Module Principles of Accounting Part II Final

JIMMA UNIVERSITY
FACULTY OF BUSINESS & ECONOMICS
SCHOOL OF CONTINUING AND DISTANCE

STUDIES
DISTANCE EDUCATION MODULE

FOR
PRINCIPLES OF ACCOUNTING PART II
(ACCT 202)
Prepared By: AREGA SEYOUM [MBA, BA]

DR SHANKAR KUMAR SINGH JHA (Ph.D)
MR M.P. NAIDU [BA, MCOM]
June 20, 2009

J imma, Ethiopia
MODULE CONTENTS
PAGE
1. UNIT ONE: Accounting for Inventories ..............................1

(BY AREGA SEYOUM)
2. UNIT TWO: Determining The Cost Of Inventory.............18
(BY AREGA SEYOUM)
3. UNIT THREE: Additional Valuation Problems for
Inventories..................................................................32
(BY AREGA SEYOUM)
4. UNIT FOUR: Accounting for Plant Assets and Depreciation 43
(BY DR SHANKAR KUMAR SINGH JHA)
5. UNIT FIVE: Disposal of Plant Assets ..........................63
(BY AREGA SEYOUM)
6. UNIT SIX: Accounting System for Payroll and Payroll Tax
Liabilities ................................................................78
(BY AREGA SEYOUM)
7. UNIT SEVEN: Fundamental of Accounting Concepts
and Principles ..........................................................99
(BY DR SHANKAR KUMAR SINGH JHA)
8. UNIT EIGHT: Accounting for Partnership ....................113
(BY MR M.P. NAIDU)
9. UNIT NINE: Accounting for Corporations ....................143
(BY MR M.P. NAIDU)
1
UNIT ONE: ACCOUNTING FOR INVENTORIES
Contents
 Unit Objective
 Introduction
1.1 Importance of Inventories
1.2 Effects of Inventories on Financial Statements
1.2.1 Effects of Ending Inventory on Current Period’s Financial Statements
1.2.2 Effects of Beginning Inventory on Current Period’s Financial Statements
1.2.3 Effects of Ending Inventory on the Following Period’s Financial
Statements
1.3 Inventory Systems
1.3.1 Periodic Inventory System
1.3.2 Perpetual Inventory System
1.4 Determining Actual Quantities in the Inventory
 Summary
 Model Examination Questions
 List of References
Unit Objective
This unit aims at discussing the meaning, importance and effects of inventories. It also discusses
the inventory systems and determining actual quantities in inventories. After studying this unit,
you will be able to:
1
 explain the meaning of inventories
 describe the effect of inventory on the financial statements of the current period and the
following period
 differentiate the two principal inventory systems
 identify the procedures for determining the actual quantities in inventory.
Introduction
Dear students! Have you heard of the term inventories before? If so, what do you understand
by the term inventories? What do you think are the major types of inventories? Give your
answer in writing before you go through the discussion below.
In the last section of Principles of Accounting I, you have learned about the principles and
practices of accounting for receivables – one of the current asset items in the balance sheet of a
retail business. In this unit you will learn and discuss the concepts in accounting for inventories
such as types of inventories, quantity and cost of inventories, types of inventory systems, etc.
Inventories are asset items held for sale in the ordinary course of business or goods that will be
used or consumed in the production of goods to be sold. They are mainly divided into two major
parts:
 Inventories of merchandising businesses

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

the normal course of business. These types of inventories are called merchandise
inventories.
inventories.
ii. Inventories of manufacturing businesses: manufacturing businesses are businesses
that produce physical output. They normally have three types of inventories. These
are:
 Raw material inventory
 Work in process inventory
 Finished goods inventory
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1. Raw material inventory – is the cost assigned to goods and materials on hand but not yet
placed into production. Raw materials include the wood to make a chair or other office
furniture, the steel to make a car etc.
2. Work in process inventory – is the cost of raw material on which production has been
started but not completed, plus the direct labor cost applied specifically to this material and
allocated manufacturing overhead costs.
3. Finished goods inventory – is the cost identified with the completed but unsold units
units on hand
at the end of each period.
In this unit only the determination of the inventory of merchandise purchased for resale
commonly called merchandise inventory will be discussed.
1.1 Importance of Inventories
Dear students, we believe that from the above discussion you have acquired some concepts
regarding inventories. In the operation of wholesale and retail businesses the determination of
inventories plays a significant role. What do you think are some of the important roles that
inventory determination plays?
Merchandise, being continually purchased and sold is one of the most active elements in
merchandising business, i.e. in wholesale and retail type of businesses. This is due to the
following reasons:
1. The sale of merchandise provides for the principal source of revenue for them.
2. The cost of merchandise sold is the largest deductions from sales.
3. Inventories (ending inventories) are the largest of the current assets of such firms.
Inventory determination plays an important role in matching expired costs with revenues of the
period. An error in the determination of the inventory figure at the end of the period will cause
an equal misstatement of gross profit and net income, and the amount reported for both assets
and owner’s equity in the balance sheet will be incorrect by the same amount. Because of the
above reasons inventories have effects on the current and the following period’s financial
statements. If inventories are misstated (understated of overstated), the financial statements will
be distorted.
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Check Your Progress: Exercise -1.1
1. Describe the three types of inventories for a manufacturing business

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2. Why do we consider inventories the most active elements in the operation of a merchandising
business?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
1.2 Effects of Inventories on Financial Statements
1.2.1
1.2.1 Effect
Effect of
of Ending
Ending Inventory
Inventory on
on Current
Current Period’s
Period’s Financial Statements
Ending inventory is the cost of merchandise on hand at the end of the accounting period. Let us
see its effect on current period’s financial statements.
Income Statement
a. Cost of goods (merchandise) sold =Beginning inventory + Net

purchase – Ending inventory
As you see, ending inventory is a deduction in the computation of cost of merchandise sold. So,
it has an indirect (negative) relationship to cost of merchandise sold, i.e. if ending inventory is
understated, the cost of merchandise sold will be overstated, and if ending inventory is
overstated, the cost of merchandise sold will be understated.
b. Gross Profit = Net sales – Cost of merchandise sold

Here, the cost of merchandise sold had indirect relationship to gross profit. So, the effect of
ending inventory on gross profit is the opposite of the effect on cost of merchandise sold. That is,
if ending inventory is understated, the gross profit will be understated and if ending inventory is
overstated, the gross profit will be overstated. This is a direct (positive) relationship.
c. Operating income = Gross Profit – Operating Expenses

Gross profit and operating income have direct relationships. Thus, the effect of ending inventory
on net income is the same as its effect on gross profit, i.e. direct (positive) effect (relationship).
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Balance Sheet
a. Current assets – Ending inventory is part of current assets, even the largest. So, it has a
direct (positive) relationship to current assets. If ending inventory balance is understated
(overstated), the total current assets will be understated (overstated). Since current assets
are part of total assets, ending inventory has direct relationship to total assets.
b. Liabilities – No effect on liabilities. Inventory misstatement has no effect on liabilities.
c. Owners’ equity – The net income will be transferred to the owners’ equity at the end of
accounting period. Closing income summary account does this. So, net income has direct
relationship with owners’ equity at the end of accounting period. The effect of ending
inventory on owners’ equity is the same as its effect on net income, i.e. if ending
inventory is understated (overstated), the owners’ equity will be understated (overstated).
1.2.2 Effects of Beginning Inventory on Current Period’s Financial Statements

Beginning inventory is inventory balance that was left on hand in the previous period and
transferred to the current period. Its effect is summarized below:
Income Statement
a. Cost of merchandise sold = Beginning inventory + Net Purchases – Ending inventory
As you see, beginning inventory is an addition in determining cost of goods sold. It has
direct effect on cost of merchandise sold. That is, if the beginning inventory is
understated (Overstated), the cost of merchandise sold will be understated (Overstated)
b. Gross Profit = Net Sales – Cost of merchandise sold
The effect of beginning inventory on gross profit is the opposite of the effect on cost of
merchandise sold, i.e. indirect (negative) relationship. If the beginning inventory is
understated, the gross profit will be overstated and if it is overstated, the gross profit will
be understated.
c. Net income = Gross Profit – Operating expenses
The effect of beginning inventory on net income is the same as its effect on gross profit.
Balance Sheet
a. Current assets – The inventory included in current assets is the ending inventory. So,
beginning inventory has no effect on current assets.
b. Owners’ equity – If the effect comes from the previous year, the beginning inventory will
not have an effect on ending owners’ equity since the positive or negative effect of the
previous year will be netted off by the negative or positive effect of the current year. But
if the error is made in the current period, it will have indirect effect on ending owners’
equity.
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1.2.3 Effect of Ending Inventory on the Following Period’s Financial Statements
The ending inventory of the current period will become the beginning inventory for the
following period. So, it will have the same effect as beginning inventory of the current period.
Let us summarize it.
Income statement of the following period
Cost of merchandise sold direct relationship

Gross profit indirect relationship
Net income indirect relationship
Balance sheet of the following period
The ending inventory of the current period will not have an effect on the following period’s
balance sheet items.
Illustration – 1.1
The following amounts were reported in Ginjo Company’s financial statements for three
consecutive fiscal year ended December 31.
2008 2007 2006

a) Cost of merchandise sold Br. 360,000 Br. 288,000 Br. 150,000
b) Net income 140,000 105,000 51,000
c) Total Current assets 320,000 285,000 195,000
d) Owner’s equity 425,000 365,000 220,000
In making the physical counts of inventory, the following errors were made:
© Inventory on December 31, 2006, understated by Br. 10,000
© Inventory on December 31, 2007, overstated by Br. 15,000
Required:
Determine the correct amount of the items listed above.
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Solution
2008 2007 2006
a) Cost of Goods Sold:
Sold:
Reported Br. 360,000 Br. 288,000 Br. 150,000
Adjustment of
2006 error _ 10,000 (10,000)
2007 error (15,000) 15,000 -__
Corrected Bal. Br. 345,000 Br. 313,000 Br. 140,000
b) Net Income:
Reported Br. 140,000 Br. 105,000 Br. 51,000
Adjustment of
2006 error _ (10,000) 10,000
2007 error 15,000 (15,000) -_
c) Total Current Assets:

Reported Br. 320,000 Br. 285,000 Br. 195,000
Adjustment of
2006 error - - 10,000
2007 error -___ (15,000)
(15,000) -__
d) Owner’s Equity:
Reported Br. 425,000 Br. 365,000 Br. 220,000

Adjustment of
2006 error - - 10,000
2007 error - (15,000) -__
Check Your Progress: Exercise 1.2
Why does an understated ending inventory understate net income for the period by the same
amount?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
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1. Why does an error in ending inventory affect two accounting periods?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
1.3. Inventory Systems:
Dear students! What are the two basic types of inventory systems?
There are two principal systems of inventory accounting: periodic and perpetual.
1.3.1 Periodic Inventory System

Under this system there is no continuous record of merchandise inventory account. The
inventory balance remains the same throughout the accounting period, i.e. the beginning
inventory balance. This is because when goods are purchased, they are debited to the purchases
account rather than to the merchandise inventory account.
The revenue from sales is recorded each time a sale is made. At the time of sale no entry is made
to record the cost of goods sold. Consequently, a physical inventory must be taken periodically
(usually at the end of each fiscal period) to determine the cost of inventory on hand and goods
sold. In the periodic inventory system merchandise purchased is recorded or accumulated in the
‘Purchases’ account.
The periodic inventory system is less costly to maintain than the perpetual inventory system, but
it gives management less information about the current status of merchandise.
This system is often used by retail enterprises that sell many kinds of low unit cost merchandises
such as groceries, drugstores, hardware etc.
The journal entries to be made are:

1. At the time of purchase of merchandise:
Purchases XX at cost
Accounts payable or cash XX
2. At the time of sale of merchandise:
Accounts receivable or cash XX at
at retail
retail price
price
Sales XX
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3. To record purchase returns and allowances:
Purchase returns and allowances XX
4. To record adjusting entry or closing entry for merchandise inventory:

Income Summary XX
Merchandise inventory (beginning) XX
To close beginning Merchandise inventory
Merchandise inventory (ending) XX
Income Summary XX
To record ending Merchandise inventory

1.3.2 Perpetual Inventory System
In contrast to the periodic inventory system, the perpetual inventory system uses accounting
records that continuously disclose the amount of inventory. A separate account for each type of
merchandise is maintained in a subsidiary ledger. So, the inventory balance will not remain the
same in the accounting period. All increases are debited to merchandise inventory account and
all decreases are credited to the same account. The balances of accounts are called book
inventories of the items on hand. Irrespective of the case with which the perpetual inventory
records are maintained, their accuracy must be tested by taking physical inventory of each type
of merchandise at least once in a year. The records are then compared with the actual quantities
on hand and any differences are corrected.
There are no purchases and purchase returns and allowances accounts in this system. At the time
of sale, the cost of goods sold is recorded in addition to journal entry for the sale. So, we can
determine the cost of inventory as well as goods sold from the accounting records. No need of
physical counting to determine their costs.
Companies that sell items of high unit value, such as appliances, fur garments or automobiles,
tended to use the perpetual inventory system.
Given the number and diversity of items contained in the merchandise inventory of most
businesses, the perpetual inventory system is usually more effective for keeping track of
quantities and ensuring optimal customer service. Management must choose the system or
combination of systems that is best for achieving the company's goal.
Journal entries to be made are:
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1. At the time of purchase of merchandise
Merchandise inventory XX at cost
Accounts payable/cash XX
To record cost of Merchandise purchased
2. At the time of sale of merchandise
Accounts receivable or cash XX at
at retail
retail price
Sales XX
To record the sale
Cost of goods sold XX
Merchandise inventory XX at cost
To record the cost of merchandise sold or cost of sale
3. To record purchase returns and allowances

Merchandise inventory XX
4. No adjusting entry or closing entry for merchandise inventory is needed at the end of
each accounting period.
In its beginning inventory on Jan 1, 2008, Ziquala Trading Company had 280 units of
merchandise that cost Br. 10 per unit. The following transactions were completed during 2008.
January 17 Purchased 200 units of merchandise on account at Br. 12 per unit.
24 Returned 50 defective units from the January 17 purchases to the supplier
(payment for the entire invoice was not made).
April 19 Purchased 300 units of merchandise for cash at Br 15 per unit.

August 26 Sold 480 units of merchandise for cash at a price of Br. 17 per unit.
These goods are: 230 units from the beginning inventory and 100 units from
January 17 purchase and the rest from the April 19 purchases.
December 31 248 units are left on hand, 50 units from January 1 inventory, another
50 units from the January 17 purchase, and the rest from the last purchase.
Required: Prepare general journal entries for Ziquala Trading Company to record the above
transactions and adjusting or closing entry for merchandise inventory on December 31, 2008 (the
end of the current fiscal period) under:
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a) Periodic inventory system
b) Perpetual inventory system
Solution
a) Under Periodic Inventory System:
January 17 Purchases (200 x Br.12) 2,400
Accounts payable 2,400
24 Accounts payable (50 x Br. 12) 600
Purchase returns and allowances 600
April 19 Purchases (300 x Br. 15) 4,500
Cash 4,500
August 26 Cash (480 x Br. 17) 8,160

Sales 8,160
December 31 To record or close the merchandise inventory account
Income summary (280 x Br. 10) 2,800
Merchandise inventory (beginning) 2,860
To close the beginning inventory
31. Merchandise inventory (ending) 3,320
Income summary [(50 x Br. 10) + (50 x Br. 12) + (148 x Br. 15)] 3,320
To record the ending merchandise inventory
b) Under Perpetual Inventory System:

January 17 Merchandise inventory (200 x Br. 12) 2,400
Accounts payable 2,400
24 Accounts payable (50 x Br. 12) 600

Merchandise inventory 600
April 19 Merchandise inventory (300 x Br. 15) 4,500
Cash 4,500
August 26 i) To record the sale:
Cash (480 x Br. 17) 8,160
Sales 8,160
ii) To record cost of goods sold:
= [(230 x Br. 10) + (100 x Br. 12) + (150 x Br. 15)]
= Br. 2,300 + Br. 1,200 + Br. 2,250 = Br. 5,750
Cost of Goods Sold 5,750
Merchandise inventory 5,750
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December 31. No entry is needed to record or close merchandise inventory account. This is
because the Merchandise Inventory ledger account reflects its correct balance at the end of the
period. The merchandise Inventory ledger account after posting the above transactions is shown
below:
Merchandise Inventory
Jan. 1. Bal. 2,800 Jan. 24. 600

Jan. 17. 2,400 Aug. 26 5,750
April 19. 4,500 6,350
9,700
Dec.31. 3,350 Dec. 31. 30
Dec. 31. Bal. 3,320
Under the perpetual inventory system the Merchandise Inventory ledger account shows a debit
balance of Birr 3,350, which is the correct amount. However, the actual count of the merchandise
inventory on hand shows a balance of Birr 3,320. The difference of Birr 30 (Br. 3,350 – Br.
3,320), therefore, is considered as inventory shortage,
shortage, and it should be recorded as a credit to the
Merchandise Inventory account as shown below:
Dec. 31. Inventory Shortage 30.00

Merchandise Inventory 30.00
To adjust the Merchandise Inventory account
After posting the above entry to the merchandise inventory account, the Merchandise Inventory
account in the general ledger reflects the correct amount of the inventory on hand as of Dec. 31,
2008, as shown above in the T account.
Review Exercises
1. Differentiate between the periodic inventory system and a perpetual inventory
system. Which system is more costly to maintain?
2. Under which inventory system – periodic or perpetual – must a physical inventory
be taken to determine the cost of the inventory at the end of an accounting period?
3. If the perpetual inventory system is used, is it desirable to take a physical
inventory? Discuss.
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4. In which of the following types of businesses would a periodic inventory system
commonly be used: (i) spare part store, (ii) drugstore, (iii) fur garment shop,
(iv)
(iv) automobile dealer store, (v) supermarket, (vi) office and home appliance
store. In which of the above types of businesses would a perpetual inventory
system suitable?
5. The merchandise inventory at the end of Year 1 was inadvertently overstated by
Br.15,000. (a) Did the error cause an overstatement or understatement of the net
income for the same year? Why? (b) Assuming there was no error in the
following fiscal year, did the error cause an overstatement or understatement of
the (i) cost of goods sold, (ii) gross profit (and net Income), (iii) total assets in
Year 2?
1.4. Determining Actual Quantities in the Inventory
Dear students! How can and when a business enterprise determines the quantities of the
inventories on hand? When does title to merchandise pass from the seller to the buyer? Is
there any agreement between the seller and the buyer that determines ownership right of the
goods? Give your answer in writing before you read the discussion below.
The first stage in the process of taking inventory is to determine the quantity of each kind of
merchandise owned by an enterprise. The physical count of inventory is needed under both
inventory systems.
Under periodic inventory system, it is needed to determine the cost of inventory and goods sold.
When the periodic system is used, the counting, weighting, and measuring should be done at the
end of the accounting period. To accomplish this, the inventory crew may work during the night
or business operations may be stopped until the count is finished.
The inventory account under a perpetual inventory system is always up to date. Yet events can
occur where the inventory account balance is different from inventory on hand. Such events
include theft, loss, damage, and errors. The physical count (some times called “taking an
inventory”) is used to adjust the inventory account balance to the actual inventory on hand.
We determine a Birr (dollar) amount for physical count of inventory on hand at the end of a
period by:
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(1) Counting the units of each product on hand
(2) Multiplying the count for each product by its cost per unit
(3) Adding the cost for all products
At the time of taking an inventory, all the merchandise owned by the business on the inventory
date, and only such merchandise, should be included in the inventory. The merchandise owned
by the business may not necessarily be in the warehouse. They may be in transit.
The legal title to the merchandise in transit on the inventory date is known by examining
purchase and sales invoices of the last few days of the current accounting period and the first few
days of the following accounting period. This legal title depends on shipping terms (agreements).
There are two main types of shipping terms: FOB shipping point and FOB destination
(1) FOB Shipping Point
Point – the ownership title passes to the buyer when the goods are
shipped (when the goods are loaded on the means of transportation, i.e. at the seller’s
point). The purchaser is responsible for freight charges.
(2) FOB Destination – the title passes to the buyer when the goods arrive at their destination,
i.e. at the buyer’s point.
So, in general, goods in transit purchased on FOB shipping point terms are included in the
inventories of the buyer and excluded from the inventories of the seller. And goods in transit
purchased on FOB destination terms are included in the inventories of the seller and excluded
from the inventories of the buyer.
There is also a problem with goods on consignment at the time of taking an inventory. Goods on
consignment to another party (agent) called the consignee.
consignee. A Consignee is to sell the goods for
the owner usually on commission are included in the consignor’s inventories and excluded from
the consignee’s inventories.
Aba Jifar Company, found in Jimma, purchased goods from Zumra Trading, found in Gondar, on
FOB Destination terms.
1. Who will cover transportation charges? Why?
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______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2. Assume these goods are in transit at the end of the accounting period. In which Company’s
inventories do we include these goods?
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______________________________________________________________________________
2. A manufacturer ships merchandise to a wholesaler on a consignment basis. If the
merchandise is not sold at the end of the period, in whose inventory should the merchandise
be included?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Model Examination Questions
A. Short answer questions

1. Define inventories
2. From the two inventory systems, which method is better considering internal
controls?
3. If ending inventory is misstated, it will not have an effect in the owners’ equity of the
following period. Why?
B. Workout questions
1. Omo Nada Company reported annual net income as follows
2000 Br. 210,000
2001 280,000
2002 315,000
Analysis of its inventories shows that the following incorrect inventory amounts were used (the
correct amounts are also shown)
Incorrect inventory Correct inventory

Amount Amount
December 31, 2004 Br. 160,000 Br. 152,000
December 31, 2005 172,000 177,000
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Compute the correct amount of net income for each of the three years assuming the
incorrect
incorrect inventories had been used.
2. Condensed income statement for Gheda Supermarket for two years is shown below:
20x1 20x2
Sales (net) Br. 205,000 Br. 315,000
Cost of Goods Sold 150,000 175,000
Gross Margin Br. 75,000 Br.140,000

Operating Expenses 40,000 85,000
Net Income Br. 35,000 Br. 55,000
After the end of 20x2 it was discovered that an error had resulted in a Br. 12,000 understatement
of 20x1 ending inventory.
Required: Compute
a) the corrected net income for 20x1
b) the corrected cost of goods sold for 20x2
c) the corrected net income for 20x2
d) What effect will the error have on net income and ending owner’s equity for
20x3?
3. Gidu Lulesa Company engaged in the following transactions in March 2009:
March 1- Sold merchandise to Choche Co. on credit, terms n/30, FOB shipping point, Br.
3,600 (cost Br. 2520)
3 – Purchased merchandise on credit from Dedo Co., terms n/30, FOB shipping
point, Br. 6200
5 – Paid Express Transit for freight charges on merchandise received, Br. 500
6 – Purchased office supplies on credit from Shebele Trading, terms n/30, Br.
1,500
8 – Purchase merchandise on credit from Dedo Co., terms n/30, FOB shipping
point, Br. 12,400, which includes Br. 1,200 freight costs paid by Dedo
Company.
12 – Returned some of the merchandise received on March 3 for credit, Br. 1000.
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List of Reference Materials
1.. Introduction to Accounting, 21st Century

2. Fess and Warren, Accounting Principles, 16th edition, South – Western publishing
Company.
Company.
4. Weygandt, Kieso, Kimmel, Accounting Principles, 5th edition, John Wilily and Sons,
Inc.
5. Mosich A. N. Intermediate Accounting, 6th edition, McGraw – Hill Book Company.
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UNIT TWO: DETERMINING THE COST OF INVENTORY
Contents:
 Unit Objective
 Introduction
2.1 Inventory Costing Methods Under Periodic Inventory System
2.1.1 Specific Identification Method
2.1.2 First-in, First-out Method
2.1.3 Last-in, First-out Method
2.1.4 Weighted Average Method
2.2 Comparison of Inventory Costing Methods
2.3 Inventory Costing Methods Under Perpetual Inventory System
2.3.1 First-in, First-out Method
2.3.2 Last-in, First-out Method
2.4 Unit Summary
2.5 Model Examination Questions
Unit Objective
This unit aims at discussing inventory cost determination and inventory costing methods.
After going through this unit, you will be able to:
 describe the determination of the cost of inventory
 understand the most common inventory costing methods under a periodic system
 compare the effect of the methods on operating results
 describe the accounting for inventory under the perpetual system, etc.
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Introduction
Dear students, after having determined the actual quantities of the inventories unsold at the
close of the period, we have to assign relevant cost to the quantities on hand to determine total
cost of the inventories. How can we assign costs to the actual quantities on hand? Which costs
are to be included in the inventory cost, and which ones are not included? Give your answer
in writing before you go through the following discussion.
In the previous unit you were acquainted with the meaning and concepts of inventories in general
and merchandise inventory in particular. In unit one, you were also learned the effect that
inventory misstatement would have on the current and following period’s financial statements.
This unit is the continuation of the previous unit. In this unit, you will discuss the determination
of the cost of inventory.
Costs included in merchandise inventory are those expenditures necessary, directly or indirectly,
to bring an item to a salable condition and location. In other words, cost of an inventory item
includes its invoice price minus any discount, plus any added or incidental costs necessary to put
it in a place and condition for sale. Added or incidental costs can include import duties,
transportation-in, storage, insurance against losses while the goods are in transit, and costs
incurred in an aging process(for example, aging of wine and cheese).
Minor costs that are difficult to allocate to specific inventory items may be excluded from
inventory cost and treated as operating expenses of the period. This is based on materiality
principle or the cost - to - benefit constraint.
Check Your Progress: Exercise 2. 1

1. An art gallery purchases a painting for Br. 11,400 on terms FOB shipping point.
Additional costs in obtaining and offering the artwork for sale include. 130 for
transportation-in, Br. 150 for import duties, Br. 100 for insurance during shipment, Br. 180
for advertising, Br. 400 for training, and Br. 800 for sales salaries. For computing inventory,
what cost is assigned to the painting?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
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2.1 Inventory Costing Methods under Periodic Inventory System
Dear students! How do we determine the cost of the merchandise sold and the inventory cost
at the end of the period? What costs should be included in the cost of inventories? What
objectives are considered in deciding what costs are to be included in inventories? Attempt the
question by your own before you go through the following discussion.
One of the most important decisions in accounting for inventory is determining the per unit costs
assigned to inventory items. When all units are purchased at the same unit cost, this process is
simple since the same unit cost is applied to determine the cost of goods sold and ending
inventory. However, when identical items are acquired at different unit costs, a question arises as
to what amounts are included in the cost of merchandise sold and what amounts remain in
inventory. When such is the case, it is necessary to determine the unit cost of the items still on
hand. A periodic inventory system determines cost of merchandise sold and inventory at the end
of the period. How we assign these costs to inventory and cost of merchandise sold affects the
reported amounts for both systems.
The assumed flow of costs to be used in the assignment of costs to inventories and to goods sold
need not conform to the physical flow of goods. Cost flow assumption relate to the flow of costs,
rather than to the physical flow of goods. The question of which physical units of identical goods
were sold and which remain in inventories is not relevant to income measurement and inventory
valuation.
All methods of inventory valuation are based on the cost principle; no matter which method is
selected, the inventory is stated at cost. In general, a major objective of accounting for
inventories is the proper determination of income through the process of matching appropriate
costs against revenue.
There are four methods commonly used in assigning costs to inventory and cost of merchandise
sold. These are:
I) Specific identification
II) First-in first-out(FIFO)
III) Last-in first-out (LIFO)
IV) Weighted average
21
Let us see these costing methods under periodic inventory system using the following
illustration.
Illustration 2.1
Ghibe Trading began the year and purchased merchandise as follows:
Jan. 1 Beginning inventory 150 units @ Br. 40 = Br. 6,000
Mar. 17 Purchase 900 units @ 45 = 40,500
June. 21 Purchase 1200 units @ 48 = 57,600
Sept 1 Purchase 860 units @ 52 = 44,720
Nov. 13 Purchase 750 units @ 55 = 41,250
Total 3860 units Br.190,
Br.190, 070
 The ending inventory consists of 800 units; 50 units from the opening stock, 150 units
from the first purchase and 200 from each of the last three purchases.
2.1.1 Specific Identification Method
Dear students, for which type of business do you think is the specific identification method a
feasible means of valuation? Why? Give your answer in writing before you read the following
discussion.
When each item in inventory can be directly identified with a specific purchase and its invoice,
we can use specific identification (also called specific invoice pricing) to assign costs. This
method is considered appropriate for a business enterprise handling a small number of items and
when the variety of goods carried in stock is small and the volume of sales is relatively small, for
example, an automobile dealer, it becomes completely inoperable in a complex manufacturing
business when the identity of the individual item is lost.
For example, from the above illustration, it is given that the ending inventory consists of 800 units;
50 from the opening stock, 150 from the purchase of March 17, and 200 units from each of the last
three purchases. So, the items on hand are specifically known from which purchases they are:
Cost of ending inventories under specific identification method, therefore, is:
From Jan 1. Inventory 50 units @ Br. 40 = Br. 2000
Mar 17. Purchase 150 units @ 45 = 6750
June 21. Purchase 200 units @ 48 = 9600
Sept 1. Purchase 200 units @ 52 = 10,400
Nov 13. Purchase 200 units @ 55 = 11,000
800 units Br. 39,750
22
® Cost of Ending inventory = Br. 39,750
® The Cost of Goods Sold = Cost of Goods Available for Sale – Ending
inventory
= Br. 190,070 – Br. 39,750 = Br. 160,320
2.1.2 First-in, First-out (FIFO)
This method of assigning cost to inventory and the goods sold assumes inventory items are sold
in the order acquired. This means the cost flow is in the order in which the expenditures were
made. So, to determine the cost of ending inventory, we have to start from the most recent
purchase and continue to the next recent. Because the first purchased items (old purchases) are
the first to be sold they are used (included) in the computation of cost of goods sold.
For example, easily spoiled goods such as fruits, vegetables etc., must be sold near the time of
their acquisition. So, the inventory on hand will be from the recent purchases. As an example,
consider the above illustration.
The cost of ending inventory under FIFO method would be:
From Nov. 13 purchase 750 units @ Br. 55 = Br. 41,250
From Sept. 1 purchase 50 units @ 52 = 2,600
Total 800 units Br. 43,850
® Cost of Ending inventory Br. 43,850

® Cost of Goods sold = Br. 190,070 – Br. 43,850 = Br. 146,220
2.1.3 Last-in, First-out (LIFO)
This method of assigning cost assumes that the most recent purchases are sold first. Their costs
are charged to cost of goods sold, and the costs of the earliest purchases are assigned to
inventory. The cost flow is in the reverse order in which expenditures were made.
In calculating the cost of goods sold, we will start from the earliest purchases.
As an example, consider the previous illustration. The cost of ending inventory under LIFO
method is:
From January 1. Inventory 150 units @ Br. 40 = Br. 6000
From March 17. Purchase 650 units @ 45 = 29,250
Total 800 units Br. 35,250
® Cost of Ending inventory = Br. 35,250
® Cost of Goods Sold = Br. 190,070 – Br. 35,250 = Br. 154,820
23
This method of assigning cost requires computing the average cost per unit of merchandise
available for sale. That means the cost flow is an average of the expenditures.
The weighted average unit cost is determined by dividing the total cost of the identical units of
each commodity available for sale during the period by the total number of units of merchandise.
Average cost per unit = Cost of goods available for sale

Total units available for sale
Once the average unit cost is determined, then it is multiplied by units on hand (unsold) at the
end of the period to calculate the cost of ending inventory. Also, the same average unit cost is
applied in the computation of cost of goods sold.
Once again, using the previous illustration the costs of ending inventory and goods sold for
Ghibe Trading would be computed as follows:
Weighted average unit cost = Br. 190,070 = Br. 49.24

3860 units
® Ending inventory cost = Br. 49.24 x 800 = Br. 39,392

® Cost of Goods Sold = Br. 190,070 - Br. 39,392 = Br.
Br. 150,678
2.2. Comparison of Inventory Costing Methods
If the cost of units and prices at which they are sold remains stable, all the four methods yield the
same results. But if prices change, the three methods usually yield different amounts for: Ending
inventory, cost of merchandise sold, and gross profit or net income.
 During periods of rising (increasing) prices (or if there is inflationary trend):
FIFO Yields:
Yields: –
 higher ending inventory
 Lower cost of goods sold
 Higher gross profit (net income)
24
LIFO Yields:
Yields: –
 Lower ending inventory
 Higher cost of goods sold
 Lower gross profit (net income)
 Weighted average yields the results between the two.
 In periods of declining (decreasing) prices (or if there is deflationary trend):
FIFO Yields:
Yields: –
 Lower ending inventory
 Higher cost of goods sold
 Lower gross profit (net income)
LIFO Yields:
Yields: –
 Higher ending inventory
 Lower cost of merchandise sold
 Higher gross profit (net income)
 Weighted average yields the results between the two.
1. Which of the methods of inventory costing will in general yield an inventory cost nearly
approximating current replacement cost?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2. Do the terms FIFO and LIFO refer to techniques employed in determining quantities of
various merchandise on hand?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2.3 Inventory Costing Methods under Perpetual Inventory System
The use of perpetual inventory system provides the most effective means of control over this
important asset. Although it is possible to maintain a perpetual inventory memorandum records
25
only or to limit the data to quantities, a complete set of records integrated with the general ledger
is preferable. As you learned in Part I, the basic feature of this system is recording all
merchandise increases and decreases in a manner similar to the recording of increases and
decreases in cash. That means, all purchases of merchandise are debited to the Merchandise
Inventory account and sales and other reductions of merchandise are credited to the Merchandise
Inventory account. Thus, the balance of merchandise inventory reflects the amount of
merchandise inventory assumed to be on hand.
Under perpetual inventory system we will apply the inventory costing methods each time sale of
merchandise is made. We calculate the cost of goods (merchandise) sold and inventory on hand
at the time of each sale. This means the merchandise inventory account is continually updated to
reflect purchase and sales.
Illustration 2.2
The beginning inventory, purchases and sales of Shebe Business Group Ltd for the month of
December are as follows:
Units Cost
Dec. 1 Inventory 21 Br. 60.00
5 Sale 8
13 purchase 12 Br. 64.00
17 Sale 15
26 Sale 19
30 Sale 6
31 Sale 15
2.3.1 First-in First-out Method
The assignment of costs to goods sold and ending inventory using FIFO is the same for both the
perpetual and periodic inventory systems. Because each withdrawal of goods is from the oldest
stock on hand. The oldest is the same whether we use periodic inventory system or perpetual
inventory system.
Using the data above, let us calculate the cost of goods sold and ending inventory in each of the
inventory costing methods under perpetual inventory system.
26
Perpetual - FIFO
Purchase Cost of merchandise sold Inventory
Date Qty. Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Dec. 1 21 Br. 60.00 Br. 1260
5 8 Br. 60.00 Br.480.00 13 60.00 780
13 60.00 780
13 12 Br. 64.00 Br.768.00 12 64.00 768
17 13 60.00 780.00 10 64.00 640

2 64.00 128.00
10 64.00 640
24 25 69.00 1725.00 25 69.00 1725
26 10 64.00 640.00 16 69.00 1104

9 69.00 621.00
16 69.00 690
28 20 72.00 1440.00 20 72.00 1440
30 6 69.00 414.00 10 69.00 690

20 72.00 1440
31 10 69.00 690.00 15 72.00 1080
5 72.00 360.00
63 4113.00 15 72.00 1080
So, the cost of merchandise sold and ending inventory under perpetual- FIFO method are Br.
4,113 and Br. 1,080, respectively.
Let us see them under periodic - FIFO method:

Units on hand = Units available for sale – Units sold
= (21 + 12 + 25 + 20) – (8+ 15 + 19 + 6 + 15)
= 78 - 63 = 15 units
 Cost of Ending inventory = 15 units @ Br. 72.00 = Br. 1,080
Cost of goods available for sale = Br. 1,260 + Br. 768 + Br. 1,725 + Br. 1,440 = Br. 5,193
Cost of goods sold = Cost of goods available for sale – Cost of ending inventory
= Br. 5,193 – Br. 1,080 = Br. 4,113
So, we can see that FIFO method of inventory costing results the same amounts of cost of goods
sold and ending inventory under both periodic and perpetual inventory systems.
27
2.3.2 Last-In, First-Out Method
Unlike the FIFO method, in LIFO different results may occur under periodic and perpetual
inventory systems. The most recent purchases change when new purchase occurs.
Let us calculate first the cost of goods sold and ending inventory for the above illustration under
perpetual inventory system. Then, we will see the results under periodic inventory system.
Perpetual - LIFO
Date Purchase Cost of Goods Sold Inventory
Qty Unit cost Total cost Qty Unit Total cost Qty Unit cost Total cost
cost
Dec. 1 21 Br. 60.00 Br. 1,2600
5 8 Br.
Br. 60.00 Br. 480.00 13 60.00 780
13 12 Br. 64.00 Br. 768.00 13 60.00 780
12 64.00 768
17 12 Br. 64.00 Br. 768.00 10 60.00 600
3 60.0 180.00
0
24 25 69.00 1725.00 10 60.00 600
25 69.00 1725
26 19 69.00 1311.00 10 60.00 600

6 69.00 414
28 20 72.00 1440.00 10 60.00 600
6 69.00 414
20 72.00 1440
30 6 72.00 432.00 10 60.00 600
6 69.00 414
14 1008
72.00
31 14 72.00 1008.00 10 60.00 600
1 69.00 69.00 5 69.00 345
63 Br.
Br. 4248.00 15 Br.
Br. 945.00
So, the cost of goods sold and ending inventory under perpetual inventory system (perpetual
LIFO) are Br. 4248.00 and Br. 945.00 respectively.
The results under periodic inventory system are:
Cost of ending inventory = Br. 60 x 15 = Br. 900.000
28
Cost of merchandise sold = Cost of goods available for sale – cost of ending inventory
= Br. 5193.00 – Br. 900.00
= Br. 4293.00
As you see, the results are different under periodic & perpetual inventory systems.
2.4.3 Weighted Average Cost Method.
Under this method, the average unit cost is calculated each time purchase is made to be applied
on the sales made after the purchases. The results may be different under periodic and perpetual
inventory systems.
Let us calculate the cost of merchandise sold and ending inventory using the average cost
method from the previous illustration under perpetual inventory system.
Average Cost Method (Moving Average)

Purchase Cost of merchandise sold Inventory
Date Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Dec. 21 Br. 60.00 Br. 1260.00

1
5 8 Br. 60.00 Br. 480.00 13 60.00 780.00
25 61.92 1548.00
13 12 64.00 Br. 768.00 = 780+768
13+12
17 15 61.92 928.80 10 61.92 619.20
35 66.98 2344.20
24 25 69.00 1725.00 619.20+1725
10+25
26 19 66.98 1272.51 16 66.98 1071.63

28 20 72.00 1440.00 36 69.77 2511.63
1071.63+1440
16+20
30 6 69.77 418.61 30 69.77 2093.00
31 15 69.77 1046.51 15 69.77 1046.51
63 Br. 4146.43 15 Br. 69.77 Br 1046.51
So, the cost of goods sold and ending inventory under perpetual inventory system are Br.
4146.43 and Br. 1046.51, respectively.
29
The results under periodic inventory system are:
Weighted average unit cost = Br. 5193 = Br. 66.58
78
Ending inventory cost = Br. 15 @ Br. 66.58 = Br. 998.65
Cost of goods sold = Merchandise available for sale – cost of ending inventory
= Br. 5193.00 – Br. 998.65 = Br. 4194.35
So, the result is different under periodic and perpetual inventory systems.
1. What are the advantages of perpetual inventory system over the periodic inventory system?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2. In periods of steadily rising prices, which inventory method will give the highest
i) inventory cost _______________________
ii) lowest inventory cost__________________
iii) highest net income, ___________________
iv) lowest net income? ___________________
3. Do the FIFO and LIFO inventory methods result in different quantities of ending
inventory?
I. Short Answer Questions.

1. What is the difference between goods flow and cost flow?
2. What are the relative advantages and disadvantages of FIFO and LIFO
methods of inventory costing?
3. Why do you think it is more expensive to maintain a perpetual
inventory system?
30
4. What are the three most important advantages of the perpetual
inventory system?
5. A company using a perpetual inventory system sells merchandise to a
customer on account for Br. 1250; the cost of the merchandise was Br. 1000.
a) What entries would be made on the general ledger accounts
as a result of the transaction?
b) What is the amount of gross profit realized from this specific
sale?
II. Choose the best answer from the given alternatives
1. The inventory system that does not attempt to record the cost of goods
sold each time sale is made is;
a) FIFO b) Periodic c) Perpetual d) Physical
e) b and d f) c and d
2. If merchandise inventory is being valued at cost and the price level is

consistently falling, which method of costing will yield the lowest net income?
a) LIFO b) FIFO c) Average cost d) a or b
e) None of the foregoing
3. Identify the correct statement

a) If the FIFO method of inventory costing is selected by a company
the method shall be used for all inventory items.
b) Under the average cost method, the same unit cost is used to
compute both the cost of goods sold and the cost of inventory.
c) One of the major drawbacks of LIFO is that it does not attempt to
match current costs with current revenues.
d) All of the foregoing
e) None of the foregoing
4. Identify the wrong statement:
a) The FIFO method in periods of rising prices causes businesses to
report more than their true profit resulting in the payment of excess income taxes.
b) Over a period of rising prices a business that use LIFO method
may report the value of inventory at a cost figure far below what it currently pays for
the same item.
c) Pricing the inventory and cost of goods sold using the specific
identification method is the same under both periodic and perpetual systems.
31
d) The FIFO method of inventory costing is not the best measure of
the current balance sheet value of inventory.
e) None of the foregoing.
5. In which method of inventory costing the flow of cost and income
determination is given due consideration?
a) Average cost b) FIFO c) LIFO
d) Gross profit e) None of the foregoing
III. Problems
1. Eyassu Furniture Company sold 2200 doors during 2008 at Br. 320 per door. Its
beginning inventory on January 1 was 130 doors at Br. 112. Purchases made during the year
were as follows:
February 225 doors @ Br. 124

April 350 doors @ Br. 130
June 700 doors @ Br. 140
August 300 doors @ Br. 132
October 400 doors @ Br. 136
November 250 doors @ Br. 144
The Company's selling and administrative expenses for the year were Br. 202,000, and the
Company uses the periodic inventory system.
Required:
1. Prepare a schedule to compute the cost of goods available for sale.
2. Prepare an income statement under each of the following assumptions:
(a) costs are assigned to inventory using the average cost method
(b) costs are assigned to inventory using the FIFO method
(c) costs are assigned to inventory using LIFO method

Company.
32
Company.
Inc.
33
UNIT THREE: ADDITIONAL VALUATION PROBLEMS
FOR INVENTORIES
Contents
 Unit Objective
 Introduction
3.1 Valuation of Inventories at Lower of Cost or Market [LCM] Method
3.2 Estimating Inventory Cost
3.2.1 Retail Method of Inventory Costing
3.2.2 Gross Profit Method of Inventory Costing
3.3 Answers to Check Your Progress
 Unit Summary
 List of Reference Materials
Unit Objective
This unit aims at discussing various valuation methods like lower of cost or market, retail
method and gross profit method.
After studying this unit, you would be able to:

۞ explain the valuation of inventory at other than cost, including valuation at the lower
of cost or market
۞ understand the various methods of estimating cost of an inventory, such as retail
method and gross profit method
34
Introduction
Dear students, so far you have discussed with examples the basic cost flow assumptions in
valuating the inventories and in determining the cost of goods sold. In all of the cost flow
assumptions discussed in unit 2 the cost principle is strictly followed.
Under certain circumstances, however, inventory is valued at other than cost. Under what
conditions, if any, is it appropriate to use non-cost methods of valuing inventories? Attempt
the question before you go through the following discussion.
As discussed in the preceding sections, cost is the primary basis for the valuation of inventories.
Under certain circumstances, however, inventory is valued at other than cost. Two such
circumstances arise when (1) the cost of replacing items in inventory is below recorded cost,
cost, and
(2) the inventory is not salable at normal sales prices because of imperfections, shop wear, style
changes, or other causes.
An attempt has been made in this unit to explain other methods of inventory valuation and the
problems such as valuation at lower of cost or market, retail method and gross profit method of
estimating an inventory cost.
3.1 Valuation of Inventories at Lower of Cost or Market [LCM] Method
Dear students, how do you valuate the inventory unsold at the end of the fiscal period, if the
replacement cost of the inventory on the balance sheet date is less than its acquisition cost? In
the phrase “lower of cost or market” what does “market” represent? Give your response in
writing before you read the following discussion.
35
It was explained how costs are assigned to ending inventory and cost of goods sold using one of
four costing methods (FIFO, LIFO, Weighted Average, or Specific Identification). Yet, the cost
of inventory is not necessarily the amount always reported on a balance sheet. Accounting
principles require that inventory be reported at the market value of replacing inventory when
market is lower than cost. Merchandise inventory is then said to be reported on the balance sheet
at the lower of cost or market (LCM).
In applying LCM, cost is the acquisition price of inventory computed using one of the historical
cost methods - Specific Identification, FIFO, LIFO, and Weighted Average; market is defined as
the current market value (cost) of replacing inventory. It is the current cost of purchasing the
same inventory items in the usual manner. It is important to know that market is not defined as
the sales prices. A decline in market cost reflects a loss of value in inventory. This is because the
recorded cost of inventory is higher than the current market cost. When this occurs, a loss is
recognized.
recognized. This is done by recognizing the decline in merchandise inventory from recorded cost
to market cost at the end of the period.
LCM is applied in one of three ways:

(1) Separately to individual item
(2) To major categories of items
(3) To the inventory as a whole
The less similar the items are that make up inventory, the more likely it is that companies apply
LCM to individual items. Advances in technology further encourage the individual item
application.
Illustration 3.1
The following are the inventory of Ghibe Trading Company, a retailer.
Inventory Units Per Unit
Items on hand Cost Market
Men Suits
Jacket 300 Br 600 Br 570
Trousers 500 300 340
Women Suits
Shirt 1000 200 220
Miniskirt 2000 150 100
36
Let us see LCM computation under the three ways:
(1) Separately to Each Individual Item
Inventory Items Total Cost Total Market LCM
Jacket Br. 180,000 Br. 171,000 Br. 171,000

Trousers 150,000 170,000 150,000
Categories sub total Br. 330,000 Br.341, 000
Shirt 200,000 220,000 200,000
Miniskirt 300,000 200,000 200,000
Categories sub total Br. 500,000 Br. 420,000
Totals Br.830, 000 Br. 761,000 Br. 721,000
(2) Major Categories of Items
Inventory Categories Categories LCM

Categories total cost total market
Men Suits Br. 330,000 Br. 341,000 Br. 330,000

Women Suits 500,000 420,000 420,000
Totals Br. 830,000 Br. 761,000 Br. 750,000
(3) LCM applied to the whole Inventory

Total Cost Total Market LCM
Totals Br 830,000 Br 761,000 Br 761,000
When LCM is applied to the whole of inventory, the market cost is Br. 761,000. Since this
market cost is Br. 69,000 lower than Br. 830,000 recorded cost, it is the amount reported for
inventory on the balance sheet. When LCM is applied to individual items of inventory, the
marked cost is Br. 721,000. Since market is again less than Br. 830,000 cost, it is the amount
reported for inventory. When LCM is applied to the major categories of inventories, the market
is Br. 750,000 which is also lower than cost.
37
1. In the phrase lower of cost or market, what is meant by “market”?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2. Asandabo Trading value its inventory, shown below, at the lower of cost or market.
Compute Asandabo's inventory value using (i) item – by – item method, and (ii) the major
category method.
Per Unit
Quantity Cost Market
Product Line A
Item I 100 Br. 10.00 Br. 11.50
Item II 200 6.00 4.80
Item III 300 20.00 19.60
Product Line B
Item IV 600 40.00 41.20
Item V 400 52.00 50.00
3.2 Estimating Inventory Cost
Dear students, under what conditions, if any, are the cost of inventory estimated? Give your
response in writing before you go through the following discussion.
In practice, an inventory amount is estimated for some purposes, when it is impossible to take a
physical inventory or to maintain perpetual inventory records. The following are some of the
circumstances in which the cost of inventories is estimated.
1) Monthly income statements are needed. It may be too costly, to take

physical inventory. This is especially the case when periodic inventory system is used.
2) When a catastrophe such as a fire has destroyed the inventory. In
such case, to ask claims from insurance companies, there is a need of estimating inventory.
38
3) When we want to test the validity of cost data.
To estimate the cost of inventory, two methods are commonly used. These are retail method and
gross profit method.
3.2.1 Retail Method of Inventory Costing
This method is mostly used by retail businesses. The estimate is made based on the relationship
between the cost and the retail price of merchandise available for sale.
The steps to be followed are:

(1) Calculate the cost- to-retail ratio = Cost of merchandise available for sale
Retail Price of merchandise available for sale
(2) Calculate the ending inventory at retail price

Ending inventory at retail price = retail price of merchandise available for sale –
Sales
(3) Calculate the estimated cost of ending inventory

Estimated cost of ending inventory = Cost to retail ratio X Ending inventory at
at retail
Illustration 3.2
Cost Retail
Dec. 1, beginning inventory Br. 160,000 Br. 200,000
Purchases in December (Gross) 620,000 780,000
Purchase Returns and Allowances 15,000
Purchase Discounts 5,000
Sales in December (net) 740,000
(1) Cost-to-retail ratio = Br. 160,000 + Br. 620,000 – [15,000 + 5000] = 0.7755
0.7755 or 77.55%
Br. 200,000 + Br. 780,000
(2) Ending inventory at retail = (Br. 200,000 + Br. 780,000) – Br. 740,000 = Br.
Br. 240,000
(3) Estimated ending inventory at cost = 0.7755 x Br. 240,000
= Br. 186,120
39
1. An enterprise using the retail method of inventory costing determines the merchandise
inventory at retail is Br. 300,000. If the ratio of cost-to-retail price is 70%, what is the
estimated cost of inventory?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2. Does the retail inventory method mean that inventories are measured at retail value on the
balance sheet? Explain.
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
3.2.2 Gross Profit Method of Inventory Costing
This method uses an estimate of the gross profit realized during the period to estimate the cost of
inventory. The gross profit rate may be estimated based on the average of previous periods’ gross
profit rates.
The steps are as follows:

(1) The gross profit rate is estimated and then estimated gross profit is calculated:
Estimated gross profit = Gross profit rate x Current period Sales
(2) Cost of goods sold is estimated:

Estimated cost of goods sold = Current period Sales – Estimated gross profit
(3) Calculate the estimated cost of ending inventory:

Estimated cost of ending inventory =
Cost of goods available for sale – Estimated cost of goods sold.
Illustration 3.3
Jan. 1, beginning inventory (cost) Br. 120,000
Purchases during January (cost) 490,000
Purchase Returns and Allowances 10,000
Net sales during January 580,000
Estimated gross profit rate is 30%
40
The ending inventory is estimated as follows:
(1) Estimated gross profit = 0.30 x 580,000
= Br. 174,000
(2) Estimated cost of goods sold

= Br. 580,000 – Br. 174,000
= Br. 406,000
(3) Estimated cost of ending inventory

= [Br. 120,000 + (490,000 – 10,000) – Br. 406,000]
= Br. 600,000 – Br. 406,000
= Br. 194,000
1. Cost of goods available for sale is Br. 420,000 and net sales for the period is Br. 400,000.
If the cost of goods sold percentage of sales is 75%, what is the estimated cost of the
inventory to be reported on the balance sheet?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2. For what purposes may the retail method of inventory estimation be used?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________

A. Short answer questions
1. What is the lower of cost or market and why are inventories valued at lower of cost or
market?
2. From the three ways of applying lower of cost or market, which one results in minimum
value of inventory?
3. What uses can be made of the estimate of the cost of inventory determined by the gross
profit method?
4. Describe the procedure required to estimate inventories on the retail method
5. Describe the procedure required to estimate inventories on the gross profit method
41
B. Work out questions
1. Surbo Company’s ending inventory includes the following items.
Product Units on hand Unit cost Replacement cost per unit

A 50 Br. 20 Br. 24
B 60 25 20
C 70 35 33
D 84 40 43
Replacement cost is determined to be the best measure of market. Calculate lower of cost or
market for the inventory
a. As a whole b.
b. Applied separately to each products
2. The records of the Bulbul Corporation provided the following information for the year
ended December 31:
At cost At retail
Jan. 1 beginning inventory Br. 160,450 Br. 264,900
Purchases 1,100,140 1,828,200
Purchases returns 17,600 34,100
Sales _ 1,570,200
Sales returns _ 15,600
Transportation in 13,000 _
Required: calculate the estimated cost of ending inventory

a. By retail method
b. By gross profit method if the gross profit rate is 30%
2. Semira Shop had net retail sales of Br. 2,500,000 during the current year. The following
additional information was obtained from the accounting records:
At Cost At Retail
Beginning Inventory Br. 500,000 Br. 649,350
Net Purchase 2,200,000 2,972, 973
Transportation – In 290,000
42
Required:
a) Estimate Semira Shop’s ending inventory at cost using the retail method.
b) Assume that a physical inventory taken at year-end revealed an inventory on hand of Br.
1,100,000 at retail value. What is the estimated amount of inventory shrinkage (loss due
to theft, damage, and so forth) at cost?
3. Kundido and his family is a large retail furniture Company that operates in two adjacent
warehouses. One warehouse is a showroom, and the other is used to store merchandise. On
the night of May 27, a fire broke out in the storage warehouse and destroyed the merchandise
stored there.
Fortunately, the fire did not reach the showroom, so all the merchandise on display was
saved.
Although, the company maintained a perpetual inventory system, its records were rather had
hazard, and the last reliable physical inventory was taken on December 31. In addition, there
was not control of the flow of the goods between the showroom and the warehouse.
Thus, it was impossible to tell what goods should be in either place. As a result, the insurance
company required an independent estimate of the amount of loss. The insurance company
examiners were satisfied when they were provided with the following information.
1. Merchandise Inventory on December 31 Br. 1,454,800

2. Purchase, January 1 to May 27 2,412,200
3. Purchase Returns, Jan. 1 to May 27 (10,706)
4. Freight – In, Jan 1 to May 27 53,100
5. Sales, January to May 27 3,959,050
6. Sales Returns, Jan 1 to May 27 (29,800)
7. Merchandise Inventory in Showroom May 27 402,906
8. Average gross Margin 40%
Required:
Prepare a schedule that estimates, the amount of the inventory lost in the fire.
4. Sanete Trading Company switched recently to the retail inventory method to estimate
the cost-ending inventory. To test this method, the Company took a physical inventory one
month after its implementation. Cost, retail, and the physical inventory data are as follows:
43
At Cost At Retail
Beginning Inventory, January 1 Br. 472,132 Br. 622,800
Purchase 750,000 1,008,400
Freight – In 8,350
Purchases Returns and Allowances (25,200) (34,800)
Sales 1,060,000
Sales Returns and Allowances (28,000)
January 31, Physical Inventory 508,200
Required:
a) Prepare a schedule to estimate the amount of Sanete Company's January 31 inventory

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

Company.
Company.
Inc.
44
UNIT FOUR: ACCOUNTING FOR PLANT ASSETS AND
DEPRECIATION
 Unit Objectives
 Introduction
4.1 Meaning of Long-Term Assets (Plant Assets)
4.2 Cost of Long Term Assets (Plant Assets)
4.3 Nature of Depreciation
4.4 Factor in Computing Depreciation
4.5 Methods of Computing Depreciation
4.5.1 Straight Line Method
4.5.2 Accelerated Method
4.5.2.1 Written down Value Method or (Diminishing Balance Method)
4.5.2.2 Annuity Method
4.5.2.3 Sum-of-the-Years Digits Method
4.5.2.4 Double Declining Method.
4.5.2.5 Depletion Method
4.6 Capital and Revenue Expenditures
4.6.1 Capital Expenditures
4.6.2 Revenue Expenditures
 Unit Summary
 Model Exam Questions
Unit Objectives
This unit aims at discussing the meaning of long term assets (like plant, Building, land,
Machinery), accounting for depreciation of plant assets. In this unit we also discuss the periodic
depreciation of plant asset is credited to the accumulated depreciation account, instead of the
asset account. At the end of the life of the plant asset the accumulated depreciation account
balance should equal to the depreciable cost of the asset. After successfully going through this
chapter, you are able to understand:
 Describe plant assets and issues in accounting for them
45
 Explain depreciation and the factors affecting its computations
 Explain depreciation for partial years and changes in estimates
 Compare and analyze depreciation for different methods.
 Apply cost principle to compute the cost of plant assets
 Distinguish between revenuer and capital expenditures, and account for these
expenditures
Introduction
Dear students! Have you heard of the term plant asset before? If so, what do you
understand by the term plant asset? What do you think about the purpose of plant assets?
Give your answer in writing before you go through the discussion below.
Before taking up depreciation, it should be understood that the costs relating to the use of long-
term assets should be properly calculated and matched against the revenue earned so that
periodic net income can be determined. These use costs or expense or periodic write off are
known by different names for different category of assets given as under:
Types of Long-Term Assets (Plant Assets) Term of expenses or write off or use costs
1. Tangible Assets:
(i) Land None
(ii) Plant, Building, Equipments Tools,
Furniture, Fixtures, and Vehicles Depreciation
(iii) Natural Resources such as Oil, Timber,
Coal, Minerals Deposits Depletion
2. Intangible Assets such as Patents, Copyrights,
Trademarks, Goodwill Amortization
4.1 Meaning of Long-Term Assets (Plant Assets)

Long-term assets are tangible assets that are used in the operations of a company and have a
useful life of more than one accounting year. These types of assets are land, building, structures
of all types, machinery, equipments, furniture etc. Among these assets, land is a tangible asset
that has an indefinite or unlimited useful life. Therefore, it is not subject to depreciation or
periodic write off to expenses.
46
Natural Resources:
Depletion is the name of expenses or writes off in the case of natural resources. Depletion refers
to the systematic and rational allocation of the acquisition cost of natural resources to future
periods in which the use of those natural resources contributes to revenue. Natural resources are
exhausted or used up through mining, cutting, pumping etc.
Intangible Assets:
The term Amortization is used in case of intangible assets. Amortization refers to the systematic
and rational allocation of the acquisition cost of intangible assets to future periods in which the
benefits contribute to revenue.
It is the periodic write off to expenses of the intangible asset’s cost over its expected useful life.
The term depreciation refers to periodic allocation of the acquisition cost of a tangible long-term
asset over its useful life.

1. What are the major characteristics of property, plant, and equipment?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Accounting Problems Related to Long-Term Assets
Dear students, we believe that from the above discussion you have acquired some
concepts regarding long term assets. Have you heard of accounting problems related
with long term assets? What are they? Give possible examples of these accounting
problems related with long term assets.
Basically, there are two problems relating to accounting of long-term assets.

(2) What is the original acquisition cost of a particular long-term asset?
(3) How should the amount of expense or periodic write off should be determined
and allocated against yearly revenue to reflect the asset’s consumption?
(4) How to record costs incurred after the asset is acquired and placed a services
(capital and revenue expenditure).
47
4.2 Cost of Long-Term Assets (Plant Assets)
Cost of Plant Asset

Acquisition cost includes all expenditures necessary to get the long-term assets in place and
ready for use.
Cost of long term asset is easy to determine when the asset is purchased for cash. In this case,
cost of assets is equal to cash paid for the asset plus expenditure for freight, insurance while in
transit, sales tax, special foundation, installation and other necessary costs. When a second hand
asset is purchased, the initial cost of getting it ready for use, such as expenditures for new parts,
repairs and painting are added to the cost of assets.
Some costs associated with the acquisition of an assets are not added to the cost of asset, if they
are found not necessary to get the asset ready for use and therefore, do not increase asset’s
usefulness. Expenditures resulting from carelessness or errors in installing the asset, from
vandalism or from other unusual occurrences do not increase the usefulness of the assets and
should be treated as expenses.
If a debt is incurred for the purchase of the asset, the interest charges are not the cost of the asset
but are the cost of borrowing money to purchase the asset. They are therefore an expense for the
period. But interests incurred during the construction period of an asset are treated as part of the
cost of an asset.
Cost of Land:
Cost of land includes: purchase price, brokerage fee, title transfer fee, cost of clearing trees &
plants from the land, cost of leveling and grading the land, cost offsite such as proceeds (cash)
received from the sale of scraps collected from the land.
Improvements to land such as parking lots, private side walks, driveways, fences are not added to
the cost of land but to a separate account, LAND INPROVEMENT ACCOUNT. These
expenditures are depreciated over the estimated lives of the improvements.
Cost of Building:
When an existing or old building or used machinery is purchased, its cost includes the purchase
price plus all repairs, renovation and other expenses incurred by the purchaser prior to use of
asset. Ordinary repair costs incurred after the asset is placed in use are normal operating
expenses when incurred.
48
Cost of Self Construction:
When a business constructs its own buildings, the cost includes all reasonable and necessary
expenditures such as those for materials, labour; some related overhead and indirect costs,
architects’ fees, and insurance during construction and interest on construction loans during the
period of construction, lawyer’s fees. If outside contractors are used in the construction, the net
contract price plus other expenditures necessary to put the building in usable condition are
included.
Group Purchases:
Sometimes, basket purchases (also known as group purchases, package purchases) of assets are
made by the purchaser wherein two or more types of long term assets are acquired in a single
transaction and for a single lumpsum.
In basket or package purchases, cost of each asset acquired must be measured and recorded
separately. For example, assume that a purchaser has purchased land and the building situated on
the land for a lumpsum of payment of Birr 850,000. The total purchase price can be divided
between these two assets on the basis of relative market or appraisal values, as shown below.
Assets Estimated Market Percent of Total Allocation of Estimated
Value price Purchase Price Useful Life
(Birr) (%) (Birr)
Land 100,000 10 85,000 Indefinite
Building 900,000 90 765,000 30 Years.
10,00,000 100 850,000
When a long term asset is purchased and a non-cash consideration is included in part or in full
payment for it, the cash equivalent cost is measured as any cash paid plus current market value of
the non-cash consideration given. Alternatively, if the market value of the non-cash
consideration given cannot be determined, the current market value of the asset purchased is
used for measurement purposes.
As a general rule, long term assets are recorded at cost due to the basic criterion of objectivity.
However, there could be some exceptions to this rule of cost basis. For example, if an asset
acquired by donation or pays substantially less than the market value of the asset, the asset is
recorded at its fair market value.
49
1. What are the accounting policies for the acquisition (cost) of
long-term assets (plant assets)?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
2. Identify the costs included in the initial valuation of land, building and equipment.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
3. Describe the accounting problems associated with interest capitalization.

___________________________________________________________________________
___________________________________________________________________________
__________________________________________________________________________
4. Describe the accounting problems associated with self-constructed assets.
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
4.3 Nature and Meaning of Depreciation
Dear students! Having discussed the concepts about the cost of plant assets, we feel that
now you have the clear idea about what is to be included in the cost of plant assets and
what is not to be included to the cost of plant assets. Have you heard about deprecation
of plant asset? Will you try to give some ideas about deprecation of plant assets?
As plant assets are used in the operations of a business, their value to provide service decreases
through usage and the passage of time.
50
This cost allocation of plant asset, called depreciation,
depreciation, is recorded in the accounting books
periodically.
Depreciation is frequently misunderstood. The term depreciation, as used in accounting, does not
refer to the physical deterioration of an asset or the decrease in market value of asset overtime.
Depreciation means the allocation of the cost of a plant asset to the periods that benefit from the
services of the asset.
The term depreciation is used to describe the gradual conversion of the cost of the asset into an
expense. Depreciation is not a process of valuation.
valuation.
Ac counting records are kept in accordance with the cost principle; they are not indicators of
changing price levels. It is possible that, through an advantageous buy and specific market
conditions the market value of a building may rise. Nevertheless, depreciation must continue too
be recorded because it is the result of an allocation, not a valuation process.

1. What do you understand by Depreciation?
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
4.4 Factors Affecting the Computation of Depreciation
Dear students! Having discussed the concepts about the deprecation of plant asset we
feel that now you have the clear idea about what is to be discussed about depreciation.
Have you heard about the factors affecting the computation of depreciation? Will you
try to give some ideas about the factors affecting the computation of depreciation?
Four factors affect the computation of depreciation. They are:

(1) Cost
(2) Residual value
(3) Depreciable cost, and
(4) Estimated economic (useful) life.
51
Cost- is the net purchase price plus all reasonable and necessary expenditures to get the asset in
place and ready for use.
Residual value- also known as salvage value,

value, disposal value, scrape value, or trade-in value
represents the estimated market value of the asset at the time of its retirement.
Depreciable cost - represents the difference between the asset cost and its estimated residual
value. For example, an item of equipment that costs Br. 5000 and has a residual value of Br. 500
would have a depreciable cost of Br. 4500, (Br. 5000 - Br. 500). The depreciable costs must be
allocated over the estimated economic life of the asset.
Estimated economic (useful) life- the estimated economic life of an asset is the total number of
service units expected from the asset. Service units may be measured in terms of years the asset
is expected to be used, units expected to be produced, miles or kilometers expected to be driven,
or similar measures. In determining the estimated useful life of an asset, the accountant should
consider all relevant information, including (1) past experience with similar repair assets, (2) the
asset’s present condition, (3) the company’s repairs and maintenance policy, (4) current
technological and industry trends, and (5) local conditions such as whether.

1. What are the factors which affect the computation of Depreciation?
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
Dear students! Having discussed the concepts about the factors affecting the
computation of depreciation we feel that now you have the clear idea about what is to be
discussed about the factors affecting the computation of depreciation? Have you heard
about the methods of computing depreciation? Will you try to give some ideas about
this?
52
4.5 Methods of Computing Depreciation
Dear students! Having discussed the concepts about the factors affecting the
computation of depreciation we feel that now you have the clear idea about what is to be
discussed about the factors affecting the computation of depreciation? Have you heard
about the methods of computing depreciation? Will you try to give some ideas about
this?
Depreciation methods differ primarily in the amount of cost allocated to each period. A list of
depreciation amounts for each year of an asset’s useful life is called depreciation schedule.
schedule.
The most common methods of computing depreciation for plant assets are:
(1) The straight line method
(2) The units of production method
(3) The double-declining balance method, and
(4) The sum-of- the years-digits method.
4.5.1 Straight-Line Depreciation
When this method is used to allocate depreciation, the depreciable cost of the asset is spread
evenly (uniformly) over the useful life of an asset. The straight-line method is based on the
assumption that depreciation depends only on the passage of time. The depreciation expense for
each period is computed by dividing the depreciable cost by the number of accounting periods in
the asset’s estimated useful life. The depreciation expense to be reported is the same in each
year. The following illustration will help us to understand the Straight-Line method of computing
depreciation.
Illustration - 2
Suppose, for example, a business enterprise acquires a new computer (office equipment) at a cost
of Birr 6000. It is estimated that the computer has an estimated residual value of Birr 1000 at the
end of its estimated useful life of 4 years. The yearly (annual) depreciation would be Birr 1250
computed as follows:
Annual depreciation = Cost - Salvage value
Estimated useful life
53
= Birr 6000 – Birr 1000 = Birr 1250
The depreciation to be reported for each of the four years would be as follows:
Depreciation Method- Straight-Line Method
Year Cost Yearly Accumulated Carrying value
Depreciation Depreciation (Book Value)
Beginning of first year Br. 6000 - - Br. 6000.00
End of first year 6000 Br. 1250.00 Br. 1250.00 4750.00
End of second year 6000 1250.00 1250.00 3500.00
End of third year 6000 1250.00 3750.00 2250.00
End of fourth year 6000 1250.00 5000.00 1000.00
NB.
NB. There are three important points to note from the depreciation schedule for the straight-line
depreciation method. First, the depreciation is the same each year. Second, the accumulated depreciation
increases uniformly. Third, the carrying (Book) value decrease uniformly until it reaches the estimated
residual value.
4.5.2 Units of Production/Activity Method
The production method of depreciation is based on the assumption that depreciation is mainly the
result of use and that the passage of time plays no role in the depreciation process. If we assume
that the office equipment from the previous illustration has an estimated useful life of 10,000
hours, the depreciation cost per hour would be determined as follows:
Hourly depreciation = Cost – Salvage value = Br. 6000.00 – 1000 = Br. 0.50
Estimated units of useful life 10,000 operating hrs.
If we assume that the use of the equipment was 2800 hours for the first year, 3600 hours for the
second, 2400 hours for the third, and 1200 hours for the fourth, the depreciation schedule for the
office equipment would appear as follows:
Depreciation Schedule – Production/Activity Method

Year Cost Hours Depreciation Yearly Accum. Carrying value
Per Hour Deprn. Deprn. (Book value)
Beginning of the Br. 6,000 - Br. 0.50 - - Br. 6,000.00
First year
End of first year 6,000 2,800 0.50 Br. 1,400.00 Br. 1,400.00 4,600.00
End of second year 6,000 3,600 0.50 1,800.00 3,200.00 2,800.00
End of third year 6,000 2,400 0.50 1,200.00 4,400.00 1,600.00
End of fourth year 6,000 1,200 0.50 600.00 5,000.00 1,000.00
54
Under the production method, there is a direct relation between the amounts of depreciation each
year and the units of output or use. Also, the accumulated depreciation increases each year
indirect relation to units of output or use. Finally, the carrying amount decreases each year in
direct relation to units of output or use until it reaches the estimated residual value.
Under the production method, the units of output or use that is used to measure estimated useful
life for each asset should be appropriate for that asset. For example, for one machine number of
units produced may be an appropriate measure, for another number of hours may be a better
measure. The production method should be used only when the output of an asset over its useful
life can be estimated with reasonable accuracy.
4.5.3 Declining Balance Method
This method of depreciation results in relatively large amount of depreciation in the early years
of an assets life and smaller amounts in later years. This method is based on the assumption of
the passage of time. Since most kinds of plant assets are most efficient when new, and so they
provide more and better service in the early years of useful life. It is consistent with the matching
rule to allocate more depreciation to the early years than to later years if the benefits or services
received in the early years are greater.
The declining-balance method is the most common accelerated method of depreciation. Under
this method depreciation is computed by applying a fixed rate to the book value of the asset,
resulting in higher depreciation charges during the early years of the asset’s life. Though any
fixed rate might be used under the method, the most common rate is a percentage equal to twice
the straight-line percentage. When twice the straight-line rate is used, the method is usually
called the double-declining balance method.
method.
Referring to the previous example, the equipment had an estimated useful life of four years.
Consequently, under the straight-line method, the depreciation rate for each year was 25 percent,
(100/ estimated useful life of the asset for 100/ 4 years).
Therefore, under the double-declining balance method, the fixed rate is 50 percent (2X 25
percent). This fixed rate of 50 percent is applied to the remaining carrying value at the end of
each year. Estimated residual value is not taken into account in computing depreciation except in
the last year of an asset’s useful life, when depreciation is limited to the amount necessary to
bring the carrying value down to the estimated residual value. The depreciation schedule for this
method is as follows:
55
Depreciation Schedule, Double-Declining Balance Method
Year Cost Fixed Deprn. Yearly Accumulated Carrying

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

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
4.5.4 The Sum of the Years Digits Method
Like the declining balance method, the sum of the years’ digits method provides a higher amount
of periodic depreciation expense in the earlier use of the asset's life and decline depreciation
expense thereafter because a successively smaller fraction is applied each year to the depreciable
cost of the asset. Under this method, first we must determine the denominator of the fraction,
which is the sum of the digits representing the years of life. While computing depreciation, the
denominator of the fraction is unchanged and would remain the same. On the other hand the
numerator of the fraction, decreases year by year (4/10, 3/10/2/10/1/10). At the end of the asset’s
useful life, the balance remaining should be equal to the salvage value. For example, for a plant
asset with an estimated life of 4 years, the denominator of the fraction is 4+3+2+1 = 10. The
depreciation schedule for this method is as follows:
DEPRECIATION SCHEDULE- SUM - OF - THE - YEARS - DIGITS METHOD

Year Depreciable Rate Yearly Accumulated Book Value
Cost Depreciation Depreciation
Date of purchase Br 6000 - - - Br. 6000
End of first year 6000 4/10 Br. 2200 Br. 2200 3800
End of second year 6000 3/10 1650 3850 2150
End of third year 6000 2/10 1100 4950 1050
End of fourth year 6000 1/10 550 5500 500
56
NB.
NB. The above illustration for the sum of year’s digit method is based on the assumption that the
first use of the asset coincide with the beginning of the fiscal period. When the first use of the
asset does not coincide with the beginning of a fiscal year, it is necessary to allocate each full
year’s depreciation b/n the two fiscal years benefited. Assuming that the asset in the example
was placed in service after four months of the fiscal year had been elapsed, the depreciation for
that fiscal year would be Br. 1466.67 computed as follows:
First year depreciation = 4/10 X (6000 – 500) X 8/12…………………. Br. 1466.67

Therefore, the depreciation for the second year would be Br. 1833.33
Computed as follows:
= 4/10 X (6000 – 500) X 4/12………… Br.733.33

= 3/10 X (6000 – 500) 8/12………………1100.00
8/12………………1100.00
Total, second fiscal year depreciation…………………Br.

depreciation…………………Br. 1833.33
1.
1. What happens if the estimated economic life of the asset is, let say, 25 years? How would you
calculate the sum-of-years-digits?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
4.6 Comparison of Depreciation Methods
Dear students, now we feel that you have got the basic ideas about methods for calculating
deprecation. Which method is/are produce high depreciation expense at the earlier uses of the
life of the asset? Why? Which methods produce uniform depreciation expense throughout the life
of the asset? Can you mention some of limitations of units of production method?
The straight-line depreciation provides a uniform or equal depreciation charges to expense

throughout the service life of the asset.
57
The production method of depreciation provides for periodic charges to depreciation expense
that may vary considerably, depending upon the amount of usage of the asset.
The production method does not generate a regular pattern because of the random fluctuation of
the deprecation from year to year.
The major limitation of the production method is that it is not appropriate in situation in which
depreciation is a function of time instead of activity. Another problem in using the production
method is that an estimate of units of output or service hours received is often difficult to
determine.
Both the declining balance and the sum of the years digits methods are referred to as accelerated
depreciation methods, because they provides (report) relatively higher depreciation expense in
the earlier uses of the life of the asset and a gradually declining periodic expense thereafter.
The main justification for this approach is that more depreciation should be charged in earlier
years because the asset suffers its greatest loss of services in those years.
Accelerated depreciation method also recognizes that changing technologies make some
equipment lose their capacity to yield services rapidly. Thus, it is appropriate to allocate more to
depreciation in the early years, than in later years.
Another argument in favor of an accelerated method is that repair (maintenance) expense is

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

1. Discuss straight line, accelerated method of deprecation?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2. Identify the factors involved in the depreciation process?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
58
Composite Depreciation Methods
Many business enterprises find it means to account for depreciation of certain kinds of plant
assets on a composite or group basis, to minimize the record keeping for individual assets.
Composite or group depreciation is a process of averaging the economic lives of a number of
plant assets and computing depreciation on the entire class of assets as if it were an operating
unit. The term composite generally refers to a collection of somewhat dissimilar plant assets; the
term group usually refers to a collection of similar assets. The procedures for the computation of
periodic depreciation are essentially the same in either case.
Several methods may be used to develop a composite or group depreciation rate to be applied to
the total cost of a group of plant assets. The computation of a straight-line composite
depreciation rate for a group of machines owned by XYZ Company is illustrated as follows:
XYZ Company
Computation of Straight-Line Composite Depreciation Rate for Machinery

Machine Cost Net Residual Value Deprn. Est. Life Annual Deprn.
A Br 60,000 - Br 60,000 5 Br 12,000
B 100,000 12,000 88,000 8 11,000
C 150,000 10,000 140,000 10 14,000
D 190,000 10,000 180,000 12 15,000
Total Br 500,000 Br 32,000 Br 468,000 Br 52,000
Composite Depreciation Rate based on Cost: Br 52,000 / 500,000 =10.4%
Composite Economic Life of Machines: Br 468,000 / Br 52,000 = 9 Years.
The composite depreciation rate is 10.4%, and the composite rate to the cost of $ 5,00,000 will
reduce the composite net residual value of the machines to $ 32,000 in exactly 9 years [Br
5,00,000 – (52,000 X 9) = Br 32,000}.
Once the composite depreciation rate is computed, it is continued in use until a material change
occurs in the composition of plant assets or in the estimate of their economic lives. The
assumption underlying the use of composite depreciation methods are (1) plant assets are
regularly retired near the end of their economic lives (2) retired plant assets are regularly
replaced with similar assets, and (3) proceeds on retirement are approximately equal to the net
residual value for the computation of the composite depreciation rate. If the assets are not
replaced, for example, the use of 10.4% rate computed above eventually would result in the
recording of excessive depreciation.
59
In the determination of yearly depreciation, the 10.4% rate is applied to the balance of the
Machinery ledger account at the beginning of the year, which balance excludes the original cost
of all machines retired prior to the beginning of the year. Thus, for each of the first five years,
annual depreciation is Br 52,000; and in the sixth year (assuming machine X was replaced at the
end of the fifth year with a similar machine costing Br 90,000), depreciation would be Br 55,120
[Br 5,00,000 – Br 60,000 + Br 90,000) X 10.4% = Br 55, 120]. The composite depreciation rate
is not revised when plant assets are replaced with comparable assets, and the asset group should
not be depreciated below net residual value at any time.
When composite depreciation procedures are employed, a record is not maintained for
accumulated depreciated or individual plant assets. When an asset is retired from use or sold, a
journal entry is required to remove the original cost from the plant asset account, and any
difference between original cost and the proceeds received is debited to Accumulated
depreciation; a gain or loss is not recognized because gains or losses are assumed to offset over
time. As for example: If machine were sold at the end of the fourth year for Br 15,000, the
journal entry to record the sale would be as follows:
Cash A/c ………………………………………… 15,000

Accumulated Depreciation of Machinery………… 45,000
To Machinery Account…………………. 60,000
To record sale of machine XYZ Company depreciation method is used; therefore, no gain or loss
is recognized.
The primary advantage of the composite depreciation method is that the averaging procedure
may obscure significant variations from average. The accuracy of the straight line composite
depreciation rate may be verified by recomputing depreciation on the straight line basis for
individual plant assets. Any significant discrepancies between the two results require a change in
the composite depreciation rate.
The advantages claimed for the composite method are simplicity, convenience, and a reduction
in the amount of detail involved in plant asset records and depreciation computations. The
availability of computers has reduced the force of this argument. In many cases unit plant asset
records are now feasible, although composite methods previously were considered a necessity.
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The requisites for the successful operation of composite depreciation procedures are that there
are a large number of homogeneous plant assets, of relatively small individual value, with similar
economic lives. Telephone and Electricity transmission poles, underground cables, railroad
tracks, and hotel furniture are examples of plant assets for which composite depreciation
methods may give satisfactory results.

1. Explain special depreciation method?
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4.7 Capital and Revenue Expenditures
Dear students! Having discussed the general concepts of deprecation, we feel that now
you understood the very concept of depreciation and different methods to calculate
depreciation on plant assets as well as their advantages and disadvantages. What do you
think about costs incurred after the plant asset has been acquired and placed a service?
Expenditures for acquiring plant assets or for additions to plant assets and expenditures that add
to the utility of plant assets for more than one accounting period are called a capital expenditures.
Such expenditures are debited to the asset account or to a related accumulated depreciation
account. Expenditures that benefit only the current period and that are made in order to maintain
normal operating efficiency are called revenue expenditures. Such expenses are debited to
expense accounts. Capital expenditures will affect the depreciation expense of more than one
period, while revenue expenditure will affect the expenses of only the current period.
4.7.1 Capital Expenditure
(a) Addition to Plant Assets

Expenditures for additions to existing plant assets would be debited to plant asset accounts. The
costs of additions would be depreciated over the estimated useful life of the additions. As for
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example, the costs of adding an air conditioning system to a building or of addition of a wing to a
building would be treated as capital expenditures.
(b) Betterments
Expenditures that increase operating efficiency or capacity for the remaining useful life of a plant
asset are called betterments. Such expenditures would be added to the plant asset account. As for
example, if the power unit attached to a machine is replaced by one of the greater capacity, the
cost would be debited to the plant asset account. Also, the cost and the accumulated depreciation
related to the old power unit would be removed from the accounts. The cost of the new power
unit would be depreciated over its estimated useful life.
(c) Extra Ordinary Repairs

Expenditures that increase the useful life of an asset beyond the original estimate are called
extraordinary repairs. They should be debited to the appropriate accumulated depreciation
account, however, rather than to asset account.
In such circumstances, the extra ordinary repairs may be said to restore or “make good” a portion
of the depreciation accumulated in prior years. In addition, the periodic depreciation for future
periods would be redetermined on the basis of the revised book value of the asset and the revised
estimate of the remaining useful life.
4.7.2 Revenue Expenditures

Expenditures for ordinary maintenance and repairs of a recurring nature should be classified as
revenue expenditures and debited to expenses accounts. For example, the costs of replacing
spark plugs in the automobile or the cost of repainting a building should be debited to proper
expenses accounts.
Small expenditures are usually treated as repair expense, even though they may have the
characteristics of capital expenditure.
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Revenue Increase Operating NO Increase NO
Expenditure Efficiency or Adds to capacity Useful
Expenditure (Additions and Betterment)? Life debit expense
(Extraordinary account
Y
Repairs for
E
Ordinary
Y
S
E Maintenance
S
and Repairs
Capital Expenditure Capital Expenditure

Debit plant asset Debit accumulated
Account depreciation account

1. Distinguish between the capital and revenue expenditure?
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______________________________________________________________________________
______________________________________________________________________________
2. Discuss the concepts of Additions, Betterment, and Extra ordinary repairs?

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PART I Multiple Choice Questions
1. An example of an accelerated depreciation method is:
(a) Units-of-production (b) Sum-of-the-years-digits (c) Straight-Line
(d) None of the above.
2. Which of the example is an example of an intangible asset?
(a) Copyrights (b) Patents (c) Goodwill (d) All of the above
3. Which of the following expenditure incurred in connection with the acquisition of
machinery is a proper charge to the asset account?
(a) Installation costs (b) Transportation charges
(c) Neither A nor B. (d) Both A and B
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4. If a plant asset with a ten year economic life is sold during the second year, how would
you use of the sum-of-the-year’s-digits method of depreciation instead of the straight-
line method of depreciation affect the gain or loss on disposal of the asset?
Gain Loss
(a) Decrease Increase
(b) Increase Decrease
(c) No Effect No Effect
(d) No Effect Decrease
5. The composite depreciation method:
(a) Is applied to a group of homogeneous plant assets
(b) Is an accelerated method of depreciation
(c) Does not involve the recognition of a gain or loss on the retirement of an
individual plant asset of the group
(d) Disregards net residual value in the computation of the depreciation base.
PART II Short Answer Questions
1. What do you understand by ‘depreciation accounting”? Which policy of charging
depreciation should be adopted by the management in the period of rising prices?
2. Distinguish between ‘Declining Balance’ and ‘Double Declining Balance’
methods of depreciation. Which of these methods is recognized for financial reporting
purposes?
3. Is a company allowed to change its method of depreciation for reporting
purposes? If so, can’t be made effective with retrospective effect. Explain briefly.
4. “Depreciation is a systematic allocation cost or other value over the service life of
an asset in systematic and rational pattern.” Explain.
5. Mention the factors influencing the selection of a depreciation method.

1. APB Statement No. 4, Basic Concepts and Accounting Principles
Underlying Financial Statements of Business Enterprise, 1970, Para 159.
2. International Accounting Standard Committee, IAS 4, Depreciation
Accounting, March 1976
3. Sidney Davidson, et al., Financial Accounting, The Dryden Press, 1988, p.367.
4. The Institute of Chartered Accountant of England and Wales, SSAP 12,
Accounting for Depreciation, London: ICAEW, Dec 1977, Para 15.
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UNIT FIVE: DISPOSAL OF PLANT ASSETS
Contents
 Unit Objective
 Introduction
5.1 Disposal of Plant Assets
5.1.1 Recording Discarding of Plant Assets
5.1.2 Recording the Sale of Plant Assets
5.1.3 Recording Exchanges of Plant Assets
5.2 Accounting for Intangible Assets and Natural Resources
 Unit Summary
 Answer to Check Your Progress
Unit Objective
This unit aims at discussing the meaning of disposing of plant assets, the different ways of
disposing plant assets, and the accounting procedures involved in recording transactions relating
to the discarding, sale and exchange of plant or (fixed) assets. Thus, after going through this unit,
you will be able to;
 understand the concept of disposing of plant assets
 examine the different ways of disposing of plant assets
 Analyze the transactions involving the discarding, sale, and exchange of plant assets
 Record the transactions involving the discarding, sale, and exchange of plant assets, and
 differentiate accounting for financial reporting from accounting for income tax with
respect of exchange of plant assets
Introduction
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So far you have seen how to account for property, plant, and equipment assets, from calculating
acquisitions cost to depreciating this cost up to the end of the asset’s useful life. Plant assets,
such as equipment, delivery trucks, or machineries cannot be used forever. The assets may wear
out or the business may replace them with newer model. When a plant asset is no longer useful
to a business the asset may be disposed of either through discarding, sale, or traded-in with
similar or dissimilar assets. This unit, therefore, will present this concept in detail.
5.1 Disposals of Plant Assets
Dear students, in unit 4 you discussed accounting for depreciation of plant assets. You also
discussed that the periodic depreciation of plant asset is credited to the accumulated
depreciation account, instead of the asset account. At the end of the life of the plant asset the
accumulated depreciation account balance should equal to the depreciable cost of the asset.
Assuming that after having fully depreciated, a plant asset is still strong to provide service in
the business; will the asset be retired from service and discarded? Or, will the Company
continue to use the asset? Why? If your response is “yes”, will depreciation be continued to be
recorded on the asset or not? Explain. When should an entry be made to remove the cost and
accumulated depreciation from the accounts?
A plant asset rarely lasts exactly as long as its estimated life. If it lasts longer than its estimated
life, it is not depreciated past the point at which its carrying value equals its residual value. The
purpose of depreciation is to spread the depreciable cost of the asset over the economic life of the
asset. Thus, the total accumulated depreciation should never exceed the total depreciable cost. A
plant asset should not be removed from the accounts only because it has been depreciated for the
full period of its estimated life. If the asset is still used in the business beyond the end of its
estimated life, its cost and accumulated depreciation remain in the ledger accounts. Otherwise
the accounts would contain no evidence of the continued existence of such plant assets and the
control function of the ledger would be impaired. Proper records will thus be available for
maintaining control over plant assets. If the residual value is zero, the book value of a fully
depreciated asset is zero until the asset is disposed off. If such an asset is discarded, no gain or
loss results. A plant asset may be disposed by:
(1) Discarding it as worthless; (2) Selling it; or (3) Trading it in on a new asset
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5.1.1 Recording Discarding of a Plant Asset
Dear students, what would you make for a plant asset that is no longer useful to the business
and have no market value? Will there be a loss if the plant asset is fully depreciated? What
will be the loss amount if the plant asset is retired from service before it is fully depreciated?
Give your response before you go through the following discussion.
If a plant asset is of no further use to the business and cannot be sold or traded, then the plant
asset is discarded. If the asset has no book value (i.e., if it is fully depreciated), the plant asset
account is credited for the amount of the original cost of the item being discarded. At the same
time, the accumulated depreciation account is debited for the amount of the total accumulated
depreciation of the item being discarded. In this case neither gain nor loss is realized. On the
other hand, if a plant asset has a book value (if not fully depreciated) at the time it is discarded,
the business incurs a loss.
Suppose for example, on June 30, 2008, equipment that was acquired On Jan 15, 1999, at a cost
of Br. 21,000, is discarded as worthless. The discarded equipment has a carrying value of Br.
3,500 at the time of disposal. The carrying value is computed as the difference between the cost
of asset Br. 21,000 and accumulated depreciation, Br. 17,500. A loss equal to the carrying value
should be recorded when the equipment is discarded.
Solution:
The journal entry required to discard the plant asset as of July 5, year 5, is:
2008
June 30. Accumulated Deprecation, Equipment …………17,500.00
Loss on disposal of plant Asset………………… 3,500.00
Equipment ………………………………. 21,000.00
Discarding Equipment no longer used in the business.
5.1.2 Recording the Sale of Plant Asset
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The entry to record the sale of an asset for cash is similar to the one illustrated above except that
the receipt of cash should also be recorded. The following entries show how to record the sale of
equipment under three assumptions about the selling price. In the first case, the Br. 3,500 cash
received is exactly equal to the book value of the equipment (which is equal to Br. 3,500).
Case 1.
1. Sold at an amount equal to Book Value, Br. 3,500, no gain or loss results:
2008
June 30. Cash …………………………………… 3,500.00
Accumulated Depreciation, Equip……... 17,500.00
Equipment …………………………… 21,000.00
Sale of equipment at an amount equal to book value
Case 2. Sold at Br. 2,500 cash; Loss of Br. 1000, (BV = Br. 3,500)
2008
June 30. Loss on sale of equipment…………………. 1000.00
Accumulated Depreciation………………… 17,500.00
Cash ………………………………………. 2,500.00
Equipment…………………………. 21,000.00
Sale of equipment at less than the book value, Loss of Br. 1000
Case 3. Sold at Br. 4000 cash; gain of Br. 500, cash received through Sale less book
value of the asset (Br. 4000 – Br. 3,500)
2008
June 30. Cash ………………………………………. 4000.00
Accumulated Depr, Equipment…………… 17,500.00
Equipment……………………….. 21,000.00
Gain on sale of plant asset……….. 500.00
Sale of equipment at more than the book value; gain of Br. 500,
(Br. 4000 – Br.3, 500) recorded
5.1.3 Recording Exchange of Plant Assets
Businesses also dispose of plant assets by trading them in on the purchase of other plant assets.
Exchanges may involve similar assets, such as an old machine traded-in on a newer model, or
dissimilar assets, such as a machine traded-in on a truck. In either case, the purchase price is
reduced by the amount of the trade-in allowance.
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 The basic accounting for exchanges of plant assets is similar to accounting for sales of
plant assets for cash. If the trade-in allowance received is greater than the carrying value
of the assets surrendered, there has been a gain. If the trade-in allowance is less than the
carrying value, there has been a loss.
There are special rules for recognizing these gains and losses, depending on the nature of the
assets exchanged.
Exchange Losses Recognized Gains Recognized
For Financial Reporting Purposes:
 Of Similar Assets Yes No
 Of Dissimilar Assets Yes
Yes
For Income Tax Purposes:
 Of Similar Assets No No
 Of Dissimilar Assets
Yes Yes
Both Gains and Losses are recognized when a company exchanges dissimilar assets. Assets are
dissimilar when they perform different functions; assets are similar when they perform the same
function.
For financials reporting purposes, gains on exchanges of similar assets are not recognized
because the earning lives of the asset surrendered are not considered to be completed.
When a company trades-in an older machine on a newer machine of the same type, the economic
substance of the transaction is the same as that of a major renovation and upgrading of the older
machine.
Accounting for exchange of similar assets is complicated by the fact that neither gains nor losses
are recognized for income tax purposes.
Loss Recognized on the Exchange

A loss is recognized for financial reporting purposes on all exchange in which a material loss
occurs.
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To illustrate the recognition of a loss, assume that the business exchange equipment with a cost
of Br. 21,000, and accumulated depreciation of Br. 17,500 for a newer more modern equipment
on the following terms:
Cost of new equipment …………………………………………Birr 23, 000
Trade-in Allowance for old equipment……………………………… (2,500)
Cash payment required (Boot)………………………………... Birr 20,500.
Solution
In the illustration above, the trade-in allowance (Br. 2,500) is less than the carrying value (Br.
3,500) of the old machine. The loss on the exchange is Br. 1000, (Br. 3,500 – Br. 2,500).
Therefore, the journal entry required to record the exchange of assets would be as follows:
2008
June 30. Equipment (New)………………………. 23,000.00
Accum. Depreciation-Equip…………….. 17,500.00
Loss on Exchange of plant assets………. 1000.00
Equipment (old)……………………… 21,000.00
Cash…………………………….……. 20,500.00
1. What is the justification for the non-recognition of gains that results from the exchange of
similar assets?
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Loss Not Recognized on the Exchange
In the previous illustration, in which a loss was recognized, the new asset was recorded at the
purchase price of Br. 23,000 and a loss of Br. 1000 was recognized. If the transaction is for
similar assets and is to be recorded for income tax purpose, the loss should not be recognized. In
this case, the cost basis of the new asset will reflect the effect of the unrecorded loss. The cost
basis for the new asset, therefore, is computed by adding the cash payment to the carrying value
of the old asset:
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Carrying (Book) value of old Equipment……………………..Birr 3,500.00
Cash paid (Boot given)………………………………………… 20,500.00
Cost-basis of new Equipment ……………………………… Birr 24,000.00
 Note that no loss is recognized in the entry to record this transaction.
2008
June 30. Equipment (New)………………………………. 24,000.00
Accumulated Depreciation……………………… 17,500.00
Equipment (old)…………………………… 21,000.00

Cash……………………………………….. 20,500.00
To record exchange of Equipments - cost of old Equipments and its related Accumulated
Depreciation removed from the accounts; new equipment recorded at amount equal to
book value of old equipment plus boot given..
NB.
NB. The new equipment is recorded (reported) at a purchase price of Br. 24,000 plus the
unrecognized loss of Br. 1000. The non recognition of a loss, in effect is a postponement of the
loss. Since depreciation of the new equipment will be computed based on a cost of Br. 24,000
instead of Br. 23,000, the “unrecognized” loss results in more depreciation each year on new
equipment than the loss had been recognized.

1. A plant asset priced at Br 90,000 is acquired by trading in a similar asset and paying cash
for the remainder. Assuming that the trade-in allowance is Br 35,000, what is the amount
of boot given?
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2. Assuming that the book value of the asset traded in is Br 37,500, (a) compute the gain or
loss on the exchange, (b) what is the cost-basis of the new plant asset for financial
reporting purposes, and (c) what is the cost-basis of the new asset for federal income tax
purposes?
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Gain Recognized on the Exchange
Gains on exchanges are recognized for financial reporting purposes when dissimilar assets are
exchanged. To illustrate the recognition of a gain, assume the following terms in which the
machines being exchanged serve different functions:
Price of new equipment……………………………… Birr 23,000.00

Trade-in Allowance for old equipment………………… (4000.00)
Cash payment required (Boot given)………………… Birr 19,000.00
Here the trade-in allowance (Br. 4000) exceeds the carrying value (Br. 3,500) of the old
equipment by Br. 500. Thus, there is a gain on the exchange, if the trade-in allowance represents
the fair market value of the old equipment. Assuming that this condition is true, the entry to
record the transaction is as follows:
2008
June 30. Equipment (New)…………………………… 23,000
Accumulated Depreciation……………………. 17,500
Equipment (old)…………………………. 21,000
Cash ……………………………………… 19,000
Gain on exchange of Equip……………….. 500
To record the exchange of Equipments to remove cost of old equipment and the related
accumulated depreciation, new equipment recorded at cost price; gain recognized .
Gain Not Recognized on the Exchange

A gain on an exchange should not be recognized in the accounting records if the assets perform
similar functions. The cost basis for the new equipment must indicate the effect of the
unrecorded gain. This cost basis is computed by adding the cash payment to the carrying value of
the old asset:
Carrying value of old equipment ……………………………………Birr 3,500.00
Cash paid (Boot Given)……………………………………………… 19,000.00
Cost basis of new Equipment…………………………………….. Birr 22,500.00
The entry to record the transaction is as follows:

2008
June 30. Equipment (New)…………………………. 22,500.00
Accumulated Depreciation………………… 17,500.00
Equipment (old)………………………………….. 21,000.00
Cash……………………………………………… 19,000.00
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To record exchange of Equipment to remove the cost of old equipment and the
related
related accumulated depreciation. of old assets; new equipment recorded at a cost equal
to BV of old asset plus cash paid.
As with the no recognition of losses, the no recognition of the gain on exchanges is, in effect, a
postponement of the gain. Since depreciation will be computed on the cost basis of Br. 22,500,
the “unrecognized” gain is reflected in less deprecation each year on new equipment than if the
gain had been recognized.

1. In what sections of the income statement are gains and losses from the disposal of plant
assets presented?
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___________________________________________________________________________
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2. Assuming that a plant asset priced at Br 75,000 is acquired by trading in a similar asset.
Assume further that the trade-in allowance given on old asset is Br 17,500, (a) what is the
amount of boot given? (b) Assuming the book value of the asset traded-in is Br 16,000,
what is the cost-basis the new asset for financial reporting purposes? (c) What is the cost
basis of the new asset for income tax purposes?
___________________________________________________________________________
___________________________________________________________________________
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Illustrative Problem
Zola Company acquired Asset A for Br. 168,000 on January 3, 2002. Asset A had an estimated
useful life of six years with no salvaged value. The asset was depreciated on the basis of Sum-of-
the-years-digits’ method. On April 30, 2005, Asset A was exchanged for another similar asset –
Asset B. The new asset had a cash price of Br. 190,000. In addition to Asset A, cash of Br.
50,000 and three notes for Br. 90,000 was given up in the exchange. Asset B has an estimated
useful life of seven years and salvage value of Br. 4000. Asset B is to be depreciated using the
straight-line method. The Company had the experience of recording the exchange for financial
reporting purposes.
Required: With reference to the above information:

1. Compute the cost-basis for Asset B in line with Company experience.
2. Pass the journal entry made by Zola Company to record the exchange of the asset.
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3. Compute the depreciation expense to be made on Asset B for 2005 fiscal year ending
Dec. 31 for financial reporting purposes.
4. Compute the cost-basis of Asset B for income tax regulation.
5. Pass the journal entry to record the exchange for purposes of income tax regulation.
Solution to Illustrative Problem

1. Depreciation for the year 2002, on Asset A is:
n(n + 1) = 6(6 + 1) = 21
2 2
6 x 168, 000 = …………………………………… 48,000.00
21
 Depreciation for 2003, 5/2 x 168,000………………………………. 40,000.00

 Depreciation for 2004, 4/21 X 168,000……………………………. 32,000.00
 Depreciation for 2005 (for four months only) 3/12 x 168,000 x 4/12 14,000.00
 Total Accumulated Depreciation as of April 30, 2005, Br. 134,000.00
Old Equipment Traded-In (Asset A)

Cost………………………………………………………… Birr 168,000
Accumulated Depreciation, April 30, 2005…………………. 134,000
Book Value…………………………………………………. Birr 34,000
New Equipment Traded-In (Asset B)

Purchase (List) price……………………………………….. Birr 190,000
Trade-in Allowance on old Asset [Asset A]……………… 50,000
Boot Given (cash + Notes)………………………………… Birr 140,000
Therefore, the cost-basis of Asset B can be obtained by adding the Book Value and the amount
of Boot given which is ; Br. 34,000 + 140,000 = Br. 174,000.
174,000. There unrecognized gain on the
exchange.
(2) 2005
April 30. Asset B………………………………….. 174,000.00
Accumulated Depreciation …………………. 134,000.00
Asset A……………………………………………...168, 000.00
Cash………………………………………………… 50, 000.00
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Notes payable……………………………………… 90, 000.00
3. Depreciation Expense on Asset B for year ending Dec. 31, 2005 by the straight line method is:
Annual Depreciation. = Br. 174,000.00 – Br. 4000.00 = Br. 24,285.71

7 Years
 Since the Asset is employed in service after four months had been elapsed, the
depreciation for 8 months, (May through Dec. 31) would be:
Br. 24,285.71 x 8/12 = Br. 16,190.48
4. The cost-basis for Asset B for income tax regulation is:

 Since gains and losses resulting from the exchange of similar assets are not recognized
for income tax purposes, the cost basis of the Asset B is the same, that is, Br. 174,000.
5. Journal entry to record the exchange of Asset B for purposes of income tax regulation would
be:
2005
April 30. Asset B………………………………………… 174,000
Accumulated Depreciation, Asset A…………… 134,000
Asset A………………………………. 168,000
Cash …………………………………. 50,000
Notes Payable………………………… 90,000
5.2 Accounting for Intangible Assets and Natural Resources
Dear students, up to this point you have discussed in detail the accounting for plant assets,
depreciation and disposal. Have you heard of intangible assets? What are intangible assets?
Give possible examples of intangible assets.
Intangible Assets:
Assets: are long-term assets that do not have physical substance and in most cases
relate to legal rights or advantages held.
Intangible assets include patents, copyrights, trademarks, franchises, organization costs,

leaseholds, leasehold improvements, and goodwill. The allocation of intangible assets to the
periods they benefits is called amortization.
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Intangible assets are accounted for at acquisition cost, that is, the amount paid for them. Some
intangible assets such as goodwill and trademarks may be acquired at little or no cost. Even
though they may have great value and be needed for profitable operations they should not appear
on the balance sheet unless they have been purchased from another party at a price established in
the market place.
The Accounting Principles Board (APB) has decided that a company should record as assets the
costs of intangible assets acquired from others. However, the company should record as expenses
the cost of developing intangible assets. Also, intangible assets that have a determinable useful
life such as patents, copyrights, and leaseholds, should be written off through periodic
amortization over that useful life in much the same way that plant assets are depreciated.
Even though some intangible assets, such as goodwill and trademarks, have no measurable limit
on their lives, they should also be amortized over a reasonable length of time (not to exceed forty
years).
Illustration 5.3
Assume that on Jan 10, 2007 East African Bottling Company purchased a patent on a unique
bottle cap for Br. 140,000.
The entry to record the patent would be as follows:
2007
Jan 10. Patent…………………………………… 140,000.00
Cash………………………………. 140,000.00
To record the purchase of Bottle cap patent
Assume that East Africa Bottling Company’s management determines that, although the patent
for the bottle cap will last for seventeen years, the product using the cap will be sold only for the
next five years. The entry to record the annual amortization would be as follows:
Amortization Expense……………………….. 28,000.00

Patent…………………………………………… 28,000.00
To record annual amortization of patent (Br. 140,000/ 5years)
Note that the patent account is reduced directly by the amount of the amortization expense. This
is in contrast to other long-term asset accounts in which depreciation or depletion is accumulated
in a separate contra account.
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If the patent becomes worthless before it is fully amortized, the remaining carrying value is
written off as a loss. For instance, assume that after the first three years East African Bottling
Company’s chief competitor’s offers a bottle with a new type of cap that makes East African
Bottling Company’s cap obsolete. The entry to record the loss is:
Loss on patent…………………………… 56,000.00
Patent…………………………………… 56,000.00
To record the loss resulting from patents becoming worthless
Depletion of Natural Resources
We now turn our attention to another group of long-lived assets, natural resources,
resources, such as
minerals, oil, and timber or lumber. These natural resources are extracted from the earth.
Depletion is the accounting measure used to allocate the acquisition cost of natural resources.
Depletion differs from depreciation because depletion focuses specifically on the physical use
and exhaustion of the natural resources, while depreciation focuses more broadly on any
reduction of the economic value of a plant or fixed asset. The costs of natural resources are
usually classified as long-term assets.
Depletion expense is the measure of that portion of long-term assets that is used up in a
particular period.
Illustration 5.4
Suppose for example, Berta Construction has acquired the right to use 50,000 acres of land in
Benishangul Gumz Region to mine for gold and other minerals at a total cost of, Br. 25,000.000.
The Company estimated that the mine will provide approximately 2,500,000 grams of gold and
other minerals. The depletion rate established is computed in the following manner.
Total cost – Salvage value

Depletion cost per unit =
Total estimated units available
= Br. 25,000,000 = Br. 10 per gram

2,500,000 units
If 300,000 grams are extracted in the first year, then the depletion for the year is 3,000,000 (300,
000 x Br. 10.00). The entry to record the depletion is therefore:
Depletion Expense………………………… 3,000,000
Accumulated Depletion………………………. 3, 000,000
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1. Distinguish between amortization and depletion.

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______________________________________________________________________________
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TYPE A – Answer the Following Questions:

1. Explain the accounting procedures for discarding of plant assets.
2. Explain the entries required in selling a plant asset for cash.
3. Distinguish between amortization and depletion.
4. What is meant by Intangible Asset?
TYPE B – Choose the best answer for the following questions:

1. If plant asset is retired before it is fully depreciated, and no salvage value or scrap value
is received.
A) a gain on disposal will be recorded
B) Loss on disposal will be recorded
C) Neither gain nor loss on disposal will be recorded
D) All of the foregoing
E) None of the foregoing
2. One of the following is not an example of intangible assets.

A) Patents B) Franchise C) Trademarks
D) Organization cost E) None of the foregoing
3. A plant asset priced at Br. 100,000 is acquired by trade-in a similar asset that has a book
value of Br. 25,000. Assuming that the trade-in allowance is Br. 30,000 and that Br.
70,000 cash is paid for the new asset. What is the cost basis for the new assets for
financial reporting purpose?
A) Br. 100,000 B) Br. 70,000 C) Br. 30,000
D) Br. 125,000 E) None of the foregoing
78
4. Good will in the amount of Br. 60,000 was purchased on January 15, the first month of
the fiscal year. It is decided to amortize over the maximum period allowable. The current
amortization expense would be:
A) Br. 5000 C) Br. 1,500
B) Br. 6000 D) Br. 10,000 E) None of the foregoing
TYPE C-
C- Work out the following problem:
1. On June 30 sold a truck for Br. 950.00. The truck had been purchased two years ago on
January 2 for Br. 2300.00.The amount of depreciation is Br. 400.00 a year. Accumulated
depreciation for that amount was recorded at the end of the two previous years.
A) Record the depreciation for the current year to June 30.
B) Record the sale of the truck.
2. Discarded office equipments for which there was no further use and which could not be
sold. The office equipment cost Br. 290.00 and had a book value of Br. 60.00 at the time
it was discarded.

Company.
Company.
Inc.
79
UNIT SIX: ACCOUNTING SYSTEM FOR PAYROLL AND
PAYROLL TAX LIABILITIES
Contents
 Unit Objective
 Introduction
6.1 Importance of Payroll Accounting
6.2 Definition of Payroll Related Terms
6.3 A Payroll Register [Sheet] and its Components
6.4 Activities Involved in Accounting for Payroll
6.5 Illustration of Payroll Accounting
 Unit Summary
Introduction
Dear students! Are you familiar with the term payroll? What does it mean to you? Please give
your response in writing before you go through the discussion.
Accounting systems for payroll and payroll taxes are concerned with the records and reports
associated with the employer-employee relationship. It is important that the accounting system
provide safeguard to ensure that payments are in accord with management’s general plans and its
specific authorizations.
80
All employees of an organization expect and are entitled to receive their remuneration at regular
intervals following the close of each payroll period. Regardless of the number of employees and
the difficulties in computing the amounts to be paid, the payroll system must be designed to
process the necessary data quickly and assure payment of the correct amount to each employee.
The system must also provide adequate safeguards against unauthorized payments to employees
and other misappropriations of funds.
Various federal, state, and local laws require employers to keep accurate payroll records and to
prepare and submit to the appropriate governmental units. The law also requires employers to
remit the amount withheld from its employees and for taxes imposed on it. These records must
be kept for specified periods of time and be available for inspection by those responsible for
enforcement of the laws. Besides, payroll data may be useful in negotiations with labor unions,
in settling employee grievances, and in determining rights to vacations, sick leaves, and
retirement pensions.
Here, in this unit, you are going to learn intensely and worked through the major concepts that
are common to most payroll systems such as the employee’s earnings record, payroll sheet (or
register), and journal entries related to payroll. Each of these concepts is illustrated and discussed
by taking into account the current tax law of the country. As much as possible the unit attempts
to give you adequate knowledge about payroll systems in Ethiopia. However, if you come across
any confusion or difficulties you can consult the authorities in the Ministry of Finance or Inland
Revenue Administration in your locality, or refer to the various proclamations especially;
Proclamation No. 286/2002, the Council of Ministers Regulation No. 78/2002, and Article 33 of
Proclamation No. 64/1975.
Unit Objective
This unit aims at discussing the accounting for payroll and payroll tax liabilities. The techniques
and procedures used in computing personal income tax, pension contributions, and other
deductions are discussed in detail. Also, the journal entries and other records necessary in
accounting for payroll will be explained and illustrated based on examples. Thus, after reading
and covered this unit your will be able to:
 Understand the importance of payroll accounting
81
 Define payroll related terms
 Describe the components of a payroll register
 Prepare a payroll register
 Calculate income taxes, pension contribution and other deductions and net pay
 Record journal entries related to payroll and payroll taxes
6.1 Importance of Payroll Accounting
Dear students! Having discussed the general remarks given in the introduction part of this
unit, we feel that now you understood the very concept of payroll. If this is so, what do you
think are some of the significances of payroll and its accounting?
Accounting for payroll is particularly important because:

1. Payroll often represents the largest expense that a company incurs.
2. Both federal and state governments require that detailed payroll records be kept, and
3. Employees are sensitive to payroll errors or irregularities. To maintain good employee
morale payroll must be paid on a timely and accurate basis.
6.2 Definition of Payroll Related Terms
a. Salary and Wages: Salary and Wages are usually used interchangeably. However, the
term wages is more correctly used to refer to payments to unskilled-manual labor. It is
usually paid based on the number of hours worked or the number of units produced.
Therefore, wages are usually paid on a weekly basis or when a particular piece of work is
completed.
On the other hand, salaries refer to payments to employees who render managerial,
administrative, or similar services, and they are usually paid to skilled labor on a monthly
or yearly basis.
In this context wages and salaries means a payment to an ‘employee’ who works
primarily to an organization and whose activities are under the direct supervision of the
employer. A self-employed person on the other hand, provides (gives) his/her services on
a fee basis to various firms.
82
b. The Pay Period: A pay period refers to the length of time covered by each payroll
payment.
c. The pay day: The payday is the day on which wages or salaries are paid to employees.
This is usually on the last day of the pay period.
d. A Payroll Register (sheet): is the list of employees of a business along with each
employee’s gross earnings; deductions, and net pay (take home pay) for a particular pay
period. The payroll register (sheet) is prepared based on attendance sheets, punched
(clock) cards or time cards.
e. Pay Check: A business can pay payroll by writing a check for the net pay. A check is
prepared in the name of each employee and handed to employees. Alternatively, a check
for the total net pay can be prepared for employees to be paid by cash at the organization.
f. Gross Earnings: is the total earnings of the employees for a given pay period before
deductions.
g. Withholding Taxes: are taxes collected from the earnings of employees by the employer
organization as per the regulations of the government. These have to be remitted (paid) to
the government because employer organization is only acting as an agent of the
government in collecting these taxes from employees.
h. Payroll Deductions: are deductions from the gross earnings of an employee such as
employment income taxes, employee pension contributions (withholding taxes), labor
union dues, fines, credit association pays etc.
i. Net Pay: Net Pay is the earning of an employee after all deductions have been made.
This is the take home pay amount collected by an employee on the payday.
6.3 A Payroll Register and its Components
Dear students! What does it mean by a payroll register? What do you think are some of the
possible components that make up a payroll register? Try to give your answer in writing
before you go through the following discussion.
a. Employee Number: Number assigned to employees for identification purpose when a

relatively large number of employees are involved in a payroll register. It could be an
identification card of the employees or a simple serial number.
b. Name of Employees: this column lists names of employees of the organization.
c. Earnings: Money earned by an employee from various sources. This may include.
83
(1) Basic Salary: a flat monthly salary of an employee for carrying out the normal
work of employment and subject to change when the employee is promoted.
(2) Allowances: money paid monthly to an employee for special reasons, like:
i. Position allowance – a monthly allowance paid to an employee for bearing a
particular office responsibility.
ii. Housing allowance – a monthly allowance given to cover housing costs of the
individual employee when the employment contract requires the employer to
provide housing but the employer fails to do so.
iii. Hardship allowance/or disturbance allowance – a sum of money given to an
employee to compensate for an inconvenient circumstance caused by the
employer. For example, unexpected transfer to a different and distant work area
or location.
iv. Desert allowance – a monthly allowance given to an employee because of
assignment to a relatively hot region.
v. Transportation (fuel) allowance – a monthly allowance to an employee to
cover cost of transportation up to his/her workplace if the employer has
committed itself to provide transportation service.
(3) Overtime Earning: Overtime work is the work performed by an employee beyond
the regular working hours. Overtime earnings are the amount paid to an employee
for overtime work performed.
Article 33 of proclamation No. 64/1975 discussed the following about how overtime work
should be paid:
A worker shall be entitled to be paid at a rate of

i. One and one-quarter (1¼) times his ordinary (regular) hourly rate for overtime
work performed before 10:00 P.M. in the evening.
ii. One and one half (1½) times his ordinary (regular) hourly rate for overtime work
performed between 10:00 P.M. and Six (6:00 AM) in the morning.
iii. Two times the ordinary (regular) hourly rate for overtime work performed on
weekly rest days.
iv. Two and one half (2½) times the ordinary (regular) hourly rate for overtime work
performed on a public holiday.
All in all, the gross earnings of an employee may include the basic salary, allowance and
overtime earnings.
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Check Your Progress: Exercise – 6.1
1. What term is frequently used to refer to the total amount paid to employees for a certain
period?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2. Distinguish between salaries and wages?

______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
3. An employee earns Br. 120 per hour with one and quarter (1¼) times the regular hourly rate
for all hours in excess of 40 per week. If the employee worked 52 hours during the current
week, what were the gross earnings for the week?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
d. Deductions: are subtractions made from the earnings of an employee required either by
the government or permitted by the employee himself. Some of the common types of
deductions in Ethiopia are discussed hereunder.
i. Employment Income Tax: Every citizen is required to pay employee tax to the
government in almost all countries. In Ethiopia also, income tax is charged on the gross
earnings of the employee at the rates indicated under Schedule A of the Proclamation
No. 286/2002-Income Tax Proclamation.
The tax rates under Schedule A are presented below:

Employment Income Income
(per month) Tax Rate * In computing and withholding tax, the
Exempt income tax proclamation dictates that
0 150 (Free from Tax) income attributable to the month of
151 650 10%
Nehassie and Pagumen shall be
651 1400 15%
1401 2350 20% aggregated (added) and treated as the
2351 3550 25% income of one month.
3551 5000 30%
Over 5,000 35%
85
Taxable income includes any payment or gains in cash or in kind received from
employment by an individual, including income from former employment, or otherwise,
from prospective employment.

1. What is the total amount deducted as income tax for an employee who earns a basic monthly
salary of Br. 4000, a monthly non taxable allowance of Br. 600, and an overtime earning of
Br. 1200?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2. Describe (i) Basic (regular) pay, (ii) Overtime pay
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
Short cut to Income Tax Calculation

Employment Income Income
(per month) Tax Payable
From Birr To Birr
0 150 No tax (free from tax)
151 650 (10%XEI) – 15*
651 1400 (15%XEI) – 47.5
1401 2350 (20%XEI) – 117.5
2351 3550 (25%XEI) – 235
3551 5000 (30%XEI) – 412.5
Over Br. (35%XEI) – 662.5
5000
EI = Employment Income or taxable income

* 15 = (150x0.1) – 0
47.5 = [(150x.15) – 0] + [(500x0.15) – (500x0.1)] and so forth
86
Proclamation No. 286/2002 states that the following are not taxable.
1. Income from employment received by causal employees who are not regularly employed
provided that they do not work for more than one month for the same employer in any
twelve months period.
2. Pension contribution, provident fund and all forms of retirement benefits contributed by
employers in an amount that doesn’t exceed 15% of the monthly salary of the employee.
3. Payments made to (an employee) as a compensation or gratitude in relation to:
 personal injuries suffered by that person
 the death of another person
The Council of Ministers Regulation No. 78/2002
Regulations issued pursuant to the income tax proclamation further exempt the following from
income tax.
1. Amounts paid by employers to cover the actual cost of medical treatment of employees.
2. Allowance in view of means of transportation granted to employees under contract of
employment, i.e., transportation allowance.
3. Hardship allowance (Disturbance allowance).
4. Amounts paid by employee in reimbursement of traveling expenses incurred on duty.
ii. Pension Contribution

Permanent employees of a governmental organization in Ethiopia are expected to pay
or contribute 4% of their basic salary to the governments’ pension trust fund.
This amount is withheld by the employer from each employee on every payroll and
later be paid to the respective government body.
The employer is also expected to contribute towards this same fund 6% of the basic
salary of every permanent government employee.
Therefore, the total contribution to the pension fund of the Ethiopian government is
equal to 10% of the basic salary of all of its permanent employees.
That is, 4% comes from the employees and 6% comes from the employer. For
militaries, the employer (government) contributes 16% and the employee contributes
4% of his/her basic salary towards his/her pension trust fund.
87
This enables a permanent employee of a government organization to be entitled to the
pension pay when retired provided that the employee satisfies the minimum
requirements to enjoy the benefits.
Businesses and non-governmental not-for-profit organizations (NGO’s) also have this

kind of scheme to benefit their employees with some modifications. A fund known as
provident fund is established and both the employer and the employee contribute
towards this fund monthly. When an employee retires or leaves employment, a lump
sum amount is paid to him/her.
iii. Other Deductions

A part from the above two kinds of deductions, employees may individually authorize
additional deductions such as deductions to pay life insurance premiums, to repay loan
from the employer, to pay for donation to charitable organization, contributions to
“idir” etc.

1. Identify the federal and state taxes that most employers are required to withhold from
employees?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
2. What is the employer’s share of pension contributions for a government permanent
employee whose regular monthly salary of Br. 5400?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
e. Net Pay
Net pay represents the excess of gross earnings over total deductions of an employee.
f. Signature
The payroll sheet should have a column for signature of the employee to be taken when the
employee collects the net pay.
88
6.4 Activities Involved In Accounting For Payroll
Dear students! Would you list some of the activities that must be undertaken in the payroll
department of the organization in relation to payroll preparation? List them in writing before
you go through the following discussion.
i. Gathering the necessary data – All the relevant information about every employee
should be gathered. This requires reviewing various documents such as attendance sheets
and doing some arithmetic work.
ii. Entering the names of employees along with the gathered data such as earnings,
deductions and net pays in the appropriate columns of the payroll register.
iii. Totaling and proving the payroll register – the grand total for earnings must be checked if
it is equal to the sum of the grand totals of deductions and net pays.
iv. The accuracy and authenticity of the information summarized in the payroll should be
verified by a different person from the one who prepared it.
v. The payroll should be approved by authorized personnel (individual)
vi. Paying the payroll either in cash or by writing a check.
vii. The payment of the payroll and income taxes withheld from employees (withholding tax
liability) should be recorded in journal entry form.
viii. The withholding tax must be paid to the relevant government authority in time
(promptly) and this is recorded in journal entry form.
1. How is Net Pay computed?
___________________________________________________________________________
___________________________________________________________________________
___________________________________________________________________________
2. Assume an employee’s regular hourly pay is Br. 30, with a time and a half for every hour
worked in excess of 48 during a week. The following data are available:
Hours worked during current month 204 hrs
Regular monthly salary Br. 5760
Allowance (transportation) Br. 700
Assume that according to Company policy transportation allowance in excess of Br. 400 is
subject to employment income tax.
89
Based on the above data, compute the amount of the employee’s:
i. employment income tax,
ii. Total deductions, assuming the employee is permanent civil servant.
iii. Net pay for the current month;
6.5 Illustration of Payroll Accounting
Omo Nada Enterprise is a government agency recently organized around Jimma and its
surroundings to rehabilitate street children. It has five employees whose salaries are paid
according to the Ethiopian calendar month. The following data relates to the month of Tahisas,
2001.
Serial Basic Transportation Overtime

No. Name of Employee Salary Allowance worked(hr) Duration of OT Work
01 Abraham Getu Br. 730 200 4 6:00-10:00 P.M
02 Bekuma Jirra 1020 ____ 8 Sunday(8:30 – 5:30)
03 Meymuna Hunduma 5300 ____ ____ ____
04 Tweodros Alemayehu 1470 ____ ____ ____
05 Yetimwork Kebede 950 ____ 6 Public Holiday
Additional Information:
- The management of the enterprise usually expects a worker to work 40 hours in a week
and during Tahisas there are four weeks.
- There were no absentees during the month
- All employees are permanent except Tewodros and Yetimwork.
- Bekuma agreed to contribute monthly Br. 300 from his salary as a monthly saving in the
credit association of the enterprise.
Required:
1. Prepare a payroll register (sheet) for the enterprise for the month of Tahisas, 2001.
2. Record the payment of salary as of Tahisas 30, 2001 using check stub No. 0123.
3. Record the payment of the claim of the credit association of their enterprise on Tir 1,
2001. Use check stub No. 0124.
4. Record the payment of the withholding taxes and pension contribution to the concerned
government body on Tir 5, 2001.
5. Compute and recognize the total payroll tax expense for the month of Tahisas, 2001.
Computation of Earnings, Deductions, and Net Pay
90
Gross Earnings = Basic salary + Allowance + Overtime Earning
A. Overtime Earning
Overtime earning = OT hrs worked x (ordinary hourly rate x relevant OT rate)
1. ABRAHAM:
- OT Earning = 4 hours x Br. 730 x 1.25 = Br. 22.81
160 hours
NB. Every employee is expected to work 160 hours per month
(I.e. 40 hours x 4 weeks)
- You should compute the regular hourly rate first:
Regular Hourly Rate = Monthly salary (Basic salary)
Total Hours worked in the Month
= Br. 730
160 Hours
- Therefore, the regular hourly payment = Br. 4.56
The regular hourly payment must be multiplied by the appropriate OT rate as follows:
Br. (4.56 x 1.25) x 4 hours …………………… Br. 22.81
2. BEKUMA:
- OT Earning = 8 hours x Br. 1020 x 2 ………... Br. 102.00
160 hours
3. YETIMWORK:
- OT Earning = 6 hours x Br. 950 x 2.5 …………………… Br. 89.06
160 hours
B. Gross Earnings
Gross Earnings = Basic salary + Allowance + OT Earning
1. ABRAHAM:
 Gross Earnings = Br. 730 + Br. 200 + Br. 22.81 = Br. 952.81
 Remember taxable income in this case is Br. 752.81 because the transportation
allowance of Br. 200 is not subject to taxation.
91
2. BEKUMA:
 Gross Earnings = Br. 1020 + Br. 102 = Br. 1122
 The Gross Total Earnings of Bekuma consists of the Br. 1020 basic salary plus the
overtime earnings of Br. 102, which is Br. 1122.
3. MEYMUNA:
 Gross Total Earnings = Br. 5300, which include the basic salary alone
4. TEWODROS:
 Gross Total Earnings = Br. 1470, which is the basic salary
5. YETIMWORK:
 Gross Total Earnings = Br. 950 + Br. 89.06 = Br. 1039.06
C. Deductions and Net Pay
1. ABRAHAM:
 Gross Total Earnings …………………………………. Br. 952.81
 Gross Taxable Income (Br. 952.81 – Br. 200) ……….. 752.81
i. Employee Income Tax:
Earnings X Income Tax Rate = Income Tax

0 – 150 Br. 150 0 Br. 00.00
151 – 650 on Br. 500 10% 50.00
651 – 752.81 on Br. 102.81 15% 15.42
Total Br. 752.81 Br. 65.42
ii. Pension Contribution:

Basic salary x 4%
= Br. 730 x 0.04 …………………………………… 29.20
 Total Deduction (Br. 65.42 + Br. 29.20) ……… Br. 94.62
NB. The income tax would be computed using the short-cut method as follows:
= (Taxable Income x 15%) – Br. 47.5
= (Br. 752.81 x 0.15) – Br. 47.5 = Br. 65.42
2. BEKUMA:
 Gross Total Earnings ……………………………… Br. 1122
92
i. Employee Income tax:
Earning X Income Tax Rate = Income Tax
0 – 150 Br. 150 0 Br. 00.00
151 – 650 on Br.500 10% 50.00
651 – 1122 on Br. 472 15% 70.80
Total Br. 1122 Br. 120.80
ii. Pension Contribution:
(Br. 1020 x 0.04) ………………………………………………… Br. 40.80
iii. Credit Association ……………………………………………………… 300.00
 Total Deductions ………………………………………………. Br. 461.60
3. MEYMUNA:
Gross Total Earnings……………………………………………………. Br. 5300.00
i. Employee Income tax:
0 – 150 Br. 150 0 Br. 00.00
151 – 650 on 500 10% 50.00
651 – 1400 on 750 15% 112.50
1401 – 2350 on 950 20% 190.00
2351 – 3550 on 1200 25% 300.00
3551 –5000 on 1450 30% 435.00
Over 5000 on 300 35% 105.00
TOTAL Br. 5300.00 ----------------------------- Br. 1192.50
ii. Pension contribution (Br. 5300 x 0.04) ------------ 212.00
 Total Deductions ------------------------------------ Br. 1404.50
4. TEWODROS:
Gross Total Earnings ………………………………………………… Br. 1470.00
Gross Taxable Income ………………………………………………. 1470.00

0 – 150 Br. 150 0 Br. 00.00
151 – 650 on 500 10% 50.00
651 – 1400 on 750 15% 112.50
1401 – 1470 on 70 20% 14.00
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TOTAL Br. 1470 ----------------------------------- Br.
176.50
NB. No pension contribution because he is not permanent employee of the organization. Therefore,
total deduction is the same as Employee Income Tax, Br. 176.50.
5. YETIMWORK:
Gross Total Earnings ……………………………………………… Br. 1039.06

0 – 150 Br. 150 0 Br. 00.00
151 – 650 on Br. 500 10% 50.00
651 – 1039.66 on Br. 389.06 15% 112.50
TOTAL Br. 1039.06 -------------------------------- Br. 108.36
NB. Pension contribution should not be computed for Yetimwork because she is not permanent
employee of the enterprise. Thus, the only deduction from Yetimwork’s earnings is the employee
income tax.
NB. It is also possible to compute income tax using the short-cut method:
Total Income Tax = (Taxable Income x 15%) – 47.5
= (Br. 1039.06 x 0.15) – 47.5
= Br. 108.30
NET PAY:
Net pay = Gross Total Earnings – Total Deductions
1. ABRAHAM:
Net pay = Br. 952.81 – Br. (94.62)
Net pay = Br. 858.19
2. BEKUMA:
Net pay = Br. 1122 – Br. (41.60)
3. MEYMUNA:
Net pay = Br. 5300 – Br. (1404.50)
94
Net pay = Br. 3895.50
4. TEWODROS:
Net pay = Br. 1470 – Br. (176.50)
Net pay = Br. 1293.50
5. YETIMWORK:
Net pay = Br. 1039.06 – Br. (108.36)
Proving the Payroll:
Total Earnings:
Basic salary ----------------------------------------------- Br. 9470.00
Allowances -------------------------------------------- 200.00
Overtime -------------------------------------------- 213.87
Grand Total -------------------------------------- Br. 9883.87
Deductions:
Employee Income taxes --------------------------------- Br. 1745.58
Pension Contributions ----------------------------------- 200.00
Other Deductions ---------------------------------------- 300.00 = Br. 9883.87
Total Deductions ------------------------------- Br. 2245.58
Total Net Pay ----------------------------------------------------- Br. 7638.29
Total Deductions plus Net pay -------------------------------- Br. 9883.87
The payroll register (or sheet) for Omo Nada Enterprise prepared for the Month of Tahisas, 2001
is shown below.
95
Omo Nada Enterprise
Payroll Register (sheet)
For the Month of Tahisas, 2001 E.C.
Ser. Earnings Deductions

Name of Employee Gross Earning Total Deduc. Net Pay Signature
No.
Basic salary Allowances Over Time Income Tax Pension Contr. Other Deduc.
1 Abraham Getu 730 200 22.81 952.81 65.42 29.2 94.62 858.19

2 Bekuma Jirra 1020 ____ 102 1122 120.8 40.8 461.6 660.4

3 Meymuna Hunduma 5300 ____ ____ 5300 1192.5 212 1404.5 3895.5

4 Tweodros Alemayehu 1470 ____ ____ 1470 176.5 ____ ____ 176.5 1293.5

5 Yetimwork Kebede 950 ____ 89.06 1039.06 108.35 ____ ____ 108.35 930.71

Grand Total Br. 9470.00 Br. 200.00 Br. 213.87 Br. 9883.87 Br. 1663.07 Br. 282.00 00.00 Br. 2215.58 Br. 7638.30
Prepared by __________________________________ Checked by __________________________ Approved by _______________
96
Journal Entries Related to Accounting for Payroll
Recording the payment of salary:

2001
Tahisas 30. Salary Expense ……………………… 9883.87
Cash…………………………………… 7638.30
Pension Contribution Payable …………… 282.00
Employees Income Tax Payable ………… 1663.07
Payment for Credit Association …………. 300.00
Also, on this same date, the Enterprise (as an employer) has to contribute 6% of the basic salary
of every permanent employee to the government’s pension trust fund.
Therefore, total basic salaries of permanent employees x 6% = (Br. 5300 + Br. 1020+730) x 6%
= Br. 423
The following journal entry, therefore, is recorded on Tahisas 30, 2001.

Tahisas 30. Pension Contribution Expense ………………423.00
Pension Contribution Payable ………………423.00
Recording the payment of deduction from Bekuma’s salary to the Credit Association:
2001
Tir 5. Payable to Credit Association ………..300.00
Cash ……………………....…………………300.00
Recording the payment of employees’ income tax withheld and the 10% pension contribution to
the government body:
2001
Tir 5. Pension Contribution Payable …….……705.00
Employee Income Tax Payable ……… 1663.57
Cash ………………………………………. 2368.57
97
Review Problems
Problem – 6.1
JIMMA RURAL DEV’T Enterprise, a government owned business, pays its employees salaries
according to the Ethiopian calendar Month. The following data relate to the month of Meskerem,
2001 E.C.
S.No Employee Name Basic Salary

A01 Alemu Tolossa Birr 6500
M02 Myron Zewde 4800
Y03 Yemisratch Fanta 3790
Z04 Zibrikrik Ayele 2565
 All workers are expected to work 40 hours per week and during Meskerem there are 4 weeks.
The workers have done as they have been expected.
 Myron Zewde has worked 10 hours of overtime during Meskerem: 3 hours during “Meskel”
and the other 7 hours before 10 p.m.
 Yemisratch Fanta has also worked 5 hours of overtime: 2 hours during weekly rest days and
3 hours between 10 p.m. – 6 a.m.
 Alemu and Myron received a monthly position allowance of Br. 550 and Br 500 respectively
which are both taxable.
 Alemu Tolossa agreed to have a monthly deduction of Br. 500 for credit association.
 All workers are permanent except Zibrikrik Ayele.
Required:
1. Compute the total deductions and net pay for each employee.
2. Compute (calculate) the total:
a. withholding Taxes
b. Payroll Taxes
c. Record the payment of salary as of Meskerem 30, 2001.
3. Pass the entry to pay the withholding taxes to the appropriate government unit.
Problem – 6.2
ABA JIFAR Trading Co. is a private business enterprise. The Company pays the salary of its
employees according to the Ethiopian calendar month. The following data relates to the month of
Hidar, 2001.
S.No Name Basic Salary

A101 Ayselech Yihenew Br. 4710
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P102 Genet Aychesh
S103 Seletene Beka
Z104 Ziyad Al-Amoudi
 The organization expects every worker to work 48 hours in a week and during Hidar there
are four weeks and all workers have done as they have been expected.
 Ato, Ayselecth and W/r, Genet are entitled to get a monthly allowance of Birr 600 and Br.
500 respectively.
 All workers are permanent except Ziyad Al-Amoudi, and they are entitled to a total of 15%
provident fund of which 10% from the employer and 5% from the employee.
 Ato Seletene Beka and W/t Genet Aychesh have worked 10 hours of overtime both on public
holidays.
 According to the Company rule, any allowance more than Birr 300 is subject to income tax.
Required:
1. Compute the income tax for each employee.
2. Compute the total deductions for each employee.
3. Determine the net pay (take-home-pay) for each employee.
4. Compute the total withholding tax for the month.
5. Compute the total payroll tax expense.
6. Pass the journal entry to record the payment of salary as of Hidar 30, 2001.
Problem – 6.3
The following data relates to the payroll of the employees of a privately owned business
organization known as “AL-AZAR Retail Enterprise”, for the month of Miazia, 2001 E.C.
Serial Overtime Worked

No. Name Basic Salary Hours Duration
01 Aleme T. Br. 4300 4 Up to 10 PM
02 Banchayehu S. 2960 12 b/n 10PM to 6 PM
03 Chemdessa N. 2450 8 Weekly rest days
04 Deniel T. 1632 10 Public holidays
05 Leilena A. 3000 - -
 The management of the business organization usually expects a worker to work 48 hours in a
week.
 There were no absentees during Miazia.
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Required:
1. Prepare a payroll sheet for the month of Miazia
2. Record the payment of salary as of Ginbot 1, 2001
3. Record the recognition of the payroll tax expense as of Ginbot 1, 2001
4. Record the payment of withholding taxes to the proper government units as of Ginbot 15, 2001

1. Fees and Warren, Principles of Accounting, 16th edition.
2. Robert M. Swanson, Kentone E. Ross, Robert D. Hanson and Lewis D. Boynton,
Introduction to Accounting, 12th century, 3rd edition, 1982, South-Western
Publishing Company. Cincinnati Ohio.
3.
 Proclamation No. 286/2002, Income Tax Proclamation.
 The Council of Ministers Regulation No. 78/2002 Regulation issued pursuant to
the income tax proclamation. About income Exempted from tax.
 Article 33 of Proclamation No. 64/1975, which discusses how overtime work
should be paid.
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UNIT SEVEN: FUNDAMENTAL OF ACCOUNTING CONCEPTS
AND PRINCIPLES
Contents
 Unit Objectives
 Introduction
7.1 Generally Accepted Accounting Principles (GAAP)
7.2 Summary
7.3 Answers to Check Your Progress Exercises
Unit Objectives
This unit aims at discussing the basic accounting concepts and procedures used in the preparation
of finical reports. It also discusses in detail the Generally Accepted Accounting Principles.
After studying this unit, you will be able to:
 describe the development of accounting concepts and principles

 identify and illustrate the application of basic accounting concepts and principle
 Solve exercises and problems.
Introduction
Dear students, have you heard about accounting principles? If so, what do you understand
about accounting principles? What do you think about the purpose of accounting principles
or concepts? Give your answer in writing before you go through the discussion below.
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The historical development of accounting practice has been closely related to economic
developments. In the earlier periods, a business enterprise was very often managed by its owner,
and the accounting records and reports were used mainly by the owner – manager in conducting
the business. Bankers and other lenders often relied on their personal relationship with the
owner rather than on financial statements as the basis for making loans for business purposes. If
a large amount was owed to a bank or supplier, the creditor often participated in management
decisions.
As business organizations grew in size and complexity, “management” and “outsiders” became
more clearly differentiated. From the later group, which includes owners (stock holders),
creditors, government, labor unions, customers and the general public, came the demand for
accurate financial information for use in judging the performance of management.
In addition, as the size and complexity of the business unit increased, the accounting problems
involved in the preparation of financial statements became more and more complex. With these
developments came an awareness of the need for a framework of concepts and generally
accepted accounting principles to serve as guidelines for the preparation of the basic financial
statements.
Accounting concepts and principles include conventions, axioms, standards, rules, guidelines and
procedures that are necessary to have accounting practice at a particular period of time. The
word “principles” as used in the context of generally accepted accounting principles does not
have the same authoritativeness as universal principles or natural laws relating to the study of
astronomy, physical or other physical sciences.
Accounting principles have been developed by individuals to help make accounting data more
useful in an ever-changing society. They represent the best possible guides, based on reason,
observation, and experimentation, to the achievement of the desired results. These principles are
continually re examined and revised to keep pace with the increasing complexity of business
operations. General acceptance among the members of the accounting profession is the criterion
for determining an accounting principle.
Responsibility for the development of accounting principles has rested primarily on practicing
accountants and accounting educators, working both independently and under the sponsorship of
various accounting organizations. These principles are also influenced by business practice and
customs, ideas and beliefs of the users of the financial statements, governmental agencies, stock
exchanges and other business groups.
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1. Accounting principles and concepts are needed due to different reasons. What are they?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
7.1 Generally Accepted Accounting Principles [GAAPs]
Dear students, we believe that from the above discussion you have acquired some concepts
regarding accounting principles or concepts. Have you heard of generally accepted
accounting principles? What are they? Give possible examples of generally accepted
accounting principles
1. Business Entity Concept
The business entity concept assumes that a business enterprise is separate and distinct from the
persons who supply its partial or all assets and from every other business. Businesses are
perceived and treated as a distinct separate entity regardless of the legal concept because in so far
as a specific business is concerned, the purpose of accounting is to record its transactions and
periodically report its financial positions and profitability. Consequently, the records and reports
of the business should not include either the transactions of another business or the personal
assets or transactions of its owner or owners. To include either would distort the financial
position and profitability of the business.
The accounting equation, Assets = Equities or Assets = Liabilities + Owners equity, is an

expression of the entity concept: i.e. the business owns the assets and owes the various claimants.
Thus, the accounting process is primarily concerned with the enterprise as a productive economic
unit and only secondarily concerned with the investor as a claimant to the assets of the business.
Note: the legal entity concept may not go in accordance with the business entity concept
depending on the type of the business enterprise, i.e., whether the business is a sole
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proprietorship, partnership or corporate entity. The two concepts match for corporate
entity but not for the other two business enterprises.
2. Going Concern Concept
Dear students, what does the going concern concept states? Give your answer in writing
before you go through the discussion below
Only in rare cases is a business organized with the expectation of operating for only a certain
period of time. In most cases, it is not possible to determine in advance the length of life of an
enterprise, and so an assumption must be made.
The nature of the assumption will affect the manner of recording some of the business
transactions, which in turn will affect the data reported in the financial statements.
The going concern concept assumes that the business enterprise continues its operations (at
profit) for indefinite period of time. A business enterprise purchases and holds assets for use in
its operations. The market value of those assets may change over time. However, the
accounting records for those assets are not adjusted to reflect the market value changes. This is
because of the going concern concept. As a going concern, the assets used in carrying on the
operation of the business are not for sale. Obviously, they cannot be sold without disturbing the
business operation. Therefore, their market values are not particularly relevant and need not be
shown. That is, the going concern concept provides much of the justification for recording plant
assets at acquisition cost and depreciating them in an orderly manner without reference to their
current realizable values. If there is no immediate expectation of selling them, plants assets
should not be reported on the balance sheet at their estimated realizable values regardless of
whether their current market value is less than or greater than their book value.
The going concern assumption similarly supports the treatment of prepaid expenses as assets,
even though they may not be salable.
Doubt as to the continued existence of a firm may be disclosed in a note to the financial
statements.
If a business enterprise is to be sold or liquidated, financial statements should be prepared from

the “quitting concern” or liquidating point of view rather than from a “going concern” point of
view. That is, in such cases, the cost principle and the going concern would not be applied in
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preparing the financial statements. Instead the estimated market values become more useful and
informative.
3. (Historical) Cost Principle
What does the historical cost (cost) principle suggests? Attempt the questions before you read
the following discussion.
Under this principle, which is a fundamental principle in accounting, all goods and services
purchased are recorded at cost, where costs are measured on a cash or equivalent basis. If the
consideration given for an asset or service is cash, cost is measured at the entire cash outlay
made to secure the asset or the service. Otherwise, cost is measured at the cash equivalent value
of the consideration given or the cash equivalent value of the thing received whichever is more
clearly evident.
For example, if a business paid Birr 200,000 for a lot of land to be used in business operation, the
land should be recorded at a cost of Birr 200,000. It does not make any difference if the buyer or
any other competent outside appraiser think that the land worth more or less than Birr 200,000.
Therefore, the journal entry would be recorded in the buyer’s book as follows:
Land……………………………… 200,000
Cash………………… 200,000
4. Objectivity Principle
This principle requires that entries in the accounting records and data reported on financial
statements be based on objectively determined evidence. This principle answers the question
why assets and services are recorded at cost rather than some other amount such as estimated
market value. As a rule, costs are objective since normally are established by buyers and sellers,
each striking the best possible bargain for themselves. If this principle is not followed, the
confidence of the many users of the financial statements could not be maintained. For example,
objective evidence such as invoices and vouchers for purchase, bank statements for the amount
of cash in bank, and physical counts for merchandise on hand supports much of the accounting.
Such evidence is completely objective and can be verified.
Evidence is not always conclusively objective, for there are many cases in accounting in which
judgments, estimates, and other subjective factors must be taken into account. In such situations,
the most objective evidence available should be used. For example, the provision for doubtful
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accounts is an estimate of the losses expected from failure to collect sales made on account. The
estimation of this amount should be based on such objective factors as past experience in
collecting accounts receivable and reliable forecasts of future business activities. To provide
accounting reports that can be accepted with confidence, evidence should be developed that will
minimize the possibility of error, intentional bias, or fraud.
1. What does the objectivity principle require for information presented in financial statement?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
2. A business shows office stationery on the balance sheet at its cost Birr 680 cost, although it
cannot be sold for more than Birr 30 as scrap paper. Which accounts principle requires this
treatment?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
5. Stable Monetary Unit Concept /Unit of Measurement
Dear students, how do you measure business transactions?
Accounting transactions are measured, recorded and reported in terms of monetary unit. In the
process of measuring, recording and reporting the monetary unit is treated as a stable unit of
measure like a gallon, a kilometer etc. However, the monetary unit is not a stable unit of
measure nevertheless; accountants use a monetary unit as a standard unit of measurement in their
reports. Money is both the common factor of all business transactions and the only feasible unit
of measurement that can be used to achieve uniform financial data.
The generally accepted use of the monetary unit for accounting for and reporting the activities of
an enterprise has got two major limitations: First, it limits the scope of accounting reports. The
scope of the report will be on information which can be quantifiable and measurable interims of
monetary unit. What so ever the information is useful to the user, unless it is measurable in
terms of monetary unit; it cannot be reported on the financial statements. Secondly, as it is stated
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above, any monetary unit in the world is not stable due to economic changes. Therefore, the
accountants report could be highly criticized for not being fully informative.
To consider the above two limitations, accountants usually prepare reports which accompany the
financial statements. These reports try to inform relevant unquantifiable information and reflect
the effects of change in purchasing power of the monetary unit.
6. The Periodicity Concept [Accounting Period Concept]
According to this concept, the life of a business entity should be broken into segment periods for
accounting purposes. A complete and accurate, picture of an enterprise’s success or failure
cannot be obtained until it discontinues operations, converts its assets into cash, and pays off its
debts. Then, and only then is it possible to determine its true net income. But many decisions
regarding the business must be made by management and interested outsiders during its
existence. Therefore, it is essential to stop the operation of the business artificially at frequent
intervals so as to produce periodic reports on operations, financial position, and cash flows.
These reports reduced will help the user how well or bad the business was operating during those
periods. These periods are timely and provide a consistent frame of reference to measure the
business activities and compare those measurements with previous periods and other companies.
Reports may be prepared when a certain job or project is completed, but more often they are
prepared at specific time intervals. For a number of reasons, including custom and various legal
requirements, the longest interval between reports is one year.
This element of periodicity creates many of the problems of accountancy. The basic problem is
the determination of periodic net income. For example, the need for adjusting entries, problems
of inventory costing, problems of recognizing the uncollectibility of the receivables, and problem
of selecting depreciation methods are directly related to the periodic measurement process.
1. What are the two major limitations of stable monetary unit concept on the accounting reports?
______________________________________________________________________________
______________________________________________________________________________
______________________________________________________________________________
7. The Matching Principle
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How well or bad the company is doing is reflected to users on the income statement prepared for
a period of time. The income statement tries to measure the business’s earnings by comparing
the revenue with expenses of that period which is covered by the income statement.
The matching principle means that after the revenues for an accounting period have been
determined, the costs associated with those revenues must be deducted in order tdetermine net
income. The term matching refers to the close relationship that exists between certain costs and
the revenue realized as a result of incurring those costs.
Thus, the use of matching as a pervasive principle in the income measurement offers another
practical reason for the widespread use of cost principle. For example, the expenditure for
advertising is a cost to be matched against the sales that is promoted. The recognition of
uncollectible accounts is also supported by the matching principle. Uncollectibles arise from
credit sales to customers who fail to pay their bills. To match this expense (uncollectible
amount), it becomes important to estimate what part of the credit sales is to be uncollectible in
the future. The use of estimate is necessary in order to carry the matching principle.
8. Revenue Recognition Principle
Dear students, at what point(s) during the creation of marketable goods or services be revenue
recognized?
States that revenue from business transactions is recorded when goods or services are sold.
Some business sell goods or services on one date but receive payment on a later date. In such
cases, the revenue is recorded on the date of sale, not necessarily when the cash is received.
9. Adequate Disclosure Principle
Dear students, what do you understand by adequate disclosure? What is to be disclosed?
All financial statements and accompanying statements should include the necessary data that
helps to facilitate the user’s understanding. Thus, all relevant information to the users must be
disclosed. However, full disclosure does not mean that everything must be disclosed. That
would be too costly. A balance must be maintained between the cost of disclosing information
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and its relevance to users. Basically, if the information will make a difference in investors’ or
creditors’ decisions it should be disclosed. Therefore, the criterion for disclosure is based on
value judgment rather than objective facts.
Financial statements are made more useful by the use of headings and subheading, and by
merging items in significant categories. Although all essential data should be disclosed with in
these categories, judgments must be exercised by excluding non-essential information to avoid
clutter. For example, detailed information as to the amount of cash in various special and
general funds, the amount on deposit in each of several banks, and the amount invested in
various marketable government securities is not needed by the reader of financial statements.
Such information displayed on the balance sheet would hinder rather than aid understanding.
In most cases, all of the pertinent data needed by the reader cannot be presented in the financial
statements themselves. The statements therefore normally include essential or explanatory
information in accompanying notes. Adequate disclosures are necessary for both historical facts
and subsequent events to the issuance of financial statements. The following are some examples:
 Summary of significant accounting policies.

 Change in accounting methods used by the business
 Contingent liabilities and commitments.
 Events subsequent to the date of statements
 Replacement cost of inventories and plant assets etc.
10. The Consistency Principle
The amount and direction of change in net income and financial position from period to period is
very important to readers and may greatly influence their decisions. Therefore, interested person
should be able to assume that successive financial statements of an enterprise are based on
consistently on the same generally accepted accounting principles. If the principles are not
applied consistently, the trends indicated could be the result of changes in the principles used
rather than the result of changes in business conditions or managerial effectiveness.
Consistency principle requires that the same generally accepted accounting principles are used
from period to period for the same accounting events. Therefore, once an accounting method or
principle is adapted, it should be used for reasonable period of time. This is because accounting
information is more useful if it can be compared with similar information for the same company
from time to time. However, consistency principle does not prohibit switching from one
accounting method to another. Changes are permissible when it is believed that the uses of a
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different principle will more fairly state net income and financial position. Examples of change
in accounting principles include a change in the method of inventory pricing, a change in
depreciation method for previously recorded assets and a change in the method of accounting for
long- term construction contracts. Consideration of changes in accounting principles must be
accompanied by consideration of the general rule for disclosure of such changes, which is as
follows:
The nature of and justification for a change in accounting principle and its effects on income
should be disclosed in the financial statements of the period in which the change is made. The
justification for the change should explain clearly why the newly adopted accounting principle is
preferable.
There are various methods of reporting the effect of a change in accounting principle on net
income. The cumulative effect of the change on net income may be reported on the income
statement of the period in which the change is adopted. In some cases the effect of the change
could be applied retroactively to past periods by presenting revised income statements for the
earlier years affected.
The application of the consistency principle does not require that a specific method be used
uniformly throughout an enterprise. For example, it is not unusual for large enterprises to use
different costing methods and pricing methods for different segments of their inventories.
11. The Materiality Concept
What do you understand by materiality concept?
In following generally accepted accounting principles, the accountant must consider the relative
importance of any event, accounting procedure or change in procedure that affects items on the
financial statements. The concept of materiality is relative. What is material for one firm may be
immaterial for another firm. The determination of what is important and what is not requires the
exercise of judgments. Precise criteria cannot be formulated. Some factors do help to identify
events as being material or immaterial. This is done by comparing the size and nature of an item
or event with the size and nature of other events or items. For example, the erroneous
classification of a Birr 5,000 asset on a balance sheet exhibiting total assets of Birr 5,000,000
would probably be immaterial. If the assets total only Birr 50,000, however, it would certainly
be material. If the Birr 5,000 represented a note receivable from an officer of the enterprise, it
might well be material even in the first assumption.
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The concept of materiality may be applied to procedures used in recording transactions. For
example, small expenditures for plant assets may be treated as an expense of the period rather
than as an asset. The saving in clerical costs is justified if the practice does not materially affect
the financial statements.
Customs and practicality also influence the criteria of materiality. For example, corporate
financial statements seldom report the cents amount or even the hundreds of dollars. A common
practice is to round to the nearest thousands. For large corporations, there is an increasing
tendency to report the financial data in terms of millions, carrying figures to one decimal.
12. The Conservatisms (Prudence) Concept
Accountants follow methods and procedures that yield the lesser amount of net income or net
asset value. Of an accountant faced two methods of handling a particular event, he /she tends to
use the method which understate the net income or net asset. This is done to protect the firm
from uncertain risk of loss. Thus, conservatism is usually expressed by the statement “anticipate
no profit but provide for all losses”. Such an attitude of pessimism has been due in part to the
need for an offset to the optimism of business management.
Current accounting thought has shifted somewhat from this philosophy of conservatism.
Conservatism is no longer considered to be a dominant factor in selecting among alternatives.
N.B: The concepts and principles of objectivity, disclosure, consistency and materiality are more
important than conservatism and the latter should be a factor only when the others don’t
play a significant role in the decisions to be made by users of financial statements.
Unit Summary
The accounting profession is guided by basic accounting concepts and principles. In recording
business transactions and in preparing financial statements, accountants apply these principles
and concepts.
Accounting principles differ from the principles related to the physical sciences. Accounting
principles are developed by individuals to help make accounting data more useful in an ever –
changing society. These principles are continually reexamined and revised to keep pace with the
increasing complexity of business operations.
Part I. Discussion Questions
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1. For accounting purposes, what is the nature of the assumption as to the length of life of
an enterprise?
2. Why should the most objective evidence available be used as the basis for data reported
on financial statements?
3. If a complete and accurate picture of an enterprise’s success or failure is desired, what

accounting period must be used to report on operations?
4. Is revenue from sales of merchandise on account more commonly recognized at the time
of sale or at the time of cash receipt?
5. When there are several acceptable alternative accounting methods that could be used, the
method used by an enterprise should be disclosed in the financial statements. Give examples
of accounting methods that fall in this category.
6. If significant changes are made in the accounting principle applied from one period to the
next, why the effect of these changes should be disclosed in the financial statements?
7. You have just been employed by a relatively small merchandising business that records
its revenues only when cash is received and its expense only when cash is paid you are
aware of the fault that the enterprise should record its revenues and expenses on the accrual
basis. Would changing to the accrual basis violate the principle of consistency? Discuss.
8. The accountant for a large department store charged the acquisition of a pencil sharpener
to an expense account, even though the asset had an estimated useful life of 10 years. Which
accounting concept supports this treatment of the expenditure?
9. Why do the financial statements of a business present its activities separate from its
owner’s activities?
10. The monetary principle assumes that money is a useful standard measuring unit for
reporting the effects of business transactions. State and explain two major criticism or
limitations of this accounting principle.
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Part II. Exercises
1. Each of the following statements represents a decision made by an accountant. State

whether or not you agree with the decision. Support your answer with reference to generally
accepted accounting principles that are applicable in the circumstance.
a) In preparing the balance sheet, detailed information as to the amount due from
hundreds of customers was omitted. The total amount was presented under the captain
“Accounts Receivable”
b) Used computer equipment, with an estimated useful life of 5 years and no salvage
value, was purchased early in the current fiscal year for Birr 150,000. Since the
company planned to purchase new equipment, costing Birr 250.000, to replace this
equipment at the end of five years, depreciation expense of Birr 50,000 was recorded
for the current year. The depreciation expense thus provided for one fifth of the cost of
the replacement.
c) All minor expenditures for office equipment are charged to an expense account.
d) Merchandise transferred to other parties on a consignment basis and not sold was
included in merchandise inventory.
e) Land, used as a parking lot, was purchased 10 years ago for Birr 50,000. Since its
market value is now Birr 90,000, the land account is debited for Birr 40,000 and a gain
account is credited for a like amount. The gain is presented as an “other income” item
in the income statement.
f) Thirty days before the end of the current year, sales catalogs were acquired for birr
45,000. Although the catalogs are not salable the unused portion is included as an asset
in the balance sheet at the end of the year.
g) Merchandise inventory at the end of the current year was estimated by the general
manager, who “eye balled”, the inventory on hand and then determined its cost, based
on the estimate of current costs. The accountant used the general manager’s estimate
for recording the cost of the inventory in the accounts.
h) Financial statements adjusted to eliminate the effects of inflation (using the current
cost method) were presented as supplementary financial data.
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Company.
Company.
Inc.
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UNIT EIGHT: ACCOUNTING FOR PARTNERSHIP
Unit Contents
 Unit Objectives
 Introduction
8.1 Partnerships and their Characteristics
8.2 Advantages and Disadvantages of a Partnership
8.3 The Partnership Agreement
8.4 Formation of Partnership
8.5 Methods of Distributing Partnership Income or Loss
8.6 Withdrawals by Partners in the Partnership
8.7 Financial Statement for a Partnership
8.8 Dissolution of a Partnership
8.9 Liquidation of a Partnership
Chapter Objectives
After studying this unit, you should be able to:
 Understand the meaning of partnerships & their characteristics
 Describe the advantages & disadvantage of partnership
 Explain the accounting entries for the formation of a partnership
 Identify the methods for distributing net income or net loss
 Describe the formation of financial statement for partnership.
 Describe the accounting treatment, when partnership dissolves.
 Describe the accounting treatment for liquidation of partnership.
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Introduction
Dear students, in the last unit you have discussed about the accounting for disposal of plant
assets. In this unit, you will discuss in detail about the accounting for partnership business,
one of the dominant forms of business ownership. Dear students, have you heard of about
partnership business? If so, what type of business is it? What differentiates a partnership
business from other forms of business establishments like sole proprietorship and corporate
forms? Give your answer in writing before you read the discussion below.
The form of business organizations are three types, viz., Sole proprietorship, Partnership and
Corporation. Partnership is one form of business organization. A partnership is a form of
business ownership formed by two or more persons as co-owners of business for profit.
Partnership business is suitable for small scale businesses where the investment in business is
low compare to corporation. This business is suitable for professions like, law firm, accounting
firm, medicine etc.
8.1 Partnerships and their Characteristics
According to the Uniform Partnership Act, Partnership as ‘an association of two or more
persons to carry on, as co-owners, a business for profits’
Partnerships have several characteristics that have accounting implications. These characteristics
are described below.
A) Ease of Formation: In contrast to a corporation, a partnership may be created by an oral or
written contract between two or more persons. This is more convenient for forming business
organization.
B) Limited Life: A partnership has a limited life. The partnership may goes out of business by
the withdrawal, bankruptcy, incapacity or death of one or more of its partners. Similarly, the
admission of new partner to the partnership dissolves (ends) the old partnership and
establishes new partnership. Dissolution refers changes in ownership in the partnership.
C) Unlimited Liability: Each partner is personally and individually liable for all partnership
liability. If the partnership becomes insolvent and the partnership assets are not sufficient for
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partnership liabilities (creditors), the partners must contribute (unlimited) sufficient personal
assets to settle the debt of the partnership.
D) Co-Ownership of Partnership property: The property invested in partnership by a partner
becomes the property of all partners jointly. Up on dissolution of the partnership, distribution
of assets to the partners is based on their capital account balances.
E) Mutual Agency: Mutual agency means that each partner acts as an agent of the partnership,
with the authority to enter in to contracts for the partnership. That is,. each partner has
authority to participate in management operations of the partnership business. Thus, the act
of each partner binds the partnership and becomes the responsibility of the all partners.
F) Participation in Income: A significant right of partner is participation in income and
according to their agreement. If there is no agreement between partners for distribution of
income and loss, which means, if partnership is silent on the method of income or loss
distribution, they shared income and loss equally.
G) Non-taxable entity: The partnership (as entity) is not required to pay tax on income to
Federal or State governments. However, the individual partners must report their share of
partnership income on their personal tax returns.
1. The owner in a partnership is called __________________________________.

2. Do you think that the Partnership agreement is based on orally or in writing? Why?
3. List out the characteristics of a partnership.
8.2 Advantages and Disadvantages of a Partnership
The partnership form of business ownership has several advantages and disadvantages.
Advantages of a partnership are:
 It is relatively easy and less expensive to organize, requiring only an agreement

between two or more persons.
 As if two or more persons involved, the formation of capital and managerial skills are
more than would a sole proprietorship.
 The partnership business is non-taxable entity.
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 It is relatively free from Government regulations.
 Ownership and management remain the same, in the case of a corporation it is
different case.
The Disadvantages of partnership are:
 It has limited life
 Each partner has unlimited liability
 One partner can bind partnership to contracts.
 It is difficult to raise more capital compared to corporation.
8.3 The Partnership Agreement

A partnership is created by a contract expressing the voluntary agreement of two or more
individuals by written or oral agreement. The written agreement, often referred to as the
partnership agreement or Articles of Co-Partnership contains such basic information as;
 The name and principal location of the firm
 The date of the business formed
 The purpose of the business
 Capital contributions of partners
 Rights and duties of partners
 Provisions for withdrawals of assets
 Rights and duties of surviving partners in the event of partner’s death, etc.
8.4 Formation of Partnership
The accounting for a partnership is the same as the accounting for any other form of business
organization. The chart of account of partnership is similar to sole proprietorship business except
Drawing and Capital accounts for each partner. The formation, income distribution, Dissolution
and Liquidation of partnership are common transactions.
8.4.1 Recording Investment

A separate entry is required for the original investment of each partner in a partnership. The
various original assets (Cash or other Assets) contributed by a partner are debited to the proper
assets accounts. Assets other than cash invested in a partnership should be recorded at their fair
market values of the assets at the date of their transfer to the partnership. All of the partners must
agree on the values assigned. Any liability assumed by the partnership is recorded as credits to
the appropriate liability account. The partners’ capital accounts should be credited for the net
amount (excess of assets over liabilities).
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Illustration 1: Recording Initial Investment of Partners
Assume that Alemu & Biya, who are sole owners of competing hardware stores; agree to
combine their business in a partnership named as Alemu & Biya partnership business. Each
partner is contributed the following assets and liabilities:
Alemu Biya
Book Market Book Market
Cash Br. 16,000 Br 16,000 Br 15,000 Br 15,000
Accounts Receivable 7,000 7,000 7,000 7,000
Merchandise inventory 4,000 4,500 6,000 5,000
Store equipment 5,000 4,000 7,000 6,500
Allowances for doubtful accounts (500) (500) (300) (300)
Accounts Payable (3.000) (3,000) (4,000) (4,000)
Required: Prepare journal entry to record the investments.
Solution:
i) To record the investment of Alemu:
Cash………………………………………………. 16,000
Accounts Receivable…………………………….. 7,000
Merchandise inventory…………………………… 4,000
Store Equipment…………………………………. 4,500
Allowances for doubtful accounts……………. 500
Accounts Payable…………………………….. 3,000
Alemu, Capital……………………………….. 28,000
ii) To record the investment of Biya:
Cash ……………………………………………….. 15,000
Accounts Receivable……………………………..… 8,000
Merchandise inventory……………………………… 5,000
Store Equipment……………………………………. 6,500
Allowances for doubtful accounts…................... 300
Account Payable ………………………………. 4,000
Biya Capital……………………………………. 30,200
Note that the accounts receivables contributed to the partnership by the partners are recorded at
their market value. The credit of Br. 500 and Br 300 to allowances for doubtful accounts is the
provision for possible future uncollectibility of the accounts receivable contributed to partnership
by Alemu and Biya.
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1. List out the advantages and disadvantages of a partnership business
____________________________________________________________________________
____________________________________________________________________________
___________________________________________________________________
2. Partners' initial investments other than cash are valued with_____________________
3. Partners' contribution in the partnership credited with__________________________
8.5 Methods of Distributing Partnership Income or Loss
The Equity of a partner in the net assets of partnership should be distinguished from a partner’s
share in earning. If each of two partners were to contribute equal services and amount of capital
and equal sharing in partnership net income would be equitable. (Or) If the partnership
agreement failed to specify the basis of sharing net income or loss, it is assumed that they will
share equally. However, if one partner is to contribute a larger portion of capital than the other
does, provision for unequal capital contributions should given recognition in the agreement for
dividing net income. Alternatively, if services of one partner are much more valuable to the
partnership than those of the other, provision for unequal service contributions should be given
recognition in their agreement.
8.5.1 Distribution of Income based on some fixed ratio or equally

Illustration 2: Alex & Biya partnership business that had net income of Br 50,000 for the year
ended December 31, 2001. The partners agreed to share net income or loss in the ratio 2:3.
Required: a) Compute the share of net income for each partner.
b) Prepare the journal entry to record the share of net income.
Solution:
a) Share of Net income: Partner Alex = Br. 50,000 x 2/5= Br.20, 000
Partner Biya = Br. 50,000 x 3/5 = Br.30, 000
b) After the share of net income, it will be transferred to partners’ respective capital accounts
and its closes income summary account as:
Income Summary …………………………….. 50,000
Alex Capital…………………………………… 20,000
Biya Capital…………………………………… 30,000
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Continuing with the previous illustration, assume that the partnership is silent on the method
of sharing net income or net loss.
Solution:
If the partnership agreement is silent on the method of income distribution between the two
partners, Alex and Biya partners are going to share equally as;
a) Share of Net Income: Partner Alex = Br.25, 000

Partner Biya = Br. 25,000
b) After the share of net income, each partner’s share of net income should be transferred
to the respective capital accounts & it closes the income summary account as follows:
Income summary ……………………………… 50,000
Alex Capital……………………………. 25,000
Biya Capital……………………………. 25,000
8.5.2 Distribution of Income Based on the Ratio of Partners’ Capital Account Balance at
the Beginning and Ending of the Period
Illustration 3: Suppose Jemal & Hamdu have capital balance in the year 2001 as follows:
Jemal Hamdu
Capital balance as on January 1, 2001 Br. 60,000 Br 40,000
Capital balance as on December 31, 2001 65,000 35,000
The net income of the partnership is Br. 50,000 for the year 2001.
Required: Compute the share of net income for Jemal & Hamdu under the following conditions,
if
a) Jameal & Hamdu agree to share net income or loss on the basis of Beginning capital
account balances
b) Jemal & Hamdu agree to share net income or loss based on ending capital account
balances.
Solution:
a) Jemal and Hamdu shares net income based on Beginning Capital account balances:
 Beginning Capital Balances of Jemal & Hamdu = 60,000 + 40,000 = Br 100,000
 Net income of the partnership= Br 50,000
 Share of net income for Jemal= Br.50,000 x 60,000/100,000= Br.30,000
 Share of Net Income for Hamdu= Br.50,000 x 60,000/100,000= Br. 20,000
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Journal entry to record partners’ share of net income and to close the income summary account
would be:
Income Summary…………………………….. 50,000
Jemal Capital ……………………….... 30,000
Hamdu Capital………………………... 20,000
b) Jemal and Hamdu shares net income based on Ending Capital account balances
 Ending Capital Balances of Jemal & Hamdu = 65,000 + 35,000 = Br 100,000
 Net income of the partnership = Br 50,000
 Share of net income for Jemal = Br.50,000 x 65,000/100,000= Br.32,500
 Share of Net Income for Hamdu = Br.50,000 x 60,000/100,000= Br. 17,500
Journal entry to record partners’ share of net income and to close the income summary account
would be as follows:
Income Summary……………………………… 50,000
Jemal Capital …………………………. 32,500
Hamdu Capital………………………… 17,500
8.5.3 Distribution of Income based on Salaries Allowed to Partners (for Services) and the
Remaining Net Income or Net Loss Divided in the Specified Ratio.
Salaries and drawing are not the same thing, because the term ‘ Salaries’ suggests weekly or
monthly cash payments for personal services that are recognized as operating expenses by the
partnership for measuring net income or loss. The term ‘Drawings’ in only one sense: a
withdrawal of cash or other assets that reduces the partner’s equity but has no part in the division
of net income.
Illustration 4:
Samuel & Tofiq partnership contract provides annul salary allowance for Samuel Br.100, 000
and Tofiq Br. 60,000 respectively. The net income for the year is Br.300, 000. Assume that the
salaries are paid monthly during the year.
Required: Compute the share of net income for each partner.
Solution:
Samuel Tofiq Total
Salary allowance (for 12 months) Br100, 000 Br 60,000 Br 160,000
Remaining net income
(300,000—160,000) divide equally 70,000 70,000 140,000
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Journal entry to record partners’ share of net income and to close income summary account:
Income Summary ……………………………….. 300,000
Samuel, Capital ………………………….. 170,000
Tofiq, Capital ……………………………. 130,000
8.5.4 Income Division Recognizing Services of Partners and Investment

This plan of sharing net income or loss is more appropriate as, it recognizes services provided by
the partner and different amount of capital contributed by each partner.
Partners may agree that the most equitable plan of income sharing to allow salaries based on the
services rendered and to allow interest on the capital investments and the remainder then shared
in some other ratio.
Illustration 5:
Sultan and Tilahun partnership contract provides, that Sultan and Tilhanu (i) have monthly
salaries of Br. 2,500 and Br. 2,000 respectively; (ii) are allowed interest at 12% on their capital
balances at January 1 of the current fiscal year, which amounted to Br. 80,000 and Br. 60,000
respectively; and (iii) divide the remainder of net income equally. The partnership generated net
income for the year is Br. 75,000.
Required: Divide the above net income for Partners of Sultan & Tilahun for the year.
Solution:
Net income………………………………………….. Br.75, 000
Division of Net Income:
Sultan Tilhanu Total
Salary allowances…. (for 12 months)...… Br 30,000 Br 24,000 Br 54,000
Interest allowances……………………… 9,600 7,200 16,800
Remaining income—(share equally) … 2,100 2,100 4,200
Net income……………………………… Br 41,700 Br 33,300 Br 75,000
8.5.5 Income Division—Allowances Exceeds Net Income
Illustration 6: Assume the above illustration continuous, and the partnership generated net
income for the year is Br. 50,000.
Required: Divide the above net income for partners of Sultan & Tilahun for the year.
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Solution:
Net income ………………………………………. Br.50, 000
Division of Net income:
Sultan Tilahun Total
Salary allowances---- (for 12 months) ------ Br 30,000 Br 24,000 Br 54,000
Interest allowances---------------------------- 9,600 7,200 16,800
Total--------------------------------------------- 39,600 31,200 70,800
Excess of allowance over income (loss) (10,400) (10,400) (20,800)
Net income--------------------------------------- 29,200 20,800 50,000
8.6 Withdrawals by Partners in the Partnership
It refers taking out the cash or other assets from the partnership business. Partners generally
make withdrawals of assets from the partnership during the year in anticipation of salary or
profits. A separate drawing account often is used to record the period’s withdrawals and is then
closed to the partner’s capital account at the end of the period.
For example, the following entry is in the Alemu& Biya made partnership’s books for Br. 3000
cash withdrawal by Biya on May 1, 2001:
Biya Drawing ………………………………. 3,000
Cash ………………………………… 3,000
At the end of the year Biya’s drawing account closes with Biya capital account as;
Biya capital ………………………………… 3,000
Biya Drawings ……………………… 3,000

1. Alex and Biya have capital balances of Br 40,000 and Br 60,000, respectively, in a
Partnership. The partnership agreement indicates that the net income or net loss should be
shared equally. If the net come for a partnership is Br 20,000, how should the net income be
divided? Prepare the entry to record the division of net income.
__________________________________________________________________________
__________________________________________________________________________
________________________________________________________________
2. Chali and Mulluneh, currently formed a partnership, investing Br 50,000 and Br 100,000
respectively. Determine their participation in the year's net income of Br 60,000 under each
of the following assumptions: A) No agreement concerning division of net income. B)
Divided in the ratio of original capital investment; C) Interest at the rate of 12% allowed on
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15,000 and 30,000 respectively, and the balance divided equally; D) Allowances of interest
at the rate of 12% on original investments, salary allowances of Br 15,000 and Br 30,000
respectively, and the remainder divided equally.
__________________________________________________________________________
__________________________________________________________________________
_________________________________________________________________
8.7 Financial Statement for a Partnership
A partnership is a separate reporting entity for accounting purpose, and three financial statements
—Income statement, Balance sheet and Statement of cash flow—typically are prepared for the
partnership at the end of each reporting period. The financial statements for a partnership are
similar to those of a sole proprietorship. In addition to the three basic financial statements, a
detailed of the changes in the owner’s equity of a partnership during the period should also be
presented in a Statement of owners’ equity. The purposes of this statement and the data
included in it correspond to those of the statement of owner’s equity for a sole proprietorship.
Illustration 7:
The capital accounts of Ayele and Betel have balance of Br 50,000 and Br. 70,000 respectively
on January 1, 2001, the beginning of the current fiscal year. On March 1, Betel invested
additional Br. 15,000 during the year. Ayele and Betel withdrew Br. 36,000 and Br. 30,000
respectively, and net income for the year was Br. 90,000. Both partners are going to share net
income or loss in the ratio of 2:1.
Required: Prepare a statement of owner equity for the current year.

Solution:
 Total net income for year: Br 90,000
 Share of net income in the ratio of 2:1 as
Partner Ayele: Br. 90,000 x 2/3 = Br. 60,000
Partner Betel Br. 90,000 x 1/3 = Br. 30,000
Statement of owner equity as:
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Ayele and Betel Partnership
Statement of Owner’s Equity
For the year ended December 31, 2001.
Ayele Betel Total
Capital, January 1, 2001……………… Br 50,000 Br 70,000 Br 120,000
Additional investment during the year _____ 15,000 15,000
Sub total Br 50,000 Br 85,000 Br 135,000
Net income for the year (2:1 above) 60,000 30,000 90,000
Br 110,000 Br 115,000 Br 225,000
Withdrawals during the year 36,000 30,000 66,000

Capital, December 31, 2001 Br 74,000 Br 85,000 Br 159,000
8.8 Dissolution of a Partnership

One of the basic characteristic of the partnership from of organization is its limited it its limited
life. Any change in the personnel of the ownership results in the dissolution of the partnership.
The admission of a new partner dissolves the old firm. Similarly, death, bankruptcy, or
withdrawal of a partner causes dissolution. Dissolution of the partnership is not necessarily
followed by the winding up of the affairs of the business. When a partnership is dissolved, a new
partnership may be formed and the new article of partnership should be prepared. The changes in
the personal ownership (dissolution) are the result of the following:
8.8.1 Admission of a Partner

An additional person may be admitted to a partnership enterprise only with the consent of all the
current partners. Under common law if a partner’s interest was transferred, the partnership was
automatically dissolved. Under the Uniform Partnership Act, a partner’s capital interest cannot
be transferred without the consent of the remaining partners.
 An additional person may be admitted to a partnership through either of two procedures:

a) By purchase of an interest from one or more of the current partners
b) By contribution of assets to the partnership.
a) Admission of a new partner by purchasing capital interest from one or more of the
existing partners
When an additional person is admitted to a firm by purchasing an interest from one or more of
the partners, the purchase price is paid directly to the selling partners. It is a personal transaction
between the buying partner and selling partner. Due to this neither the total assets nor the total
owner’s equity of the business is affected.
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Hence, the purchasing interest is personal transaction and the only entry needed in the book of
the partnership is the transfer of the proper amounts of owner’s equity from the capital accounts
of the selling partners to the capital account established for the incoming (new) partner. The
selling partner or partners’ capital account balances are debited and purchasing partner or
partners’ capital account balances are credited
Illustration 9: Assume that partners Tezera & Umer have capital balance of Br. 50,000 each (a
total Br. 100,000) on June 1. Each sells one-fifth (1/5) of his respective equity to Solomon for
Br. 10,000 in cash.
Required:
(i) Prepare journal entry to record the admission of Solomon
(ii) Compute the total capital of the partnership after admission.
Solution:
(i) Journal entry:
June 1 Tezera Capital (1/5 th ) ……………. 10,000
Umer Capital ( 1/5 th)……………. 10,000
Solomon Capital …………….. 20,000
(ii) Total capital of the partnership after admission of Solomon:

Solomon Capital ………………………………………….. Br. 20,000
Tezera Capital ( 50,000—10,000 )....................................... 40,000
Umer Capital ( 50,000—10,000).......................................... 40,000
Total Capital …………………………………................... Br 100,000
Note that the total capital of the partnership is remained unchanged, as Br. 100,000 remain same.
Only the change is that old partners decreased capital interest (selling partners), and their capital
balances are adjusted with new partner Solomon.
b) Admission by contribution of assets in a partnership

Instead of buying an interest from the current partners, the incoming partner may contribute
assets to the partnership. In this case, both the total assets and the total owner’s equity of the
partnership business are increased. The investment by the new partner may be cash, equipment,
furniture, stock, or other assets. If the partners contribute assets to the partnership other than
cash, those assets valued with market value.
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Illustration 10: Assume Dawit and Elias are partners, share net income or loss equally and that
each has a capital account balance of Br. 60,000. Assume also that the carrying amounts of
partnership assets are approximately equal to current fair values. On June 1, Fikadu invests own
land that had a cost of Br. 30,000 and Br. 20,000 cash. Dawit and Elias agree to admit Fikadu to
the partnership by investment of land and cash; net income and losses of the new partnership are
to be shared equally. The land has a market value of Br. 40,000.
Required:
1. Compute the partnership total capital before admission of Fikadu
2. Prepare the entry to record Fikadu’s admission.
3. Determine total capital of the partnership after admission.
Solution:
1. Partnership capital before admission of Fikadu
Dawit Capital ……………………………… Br. 60,000
Elias Capital ……………………………….. 60,000
Total Capital ………………………………. Br. 120,000
2. Computation of Fikadu’s investment in the partnership:
Cash ……………………………………….. Br. 20,000
Land (Market value) ……………………… Br. 40,000
Total investment of assets ………………… Br. 60,000
Note that new partner assets other than cash are valued recognized at current market value.
Entry to record admission of Fikadu would be:
Cash ………………………………… 20,000
Land ………………………………… 40,000
Fikadu Capital ……………….. 60,000
3. Computation total capital of the partnership after admission of Fikadu:
Dawit Capital …………………………….. Br. 60,000
Elias Capital ……………………………… 60,000
Fikadu Capital ……………………………. 60,000
Total Capital ……………………………… Br.180, 000
At the time of admitting new partner, the partnership assets should be re-valued with current
market values and adjusted to existing partners capital balances in their income sharing ratio, if
there is any difference between cost and market value of the existing
partnership's assets and liabilities.
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Illustration 11: Assume Siraj and Tilahun are partners, share net income or loss equally. Each
has a capital account balance of Br. 50,000. Assume also that the carrying amounts of
partnership assets are approximately equal to current fair values. On June 1, Umer invests Br.
50,000 cash. Siraj and Tilahun agreed to admit Umer. Assume that the balance of land account
had been Br. 70,000 before Umer’s admission and its current market value is Br. 90,000.
Required:
a) Determine total capital of old partnership before dissolution.
b) Prepare the entry to record the adjusted capital account balances after revaluation
of assets.
Solution:
a) Siraj Cpaital ……………………………………… Br. 50,000
Tilahun Capital …………………………………… 50,000
Total capital ………………………………………. Br 100,000
b) Entry to record asset revolution and adjusted capital balances
Increase in land value = 90,000 – 70,000 = Br 20,000
Share equally to both partners as:
To Siraj …………………… Br. 10,000
To Tilahun ………………... Br. 10,000
Journal entry:
Land ……………………………………… 20,000
Siraj Capital ………………………. 10,000
Tilahun Capital ……………………. 10,000
Goodwill
When a new partner is admitted to a partnership, goodwill attributable either to the old partners
or to the incoming partner may be recognized. Although there are various methods of estimating
goodwill, bargaining abilities of the partners will influence the final determination. The amount
of goodwill agreed upon is recorded as an asset, with a corresponding credit to the appropriate
capital accounts.
Goodwill to old Partners

Illustration 12: Assume that on March 1 the partnership of Hamdu & Jemal admitted Israel,
who is to contribute cash of Br. 15,000. After the tangible assets of the old partnership have been
adjusted to current market prices, the capital balances of Hamdu & Jemal are Br. 20,000 and Br.
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24,000 respectively and both partners were sharing equally. Israel & old partners agree, however,
the enterprise is worth of Br. 65,000 after his admission.
Required:
1. Compute the capital investment of the partners after the admission of Israel.
2. Compute the amount of goodwill recognized.
3. Prepare journal entry for admission of Israel.
Solution:
1. Computation of total original investment:
Hamdu capital……………………………… Br. 20,000
Jemal Capital………………………………. 24,000
Israel investment (Cash)…………………… 15,000
Total investment-------------------------------- Br 59,000
2. Computation of the amount of goodwill recognized:
Net worth of the business enterprise ………. Br. 65,000
Original capital invested by partners ………. 59,000
Amount of goodwill recognized …………… Br. 6,000
Note that net worth means, the amount of capital that are available to the partners after paying
liabilities. (Assets = Liabilities + Capital or Net Assets = Capital or net worth).
3. Journal entry to record the admission of Israel to the partnership:

Cash …………………………………. 15,000
Israel capital………………….. 15,000
Goodwill is treated as intangible asset. Goodwill increases the total assets of the partnership by
Br.6000, shared by Hamdu & Jemal equally, and credited to their respective capital balances as
shown below
March 1. Goodwill …………………………… 6,000
Hamdu Capital ………………... 3,000
Jemal Capital ………………….. 3,000
Goodwill to New [or Incoming] Partner

If a partnership admits a new partner who is expected to improve the earnings of the firm in
future, the parties might agree to recognize this high earnings potential as goodwill to the new
partner.
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Illustration 13: Assume that Chemda is to be admitted to the partnership of Alemu and Birhanu
for an investment of Br.30,000 cash. Even though Chemeda contributed Birr 30,000 to the
partnership, Alemu and Birhanu agreed to provide him a capital balance of Br 35,000.
Required: 1. Compute the amount of goodwill recognized for Chemda

2. Pass the necessary journal entry for the admission of Chemeda.
Solution:
1. Chemeda Capital in the partnership……………………. Br. 35,000
Chemeda’s Contribution (cash)…………………… ……. 30,000
Goodwill recognized for Chemeda …………………… Br. 5,000
2. Cash ………………………………………. 30,000
Goodwill ………………………………….. 5,000
Chemeda Capital …………………… 35,000
۞ Note that goodwill recognized and recorded as asset (intangible).
1. Hiwot & Getachew shares income on a 3:2 basis. They have capital balances of Br 30,000 &
Br 40,000 respectively, when Israel is admitted to the partnership.
Prepare journal entry to record the admission of Israel under each of the following
assumptions:
a) Purchased of one-half of Hiwot's equity for Br 25,000
b) Purchased one-half of Getachew’s equity for Br 18,000
____________________________________________________________________________
____________________________________________________________________________
___________________________________________________________________
2. Jemal and Anwar share income on a 3:2 basis. They have capital balances of Br 45,000 and Br
35,000, respectively, when Biya is admitted to the partnership.
Prepare journal entry to record the admission of Biya under each of the following
assumptions:
a) Investment of Br 40,000 cash for a one-fourth ownership interest with bonuses to the
existing partners.
b) Investment of Br 20,000 cash for a one-fourth ownership interest with a bonus to the new
partner.
__________________________________________________________________________
__________________________________________________________________________
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8.6.2 Withdrawal of a Partner
A partner may withdraw from a partnership voluntarily by selling his or her equity in the firm or
involuntarily by reaching mandatory retirement age or dying. The withdrawal of a partner, like
the admission of a partner, legally dissolves the partnership. The legal effects may be recognized
in accounting for a withdrawal by dissolving the firm. However, it is customary to record only
the economic effects. As indicated earlier, the partnership agreement should specify the terms of
withdrawal. The withdrawal of a partner may be accomplished by:
(1) Payment from partner’s personal assets or
(2) Payment from partnership assets
(1) Payment from Partner’s Personal Assets
when a partner retires or for some other reason wishes to withdraw form the firm, one or more of
the remaining partners may purchase the withdrawing partner’s interest and the business may be
continued without apparent interruption. In such case, settlement for the purchase and sales is
made between the partners as individuals, in a manner similar to the admission of a new partner
by purchase of an interest, and thus is not recorded by the partnership. The only entry required
by the partnership is debit to the capital account of the partner withdrawing and a credit to the
capital account of the partner or partners acquiring the interest.
Illustration 14: Amanuel, Belachew & Chemeda have capital balances of Br 50,000, Br 60,000
and Br 45,000 respectively. Assume further that Belachew decided to withdraw from the
partnership, and Amanual and Chemeda agreed to buy Belachew's ownership equity in the
partnership. Each of them agreed to pay Belachew Br 35,000 in exchange for one-half of
Belachew's ownership interest of Br 60,000.
Required:
a. Compute the total capital before Belachew's withdrawal.
b. Prepare the entry to record Belachew's withdrawal
c. Determine the capital balance of each partner and total capital after Belachew's
withdrawal.
Solution:
a) Total Capital before withdrawals:
Amanual capital…………………………….. Br 50,000
Belachew Capital …………………………… 60,000
Chemda Capital …………………………….. 45,000
Total Capital ………………………………… 155,000
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b) The entry to record the withdrawal of Belachew from the partnership:
Belachew capital ……………………………. 60,000
Amanual capital ………………………. 30,000
Chemda capital ……………………….. 30,000
c) Capital balances of each partner and total capital of the partnership after withdrawal of
Belachew:
Amanual capital (50,000 + 30,000) …………... Br 80,000
Chemeda Capital (45,000 + 30,000) ………….. 75,000
Total Capital …………………………………... Br 155,000
When the partner or partners with draw by payment from partnership assets, the effect is to
reduce the assets and the owner’s of the firm. To determine the ownership equity of the
withdrawing partner, the asset accounts should be adjusted to current market prices. The net
amount of the adjustments should be divided among the capital accounts of the partners
according to the income- sharing ratio. In the event that the cash or the other available assets are
insufficient to make complete payment at the time of withdrawal, a liability account should be
credited for the balance owned to the withdrawing partner.

1. Shiran, Tilahun & Umer have capital balances of Br 50,000, Br 30,000 and Br 24,000
respectively, and their income sharing ratios are 5:3:2. Umer withdraws from the partnership
under each of the following independent conditions:
(a) Shiran Tilahun agreed to purchase Umer’s equity by paying Br 15,000 each from their
personal assets. Each of them receives 50% of Umer's equity.
(b) Tilahun agreed to purchase all of Umer's equity by paying Br 20,000 cash from his
personal assets.
Required: Prepare journal entries for the withdrawal of Umer under each of the
above.
_________________________________________________________________________
_________________________________________________________________________
_________________________________________________________________________
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8.6.3 Death of a Partner
The death of a partner dissolves the partnership, but provision generally is made for the surviving
partners to continue operations. When a partner dies, it usually is necessary to determine the
partner’s equity at the date of the death as;
(i) Determine the net income or loss for the year to date,
(ii) Closing the books, and
(iii) preparing financial statements
The surviving partners may agree either to: (i) Purchase the deceased partner’s equity from their
personal assets or (ii) use partnership assets to settle with deceased partner’s estate.
8.7 Liquidation of a Partnership
The Liquidation of a partnership terminates the business. When a partnership goes out of
business, it usually sells the assets, pays the creditors, and distributes the remaining cash or other
assets to the partners according their claims. The winding up process may be generally termed as
Liquidation.
When ordinary business activities are discontinued as the partnership goes out of business, the
accounts should be adjusted and closed according to the customary procedures of the periodic
summary. The only accounts remaining open then will be the various assets, contra assets,
liabilities, and owner equity accounts.
The sale of noncash assets for cash is called realization, and the difference between book value
and the cash proceeds is called the gain or loss on realization. As the cash is realized, it is
applied first to the payment of the claims of creditors. After all liabilities have been paid, the
remaining cash is distributed to the partners, based on their ownership equities as indicated by
their capital accounts in the partnership business.
If the assets are sold in installment basis, the cash realization on assets also installment receipts,
the liquidation process may extend over a considerable period of time. This situation creates no
special problem; however, the distribution of cash to the partners is delayed until all of the assets
have been sold. These situations are illustrated below:
Case 1: Gain on Realization

Illustration: Fikadu, Girma & Hailu shares income and losses in a ratio of 5:3:2 (5/10, 3/10,
2/10. On April 9, after discontinuing the ordinary business operations of their partnership and
closing the accounts, the following summary of the general ledger is prepared:
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Cash ……………………………………… Br 11,000
Non-cash assets ………………………….. 64,000
Liabilities ………………………………… Br 9,000
Fiakdu Capital…………………………….. 22,000
Giram Capital …………………………….. 22,000
Hailu Capital ……………………………… 22,000
Total……………………………………….. 75,000 Br 75,000
Between April 10 and April 30 of the current year, Fikadu , Girma & Hailu sell all noncash
assets for Br. 72,000, realizing gain of Br. 8,000 (Br 72,000 — Br 64,000).
Required:
1. Prepare statement of partnership liquidation.
2. Prepare the entry to record transactions in the liquidation process.
Solution: 1) Statement of Partnership Liquidation;
Fikadu, Girma & Hailu

Statement of Partnership Liquidation
For the period April 10th to 30th, 2001
Assets = Liabilities + Capital _
Cash + Noncash Fikadu + Girma + Hailu
[50%] [30%] [20%]
Balances before realization Br 11,000 Br 64,000 Br 9,000 Br 22,000 Br 22,000 Br 22,000
Sale of non cash assets and
division of gain Br 8.000 +72,000 -64,000 ------ +4,000 +2,400 +1,600
Balances after realization Br 83,000 0 Br 9,000 Br 26,000 Br 24,400 Br 23,600
Payment of liabilities - 9,000 - 9,000 , --- --- -------
Balances after payment

of liabilities Br 74,000 0 0 Br 26,000 Br 24,400 Br 23,600
Distribution of cash
to partners Br -74,000 ------ ----_ - 26,000 - 24,400 - 23,600
Final balances 0 0 0__ 0 _ 0___ 0___
The statement of partnership liquidation is organized around the basic accounting equation. The
gain of Br.8,000 on sale of non cash assets ( Br 72,000 – Br 64,000) is distributed and credited
to (+) all partners in their income sharing ratio as; Gain to
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Fikadu = Br. 8,000 x 5/10 = Br 4,000
Girma = Br. 8,000 x 3/10 = Br 2,400
Hailu = Br. 8,000 x 2/10 = Br 1,600
After cash is realized from the sale of non-cash assets, first, it is applied for the payment of
liabilities; the remaining amount is distributed to the partners according to the balances (credit)
in their capital accounts.
2. Entries to records the transactions in the liquidation:
a) Sale of Assets and Recognition of Gain on Realization:
Cash…………………………………….. 72,000
Noncash Assets………………… 64,000
Loss or Gain on Realization……. 8,000
b) Entry to Record the Division of Gain on Realization to the Partners:
Loss and Gain on Realization ……………………. 8,000
Fikadu Capital ……………………............. 4,000
Girma Capital …………………………….. 2,400
Hailu Capital …………………………….. 1,600
c) Entry to Record the Payment of Liabilities:
Liabilities …………………………………………. 9,000
Cash ………………………………………. 9,000
d) Entry to Record Distribution of Cash to Partners According to the Balances in their
Capital Accounts:
Fikadu Capital ……………………………………. 26,000
Girma Capital …………………………………….. 24,400
Hailu Capital ……………………………………… 23,600
Cash ………………………………………. 74,000
Case 2: Loss on Realization; No Capital Deficit
Illustration: Fikadu, Girma & Hailu shared income and losses in the ratio of 5:3:2 [5/10, 3/10,
2/10]. On April 9, after discontinuing the ordinary business operations of their partnership and
closing the accounts, the following summary of the general ledger is prepared:
Cash Br 11,000
Non cash assets 64,000
Liabilities Br 9,000
Fiakdu Capital 22,000
Giram Capital 22,000
Hailu Capital __ 22,000
Total Br 75,000 Br 75,000
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Between April 10 and April 30 of the current year, Fikadu , Girma & Hailu sell all noncash
assets for Br. 44,000, incurring a loss of Br. 20,000 (Br 64,000— Br 44,000).
Required:
1. Prepare statement of partnership liquidation.
2. Prepare the entry to record transactions in the liquidation process.
Solution: (1) Statement of Partnership Liquidation;

Assets = Liabilities + Capital___________
Cash + Noncash Liabilities Fikadu + Girma + Hailu
50% 30%_ 20%
Balances before realization Br 11,000 Br 64,000 Br 9,000 Br 22,000 Br 22,000 Br 22,000
division of loss +44,000 -64,000 ------ - 10,000 -6,000 -4,000
Balances after realization Br 55,000 0__ Br 9,000 Br12,000 Br 16,000 Br 18,000
Payment of liabilities - 9,000 0__ -9,000 --- ---_ ---__
of liabilities Br 46,000 0 0 Br 12,000 Br 16,000 Br18,000
to partners - 46,000 _ -- _ --- - 12,000 - 16,000 - 18,000
Final balances 0___ __0 _ 0_-- 0 0 0_
The loss of Br.20,000 on sale of non cash assets ( Br 64,000 – Br 44,000) distributed and
debited to (or deducted from) all partners in their income sharing ratio as; Loss to:
Fikadu = Br. 20,000 x 5/10 = Br 10,000
Girma = Br. 20,000 x 3/10 = 6,000
Hailu = Br.20,000 x 2/10 = 4,000
After realizing cash from non cash assets, first the it is paid to settle liabilities, the remaining
amount is distributed to the partners according to the balances (Credit) in their capital accounts.
(2) Entries to record the transactions in the liquidation:
a) Entry to Record the Sale of Noncash Assets and Realization of Loss:
Cash …………………………………… 44,000
Loss or Gain on Realization ………….. 20,000
Noncash Assets ………………. 64,000
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b) Entry to Record Division of Loss on Realization among the Partners:
Fikadu Capital…………………………….. 10,000
Giram Capital …………………………….. 6,000
Hailu Capital……………………………… 4,000
Loss and gain on realization ……… 20,000
Liabilities …………………………………. 9,000
Cash ………………………………. 9,000
d) Entry to Record Distribution of cash to the Partners According to their Capital Balances:
Fikadu Capital ……………………………. 12,000
Girma Capital …………………………….. 16,400
Hailu Capital ……………………………… 18,000
Cash ………………………………. 46,000
.
Case 3: Loss on Realization; Capital Deficiency
In the above example, the capital account of each partner was more than sufficient to absorb the
appropriate share of the loss from realization. The partners shared in the distribution of cash to
the extent of the remaining credit balance (positive) in their respective capital accounts.
However, the share of the loss chargeable to a partner may be such that it exceeds that partner’s
equity. The resulting debit balance in the capital account, called a Deficiency, is a claim of the
partnership against the partner. Pending collection from deficient partner, the partnership cash
will not be sufficient to pay the other partners in full. In such cases, the available cash should be
distributed in such a manner that, if the claim against the deficient partner cannot be collected,
each of the remaining capital balances will be sufficient to absorb the appropriate share of the
deficiency.
Illustration: Assume that in the above example, Fikadu, Girma & Hailu sell all non cash assets
for Br. 10,000, incurring a loss of Br. 54,000 (Br 64,000—Br 10,000). Prepare a statement of
Realization & Liquidation, and journal entries for the liquidation.
Solution:
Loss from sale of assets: Br. 54,000 allocate to all partners in their income-sharing ratio as
Fiakdu = Br. 54,000 x 5/10 = Br 27,000
Girma = Br. 54,000 x 3/10 = Br 16,200
Hailu = Br. 54,000 x 2/10 = Br 10,800
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______________Capital________________________
Fikadu( 50%) Girma( 30%) Hailu( 20%) Total
Balance before realization Br. 22,000 Br 22,000 Br 22,000 66,000
Division of loss on realization –27,000 – 16,200 – 10,800 – 54,000
Balance after realization –5,000 5,800 11,200 12,000
Division of potential
additional deficiency 5,000 –3,000 – 2,000 ---___
Claims to partnership cash 0 _ 2,800 9,200 12,000
The part of the loss allocable to Fiakadu, Br 27,000 (50% of Br. 54,000), exceeds the Br.22,000
balance in Fikadu’s capital account. This deficiency of Fiakdu is a potential deficiency to Girma
and Hailu and must be temporarily divided between them in their income sharing ratio of 3:2
(3/5 and 2/5). The capital balances remaining represent their claims on the partnership cash.

For the period April 10 to 30th, 2001
Assets = Liabilities + Capital______
[50%] [30%] [20%]
Balances before realization Br 11,000 64,000 9,000 22,000 22,000 22,000
division of loss Br 20.000 +10,000 –64,000 ------ –27,000 –16,000 –10,800
Balances after realization Br 21,000 0 9,000 5,000 (Dr) 5,800 11,200
Payment of liabilities - 9,000 -9,000 --- --- ---__
of liabilities Br 12,000 0 0 5,000(Dr) 5,800 11,200
to partners - 12,000 -- ---_ __ 2,800 – 9,200
Balances 0 0 0_ 5,000(Dr) 3,000 2,000

a) Entry to Record the Sale of Noncash Assets and Realization of Loss:
Cash……………………………………. 10,000
Loss on Gain on Realization …………… 54,000
Noncash Assets ………………… 64,000
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b) Entry to Record Division of Loss on Realization among the Partners in the ratio of 5:3:2
Fikadu Capital ………………………….. 27,000
Giram Capital …………………………… 16,200
Hailu Capital …………………………… 10,800
Loss and gain on realization ……. 54,000
Liabilities ………………………………. 9,000
Cash ……………………………. 9,000
d) Entry to Record Distribution of cash to the Partners According to their Capital Balances:
Girma Capital…………………………… 2,800
Hailu Capital …………………………… 9,200
Cash ……………………………. 12,000
The affairs of the partnership are not completely closed until the claims among the partners are
settled. As you know the partners liability is unlimited, payments to the firm by the deficient
partner are credited to the partner’s capital account. Any uncollectible deficiency becomes a loss
to the partnership and is written off against the capital balances of the remaining partners.
Finally, the cash received from the deficient partner is distributed to the other partners according
to their ownership claims.
Illustration: Assume the above problem continuous,

Assumption 1: Fikadu pays the entire amount of the Br. 5,000 deficiency to the partnership
(no loss).
Solution: The receipt of the Br. 5,000 paid by Fikadu to the partnership and the distribution of
the Br. 5,000 to partners (Girma & Hailu) are indicated in the following statement of
partnership liquidation:
Assets = Liabilities + Capital_______
[50%] [ 30%] [20%]
Balances 0 0 0 5,000(Dr) 3,000 2,000
Receipt of deficiency + 5,000 --- ---- +5,000 --- -__
Balances 5,000 0 0 0 3,000 2,000
Distribution of cash to partners – 5,000 -- ---- ---- -3,000 -2,000
Final balances 0 __0__ 0 0 0 0__
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The entries to record the final settlement are as follows:
a) Entry to record receipt of cash from the deficient partner (i.e., from Fikadu):
Cash …………………………………… 5,000
Fikadu Capital ………………… 5,000
b) Entry to record the distribution of cash to partners Girma & Hailu:
Girama Capital ………………………… 3,000
Hailu Capital ………………………….. 2,000
Cash …………………………… 5,000
After the two transactions above are completed, all of the partnership’s assets will have been
distributed, the liabilities paid, and the partners’ capital balances reduced to Zero.
Assumption 2: Fikadu pays Br. 3,000 of the deficiency to the partnership and the remainder is
considered to be uncollectible (Br. 2,000 loss).
Solution:
Assets = Liabilities + Capital_________
[50%] [ 30%] [ 20%]
Balances 0 0 0 Br 5,000(Dr) Br 3,000 Br 2,000
Receipt of deficiency + 3,000 --- ---- +3,000 --- ---
Balances 3,000 0 0 2,000(Dr) 3,000 2,000
Distribution of cash to partners – 3,000 ---- --- ---- – 1,800 –1,200
Final balances 0__ __0__ 0_ 0 0 0
It should be noted that the Br.2,000 loss was divided between Girma and Hailu in their income
sharing ratio of 3:2 ( 3/5 and 2/5).
The entries to record the final settlement are as follows;

a) Entry to record the receipt of cash from the deficient partner (i.e., from Fikadu):
Cash ……………………………………. 3,000
Fikadu Capital …………………. 3,000
b) Entry to record the division of loss to the remaining partners of Girma and Hailu in their income sharing
ratio of 3:2
Girama Capital …………………………. 1,200
Hailu Capital …………………………… 800
Fiakdu Capital …………………. 2,000
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c) Entry to record distribution of cash to partners (i.e., Girma and Hailu) as per their capital interest in the
business:
Girma Capital ………………………….. 1,800
Hailu Capital …………………………… 1,200
Cash ……………………………. 3,000
After the two transactions above are completed, all of the partnership’s assets will have been
distributed, the liabilities paid, and the partners’ capital balances reduced to Zero.
Assumption 3: Fikadu is unable to pay any part of the Br.5,000 deficiency ( Br. 5,000).

50% 30% 20%
Balances 0 0 0 5,000(Dr) 3,000 2,000
Division of loss --- --- ---- +5,000 -3,000 -2,000
Final balances 0 __0__ 0 0 0 0_
The Br. 5,000 loss was divided between Girma and Hailu in their income sharing ratio of 3:2
(3/5 and 2/5). The following entry that reduces the partnership account balances to Zero.
Division of loss
Girma Capital …………………………….. 3,000
Hailu Capital ……………………………… 2,000
Fikadu Capital …………………….. 5,000.

After closing the accounts on June 1, prior to liquidating the partnership, the capital account
balances of Girm, Helen and Israel are Br. 13,000, 26,000 and 31,000 respectively. Cash,
noncash assets, and liabilities total Br. 17,000, 83,000 and Br 30,000 respectively. Between June
1 and June 30, the noncash assets are sold for Br 41,000, the liabilities are paid, and the
remaining cash is distributed to the partners. The partners share net income and loss in the ratio
of 1:2:3.
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Required: Distribute the cash for each partner and record the necessary journal entries to
liquidate the partnership for the period June 1- 30.
______________________________________________________________________________
______________________________________________________________________________
_______________________________________________________________
8.1) Samuel and Tigist are partners who share in net income equally and have capital balances
of Br. 60,000 and Br. 62,000 respectively. Samuel with the consent of Tigist, sells one third
of his interest to Jemal. What entry is required by the partnership if the sale price is (a) Br.
10,000? (b) Br. 30,000?
8.2) The capital account of Mitiku and Elias have balances of Br. 56,000 and Br. 100,000
respectively. Alex and Juhar are to be admitted to the partnership. Alex purchases one
fourth of Mitiku's interest for Br. 22,500 and one fifth of Elias's interest for Br. 30,000.
Juhar contributes Br. 60,000 cash to the partnership, for which he is to receive ownership
equity of Br. 60,000.
Required:
a) Present the entries to record and admission of Alex and Juhar.
b) What are the capital balances of each partner after the admission of the new partner?
8.3) Chemda and Dawit have decided to form a partnership. They have agreed that Chemda is
to invest Br. 60,000 and the Dawit is to invest Br. 30,000. Chemda is to devote one half
time to the business and Dawit is to devote full time. the following plans for the division of
income are being considered:
a) Equal division
b) In the ratio of original investments
c) In the ratio of time devoted to the business
d) Interest of 12% on original investments and the remainder equally.
e) Interest of 12% on original investments, salaries of Br 20,000 to Chemda and Br.
30,000 to Dawit and remainder equally.
8.4) After the accounts closed on April 3, prior to liquidating the partnership, the capital
accounts of Engda, Fikru and Girma are Br. 20,000, Br. 30,000 and Br. 10,000
respectively. Cash and noncash assets total Br 2,000 and Br 61,000 respectively. Amount
owed to creditors total Br. 30,000. The partners share income and losses in the ratio of
2:1:1. Between April 3 and April 25, the non cash assets are sold for Br. 21,000, the
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partner with the capital deficiency pays his deficiency to the partnership, and the
liabilities are paid.
Required:
Prepare a statement of liquidation.
List of References Materials

1. Fess. Warren Accounting principle, 16th Edition, McGraw-hill, Boston
2. Weygandt -Kieso - Kell, Accounting Principles, 3rd Edition.
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UNIT NINE: ACCONTING FOR CORPORATIONS
 Unit Objective
 Introduction
9.1 Meaning and Basic Features of Corporation
9.2 Advantages and Disadvantages of Corporation\
9.3 Formation of a Corporation\
9.4 Authorization and Issuance of Stocks
9.5 Accounting for Dividends and Retained Earnings
9.6 Treasury Stock
9.7 Calculating Equity per Share.
 Summary
Unit Objectives
 Identify the Basic features of Corporation
 Discuss the advantage and disadvantages of Corporation
 Identify the establishment of a Corporation.
 Describe the main sources of stockholder's equity.
 Identify the Common characteristics of Capital stock
 Describe the account for Dividends & Retained Earnings
 Describe and illustrate the accounting for treasury stock.
 Describe and illustrate the computation of equity per share of stock.
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Introduction
Dear Students! In the previous section you discussed in detail about the partnership form of
business, i.e., about its formation, dissolution and liquidation. In this section you will be
acquainted with the accounting for corporation. Dear students, have you heard about
corporate businesses? What is a corporation? What distinguishes a corporation from other
forms of businesses? Give your answer in writing before you read the discussions that
follow
On the basis of ownership, an organization can be divided into three dominant forms viz., Sole
Proprietorship, Partnerships and Corporations. Accounting for a Corporation is the primary
concern of this unit.
9.1 Meaning & Basic Characteristics of Corporation
Meaning: A Corporation is a business unit owned by many people, created under the
authority of law, which exists and has powers and liabilities independent of its members.
Corporations are well suited to today's trends towards large organization, international trade
& profession management. Corporations may be classified as nonprofit & Profit.
Nonprofit corporations include those organized for recreational, educational, charitable, or for
philanthropic purposes.
Profit corporations are engaged in business activities, they depend upon profitable operations
for their continued existence.
Large profit corporations whose shares of stock are widely traded and distributed in a public
markets are often called Public Corporations. On the other hand, corporations whose shares
of stock are owned by a small group of people are called Nonpublic Corporations.
Characteristics of a Corporation:
The corporation form of business organization has several characteristics, among them are;
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1) Separate Legal Entity: A Corporation is a separate legal entity that has most of the rights
of a person except those of voting and marrying. As such, it can buy, sell or own property, sue
and sued; enter into contracts; hire and fire employees, and be taxed.
2) Limited Liability: Because a corporation is a separate legal entity, it is responsible for its
own actions and liabilities. Since the owners of a corporation are not responsible for the
corporation's debts, their liability is limited to their shares in the corporation.
3) Easy to raise capital: it is fairly easy for a corporation to raise capital because shares of
ownership in the business are widely available to potential investors.
4) Easy of transfer of ownership: the ownership of a corporation is represented by a
transferable unit, a share of stock. An owner of shares of stock, or a stockholder, normally can
buy and sell shares of stock without affecting the activities of a corporation or needing the
approval of other owners.
5) Lack of Mutual Agency: There is no mutual agency in the corporate form of business. If a
stockholder, acting as an owner, tries to enter into a contract for the corporation, the
corporation is not bound by the contract.
6) Continuous Existence/ Unlimited life: Another feature of a corporation being a separate
legal entity is that an owner's death, incapacity, or withdrawal, does not affect the life of the
corporation.
7) Centralized Authority and Responsibility: the board of directors represents the
stockholders and delegates the responsibility and authority for the day to day operation of the
corporation to single person, usually the president of general manager. This power is not
divided among the many owners of the business.
Stockholders
Board of Directors
Officers
Employees
8) Professional Management: Large corporations are owned by many people who probably
do not have the time or training to make timely decisions about the business's operations. So in
most cases, management and ownership are separate. This allows the corporation to hire the
best talent available to manage the business.
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9) Government Regulation: Corporation must meet the requirement of the state laws. This
creature of the state is subject to greater control and regulation by the state than are other
forms of business.
10) Taxation: A major disadvantage of the corporation is double taxation. .

1. The owners in a corporation are called______________________________________
2. The stock holder liability in the corporation______________________________
3. The contract by which a corporation if formed is called_______________________
9.2 Advantages and Disadvantages of Corporation
From the foregoing discussion about a corporate business, we can identify the following
advantages and disadvantages of a corporation compared to a proprietorship and partnership.
9.2.1 Advantages of a Corporation
a) Separate Legal Existence
b) Limited liability of stock holders
c) Transferable ownership rights
d) Ability to acquire Capital
e) Continuous life [unlimited life]
f) Corporation management – Professional management
9.2.2 Disadvantages of a Corporation

a) Corporation management -- separation of ownership and management
b) Government Regulations
c) Additional taxes [double taxation]
9.3 Formation of a Corporation
The initial step in the formation of a corporation is to file an application with the secretary of
state in which incorporation is desired. After the incorporated fee is paid and the application
approved, a Charter is granted. The charter may be an approved copy of the application form
or it may be a separated document containing the same basic data. The issuance of the charter,
often referred to as the Articles of Incorporation, creates the corporation.
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Organization cost: the costs of forming a corporation are called organization costs. These costs
which are incurred before the corporation begins operation include:
 State incorporation fee
 Attorney's fees for drawing up the articles of incorporation
 Promotional costs
 The cost of printing stock certificates
 Other expenditure which are incurred for forming the corporation.
9.4 Authorization and Issuance of Stocks

The components of stockholders equity: The owners' equity in a corporation is commonly
called Stockholders Equity or Shareholders Equity or Shareholders Investment, or
Shareholders Capital.
 There are two main sources of stockholders' equity are;

a) Investments contributed by the stockholders, called paid in capital or Contributed
Capital and
b) Net income retained in the business, called Retained Earnings
a) Paid in Capital Or Contributed Capital: It represents the investment made by the
stockholders in the corporation or the amount invested by the stockholders in the
corporation. The paid in capital contributed by the shareholders is recorded in the
accounts maintained for each class of stock. If there is only one class of stock, the
account is entitled Common Stock or Capital Stock. The capital paid by stockholders is
regarded as permanent capital, not ordinarily subject to withdrawal.
b) Retained Earnings: is net income retained in a corporation. Net income is recorded in
the retained earnings account by a closing entry in which Income Summary is debited and
Retained Earnings is credited.
Example: assuming that net income for Delta Company in its first year of operations is
Br.130, 000, the closing entry is:
Income Summary ………………………………. 130,000

Retained Earnings ……………………… 130,000
(To close income summary and transfer net income to retained earnings).
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The term "retained earnings" vary among which are earnings retained for use in the business,
earnings reinvested in the business, earnings employed in the business, and accumulated
earnings.
Sometimes the retained earnings account may have a debit balance after closing income
summary. The debit balance in retained earnings account represents "deficit" and should be
shown as a deduction from stockholders' equity in the balance sheet.
Characteristics of Capital Stock

The general term applied to the shares of ownership of a corporation is Capital Stock. The
number of shares that a corporation is authorized to issue is set forth (declared) in the articles
of incorporation or charter.
The share of capital stock are often assigned an arbitrary monetary figure, know as Par. The
par amount is printed on the stock certificate, which is the evidence of ownership issued to the
stockholder. The stock may also be issued without par, in which case it is called No-Par stock.
Many states provide that the board of directors must assign a stated value to no-par stock,
which makes it similar to part stock.
 Some common characteristics of a capital stock are:

1) Authorized Shares: It represents the maximum number of shares of stock the corporation
is allowed to issue. Most corporations are authorized to issue more shares of stock at the
time of organization. However, they issue only a part of these stocks at the time of their
establishments. This will enable them to issue the remaining authorized stock in the future
whenever they need additional capital needed.
2) Issued Stock or Shares: The issued stock of a corporation is the shares sold, or otherwise
transferred to stockholders.
3) Outstanding Shares or Stock: It represents the number of shares that have been issued
and are in the hands of shareholders. Outstanding shares may be equal to or less than issue
shares. The number of outstanding shares is less than issued shares if the corporation
reacquired some shares.
4) Par Value: It represents an arbitrary monetary figure assigned to a share of stock by the
corporation. Par value is a legal concept in the sense that it represents the legal capital per
share. Legal capital is the amount below which stockholders' equity cannot be reduced
except by losses from business operations.
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Addis Corporation has authorized 150,000 shares and issues 100,000 shares at the time of
establishment as on January 1, 1995 at a par value of Birr 20 per share for cash. Determine the
following:
a) The total par value of outstanding share.
b) The amount by which capital stock is credited
c) If, on average, one share was issue for Br 25, will the legal capita be changed? If so,
what is the amount of the legal capital?
____________________________________________________________________________
____________________________________________________________________________
___________________________________________________________________
Classes of Stock
Generally, there two basic types of stock: Common Stock and Preferred Stock.
A) Common Stock:
Common stock is the basic type of capital stock issued by every corporation. Every
corporation has common stock. The major basic rights accompany ownership of a share of
common stock are:
i. The right to vote in matters concerning the corporation.
ii. The right to share in distributions of earnings.
iii. The preemptive right , which is the right to maintain the same fractional interest in the
corporation by purchasing a proportionate number of shares of any additional
issuance of stock and,
iv. The right to share in assets upon liquidation. Each share generally has equal rights.
B) Preferred Stock:
The second kind of stock a company can issue is called Preferred Stock. Both common and
preferred stocks are sold to raise money. But investors in preferred stock have different
investment goals from investors in common stock.
Preferred stock has preference over common stock in one or more areas. There can be several
different classes of preferred stock, each with distinctive characteristics to attract different
investor. Most preferred stock has one or more of the following characteristics.
i) Preference as to dividend: Preferred stockholders are entitled to receive a
dividend of a specified amount each year before any dividend is paid to common
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stockholders. Preferred stock has fixed dividend rate. This rate may be stated as
dollar amount per share, or a percentage of par values.
ii) preference as to the assets of the business upon liquidation of the organization
iii) Convertibility: This preferred stock can be exchanged with common stock, or
redeemed.
iv) Has no voting right
v) Callable at the option of the issuing corporation: the corporation may call back
some or all of the preferred stocks.
1. Cumulative and Non cumulative preferred stock.
Cumulative Preferred Stock:
Here a fixed dividend amount per share accumulates from year to year, and the whole amount
must be paid before any common dividend can be paid. If dividends that are not paid in the
year they are due are called dividends in arrears. Note that dividends in arrears are not
recorded as a liability of the corporation because no liability exists unit the board of directors
declares a dividend. When a dividend is declared, the corporation records the declaration as a
debit to dividends and a credit to dividends payable as current liability.
Non Cumulative Preferred Stock:

It is a preferred stock that does not have cumulative right. Any dividend that is passed will not
be paid to preferred stockholders.
Example: Assume that a corporation has been authorized to issued 10,000 shares Br 100 par
value, Br 5 cumulative preferred stock, and that the shares have been issued and are
outstanding. If no dividends were paid in 1991, at the end of the year there would be preferred
dividends of Br 50,000 (1,000 shares Br 5) in arrears. If dividends are paid in 1992 preferred
dividends must paid before any dividends on common stock can be paid.
2) Participating and Nonparticipating Preferred Stock

It is apparent that holders of preferred stock have relatively greater assurance than common
stockholders of receiving dividends regularly. On the other hand, holders of common stock
have the possibility of receiving larger dividends than preferred stockholders. The preferred
stockholders' preferential right to dividends is usually limited to a certain amount. Such stock
is said to be nonparticipating.
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Preferred stock which provides for the possibility of dividends in excess of a certain amount is
said to be participating. Preferred shares may participate with common shares to varying
degrees, and the agreement with the shareholders must be examined to determine the extent of
this participation.
Example: Eldan Corporation has outstanding stock composed of 2000 shares of Br 7

participating preferred stock of Br 100 par and 10,000 shares of Br 50 par common stock. The
preferred stock entitled to participate equally with the common, on a share for share basis, in
any dividend distribution, which exceeds the regular preferred dividend and a Br 3 per share
common dividend. The directors declare dividends of Br 62,000 for current year. The Br
62,000 dividend distribution would be allocated as follows:
Preferred Common Total

Dividend Dividend Dividend
Regular dividend to preferred (2000xBr7) Br 14,000 ------------ Br 14,000
Regular dividend to common (10,000xBr10) --------- Br 30,000 Br 30,000
Remainder to 12,000 shares totaling (Br 1.5
per share) 3,000 Br 15,000 Br 18,000
Total Br 17,000 Br 45,000 Br 62,000
Dividends per share Br 8.50 Br4.50
9.4.1 Issuing Capital Stock

The entries to record investments of stockholders in a corporation are like those for
investments by owners of other types of business organizations, in that cash and other assets
received are debited and any liabilities assumed are credited. The credit to stockholders' equity
differs, however, in that there are accounts for each class of stock.
A share of capital stock is either par or no par stock. If the capital stock is par stock the
corporation charter states the par value, and this value must be printed on each share of stock.
Par value can be Br 10, Br 1, Br 5, Br 100 etc of any amount.
Par value is the amount per share that is entered into the corporation's capital stock accounts
and that makes up the legal capital of the corporation. When par value stock is issued, the
appropriate capital stock account is credited for the par value regardless of whether the
proceeds are more or less than the par value.
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Example: Super Corporation is to issue 30,000 shares of Br 50 par value common stock and
15,000 shares of Br 100 preferred stock, issued half of the common and 20% of the preferred
stock at par for cash as of January 1, 1991.
The entry to record the stockholders' investment and the receipt of cash is as follows:
Preferred stock = 3000 x Br 100 = Br 300,000
Common stock = 15,000 x Br 500 = Br 750,000
Jan 1, 1991: Cash …………………………………. 1,050,000
Preferred stock ………………. 300,000
Common stock ………………. 750,000
Note: Cash is debited for Br 1,050,000 (Br 300,000 + Br 750,000), preferred stock is credited for Br 300,000
and common stock is also credited for Br 750,000.
Premium and Discount on Stock

When capital stock is issued at a price greater than par (premium) the proceeds in excess of
par would be credited to a capital account called Paid – in Capital In Excess of Par value,
common stock or preferred stock.
Example: assume that 5000 shares of Br 50 par of Saron Corporation common stock is sold
for Br 55 per share on January 1, 1992. The entry to record the issuance of the stock at the
price in excess of par would be as follows:
Jan 1, 1992: Cash ………………………………………. 275,000
Common stock (5,000 x Br 50)…… 250,000
Paid in capital in excess of par common stock 25,000
Paid – in capital in excess of par common stock = 5,000 x Br 5 (Br 55 – Br 50) = Br 25,000.
Note: the premium Br 25,000 is a part of the investment of the stockholders and is therefore a part of paid – in
capital. It is distinguished from the capital stock because usually it is not a part of legal capital.
Most states do not permit the issuance of stock at a discount. When stock is issued at less than
its par, it is considered to be fully paid as between the corporation and the stockholders. In
some states, however, the stockholders are contingently liable to creditors for the amount of
the discount.
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If a corporation issued stocks for less than par, an account called discount on capital stock is
debited, and cash or other assets received are debited for the amount received. The discount on
capital stock is deducted from the par amount of capital stock in the paid in capital subsection
of stockholders' equity.
Presentation of Premium on Capital Stock on the Balance Sheet

The manner in which premiums on capital stock may be presented in the stockholders' equity
section of the balance sheet is illustrated as follows:
Stockholders Equity:
Paid in Capital/ Contributed Capital:
Preferred stock – Br 100 par value, (15,000 shares
authorized, 4,000 shares issued and outstanding) …………… Br 400,000
Paid in capital in excess of par, Preferred Stock………………… 15,000 415,000
Common Stock – 20,000 shares issued and outstanding)……… Br 1,000,000
Paid in capital in excess of par, Common Stock……………….. 25,000 1,025,000
Total Paid in Capital……………………………………………. Br 1,440,000
Retained earnings……………………………………………….. 175,000
Total Stockholders' Equity --------------------------------------------- Br 1,615,000

1. On March 10, Alemu Company, with an authorization of 20,000 shares of common stock
of Br 15 par and 8,000 shares of preferred stock of Br 20 par, issued one-fourth of each
authorization for cash.
Required:
a) Prepare journal entries to record the issuance of capital stock, assume the selling price per
share and par values are same.
b) Prepare journal entry to record the issuance of capital stock if their selling prices are Br
18 per share for common stock and Br 22 for preferred stock.
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Issuing Stock for Assets Other than Cash

Stock can be issued for assets or services other than cash. In such cases, the transactions is
recorded either at the fair market price of the assets or at the fair market price of the stock
issued, whichever is more objectively determinable. The determinable of the values to be
assigned to the assets is the responsibility of the board of directors.
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Example: Suppose Alemu Corporation issue 1,000 shares of its Br 50 par value of common
stock in exchange for a piece of land. At the time of the exchange, the stock was selling on the
market for Br 56 per share. The entry to record this exchange is as follows;
January 1, 1992:
Land……………………………………… 6,000
Common stock…………………… 50,000
Paid-in capital in excess of par common stock 6,000
No Par Stock:
As explained earlier, stock can be issued without a par value. When no par stock is issued the
entire proceeds from the issuance of no par stock may be credited to the capital stock account,
even through the issuance price varies from time to time.
Example: At the time of its establishment of Silashi Corporation issue 5,000 shares of no- par
common stock at Br 52 a share and at a later date issues 2,000 additional share at Br 46, the
entries to record no- par stock would be as follows;
Cash………………………………………. 260,000
Common stock……………………. 260,000
To record original issuance of 5,000 shares of no par common stock at Br 52.
Cash……………………………………….. 92,000
Common stock…………………….. 92,000
To record subsequent issuance of 2,000 shares of no par common stock at Br 46.
Subscriptions and Stock Issuance

A corporation may sell its stock directly to investors or others, such as employees, under stock
purchase plans. In such cases the buyer may enter into an agreement with a corporation to
subscribe to shares at a certain price per share.
When stock is subscribed for at par, the subscription price is debited to the asset account Stock
Subscription Receivable and credited to the capital stock account Stock Subscribed. When stock
is subscribed for at a price above par, the stock subscriptions receivable account is debited for
the subscription price. The stock subscribed account is credited at par amount, and the difference
between the subscription price and par is credited to the Paid – In Capital in Excess of Par. After
a subscriber has completed the agreed payments, the corporation issues the stock certificate. At
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this point, the subscribed account is debited for the total par of the shares issued, and the capital
stock account is credited for the same amount.
Example: On January 8, 2002, Haleta Corporation received subscriptions to 20,000 shares of Br

30 par common stock from subscribers at Br 32 per share with a down payment of 25% of the
subscription price. The journal entries would be presented below:
Jan 8, 2002: Cash…………………………………………. 160,000

Common Stock Subscription Receivable…… 480,000
Common stock subscribed…………… 600,000
Paid-In Capital in Excess of Par, Common Stock 40,000
On March 20, 2002, Haleta Corporation received 40% of the balance of subscription receivable
from the subscribers.
March 20, 2002: Cash…………………………………….. 192,000

Common Stock Subscription Receivable 92,000
On June 21, 2002 Haleta Corporation received the remaining balance of subscription receivable
from the subscriber and issued stock certificate as evidence of ownership right over assets of the
corporation.
June 21, 2002: Cash………………………………………… 288,000
Common Stock Subscription Receivable… 288,000
Stock subscribed …………………………….. 600,000

Common Stock………………………….. 600,000
The Common Stock Subscription Receivable account is reported among the current asset section
of the balance sheet. Whereas the Stock Subscribed and the Paid-In Capital in Excess of Par, are
listed in the stockholders' equity section as contributed capital/ paid in capital. After all the
subscriptions have been collected, the Common Stock Subscriptions Receivable and the
Common Stock Subscribed accounts will have a zero balance.
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1. Assume that , Silashi Corporation acquired Land in exchange for 10,000 shares of common
stock of Br 10, par (market value of the share is Br 15) . The book value of the land is Br
120,000, and the current market value is Br 140,000.
Required: Prepare journal entry to record the above transaction.
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____________________________________________________________________________
___________________________________________________________________
2. Assume that on January 3, 2003 the company received a stock subscription of Br 20 par
common stock of 9,000 shares. The subscription price is Br 24 and the company received
20% of the subscriptions price as down payment. On February 28, 2003, the company
received 30% of the subscription price. Finally, it collected the remaining on April 7 and
issued stock certificate.
Required: Prepare the necessary entries related to the case on
a) January 3, 2003
b) February 28, 2003
c) April 7, 2003.
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9.5 Treasury Stock
Treasury stock refers to capital stock, either common or preferred, that has been issued and
reacquired (or repurchased) by the issuing company but has not been sold or retired. There are
several reasons that the corporation purchases its own stock, some of these are:
i. It may want to have stock available to distribute to employees through stock
option plans.
ii. It may be trying to maintain a favorable market for the company's stock, i.e., to
support the market price of the stock.
iii. It may want to increase the company's earnings per share.
iv. In payment of debt owed by a shareholder.
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The effect of a purchase of treasury stock is to reduce the asset and stockholders' equity of the
company. Treasury stock can be held for an indefinite period of time. Treasury stock does not
have voting rights, rights to cash dividends, or stock dividends, or right to assets upon
liquidation of the company.
There are several methods of accounting for the purchase and the resale of treasury stock. The
cost basis of accounting for treasury stock is the most common method. Under cost method,
the purchase of stock is debited to treasury stock account, and credited to cash account at the
price paid for it. The par and the price at which the stock was originally issued are irrelevant to
account for treasury stock under cost method. When the stock is resold, treasury stock is
credited at the price paid for it, and the difference between the price paid and the selling price
is debited or credited to an account entitled Paid – in Capital from Sale of Treasury Stock.
Example: Assume that on June 30, 2002 the Corporation has common stock account balance
of Br 800,000 (10,000 shares at Br 80 par) and premium on common stock of Br 300,000. On
the same date, the company acquired 2000 shares of its own common stock for Br 120 per
share. The entry to record the acquisition of stock is made below:
Treasury stock (2000 x Br 120)…………………….. 240,000
Cash………………………………………… 240,000
Treasury stock account is reported in the stockholders' equity section as a deduction from paid
in capital. After the reacquisition of 2,000 shares of common stock, the number of common
stock outstanding is reduced to 8,000 shares (10,000 - 2000).
Example: Assume further that on July 31, 2003, 1500 shares (out of 200shares) were resold
Cash (1500 x Br 200)………………………………… 300,000
Treasury stock (1500 x 120)………………………….. 180,000
Paid-In Capital from Sale of Treasury Stock (300,000- 180,000) 120,000
The account Paid-In Capital from Sale of Treasury Stock is reported in the stockholders'
equity section as addition if it has a credit balance. On the other hand (if it is sold less than its
acquisition price), this account has a debit balance, it is presented as a deduction in the
stockholders equity section.
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On January 1, 1993, the stockholders' equity section of Meka Corporation shows; Common
stock (Br 5 par value) Br 1,500,000; Paid - in Capital in excess of par value Br 1,000,000 and
retained earnings Br 1,200,000. During the year, the following treasury transactions occurred:
March.1 Purchased 50,000 shares for cash at Br 14 per share\
July 1 Sold 10,000 treasury shares for cash at Br 16 per share
Sept.1 Sold 8,000 treasury shares for cash at Br 12 per share.
Required:
a) Journalize the treasury transactions
b) Restate the entry for September 1, assuming the treasury shares were sold at Br 10 per
share.
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9.7 Equity per Share
The amount appearing on the balance sheet as total stockholders' equity can be stated in terms of
the Equity per Share or some times called Book Value per Share of Common Stock or Preferred
Stock. When there is only one class of stock, the equity per share is determined by dividing total
stockholders' equity by the number of shares outstanding as
Equity per Share = Total stockholders' Equity
Number of Common Stock Outstanding
Example: Assume that a corporation has a balance in common stock and premium on common
stock accounts of Br 200,000 and Br 100,000 respectively. Besides, it has a retained earnings
balance of Br 50,000, and there are 70,000 shares of common stock outstanding.
Total stockholders equity is Br 350,000 (Br 200,000 + Br 1 00,000 + Br 50,000). Equity per
share on Common Stock would be:
Equity per share = Br 350,000/ 70,000 = Br 5 per share.
If the corporation has both common stock and preferred stock, it is necessary first to allocate the
total equity between the two classes. Allocation is first made to preferred stock based on its
liquidation price and any participating and cumulative dividends features. After the total is
allocated to the two classes, the equity per share of each class may then be determined by
dividing the respective amounts by the related number of shares outstanding.
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Example: Assume that on December 31, 2002, a corporation has both classes of stock, and
that the preferred stock is entitled to receive Br 105 a share upon liquidation. The amounts of
the stockholders' equity accounts of the corporation as follows:
Stockholders' Equity
Preferred Br 9 stock, cumulative, Br 100 par
(1,000 shares outstanding) ………………………………………. Br 100,000
Excess of issue price over par – Preferred stock………………… 2,000
Common stock, Br 10 par (50,000 shares outstanding)…………. 500,000
Excess of issue price over par-- Common stock………………… 50,000
Retained earnings………………………………………………... 253,000
Total Equity--------------------------------------------------------------- Br 905,000
Required: Compute equity per share on both common stock and preferred stock under the
following assumptions;
a) Preferred stock is entitled only to liquidation price
b) Preferred stock is entitled to liquidation price plus two years dividend in arrears.

The stockholders' equity accounts of Dawit Company at the end of the current fiscal year are
as follows:
Preferred stock Br 10 stock, Br 100 par ----------------------Br 1,000,000
Common stock, Br 10 par, -------------------------------------- 5,000,000
Paid in capital in Excess of par-- Common stock----------- 200,000
Paid in capital in Excess of par-- Preferred stock---------- 40,000
Retained earnings-------------------------------------------------- 935,000
Required:
1) Determine the equity per share of each class of stock, assuming that the preferred stock is
entitled to Br 120 per share upon liquidation.
2) Determined the equity per share of each class of stock, assuming that the preferred stock is
entitled to receive Br 120 per share plus the dividends in arrears in the event of liquidation,
and that only the dividends for the current year are in arrears.
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1. Assume that Silashi Corporation has authorized of shares of 150,000 at the time of
establishment (January 1, 2001). it has issued 110,000 shares since its establishment. on
July 15, 2002, the corporation reacquired 5,000 shared for various reasons. if the par
value of a share is Br.15, perform the following computations:
A) Outstanding shares a of December 31, 2002
B) The total par value of outstanding share
C) If a Share issued for Br 20, what is the legal capital?
2. On March 10, Alem Company issued for cash 5,000 shares of no- par common stock
(with stated value of Br.10) a Br 14 and on August 7 it issued for cash 1,000 shares of Br
50 par preferred stock at Br 54.
Required
a) Give the entries for March 10 and August7. Assume that the common stock is to be
credited with the stated value.
b) What is the total amount invested by all stockholders as of August 7?
3. On January 11 of the current year, Silashi Company reacquired 1,000 shares of its
common stock at Br.30 per share. On July 2, 500 of the reacquired share were sold at
Br.28 per share. The remaining 500 shares were sold at Br. 35 per share on December 19.
Required:
A) Record the transactions of January 11, July2, and December 19
B) What is the balance in Pain-in-Capital from sale of Treasury stock on December 31 of
the current year?
C) Where will the balance in paid-in-Capital from sale of treasury stock e reported on the
balance sheet?
4. The stockholders equity and related accounts of Elias Manufacturing Corporation as of
November 1, 1990, the beginning of the fiscal year, are as follows:
Preferred stock subscription receivable--------------------------------- Br 120,000
Preferred 8% stock, Br 50 par (100,000 shares authorized
20,000 shares issued) ------------------------------------------------ 1000,000
Preferred stock subscribed (3,000 shares) ---------------------------- 150,000
Paid in capital in excess of pare-- Preferred stock 80,000
Common stock, Br 25 par (500,000 shares authorized,
100,000 shares issued) ---------------------------------------------- 2,500,000
Paid-in Capital in Excess of par-Common stock--------------------- 600,000
Retained earnings----- --------------------------------------------------- 3,150,000
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During the fiscal year ended October 31, 1991 Elias Manufacturing Corporation completed the
following transactions affecting stockholders' equity:
a) Purchased 5,000 shares of treasury common stock for Br 130,000.
b) Received balance due on preferred stock subscribed and issued to certificates
c) Sold 3,000 shares of treasury common stock for Br 81,000
d) Received subscriptions to 4,000 shares of preferred 8% stock at Br 51, collecting one
third of the subscription price.
E) Issue 40,000 shares of common stock at Br 27, receiving cash.
f) Sold, 1,000 shares of treasury common for Br 24,000.
Required:
1. Prepare the journal entries to record the transactions listed, identifying each transaction by
the appropriate letter.
2. Prepare the stockholders' equity section of Elias Manufacturing Company balance sheet as
October 31, 1991. The beginning retained earning balance must be increased by the net
income for the year, Br 710,000, and reduced by the dividends declared and paid, Br
280,000
List of References:
1. Fess. Warren Accounting principle, 16th Edition, McGraw-hill, Boston

2. Weygandt -Kieso - Kell, Accounting Principles, 3rd Edition.
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Answer to Check Your Progress Exercises Unit One
Exercise 1.1
1. A manufacturing concern has the following inventories:
i) Raw material inventory
ii) Work in process inventory
iii) Finished goods inventory
2. It is due to many reasons including the following:

 The sale of merchandise is the main source of revenue
 The major deduction from sales is cost of merchandise sold
 Inventories are the largest of the current assets.
Exercise 1.2
2. Ending inventory has direct effect on net income of the current period. So, if ending
inventory is understated, the net income will be understated by the same amount. In other
way round, if ending inventory is understated, cost of goods sold will be overstated,
resulting in an understatement of gross margin and net income.
3. Because the ending inventory for the current period will become beginning inventory for
the following period.
Exercise 1.3
1. The seller (Zumra Trading). The title to the goods is passed to Aba Jifar Company when
the goods arrive at its destination. So, while in transit, they are the properties of Zumra
Trading.
2. In Zumra Trading’s inventories.

3. The merchandise should be included in the inventory crew of the manufacturer.
Answer to Check Your Progress Exercises Unit Two
Exercise 2.1
1. Total cost is Br. 12,180, computed as: Br. 11,400 + 130 + Br. 150 + Br. 100 + Br. 400.
Br. 180 for advertising and Br. 800 for sales salaries are not added to cost of the
inventory. They are included in operating expenses
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Exercise 2.2
1) First-in, First-out (FIFO) method
2) No, They are the methods of determining cost of the inventory.
Exercise 2.3
1) (i) For internal control purpose. This is by comparing the perpetual
inventory record and inventory amount through physical count; we can determine the
inventory shortage or overage.
(ii) For preparation of interim financial statements, there is no need of counting the
inventory. Frequent comparisons of balance with predetermined maximum and minimum
levels facilitate the timely recording of merchandise to avoid both excess inventory and
the cost of sales.
2) i) FIFO method
ii) LIFO method
iii) FIFO method
iv) LIFO method
3) No. They result in the same quantities of inventories.
Answer to Check Your Progress Exercises Unit Three
Exercise 3.1
1. The cost to replace merchandise on the inventory date
2. (i) Item – by – item method:
Product Line A: Total Cost Total Market LCM

Item I Br. 1000 Br. 800 Br. 800
Item II 1200 1320 1200
Item III 4000 3440 3440
Product Line B: Total Cost Total Market LCM

Item IV Br. 4000 Br. 4600 Br. 4000
Item V 4200 4350 1200
Inventory of LCM Br. 13,640
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(ii) The Major Category Method
Product Line A: Total Cost Total Market LCM
Item I Br. 1000 Br. 800
Item II 1200 1320
Item III 4000 3440
Totals Br. 6200 Br. 5560 Br. 5560
Product Line B: Total Cost Total Market LCM

Item IV Br. 4000 Br. 4600
Item V 4200 4350
Totals Br. 8200 Br. 8950 Br. 8200
Inventory of LCM Br. 13,760
Exercise 3.2
5. It is Br. 210,000 computed as 0.7 x Br. 300,000
6. No, the inventory at retail is converted to cost on the basis of the ratio of cost to retail.
Therefore, it is reported on the balance sheet at its estimated cost.
Exercise 3.3
1. It is Br. 120,000 computed as follows

Cost of merchandise sold = Br. 400,000 x 0.75 = Br. 300,000
Estimated cost of ending inventory = Br. 420,000 – Br. 300,000
= Br. 120,000
2. i) To replace the retail method when records of the retail prices of beginning
inventory and purchases are not kept.
ii) To prepare interim financial statements, and
iii) To estimate the inventory lost or destroyed by theft, fire, or other hazards.
Answer to Check Your Progress Exercises Unit Four

Exercise-4.1
Fixed assets are tangible assets and refer to a firm’s property, plant and equipment. Fixed assets
are assets held with the intention of being used for the purpose of producing or providing goods
or services and are not for sale in the normal course of business.
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Plant and equipments and other property cover a wide range of assets which are generally carried
at cost, less depreciation. For plant and equipment, historical cost has generally been found to be
a satisfactory basis, partly because there is no objective basis for any different value and partly
because such assets are in reality deferred charges against future production and could not or
normally would not, be sold separately.
Exercise-4.2
1. Acquisition cost includes all expenditures necessary to get the long-term assets in place and
ready for use.
2. Cost of land includes: purchase price, brokerage fee, title transfer fee, cost of clearing trees &
plants from the land, cost of leveling and grading the land, cost offsite such as proceeds
(cash) received from the sale of scraps collected from the land.
When an existing or old building or used machinery is purchased, its cost includes the purchase
price plus all repairs, renovation and other expenses incurred by the purchaser prior to use of
asset. Ordinary repair costs incurred after the asset is placed in use are normal operating
expenses when incurred.
3. Borrowing costs are interest and other costs, such as, upfront fee, incurred by an enterprise in
connection with the borrowing of funds either for specific fixed assets or for projects or for
general purposes. Borrowing costs that are directly attributable to the acquisition or
construction of a fixed asset are capitalized as part of the cost of that asset. The amount of
borrowing costs capitalized during a period should not exceed the amount of borrowing costs
incurred during that period.
The capitalization of borrowing costs, as part of the cost of a fixed asset, is done when all the
following conditions are satisfied:
(a) Expenditure for the acquisition or construction of an asset is being incurred.
(b) Borrowing costs are being incurred.
(c) Activities that are necessary to prepare the asset for its intended use are in progress.
In other words, borrowing costs are capitalized only up to the point the asset is ready for its
intended use or when substantially all the activities necessary to prepare the asset for its
intended use are complete. Thereafter they are charged to the profit & loss account.
4. The cost of self-constructed fixed asset comprises those costs that relate directly to that
specific asset and those that are attributable to the construction of many assets in general and
can be allocated to the specific asset. When a business constructs its own buildings, the cost
includes all reasonable and necessary expenditures such as those for materials, labour; some
related overhead and indirect costs, architects’ fees, and insurance during construction and
interest on construction loans during the period of construction, lawyer’s fees. If outside
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contractors are used in the construction, the net contract price plus other expenditures
necessary to put the building in usable condition are included.
Exercise: 4.3
1. Depreciation means the allocation of the cost of a plant asset to the periods that benefit from
the services of the asset.
Exercise: 4.4
Four factors affect the computation of depreciation. They are:
1. Cost
2. Residual value
3. Depreciable cost, and
4. Estimated economic (useful) life.
Exercise: 4.5
The production method of depreciation is based on the assumption that depreciation is mainly the
result of use and that the passage of time plays no role in the depreciation process. Under the
production method, there is a direct relation between the amounts of depreciation each year and
the units of output or use. Also, the accumulated depreciation increases each year indirect
relation to units of output or use.
Exercise: 4.6
Sum-of –years digits = n (n+1) /2 = 25 (25+1) /2 = 325
Exercise: 4.7
Straight –Line method is a simple and easy-to-use method of charging depreciation. As the name
indicates, under this method, depreciation is charged evenly over the useful life of the asset. The
amount to be charged is, therefore, calculated by dividing the cost of the depreciable asset minus
its residual value by the number of years the asset is expected to be used for. Straight-line
Method is more appropriate in cases where the benefit to be gained from the use of the asset is
likely to have an even spread over its useful life.
Accelerated method of depreciation results in a higher depreciation charge in the early years of
the asset’s use and tends to reduce in lateral years. The depreciation charge is thus unevenly
spread over the useful life of the asset. The advocates of this method argue that it helps to even
out the total charges as expense for the use of the asset each year. They state that depreciation is
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not only cost charged, that there are repairs and maintenance costs as well and that these costs
usually increase with the age of the asset. Therefore, to equate total costs for each year of use,
depreciation cost should fall as the repairs and maintenance costs increase. This methods, is,
therefore, more appropriate incases where the benefit to be gained from the use of the asset is
likely to be more in its earlier years of use.
Exercise: 4.8
Many business enterprises find it means to account for depreciation of certain kinds of plant
assets on a composite or group basis, to minimize the record keeping for individual assets.
Composite or group depreciation is a process of averaging the economic lives of a number of
plant assets and computing depreciation on the entire class of assets as if it were an operating
unit. The term composite generally refers to a collection of somewhat dissimilar plant assets; the
term group usually refers to a collection of similar assets. The procedures for the computation of
periodic depreciation are essentially the same in either case.
Exercise: 4.9
1. Capital expenditure increases earning capacity of the business whereas revenue expenditure
is incurred to maintain the earning capacity.
Capital Expenditure is incurred to acquire fixed assets for operation of business whereas
revenue expenditure is incurred on day to day conduct of business. In other words, revenue
expenditure is generally recurring expenditure and capital expenditure is non- recurring by
nature.
Capital expenditure benefits more than one accounting year whereas revenue expenditure
normally benefits one accounting year.
Capital expenditure (subject to depreciation) is recorded in balance sheet whereas revenue
expenditure (subject to adjustment for outstanding and prepaid amount) is transferred to
either merchandizing account or profit or loss account.
2. Additions to assets:
According to AS- 10 pertaining to accounting for fixed assets only expenditure that increases
the future benefits from the existing asset beyond its previously assessed standard of
performance is included in the gross book value.
AS-6, the accounting standard pertaining to depreciation states that any addition or extension
which becomes an integral part of the existing asset should be depreciated over the remaining
useful life of the asset. The depreciation on the addition may also be provided at the rate
applied to the existing asset. Where the addition or extension retains a separate identity and
is capable of being used after the existing asset is disposed of, the depreciation of such
addition should be provided independently on the basis of an estimate of its own useful life.
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Solutions for Self –Examination Questions
1. B
2. D
3. D
4. B
5. A
Answer to Check Your Progress Exercises Unit Five
Exercise 5.1
1. Gains on exchanges of similar assets are not recognized for financial reporting purposes
because the earning lives of the asset surrendered are not considered to be completed.
When a Company trades-in an older asset on a newer asset of similar kind, the economic
substance of the transaction is the same as that of a major renovation and upgrading of
the older asset.
Exercise 5.2
1. Boot Given = List Price – Trade in Allowance
= Br. 90,000 – Br. 35,000
= Br. 55,000
2. (a) Loss of Br. 2,500
(b) Cost basis of new asset for financial reporting purposes is Br. 90,000
(c) Cost basis of new asset for income tax purposes is Br. 92,500 [boot given + Book
value]
Exercise 5.3
1. Gains and losses from the disposal of plant assets are presented under ‘other income’ and
‘other expenses’ sections of the income statement. Gains are presented under ‘other
income’ section whereas; losses are presented under ‘other expense’ section on the
income statement.
2. (a) The amount of boot is Br. 57,500, which is the difference between the list price of Br.
75,000 and the trade-in allowance recorded on old asset of Br. 17,500.
(b) Cost basis of new asset, if the book value of old asset is Br. 16,000, is: Br. 73,500,
[that is, book value, Br. 16,000 plus a boot given of Br. 57,500].
(c) Cost basis of new asset for income tax purpose is the same, that is, Br. 73,500, which
is the sum of book value and boot given.
170
Exercise 5.4
1. Amortization is the periodic cost allocation of intangible assets to the periods that benefit
from the assets. Whereas, depletion is the process of allocating the cost of natural
resources to the periods in which the resources are used.
Answer To Check Your Progress Exercises Unit Six
Exercise – 6.1
1. Payroll
2. (a) Salaries – represent payment for employees who are paid at a monthly or yearly rate.
Salary is usually applied to payment for managerial, administrative, or similar services.
(b) Wages – represent payment for services of employees at an hourly rate or on a
piecework basis. Wage is usually applied payment for a manual labor.
3. Gross Earnings = Basic Salary + Overtime earning for the week
Weekly Basic Salary = regular hourly rate x weekly regular working hours.
= Br. 60 x 48 hrs. = Br. 2880
 Therefore, weekly regular salary of the employee is Br. 2880
 Overtime Earning = Overtime Hours Worked x (Regular Hourly Rate x OT Rate)
OE = 7 x (Br. 60 x 1.25)
OE = 7 x (75.00)
Overtime Earning = Br. 525
 Thus, total earnings of the week = Br. 2880 + Br. 525 = Br. 3405.
Exercise – 6.2
a. Gross total earnings of the employee = Basic Salary + Allowance + Overtime earning
Gross total Earnings – Br. 1800 + Br. 300 + Br. 400
Gross Total Earnings = Br. 2500
171
Taxable Income of the employee = Br. 2200, which does not include the allowance of Br. 300,
because it is non-taxable.
0 – 150 on 150 0
151 – 650 on 500 10% 50.00
651 – 1400 on 750 15% 112.50
1401 – 2200 on 800 20% 160.00
Total Br. 2200 322.50
 Total Employee Income Tax is therefore, Br. 322.50
b. (i) Basic (Regular) pay – is 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.
(ii) Overtime pay – is the amount payable to an employee for overtime work done.
Exercise – 6.3
1. Employee income tax
- Employee pension contribution (if any)
2. Pension contribution is the amount of money that each government permanent employee
contributes towards a fund which up on the employees retirement, will be drawn to
finance the participant’s welfare.
 The employer’s share of pension contribution is 6% of the regular monthly salary
of the permanent civil employee. Thus; 0.06 x Br. 3200 = Br. 192.00
Exercise – 6.4
1. Net pay is computed using the following formula:
Net pay = Gross total Earnings – Total Deductions
2. Gross Total Earnings = Basic Salary + Allowance + Overtime earning
Gross Total Earning = Br. 3800 + Br. 300 + [18 hrs x (Br. 20x 1.50)]
= Br. 3800 + Br. 300 (18 x Br. 30)
= Br. 3800 + Br. 300 Br. 540
= Br. 4640.00
 Net pay = Total Earnings – Total Deductions
 Total Deductions = Income Tax + Pension contribution
 Income Tax: Taxable Income (Br. 4640 – Br. 200) – Br. 4440.

0 – 150 on 150 0 00.00
172
151 – 650 on 500 10% 50.00
651 – 1400 on 750 15% 112.50
1401 – 2350 on 950 20% 190.00
2351 – 3550 on 1200 25% 300.00
3551 – 5000 on 890 30% 267.00
Total Br. 4440 ------------------------------------------------ Br. 919.00
 Pension contribution = 4% of basic salary

Pension contribution = 0.04 x Br. 3800 = Br. 152.00
Total Deductions ---------------------------- Br.1071.00
 (i) net pay = Br. 4640 – Br. 1071

Net pay = Br. 3569.00
 (ii) Employee Income Tax = Br. 919.00
 (iii) Total Deductions = Br. 919 + Br. 152.00 = Br. 1071.00
Answer to Check Your Progress Exercises Unit Seven
1. Accounting principles and concepts are needed because of the following facts:
i) The development of business firm in size and form.

ii) The complexity of business transactions.
iii) The need for separation of management and owners
iv) The demand for accurate, timely and relevant information by users.
2. i) the objectivity principle requires that accounting records be based on verifiable events such
as business transactions between independent parties.
ii) The historical cost principle.
3. The two major limitations of stable monetary unit concept are:

a) The scope of the report will be on information, which can be quantifiable and
measurable in terms of money.
b) Any monetary unit in the world is not stable due to economic changes.
Answer to Check Your Progress Exercises Unit Eight

Exercise 8.1
173
1. Two partners
2. Partner
3. Both oral & written
4. i) Ease of formation ii) Limited Life
iii) Un limited liability iV) Co- ownership of partnership property
V) Mutual agency VI) Participation in Income
Vii) Non taxable entity
Exercise 8.2
Advantages
 It is relatively easy and less expensive to organize
 Partnership can form with two individuals
 The partnership business is non-taxable entity.
 It is relatively free from Government regulations.
 Ownership and management remain the same
Disadvantages:
 It has limited life
 Each partner has unlimited liability
 One partner can bind partnership to contracts.
 It is difficult to raise more capital compared to corporation.
2. Current (Fair) Market value
3. Capital Account
Exercise 8.3
1) Division of net income:
Alex= 20,000 X 1/2= Br. 10,000
Biya= 20,000 X 1/2 = Br. 10,000
Closing entry:
Income summary-------------- 20,000
Alex Capital------------------------------ 10,000
Biya Capital------------------------------ 10,000
174
2)
A) If there is no agreement (partnership is silent) before between partners, assume that partners
are going to share equally as below;
Chali= 60,000 X 1/2 = Br. 30,000
Mulluneh= 60,000 X 1/2= Br. 30,000
Closing Entry:
Income Sumary-------------------- 60,000
Chali Capital---------------------------------- 30,000
Mulleneh Capital----------------------------- 30,000
B) Division of net income in the ratio of original capital investment as;
Total investment= Br. 50,000 + Br. 100,000 = Br. 150,000
Chali= 60,000 X 50,000/ 150,000 = Br. 20,000
Mulleneh= 60,000 X 100,000/ 150,000= Br. 40,000
Closing Entry:
Income summary--------------------- 60,000
Chali capital---------------------------- 20,000
Mulleneh Capital---------------------- 40,000
C) Division of net income:
Interest allowance:
Chali= 15,000 X 12%= Br. 1,800
Mulleneh= 30,000 X 12%= Br. 3,600
Chali Mulleneh Total

Interest allowances Br. 1,800 3,600 5,400
Remaining (60,000- 5,400)
Divide equally 27,300 27,300 54,600
Net income 29,100 30,900 60,000
Closing entry:
Income summary-------------------- 60,000
Chali capital----------------------------------- 29,100
Muluneh Capital----------------------------- 30,900
175
D) Division of net income:
Chali Mulleneh Total
Interest allowances Br. 6,000 12,000 18,000
Salary allowances 15,000 30,000 45,000
Remaining (60,000- 63,000)
divide equally (1,500) (1,500) 54,600
Net income 19,500 40,500 60,000
Closing entry:
Income summary------------------- 60,000
Chali capital------------------------- 19,500
Mulleneh capital-------------------- 40,500
Exercise 8.4
A) Hiwot Capital = Br. 30,000
Israel Capital= 30,000 x ½ = 15,000
Journal Entry;
Hiwot capital------------- 15,000
Israel capital----------------------------- 15,000
B) Getachew equity in the partnership = 40,000
Journal Entry;
Getachew capital----------------- 20,000
Israel capital---------------------------------- 20,000
Exercise 8.4.2
A) Partners capital balances before Biya's admission;
Jemal capital------------- 45,000
Anwar capital------------ 35,000
Total capital-------------- 80,000
Biya’s ownership interest in the partnership =120,000 x ¼ = 30,000
Biya's investment (original) = 40,000
Note that Biya's investment (40,000) is more than ownership interest (30,000), in the partnership.
The excess amount of Br 10,000 is bonus to existing partners of Jemal and Anwar share in the
ratio of 3:2 as;
Bonus to Jemal = 10,000 x 3/5= Br. 6,000
Bonus to Anwar = 10,000 x 2/5 = Br. 4,000
176
Journal entry for Biya's admission;
Cash ---------------------- 40,000
Jemal capital ---------------------------6,000
Anwar capital--------------------------4,000
Biya's capital-------------------------- 30,000
B) Total partnership capital after admission of Biya;
Jemal capital-----------45,000
Anwar capital---------- 35,000
Biya's capital----------- 20,000
Total capital 100,000
Biya's ownership interest in the partnership is = 100,000 x ¼ = Br.25,000
Note that Biya's ownership interest in the partnership is more than his original investment of Br.
5,000 (20,000 - 25,000) debited to capital account of partner of Jemal & Anwar in the ratio 3:2
as;
Jemal-------------------- 5,000 x 3/5 = Br. 3,000
Anwar------------------- 5,000 x 2/5 = Br. 2,000
Journal entry for Biya's admission;
Cash--------------------- 20,000
Jemal capital---------- 3,000
Anwar capital---------- 2,000
Biya capital---------------------------- 25,000
Exercise 8.5
A) Total capital before Umer withdrawl;
Shiran capital------------------ Br. 50,000
Tilahun capital-------------- 30,000
Umer capital--------------- 24,000
Journal entry to record withdrawal;
Umer capital--------------------------- 24,000
Shiran capital---------------------------------- 12,000
Tilahun capital-------------------------------- 12,000
Capital balances of each partners & total capital after withdrawal
Shiran capital (50,000 + 12,000) = 62,000
Tilahun capital (30,000 +12,000) = 42,000
Total capital = 104,000
177
Note that the total capital of the partnership remains the same at Br 104,000. Note also that the
Br. 15,000 cash each paid to Umer is not recorded. Shiran & Tilahun capital is credited only for
Br. 24,000, not in the Br. 30,000 (15,000 + 15,000) they paid.
B) Total capital before Umer withdrawl
Shiran capital ----------------- 50,000
Tilahun capital---------------- 30,000
Umer capital ------------------ 24,000
Journal entry to record withdrawal;
Umer capital--------------------------- 24,000
Tilahun capital-------------------------------- 24,000
Capital balances of each partners & total capital after withdrawal
Shiran capit = 50,000
Tilahun capital (30,000 +24,000) = 54,000
Total capital = 104,000
Exercise 8.6
Girma, Helen & Israel
Cash + Noncash Girma + Helen+ Israel
[1/6] [2/6] [3/6]
Balances before realizationBr 17,000 Br 83,000 Br 30,000 Br 13,000 Br 26,000 Br 31,000
division of loss Br 42.000 +41,000 -83,000 ---- -7,000 -14,000 -21,000
Balances after realization Br 58,000 0 Br 30,000 Br 6,000 Br 12000 Br 10,000
Payment of liabilities - 30,000 - 30,000 , --- ------ -------
Balances after payment Br 28,000 _0_ 6,000 12,000 10,000
Payment of partners - 28,000 -6,000 -12,000 -10,000
Final balances 0___ 0 0__ 0 0___ 0___
The statement of partnership liquidation is organized around the basic accounting equation.
The loss of Br.42, 000 on sale of non cash assets (Br 41,000 – Br 83,000) is distributed and
debited to (-) all partners in their income sharing ratio as;
Gain to
Girma = Br. 42,000 x 1/6= Br 7,000
Helen = Br. 42, 000 x 2/6 = Br 14,000
Israel= Br 42,000 x 3/6= Br 21,000
178
After cash is realized from the sale of non-cash assets, first, it is applied for the payment of
liabilities; the remaining amount is distributed to the partners according to the balances
(credit) in their capital accounts.

a) Sale of Assets and Recognition of loss on Realization:
Cash…………………………………….. 41,000
Noncash Assets…………………83,000
b) Entry to Record the Division of loss on Realization to the Partners:

Girma Capital …………………………….. 7,000
Helen Capital …………………………….. 14,000
Israel Capital---------------------------- 21,000

Liabilities …………………………………………. 30,000
Cash ………………………………………. 30,000
d) Entry to Record Distribution of Cash to Partners According to the Balances in their
Capital Account
Girma Capital …………………………………….. 6,000
Helen Capital ………………………………………12,000
Israel Capital------------------------------------- 10,000
Cash-----------------------------------------------------------28,000
Answer to Check Your Progress Exercises Unit Nine
Exercise 9.1
1) Stockholder
2) Limited
3) Articles of incorporation (charter)
Exercise 9.2
a) Total par value = No. of share outstanding (issued) X par value/share
=100,000 x Br.20= Br 200,000
b) The Br. 200,000 is credited to capital stock
179
c) The legal capital = Br 200,000
Note that even if company issue above par value, the legal capital will be credited with par value,
i.e., (Br 20).
Exercise 9.3
a) Cash (5,000 x Br.15 + 2000 x Br20) -------- 115,000
Common stock (5,000 x 15) ----------------------------- 75,000
Preferred stock (2,000 x Br. 20) ------------------------ 40,000
To record the issuance of common stock and preferred stock for cash
b) Cash (5,000 x Br.18 + 2000 x Br22) -------- 134,000

Common stock (5,000 x 15) ----------------------------- 75,000
Paid in capital in excess of par common stock--------- 15,000
Preferred stock (2,000 x Br. 20) ------------------------ 40,000
Paid in capital in excess of par preferred stock-------- 4,000
To record the issuance of common stock and preferred stock with premium for cash
Exercise 9.4
1) Land------------------------- 140,000
Common stock (10,000 x Br. 10) --------------------- 100,000
Pain in capital in excess of par (140,000 - 100,000) 40,000
To record the issuance of common stock with premium for land
2. a) Common stock subscription receivable ( 9000x Br.24)---- 216,000

Common stock Subscribed ( 9,000 x Br.20)--------------------------------------18,000
Paid in capital in excess of par common stock ----------------------------------- 36,000
Cash--- (216,000 x 20%) ------------------------ 43,200

Common stock subscription receivable--------------- 43,200
b) Cash (216,000 x 30%) ------------------64,800

Common stock subscription receivable--------- 64,800
c) Cash (216,000 x 50%) ------------------108000

Common stock subscription receivable--------- 108000
To record the collection of remaining half
180
d) Common stock subscribed --------------------- 180,000
Common stock---------------------------------------------- 180,000
To record the issuance o stock certificates.
Exercise 9.5
A) March 1. Treasury stock (50,000 x Br.14) ---------- 700,000
Cash-------------------------------------------700,000
July 1. Cash (10,000 x Br.16) -------------- 160,000

Treasury stock (10,000 x Br.14) ---------------------------140,000
Paid in capital from sale of treasury stock------------------20,000
To record the sale of treasury stock with a gain of Br. 2 a share
Sept 1. Cash (8000 x Br.12) ------------------------- 96,000
Paid in capital from sale of treasury stock-20,000
Treasury stock------------------------------------------- 116,000
To record the sale of treasury stock with a loss of Br.2 a share
B) Sept.1 Cash (8000 x Br.10) ------------------------- 80,000
Treasury stock------------------------------------------- 112,000
To record the sale of treasury stock with a loss of Br.4 a share
Exercise 9.6
1) Total stockholders' equity:
Preferred stock--------------------------------- Br 1,000,000
Excess of issue price over par - Preferred-- 40,000
Common stock------------------------------------ 5,000,000
Excess of issue price over par- common stock 200,000
Retained earnings----------------------------------- 935,000
Total Equity 7,175,000
Total equity allocated to preferred stock:
Liquidation price (120 X 10,000 Shares) --------------- 1,200,000
Total equity allocated to Common stock :(( 7,175,000-- 1,200,000) = 5,975,000
Equity per share on:
Common stock = 5,975,000/ 500,000 = Br. 11.95
Preferred stock = 1,200,000/ 10,000 = Br. 120
181
2) Total equity-------------------------------------------------------------------- 7,175,000
Allocated to preferred stock:
Liquidation price (120,000 10,000 shares) ---1,200,000
Dividends in arrears (10 x 10,000 shares) --- 100,000 1,300,000
Allocated to common stock---------------------------------- 5,875,000
Equity per share on:
Common stock = 5,875, 000/500,000 = Br. 11.75
Preferred stock = 1,300,000/10,000 = Br 130
182

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JIMMA UNIVERSITY

FACULTY OF BUSINESS & ECONOMICS

SCHOOL OF CONTINUING AND DISTANCE

DISTANCE EDUCATION MODULE

Prepared By: AREGA SEYOUM [MBA, BA]

June 20, 2009

1. UNIT ONE: Accounting for Inventories ..............................1

 Inventories of merchandising businesses

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

1.1 Importance of Inventories

1. Describe the three types of inventories for a manufacturing business

1.2 Effects of Inventories on Financial Statements

a. Cost of goods (merchandise) sold =Beginning inventory + Net

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

c. Operating income = Gross Profit – Operating Expenses

1.2.2 Effects of Beginning Inventory on Current Period’s Financial Statements

Income statement of the following period

Cost of merchandise sold direct relationship

Balance sheet of the following period

2008 2007 2006

c) Total Current Assets:

Reported Br. 425,000 Br. 365,000 Br. 220,000

Check Your Progress: Exercise 1.2

1.3.1 Periodic Inventory System

The journal entries to be made are:

4. To record adjusting entry or closing entry for merchandise inventory:

3. To record purchase returns and allowances

Accounts payable or cash XX

April 19 Purchased 300 units of merchandise for cash at Br 15 per unit.

August 26 Cash (480 x Br. 17) 8,160

b) Under Perpetual Inventory System:

24 Accounts payable (50 x Br. 12) 600

Jan. 1. Bal. 2,800 Jan. 24. 600

Dec. 31. Inventory Shortage 30.00

1.4. Determining Actual Quantities in the Inventory

Check Your Progress: Exercise 1.3

1. Who will cover transportation charges? Why?

Model Examination Questions

A. Short answer questions

Incorrect inventory Correct inventory

Gross Margin Br. 75,000 Br.140,000

3. Gidu Lulesa Company engaged in the following transactions in March 2009:

1.. Introduction to Accounting, 21st Century

Check Your Progress: Exercise 2. 1

2.1.1 Specific Identification Method

® Cost of Ending inventory Br. 43,850

2.1.3 Last-in, First-out (LIFO)

Average cost per unit = Cost of goods available for sale

Weighted average unit cost = Br. 190,070 = Br. 49.24

® Ending inventory cost = Br. 49.24 x 800 = Br. 39,392

2.2. Comparison of Inventory Costing Methods

 Weighted average yields the results between the two.

 In periods of declining (decreasing) prices (or if there is deflationary trend):

Check Your Progress: Exercise 2.2

2.3 Inventory Costing Methods under Perpetual Inventory System

2.3.1 First-in First-out Method

17 13 60.00 780.00 10 64.00 640

26 10 64.00 640.00 16 69.00 1104

30 6 69.00 414.00 10 69.00 690

Let us see them under periodic - FIFO method:

 Cost of Ending inventory = 15 units @ Br. 72.00 = Br. 1,080

26 19 69.00 1311.00 10 60.00 600

2.4.3 Weighted Average Cost Method.

Average Cost Method (Moving Average)