 20,000
Add: Purchases (28,600+31500+26,500) ………. 86,600
Cost of Merch Avail for Sale ………………………106,600
Less: Ending Inventory (2,[email protected]) ………… 28,485
Cost of Trading Stock Disposed …………………… 78,115
 Donations and Gifts
2166

 Donations and gifts are deductible only under the

following conditions.
1. If the donations are given to welfare organizations.
2. If the payments are made under emergency call
issued by the government.
3. If the payment is made for non- commercial
education or health facilities.
 Note

 Grants and donation will be allowed as deduction only if it

does not exceed 10% of the taxable income
 Depreciation Methods (Art39, Reg410/2017)
2167

1. Fine Art, Antiques, Jewelry, and Trading Stock

and other business assets not subject to wear and
tear and obsolescence shall not be depreciated.
2. Building and Construction (Land Improvement):
at 5% on straight line basis.
3. Intangible Assets: 10% straight line basis for
intangible assets have a life more than 10 years,
100% divided by useful life for other intangible
assets.
 Depreciation Methods (cont’d…)
2168

4) Computers, information systems, software products and data storage

equipment: 20% (on a pooling system)
5) All other business assets (Eg. Machineries, furniture and fixtures,
vehicles, tools and spare parts, books, etc): 15% (on a pooling system)
6) Green house: 10%
7) Depreciable asset used in mining and petroleum development operation:
25%
 N.B.
◼ It is the date of acquisition of assets that is important not date of putting into
service.
◼ Besides, the principle of full year depreciation is used; not partial year
depreciation.
◼ Finally, revaluation of fixed & intangible assets is not permissible.
 Depreciation Base under Pooling Method
2169

 Depreciation Base = BV Beginning + Cost of Assets Acquired

(acquisition, improvement, renewal, and reconstruction)– Disposal
Value (sale or insurance received for loss of Assets)
 If the depreciation base is a Negative Amount, that amount
shall be added to taxable profit and the depreciation base
shall become zero.
 If the depreciation base does not exceed Br 1,000, the entire
depreciation base shall be a deductible business expense
 If expenses incurred for the maintenance and improvement
exceeds 20% of the net book value of the asset, the whole
will be added to the net book value of the asset.
 Activity 2 (11 Minutes)
2170

 Alpha Co. has a building that was purchased for Br

10,000,000 on Megabit 22, 1999 and was placed in service
on Hamle 14, 1999. In Sene 2005, the company made major
structural repairs on the building at a cost of Br 2,000,000.
Construction of extension for workers’ canteen also took place
in the same period at a cost of Br 550,000.
Required:
a) What is the Accumulated depreciation as at Hamle 1,
2004?
b) What is the depreciation expense for the tax year ending
on Sene 30, 2005?
 Solution
2171

a) Accumulated depreciation as at Hamle 1, 2004

 =10,000,000X5%X6

 = 3,000,000

b) Depreciation Expense (Sene 30, 2005)

BV=Acqisition Cost-Accumulated depreciation
=10,000,000- 3,000,000
=7,000,0000
New Depr Base = BV+Additions
= 7,000,0000+2,550,000
= 9,550,000
Depreciation Expense = 9,550,000X5%
= 477,500
 Activity 3 (9 Minutes)
2172

Assume ABC PLC uses the tax year Hamle 1 to Sene 30 and has the
following assets: Computers, information system, software, and data
storage.
Date of Purchase Acquisition Cost
Yekatit 10, 2003 Br 16,000
Ginbot 01, 2003 Br 6,000
Nehassie 07, 2003 Br 7,000
Required Tahisas 19, 2004 Br 3,500
Compute
depreciation base and depreciation expense for the tax year
ending on Sene 30, 2003, 2004, and 2005 assuming that ABC Plc
sold old computer at Br 3,000 on Megabit 23, 2005.
 Solution
2173

 Note
a) Hamle 1, 2002-Sene 30,2003 (Yekatit 10, 2003 & Ginbot
01, 2003)
b) Hamle 1, 2003-Sene 30,2004 (Nehassie 07, 2003 &
Tahisas 19, 2004)
c) Hamle 1, 2004-Sene 30,2005
 Solution (Cont’d…)
2174

Depreciation Base
Sene 30, 2003=16,000+6,000=22,000
Depreciation Expense =22,000@20% = 4,400
Depreciation Base
Sene 30, 2004 = BV Begin + Additions - Deductions
= (22,000-4,400) + 10,500
= 28,100
Depreciation Expense =28,100@20%=5,620
Depreciation Base
Sene 30, 2005 = BV Begin + Additions – Deductions
= (28,100-5,620) - 3,000 = 19,480
Depreciation Expense = 19,480@20% = 3,896
 Activity 4 (6 Minutes)
2175

❑ The following information relates to Zumra Company.

• The book value of the pooled machineries in the opening
balance sheet of the tax period as of Hamle 1, 2005 was
Br. 85,000.
• During the tax year 2006, Zumra bought additional
machines for Br. 50,000, received Br. 5,000 as compensation
from the vendor since one of the machines does not work
properly, paid Br 40,000 for maintenance of a machine, and
sold an existing machine for Br. 10,000.
Required
 Determine Depreciation expense for the year ended Sene
30, 2006.
 Solution
2176

Depreciation Base
= BV Beginning + Cost of Assets Acquired – Disposal Value
= 85,000+50,000-5,000+40,000-10,000
= 160,000

Depreciation expense = 160,000*0.15= 24000

 Disposal of Fixed Assets
2177

 For individually depreciating assets, gain or loss from

the disposal would be recognized by comparing the
disposal price of the asset with its book value at the time
of disposal.
 But, loss wouldn’t be recognized if the disposal transaction
is carried out between related persons.
 For business assets that depreciate in a pool, gain or loss
from disposal is not allowed for income tax purposes.
 However, the cost and accumulated depreciation of the
asset disposed of must be written off from the accounting
records of the business in the following year of the
disposal year.
 Treatment of Interest Expense
2181

 Interest Expense (Max. = Interbank rate + 2%) is

allowable for deduction only if:
a) it arises from borrowings from institutions recognized
by NBE (interest on trade payables is not
recognizable)
b) it arises from borrowing from a foreign bank under
the permission of NBE and the foreign bank is
required to file a written declaration to the tax
authority about the loan to be granted.
◼ (10% of the interest should be withheld and be paid to the
taxing authority within 2 months of the end of the tax year)
 Treatment of Interest Expense
2182

c) Interest expense arises from borrowings from the

owners of the organization (body).
 The loan should not exceed 4 times the average
share capital (basic capital or paid up capital)
during the tax year.
 If the capital exceeds this level the whole interest
payable to the shareholders would not be
deductible.
 Bad Debts
 In the determination of taxable business income, a
deduction shall be allowed for a bad debt if the
following conditions are met:
 an amount corresponding to this debt was previously
included in the income;
 the debt is written off in the books of the taxpayer;
and
 any legal action to collect the debt has been taken but
the debt is not recoverable.
 Non-Deductible Expenses
2184

 The cost of depreciable business assets (capital expenditures)

 Entertainment (food, beverage, tobacco, accommodation,
amusement, recreation or any type of hospitality to any
person)
 Personal consumption expenses of the owner paid by the
business
 Declared dividends and paid-out profit shares

 Damages covered by insurance policy (Damages not

covered would be allowed)
 Punitive damages (by court) and penalties
 Input VAT (recoverable tax) and income tax expenses
 Non-Deductible Expenses
2185

PC or PF > 15%
Interest in excess of rate used b/n NBE & commercial banks increased by 2%
Damages covered by insurance policy.
Representation expenses over and above 10% of BS
Donation Expense more than 10% Taxable income
Expenditure for maintenance of other private properties.
Losses not connected with activity of the enterprise or extra ordinary
losses.
Transportation allowance exceeding 25% of BS or Br. 2,200 which is so
ever the lower.
 Exemptions on Income
2186

 The following categories of income shall be exempt from payment

of business income tax hereunder:
 Awards for adopted or suggested innovations and cost saving
measures
 Public awards for outstanding performance

 Income specifically exempted from income tax by the law in

force in Ethiopia, by international treaty or by an agreement
made or approved by the Ministry of Revenue
 The revenue obtained by the Federal Government, Regional
Governments and Local Governments of Ethiopia and the
National Bank of Ethiopia from activities that are minor to
their operations.
 Accounting for Business Profit Tax
2187

 For bodies, apply a flat 30 % rate on the taxable profit

 For other tax payers (except category C) use the following
formula
Schedule “C”
Business Income
Taxable Business Income per Year
Tax
TB Over Birr To Birr Tax Rate Deductions
1st 0 7,200 Exempt (0%) 0
2nd 7,201 19,800 10 720
3rd 19,801 38,400 15 1,710
4th 38,401 63,000 20 3,630
5th 63,001 93,600 25 6,780
6th 93,601 130,800 30 11,460
7th 130,801 ***** 35 18,000
 Activity 6 (6 Minutes)
2188

 SHALA Merchandising Enterprise is a Category “B”

taxpayer. The enterprise reported Br 600,000 sales
revenue; Br 500,000 Cost of goods sold and Br
62,000 operating expenses during the tax year
ending Sene 30, 2007.
Required
 Determine the Taxable Business Income and
Business Profit Tax to be paid.
 Solution
2189

 Taxable Business Income

Sales ……………………………….. 600,000
Less: COGS ………………………. 500,000
Gross profit ………………………. 100,000
Less: Operating Expense ………… 62,000
Taxable Business Income ………… 38,000
Business Profit Tax ………………… 3990
Net Income After Tax …………… 34,010
 Business Profit Tax to be paid
= (38,000@15%)-1,710=5700-1710=3990
 Example
❑ Assume that the revenue from SAMARITAN S.C. is Br
2,000,000 during Tax Year ended Sene 30, 1997. Cost and
Expense were Br 1,000,000 and Br 560,000, respectively.

❑ Required: Determine the TBP and BPT Liability of this

Share Company.
2191

Solution
2002
Sale …………………..2,000,000
Cost…………………..1,000,000
GP………..………..…..1,000,000
Expense ………………..560,000
Operating income……….440,000
BIT..440,000*0.3…………132,000
Income after tax………..…308,000
 Special Items that Reduces Business Profit Tax
2192

❑ Business Profit Tax is adjusted for factors :

▪ Loss Carry Forward and Loss Carry Back
▪ Withholding of Business Profit Tax;
▪ Foreign Income Tax Credit
 Loss Carry Forward and Loss Carry Back
2193

 Loss Carry Back is a tax provision that allows

operating losses to be used as a tax shield to reduce
taxable income in prior periods.
 Loss Carry-Forward is a tax provision that allows
operating losses to be used as a tax shield to reduce
taxable income of the future years.
◼ According to Article 28 of the Proclamation loss
may be carried forward where the books of
account showing the loss are acceptable to the
Tax Authority
 Loss Carry Forward and Loss Carry Back
2194

 If there is a loss in any year, it can be set off against

taxable income in the next five years.
 A loss may be carried forward only for two periods of
five years.
 A net loss may be carried forward and deducted only
for two periods i.e.:
 Only a loss of two periods and carried forward 5 years
each for the two losses (2*5 = 10 years).
 In the process of carry forward, earlier losses should be set
off before later losses.
 Loss Carry Forward and Loss Carry Back

❑ In Ethiopia, loss can be carried forward but not carried

back except in long term construction contract.

❑ For Construction companies loss may be carried

forward and any loss that is not set off after carry
forward may be carried back to previous years.
❑ The loss set-off against TBP in next 5 tax period’s earlier losses being
set-off before later losses.
 Example 1
MOTERA Trading S.C. reported net sales and Cost &
Expense of Birr 1,000,000 and 1,200,000 during the year
ended June 30, 2001, respectively. During the year ended
June 30, 2002, the same Share Co. reported net sales of Birr
1,500,000 and Cost and Expenses of Br 1,200,000.00.
❑ Required: Determine the TBP and BPT during the tax
year ended June 30, 2002 and Record the necessary
transaction.
  Solution
 2001 2002
2197

 Sale ……………..1000,000 Sale ……………..1,500,000

 Cost and Expense …1200000 Cost and sale……..1,200,000
 Net operating loss (200000) TBP………………….300000
2001 2002

NOL Schedule

Taxable income $ (200,000) $ 300,000

Carryforward (200,000)

Taxable income (200,000) 100,000

Rate 30% 30%

Income tax (revised) $ (60,000) $ 30,000

Income Tax Expense …….90,000

Deferred Tax Asset………60,000
Deferred Tax Asset ……………60,000
Benefit Due to Loss Carryforward…60,000
Income Taxes Payable …….…30,000
 Activity 7 (9 Minutes)
2198

The following relates to taxable income for three

different companies.
Comp Taxable Income (loss) for year
any 2008 2009 2010 2011 2012 2013 2014 2015
ABC (100,000) 80,000 12,000 5,000 50,000 90,000 100,000 110,000

XYZ (50,000) 5,000 25,000 10,000 (40,000) 10,000 50,000 60,000

MARY (100,000) 90,000 (60,000) 45,000 (150,000) 40,000 170,000 100,000

Required:
Determine the taxable liability for each of the companies
for each year?
 Comp Taxable Income (loss) for year
any 2008 2009 2010 2011 2012 2013 2014 2015
ABC (100,000) 80,000 12,000 5,000 50,000 90,000 100,000 110,000
2199
XYZ (50,000) 5,000 25,000 10,000 (40,000) 10,000 50,000 60,000

MARY (100,000) 90,000 (60,000) 45,000 (150,000) 40,000 170,000 100,000

Company 2008 2009 2010 2011 2012 2013 2014 2015

ABC , TBP 0 0 0 0 47000* 90000* 100000 110000
0.3 0.3 *0.3 *0.3
14100 27000 30000 33000

XYZ TBP 0 0 0 0 0 0 10,000 60,000

*0.3 *0.3
3000 18000

MARY 0 0 0 0 0 15000* 170000 100000

TBP 0.3 *0.3 *0.3
4500 51000 30000
 Withholding Income Tax
2200

 Withholding Income Tax is an advance payment of business

income tax by a business at the time of importing trading
goods or at the time of receiving payment for sale of goods or
services locally.
 Withholding tax paid shall be deducted from business profit
tax.
Withholding Tax Rates
◼ On imported trading goods- 3% of CIF (whether the
freight paid by the importer or not doesn’t matter)
◼ On Payments for goods and services transacted locally-
2% of the gross amount of the payment (excluding VAT).
 Withholding Scheme on Local Transaction
2201

 Supply of goods involving more than Birr

10,000 in any one transaction or one supply
contract
 Rendering of the certain services involving
more than Birr 3,000 in any one transaction
or one service contract.
 NB; if the supplier failed to have TIN 30%
of the gross payment shall be withheld.
 Withholding Tax Declaration
 The withholder is required to declare WHIT
Declaration on monthly basis.
 Withholding Tax Declaration form has four
Sections:
✓Taxpayer Information;
✓Declaration Details;
✓Tax Declaration Summations; and
✓Taxpayer Certification
2203
 Example 1
❑ TENKER Pvt. Ltd. Co. purchased Birr 200,000
Stationary Materials from HALEHA Stationary
Materials Import and Distribution Pvt. Ltd. Co. on
Tikmet 18, 1997

❑ Instruction: Record the above transaction for both

the seller (withholdee) and buyer (withholder).
2205

Solution
Seller
 Cash…………………….....….196,000

 Withholding tax Receivable …….4000

 sale……………….….200000
 Buyer

 Purchase…………..200000

 Withholding payable …………….4000

 cash …………………..………….196000
 Foreign Tax Credit
2206

 Foreign Tax Credit refers to reduction of business profit

tax for income tax paid in foreign country from foreign
source income.

 Businesses can take advantage of foreign tax credit as

per Art.45, Proclamation No.979/2016
❑ If during tax period a resident derives foreign source income:
➢ The Income Tax payable by that resident in respect of that
income shall be reduced by the amount of foreign tax payable on
such income.
❑Amount of foreign tax payable shall be substantiated
(validated)by appropriate evidence such as:

✓ Tax assessment,

✓a withholding certificate or

✓ Any other similar document accepted by Tax

Authority.

The reduction of tax prescribed shall be

calculated separately in respect of each foreign
country from which income or profit is derived.
The Investment Tax Credit:

➢Refers to immediate reduction of BPT for some

investment made during the tax period.

 In Ethiopia, there is no tax provision relating to ITC

 Businesses can take advantage of foreign tax credit as

per Art. 70 or Proclamation No.979/2016
 Accounting for Business Profit Tax
❑Accounting for BPT is concerned with:

✓Determination of TBP

✓Computation of BPT.

✓Adjusting BPT.

✓Preparation of Tax Returns i.e. Profit and Loss

Account and Balance Sheet.

✓Recording Transactions Related to the BPT liability

 Preparation of Tax Returns
2212

▪ If the tax payer has deducted any expense which is non-

deductible, then such amount is to be added back.
▪ If the tax payer has not claimed any expense that is
deductible, then such amount is to be deducted
Particulars Amount
In ETB
Taxable Business Profit from IFRS Based Income Statement Xxx
Add: Non-Deductible Expenses (If they are deducted) xxx
Less: Allowable expenses (if not claimed) (xxx)
Taxable Business Profit for tax purpose xxxx
 Preparation of Tax Returns
2213

 The tax returns shall be accompanied by:

◼ The amount of business profit tax

payable in check or in cash,

◼ Tax vouchers and documents, and

◼ any other relevant information

2214
 Contents
2215

 Overview of Rental Income Tax

 Basic Legal Provisions for Rental
Income Tax
 Accounting for Rental Income Tax
 Rental Income Tax Basics
2216

Rental Income
❑ Refers to income from rental of buildings.
❑ Does not include:
❑ Income from lease of business and
❑ Income from casual rental of property
❑ Business Lease means lease of goods, equipments and building
which are part of the normal operation of a business
Rental Income Tax
❑ Rental Income is taxed under Schedule “B” of Income Tax
Proclamation No. 979/2016 and Regulation No. 410/2017
 Rental Income Tax Basics (Cont'd…)
2217

❑ A lease is a contractual arrangement calling for the lessee

(user) to pay the lessor (owner) for use of an asset.
❑ Parties in Rent of buildings
1. Lessor: a person who owns building and who provides
building rental service
2. Lessee: a person who rents/leases a building directly from
the lessor for residential, business or subleasing purpose.
3. Sub-lessor: the first lessee that sub lease the whole or a
portion of the building
4. Sub-lessee: the third party who rents the building from the
sub-lessor.
 Rental Income Tax Basics (Cont'd…)
2218

❑ Sub-lessor shall
❑ pay the tax in the difference between
❑ income from sub-leasing and
❑ the rent paid to the lessor provided that the amount
received from the sub-lessee is greater than the
amount payable to the lessor.
❑ The owner of a building who allows a lessee to sub-lease is
liable for the payment of the tax for which the sub-lessor is
liable, in case the sub-lessor fails to pay.
❑Business or individuals may lease:

✓An empty or

✓Furnished building.
❑ Furnished building is a building with all necessary inside
facilities such as furniture, equipments, household utensils,
etc.

❑ In the case of furnished building, the Gross Income is:

➢ Sum of there of for building, furniture, equipment, household

utensils,
 Taxable Rental Income (TRI)

❑ TRI = Gross Rental Income – Deductible Expenses

TRI = GRI - DE

❑Deductible items are mentioned under article 16(1) of

ITP No. 979/2016 and income tax regulation 78/2002

 Determination of Gross Rental Income
2222

 Gross Rental Income shall include:

 All payments in cash and all benefits in kind received by the
lessor (owner of the building) from the lessee;
 All payments made by the lessee on behalf of the lessor
according to the contract of lease
 The value of any renovation or improvement made under the
contract of lease to the land or building, where the cost of such
renovation or improvement was borne by the lessee in addition
to rent payable to the lessor;
 If the tax payer leased furnished quarters, the amounts received
attributable to the lease of furniture and equipment shall be
included in Gross Rental Income in addition to the above rental
incomes.
 Deductible Expenses from Gross Rental Income
2223

▪ Deductible Expenses Include

▪ Taxes Paid with respect to the land and buildings being leased
(except income tax) and:
A. For taxpayers not maintaining books of account, fifty percent (50%)
of the gross income is allowances for repair, maintenance and
depreciation (Art15(5), Proclamation No.979/2016).
B. For taxpayers maintaining books of account (category A and B), the
expenses incurred in earning, securing, and maintaining rental
income (necessary and reasonable), to the extent that the expenses
can be proven by the taxpayer and subject to the limitations
specified in Art15(7), Proclamation No.979/2016:
• Cost of lease/rent of the land
• Insurance premium for the property
• Depreciation expense for the property
• Repair and maintenance Expense of the property
• Interest Expense
• Bad debt expense
• General and administrative expenses
 Note
2224

 If The same building or house used for rental and used for
resident for owner the utility expense only deducted 75%
 If the taxpayer not maintaining accounting record the tax
authority used the contact to estimate the annual rental
income, from the estimated amount 50% taxable for
category C Tax payer but 65% for A and B category
 If the tax authority do not Accept the contract price, the
authority has right to used it assessed market price
 If there is no contact the tax authority may estimate the
annual rental income by market information
 if the lesser is Vat Registered ,Month or annual rental
income it must be clearly stated about with or with out VAT,
b/c the lesser responsible to collected VAT for tax authority
 Responsibility of the Local Administration
❑At the earlier of time of construction of a rental building is
completed or building is rented:

➢Owner and builder are required to notify administration of

‘kebele’ in which building is situated about:

✓ Completion

✓ Name & address

✓ Tax identification number of person subject to tax on

income from rental of building.
 Accounting for Rental Income
2226

 Involves with the following tasks:

 Determination of Gross Rental Income and
Taxable Rental Income

 Calculation of Rental Income Tax

 Preparation of Rental Income Tax Return

 Determination of Gross Rental
2227

Rental Income Received ……………………............... . Xxxxx

Amount on the Lease of Furniture ………………….... Xxxxx
Amount on the Lease of Equipments ……………….... Xxxxx
Payments made by the lessee on behalf lessor ……... Xxxxx
Expenditures on the land/Building paid by the lessee Xxxxx
Gross Rental Income ……………………………….... Xxxxx
 Determining Taxable Rental Income
2228

 To compute the taxable amount, apply the following

schedule

Gross Rental Income xxxxx

Less: Rental Payment (Applied by Sub-lessor) (xxxxx)
Net Rental Income xxxxx
Less: Deductible Expenses (xxxxx)
Taxable Rental Income XXXX
 Computing Rental Income Tax
2229

❑ For Bodies apply flat 30 % rate of taxable rental income

❑ For other tax payers apply the schedule below.

Schedule “B”
Taxable Rental Income per Year Rental Income Tax
TB Over Birr To Birr Tax Rate Deductions
1st 0 7,200 Exempt (0%) 0
2nd 7,201 19,800 10% 720
3rd 19,801 38,400 15% 1,710
4th 38,401 63,000 20% 3,630
5th 63,001 93,600 25% 6,780
6th 93,601 130,800 30% 11,460
7th 130,801 ***** 35% 18,000
 Activity 1 (10 Minutes)
2230

 Assume Ato Ayele, the owner of AYU BUILDING, leased the

Building at Br 2,000,000 per annum. In addition to this, the lessee
will incur Br 100,000 per annum for repair and maintenance of
the building. The cost of the building is Br 20,000,000 and the
following expenses are incurred by the lessor:
Cost of Lease payments on Land Br 100,000
Land use and Building Property Tax 20,000
Other Deductible Cash Expenses 5,200
Required
 Determine the Gross Rental Income, Taxable Rental
Income, and Rental Income Tax assuming
a) Ato Ayele maintains books of records and
b) Ato Ayele doesn’t maintain book of records
 Solution
2231

a) Assuming Ato Ayele maintains books of records

Rental Income Received ………………………………………………………………….. 2,000,000.00

Payments made by the lessee on behalf lessor ………………………………. 100,000.00
Gross Rental Income ………………………………………………………………………. 2,100,000.00
Less: Deductible Expenses ……………………………………………………………….
Cost of Lease payments on Land …………………………………………. 100,000.00
Land use and Building Property Tax ……………………………………. 20,000.00
Other Deductible Cash Expenses …………………………………………. 5,200.00
Depreciation Expense (20,000,000*5%) ………………………………… 1,000,000.00
Total Deductible Expenses …………………………………………………………….. 1,125,200.00
Taxable Rental Income ……………………………………………………………………. 974,800.00
Less: Rental Income Tax …………………………………….. (974,800.00*30%) 292,440.00
Net Income After Tax ……………………………………………………………………… 682,360.00
 Solution (Cont’d…)
2232

b) Assuming Ato Ayele doesn’t maintain book of records

Rental Income Received ………………………………………………………………………. 2,000,000.00

Payments made by the lessee on behalf lessor …………………………………… 100,000.00
Gross Rental Income ……………………………………………………………………………. 2,100,000.00
Less: Deductible Expenses ……………………………………………………………………
Cost of Lease payments on Land ……………………………………………………… 100,000.00
Land use and Building Property Tax …………………………………………………. 20,000.00
Allowance for repair, maintenance …(50% of GRI)(50% of 2.1m) 1,050,000.00
Total Deductible Expenses ………………………………………………………………… 1,170,000.00
Taxable Rental Income …………………………………………………………………………. 930,000.00
Less: Rental Income Tax ………………………………(930,000*35%-18,000) 307,500.00
Net Income After Tax ……………………………………………………………………………… 622,500.00
 Activity 2 (10 Minutes)
2233

 Habesha Rental Plc involves in renting of dwelling houses around Bole. For
the year ended Sene 30, 2014, the firm has processed the following
transactions.
 Recognized income from renting of building Br. 65,000/month. The
associated furniture and equipment were rented at a per month rate of
Br. 20,000.
 The value of building owned by the company is Br. 5,000,000 and the
value of furniture and equipment is Br. 1,000,000.
 The company paid property tax of Br. 10,000/year.

 General and administrative expenses of Br. 40,000 were also paid.

Required
Compute the taxable income and tax liability for the year 2014.
 Solution
2234

Rental Income Received (65,000*12) 780,000.00

Amount on the Lease of Furniture and Equipments (20,000*12) 240,000.00
Gross Rental Income 1,020,000.00
Less: Deductible Expenses
Property Tax 10,000.00
General Administrative Expense 40,000.00
Depreciation Expense-Building (5,000,000*5%) 250,000.00
Depreciation Expense-Furniture and Equipments (1m*15%) 150,000.00
Total Deductible Expenses 450,000.00
Taxable Rental Income 570,000.00
Less: Rental Income Tax (570,000.00*30%) 171,000.00
Net Income After Tax 399,000.00
 Exercises 1
2235

 Biftu leased its building for Br 200,000 for cash per month.
The lessee is responsible to make renovation and
improvement in the building by incurring Br 100,000 per year
as per the lease term. The cost of building is Br 10,000,000.
Biftu paid Br 100,000 for the leasehold Land. General
administrative costs of Biftu on the building rental are Br
150,000 per year.
Required
 Determine the Gross Rental Income, Taxable Rental
Income, and Rental Income Tax assuming
a) Biftu maintains books of records and
b) Biftu doesn’t maintain book of records
 Solution
2236

a) Assuming Beiftu maintains books of records

Rental Income Received …………………………………………………………200000*12 2,400,000.00

Payments made by the lessee on behalf lessor ………………………………. 100,000.00
Gross Rental Income ………………………………………………………………………. 2,500,000.00
Less: Deductible Expenses ……………………………………………………………….
Cost of Lease payments on Land …………………………………………. 100,000.00
General administrative Expenses …………………………………………. 150,000.00
Allowance Depreciation Expense(10,000,000* 0.05) ……………………… 500,000.00
Total Deductible Expenses …………………………………………………………….. 750,000.00
Taxable Rental Income ……………………………………………………………………. 1,750,000.00
Less: Rental Income Tax …………………………………….. (1,750,000*0.3) 525,000.00
Net Income After Tax ……………………………………………………………………… 1,225,000.00
 Solution (Cont’d…)
2237

b) Assuming Beiftu doesn’t maintain book of records

Rental Income Received ………………………………………………………………………. 2,400,000.00

Payments made by the lessee on behalf lessor …………………………………… 100,000.00
Gross Rental Income ……………………………………………………………………………. 2,500,000.00
Less: Deductible Expenses ……………………………………………………………………
Cost of Lease payments on Land ……………………………………………………… 100,000.00

Allowance for repair, maintenance …(50% of GRI)(50% of 2.5m) 1,250,000.00

Total Deductible Expenses ………………………………………………………………… 1,350,000.00
Taxable Rental Income …………………………………………………………………………. 1,150,000.00
Less: Rental Income Tax ………………………………(1,150,000*35%-18,000) 384,500.00
Net Income After Tax ……………………………………………………………………………… 765,500.00
 Exercise 2
2238

 ATO ZINABU leased his furnished building for Br

2,000 per month and the equipments and furniture
were leased for Br 1,000 per month. He paid Br
1,200 land and building tax to Addis Ababa
Municipality.
Required
 Determine Gross Rental Income, Taxable Rental
Income and Rental Income Tax Liability during tax
year 2012.
 Solution (Cont’d…)
2239

Assuming ATO ZINABU doesn’t maintain book of records

Rental Income Received ………………………………………………………2000*12 24,000.00

Equipment's and furniture were leased……………………………………1000*12 12,000.00
Gross Rental Income ……………………………………………………………………………. 36,000.00
Less: Deductible Expenses ……………………………………………………………………
land and building tax ……………………………………………………… 1200.00

Allowance for repair, maintenance …(50% of GRI)(50% of 36,000) 18,000.00

Total Deductible Expenses ………………………………………………………………… 19200.00
Taxable Rental Income …………………………………………………………………………. 16,800.00
Less: Rental Income Tax ………………………………(16,800*10%-720) 960.00
Net Income After Tax ……………………………………………………………………………… 15,840.00
 Declaration
2240

 RIT Declaration with books of accounts (FORM

1201)
 RIT Lessee Details Declaration and Continuation
Sheet (FORM 1202 and FORM 1203)
 RIT Declaration for taxpayers not maintaining
Books of Accounts (FORM 1205 & FORM 1206)
2241
 Chapter Contents
2242

 Legal provisions for other income taxes

 Accounting for other income taxes
1) Royalty Income (5%)
2) Technical Service Income (10%)
3) Income from Game of Chance (15%)
4) Dividend Income (10%)
5) Income from Casual Rental of Property (15%)
6) Interest Income (5% saving deposit in FI, 10% in other
case)
7) Capital Gains
◼ Buildings Held for Business, Factory, and Office (15%)
◼ Shares of Companies (30%)
 Introduction to Other Income Tax
2243

 Taxable under Schedule “D” of

◼ Income Tax Proclamation No. 979/2016 and
◼ Income Tax Regulation No. 410/2017.
 The payer of any payment subject to tax under Schedule “D” shall
withhold the amount of tax required.
 Shall pay the withheld tax to the tax authority within 15 days of the
end of each calendar month, and each payment shall be
accompanied by a statement with respect to each taxpayer who
received payments during the month
 if you earn income in Ethiopia and it is not automatically taxed through a
system called "withholding tax", you are responsible for declaring that
income to the government yourself, within two (2) months from the end of the
Ethiopian Fiscal Year.
❑ Both central and regional gov’t in Ethiopia, applies only
proportional/ flat tax rate structure. However, tax rate
applicable to OI depends on types and source of other
income

❑Generally, the tax rate applicable on OI vary from 5% to

30%

❑Minimum tax rate is 5% and maximum tax rate is 30%

2244
❑ Schedule D has no exemptions and deductions except capital gain.

❑ The Gross Income is directly considered as TOI and used to record

the tax liability on other income.

❑ GI is final tax lieu of OIT ( i.e. no additional income tax is imposed)

❑ Tax amount is withheld by the payer of schedule “D” Income such as:

✓ Ethiopian National Lottery Administrations

✓Banks

✓Book Publishing

✓Distribution Companies

✓Music Studios and others 2245

 1. Royalty Income (Article54, Pro. No., 979/2016 )
2246

 Royalty Income is any payment received for granting

the right to use:
 any copy right (literary, artistic, or scientific works)
 any patent, trade mark, design or model, plan, secret
formula or process,
 any industrial, commercial, or scientific equipment, or
 for information concerning industrial, commercial or
scientific experience.
 Royalty (Cont’d…)
2247

 Royalty Income Tax Rate = 5% (is final tax in lieu of income tax)
 If payer is resident – it is the withholding agent

 If payer is nonresident – the recipient of the money will be the withholding

agent.
Example 1
 Alpha Textiles Company, an Ethiopian resident, entered into a technical
collaboration agreement with Suji Textile Company, a Kenyan based company.
The collaboration involved exchange of trade secrets for Br 1,500,000.
Required
Determine the Royalty Income Tax and the relevant journal entries assuming:
a) The Kenyan firm (recipient) sold the secrets to the Ethiopian firm
(withholding agent)
b) The Ethiopian firm (recipient) sold the secrets to the Kenyan firm
(withholding agent)
 Solution
2248

a) Royalty Income Tax and the relevant journal entries assuming the
Kenyan firm (recipient) sold the secrets to the Ethiopian firm
(withholding agent)
Computation of other Income Tax on Royalty Income
Tax on Royalty = 5% of Royalty Income
= 5% of 1,500,000
= 75,000
P/R Debit Credit
Patent ………………………………………………………. 1,500,000
Royalty Income Tax Payable ………...... 75,000
Cash …………………………………............... 1,425,000
(To record the payment of royalty income to Kenyan firm)
Royalty Income Tax Payable ….………………… 75,000
Cash ………………………………………………….. 75,000
(To record the payment of the tax withheld to the tax authority)
 Solution (Cont’d…)
2249

b) Royalty Income Tax and the relevant journal entries assuming the
Ethiopian firm (recipient) sold the secrets to the Kenyan firm
(withholding agent)
P/R Debit Credit
Cash………………………………………………….. 1,500,000
Royalty Income Tax Payable …… 75,000
Royalty Income ………………………… 1,425,000
(To record the receipt of royalty income from Kenyan Firm)
Royalty Income Tax Payable ………….. 75,000
Cash ………………………………………... 75,000
(To record the payment of tax on royalty income to the tax authority)
 Royalty Income Tax-Example2
2250

❑ Assume that the Famous Ethiopian musician Tewderos

Kassahun (Teddy Afro) sold his album called “Tikur
Sew” at Birr 7,500,000 to Adika entertainment.
Required
 Determine
a) the amount of Royalty Income Tax and
b) record the Tax Liability at the time of payment to the
artist and to the tax authority
 Solution
2251

a) Computation of other Income Tax on Royalty Income

Tax on Royalty = 5% of Royalty Income
= 5% of 7,500,000
= 375,000
b) To record the payment of the tax withheld to the tax authority.
P/R Debit Credit
Copy Right……………………………………………………………….. 7,500,000
Royalty Income Tax Payable ……….................. 375,000
Cash …………………………………...... 7,125,000
(To record the payment of royalty income by Adika Entertainment to Teddy Afro)
Royalty Income Tax Payable ………………………………….. 375,000
Cash ………………………………………………………………… 375,000
(To record the payment of the tax withheld to the tax authority)
 2. Technical Service Income
2252

Include income derived:

 from expert advise or technological services (consultancy or
advisory, proposal evaluation, training of personnel on how to
use a machine or software)
 by a person or organization residing outside Ethiopia to
resident persons in Ethiopia.
 subject to tax at the rate of 10%
 the payer is the withholding agent
N.B.
 Incomes derived by an Ethiopian resident from rendering
technical services is taxable as per schedule “C”
 Technical Service Income Tax
2253

Example
❑ Hibir manufacturing Company has received an
expert advice on the manufacturing process of
sugar from the YBZ Inc., a UK based Company, and
paid a compensation of Br 180,000 net of tax.
Required:-
 How much is the tax to be paid to the Tax
Authority? (X-0.1X)=180,000
 Solution
2254

a) Computation of other Income Tax on payment for technical service

received
Tax on Payment = 10% of Payment
= 10% of 200,000*
= 20,000
*(X-0.1X) = 180,000 (Net of Tax)
0.9X = 180,000
X = 180,000/0.9
X = 200,000
b) To record the journal entries for the technical service rendered.
P/R Debit Credit
Technical Service Expense…………………… 200,000
Technical Service Income Tax Payable 20,000
Cash ………………………………….......... 180,000
(To record the payment for the technical service rendered)
Technical Service Income Tax Payable ….…… 20,000
Cash …………………………………………………… 20,000
(To record the payment of the tax withheld to the tax authority)
 3. Income from Games of Chance (Article57, Pro. No.,
979/2016 )
2255

❑ Include income derived from winning at games of chance.

 subject to tax at the rate of 15%.

 National Lottery Authority (NLA) shall withhold and pay the

amount to tax Authority
 shall be paid within two months from the end of the Ethiopian
Fiscal year.
Note:
 up to Br 1,000 is exempted.

 if in-kind, based on market price.

 if the NLA authorizes other persons to carryout the games of

chance, the NLA shall collect a charge of 15% from the
intended total income
 Income from Games of Chance
2256

Example
❑Ato Bedlu has won a lottery prize of Br 5,000,000
from the National Lottery Administration. W/ro
Edlawit has also won an automobile which was
offered by Glorious PLC to its customers in a game
basis. NLA determined the price of the automobile
Br 1,200, 000.
Required
 How much tax on such games of chance the NLA
withholds and pays to the Tax Authority?
2257

 Ato Bedlu
 Lottery prize(expense) ………5,000,000
 Income from Games of Chance Payable …..750,000
 Cash ……………………………….……4250,000

 Promotional expense……1,200,000
 Income from Games of Chance Payable …..180,000
 Cash ……………………………..………1,102,000
 4. Dividend Income (Article55, Pro. No.,
2258
979/2016 )
 Include income received in the form of dividend from a share
company, or withdrawals of profits from a PLC.
 Subject to tax at the rate of 10%.
 The final tax.
 The payer (the company) is the withholding agent.
 The tax shall be paid within 15 days starting the end of the month.
Example
❑ Ato Bedru is a shareholder at Dashen Bank S.C. He owned 100,000
shares of Br 1, 000 par value common shares in the bank. Dashen
Bank declared dividend of Br 3.6 per share for the current year.
Required
How much is the tax to be withheld from Ato Bedru?
2259

 At declaration data
 Retaining earning ……..XXX
 Dividend Payable ….XXX
 Dividend payable …….360,000
 Dividend income withholding Payable .36000
 Cash ……………………………324,000

 3.6*100000 = 360000
 5. Income from Casual Rental of Property (Article58,
Pro. No., 979/2016 )
2260

❑ Includes income derived from

❑ casual rental of property
❑ not engaged in a regular activity of a business.
❑ Any rental of an ongoing business’s property
❑ is regarded as a business transaction, and
❑ is regarded as a business income.
❑ The tax is 15% of the annual gross income is final.
 Income from Rental of Property
2261

Example
❑ On Tikimt 1, 2014 Ato Alemu let out his
automobile for 9 months to Solomon Tour and
Travel for a fee of Br 81,000.
Required:
◼ How much is the tax to be paid to the Tax
Authority ?
◼ Who is liable to pay the tax to the Tax Authority?
2262

 Solomon tour
 Rental expense …….81,000
 Withholding Tax payable…..12150
 Cash ………..…………….. 68850

 The owners of the property is liable to pay tax

 6. Interest Income on Deposit (Article56, Pro.
No., 979/2016 )
2263

 Include income derived on deposits.

❑ Subject to tax at the rate of 5%.

❑ the final tax.

❑ the bank is the withholding agent.

❑ The bank shall withhold the tax on interest income on accrual basis
and transfer it to the tax authority within two months from the end
of the Ethiopian Fiscal year.
Example
 On March 1, 2013, Mary Company deposited Br.500, 000 at
Dashen Bank for three months, at the prevailing interest rate of 7%
annual interest.
Required
◼ How much is the tax to be paid to the Tax Authority?
2264

 Interest Expense……8800.63
 Withholding interest payable ……440.0315
 Cash ……………………………8360.5985

 0.07/12 = 0.0058333

 FV= PV(1+i)^n = 500000(1+0.005833)^3= 508800.633

 Interest = 508800.633 -500,000= 8800.63

 7. Capital Gain Tax (Article 37)
2265

❑ Capital Gain obtained from the transfer of certain investment

property.
❑ The rates are:
 Class “A” taxable asset: buildings held for business, factory,
and office: 15%
 Class “B” taxable asset: shares Bonds of companies: 30%

❑ Exempted Capital Gain

❑ Gains from the transfer of building which has been fully used for
residence at least for two years prior to the date of transfer.
❑ Gains from transfer of building not found in Urban (Municipality)
areas.
 Capital Gain Tax (Cont'd…)
2266

❑ Loss on transfer of capital asset can be offset only

against gain on transfer of another capital asset of
similar nature.
❑ Loss on transfer of capital asset not yet offset can
be carried forward for indefinite period of time.
❑ Loss on transfer of capital assets between related
persons can’t be recognized.
 Calculating Capital Gain
2267

❑ When calculating the gain realized from the disposal of capital

assets,
 the basis of calculation of the tax shall be the historical cost of
the building or the par value of the share, as appropriate.
 inflation adjustment at a rate determined by the appropriate
authority shall be allowed as deduction
 In respect of buildings, taxes paid for the land and the building
shall be allowed as deduction.
❑ The cost registered with the appropriate government body at the
time of issuance of permit for the construction of the building shall
be taken to the cost of constructing the building.
 Computation of Capital Gain Tax
2268

a) Computation of capital Gain and Taxable Capital Gain on Building Transfer

Transfer Value of the building XXXXX
Less: Allowable Deduction
Historical cost of the building XXXX
Inflation adjustment on historical cost of the building XXXX
Taxes paid for the land on which the building is constructed XXXX
Taxes paid for the building XXXX
Other expenses in connection with transfer XXXX
Total allowable costs and expenses XXXX
Capital gain (loss) on building transfer XXXX
Less: Prior capital loss on transfer of buildings not offset (XXXX)
Taxable Capital gain on the transfer of the building XXXX
Capital Gain Tax on the transfer of the building (15% of TCG) XXXX
 Computation of Capital Gain Tax
2269

b) Computation of capital Gain and Taxable Capital Gain on Share Transfer

Transfer Value of shares XXXXX
Less: Allowable Deduction
Par value of the shares XXXX
Inflation adjustment on Par value of the shares XXXX
Other expenses in connection with transfer XXXX
Total allowable costs and expenses XXXX
Capital gain (loss) on share transfer XXXX
Less: Prior capital loss on transfer of shares not offset (XXXX)
Taxable Capital gain on the transfer of shares XXXX
Capital Gain Tax on the transfer of share(30% of TCG) XXXX
 Capital Gain Tax
2270

Example
❑ Consider the following information for Nile Share Company for the year 2006.
 In 2003, acquired 10,000 shares of Br 100 par for a total value of Br.1,250,000.
 in 2003, acquired two buildings with cost of Br.250,000 each. The buildings were
acquired for business purpose.
 During the year 2006, 500 shares were sold at a total value of Br.75,000. One
building which was acquired in 2003 was also sold at a consideration of
Br.370,000.
 Property tax paid for the building sold was Br.10,000.
 For the last three years, the average inflation rate declared by the NBE is 10%
for the three years period.
Required
Compute the Capital Gain tax for the year ended Sene 30, 2006.
 Solution
2271

a) Computation of capital Gain and Taxable Capital Gain on Building Transfer

Transfer Value of the building 370,000
Less: Allowable Deduction
Historical cost of the building 250,000
Inflation adjustment on historical cost of the building
25,000
(250,000*10%)
Property Taxes paid for the building 10,000
Other expenses in connection with transfer -
Total allowable costs and expenses 285,000
Capital gain (loss) on building transfer 85,000
Less: Prior capital loss on transfer of buildings not offset (-0-)
Taxable Capital gain on the transfer of the building 85,000
Capital Gain Tax on the transfer of the building (15% of TCG) 12,750
(15% of 85,000)
 Solution
2272

b) Computation of capital Gain and Taxable Capital Gain on Share Transfer

Transfer Value of shares 75,000
Less: Allowable Deduction
Par value of the shares (500shares@Br100 50,000
Inflation adjustment on Par value of the shares
(50000*10% ) 5,000
Other expenses in connection with transfer -0-
Total allowable costs and expenses 55,000
Capital gain (loss) on share transfer 20,000
Less: Prior capital loss on transfer of shares not offset (-0-)
Taxable Capital gain on the transfer of shares 20,000
Capital Gain Tax on the transfer of share(30% of TCG)
(30% of 20,000) 6,000
Example 2: Ato Jara sold his personal home at Birr
1,500,000 in 2012 E.C. The home was accomplished
with the cost of Birr 1000,000 in 2008 E.C.

Required: Determine the Capital Gain Tax assuming

that the person paid Br 20,000 Land and Building Tax

and the applicable Price Index is 1.25 in this regard.

2273
 Solution
2274

Computation of capital Gain and Taxable Capital Gain on Building Transfer

Transfer Value of the building 1,500,000
Less: Allowable Deduction
Historical cost of the building 1000,000
Inflation adjustment on historical cost of the building
250,000
(1000,000*25%)
Property Taxes paid for the building 20,000
Other expenses in connection with transfer -
Total allowable costs and expenses 1,270,000
Capital gain (loss) on building transfer 230,000
Less: Prior capital loss on transfer of buildings not offset (-0-)
Taxable Capital gain on the transfer of the building 230,000
Capital Gain Tax on the transfer of the building (0% of TCG) 0
(15% of 85,000)
 2275

3/6/2024
 Contents
2276

 Overview of Value Added Tax

 Components of Value Added Tax
 Basic Legal provisions of VAT in Ethiopia
 Accounting for VAT

3/6/2024
 Overview Value Added Tax
❑ VAT is tax on Value Added to goods and services by enterprise at each
stage of the production and distribution process.

❑ It arises whenever “Taxable person” makes supply of goods and

services in the course of his business.

❑ In some countries it is called “Good and Service Tax” or “GST”

❑ VAT was invented by a French Economist Maurice Laura in 1954.

❑ It is a gov’t tax w/c is charged at each stage of production.

❑ There are nearly 140 countries that use the VAT system, with the
average percentage being 15%.
The value added is the difference b/n:
✓ The receipts (from the sale) and

✓ Payments made to various factors of production (land, labor, capital and

organization)

Manufacturer or Trader is not liable to pay the tax on the entire value
of the commodity b/c the tax base for VAT is the Value Added.

VAT is ultimately borne by final consumer

In Canada, VAT is known as “Goods and Service tax” or GST;

In Japan it is known as "Consumption Tax".

It is a tax collected from someone other than the person who actually
pays the tax.
 Components of Value Added Tax
➢ There are two principal components of VAT:
✓ Output Tax
✓ Input Tax.
1.Output Tax:
❑ VAT collected on sale of taxable supplies (goods and services).
❑ It is the VAT collected on sales.

2.Input Tax:
✓ VAT paid on purchases of taxable G and S.

✓ VAT paid on purchases

❖ VAT Payable/ Liability = Output Tax >Input Tax

❖ VAT Refundable/Credit = Output Tax < Input Tax
VAT Exclusive & Inclusive Price & Determination of VAT

1. VAT Exclusive Price

❑ In this case, purchases & sales are made Exclusive of VAT.

❑When a VAT Return is prepared:

➢Output and Input Tax are determined by multiplying

Sales and Purchases Price by the existing VAT Rate.

VAT = VAT Exclusive Price @ VAT Rate

2. VAT Inclusive Price –
❖ In this case, purchases and sales are made inclusive of VAT.

❖When a VAT Return is prepared:

➢ Output and Input Tax is determined by multiplying sales and

purchases by the Ratio of VAT Rate to 1 Plus VAT Rate;

➢ Example: If VAT Rate is 15%, Sales and Purchases Price which

are VAT Inclusive are multiplied by 15/115 which is the same as
0.15/1.15)

❑ VAT = [VAT Inclusive Price] @ [VAT Rate / (1 + VAT Rate)]

 Legal Provisions on VAT in Ethiopia
2282

❑ According to Value Added Tax Proclamation No.

285/2002 and Value Added Tax Regulation No.
79/2002,
 VAT is
◼ payable on Taxable Supplies imported and made in
Ethiopia
◼ by a taxable person in the course of the taxable activity
during an accounting period.
 Taxable supply includes every transaction by a
registered person; every import of goods, other than
exempt imports, and an import of services.
 The Accounting Period is a Ethiopian calendar month.
 VAT Registration in Ethiopia
2283

I. Mandatory/Obligatory registration
 if the annual turnover/taxable transaction exceeds or
likely to exceed Br.1,000,000.
II. Voluntary Registration
 even if the annual turnover does not exceed Br.
1,000,000, a person can apply to be registered for VAT
if the person supplies more than 75% of its goods and
supplies to taxable persons.
Note:
 Input VAT is recovered for VAT registered persons only.

 The base for registration is the gross value/turnover of

taxable supplies
3/6/2024
 Benefits of Voluntary Registration

✓Input VAT can be recovered if a person is registered for

VAT.

✓It will be therefore, beneficial to voluntarily register where the

person makes mainly zero-rated supplies.

✓ In such case, Input VAT will be recovered and no VAT will

be charged on zero-rated output.

 Classification of Supplies for VAT
2285

A) Zero-Rated Supplies
 are supplies on which VAT on supply (output) is charged at
0%.
 are part of the VAT system
 the company supplying zero rated supplies must register for
VAT.
 the firm can claim the input tax credit.
Zero-Rated Supplies include:
 Export of goods and services
 The rendering of transportation or other services directly
connected with international transport of goods or passengers.
 The supply of Gold to NBE 3/6/2024
 B) Exempted Supplies
2286

 are supplies on which VAT is NOT chargeable, i.e. No output VAT.

 Input VAT can not be reclaimed from the government (i.e. no input
VAT credit). The input VAT is considered as part of the cost of the
purchase.
 The supplies are outside of the VAT system.
 Persons supplying only exempted supplies cannot register for VAT.
Exempted Supplies Includes
 Basic Food Items: agricultural crops, teff, wheat, maize, barley, rice,
milk, flour, bread, enjera, etc.
 Rendering of educational services, health services, financial services,
religious services,
 Import or supply of prescription drugs
 The supply of electricity, water (not bottled in a factory), and kerosene
 The provision of transport services (road, water, air, or railway)
3/6/2024
 B) Exempted Supplies (Cont’d…)
2287

 Supply or import of books and printed materials

 Import of gold to be transferred to the NBE
 Sale or transfer of a used dwelling (at least for 2 years)
 Supply or import of securities and currency
 Supply of postal services
 Supply or import of goods or services for humanitarian aid or
rehabilitation
 Supply of goods or services by an organization employing
more than 60% of disabled persons.
 Fees for permits and licenses

3/6/2024
 C. Standard Rated Supplies
2288

 Standard Rated Supplies: are those on which VAT is

charged at a standard (15%) rate.
Imposing VAT
❑ VAT is levied on:
 Every taxable transaction by a registered person; and

 Every import of goods, other than an exempt import

 Imports of services by registered persons or legal persons.

❑ The value of a taxable import is,

 CIF plus the sum of duties and taxes (Custom Duty and Excise Tax)
payable upon the import, excluding VAT and income tax withholding.
❑ The rendering of services incidental to an import of goods is part of the
import of goods. 3/6/2024
 Example 1
2289

❑Tabor Ceramics Share Company made taxable purchases of

Birr 230,000 and taxable import of Birr 138,000. It also made
taxable sales of Birr 345,000.
Required
 Determine the VAT Liability or VAT Refund assuming that the prices are
VAT inclusive and the VAT rate is 15%.

3/6/2024
 Solution
2290

Output VAT (345,000 * 15%/115%) …… 45,000.00

Input VAT (368,000 * 15%/115%) …….. 48,000.00
VAT Refund / Credit ……………………. 3,000.00

3/6/2024
 Example 2
2291

 Kombolcha Textile Factory Share Company made taxable sales of Birr

80,000 during the month of June 2006. It also made taxable
purchases of Birr 50,000 and imported Birr 10,000 during the same
month.
Required:
◼Determine the VAT Liability or VAT Refund assuming all the
prices are VAT Exclusive and the VAT Rate is 15%

3/6/2024
 Solution
2292

Output VAT (80,000 * 15%)……………. 12,000.00

Input VAT (60,000 * 15%) ………..…….. 9,000.00
VAT Liability ………………………..……. 3,000.00

3/6/2024
 Input Tax Credit
2293

❑ What is Input VAT credit/Tax Credit?

❑ is the amount of Input VAT that is creditable (Recoverable or Reclaimable) by
a registered person (Taxable Person) on input or import
Conditions for obtaining Input VAT Credit
1. Making of only Taxable Supplies
 For a supply/import received to make taxable transactions, the full amount
of tax paid on them shall be allowed as a credit
 Vat paid on vehicle it have >8 passenger for business purpose
 Telephone, office equipment, payment for attorney , consultancy and
accountant for business purpose
 Vat paid Organization cost before gating license, but max 6 month before
gating license

Note : Vat paid on entertainment , Maintenance expense not credited unless

the company many activity related on it, If taxable supplies transfer as gift
for employees other parity can not be credited
 Input Tax Credit
2294

❑ 2. Making of both Taxable & Exempt Supplies

 For a supply/import received for the making of taxable and
exempt outputs, the rules of apportionment of the credit shall
be as follows:
Credit (I) = A x (B/C)
A = Total input VAT;
B = Taxable Supplies made during the period;
C = Total Supplies (Taxable and Exempt) made during the
period
N.B. If the result of B/C in the formula exceeds 90%, the full
amount of the VAT paid/payable during the accounting
period (A) shall be allowed as a credit.
3/6/2024
 Example
2295

 Alpha company is a registered person that supplies both taxable and exempt supplies. The
following belongs to the company for the VAT accounting period ended on Tikimt 30, 2006.
▪ Standard rated supplies ………………………..Br 500,000
▪ Zero rated supplies………………………….…..Br 200,000
▪ Exempt supplies…………………………………. .Br 75,000
The amount of input tax paid/payable by the company during the VAT accounting period are
as follows:
 Input VAT attributable to standard rated supplies…………..Br 45,000
 Input VAT attributable to zero rated supplies……………….Br 18,000
 Input VAT attributable to exempt supplies……………….…Br 13,000
 Input VAT attributable to standard, zero rated, and exempt
supplies……………………………………………………...Br 22,000
Required
Determine total amount of input VAT that Alpha can claim

3/6/2024
 Solution
2296

 If the ratio of taxable to total supplies made during an accounting period exceeds 90%, the amount
of input tax attributable commonly to both taxable and exempt supplies are fully
creditable/reclaimable.
Credit (I) = A x (B/C)
A=Total input VAT;
B=Taxable Supplies made during the period;
C=Total Supplies (Taxable and Exempt) made during the period
= (B/C)
= 700,00/775,000
= 90.3%
 Accordingly, the amount of input VAT credit for the given VAT accounting period would be Br. 85,000
determined as follows

3/6/2024
 Solution
2297

Input VAT reclaimed on standard rated supplies ……... Br. 45,000

Input VAT reclaimed on Zero rated supplies ………….. 18,000
Input VAT reclaimed on exempt supplies ……………… ------
Input VAT reclaimed on taxable and exempt supplies ... 22,000
Total Input Tax Credit ………………………… 85,000

3/6/2024
 VAT Refund
2298

❑ If at least 25% of the value of a registered person's

taxable transactions is taxed at a zero rate, the tax
authority shall refund the amount of VAT
❑ For other registered persons, if the amount of VAT applied
as a credit is in excess of the amount of VAT charged for
the accounting period, it is to be carried forward to the
next five accounting periods. (five months)
❑ Any unused credits (exceeding Br 50) shall be refunded by
the tax authority within a period of two months from the
date the refund of application is submitted to the tax
authority.
3/6/2024
 Accounting for VAT

❑ A tax accountant shall:

✓ Identify records to be kept for VAT purposes (Sales &
Purchases)

✓ Determine the VAT Liability

✓ Record VAT Related Transactions in the Books of Accounts

✓ Preparation of VAT Return

❑ Record Keeping

❑ A registered person or any other person liable for tax under VAT
proclamation:

➢ Shall maintain for 10 years in Ethiopia the following.

✓ Original tax invoices received by taxable person
✓ A copy of all tax invoices issued by taxable person
✓ Customs documentation relating to imports & exports by person
✓ Accounting records
✓ Any other records as may be prescribed by the ERCA and useful to
determine the VAT Liability
 Recording VAT Related Transactions
2301

l. Recording Purchases
 Credit the amount to be paid to the purchaser for the
purchase plus VAT.
 Purchases are charged exclusive of VAT.
 The VAT element is debited to the VAT Receivable Account
representing ERCA-VAT Department as a debtor
II. Recording Sales
 The sales are debited to Debtor or Cash Account for the amount
of the sales plus VAT
 The sales amount is credited to sales account exclusive of VAT

 The VAT element is credited to the VAT Payable Account

representing ERCA-VAT Department as a creditor
3/6/2024
 Value of Taxable Imports

The value of taxable imports for taxation is the CIF Value plus
customs duty and excise tax paid up on the import of the
goods in to Ethiopia, excluding VAT and Income Tax
Withholding.
 CD= CIF * CD rate
 Excise tax = (CIF+CD)* Excise rate
 VAT = (CIF+ CD+ Excise)* 15%
 Sur tax = (CIF + CD+ Excise+ VAT)* sur tax
 Withholding = CIF*3%
Example: Assume that Zemach PLC imported machinery with
a cost of Br. 24,000, insurance Br. 5,000 and freight cost
of Br. 11,000. The customs duty and excise tax are Br.
25,000 and 35,000, respectively.

Required: Determine the amount of:

a. Withholding tax paid at customs clearance

b. VAT paid at customs clearance

2304

 CIF= 24000+5000+11000 = 40,000

 Withholding tax = CIF*3% = 40,000*0.03= 1200

 Value for Vat determination = 40,000+25000+35000

 = 100,000
 VAT = 100,000*0.15= 15000
Inventory …………….100,000
Vat Receivable…….….15,000
Withholding Receivable..1200
Cash ………………..116,200
3/6/2024
 Recording VAT Transactions-Example
2305

❑ Lubanja PLC, a VAT registered merchandising

company, uses the perpetual inventory system.
Selected transactions for the month of Sene 2005 are
listed below.
 Sene 7: Purchased merchandises for cash from YBZ PLC for
Br 6,500, subject to VAT for 15%.
 Sene 14: Purchased merchandises on account from YBZ PLC
for a 15% VAT inclusive price of Br 18,400.
 Sene 20: Sold merchandise on account to United PLC at
VAT exclusive price of Br. 10,000 the VAT rate is 15%.

3/6/2024
 Recording VAT Transactions- Example
2306

 Sene 22: Sold merchandise for cash to United PLC at VAT

inclusive price of Br 23,000. The VAT rate is 15%.
 Sene 24: Sold zero rated merchandise on account to United
PLC for Br 25,000.
 Sene 26: Imported merchandises for the CIF value of
Br.81,500 (i.e., 60,000+7,500+14,000). The excise tax and
custom tariff paid for those merchandises were Br 61,125.
 Sene 28: Sold merchandise for cash to United PLC at a 15%
VAT inclusive price of Br 92,000.
Required
 Record the above transactions (Consider withholding taxes
also if applicable.) 3/6/2024
 Solution
2307

Date Description P/R Debit Credit

Sene 7 Inventory …………………………….. 6,500 00
VAT Receivable ………………………. 975 00
Cash …………………………… 7,475 00
Sene 14 Inventory …………………………....... 16,000 00
VAT Receivable ……………................... 2,400 00
Accounts Payable ……………… 18,400 00
Sene 20 Accounts Receivable ………………….. 11,500 00
VAT Payable ………....................... 1,500 00
Sales ………………..................... 10,000 00
Sene 22 Cash …………………………………. 23,000 00 00
VAT Payable …………………… 3,000 00
Sales ………………………….. 20,000 00
Sene 24 Accounts Receivable …………………. 25,000 00
Sales …………………………... 25,000 00
Sene 26 Inventory ……………………………... 142,625 00
VAT Receivable ……………………… 21,393 75
Cash ………………………….. 164,018 75
Sene 28 Cash ………………………………… 92,000 00
VAT Payable …………………… 12,000 00
Sales ………………………...... 3/6/2024 80,000 00
Preparation of VAT Return
 Preparation of VAT Return is compulsory.
 When filling of VAT Return, it should be accompanied by payment
of VAT.
 Every registered person is required:
✓ To file VAT return with the Authority for each accounting period, whether or
not tax is payable in respect of that period;
✓ To pay the tax for every accounting period by the deadline for filing the VAT
return.

 For the accounting period Meskerem, the VAT Return must be filed
till 30th of Tikmet.
2309
2310
Contents

 Introduction to Turnover Tax

 Basic legal provisions

 Accounting for TOT

 Introduction to Turnover Tax
❑Turnover Tax (TOT):
TOT is
 a tax imposed on goods supplied and services rendered
locally
 by persons not registered for VAT.
➢ Turnover refers to total revenue or Sales

➢ It is a tax imposed on almost all G & S on the total turnover rather

than on the Value Added.

➢ the turnover tax is generally charged at a lower rate than the

value added tax (VAT).
 Filing of Turnover Tax Return and Payment
❑Taxpayers subject to TOT shall Pay tax for every accounting
period.

❑The Accounting period for purposes of TOT shall mean:

✓ For Category "A" taxpayers but are not required to register for VAT,

the calendar month;

✓ For category "B" taxpayers, each three months period beginning

from the first day of the Ethiopian fiscal year (tax year);

✓ For Category "C" taxpayers, the fiscal year is the accounting period.
Legal Provisions on Turnover Tax
❑ According to Proclamation No. 308/2002
❑ Rate of Turnover Tax (Article 4)
❖ 2% on Goods Sold Locally
❖ For Services Rendered Locally;
◼ 2 % on Contractors, Grain mills, Tractors and Combine-
Harvesters.
◼ 10% on others; these include services such as Consultancy,
Training, Legal advice, Auditing, etc
❑ All items exempted from VAT are also exempted from
TOT.
❑ A person who sells G&S has the obligation to collect the TOT from
the buyer and transfer it to the Tax Authority.
❑ The taxpayer of TOT are sellers
 Exemptions (Article 7)
❑The following transaction of G &S shall be exempted
from Turnover Tax:
✓ Sale or transfer of a dwelling use for a minimum 2 years, or

lease of a dwelling
✓ Rendering of financial services

✓ Supply of National or Foreign Currency and of securities

✓ Rendering of services by religious organizations of religious or other

related services
✓ Supply of prescription drugs specified in directives issued

by the relevant gov’t agency, and rendering of medical

services;

✓ Rendering of educational services provided by educational

institutions, as well as child care services for children at

pre-school institutions:

✓ Supply of goods and rendering of services in form of

humanitarian aid.

✓ Supply of electricity, kerosene, and water

 ✓ The provision of transport;

✓ Permits and license fees;

✓ The supply of goods or services by a workshop employing

disabled individuals if more than 60% of the employees

are disabled; and

✓ The supply of books

❖Bread, Injera and Milk are exempted by the Ministry of

Finance and Economic Development.
 Accounting for Turnover Tax

1. Computation of TOT Liability

 The computation of turnover tax is straight forward.

 The Gross receipt is multiplied by the tax rate either 2% or 10% to

determine the TOT Liability.

 Sometimes the TOT may be included in the selling price.

 In such a case the TOT is computed by:

Turnover Tax Liability = Selling Price @ R / (100 + R)

Where: R= the Turnover Tax Rate.

TOT Examples
Example 1
 Addis Pharmacy Sold drugs for Birr 300,000 during June,
2006.
Required
 What is the Turnover Tax Liability on this transaction?

Example 2
 NICE Enterprise rendered grinding service (that converts grains

into flour) and charged customers Birr 25,908 during the

quarter ended on Sene 30, 2003.
Required
 Determine the Turnover Tax Payable on this Transaction
assuming that the price includes the TOT amount.
 Solution
2320

 Example 1
◼ Since
the specific mentioned supplies (drugs) are exempted from tax, the
company is not liable for Turnover Tax Liability
 Example 2
TOT Liability = Taxable Supplies (TOT Inclusive)*2%
TOT Liability = 25,908*(2%/102%)
TOT Liability = 508
Examples- cont’d
Example 3
❑ A Category “B” Taxpayer Named NUFTANA Furniture PLC made
the following transactions during Tikimt, Hidar and Tihisas 2006:
 Tikimt 2006: Birr 32,000 tables, chairs and beds were sold

 Hidar 2006: Birr 27,000 Sofa, Computer Desk, and Tables were
sold
 Tihisas 2006: Birr 30,000 Office Furniture was sold

 Tihisas 2006 provide training for young Ethiopian by charging

Birr 35000 its including TOT
Required
 Prepare entries for each of the above transactions and the
payment of the total TOT to the taxing authority.
 Solution
2322

Date Description P/R Debit Credit

2006
Tikemt Cash ………………………………… 32,640
Sales ………………………… 32,000
TOT Payable ………………….. 640

Hidar Cash …………………………………. 27,540

Sales …………………………… 27,000
TOT Payable …………………... 540

Tihasas Cash …………………………………. 30,600

Sales …………………………… 30,000
TOT Payable …………………... 600
Cash ……………35000
sale …………….31818.18
TOT Payable ……318181
 2323

3/6/2024
 Contents
2324

 Introduction to Excise Tax

 Basic Legal Provisions of Excise Tax

 Accounting for Excise Tax

3/6/2024
 Introduction to Excise Tax
2325

❑ Excise Tax is a tax imposed on

❑ luxury goods,
❑ hazardous goods, and
❑ basic goods which are demand inelastic.
❑ Excise taxes are also called selective sales taxes.

❑ Why excise tax is levied?

▫ To improve government revenue.
▫ To reduce the consumption of goods that are hazardous to
health and which cause social problems

3/6/2024
2326

 Excise taxes are applied either:

✓ on a Per Unit Basis, such as:

▪ Per package of cigarettes or

▪ Per litter or

▪ Gallon of gasoline OR

✓ A fixed percentage of the sales price.

3/6/2024
❑ Every taxpayer shall:

✓ Maintain books of accounts and supporting documents

✓ Submit every 30 Days to the Tax Authority,

✓ Comply fully with requirements of the inspection of his

premises by the delegate of the Tax Authority

✓ Immediately communicate to the Tax Authority, the type and

address as well as the commencement and termination date
of his business if any;
 Legal Provisions
2328

❑ Excise Tax Rates

 vary from goods to goods
 10%-500%
 in schedule “E” of Excise Tax Proc. No.
1186/2020.
❑ Taxpayer of Excise Tax

 Importers
 Producers

3/6/2024
 Legal Provisions
2329

❑ Time of Payment of Excise Tax

 For Imported Goods: at the time of clearing the
goods from Custom Authority.
 For Goods Produced Locally: within one month
from the date of production.
❑ The Excise Tax shall be paid
 In line with goods produced locally, by the
producer; or
 In line with goods imported, by the importer
3/6/2024
2330

3/6/2024
 The basis of computation of Excise Tax
2331

3/6/2024
 Computation of Excise Tax for
Locally Produced Goods
2332

Computation of Excise Tax Payable

ex-factory selling price xxxxx
Tax Rate from Schedule “E” xx%
Excise Tax Payable xxxxx

Computation of Excise Tax for Imported Goods

Excise Tax Payable =
C.I.F +CD @ the Tax Rate in
Schedule “E”
3/6/2024
 Input tax credit
2333

Note: if the product damage due to natural or human, when transported from factor
to distributary and customer paid excise tax can be credited
3/6/2024
 Exercise
2334

❑ Assume Sirara General Trading PLC imported

Br 12,000,000.00 Chewing gum from China.
Br 480,000.00 Freight cost and Br
120,000.00 Insurance cost were incurred in
respect of the goods imported.
Required:
 Determine the Excise Tax Base and Excise
Tax Liability

3/6/2024
 Solution
2335

Excise Tax Payable

= C.I.F @ the Tax Rate in Schedule “E”
= (12,000,000+120,000+480,000) @ 10%

Computation of Excise Tax Payable for Imported Goods

Cost 12,000,000
Insurance 120,000
Freight 480,000
Tax Base for Excise Tax 12,600,000
Tax Rate from Schedule “E” 10%
Excise Tax Payable 1,260,000

3/6/2024
 2336

Foreign Trade Taxes

3/6/2024
2337
Foreign Trade Taxes
❑ Government levies five kinds of taxes on import items.
❑ These taxes
❑ are assigned on priority levels and
❑ are calculated in a sequential order.
❑ These taxes, in their sequential order, are
1. Customs Duty,
2. Excise Tax,
3. VAT,
4. Surtax and
5. Withholding Tax.
❑ Taxes on imported goods are collected by the Ethiopian
Revenues and Customs Authority (ERCA). 3/6/2024
 1. Custom Duty
2338 ❑ Customs Duty is tax imposed on imported or exported
goods.
❑ ERCA
❑ collects customs duty only on import items
❑ as no tax on export is levied except on export of certain hides and
skins of animals which is 150%. (To increase domestic leather
products such as Shoes, Purses, ready made garment, etc)
❑ Customs Duty has 6 bands or groups of rates which are
applied to imported goods.
❑ These bands of rates are 0%, 5%, 10% 20%, 30% and
35%.
❑ The base of custom duty is CIF value

3/6/2024
 2. Excise Tax
2339
❑ Excise Tax is levied
❖ whenever excisable goods are imported into the country
or
❖ whenever they are locally produced.
❑ The base of excise tax on imported goods is Cost
+ Insurance + Freight + Customs Duty
❑ Excise Tax is levied on selected goods like luxury
goods and basic goods which are demand in
elastic.(No change in quantity demanded when price
goes up or down)

3/6/2024
2340
3. VAT
❑ VAT is levied
❑ on every imported item
❑ unless exempted by the appropriate law or directive,

❑ The base of computing VAT on imported items is

CIF + Custom + Excise Tax

3/6/2024
2341
4. Sur Tax
❑ Sur Tax is
❑ a tax imposed
❑ to carry out a specific purpose by the government.
❑ In Ethiopia, for example, Sur Tax was declared to
be imposed on imports (since April 9, 2009) in
order
➢ to build the financial capacity of the government for
interventions
➢ to solve the rise in the cost of living which is affecting
consumers with low and medium income level.

3/6/2024
2342
4. Sur Tax
❑ Surtax rate is 10%.
❑ The base for surtax is
CIF + Custom + Excise Tax + VAT
of all goods imported into the country.
❑ Items exempted from Surtax:
➢ Fertilizer,
➢ Petroleum and lubricants,
➢ Motor vehicles for freight and passenger and other special purpose
motor vehicles,
➢ Air craft, spacecraft, and part there of ,
➢ Capital (investment) goods and
➢ some medicines, raw materials and other goods which are already
decided by law to be tax free.
3/6/2024
 5. Withholding Tax
2343
❑ Is imposed on the import of goods for
commercial use.
❑ The amount collected on imported goods
shall be 3 % of the sum of cost, insurance
and freight (CIF value).

3/6/2024
 Exempted Parties from WHT
2344
❑ Federal and regional government offices
❑ Nonprofit and nongovernmental organizations and
associations,
❑ Privileged individuals to import their personal
effects free of duty pursuant to the directive issued
by Ministry of Ethiopian Revenue
❑ Individuals and organizations allowed to import
duty-free items pursuant to category two of the
customs tariff. (E.g. Those importing palm oil)
❑ Individuals and organizations who are exempted
from income tax by federal and regional
investment authority.
3/6/2024
 Exempted Parties from WHT
2345 ❑ Raw materials and capital inputs like spare parts
used by individuals and organizations licensed to
engage in the activities of production.
❑ capital goods imported into the country for the
establishment or development of industry or power
generation or transportation facilities.
❑ gift items, advertising items, sample of goods,
❑ individuals and organization engaged in the
activities of mining and petroleum for they are
governed pursuant to a special tax law.

3/6/2024
 ❑Thank You for Your Attention !
2346

Question or Comment ?

The End
150) Which of the following is FALSE about public finance?
A. Public finance deals with the wants and the satisfaction of households
and firms.

B. Public finance is the study of income and the expenditure of the

government.

C. Fiscal operations and fiscal policies are integral part of public finance.

D. Public finance aims at maximizing social welfare or social benefit by

efficient use of public goods A
151) Public finance has to do with all of the following activities
of the government except
A. Stabilization activities
B. Allocation activities
C. Competition with private sector
C
D. Distribution activities
152) All of the following are characteristics of tax except:

A. Certain taxes are imposed to achieve specific objectives such as

reducing consumption of luxurious goods

B. tax is a legal collection that can be levied only by the federal

government not by any one else including regional government.

C. Tax is a compulsory contribution by the taxpayers to the

government.

D. For the payment of tax, there is no direct return to the taxpayers.

B
153) Aster is an employee in one of the government organization in Ethiopia. Her
monthly salary is Birr 4,000. During Tir 2015 she worked on Public holiday for 10
hours. She has a position allowance of Birr 1000.
Aster is a member of the saving and credit association of the organization in which
she works and decided to save 10% of her salary. She is expected to work 160
hours per month and she worked accordingly.
What is the amount of overtime related to Aster's payment?
Over time = Bs/Nwh * Rate * Hour
A. Birr 950 = 4000/160 * 2.5 * 10 = 625
D GE= 4000+1000+625 = 5625
B. Birr 781.25 Tax = 5625* 0.25 – 565 = 841.5
Pc= 4000*0.07= 280
C. Birr 500 Other Deduction = 4000*0.1= 400
Total deduction = 841.5+280+400= 1521.5
D. Birr 625
Net pay = 5625 - 1521.5 = 4103.5
154) Abebu is an employee in one of the factory owned by the
government in Ethiopia. Her monthly salary is Birr 2,600.
She has taxable allowance of Birr 300 and a non-taxable
allowance of Birr 200. She earned an overtime of Birr 100
What is the amount of tax deducted from Abebu's earning?

A. Birr 307.50 GE = 2600+300+200+100 = 3200

B. Birr 247.50 A
Taxable income = GE – non taxable income
= 3200- 200 = 3000

0 – 600 0 0
C. Birr 277.50 600 -1650 0.1 60
1650-3200 0.15 142.5

D. Birr 300 (3000*0.15) – 142.5 = 307.5

155) Which of the following is not the role played by National Bank
of Ethiopia in the Ethiopian financial system?

A. National Bank of Ethiopia provide insurance to help ensure the

soundness of financial intermediaries
B. Regular on-site examinations to monitor whether the institution is
complying with capital requirements and restrictions on asset holdings
C. Prints money
D. National Bank of Ethiopia restrict those who can set up a financial
intermediary
A
155) Which of the following is not a revenue source for the
Regional Governments of Ethiopia

A. Profit and sales tax collected from individual traders.

B. Taxes collected on income from air, train and marine

transport activities.

C. Rural land use fee. B

D. Tax on income from inland water transportation.

156) Which of the following is not a legal requirement on Category 'B'
tax payers:

A. Use registered vouchers

B. Submit the Tax Declaration Form to the tax authority within 2

months from the end of the fair year

C. Submit Balance sheet and a profit & loss statement

D. Maintain accounting records

C
157) Among the following, which one is a tax

deductible expense in the Ethiopian tax system

A. Insurance Expenses.
B. Damages covered by insurance policy or a contract
of indemnity, guarantee, or surety.
C. Depreciation expense on Buildings computed in line
with IFRS using the units of production method.
D. An expenditure of a capital nature.
A
158) Assume that the sales revenue of ABC Share Company is Birr 10,000,000 during Tax Year ended
Sene 30, 2014.
Cost of goods sold was Birr 4,000,000 (determined on the basis of the average cost method) and
expenses were Birr 1,000,000.
The operating expenses comprises of salary expense of Birr 270,000, store rent expense of Birr 100,000,
a 5% depreciation expense on a not fully depreciated Building with a cost of Birr 4,000,000, a penalty of
Birr 40,000, an interest expense of Birr 190,000 on Birr 1,000,000 principal amount of loan where the
interest rate between National Bank of Ethiopia and Commercial Banks was 10% and a donation of Birr
200,000 to help its sister Company recover from the fire damage on its working infrastructures.
What is the amount of business tax liability of the Share Company?
A. Birr 1,629,000 Sale ------------------10,000,000 Sale ------------------10,000,000
CGS---------------------4,000,000 CGS---------------------4,000,000
B. Birr 1,593,000 GP-----------------------6,000,000 GP-----------------------6,000,000
Operating expense Operating expense 1,000,000
C Birr 1,500,000 Salary expense ………270000 NI------------------------5,000,000
Rent expense ………..100,000 +Penalty -----------------40,000
D. Birr 1,533,000 Dep Exp -----------.-200,000 +Interest -----------------70000
Interest expense –120000 (0.12*1M) +Donation ……………….200000
B NI = …………………………………….5,310,000
Tax---(5,310,000 *0.3) ……………..1,593,000
TBI--------------------------5,310,000
Tax 5,310,000 *0.3) ----1593000
159) Assume that the sales revenue of ABC Share Company is Birr 12,000,000 during Tax Year ended Sene 30,
2014.

Cost of goods sold (determined on the basis of the average cost method) and Expenses were Birr 5,000,000 and
Birr 800,000, respectively.

The operating expenses comprises of store rent expense of Birr 400,000, a 5% depreciation expense on a not
fully depreciated Building with a cost of Birr 2,000,000, a penalty of Birr 50,000, and a donation of Birr 250,000
to the government of FDRE as a contribution to the 'Gebeta Lelimat Project.

What is the amount of taxable business profit to be presented on the tax return?

Sale ------------------12,000,000
CGS---------------------5,000,000
A. Birr 6,500,000 GP-----------------------7,000,000
Operating expense
B. Birr 6,600,000 Rent expense ………..400,000
Dep Exp -----------.-100,000
C. Bir 6,200,000 Donation ……………250,000
D. Bin 6,250,000
NI = …………………………………….6,250,000
D
160) All of the following are advantages of indirect tax over direct tax
except:
A. In the case of indirect tax, the tax burden is distributed on different
sections of the society in a just and equitable manner.
B. Tax evasion is relatively difficult in the case of indirect tax as taxes are
included in the prices of commodities
C. Indirect tax has wider scope than direct tax.
D. Indirect taxes are more convenient to the taxpayers than direct tax.

A
161) Good are purchased at VAT inclusive price of
Birr 180,150.
• The amount of input VAT on this transaction
• A. Birr 23,497.47
• B. Birr 27,022.50
• C. Birr 21,750.00
VAT =
• D. Birr 20,837.50 [VAT Inclusive Price] @ [VAT Rate / (1 + VAT Rate)]
= 180150* 0.15/1.15
= 23497.47
A
• The C.I.F value of the good is imported 15,000
• The excise tax rate for these goods is 10%
• Custom Tariff is 25% and Withholding tax rate is 3%
• 162) The value of imported goods for the determination of VAT is
• A. Birr 20,700 CD= CIF * CD rate = 15000*0.25= 3750
• B. Birr 20,625 Excise tax = (CIF+CD)* Excise rate = (3750+15000)*0.1=1875
B Value for determination of vat
• C. Birr 16,500 = (CIF+ CD+ Excise) = 3750+1875+15000= 20625
• D. Birr 15,000 Withholding = CIF*3% = 15000*0.03 = 450
• 163. The amount paid (Input Tax) at customs station at the time of custom clearance is
• A. Birr 3,105.00 Value for determination of vat
• B. Birr 3,093.75 B = (CIF+ CD+ Excise) =
• C. Birr 2,475.00 3750+1875+15000= 20625
• D. Birr 2,250.00
VAT = 20625*0.15= 3093.75
 Chapter I
An Overview
of the Financial System
The Financial System
 Financial System: is a set of Financial Instruments,
Financial Markets, Financial institutions, and Regulatory and
supervisory bodies established to facilitate the flow of funds
from savers to investors.

 A financial system is a system that allows the exchange of

funds between financial market participants such as lenders,
investors, and borrowers.

2363
The Financial System…
 Financial development is linked to economic growth.

 The role of the financial system is to facilitate

production, employment, and consumption.

 A financial system encourages savings, provides funds

for investment and facilitates transactions for goods
and services.

 The Resources are funneled through the system so

resources flow to their most efficient uses.

2364
 The Financial System

2365
Functions of the Financial System
 Saving function
 Public savings allow individuals and businesses to
invest in a range of investments and see them grow
over time.

 Financial claims are issued in the financial markets

which promise future income flows.

 The funds with the producers result in production of

goods and services thereby increasing society living
standards.
Functions of the Financial System (cont.)
 Liquidity function
 Liquidity is the ability to sell an asset within
reasonable time at current market prices and for
reasonable transaction costs

 The financial markets provide the investor with the

opportunity to liquidate investments like stocks,
bonds, debentures, etc whenever they need the
fund.
Functions of the Financial System (cont.)
 Payment function
 The financial system offers a very convenient
mode for payment of goods and services.
 Check system, credit card system, Electronic fund
transfer, ATM etc are the easiest methods of
payments.
 The cost and time of transactions are drastically
reduced.
Functions of the Financial System (cont.)
 Risk Management function
 The financial system provide protection against life,
health and income risks. These are accomplished
through the sale of life and health insurance and
property insurance policies.

 The financial markets provide immense opportunities

for the investor to hedge himself against or reduce
the possible risks involved in various investments.

2370
Functions of the Financial System (cont.)
 Policy function
 The government intervenes in the financial system
to stabilize the economy through influencing
macroeconomic variables like interest rates,
inflation and unemployment.

 If country needs more money government would

cut rate of interest through various financial
instruments and if inflation is high and too much
money is there in the system then government
would increase rate of interest.
2371
Components of the Financial System
1. Financial Instruments (also called financial
securities, claims or assets) are claims over a
borrowers’ future income or assets. Eg. Loans, deposits,
bonds, stocks,etc)
2. Financial Markets: are markets in which financial
instruments are traded.
3. Financial Institutions (or Financial Intermediaries):
are institutions that borrow funds from people who have
saved and in turn make loans to people who need funds.
Eg. Banks, Insurance Companies, etc.

2372
 Financial Instruments (Assets)
 Are claims by lenders against income or wealth of
borrowers, represented usually by a certificate.
 Financial instruments: are issued by a party raising funds,
acknowledging a financial commitment and entitling the holder
to specified future cash flows. E.g., stocks, bonds, insurance
policies, bank loans, notes etc.
 Financial instruments specify payment will be made at
some future date.

 Financial instruments specify certain conditions under

which a payment will be made.
2373
Functions of Financial Instruments
I. Financial instruments act as a means of payment (like money).
 Employees take stock options as payment for working.
II. Financial instruments act as stores of value (like money).
 Financial instruments generate increases in wealth that are
larger than from holding money.
 Financial instruments can be used to transfer purchasing power
into the future.
III. Financial instruments allow for the transfer of risk (unlike money).
 Futures and insurance contracts allow one person to transfer
risk to another.

2374
 Characteristics of Financial Securities
 do not provide physical services to owners, instead
provide a stream of (expected) CFs
 do not depreciate unlike physical goods,
 their physical condition or form is usually not relevant
in determining their market value.
 Their cost of transportation and storage is low, such
that they have little or no value as a commodity.
 Financial assets are fungible – they can easily be changed
in form and substituted for other assets.

2375
Fundamentals Classes of Financial
Instruments
1. Underlying instruments: are used by savers/lenders to
transfer resources directly to investors/borrowers.
▪ This improves the efficient allocation of resources.
▪ Examples: stocks and bonds.
2. Derivativeinstruments: are those where their value
and payoffs are “derived” from the behavior of the
underlying instruments.
▪ Examples: are futures and options.
▪ The primary use is to shift risk among investors.

3-2376
Securities used as store of value
1. Bank loans
 Borrower obtains resources from a
lender to be repaid in the future.
2. Bonds
 A form of a loan issued by a
corporation or government.
 Can be bought and sold in financial
markets.

3-2377
Securities as store of value
3. Home mortgages
 Home buyers usually need to borrow using the home
as collateral for the loan.
 A specific asset the borrower pledges to protect the
lender’s interests.
4. Stocks
 The holder owns a small piece of the firm and
entitled to part of its profits.
 Firms sell stocks to raise money.
 Primarily used as a stores of wealth.
3-2378
Securities used to transfer risk
1. Insurance contracts.
 Primary purpose is to assure that payments will
be made under particular, and often rare,
circumstances.
2. Futures contracts.
 An agreement between two parties to exchange
a fixed quantity of a commodity or an asset at a
fixed price on a set future date.
 A price is always specified.
 This is a type of derivative instrument.

3-2379
Securities used to transfer risk
3. Options

 Derivative instruments whose prices are based on

the value of an underlying asset.

 Give the holder the right, not obligation, to buy or

sell a fixed quantity of the asset at a pre-determined
price on either a specific date or at any time during a
specified period.

 These offer an opportunity to store value and

trade risk in almost any way one would like.
3-2380
 Financial Markets
 Financial markets are places or networks where financial
instruments are bought and sold.
 These markets are the economy’s central nervous system.
 These markets enable both firms and individuals to find
financing for their activities.
 These markets promote economic efficiency:
 They ensure resources are available to those who put them
to their best use.
 They keep transactions costs low.

2382
The Role of Financial Markets
1. Liquidity:
 Ensure owners can buy and sell financial
instruments quickly at low transaction costs.
2. Information:
 Pool and communicate information about issuers
of financial instruments, summarizing it in the
form of a price.
3. Risk sharing:
 Provide individuals a place to buy and sell risk.

2383
 Financial Markets

 Classification by nature  Classification by

of claim: immediate delivery or
 Debt market future delivery:
 Equity market  Cash (spot) market
 Classification by  Derivatives market
maturity of claim:  Classification by
 Money market organizational structure:
 Capital market  Exchange market
 Classification by  Over-the-counter market
seasoning of claim:
 Primary market
 Secondary market
1-2384
Financial Market Participants

 Brokers and dealers

 Households
 Business firms
 Federal, state, and local
governments & their agencies
 Regulators
Characteristics of a Well-Run
Financial Market
 Must be designed to keep transaction costs low.

 Information the market pools and communicates

must be accurate and widely available.

 Borrowers promises to pay lenders must be

credible.

 Lenders must be able to enforce their right of

repayment quickly and at low cost.

3-2391 © 2017 McGraw-Hill Education. All Rights Reserved.

Lending and Borrowing in the Financial System
 Business firms, households and governments play a
wide variety of roles in modern financial system.

 It is quite common for an individual/institution to be a

lender of funds in one period and a borrower in the
other, or to do both simultaneously

 Indeed financial intermediaries, such as banks and

insurance agencies operate on both sides of the
financial market; borrowing funds from customers by
issuing attractive financial claims and simultaneously
making loan available to other customers
2392
Lending and Borrowing in the Financial System
 Economists John Gurley and Edward Shaw (1960) pointed out
that each business firm, household, or unit of government
active in the financial system must conform to:
R – E = FA – D
where R = Current income receipts
E = Current expenditures
FA = Change in holdings of financial assets
D = Change in debt and equity outstanding
Lending and Borrowing in the Financial System
 If current expenditure (E) exceeds current
income receipts (R), the difference will be
made up by:
 Reducing our holdings of financial assets (-ΔFA), for
example by drawing money out of a saving account
 Issuing debt or stock (+ΔD) or
 Using some combination of both

2394
Lending and Borrowing in the Financial System
 On the other hand, if current income receipts (R) in
the current period are larger than current
expenditure (E),
 Build up our holdings of financial assets (+ΔFA) for example,
by placing money in a saving account or buying a few shares
of stock
 Pay off some outstanding debt or retire stock previously
issued by the business firm (-ΔD) or
 Do some combination of both of these steps

2395
Lending and Borrowing in the Financial System
 So, for any given period of time, the individual economic
unit falls into one of three groups:
 Deficit-budget unit (DBU): E > R, D > FA
i.e. net borrower of funds
 Surplus-budget unit (SBU): R > E, FA > D
i.e. net lender of funds
 Balanced-budget unit (BBU): R = E, D = FA
i.e. neither net lender nor net borrower
 Information Asymmetries & Information Costs
❖Information is a central element to efficient markets.
❖When the costs of obtaining information are too high, some
potentially beneficial transactions do not take place and markets
tend to stall.
❖In most all transactions, the issuer of a financial instruments,
borrowers, know some information which the buyer, saver, does
not know.This is a situation know as asymmetric information.
• Asymmetric information in a market for goods, services, or assets
refers to differences ("asymmetries") between the information
available to buyers and the information available to sellers.
• Problems arising in markets due to asymmetric information
are typically divided into two basic types: "adverse
selection;" and "moral hazard.“
3/6/2024 BY: GETNET H. (MSC.) 2398
 1) Adverse selection:
• This problem arises before the transaction ever occurs.
• Simple fact is that lenders need to know how to differentiate
between good risks and bad risks. Unfortunately for them, that is
information only the borrower has.
❖Adverse selection is a problem that arises for a buyer of goods,
services, or assets when the buyer has difficulty assessing the quality of
these items in advance of purchase.
❖Consequently, adverse selection is a problem that arises because of
different ("asymmetric") information between a buyer and a seller
before any purchase agreement takes place.
❖It occur when seller of when seller of a financial assets knows more
than the buyer. Under these conditions, the seller will try to sell low
quality asset and hold high quality ones.

3/6/2024 BY: GETNET H. (MSC.) 2399

 Solving the Adverse Selection Problem

❖ There are two basic methods for solving problems of

adverse selection.

➢ First, create more information for the investors

(disclosure of information).

➢ Second, provide guarantees in the form of contracts

that can be written such that the owners of the firms
face the same risks as the investors.

3/6/2024 BY: GETNET H. (MSC.) 2400

 2) Moral hazard
❖Moral hazard is the risk that one party has not entered into
the contract in good faith or has provided false details about its
assets, liabilities, or credit capacity.
❖Moral hazard is said to exist in a market if, after the signing of a
purchase agreement between the buyer and seller of a good,
service, or asset: the seller or buyer changes his or her for their
advantage.
❖ For example, moral hazard in banking is quite a typical
scenario, where the banks sometimes take risks by giving loans
to borrowers who cannot pay them back.
❖For example, a car driver may drive faster knowing that the damage
on their car will be covered by the insurance company if they get in an
accident.
3/6/2024 BY: GETNET H. (MSC.) 2401
 Solving moral hazard
• Methods of Reducing Moral Hazard

• They generally fall under the following headings:

• (1) good corporate governance and management;

• (2) market discipline exercised by depositors and other

creditors; and

• (3) regulatory discipline exercised by supervisory and, in

some countries, deposit insurance authorities.

3/6/2024 BY: GETNET H. (MSC.) 2402

 Financial Institutions in the
Financial System
Chapter 2
2403

3/6/2024
 Financial Institution
▪ A financial institution (FI) is a company engaged in the business
of dealing with financial and monetary transactions such as
deposits, loans, investments, and currency exchange.
▪ Financial institutions encompass a broad range of business
operations within the financial services sector including banks,
trust companies, insurance companies, brokerage firms, and
investment dealers.
▪ Probably the most important financial service provided by
financial institutions is acting as financial intermediaries. 3/6/2024
2404
 2405 Financial Institutions & capital Transfer

▪ In a well-functioning economy, capital will flow efficiently from those who

supply capital to those who demand it in 3 different ways:
▪ Direct transfers of money and securities
▪ Transfers through an investment banking houses which underwrite the issue.
An underwriter serves as a middleman and facilitates the issuance of
securities.
▪ Transfers through a financial intermediary

3/6/2024
2406 Financial Institutions & capital Transfer

3/6/2024
 2407
Function of Financial Institutions
A. Financial Intermediation
▪ Engage in process of indirect finance

B. Transaction Costs
▪ Financial intermediaries make profits by reducing transactions costs
▪ Reduce transactions costs by developing expertise and taking advantage
of economies of scale 3/6/2024
 2408 C. Allow Risk Sharing
▪ Financial intermediaries reduce exposure of investors to risk
(uncertainty about the returns on assets) through risk sharing (selling
assets with low risk, then use the funds to purchase other assets with
higher risk).
▪ Low transaction costs enable (FIs) to do risk sharing at low cost,
allowing them to earn profit on the spread between the returns of the
low and high risk assets (also called asset transformation).
▪ FIs also help individuals in diversifying their assets and therefore
lowering their exposure to risk by creating portfolios. 3/6/2024
 2409 D. Solve Problems Created by Asymmetric Information (or
inequality):
Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcomes are ones most likely to
seek loans and be selected
Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable (immoral) activities
making it more likely that won’t pay loan back
Financial intermediaries reduce adverse selection and moral hazard problems, enabling
them to make profits
3/6/2024
2410 Classifications of Financial Institutions

▪ Depository institutions (banks)

▪ Contractual savings institutions, and

▪ Investment intermediaries.
3/6/2024
 2412 I. Depository financial institutions
▪ Accept deposits from individuals and institutions and make
loans.
▪ Commercial banks
▪ Mutual savings banks
▪ Micro finance institutions
▪ Credit unions

3/6/2024
 Roles of Depository Institutions
2413

▪ They offer deposit accounts that can accommodate the amount and liquidity
characteristics desired by most surplus units.
▪ They repackage funds received from deposits to provide loans of the size and
maturity desired by deficit units.
▪ They accept the risk on loans provided.
▪ They have more expertise than individual surplus units in evaluating the
creditworthiness of deficit units.
▪ They diversify their loans among numerous deficit units and therefore can
absorb defaulted loans better than individual surplus units could.
3/6/2024
 2414 Commercial banks

▪ Raise funds primarily by issuing checkable deposits, savings

deposits and time deposits.
▪ They use these funds to make commercial, consumer, and mortgage
loans to individuals and businesses.

3/6/2024
 2415 Micro finance institutions
▪ Finance unemployed low income people or groups.
▪ They offer of financial & non-financial services to people
excluded from the traditional banking system.
▪ Accept savings and give credits
▪ Most of their assets and liabilities are similar to those of
commercial banks

3/6/2024
 Savings and Loan Associations and Mutual
2416
saving Banks
▪ obtain funds primarily through savings deposit.
▪ Depositors are the owners of the firm
▪ Stock in the bank is not sold or issued, but rather depositors
own a share of the bank in proportion to their deposits
▪ Generally have fewer liabilities than other banks because
deposits are ownership, not a liability
▪ Principal assets: Residential mortgages
▪ Principal source of funds: Deposits 3/6/2024
 Credit Unions
2417

▪ These are very small cooperative lending institutions organized

around a particular group: Union members, employees of a
particular firm, and so forth.
▪ They acquire funds from deposits called shares and primarily make
consumer loans.
▪ Characteristics:
▪ Mutual Ownership: Owned by depositors
▪ Common Bond Membership: Defined field of membership
▪ Nonprofit, Tax-Exempt Status 3/6/2024
 II. Non-Depository Institutions
Contractual Savings Institutions
1. Life Insurance Companies
2. Non-life Insurance
2418
Companies
3. Pension Funds
3/6/2024
 2419 1. Contractual Savings Institutions
▪ The liabilities of these institutions are contracts that specify, in return for
periodic payments to the institution, the institution will make payments to the
contract holders if a specified event occurs
▪ Obtain funds under long-term contractual arrangements and invest in capital
markets.
Examples:
1.1 Life Insurance Companies
1.2 Non-life Insurance Companies
1.3 Pension Funds
3/6/2024
 2420 1.1 Life Insurance Companies

▪ Insure against lost income at death.

▪ Policyholders pay premiums, which are pooled and invested in stocks, bonds,
and mortgages

▪ Investment earnings cover the costs and reward the risks of the insurance
company.

▪ Investments are liquidated to pay benefits and are regulated less strictly than
deposit type institutions.
3/6/2024
 Types of Life Insurance Policies
2421
1. Whole-life policies/contracts: This policy provides financial protection to the
dependents of insured upon the event of his death. Remains active throughout the life
of the policy holders and premiums have to be paid every year.
2. Term Insurance: is issued to provide death benefit to the beneficiary if the insured
dies within the specified time period stated in the policy.
This policy matures for payment only on the death of the insured within the term period,
but if he/she survives the policy will expire and nothing is payable to the insured
3. Endowment Insurance Policy: Endowment policy is issued for a fixed period
(endowment period) and premium is payable during that period only.
This policy provides protection of the beneficiary of the insured if he/she dies within the
endowment period. In addition, it provides for the payment of the face value of the policy
to the insured if he/she is living at the end of the policy period. 3/6/2024
 2422 1.2 Non-life Insurance Companies
▪ Covers property against loss or damage.

▪ Casualty claims are not as predictable as death claims

▪ Major type of Non life insurance

▪ Property Insurance
▪ Property insurance contacts may be written to cover either real property or personal
property, or both.
▪ Liability Insurance
▪ Liability insurance reimburses amounts that insured person become legally
obligated to pay as a result of injury to others or damage to their property
3/6/2024
 2423 1.3 Pension Funds
▪ Help workers plan for retirement.
▪ Workers and/or employers make contributions, which are pooled and invested
in stocks, bonds, and mortgages
▪ Inflow is long term and outflow is predictable so they are able to invest in
higher yielding long term securities.
TYPES
(1) defined contribution plans
▪ contributions are defined, but not the benefits.
▪ sponsors do not guarantee any certain amount upon retirement
▪ payment depends on investment performance of the asset
▪ employee bears risk of investment 3/6/2024
 2424 1.3 Pension Funds
(2) defined benefit plans
▪ benefits are defined

▪ amount of benefit is determined based on length of service and earnings of the

employee And all investment risks are borne by plan sponsors

(3) Hybrid pension plans
▪ contributions are defined with a guaranteed minimum benefit

▪ in case the fund does not generate sufficient growth to attain pre-set level of

benefit then the employee is obliged to add amount of the deficit

3/6/2024

▪ investment risk is shared

 III. Investment Intermediaries

1.Mutual Funds
2425
2.Money Mutual Funds
3.Finance Companies
4.Investment Banks
3/6/2024
 1. Mutual Funds
2426
▪ Acquire funds by selling shares to many individuals and use the proceeds to purchase
diversified portfolios of stocks and bonds.

▪ allow shareholders to pool their resources so that they can take advantage of lower
transaction costs when buying large blocks of stocks or bonds.

▪ In addition, allow shareholders to hold more diversified portfolios than they otherwise
would.

▪ Shareholders can sell (redeem) shares at any time, but the value of these shares will be
determined by the value of the mutual fund’s holdings of securities.
3/6/2024
 2427 2. Money Market Mutual Funds

▪ Like most mutual funds, they sell shares to acquire funds that are then used
to buy money market instruments that are both safe and very liquid.

▪ The interest on these assets is paid out to the shareholders.

▪ shareholders can write checks against the value of their shareholdings – i.e.,
shares in a money market mutual fund function like checking account
deposits that pay interest.
3/6/2024
 2428
3. Finance Companies
▪ raise funds by selling commercial paper (a short-term debt instrument) and
by issuing stocks and bonds.
▪ They lend these funds to consumers (who make purchases of such items as
furniture, automobiles, and home improvements) and to small businesses.
▪ Some finance companies are organized by a parent corporation to help sell
its product. For example, Ford Motor Credit Company
▪ Uses of funds
▪ Lease financing
▪ Loans to businesses (e.g. bills finance, term loans, factoring and accounts
receivable financing) 3/6/2024
 2429 4. Investment Banks
▪ Helps corporations raise funds through IPOs
▪ First it advises the corporation on which type of securities to
issue (stocks or bonds);
▪ then it helps sell (underwrite) the securities by purchasing
them from the corporation at a predetermined price and
reselling them in the market
▪ also act as deal makers and earn enormous fees by helping
corporations acquire other companies through mergers or
acquisitions. 3/6/2024
2430

3/6/2024
2431

3/6/2024
2432 Risks of Financial Intermediation
✓ Liquidity risk
✓ Interest rate risk
✓ Market risk
✓ Credit risk
✓ Off-balance-sheet risk
✓ Foreign exchange risk
✓ Country and sovereign risk
✓ Actuarial risk 3
3/6/2024
 2433 Liquidity Risk
▪ Because of the asset transformation function of FIs mismatches
between assets and liabilities can occur:
▪maturity mismatches
▪liquidity mismatches
▪ If runs (bankers’ risk), or unusually high demand for
withdrawals of demand deposits occur, this can cause a
liquidity crisis for the FI, which can begin a spiral down…asset
sales at bargain prices…etc. 3/6/2024
 2434 Interest Rate Risk
▪ Interest rate risk is the potential that a change in overall interest
rates will reduce the value of a bond or other fixed-rate
investment: As interest rates rise bond prices fall, and vice versa.
▪ Two types:
1. Refinancing risk refers to the possibility that a borrower will not
be able to replace an existing debt with new debt.
2. Reinvestment risk is the chance that cash flows received from an
investment will earn less when put to use in a new investment.
3/6/2024
 2435 Market Risk

▪ As traditional activities of the banks decline in relative

proportions (deposit-taking and lending) other forms of
activities have grown in importance.
▪ Especially trading …. Actively investing in stocks, bonds,
and derivative securities…as a profit-center.
▪ Market Risk is the risk that in active trading, the market
value of the banks asset(s) declines. 3/6/2024
 2436 Credit Risk
▪ Is the likelihood that a borrower will default on a loan…or that the issuer
of a bond that the FI has invested in, default on interest or principal
repayment.
▪ Default risk
▪ obviously, FIs are ‘diversified’ investors…their portfolio of financial
assets and portfolio of loans must be widely diversified across industries,
geographical regions and income groups.
▪ Firm-specific credit risk is the risk of default of the borrowing firm
associated with the specific types of project risk undertaken by that firm.
▪ Systematic credit risk is the risk of default associated with the health of
3/6/2024

the general economy.

 2437 Off-balance-sheet Risk
▪ Off-balance-sheet items are contingent assets or liabilities such as unused
commitments, letters of credit, and derivatives.
▪ These items may expose institutions to credit risk, liquidity risk, or
counterparty risk, which is not reflected on the sector's balance sheet
reported
▪ Commercial letter of credit is an irrevocable obligation to make payment
to a beneficiary of documents evidencing shipment of goods.
▪ BAs - Bankers Acceptances
▪ As the guarantor…of such financial instruments, the Bank remains liable
for payment, and there is always a chance that the client may become 3/6/2024

insolvent, leaving the Bank with obligation to pay…but without recourse.

 2438 Foreign Exchange Risk

▪ Mismatches between the amount of foreign currency

denominated assets and liabilities can lead to foreign
exchange losses or gains depending on the relative
movement of the two currencies involved.
 2439 Country and Sovereign Risk
▪ Sovereign credit risk is the risk of a government becoming
unwilling or unable to meet its loan obligations,
▪ Is the risk of losses experienced by an FI due to changing,
social, economic, or political factors specific to one
country….
▪ Hong Kong reverting to Chinese control….
▪ Mexico, Argentina imposing restrictions on debt repayments
of domestic corporations…etc.
▪ Greece potentially defaulting on international loan
obligations. 3/6/2024
 2440 Actuarial Risk
▪ Actuaries estimate future liabilities for insurance companies based on the
law of large numbers and using conservative financial forecasting
assumptions.
▪ Actuarial risk is the risk that those estimates turn out to be wrong.
▪ Of course, actuaries, continually review their estimates as time moves
on….they will identify “actuarial surpluses” and “actuarial deficits” in
funds that are accumulating for the purpose of meeting a future liability.
▪ This way the fund sponsor can be informed about their progress toward
their target terminal value, and can take action in advance to avoid a crisis.
3/6/2024
An overview of Banks and
their Functions
Chapter 3
 1.1. INTRODUCTION
The Origin of the word Bank
❑it is derived from the Italian word “Banca” or Old German Banc

❖ Which means in English bench, table or counter.

❑ It is derived from:
❖ The experience of the merchants of Greece and Rome.
❖ The experience of the merchants was:
➢ They used to sit on a bench in the center of the market and

❑ Receive deposits from the public and

❑ Pay to the public from the deposit.

➢ They were referred as “benchers”.
Meaning of Bank
❑ Banks are financial institutions that accept deposits and make loans.

❑ The term BANK in the modern times refers to an institution which:

➢ deals with money; it accepts deposits and advance loans

➢ deals with credit; it has the ability to create credit,

➢ is a commercial institution; it aims at earning profits, and

➢ creates a demand deposits which serve as a medium of exchange,
and as a result,
▪ the bank manages the payment system of the country.
 Commercial Banking Vs Investment Banking

▪ Commercial Banking as depository activity involves

deposit taking and lending

▪ Investment banking involves underwriting, issuing,

and distributing securities
Banking in Ethiopia
▪ The history of banking in Ethiopia can be traced back
▪ to the establishment of Bank of Abyssinia
▪ in March 1905.
▪ It was established and owned by
▪ the National Bank of Egypt,
▪ an affiliate of the Bank of England.
▪ Bank of Abyssinia opened
❖ branches in Dire Dawa, Gore and Dessie and
❖ agencies in Harrar and Gambella with the construction of
Franco-Ethiopia railway
 Commercial Banks
▪ Commercial banks are the largest group of financial institutions in terms of total
assets
▪ Major assets are loans
▪ Major liabilities are deposits—thus, they are considered depository institutions
▪ Perform services essential to financial markets
▪ play a key role in the transmission of monetary policy
▪ provide payment services
▪ provide maturity intermediation
▪ Banks are regulated to protect against disruptions to the services they perform
 Commercial Banks
▪ Because larger banks generally lend to larger corporations, their interest
rate spreads and net interest margins are usually narrower than those of
smaller banks
▪ Net Interest rate spread is the difference between lending and deposit rates
▪ Net interest margin is interest income minus interest expense divided by earning
assets
▪ For example, say a bank made loans equal to Br100 million in a year, which
generated Br5.5 million in interest income. In the same year, the bank paid Br2.5
million in interest to its depositors at a weighted average rate of 2%.
▪ Net interest margin=n(5.5 million - 2.5 million) / 100 million = 0.03, or 3%.
▪ Large banks tend to pay higher salaries and invest more in buildings and
premises than small banks
▪ Large banks tend to diversify their operations more and generate more
noninterest income than small banks
 Retail Banking Services
Deal with retail customers & services include:
▪ Checking and savings accounts
▪ Automated teller machines (ATMs)
▪ Point-of-sale (POS) debit cards
▪ Mobile banking
▪ Smart cards (stored-value) cards
▪ Foreign currency & remittance services
▪ Loans
▪ Internet banking
▪ complements existing business for already existing banks
▪ some new internet-only banks have no “brick-and-mortar”
Corporate Banking
 International Commercial Banking
▪ Commercial banking has truly become an international and global
market
▪ Advantages of international expansion
▪ risk diversification
▪ economies of scale
▪ distribute new product innovations internationally
▪ opportunity to find the cheapest and most available sources of funds
▪ service the needs of domestic multinational corporations
▪ regulatory avoidance
 International Commercial Banking
▪ Disadvantages of international expansion
▪ information and monitoring costs are generally higher in foreign markets
▪ foreign assets may be subject to nationalization or expropriation by host
country governments
▪ the fixed costs of establishing foreign organizations may be extremely high
 The Bank Balance Sheet
▪ Total assets = total liabilities + capital

▪ A bank’s balance sheet lists sources of bank funds (liabilities) and uses to which they
are put (assets)

▪ Banks invest these liabilities (sources) into assets (uses) in order to create value for
their capital providers
 The Bank Balance Sheet: Liabilities
a) Checkable Deposits (Transaction Deposits): accounts that allow the owner
(depositor) to write checks to third parties
▪ non-interest earning checking accounts (demand deposits)
▪ interest earning negotiable orders of withdrawal (NOW) accounts
▪ money-market deposit accounts (MMDAs) (limited number of transactions is
allowed per month but pay a higher yield)
▪ Lowest cost funds - safe and liquid, but offer low interest.
 The Bank Balance Sheet: Liabilities
b) Non-transaction Deposits: primary source of bank liabilities and are accounts from
which the depositor cannot write checks

▪ savings accounts

▪ time deposits (CDs or certificates of deposit)

▪ Highest cost of funding, but most stable for bank

 The Bank Balance Sheet: Liabilities
c) Borrowings: funds from the Federal Reserve System (Central Bank), other banks, and
corporations
▪ discount loans (also known as advances) (from the central bank to resolve a temporary
shortage of funds)
▪ Bonds issued by the bank (to the public)
▪ interbank offshore dollar deposits (from other banks),
▪ repurchase agreements (a.k.a., “repos”)
▪ commercial paper and notes
 The Bank Balance Sheet: Capital
▪ Bank Capital: is the source of funds supplied by the bank owners
▪ Minimum levels of equity capital are required by regulators to act as a buffer
against losses
▪ Ordinary and preference shares
▪ Share premium or additional share capital
▪ retained earnings
 The Bank Balance Sheet: Assets

a) Reserves: funds not loaned out by a private bank, but kept as vault cash or as deposit at
the central bank.
❖Required reserves represent what is required by law under current required reserve
ratios. In Ethiopia, as per Directive No.SBB/84/2022
▪ 7% on average in every calendar month of birr & foreign currency deposit liabilities held in current deposits,
saving deposits, and time deposits
▪ A minimum of 5% of these deposits at all times
❖ Cash assets are held to meet reserve requirements and to provide liquidity
❖ Any reserves beyond this area called excess reserves.
b) Cash items in Process of Collection: checks written on another bank’s account deposited
at a bank but funds from the other bank have not yet been transferred.
c) Deposits at Other Banks: usually deposits from small banks at larger banks (referred to as
correspondent banking)
 The Bank Balance Sheet: Assets
d) Securities:
▪ Government/agency securities (Because of their high liquidity, short term
government securities are called secondary reserves).
▪ municipal (state and local government) securities
▪ Equity securities (investment in shares of other organizations)
e) Loans: a bank’s income-earning assets
▪ business loans (commercial and industrial loans), real estate loans, consumer
loans, loans to other banks.
▪ Not very liquid
f) Other Assets: bank buildings, computer systems, and other equipment.
 Risks and Assets of Banks
Banks face unique risks because of their asset structure
▪ credit (default) risk is the risk that loans are not repaid

▪ liquidity risk is the risk that depositors will demand more cash than banks can
immediately provide

▪ interest rate risk is the risk that interest rate changes erode net worth

▪ credit, liquidity, and interest rate risk all contribute to a commercial bank’s level of
insolvency risk

▪ Insolvency is a financial state in which borrower is no longer able to pay the their
obligations. Usually happens when the total liabilities exceed total assets.
 General Principles of Bank Management
▪ Banks make profits through a process called asset transformation.

▪ Asset transformation is the process of creating a new asset (loan) from liabilities
(deposits) with different characteristics by converting small denomination,
immediately available and relatively risk free bank deposits into loans–new relatively
risky, large denomination asset–that are repaid following a set schedule.

▪ This means the bank borrows short and lends long.

▪ Types of Asset Transformation

• Retail: Short-term deposits from individual customers lent for
• longer terms, through mortgages, car loans, and consumer loans.
• Wholesale: Using funds deposited by large institutional investors and
• companies to fund loans for commercial real estate or infrastructure projects.
 General Principles of Bank Management
Let’s look at how a bank manages its assets and liabilities. The bank manager has four
primary concerns:
1. Liquidity management - the acquisition of sufficiently liquid assets to meet the bank’s
obligations to depositors
2. Asset management: pursuing an acceptably low level of risk by acquiring assets that have
a low rate of default and by diversifying asset holdings
▪ Managing credit risk
▪ Managing interest-rate risk
3. Liability management: acquiring funds at low cost
4. Managing capital adequacy: deciding the amount of capital the bank should maintain
and then acquire the needed capital
 Liquidity Management

How can a bank recover from a liquidity crisis?

▪ Borrow from other banks
▪ Sell securities
▪ Borrow from the central bank
▪ Reduce loan portfolio
 Asset Management
▪ To maximize its profits, a bank must simultaneously seek:
❖ the highest returns possible on loans and securities,
❖ reduce risk, and
❖ make adequate provisions for liquidity by holding liquid assets
▪ Ways of achieving these goals:
1. find borrowers who will pay high interest rates and are unlikely to default on their
loans.
2. Buy securities with high return, low risk
3. Diversify (attempt to lower risk by purchasing many different types of securities
and approving many different types of loans to many customers)
4. Manage liquidity
 The 6 C’s of Credit
▪ Banks could use the 6 C’s of credit as a means of their exposure to credit
risks:
1) Character (borrowers’ personal characteristics such as honesty,
attitudes about willingness and commitment to pay debts).
2) Capacity (the success of business)
3) Capital (financial condition).
4) Collateral
5) Conditions (economic).
6) Compliance (laws and regulations).
 Liability Management
▪ Managing sources of funds (liabilities) in order to ensure that
sufficient funds are available to meet loan demand and other
commitments.
▪ It involves:
❖ Forecasting future loan demands and other cash requirements
❖ Raising the necessary funds through either:
➢ adjusting interest rates offered on the necessary additional deposits or
➢ issuing further securities directly into the money or capital markets.
 Capital Adequacy Management
▪ Why do/don’t banks want to hold a lot of capital??
▪ Banks need to maintain at least the minimum capital ratio required by regulators.
▪ However, if the Bank maintains too much capital, each shareholder will receive a smaller
proportion of any distributed earnings.

▪ Higher is bank capital, lower is return on equity

▪ ROE = Net Profits/Equity Capital
▪ ROA = Net Profits/Assets
▪ Equity Multiplier = Assets/Equity Capital
▪ ROE = ROA  EM
▪ Capital increases, EM falls, ROE falls
 Which of the following banks is more profitable
assuming a net profit of $10Bn?

Safety Bank ROE = 10/10 = 1 Shaky Bank ROE = 10/1 = 10

Assume that Br 5B of loans went bad and had to
be written off
 Conclusion

▪ Before the bad loan Shareholders ▪ Due to this issue of risk and
would prefer shaky bank over the return tradeoff regulators put
safety bank due to the high ROE it a capital requirement on
generates. After the bad loan: banks.
▪ Safety Bank would still be in ▪ The minimum capital
operation after the write off. requirement in Ethiopia is 8%
▪ Shaky bank is insolvent (its assets of assets.
are less than its liabilities) and thus
it is destined for bankruptcy.
 Capital Adequacy Management

Strategies for Managing Capital: what should a bank manager do if s/he feels the
bank is holding too little capital?
• Issue stock
• Decrease dividends to increase retained earnings
• Slow asset growth

Reversing these strategies will help a manager if she feels the bank is holding too
much capital?
• Retire stock
• Increase dividends to reduce retained earnings
• Increase asset growth via debt (like CDs)
 Capital Requirements
▪ Minimum paid-up capital paid in cash and deposited in a blocked account
in a bank in the name of the prospective bank
▪ Recently the National Bank of Ethiopia has raised the minimum paid up
capital to five billion birr from 2 billion birr which has to be achieved by
2026 (Directive No.SBB/78/2021)
▪ A bank in process of share subscription that
▪ Succeeds to collect 500 million birr from its founding shareholders
▪ Holds subscribers’ meetings
▪ Can get banking license
▪ But required to meet capital requirement within 7 years
▪ The transition period is five years for existing licensed banks.
 Off-Balance-Sheet Activities

▪ To protect themselves against interest rate increases, banks engage in many fee-
related activities that that do not appear on their balance sheets (That is they
generate income that is not based on assets) .

Examples of such income:

▪ Fees for loan guarantees, backup lines of credit, and foreign exchange transactions.

▪ loan sales (with a promise to make good if the client defaults)

▪ Income on derivative trading (speculative activity)

▪ All these activities involve risk and potential conflicts

 Measuring Bank Performance
▪Measuring bank performance requires a look at the income statement:
▪ Operating Income
▪ Operating Expenses
▪ Net Operating Income
▪This is different from a manufacturing firm’s income statement.
▪Different performance measures are used
▪ Return on Assets = ROA = Net Profits/ Assets
▪ Return on Equity = ROE = Net Profits/ Equity Capital
▪ Cost-to-income ratio = CIR= operating expenses / operating revenues
▪ Net Interest Margin = NIM = [Interest Income − Interest Expenses]/ Assets
 Central Banks

▪ Central banks operate at the very centre of a nation’s

financial system.
▪ Governments implement their monetary policies
using their central bank
▪ They are usually public bodies but, increasingly, they
operate independently of government control or
political interference.
 Role of Central Banks

▪ Acting as banker to the banking system by accepting deposits from, and

lending to, commercial banks
▪ Acting as banker to the government
▪ Managing the national debt
▪ Regulating the domestic banking system
▪ Acting as lender of last resort to the banking system in financial crises
▪ Setting the official short-term rate of interest
▪ Controlling the money supply
 Role of Central Banks

▪ Issuing notes and coins

▪ Holding the nation’s gold and foreign currency reserves
▪ Influencing the value of a nation’s currency through activities
such as intervention in the currency markets
▪ Providing a depositors’ protection scheme for bank deposits.
▪ Licenses, supervises and regulates the operations of banks,
insurance companies and other financial institutions.
Interest-Free Products and
Contracts
Chapter 4

3/6/2024
 Introduction
▪ The concept of Islamic finance can be traced back about 1,400 years
▪ Its recent history can be dated to the 1970s when Islamic banks in Saudi
Arabia and the United Arab Emirates were launched.
▪ Bahrain and Malaysia emerged as centres of excellence in the 1990s.
▪ It is now estimated that worldwide around US $1 trillion of assets are
managed under the rules of Islamic finance.

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 Introduction
▪ Islamic finance rests on the application of Islamic law, or Shariah, and
very much in the context of Islamic finance, emphasises justice and
partnership.
▪ The main principles of Islamic finance are that:
▪ Wealth must be generated from legitimate trade and asset-based investment.
(The use of money for the purposes of making money is expressly forbidden.)
▪ Investment should also have a social and an ethical benefit to wider society
beyond pure return.
▪ Risk should be shared.
▪ All harmful activities (haram) should be avoided.

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 The prohibitions
The following activities are prohibited:
▪ Charging and receiving interest (riba).
▪ The idea of a lender making a straight interest charge, irrespective of how the
underlying assets fare, transgresses the concepts of risk sharing, partnership
and justice.
▪ It represents the money itself being used to make money.
▪ Investments in businesses dealing with alcohol, gambling, drugs, pork or
anything else that the Shariah considers unlawful or undesirable (haram).
▪ Uncertainty, where transactions involve speculation, or extreme risk.
▪ This is seen as being akin to gambling.
▪ This prohibition, for example, would rule out speculating on the futures and
options markets.
3/6/2024
 Conventional bank Vs Islamic Bank
Islamic Bank Conventional bank
Islamic Banks are not money lending Conventional banks are in the business of
institutes but they work as a trading/ lending & borrowing money based on
investment house. interest.

Islamic Banks work under the socio-religious In Conventional banks, we see no such
guidelines that prohibit charging and paying restrictions. Interest is the back-bone of this
interest and avoid all impermissible system & some of such illegal activities are
transactions like gambling and speculation allowed
Risk and return sharing between the investors Predetermined rate of interest for investors
and use of the funds (entrepreneurs) and borrowers. Borrowers risk not
considered.
Islamic Banks do not permit financing to In Conventional Banks, all types of industries
industries that cause harm to the society such are financed, only businesses deemed illegal
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as alcohol, tobacco etc by the law of the land are not supported.
 Conventional bank Vs Islamic Bank
Islamic Bank Conventional bank
Islamic Banks have strong Shariah governing In Conventional Bank, no such framework is
framework in terms of Shariah Board, that present.
approves the transactions and products in the
light of the Shariah rulings.
Islamic banking products are usually asset Conventional Bank treats money as a
backed and involves trading of assets, renting commodity and lend it against interest as its
of asset and participation on profit & loss compensation.
basis.
Relationship of customer & bank is of Seller- Relation of customer & bank is of Creditor-
Buyer and Partner. Debtor.
Compensation is always Price (Thaman) Compensation is always Interest
3/6/2024
 Sources of Funds in Interest-free Banks
▪ Funding by the owners (Equity)
▪ Paid-up capital and reserves
▪ Islamic debt (obligation) instruments
▪ short and long funds by issuing Islamic obligation instruments in the
financial market such as Sukuk
▪ Deposits/Investment Accounts
▪ demand deposits: the depositor will not share the profit and loss
▪ investment account: the depositor need to share the profit and loss
with the banks' investment account.

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 Utilization of Funds
▪ Cash and cash equivalents held at the bank
▪ Fixed assets used by the banks
▪ Financial instruments – equity participation and asset-based
credit facilities

3/6/2024
 Islamic Banking Products
▪ Serve the business sectors, retail individuals and government
where they work.
▪ Instruments offered by most of the Islamic banks worldwide
▪ Equity partnership-based products: are based on profit and loss sharing
basis and include Mudaraba and Musharka
▪ Assets-based financing: allow bank customers to finance cars, homes,
business supplies, and other major purchases & include Ijara, Murabaha,
Tawaruqq and istisna
▪ Trade Financing: short-term liquidity solutions for individuals and
corporations & include deferred payment sale and purchase with deferred
delivery

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 Mudaraba (Venture Capital)
▪ simple partnership agreement between the financier (investor)
and the working partner (fund manager) to start a business or
project based on pre-agreed profit and loss sharing ratio
▪ The investor will provide the capital, and the fund manager, using
its expertise and knowledge, will invest the capital.
▪ Mudaraba can be used as source and use of funds by Islamic
banks (banks can play both roles)
▪ Islamic banks receive the money from the customers as source of funds, and finance the
customer using the Mudaraba contract as use of funds

▪ Restricted investment Mudaraba Vs Unrestricted investment

Mudaraba
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How does Mudarabah work?

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 Musharaka (Joint Venture)
▪ is based on partnership between both parties including capital, work and
entrepreneurship.
▪ Both parties provide capital towards the financing of projects and both parties share the
profits in agreed proportions. This allows both parties to be rewarded for their supply of
capital and managerial skills.
▪ Losses would normally be shared on the basis of the equity originally contributed to the
venture.
▪ Diminishing Musharaka
▪ one of the partners share in the partnership is transferred to the other party. At the end,
one party will become the owner of the whole asset or project
▪ Back to back Musharaka
▪ each partner can keep its experience in the partnership until the very end of the joint
venture, undertaking, or business

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 Murabaha (Cost plus mark up products)
▪ is a form of trade credit for asset acquisition that avoids the payment of
interest
▪ The bank buys the item and then sells it to the customer on a deferred basis at a
price that includes an agreed mark-up for profit.
▪ The mark-up is fixed in advance and cannot be increased, even if the client does
not take the goods within the time agreed in the contract.
▪ The bank is thus exposed to business risk because if its customer does not take
the goods, no increase in the mark-up is allowed and the goods, belonging to the
bank, might fall in value.
▪ Penalty can be charged for default but given to charity

3/6/2024
Murabaha Procedure

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 Ijara (Renting or leasing of asset)
▪ Is giving items or services on a lease or rental premise
▪ whereby the bank buys an item for a customer and then leases it back over a specific period at
an agreed amount.
▪ Ownership of the asset remains with the lessor bank, which will seek to recover the capital cost
of the equipment plus a profit margin out of the rentals payable
▪ Emirates Airlines regularly uses Ijara to finance its expansion.
▪ Three arrangements:
▪ Ijara Al-Mawsufah Fi Al-Dhimmah (Forward Lease): leasing properties under
construction & lessor (financier) retains legal ownership until end of the lease term (lessee can
purchase after paying additional money or leave purchasing & get the refund)
▪ Operating Ijara (Operating lease): the asset has to be returned to the lessor at the end of
the leasing tenure.
▪ Ijara wa iqtina (lease with ownership): the lessee claims the rented resource toward the
end of the lease period. The price of the assets is at last chosen by the market value of the asset
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or an agreed price by both parties.
 Istisna’
▪ Istisna’ is a contract of exchange with deferred delivery.
▪ It is applicable to the making or constructing of ordered items.
▪ An istisna’ contract can be established between a bank and
contractor, developer or producer that allows the bank to make
progress payments as construction progresses.
▪ It is financing provided in the form of advance progress payment(s)
to the customer who builds, manufactures, constructs or develops
the object of sale.
▪ Upon completion of the project, the asset is delivered to parties
who agreed to take delivery of the asset.

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 Parallel istisna’
▪ Parallel istisna’ is used by Islamic banks.
▪ The mode consists of two separate istisna’ contracts.
▪ The first is concluded between the customer and the bank.
▪ the price is payable by the purchaser in the future, in agreed installments,
and the bank undertakes to deliver the requested manufactured
(constructed) commodity at an agreed time.
▪ The second istisna’ contract is concluded between the bank and a contractor
to manufacture (build) the item according to prescribed specifications.
▪ The bank would normally pay the price in installments in advance or during
the manufacturing process.
▪ The contractor undertakes to deliver the product to the bank on the date
prescribed in the contract, which is the same date as that stated in the first
contract.
▪ The original purchaser (i.e. the bank’s client) may be authorized to receive3/6/2024
the
product directly from the maker.
 Deferred delivery with advance payment – Salam
▪ It is a forward sale contract whereby the seller undertakes
to supply some specific goods to the buyer at a definite
future date in exchange for an advanced price fully paid
at spot.
▪ Salam is allowed only with strict conditions, such as
these:
▪ The seller legally possesses the product to be delivered on
the future date.
▪ The contract specifies the date and time of the delivery. Only
products whose quality and quantity can be specified in the
contract can be sold.
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 Tawarruq

▪ Tawarruq is an instrument used to generate cash for

the client.
▪ It purchases an item from the bank on deferred
payment i.e. a cost-plus basis but sells it back
immediately to the bank at cost price to obtain the
needed cash.

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 Sukuk
▪ Sukuk is debt finance.
▪ Islamic bonds, or sukuk, cannot bear interest. So that the sukuk are Shariah-compliant, the sukuk holders
must have a proprietary interest in the assets which are being financed.
▪ The sukuk holders’ return for providing finance is a share of the income generated by the assets.
▪ Most sukuk, are ‘asset-based’, not ‘asset-backed’, giving investors ownership of the cash flows but not of
the assets themselves.

▪ There are a number of ways of structuring sukuk, the most common of which are
partnership (Musharaka) or lease (Ijara) structures.
▪ Typically, an issuer of the sukuk would acquire property and the property will
generally be leased to tenants to generate income.
▪ The sukuk, or certificates, are issued by the issuer to the sukuk holders, who
thereby acquire a proprietary interest in the assets of the issuer.
▪ The issuer collects the income and distributes it to the sukuk holders.
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 Interest Rates in the
Financial System
Chapter 5
2499

3/6/2024
 2500 Interest Rates
▪ An interest rate is the price paid by a borrower to a lender for
the use of resources that will be used during some time
period and then returned - the cost of Money
▪ It is compensation to the lender for forgoing other useful
investments that could have been made with the loaned asset
– Opportunity cost
▪ Interest rates include base rates and risk premiums

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2501
Types of Interest rate
▪Nominal,
▪Real Rates
▪Risk-Free

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 Nominal Rates
oNominal Rate: the actual monetary price that borrowers
pay to lenders to use their money
▪ Include all the risk factors, plus the time value of the
money itself
▪ Example = If you deposit 100 Birr you can get 7 %
annual interest, which means you would have 107 birr
after 1 year.
▪ So 7 % is Nominal rate 2502
3/6/2024
 The Real Rate of Interest

▪ The real interest rate is nominal interest rate less inflation

adjustment
▪ If you earn a current rate of 7% on investment and inflation is
10%, you are losing purchasing power on investment by 3%.

▪ If you earn a current rate of 10% on investment and inflation

is 7%, you are getting 3% real interest from investment by.

3/6/2024
2503
 Risk-Free Rates
oThe risk-free rate is approximately the yield on short-
term Treasury bills
▪ Includes the pure rate and an allowance for inflation
✓Viewed as current minimum interest rate
▪No investment that does have risk can offer a
lower rate than risk free rate

3/6/2024
2504
 2505 Other different types of interest
▪ Simple Interest: interest on principal only,
SI = P*i*n
▪ Compound Interest: accumulated interest will earn
interest = CI = P (1+r/m) mt – P
▪ Fixed and Floating Rates of Interest
▪ While the interest rates remain constant in the case
of Fixed Rate of Loans, the Floating Loan Rate is
variable . 3/6/2024
2506 Theories of Interest Rates

▪ Fisher’s Law
▪ Loanable Funds Theory
▪ Pure Expectations Theory
▪ Segmented markets theory
▪ Liquidity Preference Theory 3/6/2024
 2507
Fisher’s Law
▪ It is the prediction that an x percentage point change in the
inflation rate will cause an identical x percentage point change in
the nominal interest rate.
▪ States that nominal interest rates (i) are a function of the real
interest rate (r) and a premium (p) for inflation expectations.
▪ Fisher’s Equation:
r = i – p Or i = r + p
▪ But the more accurate formula to calculate the nominal or real
interest rate is
i = (1 + r)(1 + p) - 1 3/6/2024
 2508
Fisher’s Law
▪ According to the International Fisher’s Effect, countries with higher
expected inflation rates have higher interest rates.
▪ With no government interference nominal rates vary by inflation
differential
▪ E.g. Assume that a bank is willing to make a loan to you of Br1,000 for
one year at a real rate of interest of 3 per cent. The bank expects a 10
per cent rate of inflation over the next twelve months.
▪ Calculate:
▪ The nominal interest rate (i= r+p) = 0.03+0.1 = 13%
▪ Or I = (1+0.03)*(1+0.1) - 1 = 0.1333
▪ What the bank will want after a year = 1000+(1000*0.13)= 1130 3/6/2024
 The Loanable Funds Theory
Loanable funds are the funds available in the financial system for lending
▪ Interest rates set by supply and demand of loanable funds in debt markets
Supply—funds from those willing to lend money
▪ Lenders (investors) buy debt securities such as bills, notes and bonds
▪ Supply of borrowed funds depends on their willingness to invest their savings
▪ Demand—people, companies and governments desiring to borrow money
▪ Borrowers sell bonds, notes, etc.
▪ Demand for borrowed funds depends on
▪ Opportunities available to use these funds
▪ Attitudes of people and businesses about using credit 3/6/2024
2509
 The Loanable Funds Theory
▪ The price—the interest rate
▪ Borrowers will borrow more when interest rates low
▪ Lenders will lend more (buy more bonds) when interest rates high
▪ Assumes a downward-sloping demand curve and an upward-sloping supply curve in
the loanable funds market i.e
▪ As interest rates rise demand falls
▪ As interest rates rise supply increases
▪ Equilibrum of the loanable funds market
occurs when savings capital (supply)
is equal to the investment capital (demand).

In other words, loanable funds theory determines

the equilibrium interest rate of a particular loan. 3/6/2024
2510
 2512
Pure Expectations Theory
▪ This theory assumes that present long-term interest rates depend entirely on future
short-term rates.
▪ Lenders are taken to be equally happy to hold short-term or long-term securities.
Their choice between them will depend only on relative interest rates.
▪ Securities of different maturities are perfect substitutes.
▪ For instance, a series of five one-year bonds is a perfect substitute for a five-year
bond.
▪ Assuming that lenders have perfect information, long-term interest rates will be
approximately an average of the known future short-term rates.
▪ {LTint = ( it + it+1 + it+2 + …+ it+(n-1)) / n}
▪ Or LTint = [(1 + it)(1 + it+1) ….(1 + it+(n-1))]1/n - 1 3/6/2024
 2513 Pure Expectations Theory
▪ Numerical example
▪ One-year interest rate over the next five years
are expected to be 5%, 6%, 7%, 8%, and 9%
▪ Interest rate on two-year bond today:
(5% + 6%)/2 = 5.5%
▪ Interest rate for five-year bond today:
(5% + 6% + 7% + 8% + 9%)/5 = 7%
▪ Interest rate for one- to five-year bonds today:
5%, 5.5%, 6%, 6.5% and 7%

3/6/2024
 Pure Expectations Theory (Example)
2514 ▪ We assume that lenders know that short-term rates over the next four years will be:
year 1: 8 per cent
year 2: 10 per cent
year 3: 11 per cent
year 4: 12 per cent
▪ Then, Br1,000 invested in a one-year bond, with the proceeds being invested in a further one-year bond in the
subsequent years, will produce the following results:
Principal Interest rate Interest Capital + interest
year 1 Br1,000 8 per cent Br80 Br1,080
year 2 Br1,080 10 per cent Br108 Br1,188
year 3 Br1,188 11 per cent Br131 Br1,319
year 4 Br1,319 12 per cent Br158 Br1,477
Required : Calculate the interest rates on two-year, three-year and four-year bonds.
2 year = (0.08+0.10)/2 = 0.09
3/6/2024
3 Year = (0.08+0.1+0.11)/3 = 0.0966 and 4 Year = (0.08+0.1+0.11+0.12)/4 = 0.1024
 Segmented markets theory
2515

⚫ Assumes that securities in different maturity ranges are viewed by various

market participants as being imperfect substitutes (i.e. investors will operate
within some chosen maturity range - Markets are completely segmented)
▪ Rejects pure expectations theory assumption that all bonds are perfect
substitutes (Bonds of different maturities are not substitutes at all)
▪ The choice of long-term versus short-term securities is predetermined
according to need rather than expectations of future interest rates
▪ Pension funds & life insurance companies may generally prefer LT
investments that coincide with their LT liabilities
▪ Commercial banks may generally prefer ST investments to coincide with
their ST liabilities 3/6/2024
 The Liquidity Preference Theory
2516
▪ Assumes securities of different maturities are substitutes, but are not perfect
substitutes
▪ Modifies Pure Expectations Theory with features of Market Segmentation
Theory
▪ Investors prefer shorter-term instruments which have greater liquidity, and less
maturity and interest rate risk, and, therefore, require compensation for
investing longer term . (Interest rate increases as terms to maturity increases)
▪ This compensation is called ‘liquidity premium’ - lpnt
▪ And the longer the period of time they have to give up, the more they need
to be compensated.
▪ Long-term securities are more sensitive to interest rate changes than short-
3/6/2024

term securities
2518 Factors that affect interest rates
▪ The Base Interest Rate
▪ Default risk (also called Credit Risk)
▪ Liquidity
▪ Tax status
▪ Term to maturity
▪ Inflation
▪ Special contract provisions such as embedded options

3/6/2024
 2519 Factors that affect interest rates
1. The Base Interest Rate
▪ risk-free treasury securities for given maturity
2. Default risk
▪ occurs when the issuer of the bond is unable or unwilling to make interest payments
when promised.
▪ The spread between the interest rates on securities with default risk and default-
free securities, called the risk premium, indicates how much additional interest
people must earn in order to be willing to hold that risky securities.
▪ Default risk premium = risky security yield – treasury security yield of same maturity
▪ A bond with default risk will always have a positive risk premium, and an increase in
its default risk will raise the risk premium.
3/6/2024
 2520
Factors that affect interest rates
3. Liquidity
▪ The more liquid an asset is, the more desirable it is (holding everything else
constant).
▪ A liquid investment is easily converted to cash at minimum transactions cost
▪ Investors pay more (lower yield) for liquid investment
▪ Liquidity risk premium to compensate the fact that some securities cannot be
converted to cash on a short notice at a “reasonable” price.
4. Tax status
▪ Tax status of income or gain on security impacts the security yield
▪ Investors are concerned with after-tax return or yield
▪ Investors require higher yields for higher taxed securities
▪ iat = ibt(1 – T) 3/6/2024
 2521
Factors that affect interest rates
5. Term to maturity
▪ Interest rates typically vary by maturity
▪ The longer the maturity of a security, the greater its price sensitivity to a
change in market yields and the more interest rate.
▪ Maturity Risk Premium: premium charged to compensate the risk stemming
from probability of adverse movements in the interest rates that might
cause capital losses.
6. Inflation
Inflation Premium: A premium equal to expected inflation that investors add to
the real-risk-free rate of return. 3/6/2024
 2522
▪ 7. Embedded Options
▪ Call options
▪ benefit issuers by enabling them to buy back the bonds before maturity at a
specified price
▪ Call features are exercised when interest rates have declined
▪ Investors demand higher yield on callable bonds, especially when rates are
expected to fall in the future
▪ Conversion options
▪ benefit investors by allowing them to convert the security into a specified
number of common stock shares
▪ Investors will accept a lower yield for convertible securities because investor
3/6/2024

returns include expected return on equity participation

 2523
Estimating the Appropriate Yield
r = r* + DRP + LP + MRP + IP + CALLP - COND
= 2.2 + 4.1+3+1.5+2.75+1.2- 2.5 = 12.25%
Where:
r = Nominal (quoted) Interest Rate
r* = Real Risk Free Rate of Interest (2.2%)
DRP = default risk premium (4.1%)
LP = liquidity premium (3%)
MRP = Maturity Risk Premium (1.5%)
IP = Inflation premium (2.75%)
CALLP = call feature premium (1.2%)
COND = convertibility discount (2.5%) 3/6/2024
 Chapter 6

Financial Markets in the

Financial System
 Financial Markets

• It is an arrangement that facilitate the exchange of financial

instruments
• It is the market where surplus funds of economic units are
channeled to those economic units who have shortage of
funds
• Both general markets and specialized markets exist.
• Markets work by placing many interested sellers in one
"place", thus making them easier to find for prospective
buyers.
• An economy which relies primarily on interactions
25between buyers and sellers to allocate resources is known
27as a market economy.
 Financial Markets
• Essential characteristics of a well-run financial market:
– Must be designed to keep transaction costs low.
• Operational Efficiency
– Information the market pools and communicates must be accurate and
widely available and as a result prices reflect relevant information.
• Informational Efficiency
– Borrowers’ promises to pay lenders must be credible and the market
results in highest/best use of funds.
• Allocational Efficiency
• Because of these criteria, the governments are an essential part of financial
markets as they enforce the rules of the game.
– Countries with better investor protections have bigger and deeper financial
25 markets.
28
 Types of financial markets

• Physical assets vs. Financial assets

– Physical vs claims on real assets
• Primary vs. Secondary
– Originally (IPO) sold versus traded after (Secondary offering)
• Money vs. Capital
– Short term vs long term
• Spot vs. Futures
– Now vs later price
• Public vs. Private
– Standardized on recognized exchanges versus direct
25 negotiation
• domestic vs. international
29
 Primary and secondary market

• Primary Market
– When a corporation issues securities, cash flows
from investors to the firm.
– Usually an Investment Banker is involved
• Secondary Markets
– Involve the sale of “used” securities from one
investor to another.

25
30
 Primary and secondary market

Investors
securities
Yeshi Belay
Stocks and
Firms money
Bonds
Money

Primary Market
Secondary
Market
 Primary Markets

Funds

Primary
Market
Securities

25
32
 Primary Markets
• Could be an Initial Public Offering (IPO) or issue of new shares
of an existing publicly traded company.
– Initial public offering (IPO): An IPO occurs when a company offers
stock for sale to the public for the first time.
– Seasoned equity offering (SEO): If a company already has public
shares, an SEO occurs when a company raises more equity.
• Functions of Investment Bankers in primary market
– Advising issuer on terms and timing of offering
• advisor
– Buying securities from issuer
• underwriting
– Distributing issue to public
25 • distributor

33
 Variations in the Underwriting Process

• Bought Deal
– underwriting of bonds
• Auction Process
– underwriting of stocks and bonds
• Preemptive Rights Offering
– underwriting common stock
 Bought Deal

• Investment banking firm or group of firms offers to buy an

entire issue from the issuer.
• Attractive features:
– quick in bringing issue to market
– lower risk of capital loss
 Auction Process

• In this method, the issuer announces the terms of

the issue, and interested parties submit bids for the
entire issue.
• Competitive Bidding Underwriting
– After collecting competitive bids from several underwriters, the
issuer awards the contract to the underwriter with the best price
and contract terms.
• Single-Price Auction or Dutch Auction
– all bidders pay the highest winning yield bid (or,equivalently , the
lowest winning price).
• Multiple-Price Auction
– each bidder pays whatever he/she bids
 Preemptive Rights Offering

• A preemptive right grants existing shareholders the rights

to buy some proportion of the new shares issued at a price
below market value.
• The price at which new shares can be purchased is called
the subscription price.
• the underwriting services of an investment banker are not
needed.
– However the issuing corporation may use the services of an
investment banker for the distribution of common stock that is not
subscribed.
– A standby underwriting arrangement will be used in such instances
to buy unsubscribed shares.
 Secondary Markets

Funds

Secondary
Market

Securities

are where financial claims “live”—are

25
resold and repriced
38
 Function of Secondary Markets

• Providing security values and required returns

• Providing liquidity
 Market Structures

• Continuous Market
– prices are determined continuously throughout
the trading day
• Call Market
– orders are grouped together for simultaneous
execution at the same price
• Mixed Market
– using elements of the continuous and call
market
 Perfect Markets

• Large number of buyers and sellers

• Buyers and sellers are price takers
• Market is frictionless with no transactions costs, taxes and
other impediments
 Brokers as Match Makers

• A broker acts on behalf of an investor who wishes to

execute orders.
• Broker functions:
– Receives, transmits and executes orders
– Brings together buyers and sellers
– Negotiates prices
• In return, the broker receives a commission.
 Dealers as Market Makers

• The dealer holds in inventory the financial asset traded.

• Dealer functions:
– Takes a position (long or short) in the asset
– Provides opportunity to trade immediately
– Offers price information
– Serves as auctioneer
• Dealer profit is the bid-ask spread.
 Money and Capital Markets

• Money markets: wholesale markets for short-term debt

instruments resembling money itself
• Capital markets: where “capital goods” are permanently
financed through long-term financial instruments
(“Capital goods”—real assets held long-term to
produce wealth—land, buildings, equipment, etc.)

25
44
 Money Markets
• Refers to the network of corporations, financial institutions,
investors and governments which deal with the flow of short-term
capital.
• Liquid funds flow between short-term borrowers and lenders
through money markets
• Money markets involve debt instruments with original maturities
of one year or less
• The short-term instruments are highly liquid, easily marketable,
with little chance of loss or low default risk and low cost of
executing transactions.
• Money market instruments have active secondary markets
• They usually pay interest at a fixed rate, which is determined by
market conditions at the time they are issued
• most money-market instruments do not pay periodic interest during
their lifetimes but rather are sold to investors at a discount to their
face value
 What do money markets do?
(Economic role)
• help issuers of money-market instruments with cash
management or with financing their portfolios of financial assets.
▪ attach a price to liquidity, the availability of money for
immediate investment.
▪ Interest rates for extremely short-term use of money serve as
benchmarks for longer-term financial instruments.
▪ eliminate the need to borrow from banks
▪ help the government to borrow money at a lower interest rate
▪ help the implementation of the monetary policies of the central
bank
▪ facilitate the financial mobility from one sector to the other
▪ promote liquidity and safety of financial institutions
▪ bring equilibrium between demand and supply of funds
 Interest rates and prices
▪ Value of money-market securities changes inversely to
changes in short-term interest rates.
▪ Because money-market instruments by nature are short
term, their prices are much less volatile than the prices
of longer-term instruments, and any loss or gain from
holding the security is small.
 Money Market Yields
• Some money market instruments are bought and sold
on a discount basis (e.g., Treasury bills and commercial
paper)
• Discount yields (idy) use a 360-day year
( Pf − P0 ) 360
idy = 
Pf h

Pf = the face value of the security

P0 = the discount price of the security
h = the number of days until maturity
For example, the government made an issue of
Br100,000 ninety-one day bills, each at a discount of
Br1,000. Yield/ discount rate = 4%
 Money Market Instruments

• Treasury bills (T-bills)

• Repurchase agreements (repos or RP)
• Commercial paper (CP)
• Negotiable certificates of deposit (CD)
• Banker acceptances (BA)
• Inter bank loans
 Treasury Bills (T-Bills)
▪ T-Bills are short-term debt obligations issued by
national governments
▪ The Government buys and sells T-bills to implement
monetary policy
▪ T-bills are generally considered the safest of all
possible investments
▪ They are virtually default risk free, are highly liquid,
and have little interest rate risk
▪ Bids are submitted by government securities dealers,
financial and nonfinancial corporations, and
individuals
 T-Bills
▪ In cases where a government is unable to convince
investors to buy its longer-term obligations, treasury
bills may be its principal source of financing
▪ Are now popular in emerging economies with
history of inflation and political instability
▪ As countries develop reputations for better economic
and fiscal management, they are often able to borrow
for longer terms rather than relying exclusively on
short-term instruments
 T-Bills
▪ Some emerging-market countries have issued treasury
bills denominated in foreign currencies, mainly dollars,
in order to borrow at lower rates than the one
prevailing in their home currency.
▪ When a sudden decline in the value of the currency raises
the domestic-currency cost of refinancing that debt, the
government may not be able to meet its obligations unless
foreign investors are willing to purchase new treasury bill issues
to repay maturing issues. This caused debt crises in Mexico in
1995, Russia in 1998 and Brazil in 1999.
 Repurchase Agreement
• A repurchase agreement (repo or RP) is the sale of a
security with an agreement to buy the security back at a
set price in the future
• Repos are similar to short-term collateralized loans
• The repurchase price is higher than the initial sale price, and the
difference in price constitutes the return to the lender.
• The repo rate is the difference between borrowed and paid back cash
expressed as a percentage.
• i = (R − P)/P · n; Where: R, resell value; P, purchase price
⚫ Where “n” is the fraction of a year the repo takes to mature
• NBE agrees to a repurchase deal with CBE to buy the bonds for Br1m, agreeing to
resell in fourteen days for Br1.002m. Yield =5.26%
• A reverse repurchase agreement is the opposite side of a
repo (i.e., it is the purchase of a security with an
agreement to sell it back in the future)
 Commercial Paper
• Commercial paper (CP) is the largest money market in
terms of dollars outstanding
• CP is unsecured short-term corporate debt issued to raise
short-term funds (e.g., for working capital)
• Generally sold in large denominations (e.g., Br.100,000 to
Br.1 million) with maturities between 1 and 270 days
• CP is usually sold to investors indirectly through brokers
and dealers (approximately 85% of the time)
• CP is usually held by investors until maturity and has no
active secondary market
• Yields are quoted on a discount basis (like T-bills)
 Negotiable Certificate of Deposit
• A negotiable certificate of deposit (CD) is a bank-issued time
deposit that specifies the interest rate and the maturity date
• Are interest-bearing bank deposits that cannot be withdrawn
without penalty before a specified date
• CDs are bearer instruments and thus are salable in the secondary
market
• R = D × (1 + c · n); where: R, redemption value; D, initial
deposit; c, coupon rate; n , term to muaturity (fraction of a year)
• P = R ÷ (1 + i · n); where: P, price; R, redemption value; i,
short-term rate
Exercise: Assume a three-month Br50,000 CD, paying 10%
(a) Calculate its redemption value. Br51,250
(b) Find the its price if it has 36 days to maturity and short-term
interest rates are 10%. Br50750
(c) Find the price of this same CD if short-term interest rates fall to
8%. Br50849
 Banker’s Acceptance

• A Banker’s Acceptance (BA) is a time draft payable to a

seller of goods with payment guaranteed by a bank
• Used in international trade transactions to finance trade in
goods that have yet to be shipped from a foreign exporter
(seller) to a domestic importer (buyer)
• Foreign exporters prefer that banks act as payment
guarantors before sending goods to importers
• Banker’s acceptances are bearer instruments and thus are
salable in secondary markets
 Inter Bank loans
• loans extended from one bank to another with which
it has no affiliation
• many of these loans are across international
boundaries and are used by the borrowing institution
to re-lend to its own customers
• they may be used to help the borrowing bank finance
loans to customers, but often the borrowing bank
adds the money to its reserves in order to meet
regulatory requirements
 Money Market Participants

• The Government
• Commercial banks
• Money market mutual funds
• Brokers and dealers
• Corporations
• Other financial institutions
• Individuals
 9

The Capital Market

• The capital market is a market which deals in
long-term loans.
• It functions through the stock exchange
market.
• A stock exchange market is a market which
facilitates buying and selling of shares,
bonds, and other securities for both new and
old ones.
• Capital Markets are divided in to
• Debt Markets
• Equity Markets
 0

Distinction between Money And Capital Markets

1. The money market deals in short-term funds, whereas, the
capital market deals in long-term funds.
2. The money market uses short-term instruments, such as
promissory notes, bills of exchange, treasury bills, certificates
of deposits, commercial papers, etc. whereas; the capital
market uses long-term securities such as shares, debentures,
bonds of industrial concerns and bonds and securities of the
government.
3. Institutions operating in the two markets differ. In the money
market: the central bank, commercial banks, non-bank
financial intermediaries and bill brokers operate. In the capital
market, stock exchange, mutual funds, insurance companies,
leasing companies, investment banks, investment trust, etc,
operate.
Bond Markets
 BOND MARKETS
- the word “bond” means contract, agreement, or
guarantee.
- an investor who purchases a bond is lending money to
the issuer, and the bond represents the issuer’s
contractual promise to pay interest and repay principal
according to specified terms.
- Bonds generally can trade anywhere in the world that a
buyer and seller can strike a deal.
- Generally traded in over-the-counter market—usually
by telephone
- the total size of the bond market worldwide was more
than approximately $120 trillion by the end of 2021
 WHY ISSUE BONDS?
• - diversify sources of funding.
• the issuer can raise far more money without exhausting its
traditional credit lines with direct lenders
•- help issuers carry out specific financial-
management strategies such as Minimizing
financing costs
Firms generally prefer bonds to other forms of leverage, such as
bank loans, because the cost is lower and the funds can be repaid
over a longer period
- Matching revenue and expenses.
Bonds offer a way of linking the repayment of borrowings for long
term projects to anticipated revenue.
 WHO ARE THE ISSUERS?

(1) National governments (sovereigns)

▪ the most secure (risk free) type of bond because the
government can raise taxes or simply print more money to
redeem the bond at maturity
(2) Lower levels of government
▪ bonds issued by a government at the sub-national level,
such as a city, a province or a state, are called semi-sovereigns
or municipal bonds.
(3) Corporations
▪ are issued by a business enterprise- owned by private
investors or by a government.
 ISSUING BONDS
Each issue is preceded by a lengthy legal document- the offer
document, prospectus or official statement. This document
lays out in detail
• -the financial condition of the issuer;
• -the purposes for which the debt is being sold
• -the schedule for the interest and principal payments
required to service the debt
• -and the security offered to bondholders in the event the
debt is not serviced as required.
A bond can be issued either through underwriters & dealers
or directly to the investors. Group of underwriters is called
syndicate.
 TYPES OF BONDS
Straight bonds
▪ - a.k.a debentures
▪ - are the basic fixed-income investment
▪ - owner receives interest payments of a
predetermined amount on specified dates, usually
every six months or every year following the date of
issue.
▪ - the issuer must redeem the bond from the owner at
its face value on a specific date.
 TYPES OF BONDS

Callable bonds
▪ the issuer may reserve the right to call the bonds at
particular dates
▪ the difference between the call price and the current
market price is the call premium.
▪ a bond that is callable is worth less than an identical
bond that is non-callable
 TYPES OF BONDS

Putable bonds
▪ give the investor the right to sell the bonds
back to the issuer at par value on designated
dates.
▪ this benefits the investor if interest rates rise
 TYPES OF BONDS

Perpetual debentures
▪ a.k.a irredeemable debentures,
▪ are bonds that will last forever unless the holder
agrees to sell them back to the issuer.
 TYPES OF BONDS

Zero-coupon bonds
▪ - do not pay periodic interest.
▪ - issued at less than par value and are redeemed
at par value
▪ - are designed to eliminate reinvestment risk, the
loss an investor suffers if future income or
principal payments from a bond must be invested
at lower rates than those available today.
 TYPES OF BONDS

Convertible bonds
▪ are convertible under specified conditions and strictly at the
bondholder’s option, convertible bonds may be exchanged for
another security, usually the issuer’s common shares.
▪ the prospectus for a convertible issue specifies the conversion
ratio, the number of shares for which each bond may be exchanged.
▪ has a conversion value, which is simply the price of the common
shares for which it may be traded.
 TYPES OF BONDS

Adjustable bonds
▪ - there are many varieties of adjustable bonds. The interest rate on a
floating-rate bond can change frequently, usually depending on short-
term interest rates.
▪ - inflation indexed bonds seek to protect against the main risk of bond
investing: the likelihood that inflation will erode the value of both interest
payments and principal.
- Capital-indexed bonds apply an inflation adjustment to interest
payments as well as to principal.
- Interest-indexed bonds adjust interest payments for inflation, but the
value of the principal itself is not adjusted for inflation.
- Indexed zero-coupon bonds pay an inflation-adjusted principal upon
redemption.
 PROPERTIES OF BONDS
Maturity
▪ the date on which the bond issuer will have repaid all of the
principal and will redeem the bond.
▪ bonds with maturities of 1–5 years are usually categorized as
short-term, those with maturities of 5–12 years as medium-term and
those with maturities exceeding 12 years as long-term.
Coupon
▪ the stated annual interest rate as a percentage of the price at
issuance.
▪ once a bond has been issued, its coupon never changes.
 PROPERTIES OF BONDS
Current yield
▪ - the effective interest rate for a bond at its current market price. This is
calculated by a simple formula:
Annual dollar coupon interest/ current price
▪ - if the price has fallen since the bond was issued, the current yield
will be greater than the coupon; if the price has risen, the yield will
be less than the coupon.
▪
Yield to maturity
- this is the annual rate the bondholder will receive if the bond is
held to maturity.
- Unlike current yield, yield to maturity includes the value of any
capital gain or loss the bondholder will enjoy when the bond is
redeemed.
- is the most widely used figure for comparing returns on different
bonds.
▪
Equity Markets
 EQUITY (STOCK) MARKETS

▪ where equity claims are traded

▪ common(ordinary) stock and preferred
stock
▪ Common Stock
The holders of common stock can reap two main benefits from the
issuing company: capital appreciation and dividends
▪ Preferred Stock
Preferred stock doesn't offer the same potential for profit as common
stock, but it's a more stable investment vehicle because it guarantees a
regular dividend that isn't directly tied to the market like the price of
common stock
 Issuing shares
• 1. Flotation
– Flotation, also known as an initial public offering
(IPO), is the process by which a firm sells its
shares to the public. This may occur for a number
of reasons.
• The firm may require additional capital to take
advantage of new opportunities.
• Some of the firm's original investors may want it to buy
them out so they can put their money to work
elsewhere.
• The firm may also wish to use shares to compensate
employees, and a public share listing makes this easier
25 as the value of the shares is freely established in the
77 market place
 2. Private offering

• Rather than selling its shares to the public, a firm

may raise equity through a private offering.
• Only sophisticated investors, such as money
management firms and wealthy individuals, are
normally allowed to purchase shares in a private
offering, as disclosures about the risks involved are
fewer than in a public offering.
• Shares purchased in a private offering are common
equity and are therefore entitled to vote on
corporate matters and to receive a dividend, but
they usually cannot be resold in the public markets
25 for a specified period of time.
78
 3.Secondary offering

• A secondary offering occurs when a firm

whose shares are already traded publicly sells
additional shares to the public or when one or
more investors holding a large proportion of
a firm's shares offers those shares for sale to
the public. Firms that already have publicly
traded shares may float additional shares to
increase their total capital.
25
79
 Types of orders

Market order or limit order

▪ a market order is an order to transact at the
best price available when the order reaches the
trading post
▪ a limit order is an order to transact at a
specified price
MORTGAGE MARKETS
 Mortgage?
a pledge of property to secure payment
of a debt
▪ involves two parties-mortgagor(home
owner) and mortgagee(lender)
▪ real estate that can be pledged as a
mortgage are divided into two as
residential and non-residential property
 TYPES OF MORTGAGES
Four basic types of mortgages are issued by
financial institutions
•home mortgages are used to purchase one- to four-
family dwellings
•multifamily dwellings mortgages are used to purchase
apartment complexes, townhouses, and condominiums
•commercial mortgages are used to finance the
purchase of real estate for business purposes
•farm mortgages are used to finance the purchase of
farms
 Originators

include commercial banks, mortgage

banks, etc
▪ generate income from origination
fee, application fee and profit from
selling a mortgage at a higher price
 Origination process
1. A homeowner applies for a
mortgage loan
2. The mortgage originator performs
credit evaluation of the applicant
based on Loan-to-Value ratio(LTV)
and Payment to Income ratio(PTI)
▪ contract signed
 Mortgage-backed securities
securities issued with mortgages used
as a collateral
▪ THREE types:
1. Pass through securities
2. collateralized mortgage obligation
3. mortgage backed bond
 Mortgage-backed securities

Pass through securities

-a security created by pooling mortgages
and selling shares/participation
certificates in the pool.
-gives the investors a pro rata share of
the principal and interest on the pool
-help investors eliminate the unsystematic
risk
 Mortgage-backed securities

Collateralized Mortgage Obligation

-a multi-class pass through with a
number of bond holder classes
-each bond holder has a different
guaranteed coupon paid
semiannually
 Mortgage-backed securities

3. Mortgage-backed bonds
- bonds in which mortgages are used
as a collateral
- is more a collateralization than
securitization
Foreign exchange
market
 Foreign Exchange Market
➢The foreign exchange market
➢markets where currencies of different countries are
traded
➢comprise all financial transactions denominated
in foreign currency
➢Facilitate exchange of value from one currency to
another
➢Spot rate and forward rate
➢spot rate Involving immediate exchange
➢forward rate Exchange in a specified future date
 2592

Types of Transactions
1. A Spot transaction in the interbank market is the purchase of
foreign exchange, with delivery and payment between banks to
take place, normally, on the second following business day.
– e.g. used if an Ethiopian importer has an account in USD to pay within the
next few days

2. Forward transaction requires delivery at a future date of a

specified amount of one currency for a specified amount of
another currency.
• The exchange rate is established at the time of the agreement, but payment
and delivery are not required until maturity.
– e.g. used if Ethiopian importer has to pay a USD liability in 2 months
• Forward exchange rates are usually quoted for value dates of one, two, three,
six and twelve months.
 2593

Market Participants
❖ The foreign exchange market consists of two tiers:
– the interbank or wholesale market
– the client or retail market (specific, smaller amounts).
❖ There are different categories of participants that operate within these
two tiers:
– bank and nonbank foreign exchange dealers
– individuals and firms
– speculators and arbitragers
– central banks and treasuries
– foreign exchange brokers.
– Investors & Borrowers
 2594

Market Participants
1. Banks and a few nonbank foreign exchange dealers operate in
both the interbank and client markets.
❖ They profit from buying foreign exchange at a “bid” price and
reselling it at a slightly higher “offer” or “ask” price.
2. Individuals (such as tourists) and firms (such as importers,
exporters and MNEs) conduct commercial and investment
transactions in the foreign exchange market.
▪ Exporters receive Foreign currency up on sale of goods & use forex
market to sell foreign currency & buy Birr.
▪ Importers use the FX market to buy foreign currency (sell Birr) to be
used for purchasing imports
 2595

Market Participants
3. Speculators and arbitragers seek to profit from
trading in the market itself.
❖ They operate in their own interest, without a need or obligation to
serve clients or ensure a continuous market.
❖ While dealers seek the bid/ask spread, speculators seek all the
profit from exchange rate changes and arbitragers try to profit
from simultaneous exchange rate differences in different markets.
❖ Speculation : An activity that leaves one open to exchange
rate fluctuations where one aims to make a profit.
❖ Hedging: Allows the firm to transfer exchange rate risk
inherent in foreign currency transactions or positions.
 2596

Market Participants

4. Central banks and treasuries use the market to acquire or

spend their country’s foreign exchange reserves as well as to
influence the price at which their own currency is traded.
❖ They may act to support the value of their own currency
because of policies adopted at the national level or because of
commitments entered into through membership in joint
agreements
❖ The motive is not to earn a profit as such, but rather to
influence the foreign exchange value of their currency in a
manner that will benefit the interests of their citizens.
• They may also purchase foreign currency to pay for imports
or interest on foreign debt.
 2597

Market Participants

5. foreign exchange brokers transact almost

exclusively with FX dealers
6. Investors & Borrowers
• Commercial bank foreign borrowings are usually converted into the
home currency
• Corporations and financial institutions investing overseas
– Need to purchase FX in order to make the investments
– Dividends or interest payments received from overseas
investments will be denominated in a foreign currency
 2598

Foreign Exchange Rates & Quotations

❖ A foreign exchange rate is the price of one currency
expressed in terms of another currency.

❖ A foreign exchange quotation (or quote) is a

statement of willingness to buy or sell at an
announced rate.
 2599

Bid & Ask Quotes

❖ Foreign currency dealers provide two quotes:
Bid Price: Price at which the dealer is willing to buy foreign
currency from you.
Ask Price: Price at which the dealer is willing to sell foreign
currency to you.
▪ It is always the case that the Ask Price > Bid Price. The
difference is the Bid-Ask spread.
▪ The less traded and more volatile a currency, the greater is the
spread.
 2600

Direct & Indirect Quotes

❖ Direct Quote: Home currency per unit of Foreign currency
(FC) - e.g. Birr/$ quote is 51.113 – 51.325
❖ Indirect Quote: Foreign currency per unit of Home currency
- e.g. $/Birr quote of 0.0196 – 0.0195

Bid Ask
❖ Example
$/Birr 52.153 52.371

❖ Bid: Dealer buys $ for Birr at the Bid, Client sells $ for Birr (i.e., dealer will buy
$100,000 for Br5,215,300).
❖ Ask: Dealer sells $ for Birr at the Ask, Client buys $ for Birr (i.e., dealer will sell
$100,000 for Br5,237,100).
 2601

Bid – Ask Spread

❖ Banks act as market makers and realise their

profits from the spread:
Bid-Ask Spread = (Ask-Bid)/Ask

❖ Consider the INDIRECT quote of Br52.153 – 52.371/$

% spread = 52.371 – 52.153 x100 = 0.4%
52.371
 2602

Cross Rates
❖ Many currency pairs are inactively traded, so their exchange
rate is determined through their relationship to a widely
traded third currency.
▪ For example, an Ethiopian importer needs Danish
currency to pay for purchases in Copenhagen.
▪ The Ethiopian Birr is not widely quoted against the
Danish kroner (symbol DKr).
▪ However, both currencies are quoted against the
U.S. dollar. Assume the following quotes:
Ethiopian Birr Birr52.631/US$
Danish kroner DKr7.143/US$
 2603

Cross Rates

❖ The Ethiopian importer can buy one U.S.

dollar for Birr52.631 and with that dollar
buy DKr7.143. Calculate the cross rate.
 2604

Measuring a Change in the Spot Rate

• Measuring a change in the foreign currency

for quotations expressed in home currency
terms (direct):
%∆ = Ending rate – Beginning Rate x 100
Beginning Rate

• Quotations expressed in foreign currency

terms (indirect):
%∆ = Beginning Rate – Ending Rate x 100
Ending Rate
 2605

Example
❖ The Ethiopian birr was quoted at
US$0.0501/Birr on Aug 19, 2015, while on
November 2, 2015 it was quoted at
US$0.0481/Birr.

What is the appreciation/depreciation of the Birr?

 2606

Example

❖ Thus, the appreciation/depreciation of the Birr,

relative to the US$ from t-1 to t is:

Rt-1,t = 0.0481 – 0.0501 = -4%

0.0501
Thus, the Ethiopian Birr has
depreciated relative to the U.S.$ by
4%
 2607

Example

❖ To calculate the appreciation/depreciation of the

US$, relative to the Birr, we want the
denominator currency to be the US$:
▪ At t-1: US$0.0501/Birr= Birr19.9601/US$
▪ At t: US$0.0481/Birr= Birr20.79/US$
Rt-1,t = 20.79 – 19.9601 = 4.2%
19.9601
Thus, the US$ has appreciated
relative to the Birr by 4.2%
 Determinants of Exchange Rate
▪ relative inflation rates
▪ relative interest rates
▪ relative income levels
▪ government controls
▪ expectations-about inflation,interest
rate,income level ,and government
action
 Government influence on
exchange Rates

1) Direct intervention
▪ by exchanging foreign currency with
local currency
▪ can be non-sterilized or sterilized
intervention
 Government Influence On
Exchange Rates
Non-sterilized intervention
▪ the government buys or sells local
currency to manipulate its value
▪ no offseting transaction is undertaken
in the money market to keep money
supply unaffected
 Government Influence On
Exchange Rates
Sterilized intervention
▪ the government buys or sells local
currency(in the forex market) to
manipulate the exchange rate and at
the same time undertakes an offseting
transaction in the money market to
keep money supply unaffected
 Government Influence On
Exchange Rates
2) indirect intervention
▪ adjustment of interest rate
-increase interest rate to discourage
outflow of funds
▪ using foreign exchange controls
-restriction on the exchange of the
currency
 International arbitrage

▪ Locational arbitrage-taking advantage of

price differences at different locations
▪ Triangular arbitrage- undertaking currency
transactions to take advantage of
discripancies in cross exchange rates of two
currencies
Eg. €1=$1.50 €1=22ETB 1ETB= $0.08
Suppose you want to convert ETB100,000
to Euros. What is your arbitrage profit?
 International Arbitrage
▪ Cross rate bn ETB & USD is
1ETB=$0.068
Steps
(1) convert ETB to USD $8,000
(2) convert USD to Euro €5,333
(3) spot market price of
ETB100,000 in Euros €4,545
Arbitrage Profit €788
 Purchasing power parity(PPP)

➢Absolute PPP: states that price of the

same basket of products should be the
same when measured in common
currency assuming no international
trade barrier and transport costs
 Purchasing power parity(PPP)

Relative PPP: prices of the same basket

of goods do not agree when measured
in common currency because of
transportation, tariffs and quotas. But
the rate of change in prices should be
similar as long as transportation and
other costs remain unchanged
 Purchasing power parity(PPP)
PPP is based on the fact that
consumers shift demand from local
goods to imported goods when
domestic inflation increases.
▪ this leads to appreciation of foreign
currency, causing imported goods to
be expensive.
 Purchasing power parity(PPP)

▪ PPP states that exchange rates

should change nulifying the change
in price levels, and hence making
consumers indifferent about
purchasing domestic or foreign
goods
 Purchasing power parity(PPP)
Example:
Suppose inflation in Ethiopia increased
by 8% and in Kenya by 4%, what would
be the change in the exchange rate
between ETB and Kenyan Shilings?
= [1.08/1.04]-1
= 3.8% (depreciation of ETB)
Derivative markets
 DERIVATIVE SECURITIES MARKETS
Derivative Securities
▪financial instruments the value of which is based on or derived from
the prices of an underlying asset in derivatives markets
▪Two main types of derivative contracts
▪Commodity (e.g. gold, wheat and cattle)
▪Financial (e.g. shares, government securities and money market instruments)
▪Are created to manage price volatility
Four main types of derivatives markets
1. Futures Markets
2. Forward Markets
3. Options
4. Swaps
 DERIVATIVE SECURITIES MARKETS

▪ Forward contract
-agreement between buyer and seller to
trade securities for cash on a specific date
▪ Future contract
-similar to forward contract, except that
it is traded in an organized exchange
-asset standardized and indeminity is
available in case of default
 FUTURES MARKETS
• A futures contract is the right to buy or sell a specific item at
a specified future date at a price determined today.
• Standardized contracts permit centralized trading without
market makers.
• A futures contract is an agreement between a buyer and a
seller, in which:
– the buyer agrees to take delivery of something at a specified price at
the end of a designated period, and
– the seller agrees to make delivery of something at a specified price at
the end of a designated period.
• Features:
– Exchange traded
– Dealt on standardised terms
 Main Features of futures Markets

1. Orders and agreement to trade

• Futures contracts are highly standardised and an order
normally specifies
– Whether it is a buy or sell order
– Delivery month (expiration)
– Price restrictions (if any) e.g. limit order
– Time limits on the order (if any)
 2625
Main Features of futures Markets

2. Margin requirements
– Both the buyer (long position) and the seller (short position) pay an
initial margin, held by the clearing house
– Margins are imposed to ensure traders are able to pay for any
losses they incur due to unfavourable price movements
– Subsequent margin calls may be made, requiring a contract holder
to pay a variation margin, to top-up the initial margin to cover
adverse price movements
 2626

Main Features of futures Markets

3. Closing out of a contract

– Involves entering into an opposite position
– Example: if company X initially entered into a ‘sell one ten-year
treasury bond contract’, it would close out the position by
entering into a ‘buy one ten-year treasury bond contract’
4. Contract delivery
– Most parties to a futures contract
• Manage a risk exposure or speculate
• Do not wish to actually deliver or receive the underlying
commodity/instrument and close out of the contract prior
to delivery date
 Futures Market Participants

• Four main categories of participants

– Hedgers
– Speculators
– Traders
– Arbitragers
• These participants provide depth and liquidity
to the futures market; thus, improving its
efficiency
 Four main categories of participants

• Hedgers
– Attempt to reduce the price risk from exposure to changes in
interest rates, exchange rates and share prices
– Take the opposite position to the underlying, exposed transaction
– Example: exporter has USD receivable in 90 days. To protect
against fall in USD over next 3 months, exporter enters into a
futures contract to sell USD
 Four main categories of participants (cont.)

• Speculators
– Expose themselves to risk in the attempt to make profit
– Enter the market in the expectation that the market price will
move in a favourable direction for them
– Example: speculators who expect the price of the underlying
asset to rise will go long and those that expect the price to fall
will go short
 Four main categories of participants (cont.)

• Traders
– Special class of speculator
– Trade on very short-term changes in the price of futures contracts
(i.e. intra-day changes)
– Provide liquidity to the market
 Four main categories of participants (cont.)

• Arbitragers
– Simultaneously buy and sell to take advantage of price
differentials between markets
– Attempt to make profit without taking any risk
– Example: differentials between the futures contract price and the
physical spot price of the underlying commodity
 2632

FORWARD MARKETS
• The owner of a forward has the OBLIGATION to sell or buy
something in the future at a predetermined price.
• The difference to a future contract is that forwards are not
standardized.
• A forward contract is traded in the over-the-counter market—
usually between two financial institutions or between a financial
institution and one of its clients.

• A Forward Contract underlies the same principles as a future

contract, besides the aspect of non-standardization.
 The differences between forwards and futures
• Forwards are tailor-made (the bank sets the maturity date and the
amount by responding to its client’s needs), futures contracts are
standardized.
• Forwards are an OTC instrument, futures trade in organized
centralized exchanges supported by centralized clearing houses.
• Thus, settlement and margins are strictly regulated in futures;
subject to ‘relations’ in forwards
• In futures, the clearing house is the counterparty to all outstanding
contracts.
 Options Markets
• An option gives the buyer the right, but not the obligation, to buy or
sell a specified commodity or financial instrument at a
predetermined price (exercise or strike price), on or before a
specified date (expiration date)
• Options limit the effects of adverse price movements without
reducing profits from favourable price movements
• Options involve a premium to be paid by the buyer to the seller
(writer)
• An option will only be exercised if it is in the buyer’s best interest
• Options can trade both in OTC and in organized exchanges.
 The Nature of Options

• Types of options
– Call options
• Give the option buyer the right to buy the commodity or
instrument at the exercise price
– Put options
• Give the buyer the right to sell the commodity or
instrument at the exercise price
• Options can be exercised either (option style)
– Only on expiration date (European)
– Any time up to expiration date (American)
 The Nature of Options

• Premium is the price paid by an option buyer to the writer (seller) of the option
• ‘Cap’—an options contract that places an upper limit on an interest rate/
exchange rate/security price
• ‘Floor’—an options contract that places a lower limit on an interest rate /
exchange rate/security price
• ‘Collar’—a combination of cap and floor options limiting upper and lower rates/
prices
 Exercise 1

1. Suppose a call option on a stock has an exercise

price of Br.70 and a cost of Br.2, and suppose
you buy the call. Identify the profit to your
investment, at the call’s expiration, for each of
these values of the underlying stock: Br.25,
Br.70, Br.100, Br.400.
2. Consider again the situation in question 1.
Suppose you had sold the call option. What
would your profit be, at expiration, for each of
thestock prices?
 2638

Exercise 2
• Assume the current price for a stock is Br1,000 per share, and the following premiums
exist for options to buy or sell the stock 6 months from now:

Strike Price Call Premium Put Premium

Br 950/share Br60/share Br 40/share

Required:
1. When can the option buyer exercise the right?
2. Suppose the price of stock becomes Br1050/share on the expiration date.
Should the option buyer exercise his right on this date and what should be the
profit or loss?
3. Suppose the price of stock becomes Br890/share on the expiration date. Should
the option buyer exercise his right on this date and what should be the profit or
loss?
 Swaps

▪ Agreement to exchange specified periodic cash flows

in the future based on some underlying instrument or
price
▪ eg. Interest rate swap
▪ An OTC derivate transaction where the parties
periodically exchange interest payments but
not the principal amount
▪ Client wants to swap exposure to floating rates of
interest on borrowings with fixed rates
 Chapter 7

The Regulation of Financial

Institutions & Markets
 Chapter objectives
After completing this unit, you should be able to:
• Define financial regulation
• Identify the forms of financial regulation
• Explain the purposes of financial regulation
• Identify and describe the different financial
regulations, especially banking regulation
 Contents
• Unique features of the financial system
• Meaning of Financial Regulation
• Forms of financial regulation
• Commercial Bank Regulation
 Unique features of the financial system

1. Systemic risk
– By their nature, financial transactions
involve promises to make payments at
specified times, in specified amounts and in
specified circumstances. Such promises
inevitably involve uncertainty and yet play
a fundamental role in the efficient
functioning of commerce, facilitating the
settlement of trade and channeling resources
efficiently across time and space.
 Unique features of the financial system
Systemic risk (cont’d)
– The more sophisticated the economy, the greater its
dependence on financial promises and the greater its
vulnerability to failure of the financial system to
deliver against its promises.
– The importance of finance and the potential for
financial failure to lead to systemic instability
introduces an overarching externality.
– The importance of finance and the potential for
financial failure to lead to systemic instability
introduces an overarching externality
 Unique features of the financial system
2. Information Asymmetry
• Being the second unique feature of a financial
system, it involves existence of informational
imbalances between financial institutions and
retail consumers of financial services
 Meaning of Financial Regulation
• Financial regulation refers to a process in
which there is a monitoring of the financial
institutions by a body that is directed by the
government in an effort to achieve
macroeconomic goals through monetary
policies as well as other measures permissible
by law.
 Purpose of financial regulation (1)
1. Macroeconomic and microeconomic stability
• Safeguarding of the stability of the system translates into
macro controls over the financial exchanges, clearing
houses and securities settlement systems.
• Measures pertaining to the micro stability of the
intermediaries can be subdivided into two categories:
a) General rules on the stability of all business
enterprises and entrepreneurial activities
• the legally required amount of capital,
• borrowing limits and
• integrity requirement
 Purpose of financial regulation (2)
Macroeconomic and microeconomic stability
(cont’d)
b) More specific rules due to the special nature
of financial intermediation
– risk based capital ratios,
– limits to portfolio investments
– the regulation of off-balance activities
 Purpose of financial regulation (3)
2. Transparency
– To promote transparency in the market and in
intermediaries and investor protection
– linked to the more general objective of equity
in the distribution of the available resources,
including information
 Purpose of financial regulation (4)
3. Efficiency
– the safeguarding and promotion of
competition in the financial intermediation
sector
– rules for control over the structure of
competition in the markets
– regulations in the matter of concentrations,
cartels and abuse of dominant positions
 Forms of Financial Regulation (1)
1. Financial market integrity regulation
– the regulation of fundraising and securities and
derivatives markets, both through exchanges and
‘over the counter’
– It encompasses disclosure requirements in these
areas, approval and oversight of exchanges, and
prohibitions on unfair trading practices or market
manipulation
 Forms of Financial Regulation (2)
2. Competition regulation
– laws which aim to ensure that participants in a
market engage in practices which, as far as
possible, accord with the principles of perfect
competition.
– The aim of such regulation is to prevent
concentration of ownership or collusion between
suppliers in markets where this leads to
monopolistic pricing or to prevent other conduct
which damages competition.
 Forms of Financial Regulation (3)
3. Prudential regulation
– regulation whose aim is to ensure, or increase the
likelihood, that financial institutions are able to
meet their promises, whether to address systemic
risk or to reduce risks for consumers.
– aims mainly at preventing credit risk for the
depositor, market risk, and payment risk
– Examples of prudential regulations are capital
adequacy requirements, solvency and liquidity
requirements, investment guidelines or restrictions,
and requirements to undertake particular risk
management procedures.
 Forms of Financial Regulation (4)
4. Consumer protection regulation
– regulating the conduct of business with
consumers
– regulating for disclosure of information relating
to products and services (such as prices, terms
and conditions)
– enforcing contracts, preventing fraud and
resolving disputes
– providing arrangements for the protection of
depositors (or other investors) from losses due to
financial failures
 Review Questions
1. What are the unique features of a financial
system?
2. What is financial regulation?
3. What are the purpose of financial regulation?
4. Mention the different forms of financial
regulation
Commercial Bank Regulation
 1. Safety and soundness regulation
– Assets must be diversified: cannot make loans
greater than:
• 25% of the total capital to any one unrelated
party borrower
• 15% of the total capital to one related party,
and
• 35% of the total capital to all related party
borrowers
– A shareholder is said to be related party to the
bank if it holds 2% or more of the banks
subscribed capital
 Safety and soundness regulation (cont’d)
– Banks must maintain adequate equity capital levels to
protect against insolvency risk i.e. ETB 500,000 million
(27.7 million USD) & plan to increase to ETB 2 billion.
– Selected country experience (Source: Deloitte,2013):
• Kenya - US$11,709,600
• Mozambique – US$2.5 million
• Ghana - US$31.9 million
• Angola - US$6 million
• Nigeria - US$159 million
• South Africa - US$29.4 million or 10% of risk
weighted assets, higher of the two
 Safety and soundness regulation (cont’d)
– Guarantee funds: provision of guarantee funds
such as the Deposit Insurance Fund (DIF) protects
depositors in the event of default and prevents
bank runs (does not exist in Ethiopia)
– Monitoring and surveillance: banks must submit
(publicly accessible) quarterly and annual reports
and are subject to on-site examinations
 2. Monetary policy regulation
– The Central Bank (the National Bank of
Ethiopia) directly controls the quantity of
notes and coin (i.e., outside money) in the
economy
– However, the bulk of the money supply is held
as bank deposits, called inside money
– Regulators require cash reserves to be held at
commercial banks and central bank
 3. Credit allocation regulation
– Regulators encourage (and often require) lending
to socially important sectors of the economy
(e.g., Agriculture, manufacturing)
– lending regulation cap interest rates that can be
charged on loans i.e. 7.5% to priority sectors
through Development Bank of Ethiopia
4. Investor protection regulation
– Regulation protecting investors against insider
trading, lack of disclosure, and breach of
fiduciary responsibility
– In Ethiopia, the maximum single shareholding
limit by an investor is 5%, including a related
party. Besides, limitations are placed by NBE on:
• the number of votes by proxy in any meeting
of shareholders
• voting right of a holder, who borrowed
money from the bank
Investor protection regulation (cont’d)
Selected country experience (Source:
Deloitte,2013):
• Kenya – 25%
• Angola – Not required
• South Africa - Not required
5. Entry and chartering regulation
– The entry of commercial banks is regulated by
the Central Bank (National Bank of Ethiopia)
which is the sole authority responsible for
issuing banking licenses (Proclamation No
592/2008).
– In Ethiopia, foreign entities are not allow to
entry in any form of banking.
– The permissible activities of commercial banks
are defined by regulators
6. Activity restrictions
• There are four fundamental areas of activity
restrictions, namely: securities dealings, insurance
business, real estate and non-financial firms dealing.
• Banks may be allowed to directly conduct a full range
of securities dealings and insurance business. However,
Ethiopia does not allow these activities.
• In some countries, a full range of real estate activities is
allowed for banks. Although Ethiopia has no law that
prohibits banks from financing real estate, there are
some temporary restrictions of financing the real estate
sector.
Activity restrictions (cont’d)
Some countries allow for non-financial activities
to be carried out within subsidiaries and/or in
another part of the common holding company or
parent, subject to regulatory limit or approval.
Ethiopia does not allow for any non-financial
activities to be carried out (whether directly or
within the group of associated companies)
 Activity restrictions (cont’d)
• In Ethiopia, NBE’s directive No SBB/60/2015
indicates that banks are not allowed to engage in
non-bank business except the following:
– may hold equity shares in insurance business
not exceeding 5% of an insured’s subscribed
capital
– Engage in interest free banking in line with
NBE’s directive
– Hold up to 10% equity shares in a single non-
banking business other than insurance.

13-
Activity restrictions (cont’d)
❑ SBB/60/2015 also stipulates that:
• a bank’s aggregate equity investment in all
non-bank businesses, including insurance
companies, cannot exceed 10% of its net
worth.
• No bank shall invest more than 10% of its net
worth in real estate acquisition, other than for
own business premises, without the approval
of NBE
• No bank can deal in securities. Nevertheless,
a bank can provide securities brokerage
services to its customers acting as their agent.
13-
 Activity restrictions (cont’d)
According to Deloitte (2013), a bank may
own equity in any non-financial firm in the
following selected African countries:
• Kenya – 100%
• Mozambique – 50%
• Ghana – 100%
• Angola - 100%
• Nigeria - 100%
• South Africa -100%

13-
 Review Questions
1. Indicate the lending limits of Ethiopian banks
as per NBE regulation
2. What is the minimum capital requirement for
establishing a bank in Ethiopia?
3. What are the two types of Monitoring and
surveillance mechanisms that NBE uses over
the financial system?
4. What is the maximum that a bank may own
equity in a single non-financial firm in
Ethiopia?
 7. Product Segmentation Regulation
– The main products of Commercial banking are deposit
taking and lending
– Investment banking involves underwriting, issuing, and
distributing securities.
– In Ethiopia, there is no distinction between commercial
banking and investment banking. Investment banking
activities hardly exist in Ethiopia.
– The Act or law of some countries restrict insurance
companies from owning or being affiliated with commercial
banks.
– In Ethiopia, banks can have 5% ownership in insurance
companies (SBB/60/2015).
– The laws of some countries restrict commercial firms from
acquiring banks or banks to invest in commercial firms.
 8. Geographic Expansion Regulation
• Restrictions on intrastate banking
– Some countries allows only unit banks i.e.,
banks with single offices
– In Ethiopia, Banks can open branches in any
part of the country and foreign countries.
– As of November 2016, there are more 3800
bank branches (Fortune 18 December 2016) all
over the country, the bank with largest
branches being CBE (1140)
9. External Auditing requirements
• According to Basel Accord, the key means of
ensuring reliable information within banks is
sound and comprehensive internal control and
risk management systems, complemented by
effective internal audit activities
• In addition, assurance about the reliability of
disclosed information can be enhanced through
audit by independent external auditors.
 10. Appointment of an auditor
– Central banks (e.g. the National Bank of Ethiopia)
require all commercial banks to appoint a
professional external auditor. In Ethiopia, the
National Bank of Ethiopia approves the
appointment of the auditor for commercial banks
(SBB/19/1996).
– Such an auditor is required to have passed a specific
exam or to possess an accepted professional
qualification and/or to have registered with a
recognised professional body.
– A rotation policy for the audit firm exists in all
countries, every three years in Ethiopia
11. Audit Scope, findings, & reports
• Audit Scope
– Regulations in most countries require audits to
be conducted in accordance with the
International Standards on Auditing (ISA).
• Audit Findings and reports
─ All countries require the audit report on the
financial statements to be made publicly
available and handed to the central bank or
banking regulatory body.
─ The audit statements are to be accompanied by
the auditor’s letter to the bank management
 12. Balance Sheet Regulation (1)
1. Liquidity regulation
– Banks must hold minimum levels of reserves
against net transaction accounts
– ensures that banks can meet required
payments on liability claims such as deposit
withdrawals
– In Ethiopia, commercial banks are required
to maintain liquid assets of not less than 15%
of its net current liabilities (SBB/57/2014).
 Balance Sheet Regulation (2)
Liquidity regulation (cont’d)
– Liquid assets include cash in hand, balance
with NBE, balance with other banks (both in
Ethiopia and abroad), and money at call and
short notice.
– Current liabilities refer to the sum of demand
deposits, saving deposit, time deposits and
similar liabilities with less than one-month
maturity.
 Balance Sheet Regulation (3)
Liquidity regulation (cont’d)
• All commercial banks are required to submit a
properly certified liquidity position report to
NBE on the week ended each Wednesday.
 Balance Sheet Regulation (4)
2. Capital adequacy regulation
– Regulatory capital requirements are provided
to cover various types of risk (credit, market
and operational risk)
– In some countries, commercial banks have
faced two different capital requirements
a) Tier I capital risk-based ratio
b)Total capital (Tier I + Tier II) risk-based
ratio
 Balance Sheet Regulation (5)
• Capital adequacy regulation (continued)
– Tier I capital is composed of the book value of common
equity plus an amount of perpetual preferred stock plus
minority equity interests held by the bank in subsidiaries minus
goodwill (allowed in Ethiopia)
– Tier II capital includes secondary capital resources such as
loan loss reserves and convertible and subordinated debt (not
allowed in Ethiopia
– risk-adjusted assets include both on- and off-balance-sheet
assets whose values are adjusted for approximate credit risk
– the total risk-based capital ratio is equal to the sum of Tier I
and Tier II capital divided by risk-adjusted assets
– the Tier I (core) capital ratio is equal to Tier I capital divided
by risk-adjusted assets
 Balance Sheet Regulation (6)
• Capital adequacy regulation (continued)
– Banks may also be assessed based on their
capital-to-assets (i.e., leverage) ratio
• capital-to-assets ratio = core capital ÷ total assets
• does not account for market values, riskiness of
assets, or off-balance-sheet activities
– In Ethiopia, the minimum capital to risk
weighted assets ratio is 8% (SBB/50/2011)
 Balance Sheet Regulation (7)
3. Depositor (savings) protection schemes
• Some countries (e.g. USA, Nigeria) offer
Depositor protection schemes in the form of
insurance, reserve, deposit protection fund etc
• In Ethiopia, banks are required to maintain a
reserve account with NBE and contribute 25% of
their annual net profit until it reaches the paid-up
capital of the bank and 5% annually afterward.
 Balance Sheet Regulation (8)
4. Asset classification, provisioning and
write-off requirements:
• Countries normally have an asset
classification system under which banks have
to report the quality of their loans and
advances.
• For example, the provisioning rules are on
the next slide.
 Balance Sheet Regulation (9)
Provisioning and write-off requirements (SBB/43/2008):
Loan category Past due Extent of Provision
Required
Pass loans Past due but fully 1% of outstanding loan
protected balances
Special mention loans 30<X<90 3% of the outstanding loan
balances
Substandard loans 90<X<180 20% of the net loan
balance
Doubtful loans 180<X<360 50 % of the net loan
balance
Loss loan 360 days 100% of the net loan
balance
 13. Off-Balance-Sheet Regulation
• Banks earn fee income with off-balance-sheet
(OBS) activities
• By engaging in OBS activities, banks can avoid
regulatory costs such as reserve requirements,
deposit insurance premiums, and capital adequacy
requirements
• Banks may be required to report notional values of
OBS activity on a separate schedule.
• OBS activity is incorporated into the total risk-based
capital ratio and the Tier I capital ratio, but not the
leverage ratio
 Review Questions
1. What is the permissible ownership interest that
an Ethiopian commercial bank can have in
insurance business?
2. What is the role of NBE in the appointment of
external auditors by Ethiopian banks?
3. What is the minimum capital to risk weighted
assets ratio required of Ethiopian banks?
The end
46) Which one of the following is not a role played by an investment
bank?

A. Buying the securities from the issuer and then reselling them in the
market.

B. Advising the issuer on the terms and the timing of the offering.

C. Distributing newly issued securities to the public.

D. Investing in a diversified portfolio on behalf of its shareholders

D
47) The function of buying securities from a corporation at a
predetermined price and then reselling them in the market by an
investment bank is called:

A. Distributing

B. Underwriting. B
C. Advising.

D. Undertaking.
48) Which of the following is the common characteristics of all
financial markets:

A. It allows common stock to be traded.

B. It allows loans to be made.

C. It channels funds from lenders-savers to borrowers-spenders.

D. It determines the level of interest rates C

48) Bonds that are sold in a foreign country and are denominated in the
country's currency in which they are sold are known as

a. Country bonds.

b. Foreign bonds. B
Eurobond is an international bond issued in a different currency than the
c. Equity bonds: domestic currency. A Eurobond is also called an external bond.

Equity-linked bonds have features of both debt and equity.

d. Eurobonds
49) Which of the following is not a function of a financial
system:

A. Investment function

B. Risk elimination function

B
C. Payment function

D. Saving function
50) Which of the following financial intermediaries is not a
depository institution?

A. A finance company A

A finance company is an organization

B. A savings and loan association that makes loans to individuals and
businesses.
Unlike a bank, a finance company does
C. A commercial bank not receive cash deposits from clients,
nor does it provide some other services
common to banks, such as checking
D. A credit union accounts.
51) Which of the following is commonly traded in the money
market

A. Preferred shares

D
B. Treasury note

C. Government bond

D. Treasury bill
53) Financial institutions will function in economy by:
A.Facilitate the flow of funds from savers (surplus units) to
borrowers (deficit units) in the most efficient manner.
B.Collect the savings of individuals and corporations and
channel them to firms that use the money to finance their
investments
C.Provision of liquidity and the transformation of the risk
characteristics of assets.
D.All of the above D