Intermediate Financial Accounting-I

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 CHAPTER ONE
ACCOUNTING PRINCIPLES AND PROFESSIONAL PRACTICE
INTRODUCTION
THE ENVIRONMENT OF ACCOUNTING
Like other human activities and disciplines, accounting
is largely a product of its environment.
The environment of accounting consists of social –
economic – political - legal conditions, restrictions and
influence that vary from time to time.
As a result, accounting objectives and practices are not
the same today as they were in the past.
Cont…
 Accounting communicates financial information about an economic entity
to interested persons.
 The financial statements are expected to present fairly, clearly, and
completely the economic facts of the existence and operations of the
enterprise. In preparing financial statements, accountants are confronted
with the potential dangers of bias, misinterpretation, inexactness, and
ambiguity. In order to minimize these dangers, the accounting profession
has attempted to develop a set of standards that is generally accepted and
universally practiced
 USERS OF ACCOUNTING INFORMATION

The accounting system serves the information needs of various kinds of users.

The information that a specific user needs depends on the kind of decision that

user makes. The difference in decisions divides the users in to two broad

groups: the internal users and external users.

Internal users include all the management personnel of a business enterprise

who use accounting information either for planning and controlling current

operations or for formulating long range plans and making major business

decisions.
Cont…

SFAC No.5. "Recognition and Measurement in Financial

Statement of Business Enterprises," sets forth recognition and
measurement criteria and guidance on what information
should be formally incorporated in to financial statements and
when.

SFAC No.6. “Elements of Financial Statements", replaces

statement of Financial Accounting Concept No.3 and expands
its scope to include not-for –profit organizations.
 Cont…
External users of accounting information include
stockholders, bondholders, potential investors, bankers and
other creditors, financial analysts, economists, labor unions,
and numerous governmental agencies.
CONCEPTUAL FRAMEWORK FOR FINANCIAL ACCOUNTING AND REPORTING

A Conceptual framework is like a constitution: it is a coherent

system of interrelated objectives and fundamentals that can lead
to consistent standards and that prescribes the nature, function,
and limits of financial accounting and financial statements.
 Cont…
The conceptual framework for financial accounting can be presented pictorially as
the one on presented as First level, second level, third level.

First Level: Objectives of Financial Reporting And Financial Statements

 Providing information for users of Accounting information it may be internal or
External users

Second Level: Fundamental Concepts(qualitative Characteristics of Accounting

information)
 It is classified as
 Primary qualities
 Secondary qualities
 Primary qualities

Primary qualities includes

 Relevance

 Reliability

Relevance
Accounting information must be capable of making
difference in decision. If certain information has no bearing
on a decision, it is irrelevant to that decision.
Relevance can be evaluated according to three qualitative
criteria:-
a. Timeliness- for information must be available to decision makers
before decision making .
 b. Predictive value

Increasing the ability to make prediction about the out

comes of future events.
c. Feedback value- confirming past predictions or make
updates, adjustments, or corrections to predictions.
2. Reliability
Means users of Accounting information can be depend on
accounting information to present economic condition
or events
The information provide is free from error or bias.
 Secondary Qualities: Comparability and
consistency

Comparability and Consistency

Comparability
 Enables users to identify the real similarities and differences in

economic phenomena because these similarities and differences

have not been obtained by the use of non comparable financial
statements.
Consistency
 When an entity applies the same accounting treatments to similar

events, from period to period, the entity is considered to be

consistent in its use of accounting standards.
 The consistency principle does not mean that particular method of

accounting, once adopted, should not be changed.

 Elements of Financial Statements

SFAC No. 6, which replaced SFAC NO.3, defines the ten interrelated
elements that are most directly related to measuring the performance and
financial status of an enterprise as follows:
Assets:
 Assets are probable future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events.
Liabilities
 Liabilities are probable future sacrifices of economic benefits arising
from present obligations of a particular entity to transfer assets or
provide services to other entity's in the future as a result of past
transactions or events.
Cont…
Equity
 Equity is the residual (ownership) interest in the assets of an

entity that remains after deducting its liabilities.

Investment by owners
 Are increases in net assets of a particular enterprise resulting

from transfer to it from other entities of something of value to

obtain or increase ownership interest (or equity) in it.
Distribution to owners
 Are decreases in net assets of a particular enterprise resulting

from transferring assets, rendering services, or incurring

liabilities by the enterprise to owners.
 Cont…
Comprehensive Income
 Is the change in equity (net asset) of an entity during a period from

transactions and other events and circumstances from non owner

sources. It includes all changes in equity during a period except those
resulting from investments by owners and distribution to owners.
Revenues
 Are inflows or other enhancements of assets of an entity or settlement

of its liabilities (or a combination of both) during a period from

delivering or producing goods, rendering services, or other activities
that constitute the entity on going major or central operations. The two
essential characteristics of a revenue transaction are
 Cont…

Expenses
 Are outflows or other using up of assets or incurrence of liabilities (or a

combination of both) during a period from delivering or producing goods, rendering

services, or carrying out other activities that constitute the entity's on going major
or central operations.
Gains
 Are increases in equity (net asset) from peripheral or incidental transactions of an

entity and from all other transactions and other events and circumstances affecting
the entity during a period except those that result from revenues or investment by
owners.
Losses
 Are decreases in equity (net asset) from peripheral of incidental transactions of an

entity and from all other transactions and other events and circumstances affecting
the entity during a period except those that result from expenses or distributions to
owners.
 Activity
Activity Elements Affected
 You have borrowed $6,000 from a bank payable after one year.

 You have invested $10,000 in your business at the start of the

business
 You have purchased three computers for $5000 each to be used

in your business
 You have paid a salary of $2,000 for your employees

 You have sold one of the computers you purchased and earned

$500 more than the book value

 You have sold stationary items for $ 52,000 during the year

 You have paid an interest of $360 on the money borrowed

Third level: Recognition and Measurement concepts

The third level of the framework consists concepts that implement the basic
objectives of level one. These concepts explain which, when and how financial
elements and events should be recognized, measured, and reported by the
accounting system.

Generally accepted accounting principles (GAAP) or IRFS

The goal of IFRS

 To make international comparisons as easy as possible. Obviously, there are major
differences in financial reporting of companies in different countries. These
differences result in complications for preparing, consolidating, auditing and
interpreting published financial statements .
Cont…
There has been a greater need to bridge the gap between the differences in
financial reporting standards among countries. To make this a reality,
several organizations have been involved in trying to harmonize the
financial reporting standards worldwide.
Objectives of harmonizing accounting practices :
1. financial analysts and investors need comparable and comprehensible
financial information of foreign companies to be better help in their
decision whether to buy a particular share or invest in other ventures.
2. multinational companies are required to prepare a consolidated financial
statement so as to reflect the overall activities of the parent company and
all the subsidiaries under its wings. It would be a great relief to
accountants if accounting standards were harmonized since the same
standards would be used in preparing financial statements by the
subsidiaries in other countries.
 Cont…
3.International accountancy firms are also much interested
in harmonizing accounting standards in that it helps
them in regulating their large client base.
4. Tax authorities also would benefit from harmonization
of international accounting standards because it would
be beneficial in “dealing with foreign incomes by
differences in the measurement of profit in different
countries”,
 GAAP vs IFRS
 Similarities
There are many similarities in US GAAP and IFRS guidance on financial
statement presentation.
Under both sets of standards, the components of a complete set of
financial statements include: a statement of financial position, a
statement of profit and loss (i.e., income statement) and a statement of
comprehensive income (either a single continuous statement or two
consecutive statements), a statement of cash flows and accompanying
notes to the financial statements.
Both standards also require the changes in shareholders’ equity to be
presented. However, US GAAP allows the changes in shareholders’
equity to be presented in the notes to the financial statements while IFRS
requires the changes in shareholders’ equity to be presented as a separate
statement.
Point of difference GAAP
Financial periods required Generally, comparative financial statements are
presented; however, a single year may be presented
in certain circumstances. Public companies must
follow SEC rules, which typically require balance
sheets for the two most recent years, while all other
statements must cover the three-year period ended on
the balance sheet date.
IFRS
Comparative information must be
disclosed with respect to the previous
period for all amounts reported in the
current period’s financial statements.

Layout of balance sheet No general requirement within US GAAP to prepare IFRS does not prescribe a standard
and income statement the balance sheet and income statement in layout, but includes a list of minimum
accordance with a specific layout line items.

Balance sheet presentation Debt for which there has been a covenant violation Debt associated with a covenant
of debt as current versus may be presented as non-current if a lender violation must be presented as current
non-current agreement to waive the right to demand repayment unless the lender agreement was
for more than one year exists before the financial reached prior to the balance sheet
date(end of accounting year)
statements are issued or available to be issued.

Income statement No general requirement within US GAAP to classify
classification of expenses income statement items by function or nature.
However, SEC registrants are generally required to
present expenses based on function (e.g., cost of
sales, administrative).
Entities may present expenses based on
either function or nature (e.g., salaries,
depreciation). However, if function is
selected, certain disclosures about the
nature of expenses must be included in
the notes.

Income statement Restricted to items that are both unusual and Prohibited.
extraordinary items criteria infrequent.
 IFRS progress in Ethiopia
 Already started (2011) tasks of organizing a separate institute fostering the

implementation of IFRS that can enforce the legislation issue for the

implementation of IFRS.

 A panel is working on a proposed bill, to be called the “Financial Report

Proclamation of Ethiopia”. If it is approved by Parliament, the bill will bring

fundamental changes to Ethiopia’s financial reporting system by requiring

compliance with international financial reporting standards (IFRS).

 Cont…
 Adopting IFRS will make it easier for investors and businesses to evaluate the
financial performances of organizations with which they might do business or
invest in: “The standardized auditing system will enable the Ethiopian Revenues
and Customs Authority (ERCA) to rely on external auditor’s reports for their tax
collection. It will also afford banks the confidence to grant loans based on the
financial statements of a company.
 BUSINESS ENTITY PRINCIPLE

 Because economic activity is carried on by various legal and

economic entities, accounting results are summarized in terms of

these entities. Accounting deals with specific, identifiable business

entities, each considered an accounting unit separate and apart

from its owners and other entities.

 GOING - CONCERN PRINCIPLE

 Under this principle, the business entity in question is

expected not to liquidate, but to continue operations for the

foreseeable future. That is, it will stay in the business for a

period of time sufficient to carry out contemplated

operations, contracts and commitments. Generally

accountants assume that business entity will continue to

exist indefinitely.
REVENUE REALIZATION PRINCIPLE

 The revenue realization principle deals with the point of

time at which the revenue is considered as earned. It
asserts that revenue is realized when goods are transferred
or services are rendered to a customer. Revenue is not
realized when an order is received from a customer
VALUATION PRINCIPLE
 Realization, which is a key principle in income
measurement, forms the basis for distinguishing methods
of valuation used in the reporting of assets and liabilities
in the balance sheet.
 MATCHING PRINCIPLE

 The matching principle means that after the revenue (accomplishment) for
an accounting period has been determined, the cost (effort) associated with
the revenue must be deducted from the revenue to measure net income. The
term matching refers to the close relationship that exists between certain
costs and the revenue recognized as a result of incurring those costs.

MONETARY PRINCIPLE

The monetary principle states that money is the common denominator or a

useful standard measuring unit for reporting the effects of business
transactions.
DISCLOSURE PRINCIPLE

 The disclosure principle requires that financial statements be complete in the

sense of including all information necessary to users of the statements. If the

omission of certain information would cause the financial statements to be

misleading, disclosure of such information is essential.

CASH FLOWS AND INCOME MEASUREMENT

ACCRUAL BASIS OF ACCOUNTING

When this system is used, revenues are reported in the income statement when

they are earned and expenses are reported in the income statement when they

are incurred, without regard to the timing of cash receipts or payments.

CASH BASIS OF ACCOUNTING

 The cash basis of an accounting system is an

accounting system based on the timing of cash
payments and receipts. Under this system, revenue
is recorded only when cash is received and
expenses are recorded only when cash is paid.
End of chapter One
 CHAPTER TWO

Fair value measurement and Impairment

Definition of Fair value measurement
 The definition of fair value focuses on assets and liabilities
because they are a primary subject of accounting
measurement. In addition, this IFRS shall be applied to an
entity’s own equity instruments measured at fair value.
 Fair value is the price that would be received to sell an asset

or paid to transfer a liability in an orderly transaction

between market participants at the measurement date.
 Fair value is an exit price (e.g. the price to sell an asset

rather than the price to buy that asset).

 Cont…
 Fair value is a market-based measurement, rather than an entity-specific
measurement, and is measured using assumptions that market participants
would use in pricing the asset or liability, including assumptions about risk.
 Fair value is measured assuming a transaction in the principal market for
the asset or liability
 A fair value measurement is made up of one or more inputs, which are the
assumptions that market participants would make in valuing the asset or
liability.
 The most reliable evidence of fair value is a quoted price in an active
market.
 When this is not available, entities use a valuation approach to measure fair
value, maximizing the use of relevant observable inputs and minimizing the
use of unobservable inputs.
Measurement

The asset or liability:

A fair value measurement is for a particular asset or liability. Therefore, when

measuring fair value an entity shall take into account the characteristics of
the asset or liability if market participants would take those characteristics
into account when pricing the asset or liability at the measurement date.
Such characteristics include, for example, the following:

(i) the condition and location of the asset; and

(ii) (ii) restrictions, if any, on the sale or use of the asset

 Cont…
The transaction:
A fair value measurement assumes that the asset or liability
is exchanged in an orderly transaction between market
participants to sell the asset or transfer the liability at the
measurement date under current market conditions. A fair
value measurement assumes that the transaction to sell
the asset or transfer the liability takes place either:
(i) In the principal market for the asset or liability; or
(ii) In the absence of a principal market, in the most
advantageous market for the asset or liability.
 Cont…
 The price: Fair value is the price that would be received to sell an asset or

paid to transfer a liability in an orderly transaction in the principal (or most

advantageous) market at the measurement date under current market

conditions (i.e. an exit price) regardless of whether that price is directly

observable or estimated using another valuation technique.

 Market participants: An entity shall measure the fair value of an asset or a

liability using the assumptions that market participants would use when

pricing the asset or liability, assuming that market participants act in their

economic best interest.

Fair Value At Initial Recognition
 When an asset is acquired or a liability is assumed in
an exchange transaction for that asset or liability, the
transaction price is the price paid to acquire the asset
or received to assume the liability (an entry price).
 When determining whether fair value at initial
recognition equals the transaction price, an entity
shall take into account factors specific to the
transaction and to the asset or liability.
 For example
The transaction price might not represent the fair value of an asset or a liability at
initial recognition if any of the following conditions exist:
(a) The transaction is between related parties, although the price in a related party
transaction may be used as an input into a fair value measurement if the entity
has evidence that the transaction was entered into at market terms.
(b) The transaction takes place under pressure or the seller is forced to accept the
price in the transaction. For example, that might be the case if the seller is
experiencing financial difficulty.
(c) The unit of account represented by the transaction price is different from the unit
of account for the asset or liability measured at fair value. For example, that
might be the case if the asset or liability measured at fair value is only one of the
elements in the transaction
 Cont…
(d) The market in which the transaction takes place is
different from the principal market. For example, those
markets might be different if the entity is a dealer that
enters into transactions with customers in the retail
market, but the principal market for the exit transaction
is with other dealers in the dealer market.
 Valuation techniques
An entity shall use valuation techniques that are appropriate in the circumstances and
for which sufficient data are available to measure fair value, maximizing the use of
relevant observable inputs and minimizing the use of unobservable inputs.
This Standard requires entities to apply valuation techniques consistent with any of
the following three methods:
a. Market approach - uses prices and other relevant information generated by
market transactions involving identical or comparable (i.e. similar) assets,
liabilities or a group of assets and liabilities, such as a business
b. Cost approach - reflects the amount that would be required currently to replace
the service capacity of an asset (often referred to as current replacement cost).
c. Income approach - converts future amounts (e.g. cash flows or income and
expenses) to a single current (i.e. discounted) amount. The fair value
measurement is determined on the basis of the value indicated by current market
expectations about those future amounts.
 Cont..
If the transaction price is fair value at initial recognition
and a valuation technique that uses unobservable
inputs will be used to measure fair value in
subsequent periods, the valuation technique shall be
calibrated so that at initial recognition the result of the
valuation technique equals the transaction price.
 Fair value hierarchy
IFRS 13 introduces a fair value hierarchy that categorizes inputs to valuation

techniques into three levels. The highest priority is given to Level 1 inputs and the

lowest priority to Level 3 inputs. An entity must maximize the use of Level 1 inputs

and minimize the use of Level 3 inputs.

Level 1 inputs

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or

liabilities that the entity can access at the measurement date. An entity shall not

make adjustments to quoted prices, only under specific circumstances, for example

when a quoted price does not represent the fair value (i.e. when a significant event
 Level 2 inputs
Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable

for the asset or liability, either directly or indirectly. Adjustments to Level 2 inputs will

vary depending on factors specific to the asset or liability.

Level 2 inputs include the following:

a. quoted prices for similar assets or liabilities in active markets.

b. quoted prices for identical or similar assets or liabilities in markets that are not active.

c. inputs other than quoted prices that are observable for the asset or liability, for example:

d. market-corroborated inputs.
 Level 3 inputs

Level 3 inputs are unobservable inputs for the asset or

liability. An entity shall use Level 3 inputs to measure
fair value only when relevant observable inputs are not
available.
 Presentation and disclosure
An entity shall disclose information that helps users of its
financial statements assess both of the following:
a. for assets and liabilities that are measured at fair value
on a recurring or non-recurring basis in the statement of
financial position after initial recognition, the valuation
techniques and inputs used to develop those
measurements.
b. for recurring fair value measurements using significant
unobservable inputs (Level 3), the effect of the
measurements on profit or loss or other comprehensive
income for the period.
IMPAIRMENTS

 The general accounting standard of lower-of-cost-

or-market for inventories does not apply to
property, plant, and equipment. Even when
property, plant, and equipment has suffered partial
obsolescence, accountants have been reluctant to
reduce the asset’s carrying amount.
 Recognizing Impairments

Impairment—Example 1

Alem trading has equipment that, due to changes in its use, it reviews for possible

impairment. The equipment’s carrying amount is $600,000 ($800,000 cost

less$200,000 accumulated depreciation). Alem trading determines the expected future

net cash flows (undiscounted) from the use of the equipment and its eventual disposal

to be$650,000.The recoverability test indicates that the $650,000 of expected future

net cash flows from the equipment’s use exceed the carrying amount of $600,000. As

a result, no impair-ment occurred. (Recall that the undiscounted future net cash flows

must be less than the carrying amount for Alem trading to deem an asset to be

impaired and to measure the impair-ment loss.) Therefore, Alem trading . does not

recognize an impairment loss in this case

 Impairment—Example 2

Assume the same facts as in Example 1, except that the expected future net cash flows from Alem trading

equipment are $580,000 (instead of $650,000). The recoverability test indicates that the expected future

net cash flows of $580,000 from the use of the asset are less thanits carrying amount of $600,000.

Therefore, an impairment has occurred.The difference between the carrying amount of Alem trading

asset and its fair value is theimpairment loss. Assuming this asset has a fair value of $525,000,

Illustration 11- 15shows the loss computation.

ILLUSTRATION 11-15

Computation of

Impairment Loss

Carrying amount of the equipment $600,000

Fair value of equipment (525,000)

Loss on impairment $ 75,000

 Journal entry
Alem trading records the impairment loss as follows.
Loss on Impairment 75,000
Accumulated Depreciation—Equipment 75,000
 Adjusting Entries

 Adjusting entries is updating the accounting records at the end of accounting period
 In order to do this, adjusting entries are made at the end of the accounting period. In
short, adjustments are needed to ensure that revenue recognition and matching
principles are followed.
 The use of adjusting entries makes it possible to report on the balance sheet the
appropriate assets, liabilities, and owners' equity at the statement date and to report
on the income statement the proper net income (or net loss) for the period.
However, the trial balance (unadjusted) may not contain up to-date and complete

data. This is true for the following reasons:

Reasons of Adjusting entries

 Some events are not journalized daily because it is

inexpedient to do so. Examples are the consumption of
supplies and the earning of wages by employees.
 Some costs are not journalized during the accounting
period because these costs expire with the passage of time
rather than as a result of recurring daily transactions.
Examples of such costs are building and equipment
deterioration and rent and insurance
 Some items may be unrecorded. An example is a utility
service bill that will not be received until the next
accounting period.
 Cont…
 In order to bring the accounting records up to date,
adjusting entries are required not only at the end of the
accounting period but also every time financial
statements are prepared.
 To illustrate the wide variety of adjusting entries, it is

helpful to classify them into the following groups.

- Apportionment of recorded costs
- Accrual of unrecorded expense
- Accrual of unrecorded revenue
Apportionment of Recorded Costs

 Costs that will benefit more than one accounting period

frequently are incurred. These costs must be apportioned
between periods in a manner that approximates the
usefulness derived from the goods and services in the
realization of revenue
 Apportionment process is a necessary step under the
matching principle to determine net income of each period.
 These cost are cost of fixed asset account such as
 Building
 Equipment
 Machinery etc.
 Example
For two million DH Geda Company purchase machine that
will have an estimate useful life of five years. The
company also estimate in five years the Company will be
able to sell it for $200,000 for scrap part.
Nb: Co Use straight line to determine depreciation expense
Annual Depreciation=2000,000-200,000 =360,000
5
Depreciation Expense………………360,000
Accumulation Depreciation……………360,00
 Deferral
Are for cash flow that occurs before revenue and Expense
recognition
 These Adjusting journal entries are recorded cash paid for

expense that apply to more than one accounting period or cash is

received for revenue that apply for more than one Accounting
period.
 The portion of revenue or Expense that applies for the future

period is deferred Unearned revenue (liability) or prepaid

expense(Asset)
 The adjusting journal entries for deferred depends on the method

of Accounting used to record routine operational cash payment

and receipt that precede expense and revenue recognition.
Deferred expense initially recorded as prepayment

This method records an asset on payment of cash before

goods and service are received.
 Prepayment debit asset Account:

Expense is paid in cash and recorded as asset before they

are used or consumed are identified as prepaid expense.
Prepayment occurred regarding Supplies ,Rent ,Insurance
and Advertising etc.
 These adjusting entries at the end of year require

recognizing expense and expiration of the Asset or

prepayment .
 Example
Assume that yam rot PLC paid cash birr 12000 as
prepayment for the rent office building on August 1,2020
to cover six month rent
Prepaid rent……..12000
cash……………………12000
On December 31,2020 the end accounting period recognize
five month rent service received. The adjusting entries are
Rent expense……..10,000
prepaid rent …………10,0000
Deferred expense recorded initially as expense

This method records prepayment as expense initially when cash is paid

before good and service are received.
Prepayment debt expense account
 The adjusting entries is required to transfer the un expired portion of the

cost to an asset account:

Example
on the above example : yam rot PLC paid cash birr 12000 as
prepayment for the rent office building on August 1,2020 to cover six
month rent
On December 31,2020 the end of Accounting period recognize one month
rent received for the next coming year
Prepaid rent ………….2000
Rent expense……………2000
A. Deferred revenue initially recorded as liability

Deferred revenue are present revenue received in cash before

good and service are provide to customer or its earned ,such
as Advance collection is liability to the business until good
and service are provide to customer.
Example :
Assume TG printing press received cash birr 36000 to provide
three years advertising service on one of it monthly magazine
Tana trading on march 1,2020. the initial recording
 Collection of cash on march 1,2020

Cash ………….36000
Unearned subscription revenue …….36000
 Cont…
At the end of period on December 31,2020 this amount
partially earned and the remaining will be earned in
the coming year. on December 31,2020 the end of
Accounting period recognized 10 month subscription
for service provide during 2020 would be
Unearned subscription revenue …..10,000
Subscription revenue …………………..10,000
B. Deferred revenue initially recorded as revenue on subscription
revenue account.

Under this method recording deferred revenue the cash received

before providing advertising service on march 1,2020
Example :on the above example TG printing press received cash
birr 36000 to provide three years advertising service on one
monthly magazine Tana trading on march 1,2020.
Cash …….360000
subscription revenue ….36000
On December 2020 the end of Accounting period recognize 10
month service provide to next coming year .
Subscription revenue …….10,000
Unearned subscription revenue …..10,000
Accruals
Are for the cash flow that occurs after expense and
revenue recognized.
These adjusting entries are recorded when cash is
paid or received in the future accounting period but
portion of the future cash flow applies to expense
or revenue of the current accounting period.
There are two Accruals
 Accrued Expense

 Accrued Revenue
Accrued Expense

Are expense incurred for good and service received but not yet
paid and recorded during the period
Adjustment records on Accumulated expense and liability during
the period because it is not paid in cash in the current period.
Example: Assume that safi Retail signed a bank loan of 12% birr
10,000 six month note on November1,2020.
Cash………10,000
Note payable……….10,000
On December 31,2020 to accrue two month of interest expense
Interest Expense………..200
Interest payable……………..200
Accrued Revenue

Are revenue earned for the good and service provide but not yet
received in cash and records.
Assume that AD Company received birr 18000 12% 13 month
note from Tk store as settlement of on account this year on
November 30,2020.
Note receivables….18000
Account Receivables ……18000
On December 31,2020 to record 1 month interest income on
Note receivables
Interest receivables ……..180
Interest Income ……….180
End of Chapter two

Thank you
 Chapter three
Cash and Receivables
Cash is a medium of exchange that a bank will accept for deposit and
immediate credit to the depositors account. To achieve efficient use of all
resources, management of business enterprises frequently turns
unproductive cash balances in to productive resources through the
acquisition of short-term investments
Meaning of cash
Cash includes money on deposit in banks and other items that a bank will
accept for immediate deposit.
Money on deposit in banks includes checking and saving accounts. Other
items such as ordinary checks received from customers, money orders,
coins and currency and petty cash also are included as cash.
Banks do not accept postage stamps, travel advances to employees, notes
receivable or post-dated checks as cash.
 Characteristics of cash
The following are some of the characteristics of cash:
 Cash is used as medium of exchange

 Cash is the most liquid asset

 Cash is mostly affected by business transactions

 Cash is used to measure the value of other assets

 Cash is mostly exposed to embezzlements

Management of cash

Cash management refers to planning, controlling and

accounting for cash transactions and cash balances. Efficient
management of cash is essential to the survival and success of
every business organization. Managing cash requires planning
wisely so that there will not be excess cash held on hand at
any point in time; or there is no shortage of cash at any point
in time to meet the business’s needs.
Internal control procedures
A system of internal control is not designed primarily to
detect errors but rather to reduce the opportunity of
errors or dishonesty to occur. Effective system of
internal control procedures should consider the
following points:
 Segregation of duties; like separating one that works

on custody with record keeper, purchaser or receiver of

purchased item. Here the separation of duties enables to
protect assets against either fraud or error. In addition
the work of one helps to cross check the of the other
Cont…

Assignment of Responsibilities and Authorities; giving a specific

authority to a specific body helps a company to create responsibility
and accountability in the actions of each party, department or
division. For example, to set an internal control procedure for cash
payments on enterprise could set a purchase procedure which gives
responsibility to order and acquire goods to purchase department
maintain a record and make payments for invoices to accounting and
finance department and receive the purchased stocks to receiving
department.
 Cont…
 Using mechanical devices and pre-numbered documents; using cash registers, check

protector holes and pre-numbered business forms are very helpful to ensure the accuracy and

reliability of accounting data.

 Maintaining physical safeguarding tools; for example safe boxes, drawers with lockers,

having daily deposits etc.

 Implementing periodical performance evaluation methods; evaluating helps to take

periodical corrections and to take sure that regulations are properly implemented.

 Hiring competent employee and having computer help, creates to have efficient and accurate

record keeping and report preparation function

 Planning (budgeting):- forecasting cash necessary for future operations such as through

preparing periodic cash budgets.

 Internal control of cash
An internal control system is a set of policies and procedures designed to protect assets,

provide accurate accounting records and evaluate performances.

Internal control for cash should include the following procedures:

 The individuals who receive cash should not also disburse (pay) cash
 The individuals who handle cash should not access accounting records
 Cash receipts are immediately recorded and deposited and are not used directly to

make payments.
 Disbursements are made by serially numbered checks, only upon proper authorization

by someone other than the person writing the check

 Bank accounts are reconciled monthly.
 Control of Cash through Bank Accounts

Bank accounts are one of the most important means of

controlling cash that provide several advantages such
as:
 Cash is physically protected by the bank,

 A separate record of cash is maintained by the bank,

 And customers may remit payments directly to the

bank.
 Cont…

If a company uses a bank account, monthly statements are received

from the bank showing beginning and ending balances and
transactions occurring during the month including checks paid,
deposits received, and service charges. These monthly statements
(reports) received from the bank are called bank statements. Bank
statements generally are accompanied by checks paid and charged
to the accounts during the month, debit and credited memos,
which inform the company about changes in the cash accounts.
 Reconciliation of Bank and Book Cash Balances

Monthly reconciling of the bank balance with the

depositor’s cash accounts balance is essential cash
control procedure. To reconcile a bank statement means
to verify that the bank balance and the accounting
records of the depositor are consistent.
The balance shown in a monthly bank statement seldom
equals the balance appearing in the depositor’s
accounting records. Certain transactions recorded by the
depositor may not have been recorded by the bank and
vice versa.
Cont…
The most common examples that cause disparity between the two
balances are:
 Outstanding checks:

Checks issued and recorded by the company, but not yet presented to
the bank for payment.
 Deposits in transit:

Cash receipts recorded by the depositor, but not reached the bank
to be included in the bank statement for the current month.
 Service charges:

Banks often charge a fee for handling checking accounts. The

amount of this charge is deducted by the bank form bank balance
and debit memo is issued for the depositor.
 Cont…
 Charges for depositing NSF- checks:

NSF stands for “Not Sufficient Funds.” When checks are deposited in an account, the

bank generally gives the depositor immediate credit. On occasion, one of these

checks may prove to be uncollectible because the maker of the check does not have

sufficient funds in his or her account. In such a case, the bank will reduce the

depositor’s account by the amount of this uncollectible item and return the check to

the depositor marked “NSF”.

 Notes collected by bank:

If the bank collects a note receivable on behalf of the depositor, it credits the depositor’s

account and issues a credit memorandum for the depositor.

 Steps in Preparing Bank Reconciliation

A bank reconciliation is a schedule prepared by the depositor to bring the balance

shown in the bank statement and the balance shown in the depositor’s accounting
into agreement.

The steps to prepare a bank reconciliation are:

 The deposits listed on the bank statement are compared with the deposits shown in
the accounting records. Any deposits not yet recorded by the bank are deposits in
transit and should be added to the balance shown in the bank statements.
 The paid and received checks from the bank are compared with the check stubs.
Any checks issued but not yet paid by the bank are outstanding checks and should
be deducted from the balance reported in the bank statements.
 Cont…
 Any credit memorandums issued by the bank that have not
been recorded by the depositor, are added to the balance per
depositor’s record.
 Any debit memorandums issued by the bank that have not
been recorded by the depositor are deducted from the balance
per depositor’s record.
 Any errors in the bank statement or depositor’s accounting
records are adjusted.
 The equality of adjusted balance of statement and adjusted
balance of the depositor’s record is compared.
 Journal entries are prepared to record any items delayed by
the depositor.
Illustration of Bank Reconciliation
 The January bank statement sent by Awash Bank to RAM Company shows Br. 5000.17. Assume also that

on January 31, 2000, the Cash account of RAM Co. shows a balance of Br. 4262.83. The accountant of

RAM Company has identified the following items:

 A deposit of Br. 410.90 made after banking hours on Jan. 31 does not appear on the bank statement.
 Two checks issued in January have not yet been paid by the bank:

Check No. 301 Br. 110.25

Check No. 342 607.50

 A credit memorandum was included in the bank statement, which was for proceeds from collection of a

non-interest bearing note receivable from MAN company Br. 524.74.

 Three debit memorandums accompanied the bank statement: Fee charged by bank for handling collection

of notes receivable Br.5; a check of Br. 50.25 received from a customer, RON company, and deposited by

RAM company was charged back as NSF; and service charge by bank for the month of January amounts

to Br. 12.00.
Cont…

 Check No. 305 was issued by RAM Company for payment of

telephone expense in the amount of Br. 85 but was

erroneously recorded in the cash payments journal as Br. 58.

The January 31 bank reconciliation for RAM Company is shown

below:
Cont…
RAM Company
Bank Reconciliation
January 31, 2000
Bank statement :
Balance per bank statement, Jan. 31,2000 Br. 5,000.17
Add: Deposit of Jan. 31 not recorded by bank 410.90
Subtotal Br. 5,411.07
Deduct: outstanding checks:
No. 301 Br. 110.25
No. 342 607.50 117.75
Adjusted cash balance Br. 4,693.32
Cont…
Depositor statement
Balance per depositor’s record, Jan. 31,2000 Br. 4,262.83
Add: Note Receivable collected by bank 524.74
Subtotal Br. 4,787.57
Deduction:
Collection fee Br. 5.00
NSF check of Ron Co. 50.25
Service charge 12.00
Error on check stub No. 305 27.00 94.25
Adjusted cash balance Br. 4,693.32
 Journal entries related to the bank reconciliation

Jan. 31 Cash…………524.74
Notes Receivable……….524.74
To record collection of note receivable collected by bank
Jan. 31 Miscellaneous Expense……….17.00
Accounts Receivable-RON Co……….50.25
Utilities Exp………………………….27.00
Cash……………………………94.25
To record bank service charges, NSF check and error in recording Check No. 305
 Petty Cash Fund

Petty cash fund, which is part of the total cash balance, is

used to handle many types of small payments such as
employee transportation costs, purchase of office supplies,
purchase of postage stamps, and delivery charges.
Establishment of Petty Cash
To establish a petty cash fund a check is issued to a bank.
This check is cashed and the money is kept on hand in a
petty cash box. One employee is designated as custodian
of the fund. The issuance of the check for establishment is
recoded by debiting petty cash account and crediting cash.
Replenishment of Petty Cash

During the period, the custodian makes small payments

form the petty cash fund and obtains a receipt or prepares
a petty cash voucher. This petty cash voucher explains the
nature and amount of every expenditure and is kept with
the fund. When the fund runs low or at the end of the
company’s fiscal period, a check is issued to reimburse
the fund for the expenditures made during the period.
Accounting for receivables

Accounts receivable are amounts that customers owe the company

for normal credit purchases. Since accounts receivable are
generally collected within two months of the sale, they are
considered a current asset and usually appear on balance sheets
below short-term investments and above inventory.
Notes receivable are amounts owed to the company by customers
or others who have signed formal promissory notes in
acknowledgment of their debts. Promissory notes strengthen a
company's legal claim against those who fail to pay as promised.
The maturity date of a note determines whether it is placed with
current assets or long-term assets on the balance sheet.
 Characteristics of Notes Receivable

A note is a written promise to pay a sum of money on demand

or at a definite time. As in the case of a check it must be
payable to the order of a certain person or firm or to bearer.
It must also be signed by the person or firm that makes the
promise. The one to whose order the note is payable is called
the payee, and the one making the promise is called the
maker. Notes have several characteristics includes the
followings:
 Due Date
The date a note is to be paid is called the due date or maturity date. The period of
time between the issuance date and the due date of a short term note may be
stated in either days or months.
When the term of a note is stated in days the due date is the specified number of day
after its issuance. To illustrate, the due date of the 90 day note presented above
may be determined as follows.
Term of the note ………………………….……………..90
March (days) ……………………………..31
Date of note …………………………...…16 15
Number of days remaining……………………………….75
April (days) ………………………………………....……30
Number of days remaining …………………………........45
May (days) ……………………………………....……..………..31
Due date, June ………………………………………………....14
 Interest Bearing Notes and Non-Interest Bearing Notes

Interest Bearing Notes

Interest rate for interest bearing notes are usually stated
in terms of a period of one year regardless of the
actual period of time involved.
The basic formula for computing interest.
Interest = Principle x Rate x Time
Example: The 2,500, 90 day 10% note is computed as
follows:
2.500 x 10/100 x 90/360 = $62.50 interest .
 Maturity Value
The amount that is due at the maturity or due date is called the
maturity value. The maturity value of a non interest bearing
note is the face amount. The maturity value of an interest
bearing note is the sum of the face amount and the interest.
Accounting for Notes Receivable
Notes Receivable are usually recorded in a single note
Receivable account to simplify record keeping. We need
only one account because the original notes are kept on file.
This means the maker; rate of interest, due date, and other
information can be learned by examining the actual note.
Cont….
To illustrate the recording of the receipt of a note,
assume that on Jannuary-10, Nile Co. sales
merchandise on account to Fana Co. and receive a
Br. 8,000, 90-day, 12% promissory note.
This transaction is recorded as: -
Jan. 10. Notes Receivable ------------------------8000
Sales----------------------------------8000
 Cont…
The maker of the note usually honors the note and pays it
in full. The entry required to record the receipt of cash
by Nile Co. from Tana Co. is as follows:

April-10 Cash-----------------8240
Notes Receivable-------------------8000
Interest Revenue (5000 X 12/100 X 90/360)----240
Accounting For Uncollectible Accounts Receivable

When credit is extended, some amount of uncollectible

receivables is generally inevitable regardless of the
care taken in granting credit and the control
procedures used. The operating expense incurred
because of the failure to collect receivables is called
Uncollectible Accounts Expense or Bad Debts
Expense or Doubtful Accounts Expense.
There are two methods of accounting for uncollectible
receivables. The allowance method and the direct
write-off method
1 Allowance Method
The allowance method of accounting for bad debts matches the expected
loss from uncollectible A/R against the sales they helped produce. We
must use expected losses since management can’t exactly identify the
customers who won’t pay their bills at the time of sale.
To illustrate this method, assume the A/R account has a balance of Br.
50,000 and based on careful study of the experience of other companies,
Nile Co. estimates that a total of Br. 2000 will be uncollectable.
This estimated expense is recorded through the following adjusting entry.
Dec. 31 Uncollectible Accounts Expense 2000
Allowance for Doubtful Accounts 2000
To record estimated bad debts
The Direct- Write-Off Method

The Direct Write-off method of accounting for bad

debts records the loss from an uncollectible A/R at
the time it is determined to be uncollectible. No
attempt is made to predict uncollectible accounts
expense. Bad debt expense is recorded when
specific accounts are determined to be worthless.
Cont…
If Wonji sugar Co. uses a direct write-off method and
determines on Feb. 20, it can’t collect from a
customer- Home Co.- Br. 500. The entry to write-
off the customer’s account is as follows
Feb. 20 Uncollectible Accounts Expense 500
A/R- Home Co.
500
Cont…
Some times an amount previously written off is later
collected. This can be due to factors such as continual
collection efforts or the good fortune of a customer.
the following two entries record this recovery.
Mar. 5 - A/R- Home Co.---------------------500
Uncollectible Accounts Expense --------500
To reinstate account
Mar. 5 - Cash -----------------------500
A/R- Home Co.------------------500
End of Chapter three

Thanks you
 Chapter Four
Nature and Classification of Inventory
 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:
 Inventories of merchandising businesses

 Inventories of manufacturing businesses

Cont…
A) Inventories of merchandising businesses are
merchandise purchased for resale in the normal
course of business. These types of inventories are
called merchandise inventories.
B) Inventories of manufacturing businesses
manufacturing businesses are businesses that
produce physical output
Cont…
They normally have three types of inventories. These
are:
 Raw material inventory

 Work in process inventory

 Finished goods inventory

Cont…
In this unit only the determination of the inventory of merchandise purchased
for resale commonly called merchandise inventory will be discussed.
1. Raw material inventory -is the cost assigned to goods and materials on
hand but not yet placed into production. Raw materials include the wood
to make a chair or other office furniture’s, the steel to make a car etc.
2. Work in process inventory- is the cost of raw material on which production
has been started but not completed, plus the direct labor cost applied
specifically to this material and allocated manufacturing overhead costs.
3. Finished goods inventory- is the cost identified with the completed but
unsold units on
hand at the end of each period
Inventory Systems: Periodic Vs Perpetual

There are two principal systems of inventory accounting periodic and

perpetual.
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 merchandise inventory account.
 The revenue from sales is recorded each time a sale is made. No

entry is made for the cost of goods sold. So, physical inventory must
be taken periodically to determine the cost of inventory on hand and
goods sold
 Cont
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 merchandise such as
groceries, drugstores, hardware etc
 Cont…
The journal entries to be prepared are:
1. At the time of purchase of merchandise
Purchase………………. XX
Accounts Payable Or Cash ……….XX
2. At the time of sale of merchandise
Accounts receivable or cash………XX
Sales……………………. XX
3. To record purchase returns and allowance:
Accounts payable or cash …….XX
Purchase returns and allowance ……..XX

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

Income Summary…………….XX
Merchandise inventory (beginning)……XX
 Cont…

Income Summary…………….XX

Merchandise inventory (beginning)……XX

To close beginning inventory

Merchandise Inventory(Ending)…..xx

Income Summary……………….xx

To record ending Inventory

 Perpetual inventory system

Under this system the accounting record continuously disclose the

amount of inventory. So, the inventory balance will not remain
the same in the accounting period. All increases are debited to
merchandise
inventory account and all decreases are credited to the same
account.
There are no purchases and purchase returns and allowances
accounts in this system. At the time 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 record. No need of physical counting to
determine their costs
 Accounting treatment
1. At the time of purchase of merchandise
Merchandise inventory ….XX
Account payable or cash ……………………XX
2.At the time of sale of merchandise
Accounts receivable or cash …..XX
Sales……………………………… XX
Cost of goods sold………….XX
Merchandise inventory……..XX3.
3. To record purchase returns and allowances
Accounts payable or cash…………XX
Merchandise inventory……… XX
4. No adjusting entry or closing entry for merchandise inventory is needed at the end
of each accounting period
Example
In its beginning inventory on Jan 1, 2002, Hadiya
Company had 200 units of merchandise that cost
Br. 10 Per unit.
The following transactions were completed during
2002.
February 6 Purchased on credit 250 units of
merchandise at Br. 12 per unit.
February 8 Returned 20 detective units from
February 5 purchases to the supplier.
Cont…
June 15 Purchased for cash 300 units of merchandise
at Br 10 per unit.
September 10 Sold 400 units of merchandise for cash
at a price of Br. 15 per unit. These goods are: 200
units from the beginning inventory and 200 units
for February Purchases.
December 31 330 units are left on hand, 30 units
from February 5 purchases.
 Required: Prepare general journal entries for xyz Company to record the above
transactions and adjusting or closing entry for merchandise inventory on December
31,

A)Under periodic Inventory

February 6 Purchases (250 x Br.12)………3,000
Account payable…………… 3,000
February 8Accounts payable (20 x Br. 12)……….240
Purchase returns and allowances………240
June 15 Purchases (230 x Br. 9)…..2,070
Cash………………………….2,070
B)Under Perpetual inventory

February 5 Merchandise inventory….3,000

Accounts payable……….3,000
February 9 Accounts payable……240
Merchandise inventory……240
June 15 Merchandise inventory…..3,000

Cash …………………..3,000
September 6
i)To record the sales
Cash…………….. 6,000
Sales………………………6,000
ii) To record cost of merchandise sold
Cost of merchandise sold (200 x Br.10) + (100 x Br. 12) …3,200
Merchandise inventory ……………….3,200
Inventory flows

2.1 Cost flow Assumptions

The term cost flow refers to the inflow of costs when
goods are purchased or manufactured and to the outflow
of costs when goods are sold.
There are four methods commonly used in assigning costs
to inventory and cost of merchandise sold. These are
A) Specific identification
B) First-in first-out(FIFO)
C) Last-in first-out (LIFO)
D) Weighted average
Inventory Costing Methods Under Periodic Inventory System

A) Specific identification method

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.
Examples

Beza Company began the year and purchased merchandise as follows:

Jan-1 Beginning inventory 100 units@ Br. 60 = Br. 6,000

Feb. 12 Purchase 200 units@ 50 = 10,000

Oct.1 Purchase 150 units @ 40 = 6,000

Nov. 16 Purchase 300 units@ 36 = 10,800

Dec. 31 Purchase 450 units@ 30 = 13,500

Total 1200 units Br.46, 300

Cont…
The ending inventory consists of 300 units, 100 from
each of the last three purchases.
Cost of ending inventories under specific
identification method
Br. 30 x 100 = Br. 3,000
Br. 36 x 100 = 3,600
Br. 40 x 100 = 4,000
300units Br. 10,600
Cost of Ending inventory cost = Br. 10,600
B) First-in, First-out (FIFO)
This method of assigning cost to inventory and the
goods sold assumes inventory items are sold.
For example, easily spoiled goods such as fruits,
vegetables etc., must be sold near the time of their
acquisition in the order acquired.
 Example 2
The application of the inventory costing methods, assume the
following data for the month of January relating to item A in the
inventories of B Company.
Transaction Date parchased Units Total Cost

January 1, Inventory@Br 2.00 200 400

January 8 Purchases@Br 2.50 300 750
January 15 Purchases@Br 3.00 400 1200
January 30 Purchases@Br 3.50 100 350
At end of year when physical inventory is taken ending inventory
consists 300 unit.
Cont…
As an example, consider the Above illustration
Cost of ending inventory periodic under FIFO method
=Br.100 x 3.50 = Br.350
=Br.200 x 3 = Br.600
300 Units = Br.950
Cost of Ending inventory Br. 950
Cost of merchandise sold = Br. 2,700 – Br. 950
Br. 1,750
C)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-ending inventory under FIFO method
=Br.2 x 200 = Br. 400
=Br. 2.5 x 100 = 250
300 units
Ending inventory cost = Br. 650
Cost of merchandise sold = Br. 2700 – Br. 650
= Br. 2050
 D) Weighted Average Method
This method of assigning cost requires computing the
average cost per unit of merchandise available for sale.
To calculate the cost of ending inventory, we will calculate
first the cost per unit of goods available for sale
Average cost per unit =Cost of goods available for sale
Total units available for sale
Cont…
Then the weighted average unit cost is multiplied by units on hand
at the end of the period to calculate the cost of ending inventory.
As an example, take the previous illustration
Weighted average unit cost = Br. 2700 = Br. 2.7
1000

Ending inventory cost = Br. 2.7x 300

= Br. 810
Cost of merchandise sold = Br. 2700-Br. 810
= Br. 1,890
 Perpetual FIFO
Example: The application of the inventory costing methods, assume the
following data for the month of January relating to item A in the
inventories of B Company.
Transaction Date Units
Purchased Sold On Hand
January 1, Inventory@Br 2.00 200
January 8 Purchases@Br 2.50 300 500
January 10 Sales 400 100
January 15 Purchases@Br 3.00 400 500
January 18 Sales 300 200
January 30 Purchases@Br 3.50 100
300
:
 Perpetual FIFO
Date Purchase Cost of merchandise sold Inventory

Qty. Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Jan. 1 200 Br. 2.00 Br. 400.00

8 300 2.50 750 200 2.00 400.00

300 2.50 750.00
200 2.00 400.00 100 2.50 250.00
10
200 2.50 500.00

15 400 3.00 1200.00 100 2.50 250.00

400 3.00 1200.00

18 100 2.50 250.00 200 3.00 600.00

200 3.00 600.00

30 200 3.00 600.00

100 3.50 350.0
100 3.50 350.00

700 Br. 300 Br950.00

1750.00
 Perpetual LIFO
Date Purchase Cost of merchandise sold Inventory

Qty. Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Jan. 1 200 Br. 2.00 Br. 400.00

8 300 2.50 750 200 20.00 400.00

300 2.50 750.00
300 2.50 750.00 100 2.00 200.00
10
100 2.00 200.00

15 400 3.00 1200.00 100 2.00 200.00

400 3.00 1200.00

18 300 3.00 900.00 100 2.00 200.00

100 3.00 300.00
30 100 3.50 350.00 100 2.00 200.00
100 3.00 300.00
100 3.50 350.00
700 1850.00 300 850.00
 Average Cost Method (Moving Average)

Date Purchase Cost of merchandise sold Inventory

Qty. Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost

Jan. 1 200 Br. 2.00 Br. 400.00

8 300 2.50 750.00 500 1150 400.00

500
=2.30

10 400 2.30 920.00 100 2.30 230.00

500 2.86 1430.00

15 400 3.00 Br. 1200.00 = 1200+230
100+400

18 300 2.86 858.00 200 2.86 572.00

30 100 3.50 350.00 300 3.07 921.00

572+350
100+200

700 Br1778.00 300 Br. 3.07 Br 921.00

Gross profit method
This method uses an estimate of the gross profit realized during the period to
estimate the cost of inventory. The gross profit rate may be estimated based on
the average of previous period’s 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 Sales

2. Cost of merchandise sold is estimated

Estimated cost of merchandise sold = Sales - Estimated gross profit

3. Calculate the estimated cost of ending inventory

Estimated cost of ending inventory =
Cost of merchandise available for sale – Estimated cost of merchandise sold
 Example

Nov. 1, beginning inventory (cost) – Br. 4000

Net purchases during October (cost) 200,000
Net sales during October 240,000
Estimated gross profit rate is 60%
 The ending inventory is estimated as follows:

1. Estimated gross profit = 0.6 X 240,000

= Br. 144,000

2. Estimated cost of merchandise sold

= Br. 240,000 – Br. 144,000
= Br. 96,000

3.Estimated cost of ending inventory

= (Br. 36,000 + 204,000) – Br. 132,000
= Br. 240,000 – Br. 132,000
= Br. 108,000
 Retail method of inventory costing

This method is mostly used by retail business. The estimate is made based on the relation

ship 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 ration X Ending inventory at retail
 Example

Cost Retail
Sep. 1, beginning inventory Br. 25,000 Br. 40,000
Purchases in September (net) 125,000
160,000
Sales in September (net)
140,000
 Cont…
1. Cost retail ration = Br. 25,000 + Br. 125,000 = 0.75

Br. 40,000 + Br. 160,000

2. Ending inventory at retail = (Br. 40,000 + Br.160,000) – Br.

140,000 = Br. 60,000

3. Estimated ending inventory at cost = 0.75 X Br.60,000

= Br. 45,000
End of chapter four

Think you for listening

 Chapter- Five
Property, Plant, and Equipment (PPE)
are tangible, long-lived assets used by a firm.
Tangible assets derive value from their physical
substance. These assets include land, land
improvements (such as parking lots and roads),
office buildings, office equipment, manufacturing
facilities (factories), and factory equipment.
Broadly, operational long-term assets are divided
into tangible and intangible.
Features of Intangible assets

 Do not have physical existence.

 Don’t touch body hand and seen by naked eye.
 Cost of acquiring is amortizing.
 Examples, include goodwill, copyrights, patents,
trademarks, franchises, etc.
Features of Tangible (P, P, &E) assets

 They do have physical existence.

 To be touch and seen.
 Cost Acquiring is depreciation.
 Acquired for use in operation but they are not
incorporated into finished goods as raw materials do.
Examples of plant assets include land; buildings,
machinery, equipment, leasehold improvements, etc.
 Almost all plant assets have limited economic lives.
Natural Resources

 These are resources that are going to be exhausted

(i.e. finished) through extraction.
Examples include oil and gas deposits, timber,
mineral deposits, etc.
 The costs of acquiring is depletion.
The major characteristics of property, plant, and equipment
are as follows.

 They are acquired for use in operations and not for

resale
 They possess(own) physical substance
 They are long-term in nature and usually
depreciated(tangible).
5.2. Acquisition cost of property, plant and equipment

Most companies use historical cost as the basis for

valuing property, plant, and equipment
The main reasons for this position are as follows.
1.Historical cost involves actual, not hypothetical,
transactions and so is the most reliable.
2.Companies should not anticipate gains and losses
but should recognize gains and losses only when
the asset is sold.
Cost of Land

All expenditures made to acquire land and ready it for

use are considered part of the land cost and
considerations are.
1.The purchase price.
2.Closing costs, (title to the land, attorney’s fees, and
recording fees).
3. Costs incurred in getting the land in condition for its
intended use ( grading and clearing)
4. Any additional land improvements that have an
indefinite life.
In general, the following costs are must be considered to be debited to the
Land account

 cash purchase price

 closing costs such as title and attorney’s fees
 Broker’s commissions
 Title fees
 Surveying fees
 removing unwanted buildings, less any salvage
 Grading and leveling
LAND IMPROVEMENTS

Some improvements to real estate, such as driveways,

parking lots, and fences, have a limited life and
thus are subject to depreciation
Note: such type of costs is depreciable and not
included under land account
 Example
AB Company buys land for a new retail operation.
The net purchase price is $340,000. The company
also pays brokerage fees of $12,000, legal fees of
$4,000, $20,000 to have an old building on the site
torn down, and $2,000 to have the site graded. It
received $8,000 in salvage from the old building
Required
Determine the cost of the land and record the necessary
journal entry
The cost of the land is calculated as follows:
Net purchase price $340,000
Brokerage fees +12,000
Legal fees 4,000
Tearing down old building $20,000
Grading 2,000
Less salvage (8,000)
Total cost $370,000
Journal entry
Land --------------------------370, 0000
Cash-----------------------------370,000
Cost of equipment
The term “equipment” in accounting includes
delivery of equipment, office equipment,
machinery, furniture and fixtures, furnishings,
factory equipment, and similar fixed assets
Cont
 In general, the cost of machinery and equipment
includes:
 Purchase price (less any discounts),
 Transportation charges(less transaction cost),
 Insurance while in transit (if damage),
 Sales tax and other taxes (if taxable),
 Purchase commission (Agreement consideration),
 the cost of testing the asset before it is used
Cost of Buildings

These costs include

1. Materials, Labor (D, ID), and FOH costs incurred
during construction, and
2. Professional fees and building permits
Cont
The cost of a building depends on whether the company is
constructing the building by it self or is buying an
existing one.
These costs include the following:
A. Constructing a Building
 Architectural fees

 Building permits

 Contractor charges

 Payments for material, labor, and overhead

 Capitalized interest cost, if self-constructed

B. Purchasing an Existing Building

 Purchase price
 Costs to renovate the building to ready the building
for use, which may include any of the charges
listed under “Constructing a Building
Interest Costs during Construction of new Building and The accounting
problems associated with interest capitalization. (FASB, SFAC no 34)

Cost of self constructed building (Asset) =All cost incurred for

construction plus interest capitalization

How to determine interest capitalization

There are three Approach haven suggested to account the interest
incurred in Financing the construction of property
1. Capitalize no interest charges during construction.

Under this approach, if a company had

used stock (equity) financing rather than
debt.
2. Charge construction with all costs of funds employed,
whether identifiable or not.

This method maintains that the cost of construction

should include the cost of financing, whether by
cash, debt, or stock.
Its advocates say that all costs necessary to get an
asset ready for its intended use, including interest,
are part of the asset’s cost.
 3. Capitalize only the actual interest costs incurred during construction

This approach agrees in part with the logic of the second

approach that interest is just as much a cost as are labor
and materials.
Under this approach, a company that uses debt financing
will have an asset of higher cost than a company that
uses stock financing.
GAAP requires the third approach. This method follows
the concept that the historical cost of acquiring an asset
includes all costs (including interest) incurred to bring
the asset to the condition and location necessary for its
intended use
To implement the third approach, companies consider three
items

1. Qualifying assets
Assets must require a period of time to get them
ready for their intended (required) use.
A company capitalizes interest costs starting with the
first expenditure related to the asset.
2. Capitalization period.
Is the period of time during which a company must
capitalize
 It begins with the presence of three conditions:

1. Expenditures for the asset have been made.

2. Activities that are necessary to get the asset ready
for its intended use are in progress.
3. Interest cost is being incurred.
3. Amount to capitalize
The amount of interest to capitalize is limited to the
lower of actual interest cost incurred during the
period or avoidable interest.
Cont
Weighted-Average Accumulated Expenditures= Amount of
Expenditure *days into month Annually
Example 1
Assume on January 1,2020 AB Equipment
company began construction of building to use as
the quarter. The building was completed
December,31,2020 the expenditure on the price
mainly to the sub constructly were as follows .
Cont
January 1,2020 ……………….500,000
March 31,2020………………..400,000
September30,2020…………..600,000
Accumulated Expenditure = 1500,000
Suppose that on January 2,2020 the company
obtained $1,000,000 construction loan at 8%
nominal rate.
Cont
a. Determine the weighted average expenditure
on which interest should be capitalized
b. Determine the interest capitalized and record
entry
c. Determine the cost of building and record
journal entries
 Cont

A. Compute the weighted-average Accumulated expenditures for the year

ended December 31 as follows.
Date Expenditure capitalization period weighted
average
Accumulated

Expenditure
January 1 $ 500,000 12/12 $500,000
March 31 $400,000 9/12 $300,000
September 30 600,000 3/12 $150,000
$1500,000 $950,000
B. Compute the amount of interest to be capitalized

Interest capitalized= weighted Average expenditure *Interest rate

= 950,000*0.08
=76,000
Journal Entries
Building ………….76,000
Interest capitalized…….76,000
C. Compute cost of Building
Cost of Building = Accumulated Expenditure +Capitalized Interest
= 1,500,000 +76,000
=1,576,000
Journal Entries
Building …………….1,576,000
Cash………………………1500,000
Interest Expense ………….76,000
 5.3. Valuation of Property, Plant, and Equipment

If asset Acquired
1. With discount
2. Group purchase
3. Issuance of stock
4. By gift
5. Deferred payment
1. Cash Discounts
When a company purchases plant assets subject to cash
discounts for rapid payment. If it takes the discount,
the company should consider the discount as a
reduction in the purchase price of the asset.
 2. Group Purchases (A Lump-Sum (Basket) Purchase of Assets)

Companies sometimes purchase land and other assets for a

lump sum. If asset is acquired in group based on
percentage of relative sales volume multiplied by the
total purchase price
Example :Assume Mr X had bought land and Building at
$40,000 where market sale value of land $20,000 and
Relative sales value of building is $30,000.
Required:
A. Determine cost of land and Building
B. Record Entry
 Cont
Sale value percentage of relative sales value
Land……………...$20,000 20,000/50,000=40%
Building ………….$30,000 30,000/ 50,000=60%
Therefore :
cost of land =purchase price *% of RVS
=40,000*0.4
= 16,000
Cost of Building =purchase price *% of RVS
= 40,000*0.6
=24,000
Journal Entries
Land ………….16,000
Building ……….24,000
cash………………..40,000
Acquisition of plant asset with Issuance of Stock

When companies acquire property by issuing

securities, such as common stock, the par or stated
value of such stock.
Plant asset= market value*No of share
Example, AX Co. decides to purchase some
adjacent land for expansion of its carpeting and
cabinet operation. In lieu of paying cash for the
land, the company issues to Deed land Company
5,000 shares of common stock (par value $10) that
have a fair market value of $12 per share
 Records the journal entry for the acquisition of land

Land (5,000 *$12) -------60,000

Common Stock ---------------------50,000
Paid-In Capital in Excess of Par--10,000
Deferred-Payment Contracts (long term credit contract)

Companies frequently purchase plant assets on long-

term credit contracts, using notes, loans, bonds, or
equipment.
Example: GT real estate Company purchases an asset
today in exchange for a $10,000 zero-interest
bearing note payable four years from now. Assuming
an appropriate interest rate of 9 percent at which to
discount this single payment of $10,000 due four
years from now.
 Records the acquisition of the asset
Lum sum payment PV= FV
(1+i)n
=10,000 = 7084
(1+0.09)4
Journal Entries
Equipment ------------------7,084
Discount on Equipment ----2916
Contract payable -----------------10,000
 Plant Assets Acquired By Gift
Companies sometimes receive or make contributions
(donations or gifts).
Such contribution asset transfer by one direction
To estimate the value of asset company consider the
market value of Asset.
Example :The Somalia Regional state offer to Tiret
PLC a land with current fair value of Br. 500, 000 as
an incentive to invest, in return Tiret Plc is going to
create a job opportunity for 50 individuals.
How do you record this transaction?

Land----------------------------500, 000
Donated Capital-----------------500, 000
 5.4. Treatment of cost incurred subsequent to acquisition of P.P, &E

Capital and Revenue Expenditures

Capital expenditures:-is the expenditure incurred to increase the asset’s
capacity or efficiency, or extend the asset’s useful life.
Capital expenditures include the purchase price plus all the other costs to
bring an asset to its intended use, and Extraordinary repair
Extraordinary repairs:
 Major engine or transmission overhaul

 Modification for new use

 Addition to storage capacity

When you treat the accounting treatments capital expenditure debited

asset account
Asset---------------------xx
cash / Account payable----------xx
Cont
An example of an extraordinary repair would be
spending $3,000 to rebuild the engine on a five-
year-old truck. This extraordinary repair would
extend the asset’s life past the normal expected life.
Journal Entries:
Truck ----------------3,000
Cash -----------------------------3000
Revenue expenditures

Revenue expenditures : expenditure incurred for

repair and maintenance a given level of service
should be expense .
Journal entries
Expense ------------xx
cash-----------------xx
 5.5 .Depreciation and Disposal

Depreciation: is the allocation of a plant asset’s cost to

expense over its useful life.
Depreciation of plant asset based three factors
 Cost

 Useful life

 Residual

Cost : is the purchase price or construction cost

Estimated useful life: is the length of the service
period expected from the asset.
 Depreciation Methods

There are several depreciation methods that attempt to

recognize those factors in varying degrees. They are :
 Straight-line method

 Accelerated methods

o Declining-balance method
o Sum-of-the-years’-digits method
 Units-of-output method
 Straight-line Method

The straight-line method is based on the assumption that a

plant asset declines in usefulness at a constant rate.
The formula for computing periodic straight-line depreciation is
Annual straight-line depreciation =cost – residual value
Estimate Economic life

Declining-Balance Method
This method utilizes a depreciation rate (expressed as a
percentage) that is some multiple of the straight-line
method.
For example, the double declining rate for a 10-year asset
would be 20% (double the straight line rate.
Cont
Assume that Famine Company recently purchased
crane for digging purposes. Pertinent data
concerning the purchase of the crane are:
Cost of crane……………………..Br. 500, 000
Estimated Economic life…………………5 years
Estimated salvage value………………..Br. 50, 000
Productive life in hours……………………30, 000
Using the doubles declining approach the
depreciation expense per year is as follow:
Cont
Year Beginning book value Rate Depreciation expense Accumulation Ending book
Depreciation value

1 500,000 40% 200,000 200,000 300,000

2 300,000 40% 120,000 320,000 180,000
3 180,000 40% 72,000 392,000 108,000
4 108,000 40% 4,3200 43,5200 6,4800
5 64,000 40% 1,4800 450,000 50,000

Limited to Br. 14, 800 because book value should not

be less than salvage value
 Sum-of-the-years’-Digits Method
This method provide variable expense from year to
year b/c its calculated by different rate.
Depreciation rate =n(n+1)
2
Cont
Year Depreciation Remaining life Depreciation Depreciation Accumulation Ending book
base rate years in expense Depreciation value
fraction

1 450,000 5 5/15 150,000 150,000 350,000

2 450,000 4 4/15 120,000 270,000 230,000

3 450,000 3 3/15 90,000 360,000 140,000

4 450,000 2 2/15 60,000 420,000 80,000

5 450,000 1 1/15 30,000 450,000 50,000

Units-of-output method
This method assumes that depreciation is a function of
use or productivity instead of the passage of time

Depreciation expense = cost minus salvage value x Hours this

year
Total estimate hours
= 500,000 -50,000 X 4000
30,000
=450000 x 4000 =60000
30000
5.6. Plant Asset Disposals
In general, plant assets that are no longer useful may
be discarded, sold, or exchanged to other plant
assets.
The book value is then eliminated by debiting
Accumulated Depreciation for the total
depreciation to the date of disposal and crediting
the asset account for the cost of the asset.
Retirement (Discarding) of Plant Assets

When plant assets are no longer useful to the business and

have no market value, they are, retired (discarded).
Journal Entry if fully depreciated
Accumulated Depreciation- machinery ----------xxx
machinery ------------------------------------------------xxx
Journal entries before fully depreciated
Accumulated Depreciation- machinery ----------xx
Loss on disposal ------------------------------------xx
machinery ----------------------------------------xxxx
Sale of Plant Assets
In a disposal by sale, the book value of the asset is
compared with the proceeds received from the sale.
If the proceeds of the sale exceed the book value of
the plant asset, a gain on disposal occurs. If the
proceeds of the sale are less than the book value of
the plant asset sold, a loss on disposal occurs.
Gain on Disposal
Example :Assume that on October 1, 2020, HD
Company sells Machinery for Br26, 000 cash.
The Machinery originally cost Br70, 000 and
as of January 1, 2020, had accumulated
depreciation of Br59, 000.
The entry to record the sale and the gain on disposal is
as follows:

Cash…………………………………..26,000

Accumulated Depreciation – machinery..59000

Machinery………………………………..70,0000

Gain on
Disposal…………………………...15000

To record gain on disposal

 Loss on Disposal
Assume that instead of selling the machinery for Br26, 000, HD
Company sells it for Br 7, 000.
Cash………………………………………..7,000

Accumulated Depreciation – machinery …..59000

Loss on disposal…………………………….4000

Machinery……………………………..70,000
Exchanges of Plant Assets
Plant assets may also be disposed of through
exchange. Exchanges can be for either similar or
dissimilar assets.
An exchange of similar assets of the same type:
This occurs, for example, when old office furniture
is exchanged for new office furniture or when old
delivery equipment exchanged for new deliver
equipment. In an exchange of similar assets, the
new asset performs the same function as the old
asset.
Loss Treatment

Example: Assume that AB Company exchanged

old computer for similar new computer. The
book value of the old computer is Br26, 000
(cost Br90, 000 less accumulated depreciation
Br64, 000), its fair market value is Br10, 000,
and cash of Br101, 000 is paid
Cont

Computer ………………………………..111,000

Accumulation Depreciation- computer …..64,000

Loss on Disposal………………………….16,000

Old computer ………………………………….90,000

Cash………………………………………….101000

To record exchange of old computer for similar new computer

Gain Treatment
Example :Assume that Sara Express decides to
exchange its old computer plus cash of Br5, 000 for
new computer. At this time, the book value of the old
computer is Br12, 000 (cost Br50,000 less
accumulated depreciation Br38, 000). In addition, it is
determined that the fair market value of the old computer is
Br20, 000
Cont

Computer (new)…………………………….17,0000

Accumulated depreciation – computer (old)…..38000

Computer ( old)…………………………50,000

Cash………………………………………5000

To record exchange of old computer for similar new

computer
5.7. Natural Resources
Definition Natural Resources
Natural resources consist of standing timber and
underground deposits of oil, gas, and minerals.
Depletion Expense
The process of allocating the cost of natural resources
to expense in a rational and systematic manner over
the resource’s useful life is called depletion
 Accounting for Intangible Assets
In general, accounting for intangible assets parallels the
accounting for plant assets. That is, intangible assets are
received at cost, and this is expensed over the useful life of
the intangible assets in a rational and systematic manner.
The allocation of the cost of an intangible asset to expense is
amortization.
The amortization period of an intangible asset cannot be
longer than 40 years.
Example of intangible asset copy right ,trademark, goodwill
etc.
 End of chapter five

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