Chapter 1: Accounting for Inventories

Chapter 1
Accounting for Inventories
Chapter Outlines
This chapter covers the following topics:
 Importance of Inventories
 Inventory Systems: Periodic versus Perpetual
 Determining Actual Quantities in Inventory
 Determining the Cost of Inventory
 Inventory Costing Methods under Periodic Inventory System
 Accounting for Inventory under Perpetual Inventory System
 Inventory Costing Methods under Perpetual Inventory System
 Valuation of Inventory at Other than Cost
 Estimating Inventory Cost
 Presentation of Merchandise Inventory on the Balance Sheet.
Chapter Learning Objectives
After studying this chapter, you should be able to:
 Describe the steps in determining inventory quantities
 Prepare the entries for purchases and sales of inventory under a periodic inventory system
 Determine cost of goods sold under a periodic inventory system
 Identify the unique features of the income statement for a merchandiser using a periodic
inventory system
 Explain the basis of accounting for inventories, and describe the inventory cost flow
methods
 Explain the financial statement and tax effects of each of the inventory cost flow methods
 Explain the lower of cost or market basis of accounting for inventories
 Indicate the effects of inventory errors on the financial statements
 Compute and interpret inventory turnover
1.1 Importance of Inventories
Definition: inventories are:
 Merchandise held for sale in the normal course of operation in merchandising businesses
 Materials in process of production or
 Materials held for production purpose (Raw Materials).
But in this chapter the emphasis is mainly on merchandises purchased and held for resale.
Objective-the major objective of accounting for inventories is the proper determination of income
through the process of matching appropriate cost against revenues.
The Importance of inventories includes:
 Merchandise inventory is one of the most active elements in the operation of a merchandising
business because it is continually purchased and sold.
 The sale of merchandise is the principal source of revenue in both merchandising and
manufacturing business.
 The cost of merchandise sold is the largest deduction from net sales in the determination of net
income or net loss.
 It is the largest portion in the current asset of merchandising businesses
The Effect of an Error in the Determination Inventory on the Financial Statements
Inventory determination plays an important role in matching expired costs with revenues of the
period. An error in the determination of the inventory amount at the end of the period will cause the
following errors:
 Misstatement of gross profit and net income
 The incorrect amount of inventory i.e. the inventory to be reported in the balance sheet is
incorrect amount.

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 Chapter 1: Accounting for Inventories
Illustration 1.5: the effect of an error in the determination of ending inventory on the current
period for BB Company. You are given the following data for year I.
Net Sales for year I............................................... Br 450,000
Beginning Inventory (January 1, Year I)............. 75,000
Net Purchases....................................................... 420,000
Other Assets (December 31, Year I).................... 310,000
Liabilities (December 31, Year I)........................ 225,000
Operating Expenses.............................................. 135,000
Instruction: Prepare Income Statement and Balance Sheet under the following assumption:
1. Ending Inventory is correctly stated at Br 220,000
2. Ending Inventory is incorrectly stated at Br 210,000
3. Ending Inventory is incorrectly stated at Br 225,000
Assumption 1: Ending Inventory is correctly stated at Br 220,000
Income Statement
BB Company
Income Statement
For the year ended December 31, Year I
Net Sales.............................................................. Br 450,000
Less: Cost Goods Sold........................................
Beginning Inventory........................... 75,000
Net Purchases..................................... 420,000
CMAS................................................ 495,000
Less: Ending Inventory....................... (220,000)
Cost of Goods Sold............................. (275,000)
Gross Profit.......................................................... 175,000
Less: Operating Expenses.................................... (135,000)
Net Income.......................................................... Br 40,000
Balance Sheet
BB Company
Balance Sheet
December 31, Year I
Merchandise Inventory........................................
220,000 Liabilities...........................
225,000
Other Assets........................................................
310,000 Capital................................
305,000
Total Assets.........................................................
530,000 Liabilities and OE.............. 530,000

Assumption 2: COEI is incorrectly stated as Br 210,000 (Understated by Br 10,000)

Income Statement
BB Company
Income Statement
For the year ended December 31, Year I
Net Sales.............................................................. Br 450,000
Less: Cost Goods Sold........................................
Beginning Inventory........................... 75,000
Net Purchases..................................... 420,000
CMAS................................................ 495,000
Less: Ending Inventory....................... (210,000)
Cost of Goods Sold............................. (285,000)
Gross Profit.......................................................... 165,000
Less: Operating Expenses.................................... (135,000)
Net Income.......................................................... Br 30,000
Balance Sheet
BB Company
Balance Sheet
December 31, Year I

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 Chapter 1: Accounting for Inventories
Merchandise Inventory..................................
210,000 Liabilities........................
225,000
Other Assets...................................................
310,000 Capital.............................
295,000
Total Assets....................................................
520,000 Liabilities and OE........... 520,000
The effects of understating Ending Inventory by Br 10,000 were as follows:
1. In the income statement
 It increases Cost of Goods Sold by Br 10,000
 It decreases Gross Profit by Br 10,000
 It decreases Net Income by Br 10,000 or increases Net Loss by Br 10,000
2. In the balance sheet
 It understates total assets by Br 10,000
 It understates Capital by Br 10,000

Assumption 3: COEI is incorrectly stated as Br 225,000 (Overstated by Br 5,000)

Income Statement
BB Company
Income Statement
For the year ended December 31, Year I
Net Sales........................................................ Br 450,000
Less: Cost Goods Sold...................................
Beginning Inventory...................... 75,000
Net Purchases................................. 420,000
CMAS............................................ 495,000
Less: Ending Inventory.................. (225,000)
Cost of Goods Sold........................ (270,000)
Gross Profit.................................................... 180,000
Less: Operating Expenses.............................. (135,000)
Net Income..................................................... Br 45,000

Balance Sheet
BB Company
Balance Sheet
December 31, Year I
Merchandise Inventory..................................
225,000 Liabilities........................
225,000
Other Assets...................................................
310,000 Capital.............................
310,000
Total Assets....................................................
535,000 Liabilities and OE........... 535,000
The effects of overstating Ending Inventory by Br 5,000 were as follows:
1. In the income statement
 It decreases Cost of Goods Sold by Br 5,000
 It increases Gross Profit by Br 5,000
 It increases Net Income by Br 5,000 or decreases Net Loss by Br 5,000
2. In the balance sheet
 It overstates total assets by Br 5,000
 It overstates Capital by Br 5,000
Summary of error in ending inventory on the financial statement of the period in which the error
occurs are as follows:

Ending Inventory Correctly Stated Understated Overstated

Cost of Goods Sold Unaffected Overstated Understated
Gross Profit Unaffected Understated Overstated
Net Income Unaffected Understated Overstated
Total Assets Unaffected Understated Overstated
Capital Unaffected Understated Overstated

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 Chapter 1: Accounting for Inventories
The understatement or overstatement of ending inventory does not only affect the financial
statement of one accounting period but also the financial statement of the subsequent period.
Illustration 1.2: The effect of an error in the determination of Ending Inventory in year I will have
the following impact on the financial statements of the subsequent accounting period. You are
given the following data for Year II:
Net Sales for Year II.................................................. Br 600,000
Net Purchases............................................................. 375,000
Ending Inventory........................................................ 150,000
Operating Expenses.................................................... 105,000
Other Assets (December 31, Year II)......................... 300,000
Total Liabilities (December 31, Year II).................... 110,000
Instruction: Prepare Income statement and balance sheet assuming that ending inventory of year I
are reported under the three assumptions above for BB Company
1. Beginning Inventory is Correctly Stated at Br 220,000
2. Beginning Inventory is incorrectly stated Br 210,000
3. Beginning Inventory is incorrectly stated at Br 225,000
Assumption 1: Beginning Inventory is correctly stated as Br 220,000
Income Statement
BB Company
Income Statement
For the year ended December 31, Year II
Net Sales............................................................................... Br 600,000
Less: Cost Goods Sold.........................................................
Beginning Inventory........................................ 220,000
Net Purchases.................................................. 375,000
CMAS............................................................. 595,000
Less: Ending Inventory.................................... (150,000)
Cost of Goods Sold.......................................... (445,000)
Gross Profit.......................................................................... 155,000
Less: Operating Expenses..................................................... (105,000)
Net Income........................................................................... Br 50,000
Balance Sheet
BB Company
Balance Sheet
December 31, Year II
Merchandise Inventory.................................................
150,000 Liabilities................................
110,000
Other Assets.................................................................
300,000 Capital.....................................
340,000
Total Assets..................................................................
450,000 Liabilities and OE................... 450,000

Assumption 2: Beginning Inventory is incorrectly stated at Br 210,000

Income Statement
BB Company
Income Statement
For the year ended December 31, Year II
Net Sales............................................................................... Br 600,000
Less: Cost Goods Sold.........................................................
Beginning Inventory........................................ 210,000
Net Purchases.................................................. 375,000
CMAS............................................................. 585,000
Less: Ending Inventory.................................... (150,000)
Cost of Goods Sold.......................................... (435,000)
Gross Profit.......................................................................... 165,000
Less: Operating Expenses..................................................... (105,000)
Net Income........................................................................... Br 60,000
Balance Sheet
BB Company
Balance Sheet
December 31, Year II
Merchandise Inventory.................................................
150,000 Liabilities................................
110,000
Other Assets.................................................................
300,000 Capital.....................................
340,000
Total Assets..................................................................
450,000 Liabilities and OE................... 450,000

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 Chapter 1: Accounting for Inventories
The effects of understating Beginning Inventory by Br 10,000, on the income statement, were as
follows:
 It understates CMAS by Br 10,000
 It understates Cost of Goods Sold by Br 10,000
 It overstates Gross Profit by the Same amount Br 10,000
 It overstates Net Income by Br 10,000 or understates net loss by the same amount
Assumption 3: Beginning Inventory is incorrectly stated at Br 225,000
Income Statement
BB Company
Income Statement
For the year ended December 31, Year II
Net Sales.............................................................. Br 600,000
Less: Cost Goods Sold........................................
Beginning Inventory........................... 225,000
Net Purchases..................................... 375,000
CMAS................................................ 600,000
Less: Ending Inventory....................... (150,000)
Cost of Goods Sold............................. (450,000)
Gross Profit.......................................................... 150,000
Less: Operating Expenses.................................... (105,000)
Net Income.......................................................... Br 45,000

Balance Sheet
BB Company
Balance Sheet
December 31, Year II
Merchandise Inventory..................................
150,000 Liabilities........................
110,000
Other Assets...................................................
300,000 Capital.............................
340,000
Total Assets....................................................
450,000 Liabilities and OE........... 450,000

The effects of understating Ending Inventory by Br 5,000 on the income statement were as follows:
 It overstates CMAS by Br 5,000 during year II
 It overstates Cost of Goods Sold by Br 5,000
 It understates Gross Profit by Br 5,000
 It understates Net Income by Br 5,000 or decrease Net Loss by Br 5000
Summary of errors in Beginning Inventory (Ending Inventory of the previous accounting period)
on the financial statement of the current of period are as follows:

Beginning Inventory Correctly Stated Understated Overstated

CMAS Unaffected Understated Overstated
Cost of Goods Sold Unaffected Understated Overstated
Gross Profit Unaffected Overstated Understated
Net Income Unaffected Overstated Understated
 If inventory amount is stated incorrectly in one period, the effect is limited to the period of the
error and the following period only.
 If there is no additional error, both total assets and owner’s equity will be correct during the
following period.
 The balance sheet will not be affected by the error of the previous period
 The error of one accounting period set-off against the error of the subsequent period. The
overstatement of items in the income statement of one accounting period will result in
understatement of items in the subsequent in the subsequent period-set off.

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1.2 Inventory Systems
Inventory system is a system through which we can determine the cost of merchandise sold and
cost of merchandise on hand. Generally, there are two widely accepted inventory system.
1. Periodic Inventory System and
2. Perpetual Inventory System
Periodic Inventory System:
 Only revenue from sales is accounted for
 No effort is made to keep up to date records of either inventory or cost of goods sold
 Purchase of merchandise is debited to purchases account
 A physical inventory is taken at the end of the period to determine the merchandise on hand
i.e. counting merchandise on hand
 COGS is the difference between CMAS and cost inventory on hand
 It is used by small businesses which sale many items with low unit cost of merchandise.
Perpetual inventory system
 A separate account or record is maintained for both cost of goods sold and merchandise
inventory on hand
 The inventory account shows the increase, decrease and the balance in the account
 Provides up to date data about each type of product that the company sells
 Used by firms which sells relatively small number of item which have high unit cost
 Physical inventory is taken to compare the balance on the records with the balance on hand
 Each time inventory is sold, it will be transferred to cost of merchandise sold account
 The appropriate inventory balance is adjusted to the quantities determined by the physical
count.
Note: a business may use different inventory system for different items of merchandise.
Illustration: recording transactions under periodic and perpetual inventory systems.
1.3 Determining Actual Quantities in Inventory
In the determination of the quantities of inventory all goods owned by a business enterprise on the
date of physical inventory must be included. This includes:
 goods in the store room and warehouse places where merchandise are kept when they
received from the port
 goods in the shelves and sales counter (show room)
 goods purchased on terms of FOB shipping point agreement and still on transit
 consigned goods but not sold by the sales agent or consignee
Goods sold on FOB destination agreement are excluded from inventory determination because once
it counted sales. If it is included, it will be double counting. The sale is already recorded. Thus, the
goods should be excluded from the inventory count.
1.4 Determining the Cost of Inventory
From theoretical point of view the cost of merchandise includes:
 A purchase price or invoice price
 All other expenditures necessary to place the items in its proper condition and location such
as transportation cost, import duties (custom duties), insurance against loss while it is in
transit and store room, cost of receiving and inspection( checking the goods whether it is
damaged or not).
 Any costs which are difficult to associate with specific inventory but related to inventory
may be prorated on some equitable basis
 Any incidental cost which is not material may be excluded from the cost of merchandise
and treated as operating expenses.
1.5 Inventory Costing Methods under a Periodic Inventory System
The term cost flow refers to the inflow of costs when goods are purchased or manufactured and to
the outflow of costs when goods are sold. The cost remaining in inventories is the difference
between the inflow and outflow of costs. The problem often faced by an accountant is determining

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the cost of merchandise sold and the cost of remaining inventories or ending inventories when
merchandise are purchased at different costs. If identical goods are purchased at different costs
during the period, there should be an arbitrary assumption as to the cost flow of merchandise
through the business such as:
1. FIFO (First In First Out)
2. LIFO (Last In Fits Out)
3. AVERAGE Costing Method
4. SPECIFIC IDENTIFICATION-which is rarely used unless it is large item
Illustration 1.3: You are given the following data for BB Electronics for the year 2003 for one of
its item called CD-RW.
Date Item Quantity Unit Cost Total Cost
January 1, 2003 Inventory 500 Units Br 10.50 Br 5,250
March 31, 2003 Sold 300 Units
April 1, 2003 Purchases 1,800 Units 12 21,600
June 30, 2003 Sold 600 Units
July 1, 2003 Purchases 500 Units 12.50 6,250
September 30, 2003 Sold 700 Units
October 1, 2003 Purchases 200 Units 13 2,600
December 31, 2003 Sold 800 Units
Required: For the CD-RW of BB Electronics compute the cost of inventory on hand as of
December 31, 2003 and cost of goods sold under the following three cost flow assumptions: FIFO
Costing Method; LIFO Costing Method; and Average Costing Method
1. FIFO Cost Flow Assumption
FIFO cost flow is in the order in which the expenditures were made. FIFO assumes that items
acquired first should be sold first to customers. FIFO charges costs against revenue in the order in
which they were incurred. Hence:
 Inventory on hand assumed the most recent costs
 Inventory sold assumed the oldest or earliest costs
Ending Inventory in Units= 3,000- 2,400= 600 units
Cost of Ending Inventory (COEI)
200 Units * Br 13...............................Br 2,600
400 Units * Br 12.50.......................... 5,000
COEI..................................................Br 7,600
Cost of Goods Sold (COGS)
500 units * Br 10.5............................. Br 5,250
1800 units * Br 12.............................. 21,600
100 units * Br 12.5............................. 1,250
COGS.................................................Br 28,100
Cost of Goods Sold (The Alternative Method)
COGS= Cost of Goods Available for Sale (COGAFS) − COEI
COGAS= Br 5,250 + 21,600 + 6,250 + 2,600= Br 35,700
COGS=Br 35,700 − 7,600
COGS=Br 28,100
FIFO-Advantage and Disadvantage
 Advantage-the merchandise inventory to be reported in the balance sheet approximates its
replacement cost
 Disadvantage-it matches old costs with current revenue
2. LIFO Cost Flow Assumption
LIFO cost flow is in the reverse order in which the expenditures were made. LIFO assumes that
items purchased last should be sold first. It charges or deducts the most recent costs against or from
revenue. Hence:

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 The ending inventory assumed the oldest purchases or earliest costs and
 The cost of merchandise sold assumed the most recent costs.
Cost of Ending Inventory
 500 Units * Br 10.5..............................................Br 5,250
 100 Units * Br 12................................................. 1,200
 COEI....................................................................Br 6,450
Cost of Goods Sold
 200 units * Br 13.................................................. Br 2,600
 500 units * Br 12.5............................................... 6,250
 1,700 units * Br 12............................................... 20,400
 COGS...................................................................Br 29,250

Cost of Goods Sold (The Alternative Method)

 COGS= COGAFS − COEI
 COGS=Br 35,700 − 6,450
 COGS=Br 29,250
LIFO Advantage and Disadvantage
 Advantage-it matches current costs with current revenue
 Disadvantage-the amount of inventory reported does not approximate its replacement costs

3. THE AVERAGE METHOD (Weighted Average Costing Method)

This cost flow is an average of the expenditure. It charges costs against revenue applying the weighted
average unit cost of the goods available for sale.
Weighted Average Unit cost = (U1*C1 + U2*C2 + U3*C3 + U4*C4 + ….) / Total Units
Weighted Average Unit cost = 500*10.5 + 1800*12 + 500*12.5 + 200*13
500 + 1800 + 500 + 200
Weighted Average Unit cost = Br 35,700 / 3,000 = Br 11.90
Cost of Ending Inventory
 COEI= Br 11.90* 600 units = Br 7,140
Cost of Goods Sold
 COGS= Br 11.90* 2,400 units = Br 28,560
Cost of Goods Sold (The Alternative Method)
 COGS= COGAFS − COEI
 COGS=Br 35,700 − 7,140 = Br 28,560

Comparison of the Three Methods:

Costing Method FIFO LIFO AVERAGE
COGAFS 35700 35700 35700
COEI 7600 6450 7140
COGS 28100 29250 28560
The higher the unit cost of ending inventory, the higher the total cost of ending inventory is, which means
the lesser the COGS. The lesser the unit COEI, the lesser the total COEI is, which means the higher the
COGS.

1.6 Accounting for Inventory under a Perpetual Inventory System

Under perpetual inventory system, all merchandises increases and decreases are recorded in a manner
somewhat similar to the recording of increases and decreases in Cash account. The merchandise inventory
account at the beginning of an accounting period reflects the merchandise on hand on that date. Then
purchases of merchandise is debited to merchandise inventory account each time purchase was made and
sales are recorded in the sales account and the cost of each sale is recorded by debiting CMS account and
crediting merchandise inventory.

1.7 Inventory Costing Methods under Perpetual Inventory System

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 Chapter 1: Accounting for Inventories
It is customarily to use the inventory cost flow assumption under perpetual inventory system, too.
Illustration 1.5: take the data For BB Electronics above and compute the cost of Ending inventory
and cost of goods sold assuming that the company uses perpetual inventory system under: FIFO,
LIFO and AVERAGE cost flow assumption.
A) FIFO Cost Flow Assumption
Date Purchases Sold Inventory
Qty UC TC Qty UC TC Qty UC TC
Jan.1 500 10.5 5,250
Mar.31 300 10.5 3,150 200 10.5 2,100
Apr.1 1,800 12 21,600 200 10.5 2,100
1,800 12 21,600
June 30 200 10.5 2,100
400 12 4,800 1,400 12 16800
July 1 500 12.5 6,250 1,400 12 16,800
500 12.5 6,250
Sep.30 700 12 8,400 700 12 8,400
500 12.5 6,250
Oct.1 200 13 2,600 700 12 8,400
500 12.5 6,250
200 13 2,600
Dec. 31 700 12 8,400 400 12.5 5,000
100 12.5 1,250 200 13 2,600
Total Br 28,100 Br 7,600
B) LIFO Cost Flow Assumption
Date Purchases Sold Inventory
Qty UC TC Qty UC TC Qty UC TC
Jan.1 500 10.5 5,250
Mar.31 300 10.5 3,150 200 10.5 2,100
Apr.1 1,800 12 21,600 200 10.5 2,100
1,800 12 21,600
June 30 600 12 7,200 200 10.5 2,100
1,200 12 14,400
July 1 500 12.5 6,250 200 10.5 2,100
1200 12 14,400
500 12.5 6,250
Sep.30 500 12.5 6,250 200 10.5 2,100
200 12 2,400 1,000 12 12,000
Oct.1 200 13 2,600 200 10.5 2,100
1,000 12 12,000
200 13 2,600
Dec. 31 200 13 2,600 200 10.5 2100
600 12 7,200 400 12 4800
Total Br 28,800 Br 6,900

C) AVERAGE (Moving Average Cost)

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 Chapter 1: Accounting for Inventories
Each time a purchase is made, new average cost will be computed and sales after that are made at
this new average unit cost.
Date Purchases Sold Inventory
Qty UC TC Qty UC TC Qty UC TC
Jan.1 500 10.5 5,250
Mar.31 300 10.5 3,150 200 10.5 2,100
Apr.1 1,800 12 21,600 2,000 11.85 23,700
June 30 600 11.85 7,110 1,400 11.85 16,590
July 1 500 12.5 6,250 1,900 12.02 22,840
Sep.30 700 12.02 8,414 1,200 12.02 14,426
Oct.1 200 13 2,600 1,400 12.16 17,026
Dec. 31 800 12.16 9,728 600 12.16 7,298
Total Br 28,402 Br 7,298

Comparison of the Three Methods

COGAFS 35,700 35,700 35,700
COEI 7,600 6,900 7,298
COGS 28,100 28800 28,402

 The results of the FIFO method under both the periodic and perpetual inventory systems
produces the same result for cost of EI and Merchandise sold
 The perpetual inventory system provides the most effective means of control over this
important asset-merchandise inventory
 An automated perpetual inventory system facilitates the processing in the case of large number
of inventory items.
1.8 Valuation of Inventory at Other than Cost
Cost is the primary basis for the valuation of inventory. However, when the cost of replacing items
in inventory is below recorded cost and when the inventory is not salable at normal selling price
because of some reason such as imperfections, shop wear, style changes, or other causes, inventory
may be valued at other than the cost. I.e. departures from Cost Valuation Methods may be allowed.
There are two valuation methods other than the cost: valuation at lower of cost or market and
valuation at net realizable value.
1. Valuation at Lower of Cost or Market (LCM)
The LCM method requires that inventory should be valued at the lower of the two values: Cost or
Market.
The LCM works as follows:
 Determine the cost of inventory using FIFO, LIFO or AVERAGE
 Determine the market value or the replacement cost
 Compare the cost with the market value and take the lower of the two as a value of inventory
Illustration 1.6: BB Electronics Compile the following data concerning items in its inventory on
December31, 2004
Category Items Quantity Unit Cost Unit Market Price
A CD-R 10,000 Br 4 Br 3.50
CD-RW 4,000 12 13
B Walkman-Sony 20 150 140
Discman-Sony 50 200 200
C VCD Player-Sony 100 500 520
DVD Player-Sony 50 650 640
Instruction: determine the total cost inventory to appear in the balance sheet of BB Electronics as
of December 31, 2004 assuming that LCM is applied to
I. To the inventory as a whole

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II. To a major category of inventory
III. To each item in the inventory or item by item basis
Items Cost Market LCM-II LCM-III
A CD-R Br 40,000 Br 35,000 35,000
CD-RW 48,000 52,000 87,000 48,000
B Walkman-Sony 3,000 2,800 2,800
Discman-Sony 10,000 10,000 12,800 10,000
C VCD Player-Sony 50,000 52,000 50,000
DVD Player-Sony 32,500 32,000 82,500 32,000
LCM-I 183,500 183,800 182,300 177,800
 If LCM is applied to the inventory as a whole, the lower is the total cost Br 183,500 and this
amount has to be reported in the balance sheet.
 If LCM is applied to a group of inventory, it is resulted in Br 182,300 value and this amount
has to be reported in the balance sheet.
 If LCM is applied to each item of inventory, it is resulted in Br 177,800 value and this
amount has to be reported in the balance sheet.
The application of the LCM rule of item by item basis resulted in the lowest inventory value where
as the inventory as a whole basis resulted in the highest value of inventory. Many authors
recommended that:
 Item by item basis shall be used for income tax purposes because it will result in lower
income tax
 The inventory as whole should be applied for financial accounting purpose to know the
actual profit of the businesses.
A restriction to the LCM method is inventory should never be carried at an amount that is greater
than its net realizable value (NRV)
2. Valuation at Net Realizable Value (NRV)
The NRV is the difference between the estimated selling price and any direct cost of disposition
(i.e. any anticipated or forecasted selling expense such as sales commissions). Obsolete, spoiled, or
damaged merchandise and other merchandise that may be sold at a price below cost should be
valued at Net Realizable Value.
Illustration 1.7: on December 31, 2003 the following data is given for the inventory of item x of
AA Company:
100 Units on hand (Cost under FIFO)................... Br 5,000
Replacement Cost of the items............................... 4,500
Selling Price........................................................... 4,500
Sales Commission to dispose the inventory........... 200
Required: at what amount should the item be presented in the balance sheet on Dec.31, 2003?
 NRV = Selling Price – Cost of Disposition
 NRV = Br 4500 – 500
 NRV = Br 4,000
What if the replacement cost of the item is Br 3,900- take the lower of the two values that is the
lower of the NRV or its current replacement cost
 NRV = Br 4,000 vs. Br 3,900 = Br 3,900

1.9 Estimating Inventory Cost

For companies using a periodic inventory system taking physical inventory to prepare interim
financial reports is both expensive and time consuming. There fore, such companies may use
estimated amount inventory balance in preparing monthly or quarterly financial statements. There
are two methods of inventory estimation: the retail method and the gross profit method.

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1. Retail Method
It is used by retailers to estimate the cost of inventory on hand. Under this method:
 Records are kept for goods available for sale at both selling price (Retail Price) and at Cost
 Sales are recorded and total sales for accounting period are deducted from the total value
of goods available for sale to determine the ending inventory at selling price.
 The EI valued at selling price is changed to estimated cost by multiplying by the cost to
retail ratio
Illustration 1.8: the following data was extracted from MM Corporation for the month of March.
Items @ Cost @ Selling Price
Beginning Inventory Br 60,000 Br 100,000
Net Purchases 96,000 160,000
CMAS 156,000 260,000
Sales 180,000
Instruction: Estimate the cost of Ending Inventory by the Retail Method
 Cost to Retail Ratio = 156,000 / 260,000= 60%
 Beginning Inventory...................................... 100,000
 Net Purchases................................................. 160,000
 CMAS............................................................ 260,000
 Less: Sales......................................................(180,000)
 Ending Inventory@ Selling Price.................. 80,000
 Ending Inventory@ Cost = 60% * 80,000 =Br 48,000

2. The Gross Profit Method

When the GP rate or percentage is known, the ending inventory can be estimated by the following
procedures:
 Determine the CMAS from the accounting records.
 Estimate the gross profit by multiplying the net sales by the GP rate.
 Determine CMS by deducting the gross profit form the net sales
 Determine the estimated ending inventory by deducting CMS from the CMAS
Illustration 1.9: the following data is taken from MM Corporation as to one of its inventory
 Beginning Inventory............................................ Br 20,000
 Net Purchases....................................................... 80,000
 Sales..................................................................... 90,000
 Estimated Gross Profit Rate................................. 25%
Instruction: determine the estimated ending inventory
 Beginning Inventory............................................ Br 20,000
 Net Purchases....................................................... 80,000
 Cost of Merchandise Available for Sales.............Br 100,000
 Less: COGS = Sales – Est. GP Rate
(Br 90,000 – 25% * 90,000)................................ (67,500)
 Estimated Cost of Ending Inventory.................... Br 32,500

12
 Chapter 2: Accounting for Plant Assets, Natural Resources, and Intangible Assets

Chapter Two
Accounting for Plant Assets
Chapter Outlines
This chapter covers the following topics:
 Nature of Plant Assets
 Acquisition Cost of Plant Assets
 Nature and Accounting for Depreciation
 Partial Year Depreciation
 Changes in Estimates and Revision of Periodic Depreciation
 Capital and Revenue Expenditures
 Disposals of Plant Assets
 Accounting and Reporting for Natural Resources
 Accounting For Intangible Assets and Amortization
 Presentation of Plant and Intangible Assets in the Financial Statements

Chapter Learning Objectives:

After studying this chapter, you should be able to:
 Describe the application of the cost principle to plant assets
 Explain the concept of depreciation
 Compute periodic depreciation using different methods
 Describe the procedure for revising periodic depreciation
 Distinguish between revenue and capital expenditures, and explain the entries for these
expenditures
 Explain how to account for the disposal of a plant asset through retirement, sale, or
exchange
 Compute periodic depletion of natural resources
 Contrast the accounting for intangible assets with the accounting for plant assets
 Indicate how plant assets, natural resources, and intangible assets are reported and analyzed
2.1 Nature of Plant Assets
Plant assets:
 Are Long lived assets usually more than a year
 Are Acquired for use in business operations i.e. must be capable of providing repeated use or
benefit
 Are not acquired for resale. Any asset that is acquired for resale purpose is not a plant asset
regardless of their durability, nature of the assets, and the length of time they are held. Example
land held for speculation purpose.
 Are subject to depreciation i.e. decline in usefulness through passage of time

2.2 Acquisition Cost of Plant Assets

The cost of a plant asset includes all expenditures that are reasonable and necessary for getting the
asset to the desired location and ready for use. They are:
 Purchase price  Special foundation
 Sales Tax  Insurance while the asset is in transit
 Installation Cost
For a newly purchased plant asset the acquisition cost may include:
 Purchase Price  Transportation Cost
 Sales Tax  Special Foundation
 Insurance  Installation Costs if it needs
For a second hand purchased plant asset the acquisition cost may include:
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 Chapter 2: Accounting for Plant Assets, Natural Resources, and Intangible Assets
 The agreed price  Cost of replacing parts
 Maintenance cost  Repairs and Painting costs
Costs of building-newly constructed building
 Fees paid to architects or designers
 For engineers for plans and supervision
 Insurance incurred during the construction
 Other costs like labor, materials and overhead costs
 Costs of walkways
 Interest incurred during the construction on money borrowed
Cost of old Building Includes:
 Agreed price  Repair and maintenance costs
 Commission  Accrued tax on property
Cost of land
 Negotiated price or agreed price
 Commission for Brokers
 Legal fees for title transfer and other expenditures for securing title
 Fees for Surveying, draining, clearing and grading or leveling the land
 The cost of removing unwanted building less any salvage recovered.
Cost of land Improvement
 Cost of Driving ways
 Cost of Fences
 Cost of Outdoor lighting system
 Cost of Parking lots
 Cost of Walkways if it does last as long as the life of the building
 Cost of Trees and Shrubs
Note: Expenditures resulting from carelessness or errors in installing the assets, from vandalism, or
from other unusual occurrences don’t increase the usefulness of the asset and should be treated as
an expense.

2.3 Nature and Accounting for Depreciation

Plant asset is expected to have a lower value or no value when it is retired from the service. This is
because plant assets decline in usefulness through the time which we call it depreciation. The
difference between the initial cost and the value remaining when it is retired (Residual Value or
Scrape Value or Salvage Value or Trade in Value) is called depreciable cost that is the cost that
should be allocated over the useful life the assets as a depreciation expense.
Depreciation is also the systematic allocation of the cost of a plant asset over its estimated life. The
causes of depreciation are divided into two broad classes:
1. Physical Usage – physical depreciation results from the wear and tear of plant assets due to
operating use and forces of nature such as earth quake, land slide, storm, etc
2. Functional or economic depreciation – results from obsolescence and inadequacy
 Obsolescence – is the process of becoming out of date because of technological innovation.
Example type writing equipment
 Inadequacy – refers to the effect of growth and change in the scale of a business operation.
Inability to meet the demand of customers. Example small machines held by large business
Accounting for Depreciation
Factors that affects periodic depreciation expense are the
 Initial cost or acquisition cost
 Residual value
 Useful life or estimated economic life and method of depreciation
Methods of Depreciation
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 Chapter 2: Accounting for Plant Assets, Natural Resources, and Intangible Assets
Usually the following 4 methods are used to allocate the depreciate cost. These are:
1. Straight line method
2. Declining balance method
3. Sum of the year’s digit method and
4. Units of production method
1. Straight Line Method (SLM)
This method allocates depreciable cost to each period of the Estimated Economic Life of the assets
equally. Depreciation per year is computed as follows:
 Depreciation per Year = (Acquisition Cost – Residua Value) / Estimated Economic Life
Illustration 2.1: assume that a machine is acquired at the beginning of 1991 for Br 100,000 and the
residual value of the machine at the end of 10 years of economic life is estimated at Br 10,000.
Instruction: compute the amount of depreciation allocable to each year and present the necessary
adjustment at the end of each year.
Depreciation per Year = (Br 100,000– 10,000) / 10 Years = Br 90,000 / 10 = Br 9,000
Depreciation Expense....................................... 9,000
Accumulated Depreciation................... 9,000
2. Declining Balance Method
This method yields a decline in periodic depreciation charges over the estimated life of the assets.
The most common techniques are to double the straight line depreciation and multiply the resulting
rate to the cost of the asset less its accumulated depreciation.
Depreciation per year = (2 / EEL) * (Acquisition Cost – Accumulated Depreciation)
Illustration 2.2: CC Corporation purchased equipment on January 1, 2000 for Br 20000 which has
an expected life of 5 years and salvage value of Br 1,000. Instruction: calculate the declining
balance rate and the amount of depreciation for its useful life.
 Cost = Br 20,000
 EEL = 5 years
 Residual Value = Br 1,000
Year 2000 = 2/ 5 * (Br 20,000 – 0) = 40% * Br 20,000 = Br 8,000
Year 2001 = 40% * (Br 20,000 – 8,000) = 40% * Br 12,000 = Br 4,800
Year 2002 = 40% * (Br 20,000 – 12,800) = Br 2,880
Year 2003 = 40% * (Br 20,000 – 15,680) = Br 1,728
Year 2004 = 40% * (Br 20,000 – 17,408) = Br 1,037
In the year 2004 the calculated amount of depreciation is Br 1037 but the actual depreciation
expense is Br 1,592 (Br 2,592 – 1000). The 2,592 is the difference between Br 20,000 (cost) and
17,408 (accumulated depreciation). The estimated residual value does not enter into the
computation of depreciation expense until the very end. This is because this method provides an
automatic residual value. If an asset has a Residual Value, this depreciation method should consider
the stated residual value. Thus, in the above example the depreciation expense for year 2004 is Br
1,592 rather than Br 1,037
3. The Sum Of Years Digits(SOYD) Method
Under this method the periodic charge for depreciation declines steadily or continuously over the
estimated life of the asset because successive small action is applied each year to the original cost
less estimated residual value. The following steps are followed to determine the depreciation charge
under this method:
 Estimate the useful life of the asset in the years
 Assign consecutive numbers for each year starting from 1
 Find the sum of these numbers using the following formula: SOYD = [N (N + 1)] / 2. Where N
= estimated useful life of the asset in years

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 Chapter 2: Accounting for Plant Assets, Natural Resources, and Intangible Assets
 Determine the numerator which is a number of the economic life of the asset remaining at the
beginning of each accounting period. Year 1= N, Year 2= N – 1, Year 2 = N – 2 , etc
 Compute depreciation using the formula: Annual Depreciation = (AC – RV) * RV/ SOYD
Illustration 2.3: JK Company purchased old building on January 1, 1995 for Br 105,000 and its
estimated life is 4 years with a salvage value of Br 5,000 and the physical period ends on December
31, 1995. Instruction: determine the sum-of-years-digit and calculate the amount of depreciation for
its useful life.
 SOYD = [N (N + 1)]/ 2 = [4 (4 + 1)] / 2 = 10
Depreciation Expense
 1995 = 4/10 (105,000 – 5,000) = Br 40,000
 1996 = 3/10 (105,000 – 5,000) = Br 30,000
 1997 = 2/10 (105,000 – 5,000) = Br 20,000
 1998 = 1/10 (105,000 – 5,000) = Br 10,000
4. Units Of Production Method
This method yields a depreciation charge that varies with the amount of usage. To apply this
method the life of the asset is expressed in terms of production capacity such as machine hours,
miles, kilo meters, or no of units, etc. Under this method depreciation is computed as follows:
 Depreciation Rate = (AC – RV) / Estimated Production Capacity
 Depreciation Expense = Depreciation Rate * Actual Usage of the Asset
Illustration 2.4: XY Company purchased diesel powered generator on January 1, 2000 at Br
50000 and the generator has estimated economic life of 5 years or a production capacity of 500000
machine hours with no residual value. Instruction: calculate the depreciation expense for the year
2000 and 2001 assuming that the generator was used for 100,000 and 120,000 machine hours,
respectively.
 Depreciation Rate = (Br 50,000 – 0) / 500,000 hours = Br 0.10 per hour
 Year 2000 depreciation expense = depreciation rate * actual usage
 Year 2000 depreciation expense = Br 0.10/ Hr. * 100000 hours
 Year 2000 depreciation expense = Br 10,000
 Year 2001 depreciation expense = depreciation rate * actual usage
 Year 2001 depreciation expense = Br 0.10/ Hr. * 120000 hours
 Year 2001 depreciation expense = Br 12,000

2.4 Partial Year Depreciation

To calculate the partial year depreciation, the following are important:
The date of purchase must be known. The number of days in the month in which the purchase is
made affects the depreciation expense in the following manner:
 If it is higher than 50% of the days in the month of purchase, compute depreciation for the
whole month
 If it is less than 50% of the days, ignore the whole month
Illustration 2.5: GG Company purchases a delivery truck on April 13, 1991 for Br 180,400. The
expected life of the truck was 4 years or 200,000 KMs and has an estimated salvage value of Br
6,400. During the year 1991 and 1992 the truck was driven for 60,000 and 40,000 KMs,
respectively. The company’s fiscal period ends on December 31 of each year. Compute
depreciation expense for the year 1991 and 1992 under all the methods of depreciation.
Straight Line Method
 Annual Depreciation= (180,400 – 6,400)/4 =Br 43,500
 1991- Partial Year Depreciation= 9/12 * Br 43,500 = Br 32,625
 1992 Depreciation = 3/12 * Br 43,500 + 9/12 * Br 43,500 = Br 43500
Declining Balance Method
 Annual Depreciation, 1st Year = 2/4 (Br 180,400 – 0)=Br 90,200
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 Chapter 2: Accounting for Plant Assets, Natural Resources, and Intangible Assets
 Annual Depreciation, 2 Year = 2/4 (Br 180,400 – 90,200)=Br 45,100
nd

 1991- Partial Year Depreciation= 9/12 * 90,200=Br 67,650

 1992 Depreciation = 3/12 * 90,200 + 9/12 * 45,100 = 22,550 + 33,825 = Br 56,375
SOYD Method
 SOYD = 4 (4 + 1)]/2= 10
 Annual Depreciation, 1st Year = 4/10 (Br 180,400 – 6,400)= Br 69,600
 Annual Depreciation, 2nd Year = 3/10 (Br 180,400 – 6,400)= Br 52,200
 1991- Partial Year Depreciation= 9/12* 69,600 = Br 52,200
 1992 Depreciation = 3/12 * 69,600 + 9/12 * 52,200= 17,400 + 39,150=Br 56,550
Units-of Production
 Depreciation Rate = (180,400 – 6,400) / 200,000KMs =Br 0.87/ km
 1991 Depreciation= 60,000 KMs * 0.87/km= Br 52,200
 1992 Depreciation= 40,000 KMs * 0.87/km = Br 34,800

2.5 Changes in Estimates and Revision of Periodic Depreciation

Residual value and estimated economic life are estimates. There may be an error in estimates. Thus,
estimates may be revised or changed. The change in estimates is applicable only to the value or cost
not depreciated so far ignoring the portion acquisition cost depreciated in the previous accounting
periods. Revision in estimates does not apply retroactively to the past accounting periods.
Illustration 2.6: assume that on January 1, 1992 AA Company purchased a delivery truck for Br
52,000. At the time of purchase the truck was estimated to last 5 years with salvage value of Br
2,000 and it was depreciated accordingly on the straight line method for two years and at the
beginning of the year 1994, the life was estimated to last 6 more years with a salvage value of Br
2,600. Determine the revised annual depreciation per annum.
 Givens: cost Br 52,000  Depreciation/Year = (52,000 – 2,000) / 5
 Salvage value= Br 2,000  Depreciation /Year = Br 10,000
 EEL = 5 Years
Depreciation from 1992 to 1993
 Accumulated Depreciation = Br 10,000 * 2 years
 Accumulated Depreciation = Br 20,000
Revised Depreciation starting from 1994
 Revised Cost (Carrying Amount) = Br 52,000 – 20,000
 Revised Cost (Carrying Amount) =Br 32,000
 Revised EEL = 6 years
 Revised RV = Br 2,600
 Revised Depreciation = Br 32,000 – 2,600 / 6 = Br 29,400/6=Br 4,900

2.6 Capital and Revenue Expenditures

Capital expenditures are those expenditures incurred for acquiring plant asset or for addition to
such an asset and that will affect the utility of the plant asset for more than one accounting period.
Such expenditures are debited to the asset account or to the related accumulated depreciation
account. The common capital expenditures in addition to the initial cost includes the following:
Additions, Betterments and Extraordinary Repairs
Additions:
 Are those expenditures or costs increase the service potential of the plant asset
 They are debited to the plant asset account
 They would be depreciated over the estimated useful life of the additions
 Example: cost of adding an air conditioning system or an elevator to the building

Betterments:

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 Chapter 2: Accounting for Plant Assets, Natural Resources, and Intangible Assets
Betterments are expenditures that increase operating efficiency or capacity for the remaining useful
life of the plant asset. These costs will be added to the plant asset account. Example: substituting
the old power point by a new power unit, substituting the old engine by new one that improves
operating efficiency.
Extraordinary repairs:
These are expenditures that increase the useful life of an asset beyond the original estimate. These
costs are debited to the appropriate accumulated depreciation account and the periodic depreciation
for the future period will be determined on the basis of the revised book value.
Illustration 2.7: assume a delivery truck costing 190,000 has estimated economic life of 9 years
with Br 10,000 residual value. It has been depreciated over the past 5 years on a straight line basis.
At the beginning of year 6 the engine was changed as an extraordinary repair at Br 40,000 which
was expected to increase the estimated economic life the truck to 8 years with the same salvage
value. Required: determine the annual depreciation charge for the remaining life of the asset.
 Initial Cost: Br 190,000
 Residual value: Br 10,000
 Estimated Economic Life: 9 years
 Annual Depreciation: Br 190,000 – 10,000/ 9 years =Br 20,000
 Accumulated Depreciation: Br 20,000 * 5 years =Br 100,000
Extraordinary Repairs: - it is debited to accumulated depreciation account
Accumulated Depreciation ................................ 40,000
Cash........................................................ 40,000
After extraordinary repairs:
 Cost ...........................................................................Br 190,000
 Accumulated Depreciation......................................... (60,000)
 Book Value................................................................ Br 130,000
 Annual Depreciation= (130,000 – 10,000) / 8=......... Br 15,000
Revenue Expenditure: these are expenditures for ordinary maintenance and repairing of a
recurring nature should be classified as revenue expenditure and debited to expense accounts.
Example, cost of repairing a building, a truck, etc
2.7 Disposal of Plant Assets
When an asset is no longer useful to the business, it is retired from the service. This is called
disposal. Disposal refers to discarding, selling, or exchanging plant assets. To journalize the
necessary entries on the date of disposal the following information are required:
 The up-to-date balance of the accumulated depreciation account
 The book value of the asset
 The loss or gain on disposal
1. Discarding Plant Assets
When a plant asset are no longer useful to the business and has no market or sales value, they are
discarded. Illustration 1: RR Company discarded a machinery on December 31, 2003, which was
fully depreciated. The machine was acquired at a cost of Br 150,000 before six years.
 BV = AC – Accumulated Depreciation
 BV = Br 150,000 – 150,000 = 0
The Accounting Entry for this disposal:
Accumulated Depreciation .............................. 150,000
Machinery............................................ 150,000
Illustration 2.8: RR Company discarded an equipment, which was purchased at a cost of Br
32,000, after it has been depreciated for 4½ years under the straight line method with a
consideration of Br 2,000 salvage value. The estimated economic life of the asset was 5 years.
Journalize the necessary transaction:
Accounting Department 18
 Chapter 2: Accounting for Plant Assets, Natural Resources, and Intangible Assets
 Annual Depreciation = Br 32,000 – 2,000/ 5
 Annual Depreciation = Br 6,000
 Accumulated Depreciation = Br 6,000 * 4.5 years
 Accumulated Depreciation = Br 27,000
 Book Value = Br 32000 – 27,000=Br 5,000
The loss on disposal is Br 5,000 as the business discards an asset with a value of Br 5,000.
The Accounting Entry for this disposal:
Accumulated Depreciation .............................. 27,000
Loss on Disposal.............................................. 5,000
Equipment............................................ 32,000
2. Selling Old Plant Asset
The entry to record the sale of a plant asset is like the entry of discarding a plant asset except that
the cash or other asset to be received must be accounted for.
 If the selling price > book value, there will be a gain on disposal
 If the selling price < book value, there will be a loss on disposal
Illustration 2.9: RA Furniture Company purchased a computer system for Br 34,000 and the
system was expected to last 8 years with a salvage value of Br 2,000. The equipment was
depreciated for 6 years based on the straight line method and sold at the beginning of year 7.
Required: Journalize the necessary entries assuming that the asset was sold for:
A) Br 15000 B) Br 10000 C) Br 9000
Acquisition Cost = Br 34,000
Residual Value = Br 2,000
Estimated Economic Life = 8 years
Annual Depreciation = Br 34,000 – 2,000/ 8
Annual Depreciation = Br 4,000
Accumulated Depreciation = Br 4,000 * 6 Years
Accumulated Depreciation = Br 24,000
Book Value = Br 34,000 – 24,000 = Br 10,000

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 Chapter 3: Current Liabilities and Payroll Accounting
A. Br 15,000 disposal price implies a gain of Br 5,000
Accumulated Depreciation .......................................24,000
Cash...........................................................................15,000
Equipment...................................................... 34,000
Gain on Disposal........................................... 5,000
B. Br 10,000 disposal price implies is neither gain nor loss
Accumulated Depreciation .......................................24,000
Cash...........................................................................10,000
Equipment...................................................... 34,000
C. Br 9,000 disposal price a loss of Br 1,000
Accumulated Depreciation .......................................24,000
Cash........................................................................... 9,000
Loss on Disposal........................................................ 1,000
Equipment...................................................... 34,000
3. Exchanging or Trading in
Old plant assets are often traded in for new plant asset having similar use or dissimilar use. Under
this situation a trade-in allowance (TIA) is usually granted on old plant asset. The trade-in
allowance can be considered an agreed selling price for the old asset. This amount is deducted from
price of new asset as consideration for old plant asset. The balance paid to the seller of the new
asset after the trade-in allowance is deducted from the purchase price is called Boots. The GAIN or
LOSS on exchange is determined by comparing the TIA and the Book Value of the old Asset:
 If the TIA > book value, there will be a gain on disposal
 If the TIA < book value, there will be a loss on disposal
According to GAAP on exchange of similar plant assets, loss should be recognized and gain should
be adjusted to the price the new asset. That is, the new asset exchanged must be recorded at the
book value of the old asset plus the cash paid (Boots) or the purchase price which ever is lower.
Illustration 2.10: BB Company acquired a machine at Br 80,000 by trading in a similar old asset
that has a cost of Br 75,000 and up-to-date accumulated depreciation account balance of this asset
was Br 72,000. Make the necessary journal entries if the TIA was:
A. Br 4,000 B) Br 3,000 C) Br 2,000
Book Value = Br 75,000 – 72,000 = Br 3,000
A. TIA=Br 4,000
 If the TIA is Br 4,000, there is a gain of Br 1,000. But the gain will not be recognized
 Boots = Br 80,000 – 4,000 = Br 76,000
 Purchase Price = Br 80,000
 Boots + Book Value = Br 76,000 + 3,000 = Br 79,000. Thus, the new machine should be
recorded at Br 79,000 because the lower is this amount
Machinery (New).......................................................79,000
Accumulated Depreciation........................................72,000
Cash............................................................... 76,000
Machinery (Old)............................................ 75,000
B. TIA=Br 3,000
 If the TIA is Br 3,000, there is neither a gain nor a loss
 Boots = Br 80,000 – 3,000 = Br 77,000
 Purchase Price = Br 80,000
 Boots + Book Value = Br 77,000 + 3,000 = Br 80,000. Thus, the new machine should be
recorded at Br 80,000 because boots plus book value and purchase price are the same.
Machinery (New).......................................................................80,000
Accumulated Depreciation......................................................... 72,000
Cash................................................................................ 77,000
Machinery (Old)............................................................. 75,000
 Chapter 3: Current Liabilities and Payroll Accounting
C. TIA=Br 2,000
 If the TIA is Br 2,000, there is a loss of Br 1,000. This loss is recorded in the accounting
records of the period.
 Boots = Br 80,000 – 2,000 = Br 78,000
 Purchase Price = Br 80,000
 Boots + Book Value = Br 78,000 + 3,000 = Br 81,000. Thus, the new machine should be
recorded at Br 80,000 since the purchase price is the lower amount.
Machinery (New).......................................................80,000
Accumulated Depreciation........................................72,000
Loss on Exchange...................................................... 1,000
Cash............................................................... 78,000
Machinery (Old)............................................ 75,000
Note: In the case of Exchange of dissimilar plant asset, both loss and gain should be recognized.
2.8Accounting for Natural Resources and Depletion
Natural resources include forests, water, minerals, metal ores, oil, gas, etc. The costs of natural
resources include all the normal, necessary and reasonable expenditure incurred to acquire these
natural resources. Intangible assets are those assets which don’t have any physical substance.
However, for accounting purposes intangible assets include patents, copy rights, trademarks, trade
names, and goodwill etc. the basic principles of accounting for intangible asset are the
determination of the acquisition costs and the recognition of periodic cost expiration which is called
amortization.
A. Patents: patent are exclusive right to produce and sell goods with one or more unique features.
In USA, Patents have the legal life of 17 years, which is given by the government.
 Cost of Patent Right – the cost of patent right includes the purchase price plus related costs.
 Amortization of Patent Right: patents have a legally granted period of 17 years. However, it
may lose their usefulness in a period less than 17 years. Thus, amortization of patent should be
computed by comparing the legal life and the estimated life and by taking the lower of the
two.
B. Copy right is an exclusive right granted by the government to protect the production and sale
of literary or artistic materials for the life of the creator plus 50 years. The cost of copy right
include all costs of creating the work plus the cost of obtaining the right.
C. Goodwill- is an intangible asset that is attached to a business as a result of such favorable factors as
location, product superiority, reputation, managerial skill, etc. Goodwill is recorded normally when it is
purchased from others. And there is no legal life for goodwill, however, it should be amortized over its
useful life or 40 years which ever is the lower. The existence of goodwill is evidenced by customers’
willingness to pay high price and high return on investment. Note: Goodwill is no more amortized as of June
30, 2001. FASB changed the rule of goodwill amortization. Instead purchased goodwill will remain on the
balance sheet as an asset and then Impairment Tests should be made periodically.
 Chapter 3: Current Liabilities and Payroll Accounting

Chapter 3
Accounting For the Payroll System in an Ethiopian Context
Chapter Outlines:
This chapter covers the following topics:
 The importance of payroll and payroll accounting
 Definition of payroll related terms
 Possible Components of Payroll Register
 Procedures involved in Payroll Accounting
 Demonstration Problem

Chapter Learning Objectives

After studying this chapter, you should be able to:
 Understand the importance of payroll and payroll accounting
 Define payroll related terms
 Identify the basic components of Payroll Register
 Prepare payroll sheet
 Compute income taxes and pension contributions as per the rule of a government
 Discuss the objectives of internal control for payroll
 Compute and record the payroll for a pay period
 Describe and record employer payroll taxes
 Identify additional fringe benefits associated with employee compensation

3.1 The Importance of Payroll and Payroll Accounting

The term Payroll often refers to any document prepared to pay remuneration to the employee for the
service rendered to an organization in a given period of time. Payroll accounting is an accounting that
is concerned with preparation of payroll and recording and reporting of remunerations. The payroll
accounting of a firm has significance and has to be given emphasis for the following reasons:
1. Employees are sensitive to payroll errors and irregularities, and maintaining good employee
moral requires that the payroll be paid on a timely, accurate basis.
2. Payroll expenditures are subject to various government regulations
3. The payment for payroll and related taxes has significant effect on the net income of most
business enterprises (salary is the largest expense in most businesses)
3.2 Definition of payroll related terms
1. Salary or Wages: Salary and wages are usually used interchangeably. However, 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. So, they are usually paid when a particular piece of work is
completed or for a period less than a month. On the other hand, compensations to employees on
monthly or annual basis are termed as salaries. It must be clear that when we say an employee, we
refer to an individual who works primarily to an organization and whose activities are under the
direction and supervision of the employer. Hence, an employee is different from an independent
contractor, a self-employed individual who works on a fee basis to a firm.
2. The Pay Period: The length of time covered by each payroll payment. Pay periods for
wageworkers are usually a weekly or biweekly period. That is, wage is paid either weekly or biweekly.
On the other hand, for salaried employees, the pay periods are a month, semi-month, quarter, semi-
annual, or a year.
3. The Pay Day: The day on which wages or salaries are paid to employees. PAY DAY is usually
the last day of the pay period.
 Chapter 3: Current Liabilities and Payroll Accounting
4. A Payroll Register (Payroll Sheet): the entire list of employees of a business along with each
employee’s gross earnings, deductions and net pay (or the take home pay) for a particular payroll
period. The basis for the preparation of the payroll register can be the attendance sheets, punched
(clock) cards or time cards.
5. Employee Earnings Record: It is a summary of each employee's earnings, deductions, and net
pay for each payroll period and of cumulative gross earnings during the year. It is a separate record
kept for each employee. The individual employees' earnings record helps the employer organization to
properly summaries and file tax returns.
6. Pay Check: An instrument for paying salary if the firm makes payment via writing a check in the
name of each employee for the net pay or a check for the total net pay.
7. Gross Earnings: The total pay to an employee before deductions for the pay period.
8. Payroll Taxes: Are taxes levied against the employer on the payroll of a firm. It is the portion of
pension or social security contribution made by the employer. It is an additional payroll related
expense to an employer.
9. Withholding Taxes: These are taxes levied against the earnings of employees of an organization
and withheld by the employer as per the tax laws of the concerned government
10. Payroll Deductions: All the reductions from the gross earnings of an employee such as
withholding taxes, union dues, fines, credit association pays, etc.
11. Net Pay: The net earnings after subtracting all the deductions. It is sometimes known as take
home pay. The amount collected by an employee on the payday.
In the above definitions of payroll related terms, the three are considered the basic records of a payroll
accounting system. These are: (1) A payroll sheet, (2) Individual employees' earnings records, and (3)
Pay checks. These records are generated from a payroll system that is operated either manually or
using computers

3.3 Components of a Payroll Register

1. Employee number – numbers assigned to employee for identification purpose. It might be alpha-
numeric character when a relatively large number of employees are included in the payroll register.
2. Name of employees – full name of each employee included in the list of payroll sheet.
3. Earnings – a benefit in cash or in kind earned by an employee from various sources of
employment. It may include:
A. The basic salary or Regular Earning – a flat monthly salary of an employee that is paid for
carrying out the normal work of employment and subject to change when the employee is
promoted.
B. Allowances: money paid monthly to an employee for special reason, which may include:
 Position Allowance - a monthly sum paid to an employee for bearing a particular office
responsibility, e.g. head of a particular Department or Division.
 House Allowance – a monthly allowance given to cover housing costs of the individual
employee when the employment contract requires the employer to provide housing but fails
to do so.
 Disturbance Allowance – a sum of money given to an employee to compensate for an
inconvenient circumstance caused by the employer. For instance, unexpected transfer to a
different and distant work area or location.
 Desert Allowance – a monthly Allowance given to an employee because of assignment to a
relatively hot region. It is some times known as Hardship Allowance
 Transportation (Fuel Allowance) – a monthly Allowance to an employee to cover cost of
transportation up to the work place if the employer has committed itself to provide
transportation service
C. Overtime Earnings
Overtime work is the work performed by an employee beyond the regular working hours or days.
Overtime earning is the amount payable to an employee for overtime work done. In Ethiopia, in this
 Chapter 3: Current Liabilities and Payroll Accounting
respect, according to Article 33 of proclamation No.64/1975 the following is discussed about payment
for overtime work.
I. A worker shall be entitled to be paid at a rate of one and one quarter (1 ¼) times his ordinary
hourly rate for overtime work performed before 10 O'clock in the evening (10 p.m.). (From
6:00 am to 4:00 pm)
II. A worker shall be paid at the rate of one and one half (1 ½) times his ordinary hourly rate for
overtime work performed between 10 O’clock in the evening (10 p.m.) and six O’clock in the
morning (6 a.m.)
III. Overtime work performed on the weekly rest days shall be paid at a rate of two (2) times the
ordinary hourly rate of payment.
IV. A worker shall be paid at a rate of two and half (2 1/2) times the ordinary hourly rate for
overtime work performed on a public holiday.
Hence, the gross earnings of an employee may, therefore, include the basic salary, allowances and
overtime earnings. You may find sometimes other form of earnings such as Bonus that is paid to
employees for achieving results better than usual.

4. Deductions
These are amounts to be subtracted from the earnings of employees because they are required by
government (mandatory deductions) or permitted by the employee himself (voluntary deductions.
Mandatory deductions include employment income tax and pension contribution. In our country, some
of the deductions against the earnings of employees are:
A. Employee Income Tax
In Ethiopia every citizen is required to pay something in the form of income tax from his/her earning
of employment. In this case, a progressive income tax system that charges higher rates for higher
earnings is applied on the gross earnings of each employee save the first 150 Birr. According to
proclamation No. 286/1994 that has become into effect beginning Hamle 1, 1994 E.C. exempts the
first Br 150 of the earnings of an employee from income tax. The money on which a person does not
have to pay income tax is an exemption. According to the new proclamation, employee income tax
has to be computed based on Schedule “A” as follows:

Employment Income per Month Deduction Tax Per Month

TB From Birr To Birr Tax Rate
1 st
0 600 0 Exempt (0%)
2 nd
601 1650 60 10%
3rd 1651 3,200 142.5 15%
4th 3,201 5,250 302.5 20%
5th 5,250 7,800 565 25%
6 th
7,801 10,900 955 30%
7 th
10,900 Above 1500 35%

Generally, taxable income from employment includes salaries, wages, allowances, director’s fees and
other personal emoluments, all payments in cash and benefits in kind. However, as per Art 13 of
Proclamation No. 286/2002 and Art 3 of Regulation No. 78/2002, the following categories of
payments in cash or benefits in kind are exempted from taxation.
a. Income from employment received by casual employees
b. Income from employment received by diplomatic and consular representatives; and other
persons employed in any Embassy
c. Payments made to a person as compensation or gratitude in relation to personal injuries; or
the death of another person.
d. Medical Allowance
 Chapter 3: Current Liabilities and Payroll Accounting
e. Transportation Allowance
f. Hardship Allowance
g. Per-diem Allowance (Daily Allowance)
h. Traveling Expenses
i. Income of persons employed for domestic duties
B. Pension Contribution
Permanent employees of an organization the employees of which are governed by the existing
regulations of the Ethiopian public servants are expected to pay or contribute 7% of their basic
(monthly) salary to the government pension Trust Fund. This amount should be with held by the
employer from the basic salary of each employee on every payroll and later be paid to the respective
government body.

On the other hand, the employer is also expected to contribute towards the same fund 7% of the basic
salary of every permanent employee of it. It is this total amount that we called earlier as payroll taxes
expense to the employer organization (i.e. 7% of the total basic salary of all permanent employees).
For military forces (police and national defence members), the employer contributes 22% of the basic
salary of every permanent military force.
Consequently, the total contribution to the pension Trust Fund of the Ethiopian government is equal to
16% of the total basic salary of all permanent employees of an organization (i.e. 7% comes from the
employees and the 9% comes from the employer as per proclamation no.714/2011 started on
Hamle1,2005). This enables a permanent employee of an organization to be entitled to the pension
pay given that the employee has satisfied the minimum requirements to enjoy this benefit when retired.
Non-government organizations are also using this kind scheme to benefit their employees with some
modifications. This is made in some NGO'S by keeping a fund known as Provident Fund. Both the
employees and the employer contribute towards this fund monthly.

C. Other Deductions (Voluntary Deductions)

Apart from the above two kinds of deductions from employees earnings, employees may individually
authorize additional deductions such as deductions to pay health or life insurance premiums; to repay
loans from the employer or credit association; to pay for donations to charitable organizations; etc.
Each of the major other deductions may be put in special column in the payroll register. Ultimately,
the sum of the employees’ income tax, pension contributions and other deductions gives the total
deductions from the gross earnings of an employee.

The column “Total Deductions” shows the total amount to be deducted from the earnings of
employees.

5. The Net Pay

This amount is held in one column of the payroll register representing the excess of gross earnings
over the total deductions of an employee. The column 'Net Pay' total tells the excess of grand total
earnings over grand total deductions made from the earnings of employees. It is the grand total take-
home pay.

6. Signature
Unless some other document is used, the payroll sheet may be designed to allow a column for
signature of the employees after collection of the net pay. In general, a payroll register should at least
show the earnings, deductions and the net pays along with the names of employees.

3.4 Major Procedures or Activities Involved in Accounting for Payroll

 Chapter 3: Current Liabilities and Payroll Accounting
1. Gathering the Necessary Data. All the relevant information about every employee should be
gathered. This activity requires reviewing various documents and to do some arithmetic work.
2. Including the names of employees along with the gathered data such as earnings, deductions and
net pays in the appropriate columns of the payroll register.
3. Totaling and proving the payroll register. It must be proved that the grand total earnings equal
the sum of the grand totals of deductions and net pays in the register.
4. The accuracy and authenticity of the information summarized in the payroll should be verified by
a different person from the one who compiles it.
5. The payroll is approved by the authorized personnel.
6. Paying the payroll either in cash (this may be after cashing a check issued for the total net
pay of the payroll) or issuing a check for every individual employee for the net amount payable to
each employee.
7. Recording the payment of the payroll and recognition of the withholding tax liabilities.
8. Recording the payroll taxes expense of the employer.
9. Paying and recording withholding and payroll tax liabilities to the concerned authority, in our
case to Inland Revenue Administration, on time.

3.5 Demonstration Problem

Ethio Relief Agency pays the salary of its employees according to the Ethiopian Calendar month. The forth
coming data relates to the month of Hider, 1998.

Name of Basic Allow OT Hrs Duration of BS per

S.No.
Employee Salary ance worked OT work hour
01 Senait Bahiru 3,200 100 10 6 AM to 10 PM 20
02 Petros Challa 1,600 __ 8 10 PM to 6 AM 10
03 Abdu Mohammed 2,400 __ 6 Weekly Rest Days 15
04 Leilla Jemal 1,920 50 __ __ 12
05 Kirkos Wolde 1,280 50 10 Public Holidays 8

Additional Information:
Note that management of the agency usually expects an employee to work 40 hours in a week and
during Hidar 1998 all employees have worked as they have been expected. Besides, all workers of this
agency are permanent employees except Petros Chala and the monthly allowance of Kirkos Wolde is
not taxable; Abdu Mohammed agreed to have Br 200 be deducted from his earning and paid to the
Credit Association of the Agency as a monthly saving.
Instructions: Based on the above information:
A. Compute of earnings, deductions and net Pays
B. Prepare a payroll register (or Sheet) for the agency for the month of Hidar, 1998
C. Record the payment of salary as of Hidar 30, 1998 using Ck. No. 41 as a source documents
D. Record the payroll tax expense for the month of Hidar, 1998. Memorandum No.006
E. Record the payment of the claim of the credit Association of the agency that arose from
Hidar's payroll assuming that the payment was made on Tahsas 1, 1998
F. Record the payments of withholding taxes and payroll taxes of the month of Hidar, 19X8
assuming that they have been paid on Tahsas 5, 1998 via Ck. No. 50
A. Computations of Earnings, Deductions and Net Pays
OVERTIME EARNING:
Overtime Earning = OT Hrs Worked @ (Ordinary Hourly Rate @ OT Rate)
1. SENAYIT BAHIRU
 10 hrs @ (20 @ 1.25) = Br 250
2. PETROS CHALLA
 Chapter 3: Current Liabilities and Payroll Accounting
 8 hrs @ (10 @ 1.5) = Br 120
3. ABDU MOHAMMED
 6 hrs @ (15 @ 2) = Br 180
4. KIRKOS WOLDE
 10 hrs @ (8 @ 2.5) = Br 200
GROSS EARNINGS:
Gross Earnings = Basic Salary + Allowance + OT Earning
1. SENAYIT BAHIRU
 Br 3,200 + 100 + 250 = Br 3,550
2. PETROS CHALLA
 Br 1,600 + 0 + 120 = Br 1,720
3. ABDU MOHAMMED
 Br 2,400+ 0 + 180 = Br 2,580
4. LEILLA JEMAL
 Br 1,920 + 50 + 0 = Br 1,970
5. KIRKOS WOLDE
 Br 1,280 + 50 + 200 = Br 1,530
DEDUCTIONS AND NET PAY:
1. SENAYIT BAHIRU
Gross Income (Gross Earning) = Br 3,550 and Taxable Income = Br 3,550
Deductions:
 Employee Income Tax:
Taxable Income Tax
150.00 x 0% = 00.00
500.00 x 10% = 50.00
750.00 x 15% = 112.50
950.00 x 20% = 190.00
1,200 x 25% = 300.00
3,550 652.50
 Pensions Contribution = Basic Salary @ 4% = Br 3,200 x 4% = Br 128.00
Net Pay:
Gross Taxable Income..........................................
Br 3,550.00
Less: Deductions
Employee Income Tax
...............................................
652.50
Pension Contribution
...............................................
128.00
Voluntary Contribution
0.00
Total Deduction........................... 780.50
Net Pay................................................................
Br 2,769.50

2. PETROS CHALLA
Gross Income = Br 1,720 and Taxable Income = Br 1,720
Deductions:
 Employee Income Tax:
Taxable Income Tax
150.00 x 0% = 00.00
500.00 x 10% = 50.00
750.00 x 15% = 112.50
320.00 x 20% = 64.00
 Chapter 3: Current Liabilities and Payroll Accounting
3,550 226.50
 Pensions Contribution = Br 0.00, he is a Contractual worker

Net Pay:
Gross Taxable Income..........................................
Br 1,720.00
Less: Deductions
Employee Income Tax
...............................................
226.50
Pension Contribution
...............................................
0.00
Voluntary Contribution
0.00
Total Deduction........................... 226.50
Net Pay................................................................
Br 1493.50
3. ABDU MOHAMMED
Gross Income = Br 2,580and Taxable Income = Br 2,580
Deductions:
 Employee Income Tax:
Taxable Income Tax
150.00 x 0% = 00.00
500.00 x 10% = 50.00
750.00 x 15% = 112.50
950.00 x 20% = 64.00
230.00 x 25% = 57.50
2,580 410.00
 Pensions Contribution = Br 2,400 x 4% = Br 96.00
 Voluntary Contribution = Br 200.00 payable to Credit Association
Net Pay:
Gross Taxable Income..........................................
Br 2,580.00
Less: Deductions
Employee Income Tax
...............................................
410.00
Pension Contribution
...............................................
96.00
Voluntary Contribution
200.00
Total Deduction........................... 706.00
Net Pay................................................................
Br 1,874.00
4. LEILLA JEMAL
Gross Income = Br 1,970 and Taxable Income = Br 1,970
Deductions:
 Employee Income Tax:
Taxable Income Tax
150.00 x 0% = 00.00
500.00 x 10% = 50.00
750.00 x 15% = 112.50
570.00 x 20% = 114.00
1,720 276.50
 Pensions Contribution = Br 1,920 x 4% = Br 76.80
 Chapter 3: Current Liabilities and Payroll Accounting
Net Pay:
Gross Taxable Income..........................................
Br 1,970.00
Less: Deductions
Employee Income Tax
...............................................
276.50
Pension Contribution
...............................................
76.80
Voluntary Contribution
0.00
Total Deduction........................... 353.30
Net Pay................................................................
Br 1,616.70
5. KIRKOS WOLDE
Gross Income = Br 1,530 and Taxable Income = Br 1,530 – 50 = Br 1,480
Deductions:
 Employee Income Tax =150 @ 0% + 500 @ 10% + 750 @ 15% + 80 @ 20% = Br 178.50
 Pensions Contribution = Br 1,280 @ 4% =Br 51.20
Net Pay:
Gross Taxable Income..........................................
Br 1,530.00
Less: Deductions
Employee Income Tax
...............................................
178.50
Pension Contribution
...............................................
51.20
Voluntary Contribution
0.00
Total Deduction........................... 229.70
Net Pay................................................................
Br 1,300.30

B. Preparing a payroll register (or Sheet)

ETHIO RELIEF AGENCY
Payroll Register (Sheet)
For Month of Hidar 1998
Pay Day: Hidar 30,19x8
Earnings Deductions
Seri. Name of Basic Allow. Over- Gross Income Pension Other Gross Net Pay
No Employee Salary time Earning Tax Ded. Ded. Ded.
01 Senayet B. 3,200.00 100.00 250.00 3,550.00 652.50 128.00 __ 780.50 2,769.50
02 Petros Ch. 1,600.00 __ 120.00 1720.00 226.50 __ __ 226.50 1,493.50
03 Abdu M. 2,400.00 __ 180.00 2,580.00 410.00 96.00 200 706 1,874.00
04 Leila J. 1,920.00 50.00 __ 1,970.00 276.50 76.80 __ 353.30 1,616.70
05 Kirkos W. 1,280.00 50.00 200.00 1,530.00 178.50 51.20 __ 229.70 1,300.30
Totals 10,400.00 200.00 750.00 11,350.00 1,744.00 352.00 200.00 2,296.00 9,054.00
Proving the Payroll:
Total Earnings:
Basic Salary........................................................................ Br 10,400.00
Allowance........................................................................... 200.00
Overtime............................................................................. 750.00
Total Earnings................................................ Br 11,350.00
Deductions:
Employee Income Tax.......................................................... Br 1,744.00
 Chapter 3: Current Liabilities and Payroll Accounting
Pension Contribution............................................................ 352.00
Other deductions................................................................... 200.00
Total Deductions.......................................................... Br 2,296.00
Total Net Pays.............................................................. 9,054.00
Total Deductions & Net pay........................... Br 11, 350.00
C. Recording the Payment of Salary on Hidar 30, 1998
Salary Expense............................................................................... 11,350
Employee Income Tax Payable..................................... 1,744
Pension Contribution Payable....................................... 352
Credit Association Payable............................................ 200
Cash............................................................................... 9,054
Ck. No. 41
D. Recording the Payroll Tax Expense for Hidar, 19X8
Ethio - Relief Agency incurred payroll tax expense of Br 528 during Hidar, 19X8. This is determined
as the product of the basic salary of all permanent employees and 6%. This is because the agency has
to contribute 6% of the basic salary of every permanent employee to the government pension trust
fund. Thus,
 Payroll Tax Expense = Total Basic Salary of all permanent Employees @ 6%
 Payroll Tax Expense = (3,200 + 2,400 + 1,920 + 1,280) @ 6% = Br 528
By the amount of Br 528 the agency's expense, payroll taxes expense, and pension contributions
payable increase. Therefore, the following journal entry is made as of Hidar 30, 1998:
Payroll Tax Expense.......................................................................
528
Pension Contribution Payable.......................................528
Memorandum No. 006
The source document is an internal office memorandum that indicates the incurrence of this expense.

E. Recording the payment of the claim of the credit Association

Credit Association Payable......................................... 200
Cash........................................................... 200
F. Recording the payments of withholding taxes and payroll taxes of the month
Look at the account balances before payment:
Employee Income Tax Payable Pension Contribution Payable
1,744 (2) 352.00 (2)
528.00 (3)
880.00

From the above accounts you can see that the agency has a total liability of Br 2,639. That is the
sum of Br 1,744.00 Employee Income Tax payable and Br 880.00 Pension Contribution payable
(1,744.00 + 880.00 = 2,624). Note also that the total pension contribution payable is equal to 10%
of the basic salary of all permanent employees. That is, Br 8,800 x 10% = Br 880. T hen, the
payment is recorded as follows:
Employee Income Tax Payable................................... 1,744
Pension Contribution Payable.................................... 880
Cash.......................................................... 2,624
Ck. No. 50
After the payment of these liabilities have been posted, the above two accounts will have zero
balances.
 Chapter 3: Current Liabilities and Payroll Accounting
REVIEW QUESTIONS
1. Discuss the importance of payroll accounting
2. Distinguish between pay period and payday
3. What are the basic records of a payroll accounting system? Describe them
4. Enumerate and explain the basic elements of a payroll sheet of a firm
5. Differentiate payroll taxes expense and withholding taxes
6. What are the four over time sessions according to article 33 of proclamation No. 64/1975
7. What are some of earnings that are not taxable in an Ethiopian context?
8. What is the over all contribution to government pension trust fund from a permanent
government employee's basic salary?
9. How non-government organizations alleviate the problem of social security pensioned
employees?
10. State the required journal entries in relation to a payroll accounting
11. Is there any principal difference between manual and computerized payroll Accounting
system? Why? Explain.

EXERCISES
Exercise 3.1:
Payroll data of a government hotel, Andinet Hotel, for the month of Hamle, 1988 are given below:
Over time in hours
Name Basic Regular Upto 10PM – Rest Holy
Salary Hourly Rate Allowanc 10PM 6AM Days Days
e
Abera Br 600 Br 3 Br 200 10 – 4 –
Abebu 420 2.10 – 20 10 – 5
Belete 980 4.90 100 – 5 – 8
Additional information: Abebu is contractual employee and the allowance to Abera is free of income
tax.
Required:
1. Prepare payroll register
2. Record on page 10 of a two column general journal:
a) The payment of salary on Hamle 30,
b) The recognition of payroll tax expense, and
c) The payment of the amounts owed, in connection with the month Hamle, 1988 payroll,
to the government on Nehase 5, 1988.
Exercise 3.2: A permanent employee of a government organization with a basic monthly salary of Br640.00
and monthly Allowance of Br100.00 has worked 20 overtime hours during days in the weekends of the
current month. This employee usually works 160 hours in a month to earn his basic salary. Based on the above
information answer the following questions:
1. What is the ordinary hourly rate of this employee?
2. How much is the gross earnings of this employee?
3. Determine the amount of employee income tax and pension contribution!!
Exercise 3.3: W/t Kedija, the employee of CMN Agency, government owned, has worked 10 hours, 8
hours and 12 hours, during the holidays, after mid night on working days and weekends respectively in
a given month. In the same month, she has earned a regular monthly salary of 1,120 BIRR as the result
of working 140 regular working hours. Determine her gross overtime earnings for the month.
Exercise 3.4: Using the following payroll data of Paradise Restaurant, government owned, for the
month of Sene 988:
Employee Name Basic Salary OT Earning
 Chapter 3: Current Liabilities and Payroll Accounting
Derbe Reta Br 200.00 Br 50.00
Rahel Amde 400.00 200.00
Michael Girma 300.00 400.00
1. Compute the (a) Income tax deduction from each employee; (b) Pension contribution by each
employee; and (c) Employer’s payroll tax expense
2. Prepare journal entries to record the (a) Payment of salary to employees; (b) Employer’s payroll
tax expense; and (c) Payment of the deductions and payroll taxes to the government at the
beginning of the following month
3. Assuming that the ordinary hourly rate of Rahel is Br 2 and all of her overtime hours were
performed during weekly rest days, how many overtime hours did she work?
Source:
A teaching material on Introduction to Accounting, prepared by Abubeker Seid, Lecturer,
Department of Accounting, AACC, 1997, Revised in September 2002.
 Chapter 4: Accounting Concepts and Principles

Chapter 4
Accounting Concepts and Principles
Chapter Outlines:
This chapter covers the following topics:
 Development of Accounting Concepts And Principles
 Basic Accounting Concepts And Principles

Chapter Learning Objectives

After studying this chapter, you should be able to:
 Understand the development of accounting principles and concepts
 Explain the meaning of generally accepted accounting principles
 Discuss the qualitative characteristics of accounting information and elements of financial
statements.
 Identify the basic assumptions used by accountants
 Identify the basic principles of accounting.
 Identify the two constraints in accounting.
4.1 Development of Accounting Concepts and Principles
Accounting theory consists of a set of basic concepts and assumptions and related principles that
explain and guide the accountant’s actions in identifying, measuring, and communicating
accounting information. This body of knowledge is referred to as “Principles” or “Generally
Accepted Accounting Principles” (GAAP) and followed as guides for developing and
communicating accounting information. In early stage of an economy, a business enterprise was
often managed by its owner and accounting records and reports were used mainly by the owner.
Banks and other lenders often rely on the personal relationship with the owner rather than on the
financial statements as the basis for making loans for business purpose and if a large amount was
owed to a bank of supplier the creditor often participated in management. However, as the business
grew in size and complexity management and outsiders become more clearly differentiated. This
size and complexity of the business results problems involved in the issuance of financial statement
to users. As a result, this development create an awareness of the need for a framework of concepts
and generally accepted accounting principles to serve as guidelines for a preparation and auditing
of the basic financial statement. These principles help the financial statement to be reliable,
understandable and comparable.
The most influential organization in developing accounting concepts and principles are:
1. Financial Accounting Standards Board (FASB)
The FASB is the primary authoritative body in developing and controlling setting process of
accounting principles and concepts (standards) for business organizations. The board issues
statements of financial accounting standards, which become part of GAAP and interpretations to
explain, clarify or elaborate on existing pronouncements which have the same authority as the
standards.
2. GASB ( Government Accounting Standard Board)
The GASB has a responsibility for establishing the accounting standards to be followed by state
and municipal or other government institution.
3. Accounting Organizations
 AICPA (American Institute of Certified Public Accountant)
 AAA (American Accounting Association)
 IMA(Institute of Management Accountant
Each organization publishes monthly or quarterly periodicals and from time to time, issues other
publications in the form of research studies, technical opinions, etc
 Chapter 4: Accounting Concepts and Principles
4. Government Organizations
 SEC (Security and Exchange Commission)
 IRS (Inland Revenue Service)

4.2 Basic Accounting Concepts and Principles

1. The Business Entity Concepts – states that regardless of the form the organization, the
business affairs of the entity must be distinguished from those of the owner. Business resources,
records, and reports must be kept separate from that of the owner’s and any other business.
2. Going Concern Concept – the going concern concept or continuity principle assumes that a
business entity will continue to exist for an indefinite period of time to carry out present plans and
meet contractual commitments. This assumption affects the manner of recording some business
transactions and as a result the data reported in the financial statements. The going concern:
 Provides much of the justification for recording plant assets at cost and depreciating them in
an orderly manner without reference to the current realizable value
 Supports the treatment of prepaid expenses as assets, even though they may not be salable
 Helps to focus attention on the determination of net income rather than on the valuation of
assets
The going concern principle does not imply permanence of existence but simply that the enterprise
will continue in existence long enough to carry out present plans and meet contractual
commitments. When there is conclusive evidence that a business has a limited life the principle
used is Quitting Concern and the Financial Statements are prepared accordingly.
3. Objective Evidence – entries in the accounting records and the data reported on the financial
statements must be based on objectively determined evidence. Each transaction is described by a
business document or paper such as sales invoice, receipts, vouchers, etc that proves the transaction
did occur. This principle is subject to verification by independent experts. Without close adherence
to this principle, the confidence of the many users of the financial statement could not be
maintained.
4. Unit of Measurement (Monetary Principle)
Unit of measurement assumption means that money is used as the basic measuring unit for
recording transactions and for financial reporting.
Limitations:
 It limits the scope of accounting reports because other factors which can not be expressed in
monetary terms will not be reported in accounting. Example: employee-employer relationship,
relative strength and defense of competitors, efforts and capabilities of top management,
employee’s devotion, customer’s brand loyalty
 It assumes the stability of the measuring unit like KMs, KGs, etc. But money is not stable. The
purchasing power is fluctuating in the market
5. Accounting Period Or Periodicity Assumption
A complete and accurate picture of an enterprise’s success or failure and determining the true net
income is possible when a business discontinued operations. However, decisions makers need
timely information so that it necessary to prepare periodic reports on operations, financial position,
and cash flows by dividing the life of the business into periods which have equal intervals specially
one year. It is also a requirement of governmental agency
6. Matching Principle or Matching Revenue and Expired Costs (Expenses)
The matching principle or the principle of matching expenses with revenues can be “Stated that
revenue from business activities and expenses associated with earning that revenue must be
recorded within the same accounting period. The determination of periodic net income is a two-fold
problem involving:
 Chapter 4: Accounting Concepts and Principles
1. The Recognition Revenue during the period and
2. The Recognition of Expired costs to be allocated to the period
The recognition of revenue
Revenue is measured by the amount charged to customers for merchandise delivered or service
rendered to them. But, the question is when should revenue be recognized or be recorded in
accounting records and reported. Under the assumption of accrual accounting, revenue should be
recognized when it is earned. However, earning does not actually take place at a single point in
time. It is usually an extended economic process. Revenue should be recognized when objective
evidence to support the recording of revenue is produced. Various criteria or methods are
acceptable for determining when revenue should be realized. The criteria or methods most
frequently used are:
A) The point of sale method
It is customary to consider revenue from the sale of commodities as being realized at the time title
passes to the buyer. At point of sale:
 The Selling price has been agreed upon
 The Buyer acquires the right of ownership in the commodity, and
 The Seller has a legal claim against the buyer
B) The Receipt of Payment Method or Cash Basis Criteria of Revenue Recognition
When the cash basis or receipts of payment method is adopted, revenue is considered to be realized
at the time the cash is collected, regardless of when the sale was made. Cash basis of accounting
does not conform to GAAP
C) The Installment Method of Recognizing Revenue
In the typical installment sale, the purchaser makes a down payment and agrees to pay the
remainder in specified amount at stated intervals over a period to time. This method considers each
cash receipts to be revenue and to be composed of partial payment of:
 The Cost of Merchandise Sold and
 The Gross Profit on the sale
 Chapter 6: Accounting for Corporate Form Business Organizations

Chapter 5
Accounting for Partnership Form Business Organizations
Chapter Outlines:
This chapter covers the following topics:
 Basics of Partnership
 Accounting for Partnership
 Dissolution of a Partnership
 Liquidation of a Partnership

Chapter Learning Objectives

After studying this chapter, you should be able to:
 Identify the characteristics of the partnership form of business organization.
 Explain the accounting entries for the formation of a partnership.
 Identify the bases for dividing net income or net loss.
 Describe the form and content of partnership financial statements.
 Explain the effects of the entries when a new partner is admitted.
 Describe the effects of the entries when a partner withdraws from the firm.
 Explain the effects of the entries to record the liquidation of a partnership.

5.1 Basics of Partnership

Definition:
Partnership is defined as a voluntary association of two or more persons to carry on as co-owners a
business for profit.
Characteristics of Partnership:
 It is based on a contract – all that is necessary is for two more legally competent people to
agree to become partners. This agreement becomes a partnership contract.
 Limited life – the life of a partnership is always limited. Death, bankruptcy or anything that
takes away the ability of one of the partners to contract automatically ends a partnership.
 Unlimited liability – most partnerships are general partnerships in which each partner is
individually liable to creditors for debts incurred by the partnership if it becomes insolvent.
 Mutual agency – each partner is an agent of the partnership with the authority to enter in to
contracts for the partnership, the act of each partner binds the partnership.
 Participation in income – net income or net loss are distributed among the partners according
to agreement
 Co-ownership of property – the property invested in a partnership by a partner becomes the
property of all the partners jointly.
 Non taxable entity – partnership is not required to pay federal income taxes.
Advantages and Disadvantages of Partnership
Advantages:
 It is relatively easy and inexpensive to organize partnership. It is requiring only an agreement
between two or more persons.
 Ability to bring together more capital more managerial skills and more experience than would
a sole proprietorship
 It is a non taxable entity
Disadvantages:
 Its life is limited
 Has unlimited liability
 One partner can bind the partnership to contract
 Raising large amounts of capital is more difficult
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 Chapter 6: Accounting for Corporate Form Business Organizations
Types of Partnership:
 Limited Partnership: is a type of Partnership in which partners have limited liability and
have no active participation in management of the business. It is with at least one general
partner.
 General Partnership: is a type of Partnership in which partners are responsible for the debt
of the business and have participated actively in management with unlimited liability. It has
all general partners.
The partnership contract:
Partnership agreement may or may not be written but it is better if it is in writing in order to lesser
chances for misunderstanding and future disagreement. A written contract called Articles of
Partnership or Partnership Agreement should list at least the following terms:
 Name, location and nature of the business
 Names of partners, their duties and rights of each
 Amount invested by each partner and the procedure for valuing any non cash assets
 Method of sharing profits and losses
 Withdrawals to be allowed by partners and the method of withdrawal
 Provision for insurance on the lives of the surviving partners or beneficiaries.
 The accounting period to be used
 Annual audit by CPAs
 Provision for arbitration of disputes
 Provision for dissolution. This part may specify a method of computing the equity of a
retiring or deceased partner and a method of settlement which will no disrupt the business.

5.2 Accounting for Partnership

Partnership accounting requires the use of separate capital account and withdrawal account for each
partner.
1. Recording Investments
A separate entry is made for the investment of each partner in a partnership. The various assets
contributed by the partner are debited to the proper asset accounts. If liabilities are assumed by the
partnership, the appropriate liability accounts are credited. All assets other than cash should be
valued at fair market values at the date of investment.
Example 5.1: assume that Rita and Katherine agreed on January 1, 2002 to form a partnership
named RK Company. Rita invested Br 8,000 Cash, Br 35,000 furniture, Br 12,000 merchandise and
Br 15,000 notes payable is assumed by the partnership which is related to Rita. Katherine invested
Br 30,000 Cash and Br 20,000 accounts receivable with the provision for uncollectible accounts of
Br 8,000. Required: Record the investment by the two owners
Investment of Rita:
Cash................................................................. 8,000
Furniture..........................................................35,000
Merchandise Inventory..................................12,000
Notes Payable................................ 15,000
Rita, Capital.................................... 40,000
Investment of Katherine:
Cash.................................................................
30,000
Accounts Receivable....................................... 20,000
Allowance FDA............................. 8,000
Katherine, Capital.......................... 42,000

The combined journal entry is as follows:

Cash.................................................................38,000
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 Chapter 6: Accounting for Corporate Form Business Organizations
Accounts Receivable.......................................20,000
Furniture..........................................................35,000
Merchandise Inventory..................................12,000
Notes Payable................................. 15,000
Allowance FDA.............................. 8,000
Rita, Capital.................................... 40,000
Katherine, Capital.......................... 42,000

2. Division of Net Income or Net Loss

If each partner is to contribute equal services and amounts of capital, an equal sharing in
partnership Net Income would be equitable. But if one partner is to contribute a larger portion of
capital or capital or the services of one partnership, provision for this should be given recognition
in the division on net income or net loss, it should be noted that division on net income or net loss
among the partners in exact accordance with their partnership agreement is of the utmost
importance, if the agreement is silent on the division on net income or net loss, the law provides
that all partners share equally, regardless of differences in amounts of capital contributed, or special
skill possessed or of time devoted to the business. The partners may however, make any agreement
they wish in regard to the division of net income and net losses.

A) Income division recognizing services of partners

Example 5.2: assume that the articles of partnership of Rita and Katherine provides for monthly
salary allowances of Br 2,500 and Br 1,500, respectively with the balance of the Net Income to be
divided equally and that the net income for the year is Br 80,000. Instruction: prepare a schedule of
income division and record the income division

Net Income.....................................................Br 80,000

Division of NI Rita Katherine Total
Salary Allowance 30,000 18,000 48,000
Remaining Income 16,000 16,000 32,000
Net Income to each 46,000 34,000 80,000
The division of net income is recorded as a closing entry, regardless of whether the partners
actually withdrew the amounts of their salary allowances. The entry for the division of Net Income
is closed as follows:
Income Summary............................................ 80,000
Rita, Capital................................... 46,000
Katherine, Capital.......................... 34,000
If they had withdrawn their salary allowances monthly, the withdrawals would have accumulated as
debits to the drawing account of each partner during the year. Recording the drawing of the two
partners each month is as follows:
Rita, Drawing.................................................. 2,500
Katherine, Drawing......................................... 1,500
Cash............................................... 4,000
At the end of the year, the drawing account of Rita and Katherine has a debit balance of Br 30,000
and 18,000, respectively. The closing entry appears as follows:
30,000
Rita, Capital...................................................
Katherine, Capital..........................................18,000
Rita, Drawing..................................... 30,000
Katherine, Drawing............................ 18,000

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 Chapter 6: Accounting for Corporate Form Business Organizations
Example 5.3: The net income of Rita and Katherine for the year is Br 80,000. Further assume that
Rita and Katherine:
 are allowed a monthly salary of Br 2,500 and Br 1,500, respectively
 are allowed interest at a rate of 10% on their Capital balance at the beginning of period
 agreed to divide the remaining income equally
Instruction: prepare a schedule of income division assuming the net income is Br 80000 and
record the income division
Net Income.....................................................Br 80,000
Division of NI Rita Katherine Total
Salary Allowance 30,000 18,000 48,000
Interest Allowance 4,000 4,200 8,200
Remaining Income 11,900 11,900 23,800
Net Income to each 45,900 34,100 80,000
The closing entry for the division of Net Income is as follows:
Income Summary............................................ 80,000
Rita, Capital................................... 45,900
Katherine, Capital.......................... 34,100
C) Income Division-Allowances Exceed Net Income
When a NI is less than the total of special allowances the remaining negative balance will be
divided among the partners as if it is a net loss.
Example 5.4: The net income of Rita and Katherine for the year is Br 50,000. Further assume that
Rita and Katherine agreed:
 to have monthly salary of Br 2,500 and Br 1,500, respectively
 to have interest allowance at a rate of 10% on their beginning Capital balance
 to divide the remaining income equally
Instruction: prepare a schedule of income division
Net Income.....................................................Br 50,000
Division of NI Rita Katherine Total
Salary Allowance 30,000 18,000 48,000
Interest Allowance 4,000 4,200 8,200
Total Allowance 34,000 22,200 56,200
Excess Allowance (3,100) (3,100) (6,200)
Net Income to each 30,900 19,100 50,000
The entry for the division of Net Income is closed as follows:
Income Summary............................................ 50,000
Rita, Capital................................... 30,900
Katherine, Capital.......................... 19,100

Accounting Department 39