B - Fund - Acc - 1 & 2

A New Vision for a New Age of Business!
Preface
This material can significantly benefit those who enter business, government, and other
organizations, where decision-makers use accounting information. These individuals will be
better prepared for their responsibilities if they understand the role of accounting
information in decision-making by managers, investors, government regulators, and others.
All organizations have accountability responsibilities to their constituents, and accounting,
properly used, is a powerful tool in creating information to improve the decisions that affect
those constituents.
Without actual business experience, business students sometimes lack a frame of reference
in attempting to apply accounting concepts to business transactions. We seek to involve the
business student more in real world business applications as we introduce and explain the
subject matter.
1 By: Mohammed G (Msc),Jimma University, Faculty Business& Economics

Introduction:
In 1494, the first book on double-entry accounting was published by Luca Pacioli. Since
Pacioli was a Franciscan friar, he might be referred to simply as Friar Luca. While Friar
Luca is regarded as the "Father of Accounting," he did not invent the system. Instead, he
simply described a method used by merchants in Venice during the Italian Renaissance
period. His system included most of the accounting cycle as we know it today.
The following is a list of accounting terms, rules and principles that Luca Pacioli described
in his book:
 The double-entry accounting system;
 Debit is the left side of an account, and the credit is the right side of an account;
 All debit amounts have to be equal to all credit amounts;
 The usage of three books: a memorial, a ledger, and a journal;
 The memorial is the document where a transaction is recorded first;
 A journal contains records about all transactions in a chronological order listed in the
debit and credit form;
 All journal information is posted to the ledger;
 Closing entries must be made at the year-end;
 The trial balance (summa summarium) is the final important step in the accounting
cycle;
 Assets (account receivables, inventories), liabilities, equity, income, and expense
accounts are presented in the ledger;
 A necessity of keeping the documents.
It is easy to see that double-entry accounting rules and steps of the recording process,
performed in the Pacioli‘s work more than 500 years ago, are still appropriate. This confirms
the significant influence of Luca Pacioli‘s book on the accounting field.
Accounting practitioners in public accounting, industry, and not-for-profit organizations, as

well as investors, lending institutions, business firms, and all other users for financial
information are indebted to Luca Pacioli for his monumental role in the development of
accounting.

Most of the world‘s work is done through organizations-groups of people who work together
to accomplish one or more objectives. In doing its work, an organization uses resources-
labor, materials, various services, buildings, and equipment. These resources need to be
financed, or paid for. To work effectively, the people in organization need information about
the amounts of these resources, the mean of financing them and the results achieved
through using them. Parties outside the organization need similar information to make
judgments about the organization. Accounting is a system that provides such information.
Organizations can be classified broadly as either for-profit or nonprofit. As these names
suggest, a dominant purpose of organizations in the former category is to earn a profit,
whereas organizations in the latter category have other objectives, such as governing,
providing social services, and providing education. Accounting is basically similar in both
types of organizations.

CHAPTER ONE
Meaning of Accounting
Accounting is the process of financially measuring, recording, summarizing and
communicating the economic activity of an organization to decision makers. Thus, the
purpose of accounting is to help decision-makers to make informed judgments and
decisions.
Accounting is ―the language of business.‖ The better you understand the language, the
better your decisions will be, and the better you can manage your finances. Effectively
communicating this information is the key to the success of every business. Those who rely
on financial information n include internal users, such as a company's managers and
employees, and external users, such as banks, investors, governmental agencies, financial
analysts, and labor unions.
Users of Accounting Information - Internal & External
Accounting information helps users to make better financial decisions. Users of financial
information may be both internal and external to the organization.
Internal users (Primary Users) of accounting information include the following:
 Management: for analyzing the organization's performance and position and taking
appropriate measures to improve the company results.
 Employees: for assessing company's profitability and its consequence on their future
remuneration and job security.
 Owners: for analyzing the viability and profitability of their investment and
determining any future course of action.
Accounting information is presented to internal users usually in the form of management
accounts, budgets, forecasts and financial statements.
External users (Secondary Users) of accounting information include the following:
 Creditors: for determining the credit worthiness of the organization. Terms of credit
are set by creditors according to the assessment of their customers' financial health.
Creditors include suppliers as well as lenders of finance such as banks.
 Tax Authorities: for determining the credibility of the tax returns filed on behalf of
the company.

 Investors: for analyzing the feasibility of investing in the company. Investors want to
make sure they can earn a reasonable return on their investment before they commit
any financial resources to the company.
 Customers: for assessing the financial position of its suppliers which is necessary for
them to maintain a stable source of supply in the long term.
 Regulatory Authorities: for ensuring that the company's disclosure of accounting
information is in accordance with the rules and regulations set in order to protect the
interests of the stakeholders who rely on such information in forming their decisions.
External users are communicated accounting information usually in the form of financial
statements. The purpose of financial statements is to cater for the needs of such diverse users of
accounting information in order to assist them in making sound financial decisions.
Accountancy encompasses the recording, classification, and summarizing of transactions and
events in a manner that helps its users to assess the financial performance and position of the
entity. The process starts by first identifying transactions and events that affect the financial
position and performance of the company. Once transactions and events are identified, they are
recorded, classified and summarized in a manner that helps the user of accounting information
in determining the nature and effect of such transactions and events.
Accounting is a very dynamic profession which is constantly adapting itself to varying needs of its
users. Over the past few decades, accountancy has branched out into different types of accounting to
cater for the different needs of the users.
Types of Accounting
Accounting is a vast and dynamic profession and is constantly adapting itself to the specific and
varying needs of its users. Over the past few decades, accountancy has branched out into different
types of accounting to cater for the diversity of needs of its users.
Main types of accounting:
Financial Accounting, or financial reporting, is the process of producing information for external
use usually in the form of financial statements. Financial Statements reflect an entity's past
performance and current position based on a set of standards and guidelines known as IFRS
(International Financial Reporting standard) or GAAP (Generally Accepted Accounting Principles).
GAAP refers to the standard framework of guideline for financial accounting used in any given
jurisdiction. This generally includes accounting standards (e.g. International Financial Reporting

Standards), accounting conventions, and rules and regulations that accountants must follow in the
preparation of the financial statements.
Management Accounting produces information primarily for internal use by the company's
management. The information produced is generally more detailed than that produced for external
use to enable effective organization control and the fulfillment of the strategic aims and objectives of
the entity. Information may be in the form budgets and forecasts, enabling an enterprise to plan
effectively for its future or may include an assessment based on its past performance and results. The
form and content of any report produced in the process is purely upon management's discretion.
Cost accounting is a branch of management accounting and involves the application of various
techniques to monitor and control costs. Its application is more suited to manufacturing concerns.
Governmental Accounting, also known as public accounting or federal accounting, refers to the
type of accounting information system used in the public sector. This is a slight deviation from the
financial accounting system used in the private sector. The need to have a separate accounting
system for the public sector arises because of the different aims and objectives of the state owned
and privately owned institutions. Governmental accounting ensures the financial position and
performance of the public sector institutions are set in budgetary context since financial constraints
are often a major concern of many governments. Separate rules are followed in many jurisdictions to
account for the transactions and events of public entities.
Tax Accounting refers to accounting for the tax related matters. It is governed by the tax rules
prescribed by the tax laws of a jurisdiction. Often these rules are different from the rules that govern
the preparation of financial statements for public use (i.e. GAAP). Tax accountants therefore adjust
the financial statements prepared under financial accounting principles to account for the differences
with rules prescribed by the tax laws. Information is then used by tax professionals to estimate tax
liability of a company and for tax planning purposes.
Forensic Accounting is the use of accounting, auditing and investigative techniques in cases of
litigation or disputes. Forensic accountants act as expert witnesses in courts of law in civil and
criminal disputes that require an assessment of the financial effects of a loss or the detection of a
financial fraud. Common litigations where forensic accountants are hired include insurance claims,
personal injury claims, suspected fraud and claims of professional negligence in a financial matter
(e.g. business valuation).
Project Accounting refers to the use of accounting system to track the financial progress of a
project through frequent financial reports. Project accounting is a vital component of project

management. It is a specialized branch of management accounting with a prime focus on ensuring

the financial success of company projects such as the launch of a new product. Project accounting
can be a source of competitive advantage for project-oriented businesses such as construction firms.
Nature of Business and Accounting
A business is an organization in which basic resources (inputs), such as materials and labor,
are assembled and processed to provide goods or services (outputs) to customers.
The objective of most businesses is to earn a profit. Profit is the difference between the
amounts received from customers for goods or services and the amounts paid for the inputs
used to provide the goods or services. In this text, we focus on businesses operating to earn a
profit. However many of the same concepts and principles also apply to not-for-profit
organizations such as hospitals, churches, and government agencies.
Types of Businesses
Three types of businesses operated for profit include service, merchandising, and
manufacturing businesses.
Merchandize business Businesses that are into the buying and selling of goods or
commodities like the grocery store, drug store and
department store.
Manufacturing business Businesses that are engaged in the processing of products or
the conversion of raw materials into finished goods that are
then sold like the furniture factory and shoe factory. A
trading or merchandising business differs from a
manufacturing concern in that the former buys finished
goods, which are ready for sale, while the latter produces or
manufactured the goods that it sells.
Service business Businesses engage in the rendering of services to others for a
fee, like the beauty parlor, banks, schools, hospitals, transport
company…etc.
What is the role of accounting in business? The simplest answer is that accounting provides
information for managers to use in operating the business. In addition, accounting provides
information to other users in assessing the economic performance and condition of the
business.
Thus, accounting can be defined as an information system that provides reports to users
about the economic activities and condition of a business. You may think of accounting as

the “language of business.” This is because accounting is the means by which businesses’
financial information is communicated to users.
The process by which accounting provides information to users is as follows:
1. Identify users.
2. Assess users‘ information needs.
3. Design the accounting information system to meet users‘ needs.
4. Record economic data about business activities and events.
5. Prepare accounting reports
Distinguish between Generally Accepted Accounting Principles (GAAP) and International
Financial Reporting Standards (IFRS)
UNITE STATE GENERAL ACCEPTED ACCOUNTING PRINCIPLEU.S GAAP
The accounting profession has developed standards that are generally accepted and universally
practiced. This common set of standards is called generally accepted accounting principles
(GAAP). These standards indicate how to report economic events
Generally Accepted Accounting Principles refer to the standard framework of guidelines

for financial accounting used in any given jurisdiction; generally known as accounting
standards or Standard accounting practice. These include the standards, conventions, and rules
that accountants follow in recording and summarizing, and in the preparation of financial
statements.
INTERNATIONAL FINANCIAL REPORTING STANDARD (IFRS)
Many countries outside of the United States have adopted the accounting standards issued by the
International Accounting Standards Board (IASB). These standards are called International
Financial Reporting Standards (IFRS).
International Financial Reporting Standards (IFRS) are designed as a common global language
for business affairs so that company accounts are understandable reliable relevant and
comparable as per the users internal or external users or across international boundaries.
In General as markets become more global, it is often desirable to compare the result of
companies from different countries that report using different accounting standards. In order to
increase comparability, in recent years the two standard-setting bodies have made efforts to
reduce the differences between U.S. GAAP and IFRS. This process is referred to as convergence

As a result of these convergence efforts, it is likely that someday there will be a single set of
high-quality accounting standards that are used by companies around the world. Because
convergence is such an important issue, we highlight any major differences between GAAP
and IFRS in International Notes at the end of each chapter.
Basic Accounting Principles and Concepts
GAAP is the framework, rules and guidelines of the financial accounting profession with a
purpose of standardizing the accounting concepts, principles and procedures.
Here are the basic accounting principles and concepts under this framework:
1. Cost principle: The cost principle (or historical cost principle) dictates that companies
record assets at their cost.This is true not only at the time the asset is purchased, but also
over the time the asset is held.
For example, if ABC purchases land for Br300, 000, the company initially reports it in its
accounting records at Br300, 000. But what does ABC do if, by the end of the next year, the
fair value of the land has increased to Br400, 000? Under the cost principle, it continues to
report the land at Br300, 000.
2. Fair value principle: The fair value principle states that assets and liabilities should be
reported at fair value (the price received to sell an asset or settle a liability). Fair value
information may be more useful than historical cost for certain types of assets and liabilities.
For example, certain investment securities are reported at fair value because market value
information is usually readily available for these types of assets. In determining which
measurement principle to use, companies weigh the factual nature of cost figures versus the
relevance of fair value. In general, most companies choose to use cost. Only in situations
where assets are actively traded, such as investment securities, do companies apply the fair
value principle extensively.
3. Going Concern: It assumes that an entity will continue to operate indefinitely. In this
basis, assets are recorded based on their original cost and not on market value. Assets are
assumed to be used for an indefinite period of time and not intended to be sold immediately.
4.Monetary Unit: The business financial transactions recorded and reported should be in
monetary unit, such as Birr, US Dollar, Canadian Dollar, Euro, etc. Thus, any non-financial
or non-monetary information that cannot be measured in a monetary unit are not recorded
in the accounting books, but instead, a memorandum will be used.

5. Matching: This principle requires that revenue recorded, in a given accounting period,
should have an equivalent expense recorded, in order to show the true profit of the business.
6. Accounting Period: This principle entails a business to complete the whole accounting
process of a business over a specific operating time period. It may be monthly, quarterly or
annually. For annual accounting period, it may follow a Calendar or Fiscal Year.
7. Consistency: This principle ensures consistency in the accounting procedures used by the
business entity from one accounting period to the next. It allows fair comparison of financial
information between two accounting periods.
8. Materiality: Ideally, business transactions that may affect the decision of a user of financial
information are considered important or material, thus, must be reported properly. This
principle allows errors or violations of accounting valuation involving immaterial and small
amount of recorded business transaction.
9. Objectivity: This principle requires recorded business transactions should have some form
of impartial supporting evidence or documentation. Also, it entails that bookkeeping and
financial recording should be performed with independence, that‘s free of bias and
prejudice.
10. Accrual: This principle requires that revenue should be recorded in the period it is
earned, regardless of the time the cash is received. The same is true for expense. Expense
should be recognized and recorded at the time it is incurred, regardless of the time that cash
is paid.
11. Business Entity: A business is considered a separate entity from the owner(s) and should
be treated separately. Any personal transactions of its owner should not be recorded in the
business accounting book, vice versa. Unless the owner‘s personal transaction involves
adding and/or withdrawing resources from the business.
A business entity may take the form of a proprietorship, partnership, and corporation. Each
of
These forms and their major characteristics are listed below.
Sole Proprietorship: A sole proprietorship is the simplest form of business. It is an
unincorporated business owned by one individual. Going into business as a sole proprietor
is easy—one merely begins business operations. However, even the smallest businesses
normally must be licensed by a governmental unit.

The proprietorship has three important advantages:

 It is easily and inexpensively formed,
 It is subject to few government regulations, and
 The business avoids corporate income taxes.
The proprietorship also has three important limitations:
 It is difficult for a proprietorship to obtain large sums of capital;
 The proprietor has unlimited personal liability for the business’s debts, which can
result in losses that exceed the money he or she has invested in the company; and
 The life of a business organized as a proprietorship is limited to the life of the
individual who created it.
For these three reasons, sole proprietorships are used primarily for small-business operations.
However, businesses are frequently started as proprietorships and then converted to corporations
when their growth causes the disadvantages of being a proprietorship to outweigh the
advantages.
Partnership: A partnership exists whenever two or more persons associate to conduct a no-
corporate business. Partnerships may operate under different degrees of formality, ranging from
informal, oral understandings to formal agreements filed with the secretary of the state in which
the partnership was formed.
The major advantage of a partnership is its low cost and ease of formation.
The disadvantages are similar to those associated with proprietorships:
 unlimited liability,
 limited life of the organization
 Difficulty of transferring ownership, and
 Difficulty of raising large amounts of capital. The tax treatment of a partnership is
similar to that for proprietorships.
Regarding liability, the partners can potentially lose all of their personal assets, even assets not
invested in the business, because under partnership law, each partner is liable for the business’s
debts. Therefore, if any partner is unable to meet his or her pro-rata liability in the event the
partnership goes bankrupt, the remaining partners must make good on the unsatisfied claims,
drawing on their personal assets to the extent necessary.

The first three disadvantages—unlimited liability, impermanence of the organization, and

difficulty of transferring ownership—lead to the fourth, the difficulty partnerships have in
attracting substantial amounts of capital. This is generally not a problem for a slow-growing
business, but if a business’s products or services really catch on, and if it needs to raise large
amounts of capital to capitalize on its opportunities, the difficulty in attracting capital becomes a
real drawback.
Corporation: A corporation is the complex and biggest form of business. It is a legal entity
created by a state, and it is separate and distinct from its owners and managers. This
separateness gives the corporation three major advantages:
 Unlimited life. A corporation can continue after its original owners and managers are
deceased.
 Easy transferability of ownership interest. Ownership interests can be divided into shares
of stock, which, in turn, can be transferred far more easily than can proprietorship or
partnership interests.
 Limited liability. Losses are limited to the actual funds invested.
The corporate form offers significant advantages over proprietorships and partnerships, but it
also has two disadvantages:
 Corporate earnings may be subject to double taxation—the earnings of the corporation
are taxed at the level, and then any earnings paid out as dividends are taxed again as
income to the stockholders.
 Setting up a corporation, and filing the many required document reports, is more
complex and time-consuming than for a proprietorship or a partnership.
Business Transactions
A business transaction is the occurrence of an event or a condition that must be recorded.
Example: Payment of telephone bill of 100birr
Purchase of merchandise on credit for 1200birr
Acquisition of Land and Building for 210,000birr
A particular business transaction may lead to an event or a condition that result in another
transaction. For example, the purchase of merchandise on credit will be followed by
payment to the creditor, which is another transaction. Each time a portion of a merchandise
sold, another transaction occurs.

Business transaction could be internal transaction or External transaction.

External transactions: are an exchange of goods or services between the business and an
outsider or occur between two different entities and are easy to record because there are
always source documents evidencing the transaction.
Internal transactions: are not an exchange of goods and services between the business and
an outsider, but these are conditions that must be recorded or occur within a single entity
and are more difficult to record because source documents my not always be present
Examples: - the wearing-out of building, consumption of office supplies, etc.
BASIC ACCOUNTING EQUATION
The resources owned by a business are its assets. Examples of assets include cash, land,
buildings, and equipment. The rights or claims to the assets are divided into two types:
(1) The rights of creditors and
(2) The rights of owners. The rights of creditors are the debts of the business and are called
liabilities. The rights of the owners are called owner‘s equity. The following equation shows
the relationship among assets, liabilities, and owner‘s equity: The following equation shows
the relationship among assets, liabilities, and owner‘s equity:
Assets = Liabilities + Owner’s Equity
The resources The rights of the The rights of the

Owned by a creditors are the debts owners
Business of the business.
This equation is called the accounting equation. Liabilities usually are shown before owner’s
equity in the accounting equation because creditors have first rights to the assets.
Creditors may legally force the liquidation of a business that does not pay its debts. In that case,
the law requires that creditor claims be paid before ownership claims.
Given any two amounts, the accounting equation may be solved for the third unknown amount.
To illustrate, if the assets owned by a business amount to Birr 100,000 and the liabilities amount
to Birr 30,000, the owner’s equity is equal to Birr70,000, as shown below
Assets - liability = owner equity

Birr 100,000 – 30,000 = owner equity
Assets are resources owned by a business. The business uses its assets in carrying out activities
such as production and sales. A common characteristic of all assets is the capacity to provide
future services or benefits. It can be classified as monetary and non-monetary assets; for
example, cash and money that customers owe to the company (called accounts receivable) are
monetary items. Other assets such as inventories (goods held for sale), land, buildings, and
equipment are non-monetary, physical items.
Liabilities are claims against assets, in other words liabilities are a business’s present
obligations to pay cash, transfer assets, or provide services to other entities in the future. Among
these obligations are amounts owed to suppliers for goods or services bought on credit (called
accounts payable), borrowed money (e.g., money owed on bank loans),salaries and wages owed
to employees, taxes owed to the government, and services to be performed.
Owner’s equity represents the claims by the owner of a business to the assets of the business.
Theoretically, owner’s equity is what would be left if all liabilities were paid, and it is sometimes
said to equal net assets. In accounting equation, we can define owner’s equity as listed below;
Owner’s Equity = Assets - Liabilities
(b) What items affect owner’s equity? Owner’s equity is affected by owner’s investments,
drawings, revenues, and expenses. An investment by owner and revenues from business
operations increases owner’s equity. Withdraw cash or other assets for personal use and an
expense decreases the owner’s equity.
 Owner investments are assets an owner puts into the company and are included under
the generic account Owner, Capital.
 INCOME: Increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases of liabilities that result in increases in
equity, other than those relating to contributions from shareholders. The definition of
income includes both revenues and gains. Revenues arise from the ordinary activities of
a company and take many forms, consulting services provided, sales of products,
facilities rented to others, and commissions from services. Gains represent other items
that meet the definition of income and may or may not arise in the ordinary activities of
a company. Gains include, gains on the sale of long-term assets or unrealized gains on
trading securities.

 Expenses: Expense decrease equity and are the cost of assets or services used to earn
revenues. The definition of expenses includes both expenses and losses. Expenses
generally arise from like costs of employee time, use of supplies, and advertising,
utilities, and insurance services from others. Losses include losses on restructuring
charges, losses related to sale of long-term assets, or unrealized losses on trading
securities.
 Owner withdrawals: Owner withdrawals are assets an owner takes from the company for
personal use.
In sum, equity is the accumulated revenues and owner investments less the accumulated
Equity
Assets = Liabilities + Owner, _ Owner, + Revenues _ Expenses
Capital withdrawals
expenses and withdrawals since the company began.

This breakdown of equity yields the following expanded accounting equation.
Net income occurs when income exceed expenses. Net income increases equity.
A net loss occurs when expense exceed income, which decreases equity.
All business transactions can be stated in terms of changes in the elements of the accounting
equation. We illustrate how business transactions affect the accounting equation by using some
typical transactions
Illustration: Assume that on November 1, 2016, Mr.X begins a business that will be known as
Royal Realty. Each transaction during Royal Realty first month of operations is described in the
following paragraphs. The effect of each transaction on the accounting equation is then shown.
Transaction A: November 1, 2016, Mr.X deposits Birr 25,000 in a bank account in the name of
Royal Realty. This transaction increases the asset cash (on the left side of the equation) by Birr
25,000.
To balance the equation, the owner’s equity (on the right side of the equation) increases by the
same amount. The equity of the owner is identified using the owner’s name and ―Capital,‖ such
as ―Mr.X, Capital.‖
The effect of this transaction on Royal Realty accounting equation is shown below.
Assets = Owner equity
Cash = Mr.x, Capital
a. 25000 25000
Since Mr.X is the sole owner, Royal Realty is a proprietorship. Also, the accounting equation
shown above is only for the business, Royal Realty. Under the business entity concept, Mr.X

personal assets, such as a home or personal bank account, and personal liabilities are excluded
from the equation.
Transaction B: Nov. 5, 2016 Royal Realty paid Birr 20,000 for the purchase of land as a future
building site
Assets = Owner Equity

Cash + land Mr. X, Capital
Bal. 25000 - = 25000
b. – 25000 +25000 25000
Bal. 5000 25000 25000
The land is located in a business park with access to transportation facilities. Mr.X plans to rent
office space and equipment during the first phase of the business plan. During the second phase,
Mr.X plans to build an office and a warehouse on the land. The purchase of the land changes the
makeup of the assets, but it does not change the total assets.
Transaction C: Nov. 10, 2016 Royal Realty purchased supplies for Birr 1,350 and agreed to
pay the supplier in the near future.
Assets = Liability + Owner Equity
Cash + supplies + land Account + Mr. X, Capital
Payable
Bal. 5000 25000 = 25000
c. ____ 1350 _____ 1350 ____
Bal. 5000 + 1350 + 25000 = 1350 + 25000
You have probably used a credit card to buy clothing or other merchandise. In this type of
transaction, you received clothing for a promise to pay your credit card bill in the future. That is,
you received an asset and incurred a liability to pay a future bill. Royal Realty entered into a
similar transaction by purchasing supplies for Birr 1,350 and agreeing to pay the supplier in the
near future. This type of transaction is called a purchase on account and is often described as
follows: Purchased supplies on account, Birr1, 350.
The liability created by a purchase on account is called an account payable. Items such as
supplies that will be used in the business in the future are called prepaid expenses, which are
assets. Thus, the effect of this transaction is to increase assets (Supplies) and liabilities (Accounts
Payable) by Birr1, 350.

Transaction D: Nov. 18, 2016, Royal Realty received cash of Birr 7,500 for providing services
to customers.
You may have earned money by painting houses. If so, you received money for rendering
services to a customer. Likewise, a business earns money by selling goods or services to its
customers. This amount is called revenue. During its first month of operations, Royal Realty
received cash of Birr 7,500 for providing services to customers. The receipt of cash increases
Royal Realty assets and also increases Mr.X equity in the business. The revenues of Birr 7,500
are recorded in a Fees Earned column to the right of Mr.X, Capital. The effect of this transaction
is to increase Cash and Fees Earned by Birr 7,500, as shown below.

Cash + supplies + land Account + capital
Payable
Bal. 5000 + 1350 + 25000 = 1350 + 25000
D. +7500 ___ _____ ____ +7500—service Rev
Bal. 12500 + 1350 + 25000 1350 + 32500
Different terms are used for the various types of revenues. As illustrated above, revenue from
providing services is recorded as fees earned. Revenue from the sale of merchandise is recorded
as sales. Other examples of revenue include rent, which is recorded as rent revenue, and
interest, which is recorded as interest revenue. Instead of receiving cash at the time services are
provided or goods are sold, a business may accept payment at a later date. Such revenues are
described as fees earned on account or sales on account. For example, if Royal Realty had
provided services on account instead of for cash, transaction (d) would have been described as
follows: Fees earned on account, Birr 7,500. In such cases, the firm has an account receivable,
which is a claim against the customer. An account receivable is an asset, and the revenue is
earned and recorded as if cash had been received. When customers pay their accounts, Cash
increases and Accounts Receivable decreases.
Transaction E: Nov. 30, 2016 Royal Realty paid the following expenses during the month:
wages, Birr 2,125; rent, Birr 800; utilities, Birr 450; and miscellaneous, Birr 275.

During the month, Royal Realty spent cash or used up other assets in earning revenue. Assets
used in this process of earning revenue are called expenses. Expenses include supplies used and
payments for employee wages, utilities, and other services.

Cash + supplies + land Account + capital
Payable
Bal. 12500 + 1350 + 25000 = 1350 + 32500
E. -3650 ____ ____ _____ -2125 –wage Expense
- 800 - Rent Expense
-450 - Utilities Expense
- 275 –Miscellaneous Exp
Bal. 8850 + 1350 + 25000 1350 + 28850
Royal Realty paid the following expenses during the month: wages, Birr 2,125; rent, Birr 800;
utilities, Birr 450; and miscellaneous, Birr 275. Miscellaneous expenses include small amounts
paid for such items as postage, coffee, and newspapers. The effect of expenses is the opposite of
revenues in that expenses reduce assets and owner’s equity. Like fees earned, the expenses are
recorded in columns to the right of Mr.X, Capital. However, since expenses reduce owner’s
equity, the expenses are entered as negative amounts. Businesses usually record each revenue
and expense transaction as it occurs. However, to simplify, we have summarized Royal Realty
revenues and expenses for the month in transactions (d) and (e).
Transaction F: Nov. 30, 2016 Royal Realty paid creditors on account, Birr 950.
When you pay your monthly credit card bill, you decrease the cash in your checking account and
decrease the amount you owe to the credit card company. Likewise, when Royal Realty pays
Birr 950 to creditors during the month, it reduces assets and liabilities, as shown below.
Cash + supplies + land Account + Mr.X Capital
Payable
Bal. 8850 + 1350 + 25000 1350 + 28850
F. -950 __ ____ -950 _____
Bal. 7900 + 1350 + 25000 = 400 + 28850

Paying an amount on account is different from paying an expense. The paying of an expense
reduces owner’s equity, as illustrated in transaction (e). Paying an amount on account reduces the
amount owed on a liability.
Transaction G: Nov. 30, 2016 Mr.X determined that the cost of supplies on hand at the end of
the month was Birr 550.
Payable
Bal. 7900 + 1350 + 25000 = 400 + 28850
G. ___ -800 _____ ___ -800 -Supplies expense.
Bal.7900 + 550 + 25000 400 + 28050
The cost of the supplies on hand (not yet used) at the end of the month is Birr550. Thus, Birr 800
(Birr1, 350 _ Birr550) of supplies must have been used during the month. This decrease in
supplies is recorded as an expense.
Transaction H: Nov. 30, 2016 Mr.X withdrew Birr 2,000 from Royal Realty for personal use.
The effect of the Birr 2,000 withdrawal is shown as follows:

Payable
Bal.7900 + 550 + 25000 400 + 28050
H. -2000 ___ ___ ____ -2000 –Mr.x withdrew
Bal. 5900 + 550 + 25000 = 400 + 26050
At the end of the month, Mr.X withdrew Birr 2,000 in cash from the business for personal use.
This transaction is the opposite of an investment in the business by the owner. Withdrawals by
the owner should not be confused with expenses. Withdrawals do not represent assets or services
used in the process of earning revenues. Instead, withdrawals are a distribution of capital to the

owner. Owner withdrawals are identified by the owner’s name and Drawing. For example, Mr.X,
withdrawal is identified as Mr.X, Drawing. Like expenses, withdrawals are recorded in a column
to the right of Mr.X, Capital.
Summary: The transactions of Mr.X are summarized below. Each transaction is identified by
letter, and the balance of each item is shown after every transaction.
Assets = Liabilities + Owner’s Equity

Cash Supplie Land Accounts. Pay Mr. x - Capital
s +
A 25000 ___ ____ = ____ 25000
B -20,000 ___ + 20,000 _____ _______
Bal. 5000 20,000 = 25,000
C ____ +1350 ___ +1350 _____
Bal. 5000 1350 20,000 = 1350 25000
D +7500 ___ ______ __ +7500—Service Revenue
Bal. 12500 1350 20,000 = 1350 32500
E -3650 __ ___ _ - 2125 – Wage expense
- 800 - Rent expense
- 450 - Utilities expense
-27-Miscellaneous expense
Bal. 8850 1350 20,000 = 1350 28850
F -950 ------- ----- -950 _____
Bal. 7900 1350 20,000 = 400 28850
G ____ -800 ____ _____ -800 --- Supplies Expense
Bal. 7900 550 20,000 = 400 28050
H - 2000 __ ___ ______ -2000—Mr.X Withdraws
Bal. 5900 550 20,000 = 400 26050
You should note the following in the preceding summary:

1. The effect of every transaction is an increase or a decrease in one or more of the
accounting equation elements.
2. The two sides of the accounting equation are always equal.
3. The owner’s equity is increased by amounts invested by the owner and is decreased by
withdrawals by the owner. In addition, the owner’s equity is increased by revenues and
is decreased by expenses.
The Basic Financial Statements
The financial statements are the basic statements normally prepared by profit-making
organizations for use by investors, creditors, and other external decision makers. They can be

prepared at any point in time (such as the end of the year, quarter, or month) and can apply to
any time span (such as one year, one quarter, or one month).
After transactions have been recorded and summarized, reports are prepared for users. The
accounting reports providing this information are called financial statements. The primary
financial statements of a proprietorship are the income statement, the statement of owner’s
equity, the balance sheet, and the statement of cash flows.
The order that the financial statements are prepared and the nature of each statement is described
as follows.
Order Financial Statement Description of Statement
Prepared
1. Income statement A summary of the revenue and expenses for a
specific period of time, such as a month or a year.
2. Statement of owner’s A summary of the changes in the owner’s equity
equity that have occurred during a specific period of time,
such as a month or a year.
3. Balance sheet A list of the assets, liabilities, and owner’s equity as
of a specific date, usually at the close of the last day
of a month or a year.
4. Statement of cash flows A summary of the cash receipts and cash payments
for a specific period of time, such as a month or a
year.
The four financial statements and their interrelationships are illustrated in End of this chapter.
The data for the statements are taken from the summary of transactions of Royal Realty.
All financial statements are identified by the name of the business, the title of the statement, and
the date or period of time. The data presented in the income statement, the statement of owner’s
equity, and the statement of cash flows are for a period of time. The data presented in the balance
sheet are for a specific date.
International Note: The primary types of financial statements required by GAAP and IFRS are
the same. In practice, some format differences do exist in presentations employed by GAAP
companies compared to IFRS companies.
1. Income statement:

A summary of the revenues and the expenses for a specific period of time, such as a month or a
year. The income statement lists revenues first, followed by expenses.
The order in which the expenses are listed in the income statement varies among businesses.
Most businesses list expenses in order of size, beginning with the larger items. Miscellaneous
expense is usually shown as the last item, regardless of the amount.
Finally, the statement shows net income (or net loss).
 Net income (total revenues greater than total expenses) or
 Net loss (total expenses greater than total revenues)
Net income for a period increases the owner’s equity (capital) for the period. A net loss
decreases the owner’s equity (capital) for the period.
Note that the income statement does not include investment and withdraws transactions between
the equity and the business in measuring net income. This type of transaction is considered a
reduction of retained earnings, which causes a decrease in owners’ equity.
IFRS: There is no prescribed format for the income statement. The entity should select a method
of presenting its expenses by either function or nature; this can either be, as is encouraged, on the
face of the income statement.
Retained earnings statement
The statement of owner’s equity reports the changes in the owner’s equity for a period of time. It
is prepared after the income statement because the net income or net loss for the period must be
reported in this statement. Similarly, it is prepared before the balance sheet, since the amount of
owner’s equity at the end of the period must be reported on the balance sheet. Because of this,
the statement of owner’s equity is often viewed as the connecting link between the income
statement and balance sheet.
Key Point: The statement of owner’s equity is also called the statement of changes in
owner’s equity.
Note: End. Capital =Beg. Capital _ Net Income _Withdrawals(dividend)
The purpose of preparing statement of owners’ Equity is to summarize these transactions

effect in summary form. It is considered as a link between the balance sheet and the income
statement.
Balance sheet statement

Balance sheet—a list of the assets, liabilities, and stockholders’ equity as of a specific date,
usually at the close of the last day of a month or a year.
The purpose of balance sheet is to show financial position an entity on a particular date. Balance
sheet format could vary from business to business. The most common and acceptable formats
are: Report format, Account format and financial position format. The difference between
these formats lies on the manner in which the information’s are arranged in the statement;
therefore it is a matter of the appearance of the report not the content.
 Report format – Under the report format liabilities and owner’s equity are listed below
the asset section.
 Account format – Under this formats assets are listed on the left and liabilities and
owner’s equity are listed on the right. It resembles the accounting equation.
 Financial position format- It is a vertical format in which current liabilities are deducted
from current assets to derive working capital. Other assets then are added and other
liabilities are deducted leaving a residual amount as an owner’s equity.
Each framework requires prominent presentation of a balance sheet as a primary statement.
 Format GAAP standards require assets, liabilities, and equity to be presented in
decreasing order of liquidity. The balance sheet is generally presented with total assets
equaling total liabilities and shareholders’ equity.
 Format IFRS guidelines don't require any specific format, but entities are expected to
present current and noncurrent assets and current and noncurrent liabilities as separate
classifications on their balance sheets, except when liquidity presentation provides more
relevant and reliable information.
Statement of cash flows
A summary of the cash receipts and cash payments for a specific period of time, such as, a month
or a year. The statement of cash flows consists of three sections, (1) operating activities, (2)
investing activities, and (3) financing activities
Operating Activities: Operating activities are those activities that are part of the day-to-day
business of a company. Major operating cash inflow results from selling goods or providing
services, while major operating cash outflows include payments to purchase inventory and to
pay wages, taxes, interest, utilities, rent, and similar expenses.

Investing Activities: Investing activities are those activities associated with buying and selling
long-term assets—primarily the purchase and sale of land, buildings, and equipment.
Financing Activities: Financing activities are those activities whereby cash is obtained from or
repaid to owners and creditors. For example, cash received from owners’ investments, cash
proceeds from a loan, or cash payments to repay loans would all be financing activities
Royal Reality
Income statement
For the Month Ended November 30, 2016
Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Birr 7,500
Expenses:
Wages expense . . . . . . . . . . . . . . . . . . . . . . .. Birr2, 125
Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . 800
Utilities expense. . . . . . . . . . . . . . . . . . . . . .. . . 450
Miscellaneous expense . . . . . . . . . . . . . . . . . . . 275
Total expense . . . . . . . . . . . . . . . . . . …... . . . . 4,450
Net income……………. . . . . . . . . . . . . . . . . . . . . . . . . . Birr 3,050
Royal Reality
Statement of Owner’s Equity
Mr.X, capital, November 1, 2016. . . . . . . . . . …….Birr 0
Add: Investment on November 1, 2009 . . . . . . . . . . . Birr25,000
Net income for November . . . …… . . . . . . . . . . . . 3,050
Birr 28,050
Less : withdrawals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Increase in owner’s equity . . . . . . . . . . . . . . . . 26,050
Mr.X, capital, November 30, 2009 . . . . . . . . . . . . . . . …... . Birr 26,050
Royal Reality
Balance Sheet
November 30, 2016

Assets Liabilities
Cash . . . . . . . . . . . . . . .Birr 5,900 Accounts payable . . .. . .... Birr400
Supplies . . . . . . . . . . . . ….. 550 Owner’s Equity
Land . . . . . . . . . . . . . . …. 20,000 Mr.X, capital . . . . . . . . . . . . . 26,050
Total assets . . . . . . . . . . Birr26,450 Total liabilities and owner’s equity. . Birr26,450
Royal Reality
Statement of Cash Flows
Cash flows from operating activities:
Cash Received from customers------------------------------------7500
Cash payments for expenses and to creditors------------------ (4600)
Net cash flow from operating activity (2900)
Cash flow from investing activity
Cash payments for purchase of land --------------------------(20,000)
Cash flow from Financing activity:
Cash received as owner’s investment---------------------------------Birr 25,000
Less: Cash withdrawal by owner--------------------------------------------(2000)
Net cash flow during the period----------------------------------------------------23000
Net cash flow and November 30, 2016, cash balance -------------------------Birr 5,900
Key Points
 International standards are referred to as International Financial Reporting Standards
(IFRS), developed by the International Accounting Standards Board (IASB).
 Recent events in the global capital markets have underscored the importance of financial
disclosure and transparency not only in the United States but in markets around the world
 As a result, many are examining which accounting and financial disclosure rules should
be followed.
GAAP IFRS
Stands for Generally Accepted Accounting International Financial Reporting
Principles Standards

Standard guidelines and structure for Universal financial reporting method

Introduction typical financial accounting. that allows international businesses to
understand each other and work
together.
Used in United States Over 115 countries, including those in
the European Union
Performance Revenue or expenses, assets or Revenue or expenses, assets or
elements liabilities, gains, losses, liabilities
comprehensive income
Required Balance sheet, income statement, Balance sheet income statement,
documents in statement of comprehensive income, changes in equity, cash flow
financial changes in equity, cash flow statement, footnotes
statements
statement, footnotes
US GAAP (or FASB) framework has Under IFRS, company management is
Purpose of the no provision that expressly requires expressly required to consider the
framework management to consider the framework if there is no standard or
framework in the absence of a interpretation for an issue.
standard or interpretation for an issue.
Objectives of In general, broad focus to provide In general, broad focus to provide
financial relevant info to a wide range of relevant info to a wide range of
statements stakeholders. GAAP provides separate stakeholders. IFRS provides the same
objectives for business and non- set of objectives for business and non-
business entities. business entities.
Underlying The "going concern" assumption is IFRS gives prominence to underlying
assumptions not well-developed in the US GAAP assumptions such as accrual and going
framework. concern.
Definition of an The US GAAP framework defines an The IFRS framework defines an asset
asset asset as a future economic benefit. as a resource from which future
economic benefit will flow to the
company.
Balance sheet Entities may present either a classified Does not prescribe a particular format.
or non-classified balance sheet. Items A current/non-current presentation of
on the face of the balance sheet are assets and liabilities is used unless a
generally presented in decreasing liquidity presentation provides more
order of liquidity. relevant and reliable information.
Statement of Similar to IFRS except that US GAAP Statement shows capital transactions
changes in share does not have a statement of with owners, the movement in
(stock) holders’ recognized income and expense accumulated profit/loss and a
equity reconciliation of all other
components of equity
Cash flow Similar headings to IFRS, but more Standard headings but limited
statements specific guidance for items included in guidance on contents. Use direct or

– format and each category. Direct or indirect indirect method.

method method used.
Sample Multiple Choice Questions
1. Which of the following best describes accounting?
A) Can be thought of as the ―language of business‖
B) Is of limited or little use by individuals outside of the business
C) Records economic data but does not communicate the data to users
D) Relies upon concepts and principles that are independent of specific user needs
2. Equipment with an estimated market value of Birr 80,000 is offered for sale at Birr85,
000. The equipment is acquired for Birr 10,000 in cash and a note payable of Birr
65,000. The amount used in the buyer‘s accounting records to record this acquisition
is:
A) Birr 80,000 B) Birr 85,000
C) Birr 10,000 D) Birr75, 000
3. The business entity concept means that:
A) An entity is organized according to state or federal statutes.
B) An entity is organized according to the rules set by the FASB
C) The entity is an individual economic unit separate and apart from its owners
D) The owner is the entity.
4. Properties owned by a business are referred to as:

A) stockholder‘s equity B) Liabilities
C) Assets D) Equities
5. If total assets decreased by Birr1,000 during a period of time and liabilities increased
by Birr 2,000 during the same period, then the amount and direction (increase or
decrease) of the period‘s changes in stockholder‘s equity is:
A) Birr 1,000 increase B) Birr 3,000 increase
C) Birr 3,000 decrease D) Birr1, 000 decreases
6. How does the rendering of services on account affect the accounting equation?
A) Liabilities increase; stockholder‘s equity decreases
B) Assets increase; liabilities increase

C) Assets decrease; stockholder‘s equity increases

D) Assets increase; stockholder‘s equity increases
7. If assets and liabilities at the beginning of the year were Birr 205,000 and Birr
140,000 respectively and at the end of the year were Birr 225,000 and Birr175, 000
respectively, calculate the net income if dividends of Birr 35,000 were paid and Birr
10,000 of additional capital stock was issued.
A) Net income of Birr 10,000 B) Net income of Birr15, 000
C) Net loss of Birr15, 000 D) Net income of Birr 25,000
8. Which of the following financial statements reports information as of a point in time?
A) Retained earnings statement B) Statement of cash flows
C) Income statement D) Balance sheet
9. Which of the following would not appear on the Retained Earnings Statement?
A) Beginning retained earnings balance B) Dividends
C) Service Revenue D) Net Income
10. The financial statements are usually prepared in which of the following sequences?
A) Income Statement, Balance Sheet, Retained Earnings, Cash Flows
B) Balance Sheet, Retained Earnings, Cash Flows, Income Statement
C) Balance Sheet, Retained Earnings, Income Statement, of Cash Flows
D) Income Statement, Retained Earnings, Balance Sheet, Cash Flows
11. Hanna Maid Service began the year with total assets of Birr 120,000 and
stockholders‘ equity of Birr 40,000. During the year the company earned Birr 90,000
in net income and paid Birr 20,000 in dividends. Total assets at the end of the year
were Birr 215,000. Stockholder‘s equity at the end of the year was:
A) Birr130, 000 B) Birr 110,000
C) Birr150, 000 D) Birr 135,000
Assume that on July 1, 2016 BEKELE Company purchases a drug costing $14,000 by
paying $8,000 cash and the remaining will be paid in the near future.
Required:
1. Determine the type of account being affected
2. Determine the direction of the effect ( is it increase or decrease

Queen Business Center had owner‘s equity of balance Br 315,000 at the beginning of the
current fiscal year. At the end of the period the company had total asset of Br 670,000 and
total liability Br 195,000.
Required: Determine the net income or net loss during the fiscal year by considering
a) There was no additional investment and withdrawal.
b) The additional investment was 25% of ending asset but no withdrawal.
c) The withdrawal was10%of beginning capital but no additional investment.
d) The additional investment and withdrawal were 25% of ending asset and 10% of
beginning Capital respectively.
Case Study Question
Semira spent much of her childhood learning the art of cookie-making from her
grandmother. They passed many happy hours mastering every type of cookie imaginable
and later creating new recipes that were both healthy and delicious. Now at the start of her
second year in college, Semira is investigating various possibilities for starting her own
business as part of the requirements of the entrepreneurship program in which she is
enrolled.
A long-time friend insists that Semira has to somehow include cookies in her business
plan. After a series of brainstorming sessions, Semira settles on the idea of operating a
cookie-making school. She will start on a part-time basis and offer her services in people‘s
homes. Now that she has started thinking about it, the possibilities seem endless. During the
fall, she will concentrate on holiday cookies. She will offer individual lessons and group
sessions (which will probably be more entertainment than education for the participants).
Semira also decides to include children in her target market.
The first difficult decision is coming up with the perfect name for her business. In the
end, she settles on ―Cookie Creations‖ and then moves on to more important issues.
Instructions
(a) What form of business organization—proprietorship, partnership, or corporation— do
you recommend that Semira use for her business? Discuss the benefits and
weaknesses of each form and give the reasons for your choice.
(b) Will Semira need accounting information? If yes, what information will she need and
why? How often will she need this information?

(c) Identify specific asset, liability, and equity accounts that Cookie Creations will likely
use to record its business transactions.
(d) Should Semira open a separate bank account for the business? Why or why not?

CHAPTER 2
ACCOUNTING CYCLE
From lessons in chapter one, we have seen the transactions completed by an enterprise
during a specific period may cause increases and decreases in many different assets, liability
and owner‘s equity item. To have the details of these transactions readily available and to
prepare periodic financial statements the effects of transactions must be recorded in
systematic manner. Thus, in Chapter 2 on this book dealing with the account, chart of
account, general rules of debit and credit, and steps in the recording process—the journal,
ledger, trial balance and adjusting entries. In generally we discussed accounting cycle for
service giving business enterprise.
Classification of Accounts
An account is a record of increases and decreases in a specific asset, liability, equity, revenue,
or expense item. Information from an account is analyzed, summarized, and presented in
reports and financial statements.
A group of accounts for a business entity is called a ledger. Accounts in the ledger are
customarily listed in the order in which they appear in financial statements, and classified
according to common characteristics. . Balance sheet accounts are classified as assets,
liabilities and owner‘s equity. Income statement accounts are classified as revenues or
expenses.
ASSETS LIABILITY EQUITY ACCOUNT

= +
Asset Accounts: Assets are resources owned or controlled by a company, and those resources
have expected future benefits or any physical thing (tangible) or right (intangible) that has a
monetary value is an asset. Assets are divided in to two groups for presentation on the
balance sheet. These are current assets and plant assets.
Current Assets: cash and other related assets that may reasonably be expected to be realized
in cash or sold or used up usually within one year or less through the normal operation of
the business. Examples, cash, accounts receivable, notes receivable, supplies, prepayments,
etc

A Cash account reflects a company‘s cash balance. All increases and decreases in cash are
recorded in the Cash account. It includes money and any medium of exchange that a bank
accepts for deposit (coins, checks, money orders, and checking account balances).
Accounts receivable are held by a seller and refer to promises of payment from customers to
sellers. These transactions are often called credit sales or sales on account (or on credit).
Accounts receivable are increased by credit sales and are decreased by customer payments.
A note receivable, or promissory note, is a written promise of another entity to pay a definite
sum of money on a specified future date to the holder of the note. A company holding a
promissory note signed by another entity has an asset that is recorded in a Note (or Notes)
Receivable account.
Prepaid accounts (also called prepaid expenses) are assets that represent prepayments of
future expenses (not current expenses). When the expenses are later incurred, the amounts
in prepaid accounts are transferred to expense accounts. Common examples of prepaid
accounts include prepaid insurance, prepaid rent, and prepaid services.
Supplies accounts are assets until they are used. When they are used up, their costs are
reported as expenses. The costs of unused supplies are recorded in a Supplies asset account.
Supplies are often grouped by purpose — for example, office supplies and store supplies.
 An office supply includes stationery, paper, toner, and pens.
 Store supplies include packaging materials, plastic and paper bags, gift boxes
and cartons, and cleaning materials.
Equipment Accounts is an asset. When equipment is used and gets worn down, its cost is
gradually reported as an expense (called depreciation). Equipment is often grouped by its
purpose as
 Office equipment includes computers, printers, desks, chairs, and shelves.
 The Store Equipment account includes the costs of assets used in a store, such as
counters, showcases, ladders, hoists, and cash registers.
Plant Assets: tangible assets used in businesses that have a permanent or relatively fixed
nature are called plant assets or fixed assets. It includes equipment‘s, machinery, building,
land, etc.

Buildings Accounts such as stores, offices, warehouses, and factories are assets because they
provide expected future benefits to those who control or own them. When several buildings
are owned, separate accounts are sometimes kept for each of them.
Land account the cost of land owned by a business is recorded in a Land account. The cost
of buildings located on the land is separately recorded in one or more building accounts.
Liability Accounts: Liabilities are claims (by creditors) against assets, which mean they are
obligations to transfer assets or provide products or services to others. Liabilities are classified
in to current liability and long term liability.
i. Current liabilities: are liabilities that will be due within a short time (usually one year
or less) and that are to be paid out of current assts. The most common are Notes
Payable, Accounts Payable, Salary Payable, Tax Payable, etc.
Accounts payable refer to oral or implied promises to pay later, which usually arise from
purchases of merchandise. Payables can also arise from purchases of supplies, equipment,
and services.
A note payable refers to a formal promise, usually denoted by the signing of a promissory
note, to pay a future amount. It is recorded in either a short-term, Note Payable account or a
long-term Note Payable account, depending on when it must be repaid.
Unearned revenue refers to a liability that is settled in the future when a company delivers
its products or services. When customers pay in advance for products or services (before
revenue is earned), the revenue recognition principle requires that the seller consider this
payment as unearned revenue.
Accrued liabilities are amounts owed that are not yet paid. Examples are wages payable,
taxes payable, and interest payable.
ii. Long- term liabilities: liabilities that will be due for a comparatively long
time (usually more than one year). As they come within the one-year range and are
to be paid, such liabilities become current.
Equity Accounts: The owner‘s claim on a company‘s assets is called equity, or stockholders‘
equity, or shareholders‘ equity. Equity is the owners‘ residual interest in the assets of a
business after deducting liabilities.

For corporation it is called stockholders‘ equity or stockholders‘ investment while Capital- is

the owner‘s equity in a sole proprietorship (and partnership). It is also called net worth.
Capital stocks- the investment of the stockholders while retained earnings- the income
retained in the business.
Drawings and dividends: Drawings represent the amount of withdrawals made by the
owner of sole proprietor ship and partnership. For corporations, dividends represent the
distribution of earnings to stock holders.
Income Statement Account: are classified in to revenue and expense
Revenue: is the gross increase in owner‘s equity as a result of the sale of merchandise, the
performance of services for a customer or clients, the rental of property, the lending of
money and other business and professional activities entered into for the purpose of earning
income. Revenue from the sale of merchandise is known as sales, other than sales revenue is
termed as professional fee, commission‘s revenue, fares earned, and interest income
Expense: are costs that have been consumed or used in the process of producing revenue are
expired costs or expenses. Examples of expense accounts are Advertising Expense, Store
Supplies Expense, Office Salaries Expense, Office Supplies Expense, Rent Expense, Utilities
Expense, and Insurance Expense.
Chart of Accounts
The number and type of accounts differ for each company. The number of accounts
depends on the amount of detail management desires. For example, the management of one
company may want a single account for all types of utility expense. Another may keep
separate expense accounts for each type of utility, such as gas, electricity, and water
Most companies have a chart of accounts. This chart lists the accounts and the account
numbers that identify their location in the ledger.
A ledger: The collection of all accounts and their balances for an information system
The numbering system that identifies the accounts usually starts with the balance sheet
accounts and follows with the income statement accounts.

Assets AssStockholders‘ Equity et a

101 Cash 311 Common Stock
112 Accounts Receivable 320 Retained Earnings
126 Supplies 332 Dividends
130 Prepaid Insurance 350 Income Summary
157 Equipment
158 Accumulated Depreciation-
Equipment
Liabilities Revenues
400 Service Revenue
200 Notes Payable Expenses
201 Accounts Payable
531 Supplies Expense
209 Unearned Service Revenue
561 Depreciation Expense
212 Salaries and Wages Payable
572 Insurance Expense
230 Interest Payable
586 Salaries and Wages Expense
592 Rent Expense
599 Interest Expense
The 1st digit indicates the major division of the account in which in the account is placed.
Accounts beginning with 1 represents assets, 2 liabilities 3 owners‘ equity (owners capital
and drawings) 4 revenue and 5 expenses
2.4 Rules of Debits and Credits
A T-account represents a ledger account and is a tool used to understand the effects of one
or more transactions.
1. The title of the account: the name of the item recorded in the account.
2. A space for recording increases in the amount of the item in terms of money
3. A space for recording decreases in the amount of the item also in monetary terms.
Account Title___________
(Left side) (Right side)
Debit side credit side
The left side of an account is called the debit side; often abbreviated Dr. The right side is
called the credit side, abbreviated Cr. To enter amounts on the left side of an account is to
debit the account. To enter amounts on the right side is to credit the account.

Balance Sheet Accounts

Assets = Liabities + Owner Equity
Debit for Credit for Debit for Credit for Debit for Credit for
Increase Decrease Decrease Increase Decrease Increase
+ - - + - +
Normal Normal Normal
Recall that some transactions affect only one side of the equation, meaning that two or more
accounts on one side are affected, but their net effect on this one side is zero. Second, the left
side is the normal balance side for assets, and the right side is the normal balance side for
liabilities and equity. This matches their layout in the accounting equation where assets are
on the left side of this equation, and liabilities and equity are on the right.
Income Statement Accounts
The debit and credit rules for income statement accounts are based on their relationship
with owner‘s equity. As shown above, owner‘s equity accounts are increased by credits.
Since revenues increase owner‘s equity, revenue accounts are increased by credits and
decreased by debits. Since owner‘s equity accounts are decreased by debits, expense
accounts are increased by debits and decreased by credits. Thus, the rules of debit and credit
for revenue and expense accounts are as follows:
Revenue Accounts Expense Accounts

Debit for Credit for Debit for Credit for
Decrease (-) Increase (+) Increase (+) Decrease (-)
Normal Normal
Owner Withdrawals
The debit and credit rules for recording owner withdrawals are based on the effect of owner
withdrawals on owner‘s equity. Since owner‘s withdrawals decrease owner‘s equity, the
owner‘s drawing account is increased by debits. Likewise, the owner‘s drawing account is
decreased by credits. Thus, the rules of debit and credit for the owner‘s drawing account are
as follows:
Owner Withdrawals
Debit for Credit for
Increase (+) Decrease (-)

Normal
Normal Balances
The sum of the increases in an account is usually equal to or greater than the sum of the
decreases in the account. Thus, the normal balance of an account is either a debit or credit
depending on whether increases in the account are recorded as debits or credits.
For example, since asset accounts are increased with debits, asset accounts normally have
debit balances. Likewise, liability accounts normally have credit balances.
The rules of debit and credit and the normal balances of the various types of accounts are
summarized below.
Accounts Increase side Decrease side Normal Balance
1. Assets Debit Credit Debit

2. Liabilities Credit Debit Credit
Balance Capital/ Credit Debit Credit
Sheet capital
Accounts 3. Owner‘s stock
equity Retained Credit Debit Credit
earnings
Drawing/ Debit Credit Debit
dividends
Income 4. Income Credit Debit Credit
Statements
Accounts 5. Expenses Debit Credit Debit
CHARACTERISTICS SERVICE GIVING COMPANIES

A service company uses its employees to provide a service for the customer. These services
can include lawn care, carpet cleaning or childcare. Some service companies purchase
expensive equipment to provide the service, such as a vehicle. Other service companies rely
on human labor more than equipment and only purchase a minimal amount of assets. The
typical financial transactions recorded for a service company include collecting a deposit
from the customer, providing the service and receiving payment. These activities may occur
in the same accounting cycle or in several cycles.

What is an accounting cycle?

The accounting cycle is process or a series of activities that begins with a transaction and
ends with the closing of the books, because this process is repeated each reporting period. It
generates useful information in the form of financial statements including income statement,
balance sheet, cash flow statement and statements of owner equity.
Computers now free accountants to focus upon the more analytical aspects of their
discipline.
These include, for example:
 Determining the information needs of decision makers.
 Designing systems to provide the information quickly and efficiently.
 Evaluating the efficiency of operations throughout the organization.
 Assisting decision makers in interpreting accounting information.
 Auditing (confirming the reliability of accounting information)
 Forecasting the probable results of future operations.
The time period principle requires that a business should prepare its financial statements on
the periodic basis. Therefore accounting cycle is followed once during each accounting
period.
Accounting cycle starts from the recording of individual transactions and ends on the
preparation of financial statements and closing entries.
Major steps in Accounting cycle
Following are the major steps involved in the accounting cycle. We will use a simple
example problem to explain each step.

1.Analyzing and recording transaction through journal entries.

Using the rules of debit and credit, transactions are initially entered in a record called a
journal.
Analyzing transactions and recording them as journal entries is the first step in the
accounting cycle. It begins at the start of an accounting period and continues during the
whole period. Transaction analysis is a process which determines whether a particular
business event has an economic effect on the assets, liabilities or equity of the business. It
also involves ascertaining the magnitude of the transaction i.e. its currency value.
After analyzing transactions, accountants classify and record the events having economic
effect via journal entries according to debit-credit rules. Frequent journal entries are usually
recorded in specialized journals, for example, sales journal and purchases journal. The rest
are recorded in a general journal.
Lists of common journals and respective transactions recorded
Types of journals Types of transactions record

1) General Journal is used Every transactions
2) Both Special J and General J are used
General journal Adjusting and closing entries
Cash receipt journal Only receipt of cash
Cash payment journal Only payment of cash
Purchase journal Only on account purchases
Sales journal Only on account journal
A standard form of a general journal looks like: -

General Journal Page __1__
Date Account Title/ Description P/R Debit Credit
On the basis of the evidence provided by the business documents, the transactions are
entered in chronological order on a journal. Thus, the journal is referred to as the book of
original entry and for each transaction the journal shows the debit and credit effects on
specific accounts.
Contribution of journal to the recording process

The process of recording a transaction in the journal is called journalizing. This form of
recording a transaction is called a journal entry. Before a transaction entered in the two-
column journal, it should be analyzed according to the following sequence of steps or the
procedures employed for the journalizing are as follows;
(a) Analyze the transaction
(1) Determine the type of account being affected
(2) Determine the direction of the effect ( is it increase or decrease)
(3) Relate the direction of the effect with the rules of Dr and Cr
(b) Entering the transaction information in a journal
 Record the date of the entry: involves the recording of the date of the year, the
month and specific day in which the transaction has occurred
 Record the debit part of the entry: involves entering the title of the account to be
debited along with the related amount
 Record the credit part of the entry: involves entering the title of the account to be
credited along with the related amount
Write short explanation (optional): Brief explanations may be written below each entry,
moderately indented. Some accountants prefer that the explanation be omitted if the nature
of the transaction is obvious. The line following an entry is left blank in order to clearly
separate each entry.
Entry: Each record in a journal. Every entry has four parts; date, debit, credit, and source
document.
A general journal entry takes the following form:
Date Name of account being debited Amount
Name of account being credited Amount
Optional: short description of transaction
The following example illustrates how to record journal entries
Example
Company AB was incorporated on January 1, 2016 with an initial capital of 5,000 shares of
common stock having Birr 20 par value. During the first month of its operations, the
company engaged in following transactions:
Date Transaction
Jan 2: An amount of Birr 36,000 was paid as advance rent for three months.

Jan 3: Paid Birr 60,000 cash on the purchase of equipment costing Birr 80,000. The
remaining amount was recognized as a one year note payable with interest rate of 9%.
Jan 4: Purchased office supplies costing Birr 17,600 on account.
Jan 13: Provided services to its customers and received Birr 28,500 in cash.
Jan 13: Paid the accounts payable on the office supplies purchased on January 4.
Jan 14: Paid wages to its employees for first two weeks of January, aggregating Birr19, 100.
Jan 18: Provided Birr 54,100 worth of services to its customers. They paid Birr32, 900 and
promised to pay the remaining amount.
Jan 23: Received Birr 15,300 from customers for the services provided on January 18.
Jan 25: Received Birr 4,000 as an advance payment from customers.
Jan 26: Purchased office supplies costing Birr 5,200 on account.
Jan 28: Paid wages to its employees for the third and fourth week of January: Birr19, 100.
Jan 31: Paid Birr 5,000 as dividends.
Jan 31: Received electricity bill of Birr 2,470.
Jan 31: Received telephone bill of Birr 1,494.
Jan 31: Miscellaneous expenses paid during the month totaled Birr 3,470
The following table shows the journal entries for the above events.
Date Description P.R Debit Credit
Jan 1 Cash 100,000 00 00
Common stock 100,000
Jan 2 Prepaid Rent 36,000 00
Cash 36,000 00
Jan 3 Equipment 80,000 00
Cash 60,000 00
Notes Payable 20,000 00
Jan 4 Office Supplies 17,600 00
Accounts Payable 17,600 00
Jan 13 Cash 28,500 00
Service Revenue 28,500 00
Jan 13 Accounts Payable 17,600 00
Cash 17,600 00
Jan 14 Wages Expense 19,100 00
Cash 19,100 00
Jan 18 Cash 32,900 00
Accounts Receivable 21,200 00
Service Revenue 54,100 00
Jan 23 Cash 15,300 00

Accounts Receivable 15,300 00

Jan 25 Cash 4,000 00
Unearned Revenue 4,000 00
Jan 26 Office Supplies 5,200 00
Accounts Payable 5,200 00
Jan 28 Wages Expense 19,100 00
Cash 19,100 00
Jan 31 Dividends 5,000 00
Cash 5,000 00
Jan 31 Electricity Expense 2,470 00
Utilities Payable 2,470 00
Jan 31 Telephone Expense 1,494 00
Utilities Payable 1,494 00
Jan 31 Miscellaneous Expense 3,470 00
Cash 3,470 00
At the end of the period, all the journal for the period are posted to the ledger accounts
2. Posting journal entries to leger accounts
The process of transferring the debits and credits from the journal entries to the accounts is
called posting. The second step of accounting cycle is to post the journal entries to the ledger
accounts.
The journal entries recorded during the first step provide information about which accounts
are to be debited and which to be credited and also the magnitude of the debit or credit (see
debit-credit-rules). The debit and credit values of journal entries are transferred to ledger
accounts one by one in such a way that debit amount of a journal entry is transferred to the
debit side of the relevant ledger account and the credit amount is transferred to the credit
side of the relevant ledger account.
After posting all the journal entries, the balance of each account is calculated. The balance of
an asset, expense, contra-liability and contra-equity account is calculated by subtracting the
sum of its credit side from the sum of its debit side. The balance of a liability, equity and
contra-asset account is calculated the opposite way i.e. by subtracting the sum of its debit
side from the sum of its credit side.

Example
The ledger accounts shown below are derived from the journal entries of Company AB.
Asset Accounts
Cash Account No.11
Balance
Date Item P. Debit Credit Debit Credit
R
2016
jan 1 1 100,000 00 100,000 00
Jan 2 1 36000 00 64000 00
Jan 3 1 60,000 4000 00
Jan 13 1 28,500 00 32,500 00
Jan 13 17,600 00 14900 00
Jan 14 19,100 00 (4200) 00
Jan 18 32,900 00 28700 00
Jan 23 15,300 00 44000 00
Jan 25 4,000 00 48000 00

Jan 28 19100 00 28900 00
Jan 31 5000 00 23900 00
3,470 00 20,430 00
Balance Ac
Date Item P. Debit Credit co
Debit Credit unt
R
2016 21,200 00 21,200 00 Re
jan 18 cei
vab
Jan 23 15,300 00 5900 00 le
Account No. 12

Office supplies
Balance
Date Item P.R Debit Credit Debit Credit Ac
co
2016 4 17,600 00 17,600 00
unt
jan
No
Jan 26 5,200 00 22800 00 .14
Prepaid rent Account No.15

Balance
Date Item P.R Debit Credit Debit Credit
2016 2 36000 00 36000 00

Jan
Office Equipment Account No.18

Balance
2016 3 80,000 00 80,000 00

Jan
Accounts Payable Account No. 21
Balance
2016 4 17,600 00 5,200 00

Jan
Jan 13 17,600 00 0 00
Jan 26 5,200 00 5,200 00
Notes Payable Account No. 22
Balance

2016 3 20,000 00 20,00 00

Jan 0
Utilities Payable Account No. 24
Balance
2016 2,470 00 2,470 00

Jan 31
Jan 31 1,494 3964 00
Unearned Revenue Account No. 26
Balance
2016 4,000 4,000 00

Jan 25
Common Stock Account No. 33

Balance
2016 100,000 00 100,000 00

Jan 1
Service Revenue Account No. 41

Balance
2016 13 28,500 00 28,50 00

Jan 0
Jan 18 54,100 00 82600 00
Dividend Account No. 34

Balance
Date Item P.R Debit Credit

Debit Credit
2016 31 5000 00 5000 00

Jan
Wage Expense Account No. 52

Balance
2016 14 19,100 00 19,100 00

Jan
Jan 28 19,100 00 38200 00
Miscellaneous Expense Account No. 54

Balance
2016 31 3,470 00 3,470 00

Jan
Electricity Expense Account No. 56

Balance
2016 31 2,470 00 2,470 00

Jan
Telephone Expense Account No. 58

Balance
2016 31 1,494 00 1,494 00

Jan
Exercise: Assume that the Cash account for Kemal Company had a normal balance of Birr
48,000 at the beginning of the month. During the month, Kemal received cash payments
from its customers of Birr 22,000 and made cash payments of Birr 8,000 for expenses
incurred. In addition, Kemal paid Birr 6,000 on account for expenses incurred in the

previous month. How much is the balance in the Cash account after posting these
transactions?
Solution: We can post to Ledger Accounts By using T-

Account
Cash
48,000 8,000
6,000
22,000
56000
The Final Cash Balance Birr 56000
The ledger accounts step of accounting cycle completes here. The next step is the
preparation of unadjusted trial balance.
3. Preparing unadjusted trial balance
A trial balance is a list of the balances of ledger accounts of a business at a specific point of
time usually at the end of a period such as month, quarter or year. An unadjusted trial
balance is the one which is created before any adjustments are made in the ledger accounts.
The preparation of a trial balance is very simple. All we have to do is to list the balances of
the ledger accounts of a business.
Example
Following is the unadjusted trial balance prepared from the ledger accounts of Company
AB.
Company ABC
Unadjusted Trial Balance
January 31, 2010
Debit Credit
Cash Birr20,430
Accounts 5,900
Receivable
Office Supplies 22,800

Prepaid Rent 36,000

Equipment 80,000
Accounts Payable Birr 5,200
NotesPayable 20,000
Utilities Payable 3,964
Unearned
 4,000
Revenue

Common Stock 100,000
Service
 Revenue 82,600
Wages Expense 38,200

Miscellaneous 3,470
Expense

Electricity 2,470
Expense
Telephone 1,494
Expense
Dividend 5,000
Total Birr 215,764 Birr 215,764
Since, in double entry accounting we record each transaction with two aspects, therefore the
total of debit and credit balances of the trial balance are always equal. Any difference shall
indicate some mistake in the recording process or in the calculations. Although each
unbalanced trial balance indicates mistake, but this does not mean that all errors cause the
trial balance to unbalance. There are few types of mistakes which will not unbalance the trial
balance and they may escape un-noticed if we do not review our work carefully. For
example, to omit an entry, to record a transaction twice, etc.
After the preparation of an unadjusted trial balance, adjusting entries are passed.
4. Preparing adjusting at the end of the period

Adjusting Entries

Adjusting Entries are journal entries that are made at the end of the accounting period, to
adjust expenses and revenues to the accounting period where they actually occurred.
Generally speaking, they are adjustments based on reality, not on a source document. This is
in sharp contrast to entries during the accounting period (such as utility bills or fees for
services rendered) that depend on source documents.
 Adjusting entries are needed to ensure that the revenue recognition and expense
recognition principles are followed.
 The trial balance may not contain up-to-date and complete data for several reasons:
 Some events are not recorded daily because it is not efficient to do so.
 Some costs are not recorded during the accounting period because these costs
expire with the passage of time rather than as a result of recurring daily
transactions.
 Some items may be unrecorded.
 Adjusting entries are required every time a company prepares financial statements.
 Every adjusting entry will include one income statement account and one
balance sheet account.
 Adjusting entries can be classified as either deferrals or accruals. Each of these classes
has two subcategories.
 Deferrals can be prepaid expenses or unearned revenues.
 Accruals are either accrued revenues or accrued expenses.
Deferrals fall into two categories—prepaid expenses and unearned revenues.
 Prepaid expenses - expenses paid in cash and recorded as assets until they are used or
consumed. Prepaid expenses are costs that expire with the passage of time (i. e. rent
and insurance) or through use (i. e. supplies).
 Unearned revenues – cash received and recorded as liabilities before the services are
performed.
 An adjusting entry for prepaid expenses will result in an increase (a debit) to an
expense account and a decrease (a credit) to an asset account.
 An adjusting entry for unearned revenues will result in a decrease (a debit) to a
liability account and an increase (a credit) to a revenue account.

 An adjusting entry for deferrals (prepaid expenses or unearned revenues) will

decrease a balance sheet account and increase an income statement account.
 Accruals fall into two categories—accrued revenues and accrued expenses.
 Accrued revenues - revenues for services performed but not yet received in cash or
recorded at the statement date.
 An adjusting entry for accrued revenues will result in an increase (a debit)
in an asset account and an increase (a credit) to a revenue account.
 Accrued expenses - expenses incurred but not yet paid in cash or recorded at the
statement date.
 An adjusting entry for accrued expenses results in an increase (a debit) to an
expense account and an increase (a credit) to a liability account.
 An adjusting entry for accruals (accrued revenues or accrued expenses)
increases both a balance sheet and an income statement account.
Discuss the effects on the income statement and balance sheet if adjustments are not made.
Summary of basic relationships:
Type of Adjustment Accounts Before Adjustment Adjusting Entry
Prepaid expenses Assets overstated Dr. Expenses
Expenses understated Cr. Assets
Unearned revenues Liabilities overstated Dr. Liabilities
Revenues understated Cr. Revenues
Accrued revenues Assets understated Dr. Assets
Revenues understated Cr. Revenues
Accrued expenses Expenses understated Dr. Expenses
Liabilities understated Cr. Liabilities
Examples of Adjusting Entries
This example is a continuation of the accounting cycle problem we have been working on.
In the previous step we prepared an unadjusted trial balance. Here we will pass adjusting
entries.
Relevant information for the preparation of adjusting entries of Company AB
1. Office supplies having original cost Birr 4,320 were unused till the end of the period.
Office supplies having original cost of Birr 22,800 are shown on unadjusted trial
balance.
2. Prepaid rent of Birr 36,000 was paid for the months January, February and March.

3. The equipment costing Birr 80,000 has useful life of 5 years and its estimated salvage
value is Birr 14,000. Depreciation is provided using the straight line depreciation
method.
4. The interest rate on Birr 20,000 note payable is 9%. Accrue the interest for one
month.
5. Birr 3,000 worth of service has been provided to the customer who paid advance
amount of Birr 4,000.
The adjusting entries of Company AB are:
Date Account Debit Credit
Jan 31 Supplies Expense 18,480
Supplies Expense = birr22,800 − birr4,320 = birr18,480
Jan 31 Rent Expense 12,000
Prepaid Rent 12,000
Rent Expense = birr36,000 ÷ 3 = birr 12,000
Jan 31 Depreciation Expense 1,100
Accumulated Depreciation 1,100
Depreciation Expense = (birr80,000 − birr14,000) ÷ (5 × 12) = birr1,100
Jan 31 Interest Expense 150
Interest Payable 150
Interest Expense = Birr 20,000 × (9% ÷ 12) = $150
Jan 31 Unearned Revenue 3,000
Service Revenue 3,000
An adjusted trial balance is prepared in the next step of accounting cycle
5. Preparing adjusting trial balance

An Adjusted Trial Balance is a list of the balances of ledger accounts which is created after
the preparation of adjusting entries. Adjusted trial balance contains balances of revenues and
expenses along with those of assets, liabilities and equities. Adjusted trial balance can be

used directly in the preparation of the statement of changes in stockholders' equity, income
statement and the balance sheet. However it does not provide enough information for the
preparation of the statement of cash flows. The format of an adjusted trial balance is same as
that of unadjusted trial balance.
Example
The following adjusted trial balance was prepared after posting the adjusting entries of
Company A to its general ledger and calculating new account balances:
Company AB
Adjusted Trial Balance
January 31, 2016
Debit Credit
Cash Birr20,430
Accounts Receivable 5,900
Prepaid Rent 24,000
Equipment 80,000
Accumulated Depreciation Birr1,100
Accounts Payable 5,200
Unearned Revenue 1,000
Interest Payable 150
Notes Payable 20,000
Common Stock 100,000
Service Revenue 85,600
Supplies Expense 18,480
Rent Expense 12,000
Miscellaneous Expense 3,470
Electricity Expense 2,470
Telephone Expense 1,494
Depreciation Expense 1,100
Interest Expense 150
Dividend 5,000
Total Birr 217,014 Birr217,014
The totals of an adjusted trial balance must be equal. Any difference indicates that there is
some error in the journal entries or in the ledger or in the calculations.
The next step of accounting cycle is the preparation financial statements
6. Preparing Financial statement

IFRS requires that companies report the following four basic financial statements with
explanatory notes:
• Balance sheet • Income statement • Statement of cash flows
• Statement of changes in equity (or statement of recognized revenue and expense)
IFRS does not prescribe specific formats; and comparative information is required for the
preceding period only.
Company AB
Income statement
For the end de 31, 2016
Revenue:
Service Revenue 85600
Expense:
Wages Expense ………………………….38,200
Supplies Expense………………………….18,480
Rent Expense……………………………..12,000
Miscellaneous Expense ……………………3,470
Electricity Expense…………………...........2,470
Telephone Expense…………………………1,494
Depreciation Expense……………………..1,100
Interest Expense……………………………..150
Total Expense…………………………………………….
Company AB
Statement of Retained Earnings
For Month Ended December 31, 2016
Retained earnings, December 1,2016……………………..0
Add: Additional investment by owner………………………100,000
Net income……………………………………………
Less: Cash dividends……………………………………
Retained earnings, December 31,2016……………………………………

This section shows how to prepare financial statements from the adjusted trial balance
The next step of accounting cycle is the preparation of closing entries
7. Closing temporary accounts through closing entries
Closing entries are journal entries made at the end of an accounting period which transfer
the balances of temporary accounts to permanent accounts. Closing entries are based on the
account balances in an adjusted trial balance.
Temporary accounts include:
1. Closing the revenue accounts—transferring the credit balances in the revenue accounts
to a clearing account called Income Summary.
2. Closing the expense accounts—transferring the debit balances in the expense accounts
to a clearing account called Income Summary.
3. Closing the Income Summary account—transferring the balance of the Income
Summary account to the Retained Earnings account.
4. Closing the Dividends account—transferring the debit balance of the Dividends
account to the Retained Earnings account.

The permanent account to which balances are transferred depend upon the type of business.
In case of a company, retained earnings account, and in case of a firm or a sole
proprietorship, owner's capital account receives the balances of temporary accounts. Income
summary account is a temporary account which facilitates the closing process.
Closing entries are better explained via an example.
Example
The following example shows the closing entries based on the adjusted trial balance of
Company AB.
Note Date Account Debit Credit

Note Date Account Debit Credit

1 Jan 31 Service Revenue 85,600
Income Summary 85,600
2 Jan 31 Income Summary 77,364
Supplies Expense 18,480
Rent Expense 12,000
Miscellaneous
3,470
Expense
Electricity Expense 2,470
Telephone Expense 1,494
Depreciation
1,100
Expense
Interest Expense 150
3 Jan 31 Income Summary 8,236
Retained Earnings 8,236
4 Jan 31 Retained Earnings 5,000
Dividend 5,000
Notes
1. Service revenue account is debited and its balance it credited to income summary
account. If a business has other income accounts, for example gain on sale
account, then the debit side of the first closing entry will also include the gain on
sale account and the income summary account will be credited for the sum of all
income accounts.
2. Each expense account is credited and the income summary is debited for the sum
of the balances of expense accounts. This will reduce the balance in income
summary account.
3. Income summary account is a ledger account used in the closing stage of the
accounting cycle. It holds all income and expense balances and helps in
determining net income or net loss for the period. Income summary account is
debited and retained earnings account is credited for the an amount equal to the
excess of service revenue over total expenses i.e. the net balance in income
summary account after posting the first two closing entries. In this case Birr
85,600 – Birr 77,364 = Birr 8,236. Please note that, if the balance in income
summary account is negative at this stage, this closing entry will be opposite i.e.
debit to retained earnings and credit to income summary.

4. The last closing entry transfers the dividend or withdrawal account balance to the
retained earnings account. Since dividend and withdrawal accounts are contra to
the retained earnings account, they reduce the balance in the retained earnings.
The last step of an accounting cycle is to prepare post-closing trial balance.
8. Preparing post-closing trial balance
Post-Closing Trial Balance
A post-closing trial balance is a list of balances of ledger accounts prepared after closing
entries have been passed and posted to the ledger accounts. Since the closing entries transfer
the balances of temporary accounts (i.e. expense, revenue, gain, dividend and withdrawal
accounts) to the retained earnings account, the new balances of temporary accounts are zero
and therefore they are not listed on a post-closing trial balance. However, all the other
accounts having non-negative balances are listed including the retained earnings account.
The preparation of post-closing trial balance is the last step of the accounting cycle and its
purpose is to be sure that sum of debits equal the sum of credits before the start of new
accounting period. It provides the openings balances for the ledger accounts of the new
accounting period.
Example
The following post-closing trial balance was prepared after posting the closing entries of
Company A to its general ledger and calculating new account balances:
Company AB
Adjusted Trial Balance
January 31, 2016
Debit Credit
Cash Birr20,430 −
Accounts Receivable 5,900 −
Office Supplies 4,320 −
Prepaid Rent 24,000 −
Equipment 80,000 −
Accumulated Depreciation − Birr 1,100
Accounts Payable − 5,200
Utilities Payable − 3,964
Unearned Revenue − 1,000
Interest Payable − 150
Notes Payable − 20,000

Common Stock − 100,000

Retained Earnings − 3,236
Total Birr134,650 Birr134,650
This is the end of the accounting cycle. In the next accounting period, the accounting cycle
will be repeated again starting from the preparation of journal entries i.e. the first step of
accounting cycle.
Reversing Entries
Reversing entries are passed at the beginning of an accounting period as an optional step of
accounting cycle to cancel the effect of previous period adjusting entries involving future
payments or receipts of cash. The benefit of reversing those adjusting entries is that this
eliminates the need to identify what part, if any, of a particular payment or receipt made or
received in the period relates to the previous period expense or revenue.
When reversing entries are not made, the accountant needs to remember last period
adjusting entries and account for any expense/revenue previously recognized relating to
current period payments or receipts. This is done using compound journal entries.
Reversing entries are best explained using an example:
Example
Two of the adjusting entries recorded by a company on year ending Dec 31, 20X2 are
shown below:
Dec 31 Interest Expense Birr1,500
Interest Payable Birr1,500
Dec 31 Rent Receivable Birr29,000
Rent Revenue Birr29,000
Interest was accrued during the months of November and December on loan of Birr100,000
obtained on Nov 1, 20X2. Interest is payable after every three months. Rent receivable is
related to a building given on rent on Dec 1, 20X2. Rent is payable after every 2 months.
Pass the journal entries recording the actual payment of interest and receipt of rent first
without reversing entries and then with reversing entries.

Solution
Interest Rate on Loan = (1,500 ÷ 2) × 12 / Birr 100,000 = 9%
Total Interest Payment on Feb 1, 20X3 (a) = 9% × 3/12 × Birr100,000 = Birr 2,250
Rent Payable on Feb 1 (b) = 29,000 × 2 = Birr 58,000
Without Using Reversing Entries:
Under this method, each payment is apportioned between expense and payable and each
receipt between revenue and a receivable. Thus:
Interest Expense in 20X3 resulting from (a) = Birr 2,250 − Birr1,500 = Birr750
Rent Expense in 20X3 resulting from (b) = Birr58,000 − Birr29,000 = Birr29,000
Feb 1 Interest Expense Birr750
Interest Payable Birr1,500
Cash Birr2,250
Feb 1 Cash Birr58,000
Rent Receivable Birr29,000
Rent Revenue Birr29,000
Using Reversing Entries:

This method involves two steps, first, the last period adjusting entries which involve future
payments or receipts are reversed as shown below:

Jan 1 Interest Payable Birr1,500
Interest Expense Birr1,500
Jan 1 Rent Revenue Birr29,000
Rent Receivable Birr29,000
At the time of actual payment or receipt, a simple journal entry is used to record them
without any regard to the part of the payment or receipt which may related to last period.
Thus,
Feb 1 Interest Expense $2,250
Cash $2,250
Feb 1 Cash $58,000
Rent Revenue $58,000

Accounting Worksheet: An accounting worksheet is large table of data which may be

prepared by accountants as an optional intermediate step in an accounting cycle. The main
purpose of a worksheet is that it reduces the likelihood of forgetting an adjustment and it
reveals arithmetic errors. A worksheet acts as a tool for an accountant and it is not usually
intended to be used by third parties. It is an informal document. A typical worksheet
consists of a column on the left showing main account titles and 10 more columns of debits
and credits showing trial balance, adjustments, adjusted trial balance, incomes statement
and balance sheet.
The heading of the work sheet in our example for AB Company consists of three parts:
1. The name of the business.
2. The title work sheet.
3. The period of time covered.
Example
The following Trial Balance has been extracted from general ledger of Champion
Professional Services.
Champion Professional Services
Unadjusted trial balance
December 31, 20X8
Debit Credit
Cash 25,000
Accounts receivable -0-
Supplies 3,800
Prepaid insurance 9,800
Prepaid rent 500
Equipment 60,000
Accumulated depreciation—Equipment 22,900
Accounts payable 6,000
Salaries payable -0-
Unearned Fees 4,000
F. Mercury, Capital 51,000
F. Mercury, Withdrawals 14,000
Fees Earned 71,900
Depreciation Expense—Equipment -0-
Salaries Expense 24,800
Insurance Expense -0-

Rent Expense 5,500

Supplies Expense -0-
Advertising Expense 6,000
Utilities Expense 6,400 _______
Totals 155,800 155,800
Using the data below, complete the worksheet on the following page by filling in the
adjustments and adjusted trial balance for Champion for the year ended December 31,
20X8.
a. 8 employees are paid weekly. At year end, 3 days‘ wages have accrued at Birr 120 a
day for each employee.
b. A physical count shows Birr 600 of office supplies on hand at year end.
c. Birr 2,600 of prepaid insurance coverage have expired.
d. Annual depreciation on the equipment is Birr 8,450.
e. On November 1, Champion contracted for a new job for which it is paid Birr1, 000 a
month. It received a 4-month advance and booked it as unearned fees.
f. A client renewed its contract for 3 months at Birr 1,300 a month, starting on
November 1. The first payment is due on February 28th.
g. The balance in Prepaid Rent is December‘s rent.
Required:
1. Prepare the adjusting entries necessary for the year ended December 31, 20X8.
2. Enter the trial balance on a work sheet, and complete the adjustment column in the
work sheet using the above information:
3. Using the adjusted trial balance, complete the Income Statement and Balance Sheet
columns of the worksheet for Champion. When the worksheet is complete, prepare
Champion‘s financial statements.
Solution for required No 1
a. Salaries Expense 2,880
Salaries Payable 2,880
Birr 120  8 employees  3 days = Birr 2,880
b. Supplies Expense 3,200
Supplies 3,200
Birr 3,800 beginning balance  Birr 600 ending balance = Birr3, 200 used up during
the year

c. Insurance Expense 2,600

Prepaid Insurance 2,600
d. Depreciation Expense 8,450
e. Unearned Fees 2,000

Fees Earned 2,000
Birr1, 000 monthly fee  2 months (JanuaryFebruary 20X8) unearned as of year
end
f. Accounts Receivable 2,600
Fees Earned 2,600
Birr 1,300  2 months earned as of year end
g. Rent Expense 500
Prepaid Rent 500

trial balance
December 31, 20X7
Unadjusted trial Adjusted trial
balance Adjustments balance
Dr Cr Dr Cr Dr Cr
Cash 25,000 25,000
Accounts Receivable -0- (f) 2,600 2,600
Supplies 3,800 (b) 3,200 600
Prepaid Insurance 9,800 (c) 2,600 7,200
Prepaid Rent 500 (g) 500 0
Equipment 60,000 60,000
Acc. Depreciation—
Equipment 22,900 (d) 8,450 31,350
Accounts Payable 6,000 6,000
Salaries Payable -0- (a) 2,880 2,880
Unearned Fees 4,000 (e) 2,000 2,000
F. Mercury, Capital 51,000 51,000
F. Mercury,
Withdrawals 14,000 14,000
Fees Earned 71,900 (e) 2,000 76,500
(f) 2,600

Depreciation Exp.— -0-

Equipment (d) 8,450 8,450
Salaries Expense 24,800 (a) 2,880 27,680
Insurance Expense -0- (c) 2,600 2,600
Rent Expense 5,500 (g) 500 6,000
Supplies Expense -0- (b) 3,200 3,200
Advertising Expense 6,000 6,000
Utilities Expense 6,400 6,400
Total 155,800 155,800 22,230 22,230 169,730 169,730

Champion Professional Services.
Worksheet
December 31, 20X8
Adjusted trial Income Balance
balance statement sheet
Dr Cr Dr Cr Dr Cr
Cash 25,000 25,000
Accounts Receivable 2,600 2,600
Supplies 600 600
Prepaid Insurance 7,200 7,200
Prepaid Rent 0 0
Equipment 60,000 60,000
Acc. Depreciation– 31,350 31,350
Equipment
Accounts Payable 6,000 6,000
Salaries Payable 2,880 2,880
Unearned Fees 2,000 2,000
F. Mercury, Capital 51,000 51,000
F. Mercury, Withdrawals 14,000 14,000
Fees Earned 76,500 76,500
Depreciation Expense– 8,450 8,450
Equipment
Salaries Expense 27,680 27,680
Insurance Expense 2,600 2,600
Rent Expense 6,000 6,000

Supplies Expense 3,200 3,200

Advertising Expense 6,000 6,000
Utilities Expense 6,400 6,400
Totals 169,730 169,730 60,330 76,500 109,400 93,230
Net Income 16,170 16,170
76,500 76,500 109,400 109,400
After the account balances are extended to the Income Statement and Balance Sheet
columns, each of the columns is totaled. The difference between the two Income Statement
column totals is the amount of the net income or the net loss for the period. This difference
(net income or net loss) will also be the difference between the two Balance Sheet column
totals.
If the Income Statement Credit column total (total revenue) is greater than the Income
Statement Debit column total (total expenses), the difference is the net income.
If the Income Statement Debit column total is greater than the Income Statement Credit
column total, the difference is a net loss.
Total of Income Statement Credit column (revenues) ………………………76,500
Less: Total of Income Statement Debit column (expenses)………………….. (60,330)
Net income (excess of revenues over expenses)…………………………. 16,170
The amount of the net income, Birr16,170, is entered in the Income Statement Debit column
and the Balance Sheet Credit column.
Income Statement
For the year ended December 31, 20X8
Revenue Birr76, 500
Less:
Salaries expense Birr 27,680
Insurance expense 2,600
Rental expense 6,000
Supplies expense 3,200
Advertising expense 6,000
Utilities expense 6,400
Depreciation expense 8,450 60,330
Net income Birr16,170
Balance Sheet
December 31, 20X8
Assets

Cash Birr25, 000

Accounts receivable 2,600
Supplies 600
Prepaid insurance 7,200
Equipment (net) 28,650
Total assets Birr 64,050
Liabilities and Capital

Accounts payable Birr 6,000
Salaries payable 2,880
Unearned fees 2,000
Fetahun, capital* 53,170
Total liabilities and capital Birr 64,050
* Fetahun, capital = Birr 51,000 + Birr 16,170 net income  Birr 14,000
withdrawals
Accruals and Prepayments
Accruals are expenses incurred but not yet paid while prepayments are payments for
expenses for that are not yet incurred. Accruals and prepayments give rise to current
liabilities and current assets respectively in accordance with the matching principle and
accrual accounting.
Matching principle requires accountants to record revenues and expenses in the period in
which they are incurred regardless of when the relevant payments are made. In order to
create this 1-on-1 correspondence between revenue and expenses, expenses are recorded if
they are incurred in a particular period even if they are not yet paid, because they were
necessary to earn the revenue for that period. On the other hand, prepayments are recorded
to represent payments related to goods and services that are to be consumed in future
periods. It is this matching principle that differentiates accrual accounting from cash-basis
accounting, which records revenues and expenses when they are received and not when
they are earned or incurred.
Examples
Woodworks, Inc. is a furniture manufacturer and retailer. You are closing the books of the
company for the year ended 30 June 2016. Suggest appropriate accounting treatment for the
following transactions:
1. The company paid salaries of Birr70, 000 for June 2016 on 4 July 2016. Total salaries for
the year 2016 do not already include this figure.

2. On 5 July 2016, the company received utility bills totaling Birr30, 000.
3. Annual rent of Birr100, 000 on Outlet A was paid on 1 January 2016 and it was recorded
as prepaid rent.
4. Semi-annual rent of Birr30, 000 on Outlet B was also paid on 1 April 2016 and the whole
amount was charged to the income statement.
5. On 30 June 2016, Birr 50,000 was paid on account of 5-year premium membership of
relevant business association.
Journal entries
The basic principle behind accrual accounting is to record revenues and expenses regardless
of payment. Following accrual and prepayment adjustments are required for 2016.
1. Though salaries of Birr 70,000 were paid on 4 July 2016, they related to services
provided by employees in June 2016. These salaries are the cost of June 2016 revenue
and must be recorded as part of June financial statements even if the payment is
made after 30 June. The following journal entry must be made:
Date General journal PR Debit Credit

June30 Salaries expense Birr70,000
Salaries payable Birr70,000
2. On 4 July 2016, at the time of actual payment is made, the following journal entry is
made:

July 5 Salaries payable Birr 70,000
Cash Birr70,000
3. Utility bills related to utilities consumed in June, so they must be reflected in

financial statements for the year ended 30 June 2014, even if they are paid later.

June Utilities expense Birr30,000
30
Utilities payable Birr30,000
4. When the bills are actually paid, the following journal entry reflects the actual
payment:

June Utilities payable Birr30,000

Cash Birr30,000
5. 12 months of rent was paid on 1 January 2016 and it was recorded as prepaid rent.
Half of this rent is related to the year ended 30 June 2016, so a journal entry should
be made to expense out half of the prepaid rent.
General Journal PR Debit Credit
Date
Jan 1
Rent expense (Birr100,000/2) Birr50,000
Prepaid rent Birr50,000
6. In April 2016, Birr30, 000 was paid on account of six months of rent on Outlet B and
it was expensed out. However, only three months of the relevant rent payment
belong to financial year 2016. A journal entry should be made to reduce the recorded
rent expense and create a prepaid rent asset equivalent to three months of use.
April Prepaid rent (Birr 300,000/6×3) Birr15,000
Rent expense Birr15,000
7. The payment of Birr 50,000 on 30 June 2016 relates to membership fee due in next 5
year. This payment is a prepayment.
Date General Journal PR Debit Credit

June 30 Prepaid membership fee Birr 50,000
Cash Birr50,000
Summary of adjustment impact on financial statements

Types adjusting Financial Statement Impact if Adjusting Entry Is Omitted
entries
Income Statement: Balance Sheet:
1. PREPAID Revenues - ---- No effect Assets - Overstated
EXPENSES Expenses - --- Understated Liabilities - No effect
Net income -----Overstated Owner‘s Equity --Overstated
2. UNEARNED Revenues ---- Understated Assets ----No effect
REVENUES Expenses ----No effect Liabilities----- Overstated

Net income - Understated Owner‘s Equity ---Understated

3. ACCRUED Revenues - Understated Assets ---- Understated
REVENUES Expenses - No effect Liabilities------ No effect
Net income - Understated Owner‘s Equity---- Understated
4. ACCRUED Revenues - No effect Assets -----No effect
EXPENSES Expenses - Understated Liabilities -----Understated
Net income - Overstated Owner‘s Equity ----Overstated
5. Revenues - No effect Assets-------- Overstated
DEPRECIA Expenses - Understated Liabilities ------No effect
TION Net income ---Overstated Owner‘s Equity -----Overstated
A Look at IFRS
International companies use the same set of procedures and records to keep track of
transaction data. Thus, in this Chapter dealing with the account, general rules of debit and
credit, and steps in the recording process—the journal, ledger, chart of accounts, and trial
balance—is the same under both GAAP and IFRS.
Both the IASB and FASB go beyond the basic definitions provided in this textbook for the
key elements of financial statements, that is, assets, liabilities, equity, revenues, and expenses.
A trial balance under IFRS follows the same format as shown in the textbook.
As shown in the textbook, dollars signs are typically used only in the trial balance and the
financial statements. The same practice is followed under IFRS, using the currency sign of
the country that the reporting company is headquartered.
Self - Study Questions and Exercises
1. Which of the steps in the accounting cycle are performed throughout the accounting
period?
2. Do you think this double entry accounting system makes sense? Can you conceive of
other possible methods for recording changes in accounts?
3. Define an account. What are the two forms of account posting illustrated in the
chapter?
4. What is meant by the term double-entry procedure, or duality

5. Store equipment was purchased for Birr 2,000. Instead of debiting the Store Equipment
account, the debit was made to Delivery Equipment. Of what help will the trial balance
be in locating this error? Why?
INSTRUCTION: For the following questions write TRUE if the statement is correct and
write False if the statement is incorrect.
1. The last step in the accounting cycle is preparing the financial statements.
2. The adjusted trial balance columns of a worksheet contain the account balances that
appear on the financial statements.
3. If the sum of the work sheet income statement debit column is greater than the
income statement credit column, it indicates net income.
4. Capital, revenue, expense, and withdrawals are closed out at the end of the year.
5. The post-closing trial balance contains only balance sheet accounts.
6. The capital in the balance sheet credit column of a worksheet represents the
beginning capital amount plus any additional capital investments during the period.
7. The difference between the debit and credit totals of the balance sheet columns of the
worksheet is net income or net loss.
8. A list of all account names used to record transactions of a company is referred to as a
T-account.
9. Receiving cash in advance from a customer for services to be provided in the future
causes assets to increase and stockholders' equity to increase.
10. The process of transferring the debit and credit information from the journal to
individual accounts in the general ledger is called journalizing.
Sample Multiple Choice Questions
1. The receipt of cash from customers in payment of their accounts would be recorded by
a:
A) Debit to cash; credit to accounts receivable
B) Debit to account receivable; credit to cash
C) Debit to cash; credit to accounts payable
D) Debit to accounts payable; credit to cash
2. Which of the following applications of the rules of debit and credit is true?
A) Increase rent expense with debits and the normal balance is a debit.
B) Decrease accounts receivable with credits and the normal balance is a credit.
C) Increase accounts payable with credits and the normal balance is a debit.

D) Decrease cash with debits and the normal balance is a credit.

3. In which of the following types of accounts are increases recorded by credits?
A) Liability, Revenue B) Dividends, Asset
C) Expense, Liability D) Revenue, Dividends
4. Which of the following entries records the payment of an account payable?
A) Debit Accounts Payable, credit Cash
B) Debit Cash, credit Accounts Payable
C) Debit Expense, credit Cash
D) Debit Cash, credit Expense
5. When a trial balance balances, it is an indication that:
A) All journal entries have been posted.
B) The account balances are correct.
C) Debits equal credits.
D) All transactions have been journalized.
6. Which of the following accounts would appear in the balance sheet credit column of the
worksheet?
A) Equipment B) Salary Payable
C) Rent Revenue D) Insurance Expense
7. Which of the following accounts is not closed out?
A) Accumulated Depreciation B) Service Revenue
C) Depreciation Expense D) Owner‘s Withdrawals
8. The chart of accounts lists a company‘s accounts in what order?
A) Assets, liabilities, revenues, expenses, stockholders‘ equity
B) Assets, revenues, expenses, liabilities, stockholders‘ equity
C) Assets, liabilities, stockholders‘ equity, expenses, revenue
D) Assets, liabilities, stockholders‘ equity, revenues, expenses
9. The entire group of accounts maintained by a company is collectively referred to as the:
A) Ledger B) Journal
C) Financial statements D) Basic equation
10. The gross increase in stockholder‘s equity attributable to business activities is called:
A) Dividends B) Revenues
C) Expenses D) Assets
EXERCISES
Exercise: 1 Supplies were purchased for cash on May 2 for Birr 8,000. Show how this
purchase would be recorded. Then show the adjusting entry that would be necessary,
assuming that Birr 2,500 of the supplies remained at the end of the year and the beginning
balance for supplies was Birr 500.
Exercise: 2 Assume that a company acquired a building on January 1, at a cost of Birr

1,000,000. The building has an estimated useful life of 40 years and an estimated residual

value of Birr 200,000. What adjusting entry is needed on December 31 to record the
depreciation for the entire year?
Exercise: 3 A firms borrowed Birr 30,000 on November 1. By December 31, Birr 300 of
interest had been incurred. Prepare the adjusting entry required on December 31
Exercise: 4 ABC Company reported net income of Birr100, 000 for the current year.
Examination of the financial data indicates that the following items were ignored:
 Accrued salaries were Birr6, 000 at December 31.
 Depreciation on equipment acquired on July 1 amounted to Birr 4,000.
Based on this information, (a) what adjusting journal entries should have been made
at December 31, and (b) what is the correct net income?
Group project: 1 in teams of two or three students, interview in person or by speakerphone a

new staff member who has worked for a CPA firm for only one or two years. Seek
information on the advantages and disadvantages of working for a CPA firm. Also, inquire
about the nature of the work and the training programs offered by the firm for new
employees. As a team, write a memorandum to the instructor summarizing the results of the
interview. The heading of the memorandum should contain the date, to which it is written,
from whom, and the subject matter.
Group project: 2 with one or two other students and using library resources write a report on
the life of Luca Pacioli, sometimes referred to as the father of accounting. Pacioli was a
Franciscan monk who wrote a book on double-entry accounting in 1494. Be careful to cite
sources and treat direct quotes properly. (If you do not know how to do this, ask your
instructor.)
Answer key for true or false and multiple choices
No True or False No Multiple choice

1 6 1 6
2 7 2 7
3 8 3 8
4 9 4 9
5 10 5 10

CHAPTER THREE
3. ACCOUNTING FOR MERCHANDIZE OPERATION
The first two chapters in this book used only service companies as examples of businesses
that prepare financial statements. This chapter introduces some of the business and
accounting practices used by companies that engage in merchandising activities.
The activities of service business differ from those of a merchandizing business. These
differences are illustrated in the following way.
Service company
The revenue activities of a service business involve providing services to customers. On the
income statement for a service business, the revenues from services are reported as fees
earned. The operating expenses incurred in providing the services are subtracted from the
fees earned to arrive at net income.
In contrast, the revenue activities of a merchandizing business involve the buying and
selling of merchandize. A merchandizing business first purchases merchandize to sell to its
customers. When this merchandize is sold, the revenue is reported as sales and its cost is
recognized as an expense. This expense is called the cost of merchandize sold. The cost of
merchandize sold is subtracted from sales to arrive at gross profit. This amount called is
gross profit because it is the profit before deducting operating expense.
Merchandizer
Minus Equals Minus Equals
Net sales Cost of Gross Expense Net
goods sold Profit income
Merchandize on hand (Not sold) at the end of an accounting period is called Merchandize
inventory. Merchandize inventory is reported as a current asset on the balance sheet.
3.1 Accounting for Merchandize operation
A merchandizer keeps track of its inventory to determine what is available for sale and what
has been sold. One of the two systems is used to account for inventory
1. Periodic inventory system
2. Perpetual inventory system

3.2.1 Periodic Inventory Systems
In periodic inventory system, merchandise inventory and cost of goods sold are not updated
continuously. Instead purchases are recorded in Purchases account and each sale transaction
is recorded via a single journal entry.
In a periodic inventory system, detailed inventory records of the goods on hand are not kept
throughout the period. The cost of goods sold is determined only at the of the accounting
period- that is, periodically. At that time, a physical inventory count is taken to determine
the cost of goods on hand (Merchandize Inventory). To determine the cost of goods sold
under a periodic system, the following steps are necessary.
1. The cost of merchandise on hand at the beginning of the period.
2. Add to it the cost of merchandise purchased during the period.
3. Subtract the cost of unsold goods on hand at the end of the period
Generally, the periodic inventory system is less costly to maintain than the perpetual
inventory system, but it gives less information about the current status of merchandise and
often used by enterprises that sell many kinds of low unit cost merchandise.
3.2.2 Perpetual Inventory Systems

In perpetual inventory system, merchandise inventory and cost of goods sold are updated
continuously on each sale and purchase transaction. Some other transactions may also require an
update to inventory account for example, sale/purchase return, purchase discounts etc. Purchases
are directly debited to inventory account whereas for each sale two journal entries are made: one
to record sale value of inventory and other to record cost of goods sold. Purchases account is
not used in perpetual inventory system.
Generally, perpetual inventory systems have been used by companies that sell merchandize with
high unit values. Examples are automobiles, furniture and major home appliances. The
widespread use of computers and electronics scanners now enables many more companies to
install perpetual inventory systems.
Not that a perpetual inventory system provides better control over inventories than a periodic
system. The inventory records show the quantities that should be on hand.
Differences Between Perpetual and Periodic System
Following are the main differences between perpetual and periodic inventory systems:

 Inventory account and Cost of Goods Sold account are used in both systems but they
are updated continuously during the period in perpetual inventory system whereas in
periodic inventory system they are updated only at the end of the period.
 Purchases account and Purchase Returns and Allowances Account are only used in
periodic inventory system and are updated at the accounting period. In perpetual
inventory system purchases are directly debited to inventory account and purchase
returns are directly credited to inventory account.
 Sale Transaction is recorded via two journal entries in perpetual system. One of them
records the sale value of inventory whereas the other records cost of goods sold. In
periodic inventory system, only former entry is made.
 Closing Entries are only required in periodic inventory system to update inventory and
cost of goods sold. Perpetual inventory system does not require closing entries for
inventory account.
Periodic Inventory VS Perpetual Inventory System Journal Entries
Periodic inventory system updates inventory balance once in a period. We discussed this concept
in the perpetual-periodic inventory comparison. Here, we will learn the typical journal entries
under a periodic inventory system and perpetual inventory system.
Let us assume that all sales and purchases are on credit. Also assume that where discounts are
provided or availed on sales/purchases, they are recorded using the gross method (to learn more
about gross method, see discount on sales and discount on inventory purchases).
Following are the typical journal entries under a periodic inventory system:
Inventory Purchase: The purchase of inventory under periodic inventory system is recorded by
debiting purchases account and crediting accounts payable. For example: Assume that on June 5.
ABC Company Purchased Birr 30,000 of merchandise on account from xyz Clothing, terms
2/10, n/30.

June 5 Purchases Birr30,000
Accounts Payable Birr30,000
Under perpetual inventory system, a purchase is recorded by debiting inventory account and
crediting accounts payable assuming that the purchase is on credit. The journal entry is shown
below:


June 5 Merchandize Inventory Birr 30,000
Accounts Payable Birr 30,000
"Purchases" has a normal debit balance since it replaces the debit to "Inventory". It has two
contra accounts known as "Purchase Discounts" (Purch. Disc.) and "Purchase Returns and
Allowances" (Purch. R&A) that reduce it to determine "Net Purchases". The balance of these
two contra accounts is a credit because "Purchases" is a debit. Remember that contra accounts
always have a normal balance that is opposite to what they are contra to. Purchase-type
accounts are temporary accounts (i.e., they are closed at year end) and only appear in a periodic
inventory system. They simply serve to replace the corresponding inventory portion of an entry
that exists in a perpetual inventory system.
Purchase Return& Allowance: Purchaser may be dissatisfied with the merchandize received.
The goods may be damaged or defective, incorrect size, color, of inferior quality, perhaps they
do not meet the purchaser’s specifications. In such cases, the purchaser may return the goods to
the seller. The purchaser is granted credit if the sale was made on credit, or a cash refund if the
purchase was for cash. This transaction is known as a purchase return. On other side the
purchaser may choose to keep the merchandize if the seller is willing to grant an allowance
(deduction) from the purchase price. This transaction is known as a purchase allowance.
The purchaser initiates the request for a reduction of the balance due through the issuance of a
debit memorandum. A debit memorandum is a document issued by purchaser to inform a
supplier that a debit has been made to the supplier’s account on the purchaser books. The
original of the memorandum is sent to supplier and one copy is retained by purchaser.
A debit memo informs the seller of the amount the buyer proposes to debit to the account
payable due the seller. It also states the reasons for the return or the request for the price
allowance. A buyer may return merchandise or be granted a price allowance before paying an
invoice. In this case, the amount of the debit memo is deducted from the invoice. The amount is
deducted before the purchase discount is computed.
Purchase returns & allowance under periodic inventory system are recorded as shown below
June 8. Returned merchandise purchased on account from XYZ Clothing on June 5, Birr 500.
General Journal PR

June 8 Accounts Payable Birr500

Purchase Returns &Allowance Birr500
When inventory purchased is subsequently returned to the supplier (seller), the journal entry
perpetual inventory system is to debit accounts payable or accounts receivable and credit
inventory account.
General Journal PR
June 8 Accounts Payable Birr500
Merchandise inventory Birr500
Under the perpetual inventory system, returns would be recorded as a credit to the merchandise
inventory account at their cost of Birr 500.
Purchase Discount: When inventory is purchased on account from a seller, the seller
offering cash discount for early payment, the buyer has an opportunity to make payment
within a specified number of days called the discount period. The buyer refers to these cash
discounts as purchases discounts. When the buyer pays within the discount period, the
accounting system records a credit to a contra-purchases account called Purchases
Discounts.
Payment terms
In some industries, credit terms include a cash discount of 1% to 3% to encourage early
payment of an amount due. A cash discount is a deduction from the invoice price that can
be taken only if the invoice is paid within a specified time. Sellers call a cash discount a sales
discount and buyers call it a purchase discount. Companies‘ often state payment terms as
follows:
•1/10, n/30—means a buyer who pays within 10 days following the invoice date may deduct
a discount of 1% of the invoice price. If payment is not made within the discount period, the
entire invoice price is due 30 days from the invoice date.
•3/EOM, n/60—means a buyer who pays by the end of the month of purchase may deduct
a 3% discount from the invoice price. If payment is not made within the discount period,
the entire invoice price is due 60 days from the invoice date.
•2/10/EOM, n/60—means a buyer who pays by the 10th of the month following the month
of purchase may deduct a 2% discount from the invoice price. If payment is not made
within the discount period, the entire invoice price is due 60 days from the invoice date.
•Net 30 —means the entire invoice price is due 30 days from the invoice date without a
discount.

Sellers cannot record the sales discount before they receive the payment since they do not
know when the buyer will pay the invoice. A cash discount taken by the buyer reduces the
cash that the seller actually collects from the sale of the goods, so the seller must indicate this
fact in its accounting records.
Companies base discounts on the invoice price of goods. If merchandise is later returned, the
returned amount must be deducted from the invoice price before calculating discounts.
For example, the invoice price of goods purchased was Birr 30,000 and the company returned
Birr 2,000 of the goods, the seller calculates the 2% discount on Birr 28,000 (Birr30, 000 original
– Birr 2,000 return).
Such inventory, on which cash discount is offered, can be recorded by the buyer using either of
the two methods known as:
 Gross Method: The gross method initially records the purchase at gross price. After
that, it depends on whether the payment is made within the discount period or after. If the
payment is made within the discount period, the buyer will record the payment by
debiting accounts payable for the gross price, crediting cash for the difference of gross
price and discount received and crediting purchase discounts for the discount received. If
discount opportunity is missed, the journal entry is made for the full payment as usual.
Under gross method, purchase discount is recorded using the following journal entry:
June 15: Paid ABC Clothing for purchase of June 5.
June 15 Accounts Payable Birr 29,500
Purchase Discounts Birr 28,910
Cash Birr 590
 Notice that less return of Birr 500 and discount of Birr 590 [(Birr 30,000 _ Birr 500) _
2%].
Under a perpetual inventory system, a purchases discount account is not used. Instead
the merchandise inventory account is credited for the amount of the discount, Birr 590
Date General Journal PR
June 15 Accounts Payable Birr 29,500
Merchandise inventory Birr28,910
Cash Birr 590

 Net Method: The net method initially records the purchase at net price (i.e. gross price
less the potential discount). If the discount is availed, the journal entry is to debit
accounts payable for the net price and credit cash. If the buyer fails to make payment
within the discount period, the journal entry is to debit accounts payable for the net price,
debit purchase discounts lost for the discount which could be availed and crediting cash
for the gross price. It is interesting to note that the purchase discounts lost represents an
expense.
The following example provides the journal entries to record inventory purchase using
gross method and net method under periodic inventory system.
Example Company XYZ purchased goods having gross price of Birr 6,000. The supplier
offered discount of 8% for payments within 15 days after sale. Pass journal entries to record the
purchase using gross method and net method on the following occasions:
(A) At the date of purchase

(B) On payment within discount period and
(c) On payment after discount period
Solution :
Gross Method Journal Entries Net Method Journal Entries
(A) At the date of purchase (A) At the date of purchase
Purchases 6000 Purchases 5,520
Accounts Payable……………………6000 Accounts Payable 5,520
(B) For payment with in discount period (B) For payment with in discount period
Accounts Payable 6000 Accounts Payable………….5,520
Cash……………………………5520 Cash……………………………5520
Purchase Discounts…………….480
(C) For payment after discount period (C) For payment after discount period
Accounts Payable………6000 Accounts Payable………….5,520
Cash……………………………..6000 Purchase Discounts Lost…….480
Cash……………………………….6000
For example, if all purchases are made on credit and all suppliers offer a 2% discount, the
balance of the Purchases Discounts contra account should equal 2% of the balance of the
Purchases account.
Purchases . . . . . . . . . . . . . . . . . . . . . . . . . …………...xx
Less: Purchases returns and allowances . . . .( xx)
Less: Purchases discounts . . . . . . . . . . . . . . …(xx)
Net purchases . . . . . . . . . . . . . …………………….…xxx.

At the end of each accounting period, the value of ending inventory is determined by physical
count. Cost of goods sold is determined either as a balancing figure in the closing entry shown at
the end or by using the following formula:
COGS = Beginning Inventory + Purchases − Ending Inventory
The closing entry required in a periodic inventory system debits:

 Inventory account by the value of ending inventory
 Cost of goods sold account by the value as determined above or by the balancing figure
and credits:
 inventory account by beginning inventory
 purchases account
The entry is shown below:
Closing entry PR debit credit

June 31 Inventory (Ending Inventory) xx
A
Cost of Goods Sold (Balancing Figure)
xx
simpli
Inventory (Beginning Inventory) xx
Purchases xx fied
form of the above journal entry uses a single debit or credit to inventory account by calculating
the difference of ending inventory and beginning inventory. If the difference is positive, the
inventory account will be debited for the difference and if it the difference is negative, the
journal entry will credit the inventory account by the difference.
The accounting features of a perpetual inventory system are:
1. Purchases of merchandise for resale or raw materials for production are debited to
inventory rather than to purchases.
2. Freight-in, purchases returns and allowances, and purchase discounts are recorded in
inventory rather than in separate accounts.
3. Cost of goods sold is recognized for each sale by debiting the account cost of goods sold,
and crediting inventory.
Sale of Merchandize: A business may sell merchandize for cash. Cash sales are entered on
cash register and recorded in accounts.

Assume that on January 3, ABC sells merchandise for Birr1, 800. These cash sales are recorded
as follows:
Date Description PR Debit Credit
January 3 Cash Birr 1800
Sale Birr 1800
Sales may be made to customers using credit cards such as Master card or VISA. Such sales
recorded as cash sales. This is because these sales are normally processed by clearing house that
contacts the bank that issued the card. The issuing bank then electronically transfers cash directly
to the retailer’s bank account .thus the retailer normally receives cash within a few days of
making the credit card sale. If the customers in the preceding sales had used master cards to pay
for their purchases the sales would be recorded exactly as shown in the preceding entry. Any
processing fees charged by the clearing house or issuing bank is periodically recorded as an
expense.
Sales on Account: A business may sell merchandise on account. Instead of using MasterCard or
VISA, a customer may use a credit card that is not issued by a bank. For example, a customer
might use an American Express card. The seller records such sales as a debit to Accounts
Receivable and a credit to Sales.
A transaction of sale is recorded via two journal entries in perpetual inventory system. The first
entry records the sale of the merchandise and either the receipt of cash or the account receivable
and the second one record the cost of goods sold and reduce the inventory balance. The two
journal entries are shown below:
Assume that on June 18. Sold merchandise on account to Gemechu Co., Birr 12,500, 1/10, n/30.
The cost of the merchandise sold was Birr9, 000.

June 18 Accounts Receivable 12500
Sales 12500
June 18 Cost of Goods Sold 9000
Inventory 9000
The entry to record the sale is the same under both systems. Under the perpetual inventory
system, the cost of merchandise sold and the reduction in merchandise inventory would also be
recorded on the date of sale but no in the periodic inventory system.

A sale has two contra accounts known as "Sales Discounts" (Sales Disc.) and "Sales Returns and
Allowances" (Sales R&A) that reduce it. The normal balance for these two contra accounts is a
debit. Sales and its contra accounts may appear with either a perpetual or periodic inventory
system.
Sales Return &Allowance: Merchandise sold may be returned to the seller (sales return).
In other cases, the seller may reduce the initial selling price (sales allowance). This might occur
if the merchandise is defective, damaged during shipment, or does not meet the buyer’s
expectations.
If the return or allowance is for a sale on account, the seller usually issues the buyer a credit
memorandum, often called a credit memo.
A credit memo authorizes a credit to (decreases) the buyer’s account receivable. A credit memo
indicates the amount and reason for the credit.
The recording of sales return also requires two journal entries. Which are shown below
June 21. Received merchandise returned on account from Gemechu Co., Birr 4,000. The cost of
the merchandise returned was Birr 2,800.
Date General journal PR Credit A
June 21 Merchandize Inventory Birr 4000 perpet
Accounts Receivable Birr4000
June 21 Merchandize Inventory Birr2800 ual
Cost of Goods Sold Birr 2800 invento
ry system, the seller debits Sales Returns and Allowances for the amount of the return or
allowance. If the sale was on account, the seller credits Accounts Receivable. The seller must
also debit (increase) Merchandise Inventory and decrease (credit) Cost of Merchandise Sold for
the cost of the returned merchandise.

June 21 sales return &Allowance Birr 4000
Accounts Receivable Birr4000
A periodic inventory system, the seller debits Sales Returns and Allowances for the amount of the
return or allowance. If the sale was on account, the seller credits Accounts Receivable.
Sales discounts: The terms of a sale are normally indicated on the invoice or bill that the seller
sends to the buyer. The terms for when payments for merchandise are to be made are called the
credit terms. Credit terms indicate particular legal details of a credit sale. These details indicate

the due date, the interest rate to be charged on overdue balances, and any discount offered for
early payment.
June 28. Received Birr 8,415 as payment on account from Gemechu Co., less return of June 21
and less discount of Birr 85 [(Birr 12,500 _ Birr4,000) X1%].
Date General Journal PR

June 21 Cash Birr8,415
Sale discount Birr 85
Accounts Receivable Birr 8500
This entry is the same under the periodic inventory system.
Under the periodic inventory system

A net sale is determined by subtracting sales returns and allowances and sales discounts from
sales. or Sales……………………………………………..xx
Less: Sales returns and allowances…………..….(xx)
Sales discounts……………………………(xx)
Net sales ………………………………………….xxx
Illustration: Transactions Using the Periodic and Perpetual Inventory Systems

June1: Purchased 30,000 of merchandise on account, terms 2/10, n/30.
Periodic Inventory System Perpetual Inventory System
Purchases . . . . . . . . . . . . . . . . 30,000 Merchandise Inventory . . . . . . 30,000
Accounts Payable . . . . . . . . . . . . 30,000 Accounts Payable . . . . . . . . . . . . . . 30,000
June 5: Returned merchandise purchased on account on June 1, Birr 500.

Accounts Payable . . . . . . . . . . . . . 500 Accounts Payable . . . . . . . . . . . . 500
Purchases Returns &Allowances... …. 500 Merchandise Inventory . . . . . . . . . 500
June 8. Paid for purchase of June 1,

Accounts Payable . . . . . 29,500 Accounts Payable . . . . . 29,500
Cash………………………..28910 Cash……..…………………..28910
Purchases discounts...……. 590 Merchandize inventory...……. 590
Less return of Birr 500 and discount of Birr

590, [(Birr30, 000 _ Birr500) X 2%].

June 15: Sold merchandise on account, Birr 12,500, 1/10, n/30. The cost of the merchandise
sold was Birr 9,000.
Accounts Receivable . . . . . . . . . 12,500 Accounts Receivable. . . . . . . 12,500
Sale……………………….....12 500 Sale………………………...... 12500
Cost of Merchandise Sold. . . . 9,000
Merchandise Inventory . . . . . . 9,000
June 21. Received merchandise returned on account, Birr 4,000. The cost of the merchandise
returned was Birr 2,800.
Sales Returns and Allowances . . . 4,000 Sales Returns and Allowances . . . 4,000
Accounts Receivable. .. . . . . . . . . . 4,000 Accounts Receivable. . . . . . . . . . . . 4,000
Merchandise Inventory . . . . . . . . 2,800
Cost of Merchandise Sold . …. . . . . . 2,800
June 22. Purchased merchandise, Birr 15,000, terms FOB shipping point, 2/15, n/30, with
prepaid freight of Birr 750 added to the invoice.
Purchases . . . . . . . . . . . . . . . . 15,000 Merchandise Inventory. . . . . . . . 15,750
Freight In . . . . . . . . . . . . . . . . . . 750 Accounts Payable . . . . . . . . . . . . 15,750
Accounts Payable . . .. . . . . . . . . 15,750
June 28 Received Birr 8,415 as payment on account from June 15 sale

Cash . . . . . . . . . . . . . . . . . . . . . . . 8,415
Cash . . . . . . . . . . . . . . . . . . . . . . . 8,415
Sales Discounts . . . . . . . . . . . . . . . . . 85
Sales Discounts . . . . . . . . . . . . . . . 85
Accounts Receivable . . . . . . . . . . . . . . . 8,500
Accounts Receivable . . . . . . . . . . . . . . 8,500
Sale less return of June 21 and less discount of
Birr 85 [(Birr 12,500 _Birr 4,000) X 1%].
June 29 Received Birr 19,600 from cash sales, the cost of the merchandise sold was Birr
13,800.
Cash. . . . . . . . . . . . . . . . . . . . 19,600 Cash. . . . . . . . . . . . . . . . . . . . . 19,600
Sales. . . . . . . . . . . . . . . . . . . . . . . . 19,600 Sales . . . . . . . . . . . . . . . . . . . . . . . 19,600
Cost of Merchandise Sold. ….. . . 13,800
Merchandise Inventory . . . . . . . . . . 13,800
Trade Discounts

Many manufacturers and whole sellers periodically publish catalogs advertising their
merchandise at list prices. However, a red granted based on the volume of merchandise
purchased or on the nature of the purchaser (whole-seller, retailer, or ultimate consumer.) A trade
discount is a convenient means of making price reductions without reprinting catalogs. Thus
business may offer special discount from the list price for customers that order large quantities.
Both buyers and sellers do not normally record the list prices of merchandise and the related
trade discounts in their accounts i.e. Trade discounts are not recorded in the accounts of either
the seller or the buyer but are deducted from the product list price in arriving at the selling price;
both the purchaser and seller record the transaction at the determined selling price.
Example 1: Wholesaler sells merchandise with a list price of 1,000 birr at a trade discount of 20
percent; a sale of 800 will be recorded by the seller. Similarly purchase a of 800 is recorded by
the buyer. If an additional cash (sales) discount is involved, it is based on invoice price rather on
the list (gross) price. Trade discounts are frequently stated in terms of a series of discounts, such
as 25/20/10, i.e. 25% of list price, 20% of remainder and again 10% of reminder.
Example 2: If a wholesaler sells merchandise with a list price of 1,000, at a trade discount
stated as 25/20/10, then the items selling price would be:
List price-----------------1, 000
Less 25% discount---- (250)
Remainder--------------750
Less 20% discount ------ (150)
Remainder----------600
Less 10% discount------- 60
Selling price---------------540
Purchases and sales of merchandise often involve freight and sales taxes. Also, the seller may
offer buyers trade discounts.
SHIPPING TERMS
Shipping terms are used to show who is responsible whether buyer or seller for paying cost
transportation (shipping) and when the title of the goods passes from seller to buyer. When a
common carrier such as a rail road, trucking company, or airline is used, the transportation
company prepares a freight bill (often called a bill of lading) in accordance with sales agreement.

To understand how to account for transportation costs, you must know the meaning of the
following terms:
 FOB shipping point agreement: The ownership of the merchandise may pass to the
buyer when the seller delivers the merchandise to the freight carrier. In this case, the
terms are said to be FOB (free on board) shipping point. As a result, the buyer is
responsible for paying freight costs from the shipping point to the final destination and
bears the risk of damage or loss while the goods are in shipment. In addition, the goods
are part of the buyer’s inventory while they are in transit because the buyer already
owns them. Such costs are part of the buyer’s total cost of purchasing inventory and are
added to the cost of the inventory by debiting Merchandise Inventory.
Note: The buyer bears the freight costs if the shipping terms are FOB shipping point.
Illustrate: Assume that on June 10, XYZ purchased merchandise as follows:

June 10. Purchased merchandise from XYZ, Birr 900, terms FOB shipping point.
June 10. Paid freight of Birr 50 on June 10 purchase from xyz.
XYZ would record these two transactions as follows:

June 10 Merchandise Inventory 900
Accounts Payable 900
Purchased merchandise, terms FOB shipping point.

June 10 Merchandise Inventory  50
Cash 50
Paid shipping cost on merchandise purchased.
 FOB destination agreement: The ownership of the merchandise may pass

to the buyer when the buyer receives the merchandise. In this case, the
terms are said to be FOB (free on board) destination. This term means that
the seller pays the freight costs from the shipping point to the buyer‘s final
destination and bears the risk of damage or loss in transit. When the seller
pays the delivery charges, the seller debits Delivery Expense or Freight Out.

Delivery Expense is reported on the seller’s income statement as a selling

expense.
Note: The seller bears the freight costs if the shipping terms are FOB destination.
To illustrate, assume that XYZ sells merchandise as follows:
June 15. Sold merchandise to JKL Company on account, Birr 700, terms FOB destination. The
cost of the merchandise sold is Birr 480.
June 15. XYZ pays freight of Birr 40 on the sale of June 15.
XYZ records the sale, the cost of the sale, and the freight cost as follows:
June 15 Accounts Receivable—JKL Company 700
Sales
700
Sold merchandise, terms FOB destination.
June 15 Cost of Merchandise Sold 480
Merchandise Inventory 480
Recorded cost of merchandise sold to JKL Company.
June 15 Delivery Expense 40
Cash
40
Paid shipping cost on merchandized sold.
The seller may prepay the freight, even though the terms are FOB shipping point. The seller will
then add the freight to the invoice. The buyer debits Merchandise Inventory for the total amount
of the invoice, including the freight. Any discount terms would not apply to the prepaid freight.
To illustrate, assume that ABC sells merchandise as follows:
June 20. Sold merchandise to XYZ Company on account, Birr800, terms FOB shipping
point. ABC paid freight of Birr 45, which was added to the invoice. The cost of the
merchandise sold is Birr 360. ABC, records the sale, the cost of the sale, and the freight as
follows
Solution
June 20:Accounts Receivable—XYZ Company…………………800
Sales…………………………………………….800
 Sold merchandized terms FOB shipping point
June 20: Cost of Merchandise Sold…………………….360
Merchandise Inventory……………………………360
 Recorded cost of merchandise sold to XYZ Company.
Accounts Receivable-xyz Company……………..45
Cash………………………………………..………….45

 Prepaid shipping cost on merchandized sold.
 Shipping terms, the passage of title, and whether the buyer or seller is to pay the freight
costs are summarized in above figure.
Sales Taxes:
Almost all states levy a tax on sales of merchandise. The liability for the sales tax is incurred
when the sale is made. At the time of a cash sale, the seller collects the sales tax. When a sale is
made on account, the seller charges the tax to the buyer by debiting Accounts Receivable. The
seller credits the sales account for the amount of the sale and credits the tax to Sales Tax
Payable.
For example, the seller would record a sale of Birr 100 on account, subject to a tax of 6%, as
follows:
Aug. Accounts Receivable 106
12 Sales 100
Sales Tax Payable 6
On a regular basis, the seller pays to the taxing authority (state) the amount of the sales tax
collected. The seller records such a payment as follows:
Aug. Sales tax payable 6
12 cash 6
Payment for sales taxes collected
during August.

Adjusting Entry for Inventory Shrinkage

Under the perpetual inventory system, the merchandise inventory account is continually updated
for purchase and sales transactions. As a result, the balance of the merchandise inventory account
is the amount of merchandise available for sale at that point in time. However, retailers normally
experience some loss of inventory due to shoplifting, employee theft, or errors.
Thus, the physical inventory on hand at the end of the accounting period is usually less than the
balance of Merchandise Inventory. This difference is called inventory shrinkage or inventory
shortage.
The amount that passed out includes the cost of goods sold, stolen, or destroyed. As a result, the
physical inventory taken at the end of the accounting period may be differing from the amount of
inventory shown in the inventory records.
Example: If the inventory records of a company shows that 63,950 of merchandise inventory
balance, but the physical inventory taken on the same date indicates a balance of only 62,150- it
means that a shrinkage for this year is 1800 (63950-62150) and the following adjusting entry is
required.
_________________________________________________________Dec. 31, 2011
Account balance of Merchandise Inventory ……… ……………….. 63,950
Physical merchandise inventory on hand…………………………….(62150)
Inventory shrinkage…………………………………………………. Birr1800
At the end of the accounting period, inventory shrinkage is recorded by the following
adjusting entry:
Cost of merchandise sold--------1800
Merchandise Inventory----------1800
Financial Statements for a Merchandising Business
Income Statement: This form of income statement, called a multiple-step income statement,
contains several sections, subsections, and subtotals.
Revenue from Sales: This section of the multiple-step income statement consists of sales, sales
returns and allowances, sales discounts, and net sales.
Revenue from sales:
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . ……………………….….xx
Less: Sales returns and allowances . . . . . …..…xx
Sales discounts . . . . . . . . . . . . . . . . …….xx
Net sales…………………………………………………………………..xxx

Cost of Merchandise Sold: Cost of goods sold is the inventory cost to the seller of the goods
sold to customers. Cost of Goods Sold is an EXPENSE item with a normal debit balance (debit
to increase and credit to decrease). Even though we do not see the word Expense this in fact is an
expense item found on the Income Statement as a reduction to Revenue.
Merchandise inventory, January 1, 2016…………………………………..xx
Add: Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ………………………xx
Less: Purchases returns and allowances . . . . . . . . ………………xx
Purchases discounts . . . . . . . . . . . . . . . . . . ………………..xx (xx)
Net purchases . . . . . . . . . . . . . . . . . . . . . . . . . . ………………………………..xx
Add: Freight in . . . . . . . . . . . . . . . . . . . . . . . . . . . …………………………………..xx
Cost of merchandise purchased . . . . . . . . . . . ……….……………………………xxx
Merchandise available for sale . . . . . . . . . . . . . . . ………………………..xxx
Less merchandise inventory, December 31, 20116…………………………xx
Cost of merchandise sold. . ………………………………………………………….xxx
Gross Profit: Gross profit is computed by subtracting the cost of merchandise sold from net
sales, as shown below.
Net sales………………………………………………………………. XX
Less: Cost of merchandise sold …………………………………………. (xx)
Gross profit…………………………………………………………………xxx
Income from Operations: Income from operations, sometimes called operating income, is
determined by subtracting operating expenses from gross profit. Operating expenses are
normally classified as either selling expenses or administrative expenses.
Selling expenses are incurred directly in the selling of merchandise. Examples of selling
expenses include sales salaries, store supplies used, depreciation of store equipment, delivery
expense, and advertising.
Administrative expenses, sometimes called general expenses, are incurred in the
administration or general operations of the business. Examples of administrative expenses
include office salaries, depreciation of office equipment, and office supplies used.
Gross profit ………………………………………………………….xx
Less: Operating expenses:
Selling expenses…………………………….xx
Administrative expenses ……………………xx

Total operating expenses ……………………………………………...xx

Income from operations …………………………………………………xx
Other Income and Expense: Other income and expense items are not related to the primary
operations of the business. Other income is revenue from sources other than the primary
operating activity of a business. Examples of other income include income from interest, rent,
and gains resulting from the sale of fixed assets. Other expense is an expense that cannot be
traced directly to the normal operations of the business. Examples of other expenses include
interest expense and losses from disposing of fixed assets.
Income from operations……………………………………..xx
Other income and expense:
Rent revenue …………………………………………………xx
Interest expense ………………………………………………(xx)
Net income……………………………………………………..xxx
COOKIE & COFFEE CREATIONS INC.
Income Statement
Year Ended October 31, 2016
Sales $462,500
Cost of goods sold 231,250
Gross profit 231,250
Operating expenses
Salaries and wages expense $92,500
Depreciation expense 3,900
Other operating expenses 35,987 132,387
Income from operations 98,863
Interest expense 413
Income before income tax 98,450
Income tax expense 19,690
Net income $ 78,760
Statement of Owner’s Equity: This statement is prepared in the same manner as for a service
business.
Balance Sheet: A merchandising company’s balance sheet includes an additional element that is
not on the balance sheet of a service company.
Notice that the current asset section includes an item called merchandise inventory. Even
though they also have inventories of supplies, most companies simply refer to merchandise on
hand as inventory (see the MD, Trading Co). This asset consists of goods the company owns on
the balance sheet date and holds for the purpose of selling to its customers.
Work Sheet of a Merchandising Business

Work sheet is a useful tool for preparing adjusting entries, closing entries, and financial
statements. The work sheet of a merchandising business is basically the same, as that of a service
business except that it has to deal with the new accounts that are needed to handle merchandising
transactions. These accounts include sales, sales returns and allowances, purchases, purchases
returns and allowances, purchases discounts, freight-in, and merchandise inventory. In the
records, they are transferred to the profit and loss account in the closing process. On the work
sheet they are extended to the Income Statement columns. This worksheet is the basis for
preparing the end of period financial statement, adjusting entries and closing entries.
Ten columns Worksheet have five sections:
1. Unadjusted Trial Balance 4. Income statement
2. Adjustment trial balance 5. Balance sheet
3. Adjusted trial balance
1. Completing Trial Balance section: A trial balance is prepared to prove the equality of debits
and credits in the general ledger. To prepare the trial balance, the number and name of each
account in the general ledger are entered on the work sheet in the account number and account
name columns. The accounts are listed in the order that they appear in the general ledger (Assets,
liabilities, stockholder equity, revenue, cost of merchandize, Expense). The balance of each
account is entered in the appropriate Debit or Credit column of the trial balance section.
Notice that every general ledger account listed, even those with zero balances. After all balances
are entered, the trial balance debit and credit columns are ruled, totaled, and proved. Then a
double rule is drawn across both columns.
2. Adjustment trial balance: Not all changes in account balances result from daily business
operations or the passage of time. For example supplies such us paper, pens, shopping bags, and
sales slips are bought for use by business. They are recorded in an asset account called supplies.
These supplies are gradually during the accounting period. Another example is insurance
premiums, which cover a certain period of time. The premiums are recorded in an asset account
called prepaid insurance. During the period some insurance is used up, or expires. At the end of
period, the balances in accounts such as supplies and prepaid insurance are brought up to date.
Entering the adjustments for merchandize inventory on the worksheet
Adjustments are entered in the adjustments columns of the work sheet. The debit and credit
parts of each adjustment are given a unique label. The label consists of a small letter in

parentheses and is placed just below and to the lefts of the adjustments amounts. The adjustments
are labeled as follows
First adjustments (a)
Second adjustment (b)
Third adjustment (c)
The number of adjustments varies depending on the business. Once the adjustments have been
entered, the work sheet provides the information needed to make the adjusting journal entries.
3. Completing the adjusting trial balance: The next step after entering all adjustments is to
finish the adjusted trial balance section. This work sheet section shows the updated balances of
all general ledger accounts. To complete this section, the accountant combines the balance of
each account in the trial balance section with the adjustment, if any, in the adjustments section.
The new balance is then entered in the appropriate adjusted trial balance column.
4. Income statement section: The income statement section contains the balances of all
temporary accounts. You will find the income summary and all revenue, cost of merchandize and
expense accounts in this section.
5. Balance sheet section: The balance sheet section contains the balances of all permanent
accounts. In that section you will find all assets, liability and capital accounts (capital stock and
retained earnings)
The following trial balance has been extracted from general ledger of MD trading company.
MD TRADING COMPANY
Trial balance
For the year ended December 31, 20-A
Account Trial Balance
number Account Name Debit Credit
101 Cash 29,410
Accounts Receivable 42,400
Merchandise Inventory 52,800
Store Supplies 2,600
Land 4,500
Building 20,600
Accumulated Depreciation- 5,650
Building
Office Equipment 8,600

Accumulated Depreciation - 2,800

Office equipment
Accounts Payable 25,683
MD Jan's Capital 118,352
MD Jan's Withdrawals 20,000
Sales 246,350
Sales Returns and Allowance 2,750
Sales Discounts 4,725
Purchases 126,400
Purchases Returns and 5,640
allowances
Purchases discounts 2,136
Freight in 8,236
Sales Salaries 22,500
Freight Out Expense 5,740
Advertising Expense 10,000
Office Salaries 26,450
Total 405,611 406,611
Adjustments:
1. Merchandize Inventory on December 31, 2016 is valued at Birr 48,300
2. Raise an Allowance for Depreciation on Office Equipment Birr 2,200
3. Insurance Unexpired is Birr 11,600
4. Office supplies consumed Birr 1,204
5. A bill of $100/- in respect of advertising is outstanding.
Required:
1. Prepare ten columns Work Sheet from the above information.
2. From the information given above, prepare income Statement and the Balance
Sheet for the year ended Dec 31, 2016.
3.
MD TRADING COMPANY
Work Sheet
For the year ended December 31, 20-A
Un adjusted Trial Adjustments Adjusted Income Balance Sheet
Balance Trial balance trial balance Statement

Account Name Debit Credit Deb Credit Debit Credit Debit Cred
it it
Cash 29,410 29,410
Accounts Receivable 42,400 42,400
Merchandise Inventory 52,800 b.48,30 a.5280 48,300
0 0
Prepaid Insurance 17,400 c.5,800 11,600
Store Supplies 2,600 d.1,540 1,060
Office Supplies 1,840 e.1,204 636
Land 4, 500 4,500
Building 20, 260 20260
Accumulated Deprecia 5 ,650 d.2,600 8250
tion -Building
Office Equipment 8,600 8,600
Accumulated 2,800 e.2,200 5,000
Depreciation Office
equipment
Accounts Payable 25 ,683 25,68
3
MD Jan's Capital 118 118,3
,352 52
MD Jan's Withdrawals 20, 000 20,000
Sales 2 246,35
46,350 0
Sales Returns and 2 ,750 2,750
Allowance
Sales Discounts 4 ,725 4,725
Purchases 126 126,40
,400 0
Purchases Returns and 5,640 5,640
allowances
Purchases discounts 2,136 2,136
Freight in 8 ,236 8,236
Sales Salaries expense 22 ,500 22,500
Freight Out Expense 5 ,740 5,740
Advertising Expense 10 ,000 10,000
Office Salaries expense 26, 450 26450
406,611 406,611
Income Summary
Insurance Expense, a.1, 1,600
Selling 600
Insurance Expense, c.4, 4,200
General 200
Selling Supplies Expense b1,5 1,540
40
Office Supplies Expense c.1, 1,204

204
Depreciation Expense- d.2, 2,600
building 600
Depreciation Expense- e.2, 2,200
office Equipment 200
13,344 13,344 272,49 302,42 186,76 157,2
5 6 6 85
29,481 29,48
1
302,42 302,42 186,76 186,7
6 6 6 66
Net Income
Adjusting and Entries
The adjusting entries are the same under both inventory systems, except for merchandise
inventory. Two adjusting entries for beginning and ending merchandise inventory are necessary
in a periodic inventory system
JOURNAL
Date Description Post. Debit Credit
Ref.
Adjusting Entries
Dec.31 Income Summary 312
Merchandise Inventory
Dec,31 Merchandise Inventory

Income Summary
Dec,31 Office Supplies Expense

Office Supplies
Dec,31 Insurance Expense

Prepaid Insurance
Dec,31 Depreciation Expense––Office

Equip.
Accumulated Depr.––Office
Equip.
Dec,31 Store supplies Expense

Office Expense
MD Trading Co.
Income Statement
For the year ended Dec 31,2016
Revenue from Sales

Gross sales 246,350

Less: Sales returns & allowances 2,750
Sales discounts 4,725 7,475
Net sales 238,875
Cost of goods sold
Merchandise inventory, Jan. 1 52,800
Purchases 126,400
Less: Purchases return & allow 5,640
Purchases discounts 2,136 7,776
118,624
Add: (freight in) 8236
Net purchases 126,860
Cost of goods available for sale 179,660
Less: Merchandise inventory, Dec. 31 . 48,300
Cost of goods sold 131,360
Gross margin from sales 107,515
Operating expenses
Selling expenses;
Sales salaries 22,5010
Freight out 5,740
Advertising expense 10,000
Insurance expense 1,600
Selling supplies expense 1,540
Total selling expense 41,380
General Administrative Expenses;
Office salaries expense 26,450
Insurance expense, general 4,200
Office supplies expense 1,204
Depreciation expense, building 2,600
Depreciation expense, office Equipment 2,200
Total general & administrative expense 36,654
Total operating expenses……………… 78,034
Net income 29,481
MD Trading Co.
Statement of owner equity Statement of
Owner’s Equ For the year ended Dec 31,2016
MD, capital, January 1, 2016. . . . . . .…….. 118 ,352
Add: Net income for November . . . . . . . . . . 29,481
Less :withdrawals. . . . . . . . . . . . . . . . . . . 20,000
MD, capital, Dec 31, 2016 . . . . . . . . . . ………..127833

MD, Trading Co.

Balance Sheet
December 31, 2016
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . ……… . . . 29,410
Accounts receivable . . . . . . . . . ……. . . . 42,400
Merchandise inventory . . . . . . . …….. . . .48300
Prepaid expenses . . . . . . . . . . ……. . . . . 11,600
Store Supplies ……………………..……1,060
Office Supplies……………………..…….636
Total current assets . . . . . . . . . . ………….……. . . .133406
Long term assets:
Land ……………………………………………...4, 500
Building ……………………………………….…20, 260.
less Accumulated Depreciation –Building…..….(8250)
Office equipment . . . . . . . . . . . . . . …….. ………… 8,600
Less accumulated amortization . . . . ……………... (5000)
Total long term assets . . . . . . . . . . . . . ……………………......20,110
Total assets . . . . . . . . . . . . . . . . . . . . ……………………………153516
Liabilities
Current liabilities:
Accounts payable . . . ……………… . . 25 ,683
Total liabilities . . . . . . . . . . . . . . . . . …………………………....25,683
Owner’s Equity
MD, Capital ……………………………….127833
Total liabilities and owner’s equity……………………………...153516 .
Closing entries:
The closing entries for MD Trading Company, under the closing entry method appeared earlier.
Note that merchandising inventory is credited in the first entry for the amount of beginning
inventory Birr 52800 and debited in the second entry for the amount of the ending inventory
(Birr 48300). Otherwise, these closing entries are very similar to those for a service company
except that the new accounts for merchandising companies introduced in this chapter must also
be closed to income summary. All income statement accounts with debit balance, for instance,
sales returns and allowances, sales discounts, purchases, and freight-in, is credited in the first
entry. All income statement account with credit balances, namely, sales, purchase returns and

allowances and purchases discounts are debited in the second entry. The third and fourth entries
are used to close the income summary account and transfer net income to the capital account and
to close the withdrawals account to the capital account.
The four closing entries under the periodic inventory system are as follows:
1. Debit each temporary account with a credit balance, such as Sales, for its balance and credit
Income Summary. Since Purchases Discounts and Purchases Returns and Allowances are
temporary accounts with credit balances, they are debited for their balances. In addition,
Merchandise Inventory is debited for its end-of-period balance based on the end-of-period
physical inventory.
2. Credit each temporary account with a debit balance, such as the various expenses, and debit
Income Summary. Since Sales Returns and Allowances, Sales Discounts, Purchases, and
Freight In are temporary accounts with debit balances, they are credited for their balances. In
addition, Merchandise Inventory is credited for its balance as of the beginning of the period.
3. Debit Income Summary for the amount of its balance (net income) and credit the owner’s
capital account. The accounts debited and credited are reversed if there is a net loss.
4. Debit the owner’s capital account for the balance of the drawing account and credit the
drawing account.
Solution

Closing Entries
DEC 3 Income Summary 220595
Sales returns and allowances 2750
Sales Discount 4725
Purchases 126400
Freight in 8236
Sales salaries expense 22500
Freight out expense 5740
Insurance expenses, selling 1600
Insurance Expense, General 4200
Selling supplies expense 1,540
Office supplies expense 1,204
Depreciation expense, building 2,600
Depreciation expense, office 2,200
equipment
(To close temporary expense and revenue accounts having debit balances)

Dec 31 Sales 2 46,350

Purchases Returns and Allowances 5,640
Purchases Discounts 2,136
Income Summary 254126
(To close temporary expense and revenue accounts having credit balances)
Dec. 31 Income summary 29031
MD's capital 29031
To close the Income Summary account
Dec 31 MD’s withdrawal 20,000
Income summary 20,000
(To close the withdrawals account)
A LOOK AT INTERNATIONAL FINANCIAL REPORTING STANDARD (IFRS)

The basic accounting entries for merchandising are the same under both GAAP and IFRS.
The income statement is required statement under both sets of standards. The basic format
is similar although some differences do exist.at IFRS
Key Points
 Under both GAAP and IFRS, a company can choose to use either a perpetual or a
periodic system.
 Inventories are defined by IFRS as held-for-sale in the ordinary course of business,
in the process of production for such sale, or in the form of materials or supplies to be
consumed in the production process or in the providing of services.
 Under GAAP, companies generally classify income statement items by function.
Classification by function leads to descriptions like administration, distribution, and
manufacturing. Under IFRS, companies must classify expenses by either nature or
function. Classification by nature leads to descriptions such as the following: salaries,
depreciation expense, and utilities expense.
 Presentation of the income statement under GAAP follows either a single-step or
multiple-step format. IFRS does not mention a single-step or multiple-step
approach.
SAMPLE MULTIPLE CHOICE
1. An agreement between a buyer and a seller about payment for merchandise is the ____.
A) Purchase invoice C) Sales invoice

B) Correcting entry D) Terms of sale

2. A form prepared by the customer showing the price deduction taken by the customer for
returns and allowances is a ____.
A) Memorandum C) Purchases allowance
B) Purchase invoice D) Debit memorandum
3. Assume that sales are $460,000, sales return and allowances are $5,000, sales discounts are
$10,000, net income is $35,000, and cost of merchandise sold is $320,000.Gross profit and
operating expenses are, respectively
A. $135,000 and $90,000 B. $125,000 and $90,000
C. $130,000 and $95,000 D. $125,000 and $85,000
4. Which of the following would be classified in an income statement as Other Income or
Other Expense?
A. Advertising Expense B. Interest Expense
C. Transportation Out D. Cost of merchandise sold
5. On August 6, your firm, which uses the perpetual method, orders $450 of inventory FOB
shipping point. Freight is $50. On August 24, the merchandise arrives and you remit $500.
For this transaction, you will:
A. debit Inventory for $500 on August 24.
B. debit Inventory for $450 on August 24.
C. debit Purchases for $450 on August 6.
D.debit Purchases for $500 on August 6.
6. On June 1, Newport Company purchased HK$15,000 of merchandise on credit (terms
2/10, net 30) and returned HK$2,000 of defective merchandise on June 3 to Super Sports,
Inc. Newport's accounts receivable balance on Super Sports, Inc.'s books on June 11 before
payment is
A. HK$15,000. B. HK$14,700.
C. HK$13,000. D. HK$12,740.
7.What account is credited when a discount is taken for prompt payment under a perpetual
inventory system?
a. Accounts Payable
b. Accounts Receivable
c. Purchase Discounts
d. Inventory

8. How does the purchaser account for transportation charges when goods are shipped to
them FOB of destination?
a. No journal entry would be made for the transportation charges.
b. Debit Delivery Expense for the amount of the transportation charges.
c. Debit Freight In for the amount of the transportation charges.
d. Debit Inventory for the amount of the transportation charges.
9. Which of the following is necessary to journalize an adjustment to account for inventory
shrinkage under a perpetual system?
a. A credit to Miscellaneous Expense
b. A credit to Cost of Goods Sold
c. A credit to Inventory
d. A debit to Miscellaneous Expense
10.What do credit terms 1/10, n/30 indicate?
a. A 10% discount is available if payment is made within 30 days
b. A 1% discount is available if payment is made within 10 days
c. A 1% discount is available if payment is made within 30 days
d. A 30% discount is available if payment is made within 10 days
Exercise
The following selected transactions were completed during August between Salem
Company and Boulder Company.
Aug 1. Salem Company sold merchandise on account to Boulder Co., $28,600, terms FOB
destination, 2/15, n/eom. The cost of the merchandise sold was $17,000.
Aug 2. Salem Company paid freight of $500 for delivery of merchandise sold to Boulder Co.
on August 1.
Aug 5. Salem Company sold merchandise on account to Boulder Co., $18,000, terms FOB
shipping point, n/eom. The cost of the merchandise sold was $10,800.
6. Boulder Co. returned $1,600 of merchandise purchased on account on August 1 from
Salem Company. The cost of the merchandise returned was $960.
9. Boulder Co. paid freight of $350 on August 5 purchase from Salem Company.
15. Salem Company sold merchandise on account to Boulder Co., $36,200, terms

FOB shipping point, 1/10, n/30. Salem Company paid freight of $900, which was added to
the invoice. The cost of the merchandise sold was $19,600.
16. Boulder Co. paid Salem Company for purchase of August 1, less discount and less return
of August 6.
25. Boulder Co. paid Salem Company on account for purchase of August 15, less discount.
31. Boulder Co. paid Salem Company on account for purchase of August 5.
Instructions
1. Journalize the August transactions for (1) Salem Company and (2) Boulder Co.
2. Journalize the entries to record the transactions for (1) Salem Company and (2)
Boulders company. Assuming that both companies use the periodic inventory system
Exercise C What is the last payment date on which the cash discount can be taken on
goods sold on March 5 for USD 51,200; terms 3/10/EOM, n/60? Assume that the bill
is paid on this date and prepare the correct entries on both the buyer’s and seller’s
books to record the payment.
Exercise H Cramer Company uses periodic inventory procedure. Determine the cost of
goods sold for the company assuming purchases during the period were USD 40,000,
transportation-in was USD 300, purchase returns and allowances were USD 1,000,
beginning inventory was USD 25,000, purchase discounts were USD 2,000, and ending
inventory was USD 13,000.
Exercise B a. Silver Company purchased USD 56,000 of merchandise from Milton
Company on account. Before paying its account, Silver Company returned damaged
merchandise with an invoice price of USD 11,680. Assuming use of periodic inventory
procedure, prepare entries on both companies’ books to record both the purchase/sale and
the return.
Group project E In teams of two or three students, go to the library (or find an annual
report atwww.sec.gov/edgar.shtml) to locate one merchandising company’s annual report
for the most recent year. Calculate the company’s gross margin percentage for each of the
most recent three years. As a team, write a memorandum to the instructor showing your
calculations and commenting on the results. The heading of the memorandum should
contain the date, to whom it is written, from whom, and the subject matter.
Group project F In a team of two or three students, contact a variety of businesses in
your area and inquire as to the types of sales discount terms they offer to credit customers
and the types of purchase discount terms they are offered by their suppliers. Calculate the

approximate annual rate of interest implied in several of the more common discount
terms. For instance, the book states that the implied annual rate of interest on terms of
2/10, n/30 is 36 per cent, assuming we use a 360-day year. Present your findings in a
written report to your instructor.
Group project G In a team of two or three students, obtain access to several annual
reports of companies in different industries (Examine their income statements and
identify differences in their formats. Discuss these differences within your group and then
present your findings in a report to your instructor.

CHAPTER FOUR
Accounting for Manufacturing Operations
Manufacturing consists of activities and processes that convert raw materials into finished
goods. Contrast this type of operation with merchandising, which sells merchandise in the form
in which it is purchased.
A typical manufacturing company purchases raw materials and converts these materials into
finished goods through the process of production. The conversion from raw materials to finished
goods results from utilizing a combination of labor and machinery.
Thus manufacturing costs are often divided into three broad categories:
a. Direct materials – the raw materials and component parts used in production whose
costs are directly traceable to the products manufactured.
Examples:
The plastic used to make a television frame
The wood or paint used to make cabinets or boomerangs
b. Direct labor - is the cost of wages to be paid to individuals who work on specific
products or in other words, the cost of wages of employees who are directly involved in
converting raw materials into finished goods.
For example, wages and related benefits of employees who operate machinery to
produce valves represent direct labor costs for Friends Company. The more valves are to
be produced, the more employees will be required to operate machinery, paint, assemble,
etc.
Notice that Direct materials and direct labor, when added together, represent the prime
cost. Direct materials and direct labor are called prime costs because they are directly
(physically, "primarily") associated with the finished goods production.
c. Manufacturing overhead – a catch – all classification, this includes all manufacturing

costs other than the costs of direct materials and direct labor.
Examples include factory utilities, supervisor salaries, equipment repairs and
depreciation on machinery.
Indirect materials are materials that are;

I. Not an integral (physical) part of the finished goods, or

ii. A minor part of the finished goods to be economically traced to the finished good or
have a very small physical association with the finished product.
Note that Direct labor and factory overhead, when added together, represent the
conversion cost. Direct labor and factory overhead are called conversion costs because
they are involved in converting raw materials into finished goods
Note that manufacturing costs are not immediately recorded as current period
expenses. Rather. They are costs of creating inventory and they remain on the balance sheet until
the inventory is sold. For this reason manufacturing costs are often calls product costs (or
inventorial costs).
Product Costs vs. Period Costs
The terms product costs and a period costs are helpful in explaining the difference between
manufacturing costs and operating expenses. In a manufacturing environment, product costs are
those costs incurred to manufacture inventory. Thus, until the related goods are sold, Product
costs represent inventory. As such, they are reported on the balance sheet as an asset. When the
goods are ultimately sold, product costs are transferred from the balance sheet to the income
statement. Where they are deducted from revenue as the cost of goods sold
Operating expenses that are associated with time period, rather than with the production of
inventory, are referred to as period costs. Period costs are charged directly to expense accounts
on the assumption that their benefit is recognized entirely in the period when the cost is incurred.
Period costs include all selling expense, general and administrative expenses, interest expense,
and income tax expense. In short period costs are classified on the income statement separately
from cost of goods sold. As deductions from a company's gross profit.
The flow of product costs and period costs through the financial statements is shown in the
diagram below
To further illustrate of the distinction between product and period costs, consider two costs
that, on the surface, appear quite similar: the depreciation of a warehouse used to store raw
materials versus depreciation of a warehouse used to store finished goods. Depreciation of the
raw materials warehouse is considered a product cost (a component of manufacturing overhead)
because the building is part of the manufacturing process. Once the manufacturing process is
complete and the finished goods are available for sale all costs associated with their storage are

considered selling expenses. Thus the depreciation of the finished goods warehouse is a period
cost.
Underlying the distinction between product costs and period costs is familiar accounting
concept – the matching principled. In short, Product costs should be reported on the income
statement only when they can be matched against product revenue, to illustrate see Table 4.1
Balance sheet
Product costs
(manufacturing as costs) Current assets
incurred inventory
When goods are
sold
Income statement
Period costs( operating as Revenue cost goods
expenses incurred and sold gross profit.
income taxes Expense net income
Inventories of a Manufacturing Business
Most manufacturing companies, however typically account for three of inventory.

I. Materials inventory – represents items that the manufacturer has purchased or
produced to use in manufacturing a product.
II. Work in process inventory – partiality completed good on which production
activities have been started but not yet completed.
III. Finished goods inventory – unsold finished products available for sale to
customers. All three of these inventories are classified on the balance sheet as
current assets. The cost of the materials inventory is based on its purchase price.
The work in process and finished goods inventories are based on the costs of direct
martial. Direct labor and manufacturing overhead assigned to them.
Flow of product costs in the manufacturing process

Manufacturing activities using a perpetual inventory system, this continuously updates records
for costs of materials, goods in process, and finished goods inventories. A manufacturing
accounting system also provides timely information about inventories and manufacturing costs
per unit of product. This is especially helpful for managers’ efforts to control costs and determine
selling prices.
Prepare journal entries for each type of manufacturing cost.
RAW MATERIALS COSTS
When ABC receives the raw materials it has purchased, it debits the cost of the materials to
Raw Materials Inventory. The company would debit this account for the invoice cost of the
raw materials and freight costs chargeable to the purchaser. It would credit the account for to
purchase discounts taken and purchase returns and allowances.
Illustrate, assume that ABC purchases 2,000 lithium batteries at Birr5 per unit (10,000) and 800
electronic modules at Birr 40 per unit (Birr 32,000) on account. For a total cost of Birr 42,000
(Birr10, 000 + Birr32, 000). The entry to record this purchase on January 4 is:
Jan. 4 Raw Materials Inventory 42000
Accounts Payable 42 000
(Purchase of raw materials on account)
FACTORY LABOR COSTS: Some of a company’s employees are involved in the

manufacturing process, while others are not.
Costs related to manufacturing employees are accumulated in Factory Labor to ensure their
treatment as product costs. Factory labor consists of three costs: (1) gross earnings of factory
workers, (2) employer payroll taxes on these earnings, and (3) fringe benefits (such as sick pay,
pensions, and vacation pay) incurred by the employer. Companies debit labor costs to Factory
Labor as they incur those costs.
To illustrate, assume that ABC incurs Birr 32,000 of factory labor costs. Of that amount, Birr
27,000 relates to wages payable and Birr 5,000 relates to payroll taxes payable in February. The
entry to record factory labor for the month is:
Jan. 31 Factory Labor 32000
Factory Wages Payable 27000
Employer Payroll Taxes Payable 5000

(To record factory labor costs)
MANUFACTURING OVERHEAD COSTS: A company has many types of overhead costs. If

these overhead costs, such as property taxes, depreciation, insurance, and repairs, relate to
overhead costs of a nonmanufacturing facility, such as an office building, then these costs are
expensed as period costs (e.g., Property Tax Expense, Depreciation Expense, Insurance Expense,
and Repairs Expense).
To illustrate, assume that ABC Factory utilities of Birr 2,200 are payable, prepaid factory
insurance of Birr 1,800 has expired, and depreciation on the factory building is Birr 3,500.
Jan. 31 Manufacturing Overhead 7,500
(To record overhead costs)
Assigning Manufacturing Costs to Work in Process

Assigning manufacturing costs to work in process results in the following entries
1. Debits made to Work in Process Inventory.
2. Credits made to Raw Materials Inventory, Factory Labor, and Manufacturing Overhead.
For example, if ABC uses Birr 24,000 of direct materials and Birr 6,000 of indirect materials in
January, the entry is:
DateDescription PR Debit Credit
Feb 5
Work in Process Inventory 24,000
Manufacturing Overhead 6,000
Raw Materials Inventory 30,000
(To assign materials to jobs and overhead)
FACTORY LABOR COSTS
Companies assign factory labor costs to jobs on the basis of time tickets prepared when the
work is performed. The time ticket indicates the employee, the hours worked, the account and
job to be charged, and the total labor cost. The time tickets are later sent to the payroll
department, which applies the employee’s hourly wage rate and computes the total labor cost.
Finally, the company journalizes the time tickets. It debits the account Work in Process
Inventory for direct labor and debits Manufacturing Overhead for indirect labor.

For example, if the Birr 32,000 total factory labor cost consists of Birr 28,000 of direct labor
and Birr4, 000 of indirect labor, the entry is:

Jan 31 Work in Process Inventory 28,000
Factory Labor 32,000
(To assign labor to jobs and overhead)
Manufacturing Overhead Costs

Historically, companies used direct labor costs or direct labor hours as the activity base. The
reason was the relatively high correlation between direct labor and manufacturing overhead.
To illustrate, assume that the overhead ABC applies to each job will be 80% of the direct labor
cost of the job for the month (direct labor cost of $28,000 X 80%). The following entry records this
application.
Jan 31 Work in Process Inventory 22,400
To assign overhead to jobs)
This entry reduces the balance in Manufacturing Overhead and increases Work in Process
Inventory by Birr 22,400.
Assigning Costs to Finished Goods
When a job is finished, ABC makes an entry to transfer its total cost to finished goods inventory.
The entry is as follows.
Jan. 31 Finished Goods Inventory 39,000
Work in Process Inventory 39,000
This entry increases Finished Goods Inventory and reduces Work in Process Inventory by Birr
39,000, as shown in the T-accounts below
Work in Process Inventory Finished Goods Inventory
24,000 39,000 39,000
28,000
22,400
Assigning Costs to Cost of Goods Sold
Companies recognize cost of goods sold when each sale occurs.

Illustrate the entries a company makes when it sells a completed job, assume that on January 31
ABC sells on account. The job cost Birr 39,000, and it sold for Birr 50,000. The entries to record
the sale and recognize cost of goods sold are:
Jan. 31 Accounts Receivable 50,000
Sales revenue 50,000
To record sale of finished Goods

Jan. 31 Cost of Goods Sold 39,000
Finished Goods Inventory 39,000
(To record cost of finished Goods
MANUFACTURING COSTS IN THE FINANCIAL STATEMENT
The financial statements of a manufacturer are very similar to those of a merchandiser. The
principal differences between their financial statements occur in two places: the cost of goods
sold section in the income statement and the current assets section in the balance sheet.
Income Statement: under merchandize inventory system, the income statements of a
merchandiser and a manufacturer differ in the cost of goods sold section.
Merchandisers compute cost of goods sold by adding the beginning merchandise inventory to
the cost of goods purchased and subtracting the ending merchandise inventory.
Manufacturers compute cost of goods sold by adding the beginning finished goods inventory to
the cost of goods manufactured and subtracting the ending finished goods inventory.
A number of accounts are involved in determining the cost of goods manufactured. To eliminate
excessive detail, income statements typically show only the total cost of goods manufactured.
Illustration 4-2 shows the different presentations of the cost of goods sold sections for
Merchandiser
merchandising and manufacturing companies. The other sections of an income statement are
+ and manufacturers.
similar for merchandisers - =
Beginning Ending
MerchandiseManufacturer
Cost of Goods
Purchased Merchandise
Inventory
+ - Inventory
Cost of
= Goods Sold
Beginning Cost of Ending

Finished Goods Goods Finished Goods
109 By: MohammedManufactured
Inventory G (Msc),Jimma University, Faculty Business& Economics
Inventory
Merchandize company Manufacture company

Income statement(partial) Income statement(partial)
For the Year ended December 31,2016 For the Year ended December 31,2016
Cost of goods sold Cost of goods sold
Merchandise inventory, Jan. 1……….xx Finished goods inventory, Jan. 1………….xx
Add : Cost of goods purchased………….xx Add: Cost of goods manufactured………xx
Cost of goods available for sale………..xx Cost of goods available for sale...…………..xx
Less: Merchandise inventory,Dec,31…….xx Less: Finished goods inventory,Dec,31…..xx
Cost of goods sold…………………..xxx Cost of goods sold…………………………..xxx
Cost of Goods Manufactured: The costs the company assigns to beginning work in process
inventory are based on the manufacturing costs incurred in the prior period.
The sum of the direct materials costs, direct labor costs, and manufacturing overhead incurred in
the current year is the total manufacturing costs for the current period.
We now have two cost amounts: (1) the cost of the beginning work in process and (2) the total
manufacturing costs for the current period. The sum of these costs is the total cost of work in
process for the year.
Beginning Total Ending Work Cost of Goods
Work in Process + manufacturing - in Process = Manufactured
Inventory costs Inventory

The cost of goods manufactured schedule reports cost elements used in calculating cost of
goods manufactured.
Current design
Cost of Goods Manufactured
For the Year ended December 31,2016
Work in process, January ……………………………………………….xx
Direct materials:
Raw materials inventory, January 1………………………………xx
Add: Raw materials purchases …………………….…………xx
Total raw materials available for use ………………………………………xx
Less: Raw materials inventory, December 31 ……………........xx
Direct materials used ……………………………………………………….xxx
Direct labor …………………………………………………………………xx
Manufacturing overhead:
Indirect labor …………………………………………………..xx
Factory repairs …………………………………………………xx
Factory utilities ………………………………………………..xx
Factory depreciation …………………………………………..xx
Factory insurance ……………………………………………..xx
Total manufacturing overhead ……………………………………………..xx
Total manufacturing costs …………………………………………………….xx
Total cost of work in process ……………………………………………….............xx
Less: Work in process, December 31 …………………………………………….xx
Cost of goods manufactured ………………………………………………………xxx
Balance Sheet: The balance sheet for a merchandising company shows just one category of
inventory. In contrast, the balance sheet for a manufacturer may have three inventory accounts.
1. Raw Materials Inventory: Shows the cost of raw materials on hand.
2. Work in Process Inventory: Shows the cost applicable to units that have been
started into production but are only partially completed.
3. Finished Goods Inventory: Shows the cost of completed goods on hand.
 Notice that Finished Goods Inventory is to a manufacturer what Merchandise
Inventory is to a merchandiser. Each of these classifications represents the goods that the
company has available for sale.

 Balance sheet (current assets section) as follows:

Current design Company
Balance Sheet
As of December 31, 2016
Assets:
Current assets:
Cash XX
Accounts receivable XX
The inventories for a Inventories:
manufacturing entity consist Raw materials XX
of materials to be used in Work in process XX
production, goods partially Finished goods XX XXX
manufactured, and goods Prepaid expenses XXX
completely manufactured. Total current assets XXX
Gemechu Drugs Share Company

Balance Sheet
As of December 31, 2016
Assets:
Current assets:
Cash xx
Accounts receivable xx
Merchandise Inventory xx
Prepaid expenses xx
Total current assets xxx
Illustration
ABC Pharmaceuticals Share Company extracted the following data from the company’s
accounting records for the year ended 30, June 2016.
Sale ……………………………………………Birr 729500
Direct labor………………………………………...142000
Purchase of raw materials…………………………240,000
Selling expenses……………………………………50,000
Administrative expense……………………………...60,000
Inventory at 1 July 2015:
Raw materials……………………………………64000
Work in process…………………………………...50,000
Finished Goods……………………………………..96000
Inventory at 30 June 2016:
Raw materials……………………………………...56000

Work in process…………………………………….48000
Finished Goods………………………………………104000
Factory overhead is applied at the rate of 110% of direct labor
Required:
A. Prepare cost of goods manufactured statement for the year ended 30 June 2016
B. What was the company’s cost of goods sold for the year ended 30 June 2016
C. What was the company’s Gross profit for the year ended 30 June 2016
Solution
ABC Pharmaceuticals Share Company
Cost of Goods Manufactured Statement
For the year ended 30 June 2016
Direct materials:
Raw materials inventory, 1 July 2015 Birr 64000
Purchase raw materials 240,000
304000
Less: Raw material inventory 30 June, 2016 56000
Raw materials issued to production Birr 248000
Direct labor …………………………………………….………..142000
Prime costs…………………………………………………390,000
Factory overhead (110% direct labor)………………………………156200
Total manufacturing costs for the period………………………….....54620
Add: work in process, 1 July 2015…………………….………………….50,000
596200
Less: work in process, 30 June 2016….……………………………………..48000
Cost of goods manufactured…………………………………………………548200
Add: finished goods 1, July 2015……………………………………….……96000
644200
Less: finished goods 1, June 2016……………………….……………………104000
B. Cost of goods sold……………………………………………………Birr540200
C ABC Pharmaceuticals Share Company

Income statement
Sales ………………………………………………729500
Less: costs of goods sold………………………………………..540200
Gross profit………………………………………………..Birr 189300
Accounting by Manufacturing Companies
The accounting cycle is the same in a manufacturing company, merchandising company, and a
service company. Journal entries are used to record transactions, adjusting journal entries are

used to recognize costs and revenues in the appropriate period, financial statements are prepared,
and closing entries are recorded.
Adjusting Entries
Adjusting Entries are journal entries that are made at the end of the accounting period, to adjust
expenses and revenues to the accounting period where they actually occurred.
Examples of Adjusting Entries

By their nature, all adjusting entries will involve a pairing of either an asset or liability account
with a revenue or expense account.
Accrued revenues — Say your company provided $1,600 worth of consulting services to the
Bogus Manufacturing Company over the past month, and today is the end of the accounting
period. The consulting hours will be billed and collected next month, well past when you’ll be
preparing a trial balance, financial statements, closing entries, etc. In this case, you need an
adjusting entry to account for the unbilled services:
Adjusting Entry Debits Credits

Accounts Receivable 1,600.00
Consulting Fees Earned 1,600.00
 Unearned revenues — Bogus Manufacturing Company purchased an annual service

contract from you for $24,000, which they paid up front. If only three months of their
contract are within this accounting period, then that means nine months of the contract’s
revenues are unearned. In order to properly reflect reality, you need an adjusting entry:

Unearned Revenue 18,000.00
Revenue 18,000.00
 Accrued expenses — If you pay weekly salaries and the accounting period ends mid-
week, you have accrued salary expenses that you haven’t yet paid. You’ll need an
adjusting entry to reflect the as-yet unpaid salaries:

Salary Expense 7,200.40
Wages and Salaries Payable 7,240.40
 Prepaid expenses — Let’s say you paid $3,000 for your property insurance six months
ago, and you still have six paid months remaining on the policy after this accounting

period. To accurately reflect the value and expense of the remaining policy, you need an
adjusting entry:

Property & Casualty Expense 1,500.00
Prepaid Insurance 1,500.00
 Other adjusting entries — Your company purchased $1 million of manufacturing

equipment two years ago, and according to your depreciation schedule it has depreciated
by $350,500 this accounting period. To ensure that your balance sheet doesn’t overstate
the equipment’s value, you need an adjusting entry:

Depreciation Expense 350,500.00
Accumulated Depreciation –
350,500.00
Equipment
Complete a work sheet for a manufacturing enterprise and journalize the

closing entries
At the end of the cycle, the closing entries are prepared. For a manufacturing company that uses
the periodic inventory method, closing entries update retained earnings for net income or loss
and adjust each inventory account to its period end balance. A special account called
manufacturing summary is used to close all the accounts whose amounts are used to calculate
cost of goods manufactured. The manufacturing summary account is closed to income
summary. Income summary is eventually closed to retained earnings. The manufacturing
accounts are closed first. The closing entries that follow are based on the accounts included in
the cost of goods manufactured schedule and income statement.
Steps in the Closing Process
1. Close the costs that appear in the statement of cost of goods manufactured into the
Manufacturing Summary account.
2. Close the Manufacturing Summary account into the Income Summary account (by the
amount of cost of goods manufactured).
3. Close the revenue account into the Income Summary account
4. Close expense accounts into the Income Summary account.
5. Close Income Tax Expense into the Income Summary account.

6. Close the Income Summary account into the Retained Earnings account (by the amount
of net income).
Illustration 2 Accounting work sheet and closing entries
The listing of the ledger accounts (Unadjusted) of woodworks Manufacturing Co.Ltd on 30
June 2016 is presented below: All ledger balances are normal balance.
Wood works Manufacturing Co.LTD
Unadjusted list of Accounts
As at June 2016
Balance
Cash at Bank………………..…………………………………………………………Birr 18375
Accounts Receivable…………………………………………………………………….41250
Allowance for doubtful debts…………………………………………………………………………….………….……3375
Finished Goods invitory,1/07/2015……………………………………….28750
Work in process inventory,1/07/2015………………………………….9375
Raw material inventory1/07/2015…………………………………………4625
Prepaid rent…………………………………………………………………………………………………67500
Machinery and Equipment……………………………………………………………..245000
Accumulated Depreciation…………………………………………………………………………………………………..43750
Account payable……………………………………………………………………………………………………………………………22500
Bills payable……………………………………………………………………………………………………………………………………93750
Share Capital……………………………………………………………………………………………………………………………………50, 000
Retained profit………………………………………………………………………………………………………………………………46250
Sales ………………………………………………………………………………………………………………………………………………………1075000
Direct Labor………………………………………………………………………………………………………….270, 000
Raw material purchases……………………………………………………………………………….256250
Indirect labor…………………………………………………………………………………………………………88750
Factory Supplies…………………………………………………………………………………………………22500
Light and power…………………………………………………………………………………………………70,000
Insurance …………………………………………………………………………………………………………………20375
Selling Expense…………………………………………………………………………………………………40, 000
Administrative expense………………………………………………………………………………83750
Interest expense…………………………………………………………………………………………………28750
Factory Rent…………………………………………………………………………………………………………39375
1334625 1334625
Additional information relating to the company is as follows:
1. The inventories as of 30 june2016 were:
Raw materials Birr 3875

Work in process 10875

Finished Goods 31250
2. On 1 January 2016 the company paid Birr 67500 for the next 12 months factory rent.
Prepaid rent was debited at the time of the transaction
3. The machinery and equipment account consists of Birr 183750 of factory machinery and Birr 61250
of office equipment. All machinery and equipment is depreciated using a 7-year life, no residual
value, and straight line method.
4. Expenses incurred as of year-end but not yet recorded are: Direct labor, Birr 5000, indirect labor Birr
1500, administrative expense 875.
5. The light and power, rent and insurance costs are related to factory operation.
6. Allow for the company income tax expense at 40% of net profit before tax
Required:
A. Prepare worksheet including a pair of column for unadjusted trial balance, adjustments,
manufacturing income statement and statement balance sheet.
B. Prepare adjusting entries and cost of Goods manufactured for manufacturing firms
C. Prepare closing entries
D. Calculate the relationship between factory overhead costs and direct labor costs
Using that relationship, calculate the labour and overhead included in the ending inventories if
work in process ending inventory contains Birr 3000 of raw materials and Birr 5000 of raw
materials is included in the finished goods inventory.
Solution :A

Wood work Manufacturing Co.LTD

Work Sheet
For the year ended June 30, 2016
Un adjusted Adjustments Adjusted trial Income Balance Sheet
Trial Balance Trial balance balance Statement
Account Name Debit Credit Debit Credit Debit Cred Debi Credi Debit Credit
it t t
Cash at Bank Birr 18375
18375
Accounts Receivable 41250 41250
Allowance for doubtful 3375 3375
debts
Finished Goods 28750 2875 31250 31250
invitory,1/07/2015 0
Work in process 9375 9375 10875 10875
inventory,1/07/2015
Raw material 4625 4625 3875 3875
inventory1/07/2015
Prepaid rent 67500 a.3375 33750
0
Machinery and 245000 245000
Equipment
Accumulated 43750 b.3500 78750
Depreciation 0
Account payable 22500 22500
Bills payable 93750 93750
Share Capital 50, 000 50, 000
Retained profit 46250 46250
Sales 1075000 10750
00
Direct Labor 270, 000 c.5000 275000
Raw material purchases 256250 256250
Indirect labor 88750 c.1500 90250
Factory Supplies 22500 22500
Light and power 70,000 70,000
Insurance 20375 20375
Selling Expense 40, 000 40,
000
Administrative expense 83750 d.875 8462
5
Interest expense 28750 2875
0
Factory Rent 39375 a.3375 73125
0
1334625 1334625
Depreciation expense- b.2625 26250
factory 0
Depreciation expense- b.875 8750
office 0
Wages payable 6500 6500
Administrative 875 875
expense-payable
7612 76125
5
Cost of goods 8330 8330
manufactured 00 00
84775 84775
0 0
Income tax expense 3295 32950
40% 0
Net profit after tax 4942 49425
5
1106 1106 384375 384375
250 250
Solution: B ALEMU.LTD
Cost of Goods Manufactured Statement
Direct materials:
Raw materials inventory, beg Birr 4625
Purchase raw materials 256250
260875
Less: Raw material inventory, end 3875
Raw materials issued to production Birr 257000
Direct labor …………………………………………275000
Factory overhead:
Indirect labor…………………………………90250
Factory Supplies…………………………......22500
Light and power………………………….....70,000
Insurance……………………………………20375
Depreciation factory………………………….26250…….302500
Total manufacturing costs for the period………………..834500
Add: work in process, beg…………………….……………9375
Total work in process…………………………………………843875

Less: work in process, end….…………………………………10875
Cost of goods manufactured………………………………………Birr833000

Solution C CLOSING ENTRIES
General journal
Date 20 Description Post.Re Debit Credit
June 30 Manufacturing summary 847750
Work in process inventory 9375
Raw material inventory 4625
Direct labor 275000
Raw material purchases 256250
Indirect labour 90250
Factory supplies 22500
Light and power 70,000
Insurance 20375
Factory rent 73125
Depreciation expense factory 26250
To close manufacturing account with debit balances
June 30 Work in process 10875

Raw materials 3875
Manufacturing summary 14750
To establish ending inventories of raw materials and work in process
June 30 Income summary 1056825

Finished goods inventory 28750
Selling expenses 40,000
Administrative expenses 84625
Interest expense 28750
Depreciation expense-office 8750
Cost of goods manufactured 833000
Income tax expense 32950
To close income statement accounts with debit balance
June 30 Finished goods inventory 31250
Sales 1075000
Income summary 1106250
To establish the ending finished goods inventory and close the sale account
June 30 Income summary 49425
Retained profits 49425
To close net profit after tax to retained profits
Solution: D

Factory overhead and direct labour cost relationships
Factory overhead costs ==== 302500 = 1.10 or 110%

Direct labor cost 275000
Labour and overhead included in ending inventories
DL + 1.10DL +3000 = 10875
2.10DL = Birr 7875
Direct labour = Birr 3750
Factory overhead = Birr 3750 * 1.10 = Birr 13750

1. Manufacturing costs incurred during the year are:
A. Shown by the expense accounts, such as Wages Expense and Utilities Expense,
that is listed in the Operating Expenses section of the income statement.
B. Are comprised of raw materials, direct labor, and manufacturing overhead and are
reported in the Operating Expenses section of the income statement.
C. Included in the computation of cost of goods manufactured.
D. Reported in the Cost of Goods Sold section of the income statement.
The correct answer is C:
The components of manufacturing cost are the raw materials used, direct labor, and
manufacturing overhead. The statement of cost of goods manufactured shows details of
the cost of goods completed for a manufacturing business. The cost of goods
manufactured is used to calculate the cost of goods sold in the income statement. Cost of
goods manufactured represents the cost of the goods that were completely manufactured
and moved to the finished goods area, while cost of goods sold represents the
manufacturing costs relating to the items that were sold during the year.
2. The cost of goods manufactured is computed by
A. Adding raw materials used and direct labor to manufacturing overhead.
B. Deducting the ending work in process inventory from the sum of the total
manufacturing cost and the beginning work in process inventory.
C. Deducting the ending finished goods inventory from the beginning finished goods
inventory.
D. Adding operating expenses to direct labor costs.
Feedback:
The correct answer is B:
Total manufacturing costs are comprised of raw materials used, direct labor and

manufacturing overhead. The cost of goods manufactured equals beginning Work in

Process plus total manufacturing costs minus the ending Work in Process Inventory.
3. Indirect labor for a manufacturing business includes the wages of
A) Factory repair and maintenance employees.
B) Employees who assemble the product.
C) Employees who sell the product.
D) Office employees.
Feedback:
The correct answer is A
Indirect labor costs are the costs of personnel who support production but are not directly
involved in the manufacture of a product, such as supervisory, repair and maintenance, and
janitorial staff. Indirect labor is included in the Manufacturing Overhead section of the
statement. Employees who sell the product and office employees are not part of the
manufacturing, and the costs of these employees are recorded as operating expenses.
4. The cost of goods sold can differ from the cost of goods manufactured because of changes in
the level of
A) Raw materials inventory.
B) Finished goods inventory.
C) Total manufacturing costs.
D) work in process inventory.
Feedback:
The correct answer is B: The cost of goods sold can differ from the cost of goods manufactured
because of changes in the level of the finished goods inventory. Some finished goods that are
sold in the current period were made in previous periods. Some products made during the current
period will be sold in later periods. In order to prepare the income statement, a count is made of
the finished goods inventory at the end of each period.
5. Gross profit for a manufacturing business is computed by

A) Deducting cost of goods sold from net sales.

B) Deducting cost of goods manufactured from net sales.

C) Deducting the ending finished goods inventory from the total goods available for sale.
D) Deducting operating expenses from the costs of goods sold.
Feedback:
The correct answer is A:
Gross profit is the difference between net sales and the cost of goods sold.
6. The balance sheet of a manufacturing business shows
A) The finished goods inventory and the cost of goods manufactured.
B) The cost of goods manufactured rather than inventory figures.
C) A single inventory figure—the amount of the finished goods inventory.
D) The raw materials inventory, the work in process inventory, and the finished goods
inventory.
Feedback:
The correct answer is D: All three inventory accounts, raw materials, work in process, and
finished goods are reported as current assets on the balance sheet of a manufacturing business.
7. The Indirect Labor account is closed by crediting it and debiting
A) Wages Payable.
B) Income Summary.
C) Manufacturing Summary.
D) Wages Expense.
Feedback:
The correct answer is C: Indirect labor is a manufacturing cost, and all manufacturing costs are
closed to the Manufacturing Summary account.
8. All of the following are examples of adjusting entries that might be recorded by a
manufacturer except
A. Debit the Administrative Expense account and credit the Allowance for Doubtful
Accounts account.
B. Debit the Supplies on Hand account and credit the Supplies Expense account.
C. Debit the Insurance—Factory account and credit the Administrative Expense
account.
D. Debit the Income Tax Expense account and credit the Income Tax Payable
account.

Feedback:
The correct answer is B: The adjusting entry for the use of supplies during the period would
debit (rather than credit) the Supplies Expense account and credit (rather than debit) the Supplies
on Hand account.
9. Closing entries for a manufacturing firm include all of the following except
A) Transferring all manufacturing cost accounts to Manufacturing Summary.
B) Transferring all Revenue and Expense account balances to Income Summary.
C) Closing Manufacturing Summary to Income Summary.
D) Closing Income Summary to Net Income.
Feedback: The correct answer is D: The closing entries of a manufacturing business are done in
three steps. Step 1 – Closing Accounts to Manufacturing Summary – Close the Purchases
Discounts account to Manufacturing Summary and close the manufacturing costs to
Manufacturing Summary. Step 2 – Closing Revenue and Expense Accounts into Income
Summary – The entries to close the revenue and expense accounts into Income Summary are
almost identical to those for a merchandising concern. An additional account, Manufacturing
Summary, is closed into Income Summary. Step 3 - Closing Income Summary – The balance of
the Income Summary account is closed to Retained Earnings.
10. Which of the following statements is not correct?
A) Reversing entries may be made for adjustments for accruals.
B) Reversing entries are made for expenditures initially debited to expense accounts and
then adjusted at the end of the year.
C) Reversing entries are required by IFRS.
D) All of the above statements are correct.
Feedback:
The correct answer is C: Reversing entries are optional; they are not required by IFRS.

CHAPTER 8:
CASH AND RECEIABLE
Chapter five presents a detailed discussion of two of the primary liquid assets of a company,
cash and receivables. Cash is the most liquid asset held by a company and possesses unique
problems in its management and control. Receivables are composed of both accounts and
notes receivables
Principles of Internal Control
Internal control consists of all of the related methods and measures adopted within a
business to:
a. Safeguard assets from employee theft, robbery, and unauthorized use; and
b. Enhance the accuracy and reliability of its accounting records by reducing the risk of
errors (unintentional mistakes) and irregularities (intentional mistakes and
misrepresentations) in the accounting process.
1. To safeguard assets and enhance the accuracy and reliability of its accounting
records, a company follows internal control principles. The following six internal
control principles apply to most companies:
 Establishment of Responsibility: An essential characteristic of internal control is the
assignment of responsibility to specific individuals.
i. Control is most effective when only one person is responsible for a given task.
ii. Establishing responsibility includes the authorization and approval of
transactions.
 Segregation of Duties: Segregation of duties is indispensable in a system of internal
control. The rationale for segregation of duties is that the work of one employee
should, without a duplication of effort, provide a reliable basis for evaluating the work
of another employee.
 There are two common applications of this principle:
i. The responsibility for related activities should be assigned to different
individuals.
ii. The responsibility for record keeping for an asset should be separate from the
physical custody of an asset.

 Documentation Procedures - Documents provide evidence that transactions and

events have occurred.
i. Documents should be pre-numbered and all documents should be accounted for.
For examples, would be numbers on checks and invoices (like restaurant receipts).
ii. Source documents for accounting entries should be promptly forwarded to the
accounting department to help ensure timely recording of the transaction and event.
 Physical, Mechanical, and Electronic Controls – Physical controls relate primarily to
the safeguarding of assets. Mechanical and electronic controls safeguard assets and
enhance the accuracy and reliability of the accounting records. Use of physical,
mechanical, and electronic controls is essential. Examples of these controls include:
a. Safes, vaults, and safety deposit boxes for cash and business papers.
b. Locked warehouses and storage cabinets for inventory and records.
c. Computer facilities with pass key access or fingerprint or eyeball scans.
d. Alarms to prevent break-ins.
e. Television monitors and garment sensors to deter theft.
f. Time clocks for recording time worked.
 Independent Internal Verification - Independent internal verification involves the
review, comparison, and reconciliation of data prepared by employees.
a. Verification should be made periodically or on a surprise basis.
b. Verification should be done by an employee independent of the
personnel responsible for the information.
c. Discrepancies and exceptions should be reported to a management
level that can take appropriate corrective action.
d. In large companies, independent internal verification is often
assigned to internal auditors.
e. Internal auditors are employees of the company who evaluate on a
continuous basis the effectiveness of the company‘s system of
internal control.
 They periodically review the activities of departments
and individuals to determine whether prescribed
internal controls are being followed.

 HUMAN RESOURCE CONTROLS

a. Bonding of employees who handle cash.
b. Rotating employees' duties and requiring employees to take vacations.
Limitations of Internal Control
a. Internal control is designed to provide reasonable assurance that assets are properly
safeguarded and that the accounting records are reliable (they are not fool-proof; a cost-
benefit relationship must be observed between controls and security).
 The concept of reasonable assurance rests on the premise that the costs
of establishing control procedures should not exceed their expected
benefit.
b. The human element is important in internal control.
 A good system can become ineffective as a result of employee fatigue,
carelessness, or indifference. Employees may become tired and not bother to
count inventory. Occasionally two or more employees may work together in
order to get around prescribed controls.
c. The size of the business may impose limitations on internal control. In a small
company, for example, it may be difficult to apply the principles of segregation of
duties and independent internal verification.
d. An important and inexpensive measure any business can take to reduce employee
theft and fraud is to conduct thorough background checks. Two tips include:
i. Check to see whether job applicants actually graduated from the schools
they list
ii. Never use the telephone numbers for previous employers given on the
reference sheet; always look them up yourself.
Nature of Cash
In accounting, cash includes coins; currency; bank deposited and negotiable instruments
such as checks, bank drafts, and money orders; amounts in checking and savings accounts;
and demand certificates of deposit. A certificate of deposit (CD) is an interest-bearing
deposit that can be withdrawn from a bank at will (demand CD) or at a fixed maturity date
(time CD). Only demands CDs that may be withdrawn at any time without prior notice or

penalty are included in cash. Cash does not include postage stamps, IOUs, time CDs, or
notes receivable.
CASH AND INTERNAL CONTROL
Internal Control to Cash Receipts
Since cash is the most liquid of all assets, a business cannot survive and prosper if it does not
have adequate control over its cash. Cash is the asset that has the greatest chance of ―going
missing‖ and this is why we must ensure that we have strong internal controls build around
the cash process. Since many business transactions involve cash, it is a vital factor in the
operation of a business. Of all the company‘s assets, cash is the most easily mishandled either
through theft or carelessness.
Cash receipts may result from cash sales; collections on account from customers; the receipt
of interest, rents, and dividends; investments by owners; bank loans; and proceeds from the
sale of non-current assets.
a. The following internal control principles explained earlier apply to cash receipts
transactions as shown:
i. Establishment of responsibility - Only designated personnel (cashiers) is authorized
to handle cash receipts.
ii. Segregation of duties - Different individuals receives cash, record cash receipts,
and holds the cash.
iii. Documentation procedures - Use remittance advice (mail receipts), cash register
tapes, and deposit slips.
iv. Physical, mechanical, and electronic controls - Store cash in safes and bank vaults;
limit access to storage areas; use cash registers.
v. Independent internal verification - Supervisors count cash receipts daily; treasurer
compares total receipts to bank deposits daily.
vi. Human resource control- Bond personnel who handle cash; require vacations;
deposit all cash in bank daily.
Internal Control to Cash Disbursement
Cash is disbursed to pay expenses and liabilities or to purchase assets.

a. Internal control over cash disbursements is more effective when payments are
made by check, rather than by cash, except for incidental amounts that are paid
out of petty cash.
b. Cash payments are generally made only after specific control procedures have been
followed.
c. The paid check provides proof of payment.
d. The principles of internal control apply to cash disbursements as follows:
i. Establishment of responsibility - Only designated personnel (treasurer) are
authorized to sign checks.
ii. Segregation of duties - Different individuals approve and make payments;
check signers do not record disbursements.
iii. Documentation procedures - Use pre-numbered checks and account for
them in sequence; each check must have approved invoice.
iv. Physical, mechanical, and electronic controls - Store blank checks in safes
with limited access; print check amounts by machine with indelible ink.
v. Independent internal verification - Compare checks to invoices; reconcile
bank statement monthly.
vi. Other controls - Stamp invoices PAID.
Methods of Disbursing and/or safeguarding Cash:
a. Electronic Funds Transfer (EFT) System: A new approach developed to
transfer funds among parties without the use of paper (deposit tickets, checks,
etc.). The approach, called electronic funds transfers (EFT), uses wire,
telephone, telegraph, or computer to transfer cash from one location to
another.
b. Petty Cash Fund - A cash fund used to pay relatively small amounts.
Information on the operation of a petty cash fund is provided in the Appendix
to this chapter.
c. Use of a Bank
 Contributes significantly to good internal control over cash by creating a
separate set of records (bank and books).

 The asset account Cash maintained by the company is the ―flip-side‖ of

the bank‘s liability account for that company. It should be possible to
reconcile these accounts—make them agree—at any time.
i. Bank statements - Each month the company receives a bank
statement showing its bank transactions and balances. For
example, some transactions and balances shown include:
ii. Checks paid and other debits that reduce the balance in the
depositor's account.
iii. Deposits and other credits that increase the balance in the
depositor's account.
iv. The account balance after each day's transactions.
d. Minimizes the amount of cash that must be kept on hand
The Bank Account as a Control Device
Keeping cash in a bank account helps because banks have established practices for
safeguarding customers‘ money. Banks also provide customers with detailed records of their
transactions. To take full advantage, the business should deposit all cash receipts in the bank
and make all cash payments through the bank. An exception is a petty cash transaction,
which we will examine later. The documents used to control a bank account include the
 Signature card- Banks require each person authorized to transact business through
an account to sign a signature card. The bank uses the signature card to protect
against forgery.
 Deposit ticket: Banks supply standard forms such as deposit tickets. The customer
fills in the Birr amount of each deposit. As proof of the transaction, the customer
keeps a deposit receipt.
 Check-To draw money from an account, the depositor writes a check, which is the
document that tells the bank to pay the designated party a specified amount of
money. There are three parties to a check: the maker, who signs the check, the
payee, to whom the check is paid, the bank on which the check is drawn.
 BANK STATEMENT Banks send monthly statements to customers. Bank
statement is the document on which the bank reports what it did with the customer‘s

cash. The statement shows the account‘s beginning and ending balances and lists the
cash receipts and payments transacted through the bank.
Bank Reconciliation
Most companies use checking accounts to handle their cash transactions. The company
deposits its cash receipts in a bank checking account and writes checks to pay its bills. Keep
in mind, a bank account is an asset to the company BUT to the bank your account is a
liability because the bank owes the money in your bank account to you. For this reason, in
your bank account, deposits are credits (remember, liabilities increase with a credit) and
checks and other reductions are debits (liabilities decrease with a debit).
The bank and the company maintain independent records of the checking account. The two
balances are seldom the same because of:
a. Time lags that prevent one of the parties from recording the transaction in the same
period.
i. Days elapse between the time a check is written and dated and the date it is
paid by the bank.
ii. A day may pass between the time receipts are recorded by the company and
the time they are recorded by the bank.
iii. A time lag may occur when the bank mails a debit or credit memo to the
company.
b. Errors by either party in recording transactions. The incidence of errors depends on the
effectiveness of internal controls maintained by the company and the bank. The bank sends
the company a statement each month. The company checks this statement against its
records to determine if it must make any corrections or adjustments in either the company‘s
balance or the bank‘s balance
A company's cash balance at bank and its cash balance according to its accounting records
usually do not match. This is due to the fact that, at any particular date, checks may be
outstanding; deposits may be in transit to the bank, errors may have occurred etc. Therefore
companies have to carry out bank reconciliation process which prepares a statement
accounting for the difference between the cash balance in company's cash account and the
cash balance according to its bank statement.

Following are the transactions which usually appear in company's records but not in
the bank statement:
 Deposits in Transit: Deposits which have been sent by the company to the bank but
have not been received by the bank at proper time before the issuance of bank
statement.
 Checks Outstanding: Checks outstanding which have been issued by the company
but were not presented or cleared before the issuance of bank statement.
 Bank Errors. Sometimes banks make errors by depositing or taking money out of
your account in error. You will need to contact the bank to correct these errors but
will not record any entries in your records because the bank error is unrelated to your
records.
Following are the transactions which usually appear in bank statement but not in
company's cash account:
 Service Charges: Service charges may have been deducted by the bank. Such charges
are usually not known to the company before the issuance of bank statement.
 Interest Income: If any interest income has been earned by the company on its bank
account, it is not usually entered in company's cash account before the issuance of
bank statement.
 Electronic funds transfers. The bank may receive or pay cash on behalf of the
depositor. An EFT may be a cash receipt or a cash payment.
 NSF Checks: NSF stands for "not sufficient funds". These are the checks deposited
by the company in bank account but the bank is unable to receive payment on those
checks due to insufficient funds in the payer's account.
 The cost of printed checks. This cash payment is handled like a service charge.
 Book Errors. List any Book errors. A common error by depositors is recording a
check in the accounting records at an amount that differs from the actual amount.
For example, a Birr 47 check may be recorded as Birr 74. Although the check clears
the bank at the amount written on the check (Birr 47), the depositor frequently does
not catch the error until reviewing the bank statement or canceled checks.
The following table will give you some examples of how these reconciling items apply in
bank reconciliation:

Bank Reconciliation
Ending Cash Balance per Bank Ending Cash Balance per Books
Add: Deposits in Transit Add: Note Collections
Add: Interest
Subtract: Outstanding Checks Subtract: Customer NSF
Subtract: Bank Service Fees
Add/Subtract Bank errors Add/Subtract Book errors
= Adjusted Bank Balance = Adjusted Book Balance
Example
Company ABC bank statement dated Dec 31, 2016 shows a balance of Birr 24,594.72. The
company's cash records on the same date show a balance of Birr 23,196.79.
Following additional information is available:
1. Following checks issued by the company to its customers are still outstanding:
No. 846 issued on Nov 29 Birr 320.00

No. 875 issued on Dec 26 49.21
2. A deposit of Birr 400.00 made on Dec 31 does not appear on bank statement.
3. An NSF check of Birr 850 was returned by the bank with the bank statement.
4. The bank charged Birr 50 as service fee.
5. Interest income earned on the company's average cash balance at bank was Birr
1,237.22.
6. The bank collected a note receivable on behalf of the company. Amount received by
the bank on the note was Birr 550. This includes Birr 50 interest income. The bank
charged a collection fee of Birr 10.
7. Errors: Check No. 443 was correctly written by ABC for Birr 430.00 and was
correctly paid by the bank, but recorded for Birr 340.00 by ABC Company.
Required
a. Prepare a bank reconciliation statement and relating Journal entries using the
above information.

b. Journalize the entries based on the bank reconciliation
Solution:
Company ABC
Bank Reconciliation
December 31, 2011
Balance as per Bank, Dec 31 Birr 24,594.72
Add: Deposit in Transit 400.00
Birr 24,994.72
Less: Outstanding Checks:
No. 846 issued on Nov 29 Birr 320.00
830.71
Adjusted Bank Balance Birr 24,164.01
Balance as per Books, Dec 31 Birr 23,196.79

Add:
Interest Income from Bank Birr 1,237.22
Note Receivable Collected by Bank 500.00
Interest Income from Note Receivable 50.00
Deposit Understated 90.00
1,877.22
Birr 25,074.01
Less:
NSF Check 850.00
Bank Service Fee 50.00
Bank Collection Fee 10.00
910.00
Adjusted Book Balance Birr 24,164.01
The bank reconciliation is an accountant‘s tool separate from the company books. It
explains the effects of all cash receipts and all cash payments made through the bank.
But it does not account for transactions in the journal. Entries from Bank
Reconciliation - Each reconciling item used in determining adjusted cash balance per
books should be recorded by the depositor. If these items are not journalized and
posted, the Cash account will not show the correct balance.

ABC company- Illustrate the process of making adjusting entries from the bank
reconciliation using the entries to adjust ABC Company cash account.
Date Description Post .Ref Debit Credit

Dec 31 Cash 610
Miscellaneous Expense 10
Notes Receivable 550
Interest Revenue 50
(To record collection of note receivable by bank)

Dec 31 Cash 90
Account payable 90
To correct error in recording

Dec 31 Accounts Receivable 850
Cash 850
(To record NSF check)

Dec 31 Miscellaneous Expense 50
Cash 50
( To record charge for printing company checks)
Bank Overdraft: When a business' bank account has a negative balance it is said to be
running a bank overdraft (more precisely an actual bank overdraft). It is a form of financing
in which the bank honors presented checks even when there is no balance in the business
account which results in negative balance in the bank account.
There is a special type of bank overdraft called 'book bank overdraft' which represent
situation in which the balance as per cash book is negative while the balance as per bank
book is positive. It arises when the checks written exceed the bank balance available thereby
resulting in negative bank balance in books but since those checks are not yet presented so
the bank balance is not negative and there is no 'actual bank overdraft'.
Balance sheet treatment of bank overdraft

When the bank has a right to offset the overdraft balance with another bank account of the
business, the overdraft is netted off against the other bank accounts maintained with the
same bank and the net bank balance is shown as the balance of cash at bank.
When the bank has no such right to offset, the overdraft is reported as a liability and when it
is material it should be reported separately from other liabilities.
Bank overdraft and statement of cash flows
For the purpose of statement of cash flows, under US GAAP any changes in bank overdrafts
for a period are appropriately reported as cash flows from financing activities.
Under IFRS however, bank overdraft is treated as part of cash and cash equivalents and
movement in bank overdraft is not reported anywhere in the statement of cash flows.
Example
Mohammed has four bank accounts: Account A and B which are maintained at Dashen
Bank. A has a balance of Birr 20 million while B has an overdraft of Birr 2 million. Account
C and D are maintained at Commercial Bank. C has a balance of Birr 50 million and D has
a balance of –Birr 10 million. On Dashen, banks are entitled to set off any negative bank
balances with positive balances while Commercial banks have no such luxury. Mohammed
applies US GAAP and Account B and D has no balance at the start of the year. Comment
on balance sheet and statement of cash flows presentation of the overdraft.
Solution
On its balance sheet, Mohammed shall report cash and cash equivalents of Birr 68 million
(Birr 20 million in Account A minus Birr 2 million in Account B plus Birr 50 million in
Account C). It will show a corresponding bank overdraft liability of Birr 10 million.
On its statement of cash flows, it shall report a cash inflow from 'changes in overdrafts' of
Birr 10 million under cash flows from financing activities.
Petty Cash Funds
At times, every business finds it convenient to have small amounts of cash available for
immediate payment of items such as delivery charges, postage stamps, taxi fares, supper
money for employees working overtime, and other small items. To permit these cash
disbursements and still maintain adequate control over cash, companies frequently establish
a petty cash fund of a round figure such as Birr100 or Birr 500. The petty cash account is a
current asset and will have a normal debit balance (debit to increase and credit to decrease).

Following are the typical transactions connected to petty cash fund.

1. Creation: Petty cash fund may be created by drawing a check on the company's
checking account and handing it over to the custodian of the fund. The journal entry
is to debit petty cash and credit cash at bank.
2. Disbursements: Individual disbursements from petty cash are not recorded via a
journal entry. Instead journal entry is passed at the time of each replenishment and at
the end of the period for the total amount disbursed.
3. Replenishment: When the balance in petty cash becomes low, a journal entry is
passed debiting various expense accounts and crediting petty cash for the sum of
disbursements made. Then petty cash is replenished usually via a check.
4. Raising Fund Level: When the volume of transactions to be handled by the petty
cash grows, the fund level is raised. The journal entry is to debit the petty cash and
credit cash at bank.
Example
Company XYZ created a petty cash fund of Birr 900 on Jan 1, 2016. The journal entry is:
Date, Description PR Debit Credit
2016
Jan 1 Petty cash 900
Cash at Bank 900
During January 3, 2016, following disbursements were made from the fund: office supplies
Birr 300, highway toll Birr 50, postage Birr 30 and freight in Birr 350.
The journal entry to record the about disbursements from petty cash is:
2016
Jan 1office supplies 300
highway toll 50
postage 30
Freight- in 350
Cash at Bank 730
The company replenished the fund via a check of Birr 730. The journal entry is:

2016

Cash at Bank 730

Example
Example 2, Assume the Birr 100 petty cash fund currently has a money balance of Birr7.40.
A summary of the vouchers shows payments of Birr 22.75 for shipping to customers, Birr
50.80 for stamps, and Birr 19.05 for an advance to an employee; these payments total Birr
92.60. After the vouchers have been examined and approved, a check is created for Birr
92.60 which restores the cash in the fund to its Birr 100 balance. Petty cash is not used in
the replenishment journal entry. The journal entry to record replenishment is:
2016
Jan 1 Delivery Expense 22.75
Postage Expense 50.80
Employee Advances 19.05
Cash 92.60
Note that the entry to record replenishing the fund does not credit the Petty Cash account.
We make entries to the Petty Cash account only when the fund is established or when
the amount of the fund is changed or when the fund is closed and we want to add back cash
in exchange for the petty cash vouchers. In this case, the cash needed to get back to Birr 100
(Birr100 fund – Birr 7.40 petty cash on hand) of Birr 92.60 equals the total of the petty cash
vouchers. But, that is not always the case.
Sometimes, the petty cash custodian makes errors in making change from the fund or
doesn‘t receive correct amounts back from users. These errors cause the cash in the fund to
be more or less than the amount of the fund less the total vouchers. When the fund is
replenished, the credit to Cash is for the difference between the established amount and the
actual cash in the fund. We would debit all vouchered items. Any discrepancy should be
debited or credited to an account called Cash Over and Short. The Cash Over and Short
account can be either an expense (short) or revenue (over), depending on whether it has a
debit or credit balance.
To illustrate, assume in the preceding example that the balance in the fund was only Birr
6.10 instead of Birr 7.40. Restoring the fund to Birr 100 requires a check for Birr 93.90
(Birr100 fund amount – petty cash remaining Birr 6.10). Since the petty cash vouchers total
only Birr 92.60, the amounts do not agree and the fund is short Birr 1.30 (Birr 93.90 needed
– Birr 92.60 in vouchers). The entry for replenishment is:

2016

Jan 1
Delivery Expense 22.75
Postage Expense 50.80
Receivable from 19.05
Employees
Cash Short and Over 1.30
Cash 93.90
The Cash Over and Short account will be used to balance the entry when the cash needed
to get back to the petty cash account does not match the total of petty cash
vouchers. Remember, for all journal entries, total debits must equal total credits.
Changing the petty cash amount
If the petty cash custodian finds that the petty cash fund is larger than needed, the excess
petty cash should be deposited in the company‘s checking account. The required entry to
record a decrease in the fund debits Cash and credits Petty Cash for the amount returned
and deposited. To illustrate, the entry to decrease the petty cash fund by Birr 50 would be:
2016
Jan 1 Petty cash 50
Cash at Bank 50
On the other hand, a petty cash fund may be too small, requiring replenishment every few
days. The entry to record an increase in the fund debits Petty Cash and credits Cash for the
amount of the increase. The entry to increase the petty cash fund by Birr 400 would be:

2016
Cash at Bank 400
A company may feel it is time to close the petty cash fund. To illustrate, we will close the
Birr 100 original petty cash fund by returning the cash to the checking account with a debit
to cash and a credit to petty cash.

2016
Jan 1 Cash at Bank 100
Cash at Bank 100

RECEIVABLES
Accounts receivable are current assets which represent amounts to be collected from
customers for goods sold and services provided. When a company sells goods or provides
services, the customers rarely makes payment on spot. Instead, they are required to make
payment within a certain time period, called credit period. The terms that determine the
due date and the discount available if payment is made by a certain date are called credit
terms.
The term trade receivable refers to any receivable generated by selling a product or
providing a service to a customer. Trade receivables can be accounts or notes receivable.
Accounts receivable are oral promises of the purchaser to pay for goods and services sold.
Accounts receivable are amounts that customers owe a company for goods sold and services
rendered on account. Payment terms for sales on account typically run from 30 to 60 days.
Companies usually do not charge interest on amounts owed, except on some past-due
amounts.
Notes receivable are written promises to pay a certain sum of money on a specified future
date. Nontrade receivables arise from a variety of transactions and can be written promises
either to pay or to deliver. A non-trade receivable would be when someone owes the
company money not related to providing a service or selling a product. For example, the
company loans employee money for a travel advance or a company borrows money from
another company.
Nontrade receivables are generally classified and reported as separate items in the balance
sheet.
Accounts receivable
When sales are made on credit, accounts receivable are created which are recorded through
the following journal entry:
Example
Record the following transactions for ABC Company.
a. On August 4, ABC sold merchandise on account to XYZ Company for Birr 450, terms,
2/10, n/30.

b. On August 7, ABC granted XYZ a sales allowance and reduced the cost of the
merchandise by Birr 50 because some of the goods were slightly damaged.
c. On August 12, XYZ paid the account in full.
Solution
2016
Aug 4 Account Receivable 450
Sale 450
‖ 7 Sales Returns and 50
Allowances
Accounts Receivable 50
Many companies allow customers certain cash discount when they make payment
quickly. The cash discount depends on the credit terms.
Date DESCRIPTION PR Debit Credit
August 12 Sales discounts 8
Cash 392
The accounts receivable balance is presented on balance sheet net of any allowance for
doubtful accounts as follows.
Accounts receivable………………………………………..XX
Less: allowance for doubtful accounts………………….… (XX)
Net accounts receivable……………………………………...XX
When cash is collected from customer, the accounts receivable balance on balance sheet is
reduced through the following journal entry:

2016
july 5 cash xx
Account Receivable xx
Accounting for Bad Debts

Bad debts are accounts receivable that a company does not expect to collect and has written
off to income statement as an expense. Bad debts are also called irrecoverable debts.

Bad debts are recognized as expense because they are not expected to generate any economic
benefits in future. Recognition of bad debt expense also results in a corresponding decrease
in the accounts receivable balance on balance sheet because bad debts are no longer an asset.
Although bad debts are a grim reality of doing business on credit, this does not mean that
one should stop selling on credit since a good credit policy outweighs this draw back by a
great margin. Selling goods on credit increases sales volume because customers like to have
the ability to purchase on credit.
There are two methods of accounting for bad debts:
(a) The direct write-off method and
(b) The allowance for doubtful accounts method
DIRECT WRITE-OFF AND ALLOWANCE METHODS
Because customers do not always keep their promises to pay, companies must provide for
these uncollectible accounts in their records. Companies use two methods for handling
uncollectible accounts.
The direct write-off method recognizes bad accounts as an expense at the point when
judged to be uncollectible and is the required method for federal income tax purposes.
The allowance method provides in advance for uncollectible accounts think of as setting
aside money in a reserve account. The allowance method represents the accrual basis of
accounting and is the accepted method to record uncollectible accounts for financial
accounting purposes.
Direct Write-off method
The direct write-off method is used only when we decide a customer will not
pay. The Direct Write-off Method is simple, objective, and is the method preferred for
income tax purposes. For example merchandize sold on account for Birr 1,000. Assumes
that three months elapse after the sale of the goods and the Birr 1000 account is determined
to be uncollectible. Using the Direct Write-off Method, the entry to write the account off
would be:
Date Accounts Post Ref Debit Credit

April 15 Bad Debts Expense 1000
Account receivable 1000
To write off customer‘s account as uncollectible

Despite its simplicity, the Direct Write-off Method has a conceptual weakness. It violates
the matching principle, because the revenue from the sale is earned in one period, and the
expense of the bad debt is not recognized until a significant time later. Specifically, the
revenue was earned in January, but the expense of the bad debt is recorded in April. It
might seem that perfect matching would be an impossible objective, given that we cannot
predict which customer accounts will actually become uncollectible, or when.
Recovery of Bad Debts
When cash is collected from a written-off account receivable, it is accounted for by reversing
the write-off and recording the collection of cash.
When an account receivable is reasonably expected to be uncollectible, it is written off as
bad debts expense in the period in which it becomes uncollectible. Since the write-off
decision is based on judgment, it might turn out to be wrong. For example, cash might be
received from a written-off account receivable when the customer‘s financial situation
improves or when its assets are liquidated to pay its debts, etc.
1. When a bad debt is recovered, two journal entries are required
Date General Journal Post Ref Debit Credit

April 15 Accounts receivable 1000
Provision for bad debts 1000
2. To record the collection of cash:
Date General Journal Post Ref Debit Credit

April 18 Cash 1000
Accounts receivable 1000
Allowance for Doubtful Accounts
In the allowance for doubtful accounts method, bad debts expense is estimated and
recognized in the period in which the relevant revenue is recognized. This makes it a more
appropriate method than direct write-off method because it is in accordance with the
matching concept.
In each period, doubtful accounts are estimated and expensed out by debiting ‗bad debts
expense account‘ and crediting allowance for doubtful accounts account.‘ Following journal
entry is required:
General journal

Date Accounts Post Debit Credit

.Ref
April 30 Bad debts expense ABC
Allowance for doubtful ABC
debts
ESTIMATING BAD DEBTS

In the period of sale, the customer that eventually will not pay, the amount that will not be
paid and the period in which the customer‘s account will become uncollectible cannot be
determined. Therefore, the uncollectible accounts expense must be estimated at the end of
each accounting period
Estimating uncollectible accounts Accountants use two basic methods to estimate
uncollectible accounts for a period.
1. Percent of sales method.
2. Analysis of the receivables method.
1. Percent of Sales Method: Since accounts receivable are created by credit sales,
uncollectible accounts can be estimated as a percent of credit sales. If the portion of credit
sales to sales is relatively constant, the percent may be applied to total sales or net sales.
Example: Percent of Sales Method: Assume that at the end of the current year, Accounts
Receivable has a balance of Birr 800,000; Allowance for Doubtful Accounts has a credit
balance of Birr 7,500; and net sales for the year total Birr 3,500,000. Bad debt expense is
estimated at 1⁄2 of 1% of net sales.
Determine:
(a) The amount of the adjusting entry for uncollectible accounts;
(b) The adjusted balances of Accounts Receivable, Allowance for Doubtful Accounts, and
Bad Debt Expense; and
(c) The net realizable value of accounts receivable.
Solution
a. Uncollectible accounts Birr 17,500 = ( Birr 3,500,000 X 0.005)
Adjusted balance
b. Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Birr 800,000
Allowance for Doubtful Accounts (Birr 7,500 +Birr 17,500)..... 25,000

Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . ……………17,500

Bad Debt Expense = Net sales (total or credit) x Percentage estimated as uncollectible
c. Accounts Receivable…………………………………………………800,000
Less: Allowance for Doubtful Accounts……………………………… (25000)
The net realizable value of accounts receivable…………………………775,000
2. Bad Debts Expense as Percentage of Receivables
The Analysis of Receivables Method assumes that bad debts are a function of how old the
receivables are. If someone has owed you money for ten days, your probability of collecting
it is higher than if someone owes you money for 120 days. To age the accounts, sort the
Accounts Receivable into pools by age, and multiply each pool by a percentage assumed
uncollectible. Note that, as the age increases, the percentage uncollectible is considered to be
higher.
These amounts are added and the sum represents the desired balance for the Allowance for
Doubtful Accounts. The adjustment is made to force the Allowance account to this
balance. Thus, you must look at the existing balance in the Allowance account before
making the adjustment.
For example, Assume Accounts Receivable was Birr 240,000 and the Allowance for
Uncollectible Accounts was Birr 3,250. After an aging of the accounts, it was determined
that an estimated Birr 26,490 of Accounts Receivable were uncollectible. But, since the
Allowance for Doubtful Accounts already had a Birr 3,250 balance, the adjustment needed
was for Birr 23,240.
Date General Journal Post.Ref Dr. Cr.
August 30 Bad Debts Expense 23,240
Allowance for Doubtful Accounts 23,240
The effect of this entry is a reduction in owner's equity and a reduction in total assets. Bad
Debts Expense, like all expenses, reduces net income.
To reiterate a major difference between the two allowance methods, the percent of sales
method computes a percent of sales and makes the bad debts expense entry using that
figure, while the analysis of receivables method computes a percent of receivables, and forces
the allowance account to that figure.

Accounts Receivable Aging Method

Accounts receivable aging is a technique to estimate bad debts expense by classifying
accounts receivable of a business according to of length of time for which they have been
outstanding and then estimating the probability of no collection for each category. The
classification of accounts receivable in the accounts receivable aging schedule also helps the
business to identify the customers who take longer to pay so that they can restrict sales to
those customers to reduce risk of bad debts.
Typically receivables are categorized into periods which are multiples of payment terms. For
example if company sells at payment terms of n/20, the typical classification in aging
schedule will be 0 to 20 days, 20 to 40 days, 40 to 60 days and so on.
The next step is to calculate the probability of no collection for each of the above category
which is then multiplied with the sum of accounts receivable from each category. This
returns the amount of accounts receivable which are expected to become bad in each
category. The sum of estimated no collected accounts receivable from each category is fixed
as the ending balance of allowance for bad debts account. Bad debts expense is calculated as
provided in percentage of receivables method of bad debts estimation.
Example
Age Category Amount Probability of No collection Uncollectible Amount
1-20 days Birr 64,200 2% Birr1,284
20-40 days 11,900 4% 476
40-60 days 5,200 7% 364
60-80 days 350 12% 42
Birr 2,166
Date General Journal Post.Ref Dr. Cr.

August 30 Bad Debts Expense 2,166
Allowance for Doubtful Accounts 2,166
Notes receivable
Note receivables are receivables supported by a written statement by the debtor to pay a
specified sum on a specified date. Like accounts receivable, notes receivable arise in the

ordinary course of business; but unlike accounts receivable they are in written form. Notes
receivable usually require the debtor to pay interest. They may be current and non-current.
When a company receives a note receivable it records it by the following journal
entry:

2016
july 5 Notes receivable xx
Sales/cash/accounts receivable xx
Interest-Bearing Notes
The typical note receivable requires the payment of a specified face amount, also called
principal, and interest at a stated percentage of the face amount. These are referred to as
interest-bearing notes. Interest on notes is calculated as:
Interest = Face amount x Annual rate x Time to maturity
Principal is the face value of the note. The interest rate is the annual stated interest rate on
the note. Frequency of a year is the amount of time for the note and can be either days or
months. We need the frequency of a year because the interest rate is an annual rate and we
may not want interest for an entire year but just for the time period of the note.
Note that in this calculation we expressed the time period as a fraction of a 360-day
year because the interest rate is an annual rate and the note life was days. If the note
life was months, we would divide by 12 months for a year. (Some companies use a 365-
day year.)
A Note with Maturity Quoted in Years
Suppose that, on June 1, you loan someone Birr 1,000 with 10% interest for one year. The
amount of interest you would be owed after one year would be Birr 1,000 x 0.10 x 1=Birr
100. The maturity date would be the same day next year, June 1.
A Note with Maturity Expressed as a Number of Months
Suppose that on September 1, you loan someone Birr 1000 on a note receivable for 3 months
at 6%. How much interest would accrue? Answer: it would earn interest of Birr 15.00,
computed as follows:
Interest = Birr 1000 X 0.06 X 3/12 = Birr 15.00
The maturity date would be December 1--simply take the loan date of September 1 and
count forward three months.

Note: an interest rate is always the rate for one year. In this example, the rate is 6% per year.
The money was loaned out for 3/12 of one year, resulting in total interest of Birr 15. If the
money had been loaned out for an entire year, the interest would amount to
.06X1000X1=Birr 60.
A Note with Maturity Quoted in Days
Similarly, a Birr 2000 note for 60 days earning an 8% rate would result in interest revenue of
Birr 26.67, computed as follows:
Interest = Birr 2000 X 0.08 X 60/360 = Birr 26.67
The maturity date for a note quoted in days requires that you count the days until maturity.
If a 60 day note is received on July 25, you would count the number of days remaining in
July (6 days), then add all of the days in August (31) and you will need 23 days in September
to make 60 days. Thus, the maturity date for the note would be September 23.
If you are working with a note quoted in days, it is vital that you know how many days there
are in each month. Here is a table:
Month Number of Days Month Number of Days
January 31 July 31
February 28, or 29 in a leap year August 31
March 31 September 30
April 30 October 31
May 31 November 30
June 30 December 31
For example, a 90-day note dated October 19 matures on January 17 of the next year, as
shown here:
Life of note (days) 90 days
Days remaining in October not counting date of origin of note:
Days to count in October (31 – 19) 12
Total days in November 30
Total Days in December 31 73
Maturity date in January
(90 total days – 73 days from Oct to Dec) 17 days
Illustration the conversion of an account receivable to a note, assume that ABC
Company had purchased Birr 18,000 of merchandise on August 1 from XYZ Company on

account. The normal credit period has elapsed, and ABC cannot pay the invoice. XYZ
agrees to accept ABC‘s Birr 18,000, 15%, 90-day note dated September 1 to settle ABC‘s
open account. Assuming ABC paid the note at maturity and both XYZ and ABC have a
December 31 year-end, the entries on the books of XYZ are:

Sep 1 Note receivable 18000
To record sale of merchandise on account
Nov. 30 Cash 18,675
Notes Receivable 18,000

Interest Revenue [18,000 675
x 15% x (90/360)]
To record receipt of ABC Company note principal and interest
Note: Maturity date calculated as November 30 since it was a 90 day note – 29 days left in
September (30 days in Sept – note day Sept 1) – 31 days in October leaves 30 days remaining
in November.
The Birr 18,675 paid by ABC to XYZ is called the maturity value of the note. Maturity
value is the amount that the company (maker) must pay on a note on its maturity date;
typically, it includes principal and accrued interest, if any.
Sometimes the maker of a note does not pay the note when it becomes due. The next section
describes how to record a note not paid at maturity.
A dishonored note is a note that the maker failed to pay at maturity. Since the note has
matured, the holder or payee removes the note from Notes Receivable and records the
amount due in Accounts Receivable.
At the maturity date of a note, the maker is responsible for the principal plus interest. The
payee should record the interest earned and remove the note from its Notes Receivable
account. Thus, the payee of the note should debit Accounts Receivable for the maturity
value of the note and credit Notes Receivable for the note‘s face value and Interest Revenue
for the interest.
Date Description P.R Debit Credit

18,675
Nov.30 Accounts Receivable-ABC company

Notes Receivable 18,000

Interest Revenue 675
To record dishonor of note.
Example Note Receivable: Assume that ABC Company surgery Center received a 120-day,
6% notes for Birr 40,000, dated March 14 from a patient on account.
a. Determine the due date of the note.
b. Determine the maturity value of the note.
c. Journalize the entry to record the receipt of the payment of the note at maturity.
Solution
a. The due date of the note is July 12, determined as follows:
March 17 days (31 _ 14)
April 30 days
May 31 days
June 30 days
July 12 days
Total 120 days
b. Birr 40,800 [Birr 40,000 +(Birr 40,000 X6% X 120/360)]

c. July 12 Cash. .. . . . . . . . . . . . . . . . . . . . . 40,800
Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . 40,000
Interest Revenue……………………………….800
Next illustration ABC Company's fiscal year end is December 31. On March 31, 2013, the
company sold carpeting to MDR Home Builders. ABC agreed to accept a Birr 300,000,
12-month, 10% notes in payment for the carpeting. Interest is payable at maturity. The
following entries record the note and related sales revenue, the accrual of interest on
December 31, 2013, and the payment of the note:
March 31, Note receivable 300,000
2013 Sales revenue 300,000
December Interest receivable 22,500

31, 2013
Interest 22,500
revenue(Birr300,000 x 10% x
9/12)

March 31, Cash [Birr300, 000 + (Birr300, 330,000

2014 000 x 10%)]
Interest revenue (Birr300,000 x 7,500
10% x 3/12)
Interest receivable 22,500
Note receivable 300,000
Self-study question
1. Why should a company establish an internal control structure?
2. Why are mechanical devices used in an internal control structure?
3. ―The difference between a company‘s Cash account balance and the balance on its bank
statement is usually a matter of timing.‖ Do you agree or disagree? Why?
4. Describe the operation of a petty cash fund and its advantages. Indicate how control is
maintained over petty cash transactions.
5. What are the two major purposes of establishing an allowance for uncollectible
accounts?
6. For a company using the allowance method of accounting for uncollectible accounts,
which of the following directly affects its reported net income: (1) the establishment of
the allowance, (2) the writing off of a specific account, or (3) the recovery of an account
previously written off as uncollectible?
7. What is a dishonored note receivable and how is it reported in the balance sheet?
MULTIPLE CHOICE QUESTIONS
1. Which of the following is a method used to account for uncollectible accounts?
A) Direct write-off method B) Allowance method
C) Bad debt expense method D) Installment method
E) Both A and B above
2. What journal entry is used to write-off an uncollectible account under the allowance
method of accounting for un-collectibles?
A) Debit Bad Debt Expense; Credit Allowance for Doubtful Accounts
B) Debit Bad Debt Expense; Credit Accounts Receivable
C) Debit Allowance for Doubtful Accounts; Credit Accounts Receivable
D) Debit Accounts Receivable; Credit Allowance for Doubtful Accounts
E) Debit Allowance for Doubtful Accounts; Credit Bad Debt Expense
3. A 60-day, 11%, promissory note that is dated June 13 will have a maturity date of
which of the following?
A) August 9 B) August 10 C) August 11 D) August 12

4. How is a debit balance in Cash Over and Short reported?

A. A liability B. A miscellaneous expense
C. A miscellaneous revenue D. An asset
5. Which of the following statements correctly describes the reporting of cash?
A. Cash cannot be combined with cash equivalents.
B. Restricted cash funds may be combined with Cash.
C. Cash is listed last in the current assets section.
D. Restricted cash funds cannot be reported as a current asset.
6. Which of the following items appearing on a bank reconciliation would require
journal entries to bring the cash account up to date?
A. Deposits in transit.
B. Checks from customers returned as NSF.
C. Outstanding checks.
D. An error made by the bank in recording a deposit.
7. On a bank reconciliation, the amount of an unrecorded bank service charge is
A. Added to the bank balance of cash.
B. Added to the company's balance of cash.
C. Deducted from the bank balance of cash.
D. Deducted from the company's balance of cash.
8. All of the following bank reconciliation items would result in an adjusting journal
entry on the company's books except:
A. Interest earned. B. Deposits in transit.
C. Service charge. D. A customer's check returned NSF.
9. When a payment is made from a petty cash fund, which of the following is required?
A. A credit to Cash B. A credit to Petty Cash
C. A debit to various expense accounts D. No accounting entry is made
10. A bank may issue a credit memorandum for
A. A bank service charge.
B. A NSF (not sufficient funds) check from a customer.
C. The collection of a note receivable for the depositor by the bank.
D. The cost of printing checks.
11. When an account becomes uncollectible and must be written off,
A. Allowance for Doubtful Accounts should be credited.
B. Accounts Receivable should be credited.
C. Bad Debts Expense should be credited.
D. Sales should be debited.
12. Short-term notes receivable are reported at
A. Cash (net) realizable value. B. Face value.
C. Gross realizable value. D. Maturity value.
13. The maturity value of a Birr4,000, 9%, 60-day note receivable dated February 10th is

A. Birr4, 060. B. Birr 4,030. C. Birr 4,000. D. Birr4, 360.

14. .A 90-day note dated June 14 has a maturity date of
A. September 14. B. September 12. C. September 13. D. September 15.
15. An aging of a company's accounts receivable indicates that Birr 9,000 is estimated to
be uncollectible. If Allowance for Doubtful Accounts has a Birr 1,100 credit balance,
the adjustment to record bad debts for the period will require a
A. Debit to Bad Debts Expense for Birr 9,000.
B. Debit to Allowance for Doubtful Accounts for Birr 7,900.
C. Debit to Bad Debts Expense for Birr 7,900.
D. Credit to Allowance for Doubtful Accounts for Birr 9,000
16. When a note receivable is dishonored,
A. interest revenue is never recorded.
B. bad debts expense is recorded.
C. the maturity value of the note is written off.
D. Accounts Receivable is debited if eventual collection is expected.
SHORT-ANSWER QUESTIONS
Exercise 1 On August 31, Honey land Company‘s petty cash fund contained coins and
currency of Birr 260, an IOU from an employee of Birr 30, and vouchers showing
expenditures of Birr 120 for postage, Birr 52 for taxi fare, and Birr 138 to entertain a
customer. The Petty Cash account shows a balance of Birr 600. The fund is replenished on
August 31 because financial statements are to be prepared.
REQUIRED: What journal entry is required on August 31?
Exercise 2: The credit manager of a company has established a policy of seeking to

completely eliminate all losses from uncollectible accounts. Is this policy a desirable
objective for a company? Explain.
Exercise 3: What are the two major purposes of establishing an allowance for uncollectible
accounts?
Exercise 4: In view of the fact that it is impossible to estimate the exact amount of
uncollectible accounts receivable for any one year in advance, what exactly does the
Allowance for Uncollectible Accounts account contain after a number of years?
Exercise 5: On December 31, 2011, the bank statement for ABC co. showed a balance
of Birr 65,456.5. The balance on the cash ledger account was Birr 60,764. In
comparing the bank balance with the cash balance in the accounting records, the
accountant of the company discovered the following items.

 Receipts of december31, 2011 amounting birr 2450 were left in the banks night
depository on December 31.
 The December bank statement included a debit memorandum for birr 27.5 for
service charges of the month.
 A credit memorandum included with the bank statement indicated that a note
receivable in the amount of birr 6000, left for the bank for collection, had been
collected and credited to the companies account for birr 6048, including interest
revenue of birr 48.
 In verification of the checks and check stubs, it was found that check no. 3214 for birr
987.5 issued on December 16 for the acquisition of office equipment, had been
entered erroneously in the cash payment journal as birr 978.5
 The checks issued in December amounting birr 1256 had not been paid by the bank
and become outstanding.
 The bank statement included a check for birr 125 drawn by a customer of the
company which was marked as NSF (not sufficient fund)
Required: using the form of bank reconciliation that reconciles both the bank balance and
the adjusted depositor‘s balance to the correct cash balance:
a) Prepare the bank reconciliation statement for ABC company on December 31, 2011
b) Record the journal entry required to update the accounting records of the company
on December 31, 2011.
Exercise 6: Assume that WX Company has established petty cash fund of Br. 600 on May 1
of the current year. At the end of the month, the petty cash vouchers revealed the following
expenditures:
 Office supplies………………….. ………… ..Br. 95
 Postage………….. ………. ………………… 44
 Store supplies…………………….. ………… 70
 Delivery, expense………………….. ……… . 124
 Daily newspaper (miscellaneous expense)....... 176.4
Total Br. 509.4
Required: Record the establishment and replenishment of the petty cash fund.
Exercise 7: Assume the following note appeared in the annual report of a company:
In 2009, two small retail customers filed separate suits against the company alleging
misrepresentation, breach of contract, conspiracy to violate federal laws, and state

antitrust violations arising out of their purchase of retail grocery stores through the
company from a third party. Damages sought range up to Birr10 million in each suit
for actual and treble damages and punitive damages of Birr 2 million in one suit and
Birr10 million in the other. The company is vigorously defending the actions and
management believes there will be no adverse financial effect.
What kind of liability is being reported? Why is it classified this way? Do you think it is
possible to calculate a Birr amount for this obligation? How much would the company have
to pay if it lost the suit and had to pay the full amount?
Essay Questions
Group project 1: With a small group of students, visit a large local company to inquire about
its internal control structure. Specifically, discover how it protects its assets against theft and
waste, ensures compliance with company policies and federal laws, evaluates performance of
its personnel, and ensures accurate and reliable operating data and accounting reports. If an
internal audit staff exists, inquire about some of its activities. Write a report to your
instructor summarizing your findings and be prepared to make a short presentation to the
class.
Group project 2: With one or two other students, locate and visit two companies that
maintain petty cash funds. Interview the custodians of those funds to identify the controls
that are used to manage those funds. Write a report to your instructor comparing the
controls used, pointing out any differences between the control systems and any deficiencies
in the systems. Be prepared to make a short presentation to the class.
Group project 3: In a group of two or three students, visit a fairly large company in your
community to investigate the effectiveness of its management of accounts receivable.
Inquire about its credit and sales discount policies, collection policies, and how it establishes
the amount for the adjusting entry for uncollectible accounts at year-end. Also ask about
how it decides to write off accounts as uncollectible.
Group project 4: In groups of two or three students; write a two-page, double-spaced paper
on one of the following topics:
Which is better—the percentage-of-sales method or the percentage-of-receivables method?
Why not eliminate bad debts by selling only for cash?
Why allow customers to use credit cards when credit card expense is so high?
Should banks be required to use 365 days instead of 360 days in interest calculations?

Present your analysis in a convincing manner, without spelling or grammatical errors.

Include a cover page with the title and authors‘ names.
Answer key for multiple choice
No No
1 9
2 10
3 11
4 12
5 13
6 14
7 15
8 16

CHAPTER 9
ACOUNTING FOR INVENTORIES
Inventory is a current asset on a company's balance sheet. Inventory includes goods for
resale, raw materials, spare parts, etc. Inventories consist of raw material, work-in-process
and finished goods which are held by a business in ordinary course of business, either for
sale or for the purpose of using them in the process of producing goods and services.
Types of Inventory
Raw Material: Raw material is a type of inventory which acts as the basic constituent of a
product. For example cotton is raw material for cloth production and plastic is raw material
for production of toys. Raw material is usually held by manufacturing companies because
they have to manufacture goods from raw material.
Work-In-Process: Work in process is a type of inventory that is in the process of production.
This means that work-in-process inventory is in the middle of production stage and it is
partly complete. Work-in-process account is used by manufacturing companies.
Finished Goods: A finished goods is a type of inventory which comes into existence after the
production process in complete. Finished goods are ready for sale inventory. In financial
accounting we are usually concerned with merchandise inventory. The other types of
inventories are studied in cost accounting.
Importance of Inventories
The sale of merchandise provides the principal source of revenue for merchandising
enterprise. When the net income is determined, the cost of merchandise sold is the largest
deduction from sales. It is usually larger than all other deductions combined. Moreover, a
substantial part of a merchandising firm‘s resources is invested in inventory. It is normally
the largest of the current assets of a merchandising firm.
Cost of Inventory:
When inventory is purchased, the cost of inventory includes the purchase price, delivery
costs, excise and custom duties etc. less any discount that is obtained. When inventory is
manufactured, its cost includes the production cost plus any cost which is incurred on
making the inventory saleable for example packing cost. However if abnormal cost is

incurred on delivery or handling etc. then only normal portion will be added to the cost of
inventory. The rest should be expensed.
The valuation of ending inventory is done using FIFO, AVCO or specific identification
methods under either periodic inventory system or under perpetual inventory system
US GAAP and IFRS both measure inventories initially at cost. Inventories are classified
as current assets on the face of the balance sheet, because they are expected to be realized
within the entity‘s normal operating cycle. Both standards require entities to disclose the
composition of inventory in the financial statements.
Determining Quantities Inventories
No matter whether they are using a periodic or perpetual inventory system, all companies
need to determine inventory quantities at the end of the accounting period. If using a
perpetual system, companies take a physical inventory for two reasons:
1. To check the accuracy of their perpetual inventory records.
2. To determine the amount of inventory lost due to wasted raw materials, shoplifting,
or employee theft.
Companies using a periodic inventory system take a physical inventory to determine the
inventory on hand at the balance sheet date, and to determine the cost of goods sold for the
period.
Determining inventory quantities involves two steps:
(1) Taking a physical inventory of goods on hand and
(2) Determining the ownership of goods.
Taking a Physical Inventory
Companies take a physical inventory at the end of the accounting period. Taking a physical
inventory involves actually counting, weighing, or measuring each kind of inventory on
hand. In many companies, taking an inventory is a formidable task. An inventory count is
generally more accurate when goods are not being sold or received during the counting.
Determining Ownership of Goods
One challenge in computing inventory quantities is determining what inventory a company
owns. To determine ownership of goods, two questions must be answered:
 Do all of the goods included in the count belong to the company?

 Does the company own any goods that were not included in the count?
Goods in transit
A complication in determining ownership is goods in transit (on board a truck, train, ship, or
plane) at the end of the period. The company may have purchased goods that have not yet
been received, or it may have sold goods that have not yet been delivered.
The accounting rule is that goods to which legal title has passed should be recorded as
purchases of the fiscal period. Goods shipped FOB shipping points that are in transit at the
end of the period belong to the buyer and should be shown in the buyer‘s records.
If the goods are shipped FOB destination, the seller is responsible for shipping and legal title
does not pass until the goods arrive at the customer's location. Therefore the goods belong to
seller and should be shown in the seller records.
Assume, for example, that ABC Company has 20,000 units of inventory on hand on
December 31. It also has the following goods in transit:
1. Sales of 1,500 units shipped December 31 FOB destination.
2. Purchases of 2,500 units shipped FOB shipping point by the seller on December 31.
ABC has legal title to both the 1,500 units sold and the 2,500 units purchased. If the
company ignores the units in transit, it would understate inventory quantities by 4,000 units
(1,500 + 2,500).
Goods on consignment
A specialized method of marketing certain products uses a device known as a consignment
shipment. Under this arrangement, one party (the consignor) ships merchandise to another
(the consignee), who acts as the consignor‘s agent in selling the consigned goods. The
consignee agrees to accept the goods without any liability, except to exercise due care and
reasonable protection from loss or damage, until the goods are sold to a third party. When
the consignee sells the goods, the revenue less a selling commission and expenses incurred in
accomplishing the sale is remitted to the consignor.
 Goods on consignment should be included in inventory of the consignor even
though not in the company's physical possession. The consignor records a sale only
when the consignee sells the goods.
Effects of an Error in the Determination Inventory on Financial Statements

In the process of maintaining inventory records and the physical count of goods on hand,
errors may occur. It is quite easy to overlook goods on hand, count goods twice, or simply
make mathematical mistakes. It is vital that accountants and business owners fully
understand the effects of inventory errors and grasp the need to be careful to get these
numbers as correct as possible. A general rule is that overstatements of ending inventory
cause overstatements of income, while understatements of ending inventory cause
understatements of income.
Inventory determination plays an important role in matching expired costs with revenue of
the period. An error in the determination of the inventory amount at the end of the period
will cause the following errors.
 Misstatement of gross profit and net income.
 The incorrect amount of inventory i.e. the inventory to report in the balance sheet
is incorrect amount.
Beginning inventory
Plus: Net purchases
Less: Ending inventory Revenues
Cost of goods sold -------> Less: Cost of goods sold
Less: Other expenses Beg. retained earnings
Net income ----------> Plus: Net income
Less: Dividends
End. retained earnings
Because of the above reasons, Ending inventories have effects on the current and the
following period‘s financial statements. If inventories are misstated (understated or
overstated), the financial statements will have been distorted.
Example: The XYZ Company uses a periodic inventory system. At the end of 2012, a
mathematical error caused a Br.800, 000 overstatement of ending inventory. Ending
inventories for 2013 and 2014 are correctly determined.
The way we correct this error depends on when the error is discovered. Assuming that the error
is not discovered until after 2013 the 2012 and 2013 effects of the error, ignoring income tax
effects are shown below. The overstated and understated amounts are Br.800, 000 in each

instance.
Analysis: U = Understated O = Overstated
2012 2013
Beginning inventory Beginning inventory O

Plus: Net purchases Plus: Net purchases
Less: Ending inventory O Less: Ending inventory
Cost of goods sold U Cost of goods sold O
Revenues Revenues
Less: Cost of goods sold U Less: Cost of goods sold O
Less: Other expenses Less: Other expenses
Net income O Net income U
 
Retained earnings O Retained earnings corrected
Illustration 1.The effect of an error in the determination of ending inventory on the current
period of for XYZ Company, you are given the following data for the year 1
Net sales ……………………………………….Br 450,000
Beginning inventory (January 1, year I)………..75000
Net purchases………………………………….420, 000
Other Assets (Dec 31, year 1)…………………...310000
Liabilities (Dec 31, year 1) ……………………225000
Operating expenses……………………………….135000
Instructions: prepare income statement and balance sheet under the following assumption
1. Ending inventory is correctly stated at Br.220,000
2. Ending inventory is incorrectly stated at Br.210,000
3. Ending inventory is incorrectly stated at Br 225,000
1. Assumption 1: Ending inventory is correctly stated at Br.220,000
ABC Company
Income statement

For the year ended Dec 31, year I

Net sales ……………………………………….Br 450,000
Less: Cost good sold:
Beginning inventory…………………75000
Net purchases……………………….420, 000
CMAS………………………………495000
Less: ending inventory……………….. (220,000)
Cost of goods sold……………………………………………….(275000)
Gross profit………………………………………………………..175000
Less: operating expense ………………………………..………….(135000)
Net income…………………………………………….……………Br 40,000
ABC Company
Balance sheet
December 31, year 1
Merchandize inventory…………….220, 000 liabilities …………………225000
Other Assets………………………310,000 Capital……………………..305000
Total Assets………………………..530,000 liabilities & OE………………530,000
Assumption 2: Ending inventory is incorrectly stated at Br.210, 000
ABC Company
Income statement
Net sales ……………………………………….Br 450,000
Net purchases……………………….420, 000
CMAS………………………………495000
Gross profit…………………………………………………..165000
Less: operating expense ……………………………………….(135000)
Net income……………………………………………………Br 30,000
ABC Company
Balance sheet
December 31, year 1
Other Assets………………………310,000 Capital……………………..295000
The effects of understating ending inventory by 10,000 were as follows

 Income statement
 To increase cost of goods sold by Br.10,000
 To decrease gross profit by Br.10,000
 To decrease net income by Br.10,000 or increase net loss by 10,000
 Balance sheet
 To understate the total assets by 10,000
 To understate capital by the amount.
Assumption 3: Ending inventory is incorrectly stated at Br.225, 000
ABC Company
Income statement
Net sales ……………………………………….Br 450,000
Net purchases……………………….420, 000
CMAS………………………………495000
Cost of goods sold……………………………………………….(270,000)
Gross profit…………………………………………………..180,000
Net income……………………………………………………Br 450,000
ABC Company
Balance sheet
December 31, year 1
Other Assets………………………310,000 Capital……………………..310,000
The effects of overstating ending inventory by 5,000 were as follows
 To decrease cost of goods sold by Br.5,000

 To increase gross profit by Br.5,000

 To increase net income by Br.5,000 or decrease net loss by 5,000
 Balance sheet
 To overstate the total assets by 5,000
 To overstate capital by the amount.
Note: The understatement or overstatement of ending inventory does not affect the
financial statement of one accounting period. It also affects the financial statement of two
subsequent periods.
Illustration 2: The effect of an error in the determination of ending inventory in year I will
have the following impact on the financial statements of the subsequent accounting period.
You are given the following data for the year II
Net sales ……………………………………….Br 600,000
Net purchases………………………………….375, 000
Ending inventory………………………………….150, 000
Other Assets (Dec 31, year II)…………………...300,000
Total Liabilities (Dec 31, year II) ……………………110,000
Operating expenses……………………………….105000
Instructions: prepare income statement and balance sheet assuming the ending inventory of
year I are reported under the three assumption above for ABC company.
1. Ending inventory (i.e. Beginning inventory)…………220,000
2. Ending inventory (i.e. Beginning inventory)……………210,000
3. Ending inventory (i.e. Beginning inventory)…………….225000
1. Assumption 1: Beginning inventory is correctly stated at Br.220, 000
ABC Company
Income statement
For the year ended Dec 31, year II
Net sales ……………………………………….Br 600,000
Beginning inventory…………………220,000
Net purchases……………………….375, 000
CMAS………………………………595000

Gross profit…………………………………………………..255000
Net income……………………………………………………Br 150,000
ABC Company
Balance sheet
December 31, year 1I
Merchandize inventory…………….150, 000 liabilities …………………110,000
2. Assumption 2: Beginning inventory is incorrectly stated at Br.210, 000
ABC Company
Income statement
Net sales ……………………………………….Br 600,000
Net purchases……………………….375, 000
CMAS………………………………580,000
Gross profit…………………………………………………..170,000
Net income……………………………………………………Br 160,000
ABC Company
Balance sheet
The effects of understating beginning inventory by 10,000 were as follows
 To understate CMAS by Br.10,000
 To understate CGS by Br.10,000
 To overstate net income by Br.10,000 or understate net loss by
10,000
Assumption 3: Beginning inventory is incorrectly stated at Br.225, 000

ABC Company
Income statement
Net sales ……………………………………….Br 600,000
Net purchases……………………….375, 000
CMAS………………………………600,000
Gross profit…………………………………………………..150,000
Net income……………………………………………………Br 45,000
ABC Company
Balance sheet
The effects of overstating beginning inventory by 5,000 were as follows
 To overstate CMAS by Br.5,000 during year two
 To overstate CGS by Br.5,000
 To understate gross profit by Br 5000
 To understate net income by Br.5,000
The misstatement in identifying the ending inventory will have the following effect:
Understatement in identifying the ending inventory will result in overstatement of the cost
of goods sold, in turn the overstatement of cost of goods sold will understate the gross profit,
the as a result the net income of the period will be understated by the same amount.
The understatement of the period net income will result in understatement of the owner‘s
equity for the period.

The understated ending inventory for these period will the beginning inventory for the next
period which still are understated. The understatement of beginning inventory in the
subsequent period will understate the cost of goods sold for the period.
The understated cost of goods in the subsequent period will overstate the period‘s net
income. The overstated net income will in turn over state the period‘s owner‘s equity which
was understated in the previous period; thus the understated owner‘s equity in the previous
period will be compensated by the overstated owner‘s equity of this period.
Thus the amount of misstatement will be equal in two subsequent periods but of opposite
direction, therefore, these two misstatements will cancel each other, these means if the effect
in the net income of an incorrectly stated inventory is not corrected, it is limited only to the
period of the error and the following period.
The balance sheet will not be affect by the error of previous period.
INVENTORY SYSTEMS: PERIODIC VS PERPETUAL
There are two principal systems of inventory accounting periodic and perpetual.
Perpetual System
Under a perpetual inventory system, a continuous record of changes in inventory is
maintained in the Inventory account. That is, all purchases and sales (issues) of goods are
recorded directly in the Inventory account as they occur. The accounting features of a
perpetual inventory system are as follows.
 Purchases of merchandise for resale or raw materials for production are debited to
Inventory rather than to Purchases.
 Freight-in, purchase returns and allowances, and purchase discounts are recorded in
Inventory rather than in separate accounts.
 Cost of goods sold is recognized for each sale by debiting the account, Cost of Goods
Sold, and crediting Inventory.
 Inventory is a control account that is supported by a subsidiary ledger of individual
inventory records. The subsidiary records show the quantity and cost of each type of
inventory on hand.
Example 2: The ABC Wholesale Beverage Company purchases soft drinks from producers
and then sells them to retailers. The company begins 2013 with merchandise inventory of
Br.120, 000 on hand. During 2013 additional merchandise is purchased on account at a

cost of Br.600, 000. Sales for the year, all on account, totaled Br.820, 000. The cost of the
soft drinks sold is Br.540, 000. ABC uses the perpetual inventory system and Periodic
Inventory System to keep track of both inventory quantities and inventory costs. The
system indicates that the cost of inventory on hand at the end of the year is Br.180, 000.
The following summary journal entries record the inventory transactions for the ABC
Company:
2013
Inventory .................................................................................. 600,000
Accounts payable ............................................................... 600,000
To record the purchase of merchandise inventory
2013
Accounts receivable ................................................................ 820,000
Sales revenue ...................................................................... 820,000
To record sales on account
Cost of goods sold ........................................................................... 540,000
Inventory ............................................................................. 540,000
To record the cost of sale
Periodic Inventory System
 Periodic inventory system adjusts inventory and records cost of goods sold only at
the end of each reporting period.
 Merchandise purchases, purchase returns, purchase discounts, and freight-in are
recorded in temporary accounts.
 Purchases plus freight-in less returns and discounts equals net purchases.
 The period's cost of goods sold is determined at the end of the period by combining
the temporary accounts with the inventory account:
Beginning inventory + Net purchases - Ending inventory = Cost of goods sold
Periodic Inventory System for the above Example
2013
Purchases ............................................................................................. 600,000
Accounts payable ............................................................... 600,000
To record the purchase of merchandise inventory
2013
Accounts receivable ............................................................................ 820,000
Sales revenue ...................................................................... 820,000
To record sales on account.

No entry is recorded for the cost of inventory sold
Inventory transactions-perpetual and periodic system

Example 2: The ABC Wholesale Beverage Company purchases soft drinks from producers
and then sells them to retailers.
1. The company began 2013 with merchandise inventory of Br.120, 000 on hand.
2. During 2013 additional merchandise is purchased on account at a cost of Br.600, 000.
3. ABC suppliers offer credit terms of 2/10, n/30. All discounts were taken. ABC uses
the net method to record purchase discounts. All purchases are made f.o.b. shipping
point.
4. Freight charges paid by ABC totaled Br.16, 000.
5. Merchandise with a net of discount cost of Br.20, 000 was returned to suppliers for
credit.
6. Sales for the year, all on account, totaled Birr 830,000.
7. The cost of the soft drinks sold is Br.550, 000 and Br.154, 000 of inventory remained on
hand at the end of 2013.
The above transactions are recorded in summary form according to both the perpetual
and period inventory systems as follows:
inventory transactions-perpetual and periodic system

Perpetual System ( in 000s) Periodic System
purchase
Inventory (600 x 98%) 588 Purchases (600 x 98%) 588
Accounts payable 588 Accounts payable 588
Freight-in
Inventory 16 Freight-in 16
Cash 16 Cash 16
Returns
Accounts payable 20 Accounts payable 20
Inventory 20 Purchase returns 20
Sales
Accounts receivable 830 Accounts receivable 830
Sales revenue 830 Sales revenue 830
Cost of goods sold 550 No entry

Inventory 550
End of period
No entry Cost of goods sold (below) 550 <-----------
Inventory (ending) 154 |
Purchase returns 20 |
Inventory (beginning) 120 |
Purchases 588 |
Freight-in 16 |
|
Supporting schedule: |
Cost of goods sold: |
Beginning inventory $120 |
Purchases $588 |
Less: Returns (20) |
Plus: Freight-in 16 |
Net purchases 584 |
Cost of goods available 704 |
Less: Ending inventory (154) |
Cost of goods sold br550
<-
Cost Flow Assumptions

What is the inventory cost flow assumption?
The inventory cost flow assumption states that the cost of an inventory item changes from when
it is acquired or built and when it is sold. Because of this cost differential, management needs a
formal system for assigning costs to inventory as they transition to sellable goods.
Unit costs are applied to quantities to determine the total cost of the inventory and the cost of
goods sold using the following costing methods:
 Specific identification
 First-in, first-out (FIFO)
 Last-in, first-out (LIFO)
 Average-cost
First-In, First-Out (FIFO) Method:
First-In, First-Out (FIFO) is one of the methods commonly used to calculate the value of
inventory on hand at the end of an accounting period and the cost of goods sold during the
period. This method assumes that inventory purchased or manufactured first is sold first and
newer inventory remains unsold. Thus cost of older inventory is assigned to cost of goods

sold and that of newer inventory is assigned to ending inventory. The actual flow of
inventory may not exactly match the first-in, first-out pattern.
First-In, First-Out method can be applied in both the periodic inventory system and the
perpetual inventory system.
Notice that the total of the units in cost of goods sold and ending inventory, as well as the
sum of their total costs, is equal to the goods available for sale and their respective total costs.
The unique characteristic of the FIFO method is that it provides the same results under
either the periodic or perpetual system. This will not be the case for any other costing
method.
Last-in-First-Out Method (LIFO)
This method of inventory valuation is exactly opposite to first-in-first-out method. Here it is
assumed that newer inventory is sold first and older remains in ending inventory. When
prices of goods increase, cost of goods sold in LIFO method is relatively higher and ending
inventory balance is relatively lower. This is because the cost goods sold mostly consists of
newer higher priced goods and ending inventory cost consists of older low priced items.
Weighted-Average Cost Method
The cost of goods available for sale (beginning inventory and net purchases) is divided by
the units available for sale to obtain a weighted-average unit cost. Ending inventory and cost
of goods sold are then priced at this average cost.
When the weighted-average assumption is applied to a perpetual inventory system, the
average cost is recomputed after each purchase. This process is referred to as a moving
average.
Average cost method (AVCO) calculates the cost of ending inventory and cost of goods sold
for a period on the basis of weighted average cost per unit of inventory. Weighted average
cost per unit is calculated using the following formula:
Weighted Average Total Merchandize available for sale

=
Unit Cost Total Units in Inventory

Example: The Browning Company began 2013 with Br.22, 000 of inventory. The cost of
beginning inventory is composed of 4,000 units purchased for Br.5.50 each. Merchandise
transactions during 2013 were as follows:
Purchases & Date of Sale Units
Date of
Purchase Units Unit Cost* Total Cost
Jan. 7 purchase 1,000 6.00 Br 6,000
Jan. 10 Sale 2,000
Mar. 22 purchase 3,000 7.00 21,000
Apr. 15 Sale 1,500
Oct. 15purchase 3,000 7.50 22,500
Nov. 20 sale 3,000
Totals 13,500 Br49,500
* Includes purchase price and cost of freight.
Beginning inventory Cost of inventory

(Br22,000) on hand at end of period?
\
Cost of goods
Available sale /
+ (Br71,500)
Purchases
\ Cost of goods sold
(Br49,500) during the period?
/
Total ending inventory plus
cost of goods sold =
Br71,500
Periodic inventory system
AVERAGE COST
Cost of goods available for sale (11,000 units) Br.71, 500
Less: Ending inventory (determined below) (29,250)
Cost of goods sold (difference) Br.42,250

Cost of ending inventory:

Br71, 500
Weighted-average unit cost = = 6.50
11,000 units
4,500 units x 6.50 = 29,250
FIFO
Cost of goods available for sale (11,000 units) Br71,500
Cost of goods sold (difference) Br.38,500
Date of
Purchase Units Unit Cost Total Cost
Mar. 22 1,500 Br7.00 Br10,500
Oct. 15 3,000 7.50 22,500
Total 4,500 Br33,000
LIFO
Cost of goods available for sale (11,000 units) 71,500
Cost of goods sold (difference) 46,500

Date of
Purchase Units Unit Cost Total Cost
Beg. Inventory 4,000 5.50 22,000
January 17 500 6.00 3,000
Total 4,500 25,000
Average cost — perpetual inventory system
Date Purchased Sold Balance
Beginnig 4,000 @ 5.50 = 22,000 4,000 @ 5.50 22,000

inventory
Jan. 10 2,000 @5.50 = 11,000 2,000 @ 5.50 11,000
Jan. 17 1,000 @ 6.00 = 6,000 11,000+6,000 = 17,000

2,000+ 1,000 = 3,000 units

17,000
= 5.667/unit
3,000 units
Mar. 22 3,000 @ 7.00 = 21,000 17,000+21,000 = 38,000

3,000+ 3,000 = 6,000 units
38,000
= 6.333/unit
6,000 units
Apr. 15 1,500 @6.333 = 9,500 4,500 @ 6.333 = 28,500
Oct. 15 3,000 @ 7.50 = 22,500 28,500+22,500 = 51,000

4,500 + 3,000 = 7,500 units
51,000
= 6.80/unit
7,500 units
Nov. 20 3,000 @6.80 = 20,400 4,500 @ 6.80 = 30,600
Total cost of goods sold = 40,900

FIFO — PERPETUAL INVENTORY SYSTEM
The same ending inventory and cost of goods sold amounts are always produced in a perpetual
system as in a periodic system when FIFO is used.
Beginning 4,000 @ 5.50 = 22,000 4,000 @ 5.50 22,000

inventory
Jan. 10 2,000 @ 5.50 = 11,000 2,000 @ 5.50 11,000
Jan. 17 1,000 @ 6.00 = 6,000 2,000 @ 5.50

1,000 @ 6.00 17,000
Mar. 22 3,000 @ 7.00 = 21,000 2,000 @ 5.50

1,000 @ 6.00 38,000
3,000 @ 7.00
Apr. 15 1,500 @ 5.50 = 8,250 500 @ 5.50

1,000 @ 6.00 29,750
3,000 @ 7.00
Oct. 15 3,000 @ 7.50 = 22,500 500 @ 5.50

1,000 @ 6.00
3,000 @ 7.00 52,250
3,000 @ 7.50
Nov. 20 500 @ 5.50 + 1,500 @ 7.00

1,000 @ 6.00 + 3,000 @ 7.50 33,000
1,500 @ 7.00 = 19,250

LIFO — PERPETUAL INVENTORY SYSTEM
Beginning 4,000 @ 5.50 = 22,000 4,000 @ 5.50 22,000

inventory
Jan. 10 2,000 @ 5.50 = 11,000 2,000 @ 5.50 11,000
Jan. 17 1,000 @ 6.00 = 6,000 2,000 @ 5.50

1,000 @ 6.00 17,000
Mar. 22 3,000 @ 7.00 = 21,000 2,000 @ 5.50

1,000 @ 6.00 38,000
3,000 @ 7.00
Apr. 15 1,500 @ 7.00 = 10,500 2,000 @ 5.50

1,000 @ 6.00 27,500
1,500 @ 7.00
Oct. 15 3,000 @ 7.50 = 22,500 2,000 @ 5.50

1,000 @ 6.00
1,500 @ 7.00 50,000
3,000 @ 7.50
Nov. 20 3,000 @ 7.50 = 22,500 2,000 @ 5.50

1,000 @ 6.00 27,500
1,500 @ 7.00
Under perpetual inventory system –LIFO methods Ending inventory

Cost of goods sold : 2,000 @ 5.50 = 11,000
Nov. 20 1,000 @ 6.00 = 6,000
Jan. 10 2,000 @ 5.50 = 11,000
1,500 @ 7.00 = 10,500
Apr. 15 1,500 @ 7.00 = Birr10,500 Total ending Inventory………27,500
Nov. 20 3,000 @ 7.50 = 22,500
Total cost of goods sold………………..44,000

COMPARISON OF COST FLOW METHODS

The three cost flow methods are compared below assuming a periodic inventory system.
AVERAGE FIFO LIFO
Cost of goods sold 42,250 38,500 46,500
Ending inventory 29,250 33,000 25,000
Total 71,500 71,500 71,500
Issue FIFO Method LIFO Method
Materials In most businesses, the actual flow of There are few businesses where the
flow materials follows FIFO, which makes oldest items are kept in inventory
this a logical choice. while newer items are sold first.
Inflation If costs are increasing, the first items If costs are increasing, the last items
sold are the least expensive, so your sold are the most expensive, so your
cost of goods sold decreases, you cost of goods sold increases, you report
report more profits, and therefore pay fewer profits, and therefore pay a
a larger amount of income taxes in the smaller amount of income taxes in the
near term. near term.
Deflation If costs are decreasing, the first items If costs are decreasing, the last items
sold are the most expensive, so your sold are the least expensive, so your
cost of goods sold increases, you report cost of goods sold decreases, you report
fewer profits, and therefore pay a more profits, and therefore pay a larger
smaller amount of income taxes in the amount of income taxes in the near
near term. term.
Financial There are IFRS does not all the use of the LIFO
reporting no GAAP or IFRS restrictions on the method at all. The IRS allows the use
use of FIFO in reporting financial of LIFO, but if you use it for any
results. subsidiary, you must also use it for all
parts of the reporting entity.

In general, LIFO accounting is not recommended, for the following reasons:

 It is not allowed under IFRS, and a large part of the world uses the IFRS
framework.
 The number of layers to track can be substantially larger than would be the case
under FIFO.
 If old layers are accessed, costs may be charged to expense that vary substantially
from current costs.
In essence, the primary reason for using LIFO is to defer the payment of income taxes in an
inflationary environment.
THE VALUATION OF INVENTORIES

To ensure the proper matching of expenses and revenues, decrease s in the value of
inventory due to usage, damage, deterioration, obsolescence, and other factors must be
recognized in the accounting period during which the decrease occurs rather than the period
during which the merchandise sells. Inventory should never be valued at more than its net
realizable value, which equals its expected sales price minus any associated selling expenses
LOWER OF COST OR MARKET
Inventories are recorded at their cost. However, if inventory declines in value below its
original cost, a major departure from the historical cost principle occurs. Whatever the
reason for a decline—obsolescence, price-level changes, or damaged goods—a company
should write down the inventory to net realizable value to report this loss. A company
abandons the historical cost principle when the future utility (revenue-producing ability) of
the asset drops below its original cost. The application of lower-of-cost-or-market principles
varies under IFRS (International Financial Reporting Standards). Instead, the international
standards speak to net realizable value as the only benchmark for assessing market.
Additionally, recoveries of previous write downs are recognized under IFRS
 Inventories are reported at the lower of cost or market (LCM).
 For LCM purposes, market is defined as replacement cost, except that market should
 Not exceed the net realizable value (NRV).
 Not be less than NRV reduced by an allowance for an approximately normal profit
margin (NRV-NP).

Net Realizable Value

Recall that cost is the acquisition price of inventory computed using one of the historical
cost-based methods—specific identification, average cost, or FIFO. The term net realizable
value (NRV) refers to the net amount that a company expects to realize from the sale of
inventory.
As stated in IAS 2 ―Net realizable value is the estimated selling price in the ordinary course
of business less the estimated costs of completion and the estimated costs necessary to make
the sale.‖
Illustrate, Assume that Gemechu Corp. has unfinished inventory with a cost ofBr.950, a
sales value of Br.1,000, estimated cost of completion of Br.50, and estimated selling costs of
Br.200. Gemechu net realizable value is computed as follows.
Inventory value—unfinished…………………………………….... Br.1,000
Less: Estimated cost of completion………………… Br. 50
Estimated cost to sell ……………………………. 200 ……………250
Net realizable value ………………………………………………….750
Gemechu reports inventory on its statement of financial position at Br.750. In its income
statement, Gemechu reports a Loss on Inventory Write-Down of Br.200 (Br.950 _ Br.750).
A departure from cost is justified because inventories should not be reported at amounts
higher than their expected realization from sale or use. In addition, a company like
Gemechu should charge the loss of utility against revenues in the period in which the loss
occurs, not in the period of sale.
Exercises: The following information relates to XYZ Company‘s inventory:
Historical Cost Birr10,000
Net Realizable Value 7,000
Replacement Cost (Market Value) 5,000
Net Realizable Value less normal profit 4,500
Which two amounts would Broom Company compare to determine whether its
inventory should be written down according to 1) IFRS 2) US GAAP? How much
the inventory would be written down according to 1) IFRS 2) US GAAP?

APPLYING THE LOWER OF COST OR MARKET

The LCM rule can be applied to individual items, group inventory categories, or the entire
inventory.
Lower of cost or market

Designated By
Market Value Individual By Product By Total
Item Cost Items Line Inventory
A Br 50,000 Br 65,000 Br 50,000
B 100,000 90,000 90,000
Total A + B Br150,000 Br155,000 Br150,000
C Br 80,000 Br 65,000 65,000

D 90,000 56,000 56,000
E 95,000 86,000 86,000
Total C, D & E Br.265,000 Br207,000 207,000
Total Br.415,000 Br.362,000 Br.347,000 Br.357,000 Br.362,000
Estimating Inventories
Companies sometimes need to determine the value of inventory when a physical count is
impossible or impractical. For example, a company may need to know how much inventory
was destroyed in a fire. Companies using the perpetual system simply report the inventory
account balance in such situations, but companies using the periodic
System must estimate the value of inventory. Two ways of estimating inventory levels are
the gross profit method and the retail inventory method.
A. The Gross Profit Method:
Gross profit method (also known as gross margin method) is a technique used to estimate
the value of ending inventory and cost of goods sold of a period on the basis of the historical
or projected gross profit ratio of the business. Gross profit method assumes that gross profit
ratio remains stable during the period.
This method is an alternative to the retail method of inventory estimation and it is usually
used to estimate the value of inventory when the retail values of beginning inventory and
purchases are not available.

A summary of steps in the gross profit method is given below:

1. Calculate the cost of goods available for sale as the sum of the cost of beginning
inventory and cost of net purchases.
2. Determine the gross profit ratio. Gross profit ratio equals gross profit divided by sales.
Use projected gross profit ratio or historical gross profit ratio whichever is more
accurate and reliable.
3. Multiply sales made during the period by gross profit ratio to obtain estimated cost of
goods sold.
4. Calculate the cost of ending inventory as the difference of cost of goods available for
sale and estimated cost of goods sold.
GROSS PROFIT METHOD ILLUSTRATION
Southern Wholesale Company began 2013 with inventory of Br.600, 000, and on March 17 a
warehouse fire destroyed the entire inventory. Company records indicate net purchases of
Br.1, 500,000 and net sales of Br.2, 000,000 prior to the fire. The gross profit percentage in
each of the previous three years has been very close to 40%.
Beginning inventory (from records) Br 600,000

Plus: Net purchases (from records) 1,500,000
Goods available for sale 2,100,000
Less: Cost of goods sold:
Net sales Br2, 000,000
Less: Estimated gross profit of 40% (800,000)
Estimated cost of goods sold* (1,200,000)
Estimated ending inventory Br 900,000
*Alternatively, cost of goods sold can be calculated as Br, 2,000,000 x (1 – .40) = Br1,200,000.
THE RETAIL INVENTORY METHOD

A method that is widely used by merchandising firms to value or estimate ending inventory
using the cost to retail price ratio is the retail method.
Retail method involves the following steps:
1. Determine the retail value of goods available for sale during the period by adding
the retail value of beginning inventory and retail value of goods purchased.
2. Subtract total sales during the period from the retail value of goods available for sale.

3. Calculate the cost to retail price ratio (formula given below).

4. Multiply the difference obtained in 2nd step and the cost to retail ratio to obtain
estimated cost of ending inventory.
Cost to retail ratio is calculated using the following formula:
Cost to Retail Ratio = A+B
C+D
Where,
A is the cost of beginning inventory;
B is the cost of inventory purchased including incidental costs such as freight-in;
C is the retail value of beginning inventory; and
D is the retail value of goods purchased during the period
The formula given above implies that records of a business using the retail method must
show the beginning inventory both at cost and at retail price. Since such information is
readily available to retail merchandising businesses, retailers commonly option to use retail
method to estimate the value of ending inventory.
RETAIL INVENTORY METHOD ILLUSTRATION
Home Improvement Store‘s bank has asked for monthly financial statements as a condition
attached to a loan dated May 31, 2013. To avoid a physical count of inventory, the company
intends to use the retail inventory method to estimate ending inventory and cost of goods
sold for the month.
Cost Retail
Beginning inventory Br 60,000 Br100,000
Plus: Net purchases 287,200 460,000
Goods available for sale 347,200 560,000
Br347,200
Cost-to-retail percentage: = 62%
Br560,000
Less: Net sales (400,000)
Estimated ending inventory at retail Br160,000
Estimated ending inventory at cost (62% x Br160,000) 99,200
Estimated cost of goods sold —
goods available for sale (at cost) minus ending inventory Br248,000
(at cost) equals cost of goods sold

Discussion Questions
1. Why is proper inventory valuation so important?
2. Why does an understated ending inventory understate net income for the period by
the same amount?
3. Why does an error in ending inventory affect two accounting periods?
4. What is the meaning of taking a physical inventory?
5. What is the accountant‘s responsibility regarding taking a physical inventory?
6. Which cost elements are included in inventory? What practical problems arise by
including the costs of such elements?
7. Which accounts that are used under periodic inventory procedure are not used
under perpetual inventory procedure?
8. What is the cost flow assumption? What is meant by the physical flow of goods?
Does a relationship between cost flows and the physical flow of goods exist, or
should such a relationship exist?
9. Why are ending inventory and cost of goods sold the same under FIFO perpetual
and FIFO periodic?
10. Which method of assigning costs to inventory is not permitted under IFRS?
11. Would you agree with the following statement? Reducing the amount of taxes
payable currently is a valid objective of business management and, since LIFO
results in such a reduction, all businesses should use LIFO.
12. What is net realizable value, and how is it used?
13. Why is it acceptable accounting practice to recognize a loss by writing down an item
in inventory to market, but unacceptable to recognize a gain by writing up an
inventory item?
14. Under what conditions would the gross margin method of computing an estimated
inventory yield approximately correct amounts?
15. What are the main reasons for estimating ending inventory?
Multiple Choice Questions

Select the one best answer for each of the following questions.
1. Which one of the following is true for periodic inventory but not true for perpetual?
A. A physical inventory count should be made at least once a year.
B. The Merchandise Inventory account in the year-end trial balance represents ending
inventory.

C. The Inventory account in the year-end trial balance represents beginning inventory.
D. Material freight-in costs should be treated as an inventory cost.
2. Which one of the following should not be included in the ending inventory of the JKL
Company?
A. JKL goods in transit to KLM Company shipped FOB Kent factory
B. Goods in transit to JKL Company that were shipped FOB shipping point
C. Goods sold by the JKL Company and segregated in JKL warehouse while awaiting
pickup by the KLM Company
D. Inventory shipped by JKL Company on consignment basis and held by the
consignee at the balance sheet date
3. Under the gross price method,
A. Purchases discounts are assumed to be taken and recorded when the purchase is
made.
B. The correct inventory cost is recorded regardless of whether purchases discounts are
taken.
C. Purchases discounts are recorded only when not taken.
D. Inventory purchases are recorded at gross prices and discounts are recorded when
taken.
4. Which of the following is not considered inventory?
A. Material used to make products for resale
B. Finished goods awaiting shipment to customers
C. Equipment used to manufacture products for resale
D. All of these items are considered inventory.
5. In a period of decreasing prices, which cost flow assumption will result in the lowest
income?
A. FIFO periodic B. Weighted average
C. Specific identification D. LIFO perpetual
6. The following data are for Jemal Shop for the firstseven months of its fiscal year:
Beginning inventory Birr 53,500
Purchases 75,500
Net sales revenue 93,700
Normal gross profit percent 30%
What is the estimated inventory on hand as determined by the gross profit method?
A. Birr 28,110 B. Birr 63,410
C. Birr 65,590 D. Birr 100,890
7. Inventory at the end of the current year is overstated by Birr 20,000. What effect will this
error have on the following year‘s net income?
A. Net income will be overstated Birr 20,000
B. Net income will be understated Birr 20,000

C. Net income will be correctly stated

D. Net income will be understated Birr 40,000
8. Which of the following systems requires that cost of goods sold be updated each time a
sale is made?
A. Periodic B. Perpetual
C. Both perpetual and periodic D. Neither perpetual or periodic
9. IFRS permits the following methods of assigning costs to inventories
A. FIFO C. Weighted Average
B. LIFO D. Both a and b
10. US GAAP and IFRS classify inventories on the balance sheet as
A. Non-current assets
B. Current assets
C. Current liabilities
D. None of the above
Exercise question
Exercise 1: KLM Company made the following purchases of Product A in its first year of
operations:
Units Unit
Cost
January 2 1,400 @ Birr7.40
March 31 1,200 @ 7.00
July 5 2,400 @ 7.60
November 1 1,800 @ 8.00
The ending inventory that year consisted of 2,400 units. KLM uses periodic inventory
procedure.
1. Compute the cost of the ending inventory using each of the following methods: (i)
FIFO, (ii) LIFO, and (iii) weighted-average.
2. Which method would yield the highest amount of gross margin? Explain why it
does.
Exercise 2: On January 1, 2007 Loren Company had 400 units of inventory on hand at a cost
of Birr12 per unit. The company purchased inventory four times during the year. The
following information relates to the inventory purchases.
March 1 Purchased 300 units @ Birr15
June 1 Purchased 200 units @ Birr 16
August 1 Purchased 250 units @ Birr 17
October 1 Purchased 300 units @ Birr18
Assume Loren Company sold 1000 units of inventory during 2007.
a) Compute the ending inventory and costs of goods sold assuming ABC
Corporation follows IFRS and chose to use the weighted average method.

b) Compute the ending inventory and costs of goods sold assuming ABC
Corporation follows US GAAP and chose to use LIFO.
c) What are the differences in ending inventory and costs of goods sold using
weighted average and LIFO?
Exercise 3: Loudon Company has inventory on hand with a historical cost of Birr 6,000. It
estimates that it would cost Birr 4,500 to replace the inventory. The inventory‘s estimated
selling price is Birr 5,500 and its estimated cost to complete and sell is Birr 500. Assuming
the company‘s normal profit margin is 15%, record the journal entries to write down the
inventory under a) IFRS and b) US GAAP
Exercise 4: Kedir Company takes a physical inventory at the end of each calendar-year
accounting period. Its financial statements for the past few years indicate an average gross
margin on net sales of 30 per cent.
On June 12, a fire destroyed the entire store building and the inventory. The records in a
fireproof vault were intact. Through June 11, these records show:
Merchandise inventory, January 1 Birr 120,000
Merchandise purchases Birr 3,000,000
Purchase returns Birr 36,000
Transportation -in Birr 204,000
Sales Birr 3,720,000
The company was fully covered by insurance and asks you to determine the amount of its
claim for loss of merchandise.
Exercise 5: Basket Ball Company, Inc., records show the following account balances for the
year ending 2010 December 31:
Cost Retail
Beginning inventory Birr 42,000 Birr 57,500
Purchases 25000 37500
Transportation-in 500
Sales 52500
Using these data, compute the estimated cost of ending inventory using the retail method of
inventory valuation.
Group project Questions
Group project 1: In teams of two or three students, interview the manager of a
merchandising company. Inquire about inventory control methods, inventory costing
methods, and any other information about the company‘s inventory procedures. As a team,
write a memorandum to your instructor summarizing the results of the interview. The
heading of the memorandum should include the date, to whom it is written, from whom,
and the subject matter.
Group project 2: In a team of two or three students, locate and visit a nearby retail store that
uses perpetual inventory procedure and periodic inventory system. Investigate how the

system works by interviewing a knowledgeable person in the company. Write a report to

your instructor and make a short presentation to the class on your findings.
Group project 3: With a small group of students, identify and visit a retail store that uses
periodic inventory procedure and uses the retail inventory method for preparing interim
(monthly or quarterly) financial reports. Discover how the retail inventory method is applied
and how the end-of-year inventory amount is calculated. Write a report to your instructor
summarizing your findings.
CHAPTER SEVEN
PLANT ASSETS, NATURAL RESOURCES, AND INTANGIBLE
ASSETS
Overview
Plant assets are long-lived assets because they are expected to last for more than one year.
Long-lived assets consist of tangible assets and intangible assets. Tangible assets have
physical characteristics that we can see and touch; they include plant assets such as buildings
and furniture, and natural resources such as gas and oil. Intangible assets have no physical
characteristics that we can see and touch but represent exclusive privileges and rights to
their owners.
In this section, we will look at the accounting treatment for plant assets, natural resources
and intangible assets.
Nature of Plant Assets
To be classified as a plant asset, an asset must: (1) be tangible, that is, capable of being seen
and touched; (2) have a useful service life of more than one year; and (3) be used in business
operations rather than held for resale. Common plant assets are buildings, machines, tools,
and office equipment. On the balance sheet, these assets appear under the heading
―Property, plant, and equipment‖.
On a classified balance sheet, the asset section contains: (1) current assets; (2) property, plant,
and equipment; and (3) other categories such as intangible assets and long-term

investments. Previous chapters discussed current assets. Property, plant, and equipment are
often called plant and equipment or simply plant assets. Plant assets are long-lived assets
because they are expected to last for more than one year. Long-lived assets consist of
tangible assets and intangible assets.
Determining the Cost of Plant Assets
When a company acquires a plant asset, accountants record the asset at the cost of
acquisition (historical cost). When a plant asset is purchased for cash, its acquisition cost is
simply the agreed on cash price. This cost is objective, verifiable, and the best measure of an
asset‘s fair market value at the time of purchase. Fair market value is the price received for
an item sold in the normal course of business (not at a forced liquidation sale). Even if the
market value of the asset changes over time, accountants continue to report the acquisition
cost in the asset account in subsequent periods.
The acquisition cost of a plant asset is the amount of cost incurred to acquire and place the
asset in operating condition at its proper location. Cost includes all normal, reasonable, and
necessary expenditures to obtain the asset and get it ready for use. Acquisition cost also
includes the repair and reconditioning costs for used or damaged assets as longs as the item
was not damaged after purchase.
Costs not necessary for getting a plant asset ready for use do not increase the asset‘s
usefulness and should not be included as part of the asset‘s account. Examples of such costs
include:
Mistakes in installation
Uninsured theft
Damage during unpacking & installing
Fines for not obtaining proper permits from government agencies
Item What assets are How Determine Assets Cost? Depreci

included? able
Land Raw land, building The cost of land includes its purchase
site, vacant lot,…etc. price and other many other costs
including: real estate commissions, title
search and title transfer fees, title
insurance premiums, existing mortgage
note or unpaid taxes (back taxes)

assumed by the purchaser, costs of No

surveying, clearing, and grading; and
local assessments for sidewalks, streets,
sewers, and water mains.
Land Paving, fencing, The cost associate with the
improve lighting, flag-boles, improvement, i.e., paving costs, fencing
ment sidewalks, etc. Built costs. Include all costs to make ready for
on piece of land. intended use. Yes
Building Factory, store office, Purchase price, architects‘ fees,
etc. engineers‘ fees, insurance costs incurred
during construction, interest on money
borrowed to finance construction,
walkways to and around the building,
sales taxes, repairs and reconditioning Yes
(purchase of existing Building),
modifying for use permits from
government agencies, etc.
Equipme Manufacturing sales taxes, freight, installation, repairs

&reconditioning (purchase of used
nt & Device, office
equipment), insurance while in transit,
Machiner equipment, vehicles assembly, modifying for use, testing for yes
use, permits from government agencies,
y , etc.
etc.
These costs should be recorded by debiting the related plant asset account, such as Land,
Building, or Machinery & Equipment.
To illustrate, Assume that ABC Company purchased new equipment to replace equipment
that it has used for five years. The company paid a net purchase price of Birr 150,000,
brokerage fees of Birr 5,000, legal fees of Birr2, 000, and freight and insurance in transit of
Birr 3,000. In addition, the company paid Birr1, 500 to remove old equipment and Birr2,
000 to install new equipment. ABC would compute the cost of new equipment as follows:
Net purchase price Birr 150,000

Brokerage fees 5,000
Legal fees 2,000

Freight and insurance in transit 3,000

Installation costs 2,000
Total Equipment cost Birr 162,000
The journal entry to record the purchase of the equipment paying Birr 50,000 cash and by
signing a note for the balance would be:
Equipment 162,000
Cash 50,000
Note Payable (162,000–50,000) 152,000
To record purchase of equipment by paying cash and signing note

Lump Sum Purchases plant assets
Sometimes a company buys land and other assets for a lump sum. When land and buildings
purchased together are to be used, the firm divides the total cost and establishes separate
ledger accounts for land and for buildings. This division of cost establishes the proper
balances in the appropriate accounts. This is especially important later because the
depreciation recorded on the buildings affects reported income, while no depreciation is
taken on the land.
Plant assets purchased for lump-sum are therefore recorded at a value calculated using the
following formula:
Fair Value of the Asset
Value of Asset = × Lump sum Paid
Fair Value of all the Assets Purchased
Let‘s look at an example: Assume a company purchases land, machinery and a
building for Birr 4,000,000 cash. The land has a market value of Birr1, 350,000,
machinery of Birr 675,000 and the building for Birr 2,475,000 for a total value of
Birr4, 500,000. We cannot report the assets at market value since the market value is
less than we paid for the assets. We will do a 2-step process to get the cost of each
asset.
Required:
1. Calculate each asset‘s percent of market value (Asset market value / total market
value of all assets).
Asset Appraisal or Market) Value % of MV
Land 1,350,000 /4,500,000 = 30%
Machinery 675,000 /4,500,000 = 15%
Building 2,475,000 /4,500,000 = 55%
Total 4,500,000

2. Calculate the cost of each asset (total price paid for all assets x % of market value)
Asset % of MV Purchase Asset Cost
Price
Land 30% x 4,000,000 Birr 1,200,000
Machinery 15% x 4,000,000 Birr 600,000
Building 55% x 4,000,000 Birr 2,200,000
Total Birr 4,000,000
3. The journal entry to record this purchase for cash would be:

Land 1,200,000
Machinery 600,000
Building 2,200,000
Cash Birr
4,000,000
Self- Exercise: Jemal Company paid Birr 640,000 cash for a tract of land on which it plans to
erect a new warehouse, and paid Birr 8,000 in legal fees related to the purchase. Jemal also
agreed to assume responsibility for Birr 25,600 of unpaid taxes on the property. The
company incurred a cost of Birr 28,800 to remove an old apartment building from the land.
Prepare a schedule showing the cost of the land acquired
Accounting for Depreciation
Companies record depreciation on all plant assets except land. Since the amount of
depreciation may be relatively large, depreciation expense is often a significant factor in
determining net income. For this reason, most financial statement users are interested in the
amount of, and the methods used to compute, a company‘s depreciation expense.
Depreciation is the amount of plant asset cost allocated to each accounting period benefiting
from the plant asset‘s use. Depreciation is a process of allocation, not valuation. Eventually,
all assets except land wear out or become so inadequate or outmoded that they are sold or
discarded; therefore, firms must record depreciation on every plant asset except land. They
record depreciation even when the market value of a plant asset temporarily rises above its
original cost because eventually the asset is no longer useful to its current owner.

Depreciation does not apply to land because its usefulness and revenue-producing ability
generally remain intact over time. In fact, in many cases, the usefulness of land is greater
over time because of the scarcity of good land sites. Thus, land is not a depreciable asset.
During a depreciable asset‘s useful life, its revenue-producing ability declines because of
wear and tear. A delivery truck that has been driven 100,000 miles will be less useful to a
company than one driven only 800 miles. Revenue-producing ability may also decline
because of obsolescence. Obsolescence is the process of becoming out of date before the asset
physically wears out.
Recognizing depreciation on an asset does not result in an accumulation of cash for
replacement of the asset. The balance in Accumulated Depreciation represents the total
amount of the asset‘s cost that the company has charged to expense. It is not a cash fund.
Factors in Computing Depreciation
Cost_ Earlier, we explained the issues affecting the cost of a depreciable asset. All
expenditures necessary to acquire the asset and make it ready for intended use.
Useful life: Useful life is an estimate of the expected productive life, also called service life, of
the asset for its owner. Useful life may be expressed in terms of time, units of activity (such
as machine hours), or units of output. Useful life is an estimate. In making the estimate,
management considers such factors as the intended use of the asset, its expected repair and
maintenance, and its vulnerability to obsolescence. Past experience with similar assets is
often helpful in deciding on expected useful life.
Salvage value: Salvage value is an estimate of the asset‘s value at the end of its useful life.
This value may be based on the asset‘s worth as scrap, residual Value, or on its expected
trade-in value. Like useful life, salvage value is an estimate. In making the estimate,
management considers how it plans to dispose of the asset and its experience with similar
assets.
Depreciation Methods
Depreciation is generally computed using one of the following methods:
I. Straight-line depreciation method
In straight line depreciation method, cost of a fixed asset is reduced uniformly over the
useful life of the asset. Since depreciation expense charged to income statement in each

period is the same, the carrying amount of the asset on balance sheet declines in a straight
line.
Due to its simplicity, straight line method of depreciation is the most commonly used
depreciation method. Accounting principles require companies to depreciate its fixed assets
using method that best reflects the pattern in which the assets are being used. While the
straight-line method is appropriate in many situations, some fixed assets lose more value in
initial years. In such situations other depreciation methods are more appropriate.
Depreciable cost is the cost of the asset less its salvage value. It represents the total
amount subject to depreciation. Under the straight-line method, to determine annual
depreciation expense, we divide depreciable cost by the asset‘s useful life.
Example on 1 Jan 2016, Company A purchased a vehicle costing 82, 00. The company
expects the vehicle to be operational for 5 years at the end of which it can be sold for Birr2,
200. Calculate depreciation expense for the year ended 31 Dec 2016, 2017, 2018, 2019 and
2020.
Beginning of End of
year 1 year 5
| | | |
Year 1 Year 2 Year 3 Year 4 Year 5

Br.8, 200 Br.2, 200
Cost residual
Br.6, 000
The Periodical Depreciation = Cost - Residual value = 8200 – 2,200 = 1200

Useful life 5years
Generally, depreciation is recorded at the end of an accounting period with an adjusting
entry that takes the following form;
Depreciation expense, asset name ………………………………1200
Accumulated depreciation, asset name…………………………………..1200

Example: The XYZ Manufacturing Company purchased a machine for Br.250, 000. The
company expects the service life of the machine to be five years. During that time, it is
expected that the machine will produce 140,000 units. The anticipated residual value is
Br.40, 000. The machine was disposed of after five years of use. Actual production during
the five years of the asset‘s life was:
Year Units Produced
1 24,000
2 36,000
3 46,000
4 8,000
5 16,000
Total 130,000
Straight-line Depreciation Method

Br.250, 000 – Br.40, 000
= Br.42, 000 per year
5 years
Alternatively, we also can compute an annual rate of depreciation. In this case, the rate is
20% (100% / 5 years). When a company uses an annual straight-line rate, it applies the
percentage rate to the depreciable cost of the asset. It shows a depreciation schedule using an
annual rate.
Computation Annual End of Year
Depreciation
Depreciable X = Accumulated Book value
Expense
Depreciable Depreciation
Year
cost Rate
1 210,000 20% Br.42000 = 42000 208000
2 210,000 20% 42000 = 84000 166000
3 210,000 20% 42000 = 126000 124000
4 210,000 20% 42000 = 168000 82000
5 210,000 20% 42000 = 210,000 40,000
*Book Value = Cost - Accumulated depreciation= 250000-210000= 40000
Note that the depreciation expense of Br.42, 000 is the same each year. The book value
(computed as cost minus accumulated depreciation) at the end of the useful life is equal to
the expected Br.40, 000 salvage value.

Example: What happens to these computations for an asset purchased during the year,
rather than on January 1? In that case, it is necessary to prorate the annual depreciation on a
time basis. XYZ had purchased the machine on April 1, 2013; The Company would own the
machine for nine months of the first year (April–December).
Thus, depreciation for 2013 would be 31500 (210,000 X 20% X 9/12 of a year).
UNITS-OF-ACTIVITY
Under the units-of-activity method, useful life is expressed in terms of the total units of
production or use expected from the asset, rather than as a time period. The unit of activity
method is ideally suited to factory machinery. Manufacturing companies can measure
production in units of output or in machine hours. This method can also be used for such
assets as delivery equipment (miles driven) and airplanes (hours in use). The units-of-
activity method is generally not suitable for buildings or furniture, because depreciation for
these assets is more a function of time than of use.
To use this method, companies estimate the total units of activity for the entire useful life,
and then divide these units into depreciable cost. The resulting number represents the
depreciation cost per unit. The depreciation cost per unit is then applied to the units of
activity during the year to determine the annual depreciation expense.
The following shows the units-of-activity formula and the computation of the first year‘s
depreciation expense.
Depreciable / Total Unit of = Depreciable
Cost Activity Cost per unit
Depreciable x Units of Annual Depreciable
Cost per unit Activity during the = Expense
Year
The units-of-activity depreciation schedule is as follows
Units Depreciation Book Value

Year Produced X Rate per Unit = Depreciation End of Year
1 24,000 Br1.50* Br 36,000 Br214,000
2 36,000 1.50 54,000 160,000
3 46,000 1.50 69,000 91,000
4 8,000 1.50 12,000 79,000
5 16,000 ** 39,000 ** 40,000
Totals 130,000 Br210,000

* Br250,000 – Birr 40,000

= Br1.50 per unit
140,000 units
** Amount necessary to reduce book value to residual value
DECLINING-BALANCE (Accelerated depreciation method)

The declining-balance method produces a decreasing annual depreciation expense over the
asset‘s useful life. The method is so named because the periodic depreciation is based on a
declining book value (cost less accumulated depreciation) of the asset. With this method,
companies compute annual depreciation expense by multiplying the book value at the
beginning of the year by the declining-balance depreciation rate. The depreciation rate
remains constant from year to year, but the book value to which the rate is applied declines
each year.
At the beginning of the first year, book value is the cost of the asset. This is so because the
balance in accumulated depreciation at the beginning of the asset‘s useful life is zero. In
subsequent years, book value is the difference between cost and accumulated depreciation to
date. Unlike the other depreciation methods, the declining-balance method does not use
depreciable cost. That is, it ignores salvage value in determining the amount to which the
declining-balance rate is applied.
Salvage value, however, does limit the total depreciation that can be taken. Depreciation
stops when the asset‘s book value equals expected salvage value.
The double declining balance method requires a 3-step process:
 Step 1: Calculate the Straight line (S/L) rate
S/L rate = 1 / useful life in years
 Step 2: Calculate the double declining (DD) rate

DD rate = 2 x S/L rate calculated in Step 1
 Step 3: Calculate Depreciation Expense

Depreciation Expense = Beginning Book Value x DD rate
Remember, book value is calculated as Asset Cost – Accumulated Depreciation.
A common declining-balance rate is double the straight-line rate. The method is often called
the double-declining-balance method. If XYZ Company uses the double-declining-balance
method, it uses a depreciation rate of 40% (2 x the straight-line rate of 20%).

Book Value at Declining- Annual

Beginning of Year X Balance Rate = Depreciable
Expense
The depreciation schedule under this method is as follows.
Book Value
Beginning of Depreciation Book Value
Year Year X Rate per Year = Depreciation End of Year
1 Birr250,000 40% Birr 100,000 Birr150,000
2 150,000 40% 60,000 90,000
3 90,000 40% 36,000 54,000
4 54,000 * 14,000 * 40,000
5 40,000 -- 40,000
Total Birr210,000
* Amount necessary to reduce book value to residual value
Because the declining-balance method produces higher depreciation expense in the early
years than in the later years, it is considered an accelerated-depreciation method. It matches
the higher depreciation expense in early years with the higher benefits received in these
years. It also recognizes lower depreciation expense in later years, when the asset‘s
contribution to revenue is less. Some assets lose usefulness rapidly because of obsolescence.
In these cases, the declining-balance method provides the most appropriate depreciation
amount.
When a company purchases an asset during the year, it must prorate the first year‘s
declining-balance depreciation on a time basis. For example, XYZ had purchased the
Machine on April 5, 2013; depreciation for 2013 would become 75,000 (Br250, 000 X 40% X
9/12). The book value at the at the end of 2013 is then 150,000(Br.250, 000 – Br.100, 000).
The sum-of- the years-digits method of deprecation
The sum-of-the-years'-digits method multiplies depreciable base by a declining fraction
whose denominator is the constant sum of the digits from one to n where n is the number of
years in the asset's service life.
Similar to decline balance method, the sum of the year‘s digit method is also accelerated
methods of depreciation and produces declining periodic depreciation by applying a
declining fraction each period to the depreciation base, initial 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 XYZ company sum-of- the years-digits
method is as follows:
Year Depreciable Depreciation Depreciation Book Value

Base Rate per Year Expense End of Year
x =
1 Br210,000 x 5/15* = Br70,000 Br180,000
2 210,000 x 4/15 = 56,000 124,000
3 210,000 x 3/15 = 42,000 82,000
4 210,000 x 2/15 = 28,000 54,000
5 210,000 x 1/15 = 14,000 40,000
Totals 15/15 210,000
* n(n+1) = = 5(5+1) = 15
2 2
Remaining Useful Life
SYD Depreciation = Depreciable Base ×
Sum of the Years' Digits
In the above formula, depreciable base is the difference between cost and salvage value of the
asset and sum of the years' digits is the sum of the series: 1, 2, 3, ... , n ; where n is the useful life
of the asset in years.
Depreciation and Income Taxes
The Internal Revenue Service (IRS) allows corporate taxpayers to deduct depreciation
expense when they compute taxable income. However, the IRS does not require the
taxpayer to use the same depreciation method on the tax return that is used in preparing
financial statements.
Many corporations use straight-line in their financial statements to maximize net income. At
the same time, they use a special accelerated-depreciation method on their tax returns to

minimize their income taxes. Taxpayers must use on their tax returns either the straight-line
method or a special accelerated-depreciation method called the Modified Accelerated Cost
Recovery System (MACRS).
GROUP AND COMPOSITE DEPRECIATION
Group and composite depreciation methods aggregate assets in order to reduce the record
keeping costs of determining periodic depreciation.
Depreciation methods are usually applied to a single asset. Under some circumstances,
however, a number (group) of asset accounts are depreciated using one rate. For example, an
enterprise such as Ethiopian Telecommunication Corp. might depreciate telephone poles,
microwave systems, or switchboards by groups.
Group depreciation - the term ―group‖ refers to a collection of assets that are similar in
nature. The group method is frequently used when the assets are fairly homogeneous and
have approximately the same useful lives. The group method more closely approximates a
single-unit cost procedure because the dispersion from the average is not as great.
Composite-rate depreciation - the term ―composite‖ refers to collection of assets that are not
similar (or dissimilar) in nature.
The composite method is used when the assets are heterogeneous and have different lives.
When depreciation is computed on the basis of a composite group of assets of differing life
spans, a rate based on averages must be developed. This is done by
 Computing the annual depreciation for each asset,
 Determining the annual depreciation, and
 Dividing the sum thus determined by the total cost of the assets.
The Express Delivery Company began operations in 2013. It will depreciate its fleet of
delivery vehicles using the group method. The costs of vehicles purchased early in 2013,
along with residual values, estimated lives, and straight-line depreciation per year by
type of vehicle are as follows:
Depreciation
Residual Depreciable Estimated per Year
Asset Cost Value Base Life (yrs.) (straight line)

Vans 150,000 30,000 120,000 6 20,000

Trucks 120,000 16,000 104,000 5 20,800
Wagons 60,000 12,000 48,000 4 12,000
Totals 330,000 58,000 272,000 52,800
The group depreciation rate is determined by dividing the depreciation per year by the total
cost. The group‘s average service life is calculated by dividing the depreciable base by the
depreciation per year.
Group depreciation rate = __52,800__ =16%
330,000
Average service life = 272,000 = 5.15 years (rounded)
52,800
If there are no changes in the assets contained in the group, depreciation of Br.52, 800 per
year (16% x Br.330, 000) will be recorded for 5.15 years.
Self-Exercise On 2009 January 2, a new machine was acquired for Birr900, 000. The
machine has an estimated salvage value of Birr 100,000 and an estimated useful life of 10
years. The machine is expected to produce a total of 500,000 units of product throughout its
useful life. Compute depreciation for 2009 and 2010 using each of the following methods:
1. Straight line.
2. Units of production (assume 30,000 and 60,000 units were produced in 2009 and 2010,
respectively).
3. Double-declining balance.
Revising Periodic Depreciation

Depreciation is one example of the use of estimation in the accounting process. Management
should periodically review annual depreciation expense. If wear and tear or obsolescence
indicates that annual depreciation estimates are inadequate or excessive, the company
should change the amount of depreciation expense.
When a change in an estimate is required, the company makes the change in current
and future years. It does not change depreciation in prior periods. The rationale is that
continual restatement of prior periods would adversely affect confidence in financial
statements.

To determine the new annual depreciation expense, the company first computes the
asset‘s depreciable cost at the time of the revision. It then allocates the revised depreciable
cost to the remaining useful life.
Example: Chambers Corporation purchased a piece of equipment for Br.36, 000. It
estimated a 6-year life and Br.6, 000 salvage value. Thus, straight-line depreciation was Br.5,
000 per year (Br.36, 000 – Br.6, 000) / 6). At the end of year three (before the depreciation
adjustment), it estimated the new total life to be 10 years and the new salvage value to be
Br.2, 000. Compute the revised depreciation.
Original depreciation expense 5 [(Br.36, 000 – Br.6, 000) / 6] = Br. 5,000
Accumulated depreciation after 2 years = 2 XBr.5, 000 = Br.10, 000
Book value = Br.36, 000 – Br.10, 000 =Br.26, 000
Book value after 2 years of depreciation Br.26, 000
Less: New salvage value 2,000
Depreciable cost 24,000
Remaining useful life 8 years
Revised annual depreciation (Br24, 000 / 8) 3,000
Exercise: Jemal Company acquired a delivery truck on 2009 January 2, for Birr 107,200.
The truck had an estimated salvage value of Birr 4,800 and an estimated useful life of eight
years. At the beginning of 2009, a revised estimate shows that the truck has a remaining
useful life of six years. The estimated salvage value changed to Birr 1,600.
Compute the depreciation charge for 2009 and the revised depreciation charge for 2009
using the straight-line method.
Expenditures subsequent to acquisition cost of plant asset

Classification of expenditure as capital expenditure or revenue expenditure depends on the
applicable accounting framework and materiality level adopted by the company.The
distinction between the nature of capital and revenue expenditure is important as only
capital expenditure is included in the cost of fixed asset.
Capital expenditure is expenditure that is expected to generate economic benefits for a
company in more than one period. Following are examples of capital expenditure: Purchase
of vehicles, Construction of buildings, Improvements to land, Licenses, patents and copy
rights, Purchase of office equipment, Development of computer software. Unlike capital

expenditure, revenue expenditure, which is recorded as an expense in income statement,

capital expenditure is recorded as an asset in balance sheet and depreciated/amortized over
its useful life using any of the acceptable depreciation/amortization methods. As capital
expenditure results in increase in the fixed asset of the entity, the accounting entry is as
follows:
August Plant Asset xx
Cash/payable xx
Capital expenditure involving purchase

August Capital work-in-progress xx
Accounts Payable/Cash xx
Long-lived asset xx
Capital work-in-progress xx
Capital expenditure involving construction:

August Depreciation/amortization xx
Accumulated depreciation/amortization xx
Depreciation/amortization of a capitalized asset:
Revenue Expenditure: Revenue expenditure incurred on fixed assets includes costs that are
aimed at 'maintaining' rather than enhancing the earning capacity of the assets. These are
costs that are incurred on a regular basis and the benefit from these costs is obtained over a
relatively short period of time. For example, a company buys a machine for the production
of biscuits. Whereas the initial purchase and installation costs would be classified as capital
expenditure, any subsequent repair and maintenance charges incurred in the future will be
classified as revenue expenditure. This is so because repair and maintenance costs do not
increase the earning capacity of the machine but only maintains it (i.e. machine will produce

the same quantity of biscuits as it did when it was first put to use). Following are examples of
capital expenditure: Repair costs, Maintenance charges, Repainting costs, Renewal expenses
etc. As revenue costs do not form part of the fixed asset cost, they are expensed in the
income statement in the period in which they are incurred. The accounting entry to record
revenue expenditure is therefore as follows:
August Revenue Expense xx
Cash/Payable xx
If the improvement does not result in an increase in useful life, account for it as an addition;
that is, debit the asset account. In comparing the handling of expenditures for assets, note
that a repair expense goes directly to the income statement, whereas, additions and
improvements add to the cost of the asset.
The Disposition of Depreciable Assets
All plant assets except land eventually wear out or become inadequate or obsolete and must
be sold, retired, or traded for new assets. When disposing of a plant asset, a company must
remove both the asset‘s cost and accumulated depreciation from the accounts. Overall, then,
all plant asset disposals have the following steps in common: Bring the asset‘s depreciation
up to date. Record the disposal by:
 Writing off the asset‘s cost.
 Writing off the accumulated depreciation.
 Recording any consideration (usually cash) received or paid or to be received or paid.
 Recording the gain or loss, if any.
In this section, you should focus upon the book value of the asset at the time of disposal. It is
the book value (Asset cost minus Accumulated Depreciation) that is compared to assets
received, if any, to determine if a gain or loss occurred.
Methods of plant asset disposal are:
I. Retirement of the Asset -- the Asset is discarded or thrown away and nothing is
received;
II. Sale of the Asset -- Cash or other assets will be received;
III. Exchange of the Asset -- for a similar one, or a different type of noncash asset.
Cash might be paid in addition to giving up the old asset.

The time at which the disposal occurs may be at the beginning, middle, or end of the year. If
the disposal is not at the end of the year, you must remember to record any depreciation for
the asset up to the time of the disposal. Depreciation usually occurs with the passage of time,
and if depreciation is not updated, the Asset's book value and the resulting gain or loss will
be misstated.
A.Retirement of Plant Assets

To illustrate the retirement of plant assets, assume that Hobart Enterprises retires its
computer printers, which cost Br.32, 000. The accumulated depreciation on these printers is
Br.32, 000. The equipment, therefore, is fully depreciated (zero book value).
The entry to record this retirement is as follows.
August Accumulated Depreciation—Equipment 32,000
Equipment 32,000
(To record retirement of fully depreciated equipment)
If a company retires a plant asset before it is fully depreciated, and no cash is received for
scrap or salvage value, a loss on disposal occurs.
For example, assume that Sunset Company discards delivery equipment that cost Br.18, 000
and has accumulated depreciation of Br.14, 000. The entry is as follows
August Accumulated Depreciation—Equipment 14,000
Loss on Disposal of Plant Assets 4000
Equipment 18,000
(To record retirement of delivery equipment at a loss)
 Companies report a loss on disposal of plant assets in the ―Other expenses and losses‖
section of the income statement.
B. Sale of Plant Assets
In a disposal by sale, the company compares the book value of the asset with the proceeds
received from the sale.

 If the sale price exceeds the book value of the plant asset, a gain on disposal occurs.
 If the sale prices are less than the book value of the plant asset sold, a loss on disposal
occurs.
 Of course, when the sales price equals the asset‘s book value, no gain or loss occurs.
Only by coincidence will the book value and the fair value of the asset be the same
when the asset is sold. Gains and losses on sales of plant assets are therefore quite
common.
To illustrate accounting for the sale of a plant asset, assume that a company sells equipment
costing Birr 45,000 with accumulated depreciation of Birr14, 000 for Birr 28,000 cash. The
company would realizes a loss of Birr3, 000 (Birr45, 000 cost – Birr14,000 accumulated
depreciation is Birr 31,000 book value— Birr 28,000 sales price). The journal entry to record
the sale is:
August Cash 28,000
Accumulated Depreciation—Equipment 14,000
Loss from Disposal of Plant Asset 3,000
Equipment 45,000
To record the sale of equipment at a price less than book value.
Another illustrates a gain on sale of plant assets; assume that on July 1, 2016, XYZ
Company sells office furniture for Br.16, 000 cash. The office furniture originally cost Br.60,
000. As of January 1, 2016, it had accumulated depreciation of Br.41, 000. Depreciation for
the first six months of 2012 is Br.8, 000. XYZ records depreciation expense and updates
accumulated depreciation to July 1 with the following entry.
July 1, Depreciation Expense 8,000
To record depreciation expense for the first 6 months of 2016
After the accumulated depreciation balance is updated, the company computes the gain or
loss. The gain or loss is the difference between the proceeds from the sale and the book value

at the date of disposal. Illustration above shows this computation for XYZ Company, which
has a gain on disposal of Br.5, 000.
Cost of office furniture Birr 60,000
Less: Accumulated depreciation (Br.41, 000 + Br8, 000) 49,000
Book value at date of disposal 11,000
Selling price of equipment 16,000
Gain on disposal of plant asset 5,000
XYZ records the sale and the gain on disposal of the plant asset as follows,
August Cash 16,000
Equipment 60,000
Gain on Disposal of Plant Assets 5,000
To record the sale of equipment at a price above than book value.
Example: To illustrate a loss on sale of plant assets, assume that instead of selling the office
furniture for Br.16, 000, Wright sells it for Br.9, 000. In this case, XYZ computes a loss of
Br.2, 000 as follows.
Cost of office furniture 60,000
Less: Accumulated depreciation 49,000
Book value at date of disposal 11,000
Proceeds from sale 9,000
Loss on disposal of plant asset 2,000
XYZ records the sale and the loss on disposal of the plant asset as follows.
August Cash 9,000
Loss from Disposal of Plant Asset 2,000
Equipment 60,000
To record the sale of equipment at a price less than book value.
Note that Companies report a loss or gain on disposal of plant assets in the ―Other expenses
and losses‖ section of the income statement.

Self-Exercise: AB trucking has an old truck that cost Br.30, 000, and it has accumulated
depreciation of Br.16, 000 on this truck. AB has decided to sell the truck.
i. What entry would AB trucking make to record the sale of the truck for Br.17, 000 cash?
ii. What entry would AB trucking make to record the sale of the truck for Br.10, 000 cash?
iii. What entry would AB trucking make to record the sale of the truck for Br.14, 000 cash?
C.Exchange of depreciable assets:

Certain types of assets, particularly vehicles and large pieces of equipment, are frequently
exchanged for other tangible assets. For example, an old vehicle and a negotiated amount of
cash may be exchanged for a new vehicle.
There are two types of exchanges: similar exchanges and dissimilar exchanges. A similar
exchange involves the exchange of one asset for another asset that performs the same type of
function. Trading in an old delivery truck to purchase a new delivery truck is an example of
a similar exchange. A dissimilar exchange, which is less common than a similar exchange,
involves the exchange of one asset for another asset that performs a different function.
Trading in an old truck for a forklift is an example of a dissimilar exchange. A dissimilar
exchange, which is less common than a similar exchange, involves the exchange of one asset
for another asset that performs a different function. Trading in an old truck for a forklift is an
example of a dissimilar exchange.
When the trade-in allowance exceeds the book value of an asset traded in and no gain is
recognized, the cost recorded for the new asset can be determined in either of two ways:
1. Cost of new asset = List price of new asset _ Unrecognized gain or
2. Cost of new asset = Cash given (or liability assumed) _ Book value of old asset
To illustrate, assume the following exchange

Similar equipment acquired (new): Equipment traded in (old):
List price of new equipment xx Cost of old equipment. xx
Add :Trade-in allowance on old Less :Accumulated depreciation at
equipment xx date of exchange ( xx)
Cash paid at date of exchange xxx Book value at date of exchange. XX

Recorded cost of new equipment:

Method One: Method Two:
List price of new equipment xx Book value of old equipment. xx
Trade-in allowance. xx Add: Cash paid at date of exchange xx
Book value of old equipment. (xx) Cost of new equipment xx
Unrecognized gain on exchange (xx)
Cost of new equipment. xx
Example: Suppose a Br.90, 000 delivery truck with a net book value of Br.10, 000 is
exchanged for a new delivery truck. The company receives a Br.6, 000 trade‐in allowances
on the old truck and pays an additional Br.95, 000 for the new truck, so a loss on exchange of
Br.4, 000 must be recognized.
Cost of Truck Traded In Br.90,000
Less: Accumulated Depreciation (80,000)
Net Book Value 10,000
Trade-in Value (6,000)
Loss on Exchange Br.4,000
The cost of the new truck is Br.101, 000 (Br.95, 000 cash + Br.6, 000 trade‐in allowance).
Therefore, the exchange is recorded by debiting vehicles for Br.101, 000 (to record the new
truck's cost), debiting accumulated depreciation‐vehicles for Br.80, 000 (to remove the old
truck's accumulated depreciation from the books), debiting loss on exchange of vehicles for
Br.4, 000, crediting vehicles for Br.90, 000 (to remove the old truck from the books), and
crediting cash for Br.95, 000.
August Vehicles (new) 101,000
Accumulated depreciation -vehicles(old) 80,000
Loss on exchange of vehicles-Vehicles (old) 4,000
Cost of Vehicles (old) 90,000
Cash 95,000
If the company exchanges its used truck for a forklift, receives a Br.6, 000 trade‐in allowance,
and pays Br.20,000 for the forklift, the loss on exchange is still Br.4, 000. Assuming the

company uses a separate account to record the cost of forklifts, the journal entry to record
this dissimilar exchange debits forklifts for Br.26,000, debits accumulated depreciation‐
vehicles for Br.80,000, debits loss on exchange of vehicles for Br.4,000, credits vehicles for
Br.90,000, and credits cash for Br.20,000.
August Forklifts (new) 26,000
Loss on exchange of vehicles 4,000
Vehicles 90,000
Cash 20,000
Exchange old truck for new forklift
 If the company receives a Br12, 000 trade‐in allowances, a gain of Br 2,000 occurs.
Cost of Truck Traded In Birr90,000
Less: Accumulated Depreciation (80,000)
Net Book Value 10,000
Trade-in Value (12,000)
Gain on Exchange (Br 2,000)
Gains on similar exchanges are handled differently from gains on dissimilar exchanges. On a
similar exchange, gains are deferred and reduce the cost of the new asset. For example, after
receiving a Br.12,000 trade‐in allowance on a delivery truck with a net book value of
Br.10,000 and paying Br.89,000 in cash for a new delivery truck, the company records the
cost of the new truck at Br.99,000 instead of Br.101,000. The Br.99, 000 cost of the new
truck equals the Br.12, 000 trade‐in allowances plus the Br.89, 000 cash payment minus the
Br.2, 000 gains. Since the Br.12, 000 trade‐in allowances minus the Br.2,000 gain equals the
old truck's net book value of Br.10,000, however, it is easier to think of the Br.99,000 cost as
being equal to the old truck's net book value of Br.10,000 plus the Br.89,000 paid in cash. To
record this exchange, the company debits vehicles for Br.99, 000 (to record the new truck's
recognized cost), debits accumulated depreciation‐vehicles for Br.80, 000 (to remove the old
truck's accumulated depreciation from the books), credits vehicles for Br.90, 000 (to remove
the old truck from the books), and credits cash for Br.89, 000.


August Vehicles (new) 99,000
Cost of Vehicles (old) 90,000
Cash 89,000
Exchange old truck for new truck
Gains on dissimilar exchanges are recognized when the transaction occurs. After receiving a
Br.12, 000 trade‐in allowances on a truck with a Br.10, 000 net book value and paying Br.14,
000 in cash for a forklift, the company debits forklifts for Br.26, 000, debits accumulated
depreciation‐vehicles for Br. 80,000, credits vehicles for Br.90, 000, credits cash for Br.14,
000, and credits gain on exchange of vehicles for Br.2, 000.
August forklifts 26,000
Accumulated depreciation -vehicles(old 80,000
Vehicles 90,000
Cash 14000
Gain on exchange of vehicles 2,000
Exchange old truck for new forklifts
Exercise: An old machine and additional cash of Br 48,000 to be exchanged by anew similar
machine that has fair market value of Br 55,000. The old machine had acquisition cost of Br
50,000 and accumulated depreciation of Br 40,000.
Required:
1. Determine the amount of trade in allowance, boot given and gain/ loss
2. Record the exchange transaction if boot given was;
A. Br 48,000
B. Br 45,000
C. Br 42,000

Note: Accounting for plant assets involving cost determination, depreciation, additional
expenditures, and disposals of plant assets is subject to broadly similar guidance for both
U.S. GAAP and IFRS. There is one area where notable differences exist, and that is in
accounting for changes in the value of plant assets (between the time they are acquired and
disposed of).
NATURAL RESOURCES
Resources supplied by nature, such as ore deposits, mineral deposits, oil reserves, gas
deposits, and timber stands, are natural resources or wasting assets. Natural resources
represent inventories of raw materials that can be consumed (exhausted) through extraction
or removal from their natural setting (e.g. removing oil from the ground).
Plant assets and natural resources are tangible assets used by a company to produce
revenues. On the income statement, depreciation expense is recorded for plant assets and
depletion expense is recorded for natural resources. On the balance sheet, accumulated
depreciation appears with the related plant asset account and accumulated depletion appears
with the related natural resource account.
The acquisition cost of a natural resource is the price needed to acquire there source and
prepare it for its intended use. For an already-discovered resource, such as an existing coal
mine, cost is the price paid for the property.
The allocation of the cost of natural resources to expense in a rational and systematic manner
over the resource‘s useful life is called depletion. (That is, depletion is to natural resources as
depreciation is to plant assets.) The reason is that depletion generally is a function of the
units extracted during the year.
Under the units-of-activity method, companies divide the total cost of the natural resource
minus salvage value by the number of units estimated to be in the resource. The result is a
depletion cost per unit of product. They then multiply the depletion cost per unit by the
number of units extracted and sold. The result is the annual depletion expense

The formula to compute depletion expense
Total Cost minus Salvage value /Total Depletion Estimated units = depletion cost per unit
Depletion cost x number units extracted = Annual Depletion Expense 0r

Per unit and sold
Cost − Salvage Value
Depletion Expense = × Number of Units Ex racted
Estimated Number of Units
Example: To illustrate, assume that Gemechu Coal Company invests Br .5 million in a mine
estimated to have 10 million tons of coal and no salvage value. In the first year, Gemechu
extracts and sells 800,000 tons of coal. Using the formulas above, Gemechu computes the
depletion expense as follows:
Br 5,000,000 / 10,000,000 = Br. 0.50 depletion cost per ton
Br 0.50 x 800,000 = Br.400, 000 (Annual depletion expense)
Gemechu records depletion expense for the first year of operation as follows.
Dec. 31, Depletion Expense 400,000
Accumulated depletion 400,000
(To record depletion expense on coal deposits
The company reports the account Depletion Expense as a part of the cost of producing the
product. Accumulated Depletion is a contra-asset account, similar to accumulated
depreciation. It is deducted from the cost of the natural resource in the balance sheet.
Gemechu coal company bb
B Balance sheet (partial years)
Coal mine Br.5, 000,000

Less: Accumulated depletion (400,000)
Book value coal 4,600,000
Many companies do not use an Accumulated Depletion account. In such cases, the
company credits the amount of depletion directly to the natural resources account.
Sometimes, a company will extract natural resources in one accounting period but not sell
them until a later period. In this case, the company does not expense the depletion until it
sells the resource. It reports the amount not sold as inventory in the current assets section.

Accounting for Intangible Assets

Although they have no physical characteristics, intangible assets have value because of the
advantages or exclusive privileges and rights they provide to a business. Intangible assets
generally arise from two sources:
1. Exclusive privileges granted by governmental authority or by legal contract, such as
patents, copyrights, franchises, trademarks and trade names, and leases; and
2. Superior entrepreneurial capacity or management know-how and customer loyalty,
which is called goodwill.
All intangible assets are nonphysical, but not all nonphysical assets are intangibles. For
example, accounts receivable and prepaid expenses are nonphysical, yet classified as current
assets rather than intangible assets. Intangible assets are generally both nonphysical and
noncurrent; they appear in a separate long-term section of the balance sheet entitled
―Intangible assets‖.
Companies record intangible assets at cost. Intangibles are categorized as having either a
limited life or an indefinite life. If an intangible has a limited life, the company allocates its
cost over the asset‘s useful life using a process similar to depreciation. The process of
allocating the cost of intangibles is referred to as amortization. The cost of intangible assets
with indefinite lives should not be amortized.
Amortization is the systematic write-off of the cost of an intangible asset to expense. A
portion of an intangible asset‘s cost is allocated to each accounting period in the economic
(useful) life of the asset. All intangible assets are not subject to amortization.
Straight-line amortization is calculated the same was as straight-line depreciation for plant
assets. Generally, we record amortization by debiting Amortization Expense and crediting
the intangible asset account. An accumulated amortization account could be used to record
amortization. However, the information gained from such accounting would not be
significant because normally intangibles do not account for as many total asset dollars as do
plant assets.
Example: To illustrate the computation of patent amortization, assume that National Labs
purchases a patent at a cost of Br.60, 000. If National estimates the useful life of the patent to
be eight years, the annual amortization expense is Br.7, 500 (Br.60, 000 / 8). National
records the annual amortization as follows.

Dec. 31, Amortization Expense 7,500

Patents 7,500
(To record patent amortization)
Companies classify Amortization Expense as an operating expense in the income statement.
There is a difference between intangible assets and plant assets in determining cost. For
plant assets, cost includes both the purchase price of the asset and the costs incurred in
designing and constructing the asset. In contrast, cost for an intangible asset includes only
the purchase price. Companies expense any costs incurred in developing an intangible asset.
A patent is a right granted by the federal government. This exclusive right enables the
owner to manufacture, sell, lease, or otherwise benefit from an invention for a limited period.
The value of a patent lies in its ability to produce revenue. Patents have a legal life of 17
years. Protection for the patent owner begins at the time of patent application and lasts for
17 years from the date the patent is granted. When purchasing a patent, a company records
it in the Patents account at cost.
A copyright is an exclusive right granted by the federal government giving protection
against the illegal reproduction by others of the creator‘s written works, such as a song, film,
painting, photograph, or book designs, and literary productions. The finite useful life for a
copyright extends to the life of the creator plus 50 years. Most publications have a limited
(finite) life; a creator may amortize the cost of the copyright to expense on a straight-line
basis or based upon the pattern in which the economic benefits are used up or consumed.
A trademark is a symbol, design, or logo used in conjunction with a particular product or
company. A trade name is a brand name under which a product is sold or a company does
business. Often trademarks and trade names are extremely valuable to a company, but if
they have been internally developed, they have no recorded asset cost. However, when a
business purchases such items from an external source, it records them at cost and amortizes
them over their finite useful life.
A lease is a contract to rent property. The property owner is the grantor of the lease and is
the lessor. The person or company obtaining rights to possess and use the property is the
lessee. The rights granted under the lease are leasehold. The accounting for a lease depends
on whether it is a capital lease or an operating lease.

Good will is an intangible asset that arises at the time of business acquisition when the price
paid for the business exceeds the fair value of the net identifiable assets.
In most cases a business is worth more than the replacement cost of its net identifiable assets
and that is why the acquiring company pays more than the fair value of the acquired
company's net identifiable assets. At the time of acquisition, the fair value of the acquired
company's assets and liabilities are added to the fair value of acquiring company's assets and
liabilities. The excess of price over the fair value of net identifiable assets (assets minus
liabilities) is recorded as a separate asset called goodwill.
It is an asset because it represents the economic value which is not captured by other assets
for example the reputation of the business, the value of its human capital, its future growth
potential, its professional management, etc.
In recording the purchase of a business, the company debits (increases) the identifiable
acquired assets, and credits liabilities at their fair values, credits cash for the purchase price,
and record the difference as goodwill. Goodwill is not amortized because it is considered to
have an indefinite life. Companies report goodwill in the balance sheet under intangible
assets.
Illustration that, Company AB purchases Company XY for Birr 15 Million and the
statements of financial positions of Company AB and Company XY with their book values
and fair values are given below (all amounts are in Birr '000').
Book Value Fair Value
Company A Company B Company A Company B
Assets
PPE 30,000 15,000 35,000 17,000
Trade Receivables 5,000 4,500 4,900 4,000
Cash 18,000 2,000 18,000 2,000
Total 53,000 21,500 57,900 23,000
Liabilities and Equity
Long-term Liabilities 19,000 8,000 18,000 7,500
Current Liabilities 8,000 4,000 7,500 4,500
Equity 26,000 9,500 32,400 11,000
Total 53,000 21,500 57,900 23,000
The goodwill on acquisition of Company XY is calculated below:
Price paid for Company B 15,000
Fair Value of Company B's Net Assets:

PPE 17,000
Trade Receivables 4,000
Cash 2,000
Long-term liabilities − 7,500
Current liabilities − 4,500
− 11,000
Goodwill 4,000
The statement of financial position of Company AB after acquisition would show the
goodwill Birr 4 million as an asset.
Assets:
Goodwill 4,000
PPE 47,000
Trade Receivables 9,000
Cash 5,000
IFRS A Total 65,000 Look at IFRS
Liabilities and Equity:
IFRS Long-term Liabilities 26,500 follows most of the same principles as GAAP in
the Current Liabilities 12,500 accounting for property, plant, and equipment.
Equity 26,000
There Total 65,000 are, however, some significant differences in the
implementation: IFRS allows the use of revaluation of property, plant, and equipment, and
it also requires the use of component depreciation. In addition, there are some significant
differences in the accounting for both intangible assets and impairments.
Key Points
The definition for plant assets for both IFRS and GAAP is essentially the same.
 Both international standards and GAAP follow the cost principle when accounting
for property, plant, and equipment at date of acquisition. Cost consists of all
expenditures necessary to acquire the asset and make it ready for its intended use.
 Under both IFRS and GAAP, interest costs incurred during construction are
capitalized. Recently, IFRS converged to GAAP requirements in this area.
 IFRS, like GAAP, capitalizes all direct costs in self-constructed assets such as raw
materials and labor. IFRS does not address the capitalization of fixed overhead,
although in practice these costs are generally capitalized.
 IFRS also views depreciation as an allocation of cost over an asset‘s useful life. IFRS
permits the same depreciation methods (e.g., straight-line, accelerated, and units-of-
activity) as GAAP. However, a major difference is that IFRS requires component

depreciation. Component depreciation specifies that any signify cant parts of a

depreciable asset that have different estimated useful lives should be separately
depreciated. Component depreciation is allowed under GAAP but is seldom used.
Example: To illustrate, assume that Allahmudin Construction builds an office building for
Br.4, 000,000, not including the cost of the land. If the Br.4, 000,000 is allocated over the 40-
year useful life of the building, Allahmudin reports Br.100, 000 of depreciation per year,
assuming straight-line depreciation and no disposal value. However, assume that Br.320,
000 of the cost of the building relates to personal property and Br.600, 000 relates to land
improvements. The personal property has a depreciable life of 5 years, and the land
improvements have a depreciable life of 10 years. In accordance with IFRS, Allahmudin
must use component depreciation. It must reclassify Br.320,000 of the cost of the building to
personal property and Br.600,000 to the cost of land improvements. Assuming that
Allahmudin uses straight-line depreciation, component depreciation for the first year of the
office building is computed as follows.
Building cost adjusted (Br.4, 000,000 – Br.320, 000 - Br600, 000)…………….. Br.3, 080,000
Building cost depreciation per year (Br.3, 080,000/40)………………………….. Br.77, 000
Personal property depreciation (320,000/5)…………………………………………… 64,000
Land improvements depreciation (Br.600, 000/10) ……………………………………60,000
Total component depreciation in first year ………………………………………..Br 201,000
 IFRS uses the term residual value, rather than salvage value, to refer to an owner‘s
estimate of an asset‘s value at the end of its useful life for that owner.
 IFRS allows companies to revalue plant assets to fair value at the reporting date.
Companies that choose to use the revaluation framework must follow revaluation
procedures. If revaluation is used, it must be applied to all assets in a class of assets. Assets
that are experiencing rapid price changes must be revalued on an annual basis; otherwise
less frequent revaluation is acceptable.
To illustrate asset revaluation accounting, assume that ABC Company applies revaluation to
plant assets with a carrying value of Br.1, 000,000, a useful life of 5 years, and no residual
value. ABC makes the following journal entries in year 1, assuming straight-line
depreciation.
Depreciation Expense……………………………… 200,000

Accumulated Depreciation—Plant Assets…………………… 200,000

 (To record depreciation expense in year 1)
After this entry, ABC plant assets have a carrying amount of Br.800, 000 (Br.1, 000,000 -
Br.200,000). At the end of year 1, independent appraisers determine that the asset has a fair
value
of Br.850,000. To report the plant assets at fair value, or Br.850, 000, ABC eliminates the
Accumulated
Depreciation—Plant Assets account, reduces Plant Assets to its fair value of Br.850,000, and
records Revaluation Surplus of Br.50,000.The entry to record the revaluation is as follows.
Accumulated Depreciation—Plant Assets ……………………200,000
Plant Assets………………………………………………. 150,000
Revaluation Surplus ……………………..……………….50,000
 (To record adjusting the plant assets to fair value)
Thus, ABC follows a two-step process. First, ABC records depreciation based on the cost
basis of Br.1, 000,000. As a result, it reports depreciation expense of Br.200, 000 on the
income statement. Second, it records the revaluation. It does this by eliminating any
accumulated depreciation, adjusting the recorded value of the plant assets to fair value, and
debiting or crediting the Revaluation Surplus account. In this example, the revaluation
surplus is Br.50, 000, which is the difference between the fair value of Br.850, 000 and the
book value of Br.800, 000. ABC now reports the following information in its statement of
financial position at the end of year 1.
Plant assets (Br.1, 000,000 - Br150, 000) ………………………………850,000
Accumulated depreciation—plant assets ……………………….……………0
Book value…. …………………………………………………………Br.850,000
Revaluation surplus (equity) Br…………………………………….………… 50,000
As indicated, Br.850, 000 is the new basis of the asset. ABC reports depreciation expense of
Br.200, 000 in the income statement and Br.50,000 in other comprehensive income.
Assuming no change in the total useful life, depreciation in year 2 will be Br.212,500
(Br.850,000 / 4).
 Under both GAAP and IFRS, changes in the depreciation method used and changes
in useful life are handled in current and future periods. Prior periods are not affected.

GAAP recently conformed to international standards in the accounting for changes in

depreciation methods.
 The accounting for subsequent expenditures, such as ordinary repairs and additions,
are essentially the same under IFRS and GAAP.
 The accounting for plant asset disposals is essentially the same under IFRS and
GAAP.
 Initial costs to acquire natural resources are essentially the same under IFRS and
GAAP.
 The definition of intangible assets is essentially the same under IFRS and GAAP.
 As in GAAP, under IFRS the costs associated with research and developments are
segregated into the two components. Costs in the research phase are always expensed
under both IFRS and GAAP. Under IFRS, however, costs in the development phase are
capitalized as Development Costs once technological feasibility is achieved.
To illustrate, assume that Laser Scanner Company spent Br.1 million on research and Br.2
million on development of new products. Of the Br.2 million in development costs, Br.500,
000 was incurred prior to technological feasibility and Br.1, 500,000 was incurred after
technological feasibility had been demonstrated. The company would record these costs as
follows.
Research Expense…………………….. 1,000,000
Development Expense………………… 500,000
Development Costs.………………….. 1,500,000
Cash ………………………………………..3,000,000
 (To record research and development costs)
 IFRS permits revaluation of intangible assets (except for goodwill). GAAP prohibits
revaluation of intangible assets.
 IFRS requires an impairment test at each reporting date for plant assets and
intangibles and records impairment if the asset‘s carrying amount exceeds its
recoverable amount. The recoverable amount is the higher of the asset‘s fair value
less costs to sell or its value-in use. Value-in-use is the future cash flows to be derived
from the particular asset, discounted to present value. Under GAAP, impairment loss
is measured as the excess of the carrying amount over the asset‘s fair value.

 IFRS allows reversal of impairment losses when there has been a change in
economic conditions or in the expected use of the asset. Under GAAP, impairment
losses cannot be reversed for assets to be held and used; the impairment loss results in
a new cost basis for the asset.
 IFRS and GAAP are similar in the accounting for impairments of assets held for
disposal.
 The accounting for exchanges of nonmonetary assets has recently converged between
IFRS and GAAP. GAAP now requires that gains on exchanges of nonmonetary
assets be recognized if the exchange has commercial substance. This is the same
framework used in IFRS.
Self- study Questions
Discussion Questions
1. What is the main distinction between inventory and a plant asset?
2. What four factors must be known to compute depreciation on a plant asset? How
objective is the calculation of depreciation?
3. What does the term accelerated depreciation mean? Give an example showing how
depreciation is accelerated
4. Distinguish between capital expenditures and revenue expenditures.
5. Discuss the primary differences between U.S. GAAP and IFRS with respect to the
acquisition and disposition of property, plant, and equipment and intangible assets.
Multiple choices Questions
Bold the letter corresponding to the response that best completes each of the following
statements or questions.
1. Each of the following would be considered property, plant, and equipment or an
intangible asset except:
A. An oil well. B. A building.
C. Inventories. D. A patent.
2. The initial cost of land would include all of the following except:
A. The cost of grading. B. Title search costs.
C. Recording fees. D. Property taxes for the current period.
3. The following expenditures relate to machinery purchased by ABC Manufacturing:
Purchase price Birr16, 000
Transportation costs 800
Installation 500

Testing 2,000
Repair of part broken during shipment 300
At what amount should ABC capitalize the machinery?
A. Birr 17,300 B. Birr 19,300
C. Birr 19,600 D. Birr17, 600
4. Goodwill is the excess of the purchase price of an acquired company over the:
A. Fair value of the net assets acquired.
B. Sum of the fair values of the assets acquired.
C. Book value of the acquired company.
D. None of the above.
5. Semira Computer exchanged a machine with a book value of Birr40, 000 and a fair value
of Birr45, 000 for a patent. In addition to the machine, Birr6, 000 in cash was given.
Semira should recognize:
A. A gain of Birr 11,000. B. A loss of Birr 1,000.
C. A gain of Birr 5,000. D.No gain or loss.
6. Assume the same facts as in question 5, except that the machine is exchanged for a
similar machine rather than for a patent. Semira should recognize:
A. A gain of Birr 11,000. B. A loss of Birr 1,000.
C. A gain of Birr 5,000. D.No gain or loss.
7. A machine with a cost of Birr 130,000 has an estimated residual value of Birr10, 000 and
an estimated life of 4 years or 18,000 hours. What is the amount of depreciation for the
second full year, using the declining-balance method at double the straight-line rate?
A. Birr 30,000 B. Birr 31,500
C. Birr 32,500 D. Birr65, 000
8. A machine with a cost of Birr 130,000 has an estimated residual value of Birr10, 000 and
an estimated life of 4 years or 16,000 hours. Using the units-of production method, what
is the amount of deprecation for the second full year, during which the machine was
used 4,000 hours?
A. Birr26, 000 B. Birr 24,000
C. Birr 30,000 D. Birr 32,500
9. Equipment with a cost of Birr 80,000 has an estimated residual value of Birr 5,000 and
an estimated life of 4 years or 12,000 hours. It is to be depreciated by the straight-line
method. What is the amount of depreciation for the first full year, during which the
equipment was used 3,300 hours?
A. Birr20, 000 B. Birr18, 750
C. Birr20, 625 D. Birr22, 000
10. A purchase of equipment for Birr18, 000 also involved freight charges of Birr500 and
installation costs of Birr 2,500. The estimated salvage value and useful life are Birr2, 000
and 4 years, respectively. Annual straight-line depreciation expense will be:
A. Birr4, 750 B. Birr 4,500
C. Birr 4,125 D. Birr 4,625

11. An asset purchased on January 1 for Birr 48,000 has an estimated salvage value of Birr
3,000. The current year‘s Depreciation Expense is Birr 5,000 and the balance of the
Accumulated Depreciation account, after adjustment, is Birr 20,000. If the company uses
the straight-line method, what is the asset‘s remaining useful life?
A. 9 years B. 4 years
C. 8 years D. 5 years
12. On January 1, 2008 Jemal Company purchased some equipment for Birr15, 000. The
estimated salvage value and useful life are Birr3, 000 and 4 years, respectively. On January1,
2010, the company determines that the asset‘s remaining useful life is 3 years. What is the
revised depreciation expense for 2010 if the company uses the straight-line method?
A. Birr3, 000 B. Birr2, 000
C. Birr4, 000 D. Birr2.250
13. On March 1, 2008, Moreno Company purchased a patent from another company for
Birr 90,000. The estimated useful life of the patent is 10 years, and its remaining legal life
is 15 years. The Amortization Expense for 2008 is:
A. Birr9, 000 B. Birr 7,500
C. Birr 6,000 D. Birr 5,000
Self- study Exercises
Exercise 1: A Fine Company purchased a heavy machine to be used in its factory for Birr
720,000, less a 2 per cent cash discount. The company paid a Fine of Birr 3,600 because an
employee hauled the machine over city streets without securing the required permits. The
machine was installed at a cost of Birr 21,600, and testing costs of Birr 7,200 were incurred
to place the machine in operation. Prepare a schedule showing the recorded cost of the
machine.
Exercise 2: Midroc Company purchased a machine for Birr3, 200 and incurred installation
costs of Birr 800. The estimated salvage value of the machine is Birr 200. The machine has
an estimated useful life of four years. Compute the annual depreciation charges for this
machine under the double-declining-balance method.
Exercise 3: ABC Company purchased a computer for Birr 60,000 and placed it in operation
on 2008 January 2. Depreciation was recorded for 2008 and 2009 using the straight-line
method, a six-year life, and an expected salvage value of Birr 2,400. The introduction of a
new model of this computer in 2010 caused the company to revise its estimate of useful life

to a total of four years and to reduce the estimated salvage value to zero. Compute the
depreciation expense on the computer for 2010.
EXERCISE 4: The ABC Company acquired all of the outstanding common stock of XYZ
Company for Birr 3,500,000. The book values and fair values of XYZ assets and liabilities
on the date of purchase were as follows:
Book Value Fair Value
Current assets Birr 860,000 Birr 830,000
Property, plant, and equipment 2,300,000 2,940,000
Liabilities 600,000 600,000
ABC Company should record goodwill of:
PROBLEM QUESTIONS
Problem 1: XYZ Company acquired and placed into use a heavy factory machine on 2009
October 1. The machine had an invoice price of Birr 360,000, but the company received a 3
per cent cash discount by paying the bill on the date of acquisition. An employee of XYZ
Company hauled the machine down a city street without a permit. As a result, the company
had to pay a Birr 1,500 fine. Installation and testing costs totaled Birr 35,800. The machine is
estimated to have a Birr 35,000 salvage value and a seven-year useful life. (A fraction should
be used for the DDB calculation rather than a percentage.)
Required:
1. Prepare the journal entry to record the acquisition of the machine.
2. Prepare the journal entry to record depreciation for 2009 under the double-declining
balance method.
3. Assume XYZ Company used the straight-line depreciation method. At the beginning of
2009, it estimated the machine will last another six years. Prepare the journal entry to
record depreciation for 2009. The estimated salvage value would not change.
PROBLEM 2: During 2013, ABC Company entered into two separate nonmonetary
exchanges.
1. Exchanged equipment that cost Birr10, 000 and had accumulated depreciation of
Birr6, 000 plus Birr 10,000 in cash for new equipment. The fair value of the old
equipment was Birr 4,600.
2. Exchanged a machine that cost Birr 40,000 and had accumulated depreciation of Birr
20,000 for a new machine and Birr 5,000 in cash. The fair value of the old machine
was Birr 25,000, which means the fair value of the new machine was Birr 20,000 (Birr
25,000 less cash received of Birr 5,000).
Required:
I. Prepare the journal entry for the first exchange assuming the exchange has
commercial substance.

II. Prepare the journal entry for the second exchange assuming the exchange has
commercial substance.
Group Project Question
Group project A: With a team of two or three students, visit two companies in your
community to inquire about why they use certain depreciation methods. Try to locate
companies that use several depreciation methods in accounting for various depreciable fixed
assets. Interview those who made the decision as to methods to use to find out the reasons
for their choices. Write a report to your instructor summarizing your findings.
Group project B: In a small group of students, visit a large company in your community to
determine how it decides to account for expenditures on fixed assets made after the assets
have been in use for some time. In other words, how does it decide whether to debit the
asset account, the accumulated depreciation account, or an expense account? What role does
materiality play in the decision? Write a report to your instructor summarizing your findings
and be prepared to make a short presentation to your class.
No Answer key for multiple choice
1 C 6 C 11
2 D 7 12
3 B 8 13
4 A 9
5 C 10
Chapter 11
Current Liabilities and Payroll
Learning Objectives
1. Describe and illustrate current liabilities related to accounts payable, current
portion of long-term debt, and notes payable.
2. Determine employer liabilities for payroll, including liabilities arising from
employee earnings and deductions from earnings.

3. Describe payroll accounting systems that use a payroll register, employee

earnings records, and a general journal.
FASB Statement of Financial Accounting Concepts No. 6 defines liabilities as ―probable future
sacrifices of economic benefits arising from present obligations of a particular entity to transfer
assets or provide services to other entities in the future as a result of past transactions or events.‖
The key elements of this definition are:
 Liabilities are present obligations requiring probable future transfer of assets
 Liabilities are unavoidable obligations
 The transaction or event creating the liability has already occurred
The current liabilities section of the balance sheet contains obligations that are due to be satisfied
in the near term, and includes amounts relating to accounts payable, salaries, utilities, taxes,
short-term loans, and so forth. This casual description is inadequate for all situations, so
accountants have developed a very specific definition to deal with more issues.
Current liabilities are debts that are due to be paid within one year or the operating cycle,
whichever is longer. Further, such obligations will typically involve the use of current assets, the
creation of another current liability, or the providing of some service.
This enhanced definition is expansive enough to capture less obvious obligations pertaining to
items like customer prepayments, amounts collected for and payable to third parties, the portion
of long-term debt due within one year or the operating cycle (whichever is longer), accrued
liabilities for expenses incurred but not yet paid, and contingent liabilities. However, the
definition is not meant to include amounts not yet ―incurred.‖ For example, salary to be earned
by employees next year is not a current liability (this year) because it has yet to be ―incurred.‖
Investors, creditors, and managers should pay close attention to current liabilities as they reflect
imminent demands on resources.
TYPICAL CURRENT OBLIGATIONS
 Accounts Payable is the amounts due to suppliers relating to the purchase of goods and
services. This is perhaps the simplest and most easily understood current liability.
Although an account payable may be supported by a written agreement, it is more
typically based on an informal working relation where credit has been received with the
expectation of making payment in the very near term.

 Notes Payable is formal short-term borrowings usually evidenced by specific written

promises to pay. Bank borrowings, equipment purchases, and some credit purchases from
suppliers involve such instruments. The party who agrees to pay is termed the ―maker‖ of
the note. Properly constructed, a note payable becomes a negotiable instrument, enabling
the holder of the note to transfer it to someone else. Notes payable typically involve
interest, and their duration varies. When a note is due in less than one year (or the
operating cycle, if longer), it is commonly reported as a current liability.
 The Current Portion of Long-term Debt is another frequently encountered current

obligation. When a note or other debt instrument is of long duration, it is reported as a
long-term liability. However, the amount of principal which is to be paid within one year
or the operating cycle, whichever is longer, should be separated and classified as a
current liability. For example, a $100,000 long-term note may be paid in equal annual
increments of $10,000, plus accrued interest. At the end of any given year, the $10,000
principal due during the following year should be reported as a current liability (along
with any accrued interest), with the remaining balance shown as a long-term liability.
 Accrued Liabilities (sometimes called accrued expenses) include items like accrued
salaries and wages, taxes, interest, and so forth. These items relate to expenses that
accumulate with the passage of time but will be paid in one lump-sum amount. For
example, the cost of employee service accrues gradually with the passage of time. The
amount that employees have earned but not been paid is termed accrued salaries and
should be reported as a current liability. Likewise, interest on a loan is based on the
period of time the debt is outstanding; it is the passage of time that causes the interest
payable to accrue. Accrued but unpaid interest is another example of an accrued current
liability. The reported accrued liabilities only relate to amounts already accumulated and
not to amounts that will arise later.
 Prepayments by Customers arise from transactions such as selling magazine subscriptions
in advance, selling gift-cards, selling tickets well before a scheduled event, and other
similar items where the customer deposits money in advance of receiving the expected
good or service. These items represent an obligation on the part of the seller to either

return the money or deliver a service in the future. As such, the prepayment is reported as
―unearned revenue‖ within the current liability section of the balance sheet.
 Collections for Third Parties arise when the recipient of some payment is not the
beneficiary of the payment. As such, the recipient has an obligation to turn the money
over to another entity. At first, this may seem odd. But, consider sales taxes. The seller of
merchandise must collect the sales tax on transactions, but then has a duty to pay those
collected amounts to the appropriate taxing entity. Such amounts are appropriately
reflected as a current liability until the funds are remitted to the rightful owner.
 Obligations to be refinanced deserve special consideration. A long-term debt may have
an upcoming maturity date within the next year. Ordinarily, this note would be moved to
the current liability section. However, companies often renew such obligations, in
essence, borrowing money to repay the maturing note. Should currently maturing long-
term debt that is subject to refinancing be shown as a current or a long-term liability? To
resolve this issue, accountants have developed very specific rules. A currently maturing
long-term obligation is to be shown as a current liability unless (1) the company intends
to renew the debt on a long-term basis and (2) the company has the ability to do so
(ordinarily evidenced by a firm agreement with a competent lender).
 Dividends payable are cash dividends that have been declared by the board of directors.
Dividends payable do not include dividends in arrears on preferred stock nor do they
include stock dividends.
 Returnable deposits are cash deposits received from customers or employees that are to
be returned at some future date.
 Unearned revenues are deferred income. The entity has received the cash but has not earned
it on the balance sheet date.
 Sales taxes payable represents the sales taxes collected on behalf of the state. The entity is
acting as a fiduciary and has the obligation to forward the sales tax to the state on a timely
basis.
 Income taxes payable are the income taxes due on corporate earnings. Normally a corporate
entity pays estimated quarterly installments so that at the end of the year the remaining
obligation reflects the last quarterly estimate plus any adjustment for the actual tax obligation
based on the final income before income taxes. The quarterly estimated tax payments are
normally debited to income tax payable during the year.

ACCOUNTING FOR CONTINGENT LIABILITIES

A subjective assessment of the probability of an unfavorable outcome is required to properly
account for most contingences. Rules specify that contingent liabilities should be recorded in the
accounts when it is probable that the future event will occur and the amount of the liability can
be reasonably estimated. This means that a loss would be recorded (debit) and a liability
established (credit) in advance of the settlement.
An example might be a hazardous waste spill that will require a large outlay to clean up. It is
probable that funds will be spent and the amount can likely be estimated. If the estimated loss
can only be defined as a range of outcomes, the U.S. approach generally results in recording the
low end of the range. International accounting standards focus on recording a liability at the
midpoint of the estimated unfavorable outcomes.
On the other hand, if it is only reasonably possible that the contingent liability will become a real
liability, then a note to the financial statements is required. Likewise, a note is required when it is
probable a loss has occurred but the amount simply cannot be estimated. Normally, accounting
tends to be very conservative (when in doubt, book the liability), but this is not the case for
contingent liabilities. Therefore, one should carefully read the notes to the financial statements
before investing or loaning money to a company.
There are sometimes significant risks that are simply not in the liability section of the balance
sheet. Most recognized contingencies are those meeting the rather strict criteria of ―probable‖
and ―reasonably estimable.‖ One exception occurs for contingencies assumed in a business
acquisition. Acquired contingencies are recorded based on an estimate of actual value.
What about remote risks, like a frivolous lawsuit? Remote risks need not be disclosed; they are
viewed as needless clutter. What about business decision risks, like deciding to reduce insurance
coverage because of the high cost of the insurance premiums? GAAP is not very clear on this
subject; such disclosures are not required, but are not discouraged. What about contingent
assets/gains, like a company’s claim against another for patent infringement? Such amounts are
almost never recognized before settlement payments are actually received.
Principal x Rate x Time = Interest Expense
B. Illustration of Notes Payable

On November 1, Max Company borrows $100,000 by signing a 3-month note at 12%

interest. Interest is payable on the due date.
 November 1 - Date of Issuance
Debit Credit
Cash 100,000
 December 31 - Year end accrual of interest

Interest Expense (100,000 x 12% x 2/12) 2,000
Interest Payable 2,000
 February 1 - Repayment of note and interest
Interest Payable 2,000
Interest Expense (100,000 x 12% x 1/12) 1,000
Cash 103,000
Note: For a longer term note, interest would have to be accrue each year before the
issuance of financial statements.
A. Bond Prices
Bonds pay a stated rate of interest that may be different from the market rate of interest when the
bonds are issued. Bond prices are usually quoted as a percentage of the face amount (i.e., the
amount which must be repaid when the bonds mature). For example, a bond price of 96 indicates
that a bond is selling at 96% of its face value (a discount), while a bond price of 103 indicates that the
bond is selling at 103% of its face amount (a premium).
The actual bond price is found by determining the present value of the cash flows for the face value and
interest payments, discounted at the market rate of interest. The following examples have already
determined the bond prices.
B. Bond Sold at Face Value (Market rate = Stated Bond Rate)
Bonds sell at 100% if the market rate equals the stated rate at the time the bonds are issued.
Example: On January 1, 2005 ABC issues Br.100, 000 of 10%, 2 year bonds. The bonds pay
interest annually each December 31. The bonds are issued at a price of 100.
 Jan 1, 2005 - Date of Issuance
Debit Credit
Cash 100,000
Bonds Payable 100,000
 Dec 31, 2005 - Interest Payment
Debit Credit

Interest Expense 10,000

Cash 10,000
 Dec 31, 2006 - Interest Payment and Maturity of
Bonds
Debit Credit
Cash 10,000
Bonds Payable ………………………… 100,000
Cash …………………………………100,000
C. Bond Sold at a Discount (Market rate > Stated Bond Rate)
Bonds sell at less than 100% if the market rate is greater than the stated rate at the time the bonds are
issued. Example: On January 1, 2005 ABC issues $100,000 of 10%, 2 year bonds. The bonds pay
interest annually each December 31. The bonds are issued at a price of 95. Assume straight-line
amortization of the discount.
Debit Credit
Cash (100,000 x 95%) 95000
Discount on Bonds Payable 5000
Note: The purpose of the discount is to force the interest expense to the higher market rate. The
Br.5, 000 discounts is actually additional interest paid upon the issuance of the bonds. The
borrower only gets Br.95, 000 but must pay back a face value of Br.100, 000.
Dec 31, 2005 - Interest Payment
DEBIT CREDIT
Discount on Bonds Payable 2,500
Cash 10,000
 Dec 31, 2006 - Interest Payment and Maturity of Bonds
DEBIT CREDIT
Discount on Bonds Payable 2,500
Cash 10,000

Cash 100,000
D. Bond Sold at a Premium (Market rate < Stated Bond Rate)

Bonds sell at more than 100% if the stated bond rate is greater than the market rate at the time
the bonds are issued.
Example: On January 1, 2005 ABC issues Br.100, 000 of 10%, 2 year bonds. The bonds pay
interest annually each December 31. The bonds are issued at a price of 105. Assume straight-
line amortization of the premium.
Debit Credit
Cash (100,000 x 105%) 105,000
Premium on Bonds Payable 5,000
 Dec 31, 2005 - Interest Payment

Debit Credit
Premium on Bonds Payable 2,500
Cash 10,000
 Dec 31, 2006 - Interest Payment and Maturity of Bonds

Debit Credit
Cash 100,000
Note: The purpose of the premium is to force the interest expense to the lower market rate. The
Br.5, 000 premiums is actually a reduction of interest granted upon the issuance of the bonds.The
borrower gets Br.105, 000 but must only pay back a face value of Br.100, 000.
The Payroll system in Ethiopian context
Importance of payroll accounting
The term payroll refers to the document prepared to pay remuneration for the services obtained
from employees for a certain period of time. Payroll can also refer to the amount of money paid
to employees for a certain period. Accounting for payroll is concerned with the records and
reports associated with the employer-employee relationships
The payroll accounting of a firm has to be given emphases of significance for the following
reasons;
 Employees are sensitive to payroll errors and irregularities and maintaining good
employee moral requires that the payroll be paid on a timely, accurate basis.
 Payroll expenditures are subject to various government regulations.
 The payment for payroll and related taxes has significant effect on the net income of

most business enterprise.

Definition of payroll related terms
A). Salary and wage: salary and wage are usually used interchangeably.
 Wage is more correctly used to refer to payment to unskilled manual labor. It is usually
paid based on the number of hours worked or the number of unit produced. There for
wages are usually paid on weekly basis or when a particular piece of work is completed.
 Salaries refer to payment to employees who render managerial, administrative or similar
service, and they are usually paid to skilled labor on 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. Hence, Self-
employed person (independent contractors), who provides his/her services on a fee basis to
various firms.
B). The pay period: Refers to the length of times covered by each payroll payment. Pay periods
for wage works are usually made on weekly basis to a firm. On the other hand, salaries
employees pay periods are monthly or semi-monthly.
C). The pay day: The pay day is the day on which wages or salaries are paid to employees .This
is usually on the last day of the pay period.
Basic records of payroll accounting system include:

1).A payroll register (sheet) 2). Individuals’ employees earning records and 3). Pay
checks
A Payroll Register (sheet): is the list of employees of a business along with each employee’s
gross earning, deduction, and net pay (take home pay) for a particular pay period.
The payroll register is prepared based on attendance sheet, punched (clock) card or time card.
Employees Earning Records: It is a summary of each employee’s earnings, deduction and net
pay for each payroll period and of cumulative gross earnings during the year.it is a separate
record kept for each employee. The individual employee’ earnings record helps the employer of
the organization to properly summarizes and file tax returns.
Pay check: An instrument for paying salary if the firms make payment through writing a check
in the name each employee for the net pay or a check for a total net pay.

Gross Earnings: is the total earning of the employees for a given pay period before deduction.
Income Tax: Income tax in Ethiopia is charged to individuals, and depending on the company
you’re working for you might have to calculate and submit returns yourself. Anybody
freelancing or contracting in Ethiopia will probably have to handle their taxes this way. Because
individual earnings can be so different, the income tax rates in Ethiopia vary according to your
level of income.
Payroll Taxes: Payroll tax in Ethiopia is very similar to income tax but it’s paid by your
employer as you earn. Social security fees, public health insurance and other deductions are all
included in this payment and other deductions in Ethiopia are dependent on your income.
Withholding taxes: are taxes collected from the earning of employees by the employer
organization as per the regulation 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.
Payroll deductions: are deductions from the gross earning of an employee such as employment
income taxes, employee pension contribution (withholding taxes), labor union dues, fines &
credit association pays, retirement investments, deposits in a savings account, loan payments,
union dues, charitable contributions, health, dental, and life insurance premiums…etc
Net pay: Net pay is the employee's gross earnings less mandatory and voluntary deductions. It is
the amount the employee receives on payday, so called ―take‐home pay.‖ An entry to record a
payroll accrual includes an increase (debit) to wages expense for the gross earnings of
employees, increases (credits) to separate accounts for each type of withholding liability, and an
increase (credit) to a payroll liability account, such as wages payable, for employees' net pay.
POSSIBLE COMPONENTS OF PAYROLL REGISTER
1. Employee number: Number assigned to employees for identification purpose when a relative
large number of employees are involved in a payroll register. It could be an identification card
of the employees or simple serial number.
2. Name of employees: this column list name of employees of the organization.
3. Earnings: Money earned by an employee from various sources. This may include.
A. Basic salary- a flat monthly salary of an employee for carrying out the normal work of
employment and subject to change when the employees are promoted.
B. Allowance- Money paid monthly to an employee for especial reasons, Like:

 Position allowance- a monthly allowance paid to an employee for bearing a

particular office responsibility.
 Housing allowance –a monthly allowance given to cover housing cost of the
individual employee when the employment contract requires the employer to
provide housing but the employer fails to do so.
 Hardship allowance /Disturbance allowance/ a sum of money given to an
employee to compensate for an inconvenient circumstance caused by the employer.
For example un expected transfer to a different and distance work area or location
 Desert Allowance-a monthly allowance given to an employee because of
assignment to relatively hot region.
 Transport allowance (fuel) –a monthly allowance to an employee to cover cost of
transportation up to his/her work place if the employee has committed itself to
provide transportation service.
C. Over time Earning: overtime work is the work performed by an employee beyond The
regular working hours.
Over time earning 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 (1 1/4) times his ordinary (regular) hourly rate for overtime work
performed before 10:00PM in the evening
II. One and none half(1 1/2) times his ordinary regular hourly rate for overtime performed
between 10:00PM -6:00AM in The morning
III. Two times( 2) the ordinary (regular) hourly rate for overtime work performed on weekly
rest days
IV. Two and one half (2 1/2) times the ordinary hourly rate for overtime work performed on
public holiday
All in all the gross earning of an employee may include the basic salary, overtime earning and
allowance
4. Deductions: Are subtraction made from the earnings of employees required either by the
government or permitted by the employee himself.

Employment income tax: Every citizen is required to pay employee tax to the government in
almost all countries. The government collects this tax from any individual employees, other than
contractors, engaged whether on a permanent or temporary basis to perform services under the
direction and control of the employer. Employment income includes any payment or gain in cash
or in kind received from employment by the employee subject to certain exemptions: see below.
In Ethiopia also, income tax is changed on the gross earnings of the employee at the rates
indicated under schedule A of the proclamation No.286/2002 –Income tax proclamation. The
employee's income tax system divides taxable income into different taxes bands. These are a
range of income bands with different tax rates. Below is a schedule that specifies tax bands
and their tax rates.
Taxable Income
Income Income tax payable
(per month)
Tax rate
Over Birr To Birr
0 150 The first 150 Exempt No tax
threshold
151 650 The next 500 10% (10% X TI) – 15
651 1400 The next 750 15% (15% X TI) – 47.5
1401 2350 The next 950 20% (20% X TI) – 117.5
2351 3550 The next 1200 25% (25% X TI) – 235
3551 5000 The next 1450 30% (30% X TI) – 412.5
Over 5,000 Over 5,000 35% (35% X TI) – 662.5

Note TI-taxable income.
According to the above tax rate schedule, employees who earn up to 150 birr a month are below
the threshold for paying employment income tax. It is presumed that this exemption has removed
hundreds of thousands of low income employees from the tax roll. However, employees who
earn 151 birr per month and above are liable to pay employment income tax. In order to impose a
heavier tax burden on those employees who earn more, the government uses a progressive
employment income tax system. Tax on income from employment has 6 bands or groups of
rates. These are 10%, 15%, 20%, 25%, 30% and 35%. The minimum tax rate applied to income

from employment is 10 percent while the maximum is 35 percent. These bands of rates in the
above schedule are used to compute the tax due.
Example 1 Example 2
Gross Salary = Br. 5200 Gross Salary = Br. 500
Tax: 5200 x 35% - 662.50 = Br. 1157.50 Tax: 500 x 10% - 15 = Br. 35
Net: 5200-1157.50 = Br. 4042.50 Net: 500-35 = Br. 465
Net Salary = Br. 4042.50 Net Salary = Br. 465
Income Tax = Br. 1157.50 Income Tax = Br. 35
Exercise :What are the total amount deducted as income tax for an employee who earns a basic
monthly salary of Br. 1800, a monthly nontaxable allowance of Br. 300, and an overtime earning
of Br. 400?
Amount of pension contribution in the new Ethiopian pension laws

One of the significant changes introduced by the new Ethiopian pension laws is the substantial
increase in the amount of pension contribution by the beneficiary and the government/employer.
Until June 2011, only the public sector was covered by the pension scheme. Starting from July
2011 those (employees and employers) in the private sector will start making a contribution
following the first private organization employees’ pension law. So what is the amount to be
contributed by employees, employers and the public organs (the government)? The following
table summarizes the contributions to be made from each respective party according to the
proclamation no.714 and 715.
In the previous (now repealed pension law) the amount of pension contribution by public
servants including military and police officers was 4% of their gross salary. However, there was
a significant variation in the contribution to be made by the government for public servants as
compared to the contribution to military and police officers.
According to article 5 and 6 of the repealed Public Servants’ Pensions Proclamation No.
345/2003 the contribution of the government to public servants pension was 6% whereas it was
16% for military and police pension.
The same variation is also reflected in the new public servants proclamation no 714/2011. The
16% government contribution has now risen to 25%, almost 1/4th of the gross salary of military
and police officers. On the contrary the government contributes only 7% for public servants.

Just refer to the following table for the specific percentage of contribution by each of the parties
with the responsibility of pension contribution under the new pension laws.
Note:
 NA= Not Applicable
 In order to calculate 1st 2nd 3rd and 4th year the time to start is July 1, 2011
The percentage is calculated based on the gross salary of the employee i.e. before deduction of
tax and other encumbrances. Salary does not include hardship allowance, transport allowance,
house allowance or other related benefits attached with certain position.
Pension Contribution
Public office Civil servants Military and police Employer
Type of pension officers (Private
fund organizations)
25% NA 7% NA
Military and Police 1st year =18% 1st year =5%
Service Pension 2nd year =20% 2nd year=6%
Fund 3rd year=22% ≥ 3rd year=7%
≥ 4th year= 25%
11% 7% NA NA
Civil service Pension 1st year =7% 1st year =5%
Fund 2nd year =8% 2nd year=6%
3rd year=9% ≥ 3rd year=7%
≥4th year=11%
NA NA NA 11%
Private Employees’ 1st year =7%
Pension Fund 2nd year =8%
3rd year=9%
≥4th year=11%
*In computing and withholding tax, the income tax proclamation dictates that income
attributable to the month of Nehassie and Pagumen shall be aggregated (added) and treated as the
income of one month.

Who shall calculate and withhold the tax due?

Unless the payment is tax-exempt, the employer is responsible for calculating and withholding
the tax from every payment to an employee and to forward it to the Tax Authority. By the Tax
Authority, we mean the Ethiopian Revenues and Customs Authority (ERCA) Head Office or any
of its branch offices established in any part of Ethiopia and the tax authorities of the Regional
State. The tax to be paid to the Tax Authority by the employers can be transmitted through
financial institutions delegated by the Authority or through electronically filing and payment
system.
How employers can determine the tax to be withheld?
To determine the tax to be withheld, the employer may use a simple calculation method. In
Ethiopia, employers can determine the tax to be withheld by following 3 key steps.
1. First add all the payments in cash and in kind made to their employees in a month.
2. Refer/consult a tax schedule (schedule that shows how much tax is owed for different amounts
of income earned by the employee) to find the tax rate applicable on the income earned by the
employee.
3. Multiply the taxable income by the tax rate and then minus the deductible fee: as indicated in
the tax schedule.
For example, an employer who pays to an employee 400 birr a month will then have 25 birr to be
withheld i.e. 400x10/100-15= 25.
What are the exemptions allowed under income tax proclamations, regulations and
directives?
 Exemptions under the proclamation:
According to the income tax law, not all incomes of the employee are taxable. The government
may tax only a portion of some types of the employee's income. Therefore employers have to
subtract incomes of employees that are not taxable.
Accordingly, article 13 of the proclamation No. 286/2002 declares the following categories of
payments in cash or benefits in kind to be excluded from computation of employment income
tax.
a) Income from employment received by casual employees who are not regularly employed
provided that they do not work for more than one (1) month for the same employer in any twelve
(12) months period.

b) Pension contribution, provident fund and all forms of retirement benefits contributed by
employers in an amount that does not exceed 15% (fifteen percent) of the monthly salary of the
employee.
c) Subject to reciprocity, income from employment, received for services rendered in the
exercise of their duties by:-
i. Diplomatic and consular representatives, and
ii. Other persons employed in any embassy, legation, consulate, or mission of a foreign state
performing state affairs, who are national of that state and bearers of diplomatic passports or who
are in accordance with international usage or custom normally and usually, exempted from the
payment of income tax.
d) Income specifically exempted from income tax by
i. any law in Ethiopia unless specifically amended or deleted by proclamation
ii. International treaty; or
iii. An agreement made or approved by the minister
e) Payment made to a person as compensation or gratitude in relation to:-
i. Personal injuries suffered by that person
ii. The death of another person
According to the income tax regulation No. 78/2002, the following incomes are
exempted from tax.
a. Amounts paid by employers to cover the actual cost of medical treatment of employees.
b. Allowance in lieu of means of transportation granted to employees under contract of
employment.
c. Hardship allowance for hot areas clearly defined by law.
d. Amounts paid to employees in reimbursement of traveling expenses incurred on duty;
e. Amounts of traveling expense paid to employees recruited from elsewhere than the place of
employment on joining and completion of employment or in case of foreigners traveling
expenses from or to their country, provided that such payments are made pursuant to specific
provisions of the contract;
f. Allowances paid to members and secretaries of boards of public enterprises and public
bodies as well as to members and secretaries of groups set up by the federal or regional
government.
g. Income of persons employed for domestic duties.

Exemptions under directive No. 21/2009

The Authority has, based on directive No 21/2009, determined the amount of payments specified
under item (b) (d) and (e) above. Accordingly, monthly travel allowances which are exempted
from tax shall account for 1/4 of the employee's gross salary and it shall under no circumstances
exceed 1000 birr.
The daily travel allowance for an employee who travels outside of theirregular work area to a
place 25 k.m away may not exceed 150 birr or it shall under no circumstances exceed 4 percent
of his or her salary.
III. Other Deductions
Apart from The above two kinds of deductions, employees may individually authorize
additional deductions such as deductions to pay life insurance premium, to repay loan from
the employer, to pay for donation to charitable organization, contribution to idir etc.
Net Pay: This amount is held in one column of the payroll register representing the excess of
gross earnings over the total deductions of an employee. The column net pay total tells the
excess of grand total earnings over grand total deductions made from the earnings of employees.
It is the grand total take-home pay.
Signature The payroll sheet should have a column for signature of the employee to be taken
when the employee collects the net pay.
MAJOR ACTIVITES INVOLVED IN ACCOUNTING FOR PAYROLL
1. 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.
2. Entering the names of employees along with gathered data such as earnings, deductions and
net pays in the appropriate columns of the payroll register.
3. Totaling and providing the payroll register – grand total of the earnings must be checked if
it’s equal to the sum of the grand totals of deductions and net pays.
4. The accuracy and authenticity of the information summarized in the payroll should be
verified by a different person from the one who prepared it.
5. The payroll should be approved by an authorized personal(individual)
6. Paying The payroll either in cash or by writing a check
7. The payment of The payroll and income taxes withheld from employees (withholding tax
liability ) should be recorded in journal entry from

The withholding tax must be paid to the relevant government authority in time (promptly) and
this is recorded in journal entry form.
ETHIOPIA TERMS AND CONDITIONS

Public Holidays in Ethiopia
Ethiopian New Year Finding of the True Cross
Eid Al-Fitr /Ramadan / Eid Al-Adha (Arafa)
Birth Day of Prophet Mohammed Epiphany
Christmas Patriot’s Day
Victory of Adwa Comm. Easter
National day May day
Notice periods
30 days advance notice of dismissal is required for employer by Labor Standard Act. However,
advance notice is not required for employee. If there is a dispute and the employee claims that
the termination is unreasonable, ex gratia payments of 2-4 months’ salary are found.
Hours of Work
The working hours per week are minimum 40 and maximum 44. Some public enterprises and all
private firms’ works Saturday’s for 4 hours that produces the 44 hours.
After 44 hours per week, employees are entitled to be paid overtime.
Normal hours of work are 0800 to 1700 with on 5 days per week.
Vacation
Basic is 14 days per year . Multinational companies often give up to 25 working days.
Special leave is often granted for:
Marriage -5 days
Birth of Child (maternity leave) 90 days
Death of near relative 3 days
Special sick leave (if necessary) 5 days/year

Demonstration problem
EXAMPLLE; ABC 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
Meskerem, 2006.
Serial Basic Transportation Overtime worked(hr)

No. Name of Employee Salary Allowance
01 Abduselam Mohammed Br. 730 150 10 Normal hours (i.e,
before 10:00 PM)
02 Jemal Kedir 1020 500 8 / Late hours (i.e,b/n
10:00PM and 6:00AM)
03 Halima Abera 5300 1500 6 / Rest days
04 Tolasa Gizachewu 3700 700 10/ Public holidays
05 Yonas Tariku 480
Additional Information:
- The management of the enterprise usually expects a worker to work 40 hours in a week
and during Mesekerm there are four weeks.
- There were no absentees during the month
- All employees are permanent except Fasil Tariku.
- Jemal 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 Meskerem, 2006.
2. Record the payment of salary as of Meskerem 30, 2006.
3. Record the payment of the claim of the credit association of their enterprise on Tikimt1, 2006.
4. Record the payment of the withholding taxes and pension contribution to the concerned
government body Meskerem, 2006.
SOLUTIONS;
Computation of Earnings, Deductions, and Net Pay
Gross Earnings = Basic salary + Allowance + Overtime Earning

A. Overtime Earning
Overtime earning = OT hrs worked x (ordinary hourly rate x relevant OT rate)
1. Abduselam:
- OT Earning = 10 hours x Br. 730 x 1.25 = Br.57
160 hours
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 10hours …………………… Br. 57
2. Jemal:
- OT Earning = 8 hours x Br. 1020 x 1.5 ………... Br. 76.5
160 hours
3. Halima:
- OT Earning = 6 hours x Br. 5300 x 2 …………………… Br. 397.5
160 hours
4. Tolasa: OT Earning = 10 hours * Br 3700/160 *2.5……………….Br 578.125
B. Gross Earnings
Gross Earnings = Basic salary + Allowance + OT Earning
1. Abduselam:
 Gross Earnings = Br. 730 + Br. 150 + Br. 57 = Br.937
2. Jemal:
 Gross Earnings = Br. 1020 + Br 500 + Br. 76.5 = Br. 1596.65
3. Halima:
Gross Total Earnings = Br 5300 + 1500 + 397.5 =Br. 7197.5
4. Tolasa:
 Gross Total Earnings = Br 3700 + br 700 + 578.125 = Br. 4978.125

5. Yonas
 Gross Total Earnings = Br. 480
C. Deductions and Net Pay
Deductions;
1. Abduselam:
 Gross Earnings …………………………………. Br. 937
Taxable Income = GROSS EARNING –EXEMPTION (937 -150)………..787
i. Employee Income Tax:
Income tax = taxable income X tax rate – deduction
= (Taxable Income x 15%) – Br. 47.5
= (Br. 787 x 0.15) – Br. 47.5 = Br.70.55
Income tax can also be determined in the following method;
Earnings X Income Tax Rate = Income Tax
0 – 150 Br. 150 0 Br. 00.00
151 – 650 on Br.500 10% 50.00
651 – 787 on Br. 137 15% 20.5
Total Br. 787 Br. 70.55
ii. Pension Contribution:
Basic salary x 7% = Br. 730 x 0.07………………… 51.10
 Total Deductions for Abduselam = (Br.70.55+ Br.51.1) ……… Br. 122
2. Jemal:
 Gross Earnings ……………………………… Br.1596.65
 Taxable income = GE –E (1596.65 -255)……………………….1341.65
i. Employee Income tax:
Income tax = 1341.65 X 15% - 47.5 = ……………………………. Br 153.8
ii. Pension Contribution:
(Br. 1020 x 0.07) ………………………………………………… Br. 71.40
iii. Credit Association……………………………………………………… 300.00
 Total Deductions ………………………………………………. Br. 525.20
3. Halima
Gross Earnings……………………………………………………. Br.7197.5
Taxable income =GE – E(7197.5 – 1000)…………………………………6197.5
i. Employee Income tax:
Income tax = 6197.5 X 35% - 662.5 = …………….. Br. 1506.6
ii. Pension contribution (Br. 5300 x 0.07) ------------ 371.00

 Total Deductions ------------------------------------ Br. 1877.60

4. Tolasa
Gross Earnings ………………………………………………… Br. Br. 4978.125
Taxable Income = GE – E(Br. 4978.125 -700)…………………………….4278
i. Employee Income Tax:
Income tax = 4278 X 30% - 412.5 = ……………….. Br. 870.9
ii. Pension contribution (Br. 3700 x 0.07) ------------ 259.00
 Total Deductions ------------------------------------ Br. 1129.9
5 . Yonas
Gross Earnings …………………………………………………BR 480
Employee Income Tax:
Income tax = 480 X 10% -15 = Br. 33
NB. No pension contribution because he is not permanent employee of the organization. Therefore,
total deduction is the same as Employee Income Tax, Br 33.
NET PAY:
Net pay = Gross Earnings – Total Deductions
1. Abduselam:
Net pay = Br. 937 – Br. (122) = Net pay = Br. 815
2. Jemal
Net pay = Br. 1596.65 – Br. (525.2) Net pay = Br. 1071.4
3. Halima:
Net pay = Br. 7197.5 – Br. (1877.5) Net pay = Br. 5320
4. Tolasa:
Net pay = Br. 4978.125 – Br. (1129) Net pay = 3849
5. Yonas:
Earnings Deductions
Employee Basic Allowa Over Gross Income Pension Other
No name salary nce time earnings tax contribution deduction Total Net Sign

deductions pay
01 Abduselam 730 150 57 937 70.55 51.10 122 815
02 Jemal Kedir 1020 500 76.5 1596.6 153.8 71.4 300 525 1071.
03 Halima Abera 5300 1500 397.5 7197.5 1506.6 371 1877.6 5320
04 Tolasa 3700 700 578.13 4978.125 870 259 1129.9 3849

Gizachewu
05 Yonas Tariku 480 480 33 33 447
Net pay = Br. 480 – Br. (33) Net pay = Br. 447
Necessary Journal entries

A) An entry to record the payment of salary;
Salary expense…………………………………..15,189.225
Cash…………………………………………………………11,502
pension contribution payable……………………………… 752.5
Employees income tax payable…………………………… 2,633.95
Credit associations payable………………………………. 300
B) An entry to record the payment of the claim of the credit association of the enterprise;
Credit associations payable………. 300
Cash ………………………………… 300
C) An entry to record the payment of withholding tax and pension contribution to concerned
government body;
Pension contribution expense …….. 967.5
Pension contribution payable …….. 752.5
Employee income tax payable ……. 2,633.95
Cash…………………………………………..4,353.95
Important information’s;
 Salary expense of 15,189.225 is the sum of gross earnings.
 Cash of 11,502 is the sum of net pays.
 Pension contribution payable of 752.5 is the sum of employees’ pension contribution,
which is 7% of permanent employees’ basic salary.
 Employees’ income tax payable of 2,633.95 is the sum of employees’ income tax.
 Pension contribution expense of 967.5 is the total pension contribution of the employer,
which is 9% of permanent employees’ basic salary.
1. Payroll expenditures represent a relatively small part of the total expenditures of most
companies.

2. Compensation expressed in terms of hours, weeks, or units produced for skilled or unskilled
labor is usually referred to as salary.
3. Companies must accumulate payroll data both for the business as a whole and for each
employee.
4. Every individual who performs services for a business is considered to be an employee.
5. The length of the pay period affects the amount to be withheld from an employee's gross pay
each pay period.
6. The payroll register is a summary of the annual earnings of each employee.
7. The employee's earnings record is a summary of the earnings of all employees for each pay.
8. The journal entry to record payroll transactions for the accounting period is to debit Wages
and Salaries Expense for the gross pay and credit the appropriate liability and cash accounts.
9. An electronic payroll system is one in which data is processed using computers equipped
with payroll software.
1. Employers usually prepare which of the following types of payroll records?
a. payroll register, employee earnings record, and payroll check
b. payroll register, payroll ledger, and employee earnings record
c. payroll journal, employee earning record, and payroll ledger
d. employee earning record, payroll check, and payroll ledger
2. The account that is credited with amounts withheld from an employee's earnings for any pension plan
contribution is
a. Pension Plan Expense. b. Pension Plan Taxes Payable.
c. Miscellaneous Expense. D. Pension Plan Deductions Payable.
3. A separate record of each employee's earnings is called a(n)
payroll register.
a.
b. employee earning record.
c. payroll ledger.
d. payroll check.


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Accounting practitioners in public accounting, industry, and not-for-profit organizations, as

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