@ Principles of Fundamentals Accounting I

PRINCIPLES OF ACCOUNTING I Acct.
201
DEGREE PROGRAMME
Table of Contents
Page
BLOCK I. STRUCTURE OF ACCOUNTING

Unit 1. Introduction to Accounting 1
Unit 2. The Accounting Cycle 46
Unit 3. Accounting for Merchandising Business 83
Unit 4. Accruals and Deferrals 124
BLOCK II. ACCOUNTING CONTROL SYSTEMS

Unit 5.Accounting System 150
Unit 6. Internal Control 166
BLOCK III. ACCOUNTING FOR CURRENT ASSETS

Unit 7. Cash 175
Unit 8. Accounting For Receivables 189
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UNIT 1. INTRODUCTION TO ACCOUNTING
Contents
1.0 Aims & Objectives

1.1 Introduction
1.2 Definition, Importance and Users of Accounting Information
1.2.1 Accounting Defined
1.2.2 Importance and Users of Accounting Information.
1.3 Bookkeeping Versus Accounting
1.4 The accounting Profession
1.5 Accounting Principles and Concepts
1.6 Forms of Business Organizations
1.7 Business Transactions and the Accounting Equation
1.7.1 Assets, Liabilities, and Owner‟s Equity
1.7.2. Transactions and the Accounting Equation.
1.8 Financial Statements of Sole Proprietorships
1.8.1 Income Statement
1.8.2 Owner‟s Equity Statement
1.8.3 Balance Sheet
1.9 Summary
1.10 Answers to Check your Progress Exercises
1.11 Model Examination Questions.
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1.12 Glossary of Terms
1.0 AIMS & OBJECTIVES

After studying this unit, you should be able to:
- explain the meaning of Accounting
- identify the users and uses of accounting
- explain the various branches in the profession of accounting
- explain the meaning of “generally accepted accounting principles”,
- explain the meaning of business entity assumption, cost principle and
monetary unit assumption
- state the basic accounting equation and explain the meaning of assets,
liabilities, and owner‟s equity
- analyze the effects of business transactions on the basic accounting
equation, and
- prepare an income statement, owner‟s equity statement, and balance sheet.
1.1 INTRODUCTION
We live in the information age-a time of communication, and a time when
information is a vital resource. In this information era, how we live, whom we
associate with, and the opportunities we have all depend on our access to and
understanding of information.
The same is true for businesses (businesses are one or more individuals selling
products or services for profit). Businesses that have better access to information
and that process information more quickly and accurately do the best.
Global computer networks and telecommunications equipment now allow us to
get access to all types of business information.
But to take advantage of these, we need knowledge of information systems.
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An information system is the collecting, processing, and reporting of
information to decision makers. Understanding and processing information is
the core of accounting.
The kind of information processed in accounting is financial i.e. of a monetary

nature.
Providing information about what businesses own, what they owe, and how they
perform is the aim of accounting. Accounting is, an information and
measurement system that identifies, records, and communicates relevant,
reliable, and comparable information about an organization‟s (a business‟s)
economic activities.
Therefore, a study of accounting helps people make better and informed

decisions about assessing opportunities, products, investments, and social and
community responsibilities.
But the use of accounting information is not limited to accountants or people in

business. You can use accounting information in your daily life. You can use
accounting information to get a loan for a house or to start a new business.
The study of accounting, therefore, opens you new and exciting possibilities
both in terms of becoming a professional accountant and using accounting
information in your daily life.
This course discusses the fundamental principles involved in processing

accounting information of business enterprises.
Understanding these fundamental principles is very important because

forthcoming courses that you are going to take in accounting will build on these
principles.
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1.2. DEFINITION, IMPORTANCE, AND USERS OF ACCOUNTING
INFORMATION
1.2.1. Accounting Defined
As a financial information system, accounting is defined as a process of
identifying measuring, recording and communicating economic events of an
organization (business or non- business) to interested users of the information.
Let‟s take a closer look at the activities involved in the process:
1. The first part of the process – identifying – involves selecting those events
that are considered evidence of economic activity relevant to a particular
organization. The sale of goods by Hadiya Super Market, the rendering of
service by Ethiopian Telecommunications Corporation, the payment of
salary by the Commercial Bank of Ethiopia, and the purchase of Building
by Unity University College are examplesof economic events.
2. Once identified and measured in Birr and cents, economic events are
recorded to provide a permanent history of the financial activities of the
organization. Recording consists of keeping a chronological diary of
measured events in an orderly and systematic manner. In recording,
economic events are also classified and summarized. (This will be
discussed in detail in unit-2)
3. This identifying and recording activity is of little use unless the
information is communicated to interested users. The information is
communicated through the preparation and distribution of accounting
reports, the most common of which are called financial statements.
A Vital element in communicating economic events is the accountant‟s ability

and responsibility to analyze and interpret the reported in formation. Analysis
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involves the use of ratios, percentages, graphs and charts to show the importance
of financial trends and relationships. Interpretation involves explaining to the
user the meaning, and limitation of reported data. The analysis and
interpretation part is left for advanced courses in accounting.
As accounting plays an important role in the decision making process of

business entities, it is often called the language of business. As a result, whether
you are an economist a marketer, investor, supplier or any other, to be
successful, you should be able to “speak” and be familiar with the basic terms
used in the business environment.
1.2.2 Importance of Accounting and Users of Accounting Information
Importance of accounting
The main purpose of accounting is to provide financial information to be used
for decision-making. For instance, Business executives and managers need the
financial information provided by the accounting system to help them plan and
control the activities of the business. Outsiders such as bankers, potential
investors, and labour unions and others also need accounting in formation.
In short the goal of the accounting system is to provide useful information to decision makers.
Thus, accounting is the connecting link between decision makers and business operations.
1.3 BOOKKEEPING VERSUS ACCOUNTING
People often fail to understand the difference between accounting and

bookkeeping. Bookkeeping is the process of recording business activities, and
keeping the records. It is the record- making phase of accounting. The
recording of transactions in Bookkeeping tends to be mechanical and repetitive;
it is only a small and probably the simplest but important part of accounting.
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Accounting, on the other hand, includes the design of an information system that
meets users‟ needs. The major goals of accounting are the analysis,
interpretation, and use of information. Accounting includes system design,
budgeting, cost analysis, auditing and tax planning and preparation.
A person might become a reasonably proficient bookkeeper in a few weeks or

months; however, to become a professional accountant requires several years of
study and experience.
Check Your Progress Exercise -1
1. Answer the following questions and compare your answer with the answer
key at the end of the unit.
a. Define accounting
b. Write in few words the importance of accounting.
c. Describe the basic distinction between accounting and bookkeeping.
Users of Accounting Information

Today‟s accountants focus on the ultimate needs of those who use accounting
information, whether the users are inside or out side the business. Accounting is
not an end by itself. The information that accounting provides allows users to
make “reasonable choices among alternative uses of scarce resources in the
conduct of business”
The people who use accounting information basically fall in to two categories:
1. External Users, and
2. Internal Users
1) External Users: External Users of accounting information are parties, which

are not directly involved in running the business enterprise. These include
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lenders, shareholders (stock holders), suppliers, employees and their Unions,
government (regulatory bodies) and others. External users rely (depend on)
accounting information to help them make better decisions in trying to
achieve their goals.
- The area of accounting aimed at serving external users is called Financial

Accounting. Its main objective is to provide to external users information
through financial statements.
Each external user has its own specified information-need depending up on the
decisions to be made. That is to say, all external users do not have the same
intentions (objectives) when they use the information.
In the following paragraphs we well try to discuss how some external users use
accounting information.
a) Lenders / Creditors
Creditors lend money or other resources to an organization. Lenders include

banks, mortgage and finance companies. Lenders look for information to help
them assess the ability of borrowers to repay their debts.
b) Share- holders (Stockholders)
Shareholders have legal control over part or all of a corporation. When it comes
to a corporation, shareholders are not directly involved in the management of the
corporation. However, as owners, they have claims over the properties of the
organization. Financial reports help to answer shareholders‟ questions such as:
- what is the income of the organization for the current and past periods?
- are the properties adequate to meet business plan?
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- will the business continue to be profitable in the future?
c) Employees and labour Unions

Employees and labor unions are interested in judging the fairness of their wages
and assessing future job prospects. They also use accounting reports as
evidence to ask for bonuses, when the organization is successful.
d) Government
The Inland Revenue Authority requires organizations to prepare financial

reports, in order to compute taxes.
2) Internal Users: These are persons that are directly involved in managing and
operating an organization. They include managers and other important
decision makers. The internal role of accounting is to provide information to
help improve the efficiency and effectiveness of an organization.
The area of accounting aimed at serving the decision-making needs of internal

users is called Management Accounting. Internal users often have access to a
lot of private and valuable information. Internal reports aim to answer questions
like:
 What are manufacturing costs per product?

 Which service activities are most profitable?
 What level of sales is necessary to break even?
1.4 THE ACCOUNTING PROFESSION

If you just joined the accounting profession, you may be wondering what job
you will be doing in the future. You probably would apply your expertise in one
of three major fields:
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 Public Accounting
 Private Accounting or
 Not – for – profit Accounting
i) Public accounting
In Public Accounting you would offer expert service to the general public in
much the same way that a doctor serves patients and a lawyer serves clients. A
major portion of public accounting practice is involved with Auditing. In this
area, a certified Public Accountant (CPA) examines, the financial statements of
companies and expresses opinion as to the fairness of presentation. When
presentation is fair, users consider the statements to be reliable.
Management consulting is another area of public accounting. In this case, the
accountant consults the management generally about the growth and
development of the business enterprise.
ii) Private Accounting

Instead of working in public accounting, an accountant may be an employee of a
business enterprise. In private accounting, you would be involved in one of the
following activities:
1. Cost Accounting: Determining the cost of producing specific products.
2. Budgeting: Assisting management in quantifying goals concerning

revenues, costs of goods sold, and operating expenses.
3. General Accounting: recording daily transactions and preparing

financial statements and related information.
4. Accounting information systems: designing both manual and

computerized data processing systems.
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5. Tax Accounting: preparing tax returns (-forms to be filled by a company
and returned to a taxing authority) and engaging in tax planning for the
company.
6. Internal Auditing: reviewing a company‟s operations to determine

compliance with management policies and evaluating efficiency of
operations.
iii) Not for Profit Accounting
Like businesses that exist to make a profit, not - for-profit organizations also
need sound financial reporting and control. Donors to such organizations want
information about how well the organization has met its objectives and whether
continued support is justified. In each of these cases, accounting expertise is
highly valued.
Check your Progress Exercise -2
1. What are the basic categories of the users of accounting information?

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2. _____________is the area of accounting aimed at serving external users of

accounting information.
3. _____________ is the area of accounting aimed at serving the decision-

making needs of internal users.
4. What are the three major fields of engagement for accountants?
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1.5. ACCOUNTING PRINCIPLES AND CONCEPTS

Accounting, as it is true for other disciplines, has got its own principles and
practices. One must be able to understand these principles and practices to
understand and prepare financial statements and reports. The principles and
concepts used in accounting are called Generally Accepted Accounting
Principles (GAAP). These principles guide accountants how to record and
report business activities.
GAAP are developed over a long span of years by the accounting profession.
That is, their development is not revolutionary rather evolutionary. The main
purpose of these basic rules is to guide accountants in measuring and reporting
financial events of business enterprises.
GAAP are not like the unchangeable laws of nature found in biology and
chemistry. They can be changed as better methods are developed or as
circumstances change. Generally, it is from research, practice, and
pronouncements of professional bodies that GAAP evolve.
In this unit, we will discuss three of the generally accepted accounting

principles: Business Entity concept, Cost principle and Monetary Unit
Assumption.
i) Business Entity Concept

Accountants frequently refer to a business organization as an accounting or
business entity. A business entity is any business organization, such as a “super
market”, laundry, barberry, or a hotel, which exist as an economic unit. For
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accounting purposes, each business enterprise has a separate existence from its
owners, creditors, employees, customers and other businesses.
This separate existence of the business enterprise is known as the business entity
concept. Thus, the business entity should have a completely separate set of
records and its financial records and reports should refer only about the business
enterprises.
For example, W/o Muna Mamo has got her own two business enterprises one
called Munaye Super Market, and another hotel called Budena Hotel. Each
Business would be considered as an independent economic business unit. The
activities of each business are kept separately from each other and from the
owner‟s personal records. Let say W/O Muna bought a house to live in. This
house would not be recorded and reported in the records of either the
supermarket or the hotel. The personal saving account she has will not as well
be included in the financial reports of either one of the businesses. She must
have to open separate bank accounts for the two businesses. The super market
should not record the payment of salary to employees of the hotel.
ii) The cost principle

The cost principle states “properties and services acquired by business
enterprises must be recorded at actual amounts paid or assumed in acquiring the
properties.”
For example, Modern Advertising Company is considering the purchase of a

building. The seller of the building offered a price of Birr 10,000 while the
buyer first offered a price of Birr 8000. However, after certain bargaining, the
seller agreed to sell the building for Birr 9000 and the buyer paid that amount.
According to the “cost principle” the buyer has to record the building in its
records at birr 9000- the actual amount paid to get the building.
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The buyer may receive an offer of Birr 12,000 for the building a month after if has been
acquired. This has no effect on the accounting records because it doesn‟t originate from an
actual exchange. It is simply a mere offer.
If the buyer sells the building for Birr 20,000 after purchasing it, a gain of Birr. 11,000 would
be realized. The new owner would use Birr 20,000 as the cost of the building.
In an exchange between a buyer and a seller, both attempt to get the best price.
Only amounts agreed up on and paid are objective enough for accounting
purposes.
Monetary Unit Assumption
All business activities (events) are recorded in terms of money (-Birr, Dollar, Pound or any
other currency). Of course, information of a non -financial nature can be recorded, but it is
only through the recording of dollar (Birr) amounts that the activities of a business can be
measured. Money is the only factor common to all business activities. Therefore, it is the
only practical unit of measurement that can produce financial data that can be compared.
The monetary unit used by a business depends on the country in which it exists.
For example, in Ethiopia the basic unit of measurement is the birr,as is the dollar
in the U.S.A, and Pound Sterling in the United Kingdom.
1. The abbreviation GAAP stands for ____________________________.
2. What do we mean by “GAAP are not like the unchangeable laws of nature”?
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3. Why do we need to record all business activities in terms of money?
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4. What is the principle that says properties acquired by business enterprises

must be recorded at actual amounts paid?
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1.6 FORMS OF BUSINESS ORGANIZATIONS

There are three basic forms of business organizations: sole proprietorships,
partnerships, and corporations. Accountants recognize each form as an
economic unit separate form its owners (Business Entity Concept).
In this course, we will begin by the accounting for sole proprietorships because
it is the simplest form of accounting.
1. Sole Proprietorships
A sole proprietorship is a business owned by one person and usually managed
by the owner. No special legal requirements must be met to start a sole
proprietorship and usually only a limited investment is required to begin
operations.
A sole proprietorship is a separate entity for accounting purposes (Business

entity Concept) but it is not a separate legal entity from the owners. That is,
from the legal point of view, the owner and the business are treated as one and
the same. The owner will be held personally responsible for the debts and
actions of the business.
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For instance, assume Flower Laundry is a sole proprietorship owned by Ato Alemu.
Assume also that the business has borrowed Birr 10,000 from the Commercial Bank of
Ethiopia and failed to pay its debts. In this case, if the Commercial Bank of Ethiopia can‟t
recover the amount it lent from the properties of the company it can go to the extent of selling
the owner‟s personal properties.
2. Partnerships
A Partnership is like a sole proprietorship in most ways except that it has more
than one owner. A partnership is not a legal entity separate from the owners but
an association that brings together the talents and resources of two or more
people. The owners of a partnership are known as partners.
The partners share the profits and losses of the partnership according to an
agreed –on formula. The personal resources of each partner can be called on to
pay the obligations of the partnership. That is, each partner is personally
responsible for the debts of the partnership. From an accounting standpoint,
however, a partnership is a business entity separate from the personal activities
of the partners.
3. Corporations
A business organized as a separate legal entity with ownership divided into
transferable units of capital is called a corporation. The owners of a corporation
are called stockholders or shareholders. The corporation issues capital stock
certificates to each stockholder showing the number of shares (orstock) he or she
owns. The stockholders are free to sell all or part of these shares to other
investors at any time. This ease of transfer of ownership adds to the
attractiveness of investing in a corporation. Since a corporation is a separate
legal entity, the owners (stockholders) are not personally liable for the debts of
the corporation. Their risk of loss is limited to the amount they paid (invested).
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Because of this limited liability in a corporation shareholders are willing to
invest in riskier, but potentially more profitable, activities.
Even though corporations are fewer in number than proprietorships and partnerships, they
contribute a lot to the economies of many countries in monetary terms.
1.7 BUSINESS TRANSACTIONS AND THE ACCOUNTING EQUATION

Business transactions are economic events that should be recorded because they
affect the financial position of the business enterprise. These businesses
transactions are the raw materials of accounting reports, as cotton is a raw
material for a textile factory.
A transaction can be an exchange (such as the purchase or sale of property, payment or

collection of a loan etc.) between two or more parties. A transaction can also be an event that
has the same effect as an exchange transaction but doesn‟t involve an exchange transaction.
Some examples of “non exchange” transactions are losses from fire, flood; physical wear and
tear on equipment; donation of property and so forth.
For a given transaction to qualify to be recorded it has:

1. to be related to the business enterprise
2. to be measurable in terms of money
3. to be completed / happened/ action.
(i.e. it should not be a mere promise or intention; it must be at least partially

completed to be recorded)
1.7.1 Assets, Liabilities and Owner’s Equity

If you have noticed, in any organization you will find properties such as a
building, furniture, land, vehicles and the like. Such properties owned by
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business enterprises are referred to as Assets. To buy these assets, businesses get
money from two sources: investments made by owners or amounts borrowed
from creditors. Therefore, both owners and creditors have a claim over the
assets of the business enterprise. The claims or rights of owners are referred to
as Equities. If the assets owned by a business amount to Birr 50,000 the
equities in the assets must also amount to Birr 50,000. The relationship between
the two may be stated in the form of an equation, as follows:
Economic Resources = claims over the

resources
Assets =Equities.
Equity may be subdivided in to two principal types: the rights of creditors and
the rights of owners. The rights of creditors represent debts of the business and
are called Liabilities. The rights of owners are called Owners’ Equity (capital).
Assets=equities
Equities = Liability + Owner‟s equity
This equation can be written as:
Assets= liability + Owner‟s Equity
It is customary to place “liabilities“ before “Owners equity” in the accounting equation

because creditors have priority (preferential) rights to the assets. Because of this, the owners
have a residual claim over the assets. To help you understand this, assume X company has
total assets of Br. 5000, liabilities of Br 2000 and owner‟s equity of Br 3000. If the business is
to be closed, the assets of the company will be sold and distributed to the claimants. In
accounting, the Owner‟s are given their share after the creditors are given their entire share.
For example, assume the assets are sold for Br 4,500. The creditors will be given their share
of Br. 2,000 and what ever remained (Br.2,500)is given to the owners. If the assets were sold
for Br. 7,000, the creditors would have been given their share of Br. 2,000 and the remaining
balance Br 5,000 would have been given to the owners.
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Liabilities
Assets &
Capital
As you can notice, the owners are given whatever is left (it could be greater or
less than their share). That is why we said owners have residual claim over the
assets of the business whereas creditors are said to have priority clam over the
assets as they are paid first
1 Business organizations are classified in to three, based on what?

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2 What do we mean by the term „unlimited liability‟?

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3 Which of the three forms of business originations is (are) separate legal entity
(entities) from their owners?
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4 ___________________ represents the claim of owner‟s against assets of the
business enterprise.
5 Assume total asset of Br 60,000, and owner‟s equity of Br 45,000.

Determine the amount of liability .
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6 L=A-C Is this an acceptable way of writing the basic accounting equation?

Explain.
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7 What do we mean when we say “owners have a residual claim over the assets
of the business enterprise”?
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8 Define a business transaction, and give at least four examples.

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1.7.2 Transactions and the Accounting Equation
All business transactions from the simplest to the complex can be stated in terms
of the resulting effect on the three basic elements of the accounting equation.
How ever, it is important to remember that each transaction leaves the equation
in balance. Assets always equal the sum of liabilities and owner‟s equity.
Let‟s examine the effects of some of the most common business transactions on
the accounting equation. As a means of illustration, suppose Ato Dawit
Gemechu establishes a sole proprietorship to be known as Effective Garage, on
September1,200x . During September, the business engages in the following
transactions:
Transection (1)- Owner’s investment

Ato Dawit starts business by depositing Br. 100,000in a bank account opened in
the name of Effective Garage. The transfer of cash from the owner to the
business is on owner‟s investment. The effect of the transaction is to increase
the assets (Cash) on the left side of the accounting equation by Birr 100,000 and
to increase owner‟s equity by the same amount.
Assets = Liabilities + Owner‟s Equity
Cash Dawit Gemechu, Capital

Tran.1 + Br. 100,000 +Br. 100,000
Balance Br. 100,000 Br. 100,000
At this point, the company has no liabilities; the only party having claim over
the assets of the company is the owner.
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N.B. the equation relates only to the business enterprise. Ato Dawit‟s personal
assets, such as his home and personal bank account and personal liability are
excluded from consideration. The business must be treated as a separate entity.
TRANSACTION (2)- PURCHASE OF LAND FOR CASH

Effective Garage bought land for Birr 20,000 in cash, to be used as a future site
for the business. This transaction changes the composition of the assets but it
doesn‟t change the total amount of assets. It has no effect on the liability and
owner‟s equity of the business.
Assets = Liabilities + Owner‟s Equity

Cash + Land Dawit Gemechu, Capital.
Bal. Birr 100,000 Birr 100,000
Tran. 2 -20,000 +20,000 __-_____
Bal. Birr 80,000 + Br.20,000 = ________________ 100,000__
After the above transaction, the company will have less cash but a new asset
(land ). The total assets (cash + Land) amount to Birr 100,000, which is equal to
the owner‟s equity.
Transaction (3) -Purchase of Supplies On credit

Ato Dawit bought office supplies for birr 2,500 on credit, to be used by the
business. Assets can be purchased on credit (on account) basis, where the buyer
promises to pay in the future. This type of transaction is called a purchase on
account and it results in a liability to the buyer; the liability created when
something is bought on credit is called Accounts Payable.
Assets______ = Liability + Owners

Equity
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Cash + Supplies + Land Accounts payable Dawit
Gem, Captal
Bal. Birr 80,000 Br.20,000 Birr 100,000
Tran(3) -___ + 2,500 - + 2,500 ___-
____
Bal. Br. 80,000 2,500 20,000 2,500
100,000
Birr 102,500 Birr 102,500
Goods that are physical consumed, such as a chalk to a school, gas oil for car, and stationery
materials for an office, are called supplies.
Transaction ( 4 ) – Payment of liability

Effective Garage paid Birr. 1,500 to creditors on account. As you might have
noticed, the business bought the supplies in transaction “C” by promising to pay
in the future, and as per the promise made it is now settling its liability. The
effect of this transaction on the accounting equation is as follows:

Equity
Gem, Captal
Bal Br 80,000 Br. 2,500 Br.20,000 Birr 2,000 Birr
100,000
Tran.4 -1,500 - - -1,500 -
___
Bal. Br. 78,500 Br.2,500 Br.20,000 Birr 1,000 Birr
100,000
Birr 101,000 Birr 101,000
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As a result of the transaction, the total cash decreases by birr 1,500 because cash
is paid and the liability of the company also decreases by the same amount.
After the above transaction is completed, the total amount the company has to
pay in the future is only birr 1,000. Please note that the transaction has no effect
on the supplies that were bought on credit.
Transaction 5 – Selling of service

The amount charged to customers for goods or services sold to them is called
revenue. For instance, the amount of money that you pay to a shopkeeper after
buying a pair of shoes or something is revenue to the shopkeeper. Different
titles may be used for revenue depending up on the source of revenue. For
example, a service fee for a garage, interest revenue for interest earned by a
bank, rent income for revenues that result from renting rooms, fares earned for
revenues from a taxi service and others.
During the first month of operation, Effective Garage earned service Fees of
Birr 30,000 receiving the amount in cash for the garage services it rendered.
The effect of this transaction is to increase assets (because cash is collected) and
to increase owner‟s equity by the same amount as revenue is earned.

Equity
Gem, Captal
Bal Br 78,500 Br. 2,500 Br.20,000 Birr 1,000 Birr
100,000
30,000 - - -
30,000
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Bol. Br. 108,500 Br.2,500 Br.20,000 Birr 1,000 Birr
130,000
Birr 131,000 Birr 131,000
Service can be given for cash or on credit. In this example, the service is given
for cash (i.e., the company collects the cash on the spot service was given). But
instead of requiring customers to pay at the time of sale, a business may let the
customers to pay in the future. Such expected collections in the future result in
an Accounts Receivable to the company. An accounts receivable is as much an
asset as cash to the business enterprise. And the revenue from the sale of the
service or good on credit is realized and recorded on the date of sale with out
waiting for the collection of the cash.
Transaction (6 )- Recording Expenses

To generate revenue, Effective Garage has to hire employees and pay salary, it
has to consume electric power and water resource and pay the bill, and so forth.
The amounts of such cash payments and using up of supplies are expenses to the
business. That is, an expense is the amount of assets consumed or services used
in the process of generating revenue. Just as revenues are recorded when they
are earned, expenses are recorded when they are incurred (i.e. when the
obligation to pay them arises).
During the month of September, Effective Garage paid Birr 15,000 for different
types of expenses (birr 10,000 to salary of employees, birr 3000 Telephone, birr
1,500 for rent, and birr 500 for advertisement).
The effect of these transactions is to decrease assets (because cash is paid) and
decrease owner‟s equity. This can be stated on the accounting equation as
follows:
25
Equity
Gem, Captal
Bal Br108, 500 Br. 2,500 Br.20,000 Birr 1,000 Birr
130,000
-15,000 - - __-___ -
15,000___
115,000
Birr 116,000 Birr 116,000
Transaction – 7 Owner’s Withdrawal

Ato Dawit Gemechu, the owner, withdrew Birr 3000 for his personal from the
business. Such assets taken out of the business for the owner‟s personal use, by
the owner are called withdrawals. Owners can withdraw in cash or in kind. For
example, an owner of a super market can withdraw soap or something for his
personal benefit instead of cash.
The effect of the transaction in our case is to decrease assets as cash is taken out,
and decrease owner‟s Equity by the same amount. This can be stated on the
accounting equation as follows:
Equity
Gem, Captal
Bal Br 93, 500 Br. 2,500 Br.20,000 Birr 1,000 Birr
115,000
26
-3,000 - - __-___ -
3,000___
112,000
Birr 113,000 Birr 113,000
Summary
The transactions of Effective Garage can be summarized in a tabular form as
shown below. Number identifies the transactions here and the balance of each
item is shown after each transaction.
Equity
Type of
Tra Accounts Dawit Gem. owner‟s
. Cash + Supplies + Land Payable Capital Transactio
No n
1 +100,000 - - - + 100,000 Owners
Investmen
t
Bal Birr - - - Birr
100,000 100,000
2 -20,000 - + 20,000 - -
Bal Birr - Birr - Birr
80,000 20,000 100,000
3 - +2500 +2500
Bal Birr Birr 2,500 Birr Birr2500 Birr
80,000 20,000 100,000
27
4 -1,500 - -1500
Bal Birr Birr 2,500 Birr Birr1,000 Birr
78,500 20,000 100,000
5 + 30,000 - - - + 30,000 Service
fe e
Bal Birr Birr 2,500 Birr Birr1,000 Birr
108,500 20,000 100,000
6 -15,000 - - - -10,000 Salary
-3000 Exp.
Teleph.
Exp
- - - - -1500 Rent Exp.
-500 Adv. Exp.
Bal Birr Birr 2500 Birr Birr 1000 Birr
93,500 20,000 115,000
7 -3,000 - - - -3000 Owner‟s
withdrowa
l
Bal Birr Birr 2500 Birr Birr 1,000 Birr
90,500 20,000 112,000
Total Assets =Birr 113,000 Total Liabilities and Owner‟s Equity
= Birr 113,000
The following Observations, which apply to all types of Businesses, should be

noted:
1. The effect of every transaction can be stated in terms of increases and /or
decreases in one or more of the elements of the accounting equation.
28
2. The equality of the two sides of the accounting equation is always
maintained.
3. The owner‟s investment and revenues increase the owner‟s equity.
Withdrawals and expenses during the period decrease the owner‟s equity.
The effect of these four types of transactions on owner‟s equity can be
illustrated as follows:
Owner‟s Equity
Decreased by: Increased by: Owner‟s Investment and Revenues

Owner‟s withdrawals and Expenses
The relationship of the above elements and their effect on the capital balance
can be shown as:
EC = BC + I – W + R - E
Where: EC – End Capital Balance
BC - Beginning Capital Balance.
I - Owner‟s Investment
W - Owner‟s Withdrawals
R - Revenue
E - Expense.
1.8 FINANCIAL STATEMENTS OF SOLE PROPRIETORSHIPS

After the effect of the individual transactions has been determined, the essential
information is communicated to users at certain intervals. The accounting
reports, which communicate this information, are called financial statements.
29
Financial statements are said to be the central features of accounting because
they are the primary means of communicating important accounting information
to users.
Financial statements are the means of transferring the concise picture of the
profitability and financial position of the business to interested parties.
The major financial statements used to communicate accounting information

about a business are:
- income statement
- balance sheet
- statement of owner‟s Equity
- statement of cash flows (will be discussed in senior courses)
Since these financial statements are in a sense the end products of the
accounting process, a student who acquires a clear under standing of the content
and meaning of financial statements will be in an excellent position to appreciate
the purpose of the earlier steps of recording and classifying business
transactions.
1.8.1 The Income Statement

The income statement is a financial statement that summarizes the amount of revenues earned
and expenses incurred by a business over a period of time. It reports the profitability of the
business by comparing revenues and expenses for a stated period of time such as a month or a
year. In accounting profitability is measured for a period of time than on a daily basis.
Though measuring daily could be possible, it will not be practical and beneficial to the
30
If the revenue of a period exceeds the expenses of that same period, net income
results. If expenses are greater than the revenues of a period, we say there is a
net loss, that is, the business has operated unprofitably.
N.B. The determination of periodic net income (net loss) is a matching process
involving two steps. First revenues earned are recognized during the period.
Second, the expenses incurred to generate revenues are matched (compared)
against revenues to determine net income or net loss.
All financial statements have a heading that you can find in any kind of a report.
The heading of these statements identifies the company, the type of statement,
and the time period covered by the statement. Note that the primary focus of the
income statement is reporting the success or profitability of the company‟s
operations over a specified period of time. To indicate that it applies for a
period of time, the income statement is dated “For the month ended…”
The following is an income statement for Effective Garage for the month ended September
30, 200x.
Effective Garage
Income statement
For the Month Ended September 30,200x
Revenues:
Service Fee Birr 30,000.00
Expenses:
Salary Expense Birr 10,000.00
Telephone Expense 3,000.00
Rent Expense 1,500.00
31
Advertising Expense 500.00
Total Expenses 15,000.00
Net Income Birr 15,000.00
1.8.2 Owner’s Equity Statement

This is a statement that summarizes the changes in owner‟s equity for a specific
period of time. Data for the preparation of owner‟s equity statement are
obtained from the owner‟s equity column of the tabular summary (Illustration 1-
) and from the income statement. The heading of this statement identifies the
company, the type of statement, and the time period covered by the statement.
The time period is the same as that covered by the income statement and
therefore is dated “ For the Month Ended September 30, 200x.” The beginning
owner‟s equity amount is shown on the first line of the statement. Then, the
owner‟s investments, net income and the owner‟s drawings are identified in the
statement.
The information provided by this statement indicates the reasons why owner‟s
equity has increased or decreased during the period. The Owner‟s equity
statement for effective Garage for the month of September is shown below:
Effective Garage
Statement of Owner’s Equity
For the Month ended September 30,200x
Dawit G. Capital, September 1……………………………………Birr -0 -

Add: Investments…………………………………Birr 100,000.00
Net income……………………………………15,000.00
115,000.00
32
115,000.00
Less:
Drawings………………………………………………………………3,000.00
Dawit G. Capital, September 30………………………………… Birr
112,000.00
1.8.3 Balance Sheet
The balance sheet, sometimes called the statement of financial Position, lists the
company‟s assets, liabilities and owner‟s equity as of a specific date- usually at
the end of a month or year.
Shown below is the balance sheet for Effective Garage as of September 30,
200x. The balance sheet heading contains the name of the company, the type of
statement, and the specific date on which assets; liabilities and owner‟s equity
are identified and measured.
The total assets must equal the total liabilities and owner‟s equity. There are tow
commonly used formats of the balance sheet:
The account format
Which lists assets on the left side and equities (i.e. liability and owner‟s equity)
on the right side. It resembles a basic accounting format called an „account‟ to
be introduced in unit 2.
_________
_________
_____
Assets Liability
33
Owner‟s
Equity
The Report Format

-Lists assets, Liability and Owner‟s equity vertically
__________
_________
_____
Assets
Liability
Owner‟s Equity
You can choose either of the two formats for your balance sheet preparation.
The following is a balance sheet prepared for effective Garage based on the
sample transactions illustrated in the chapter.
Effective Garage
Balance Sheet
September 30,200x
Assets Liability
Cash…………Birr 90,500.00 Accounts payable…… Birr
Supplies……………2,500.00 1,000.00
34
Land………………20,000.00
Owner‟s Equity
_________ Ato Dawit Gem., Capital
Total Assets……..113,000.00 Br12,000.00.
Total Liabilities and
Owner‟s equity……...Birr
113,000.00
The double line is drawn only when the total assets on the left side are equal to
total liabilities and Owner‟s equity. In the Effective Garage illustration, only
one liability- accounts payable- is reported on the balance sheet. In most cases,
there will be more than one liability. When two or more liabilities are involved,
a customary way of listing is as follows:
Liabilities
Notes payable Birr 10,000.00
Accounts Payable 1,000.00
Salaries Payable 2,000.00
Total Liabilities Birr 13,000.00
Each statement provides management, owners, and other interested parties with
relevant financial data. The financial statements are interrelated: (1) Net income
of Birr. 15,000 shown on the income statement is added to the beginning
balance of owner‟s capital in the owner‟s equity statement. (2) Owner‟s capital
of Birr 112,000 at the end of the reporting period shown in the Owner‟s equity
statement is reported on the balance sheet as the Dawit G/M. capital balance.
35
Be sure to carefully examine the format and content of each statement.
1. _____________ are assets used or consumed in the process of generating

revenue.
2. Drawings are assets taken out of the business for the owner‟s personal
benefit. Do you advise owners to withdraw cash or in kind (i.e. furniture,
automobile..)? Why?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
3. List the four factors that change owner‟s equity. What is their effect on
owner‟s equity?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
4. What are the four financial statements?

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
5. Every financial statement has three lines as a heading,
1st line____________________________
36
2nd line___________________________
3rd line __________________________
1.9 SUMMARY
Explain the meaning of accounting. Accounting is the process of identifying,
measuring recording and communicating the economic events of an organization
(business or non business) to interested users of the information. Accounting
helps us in the allocation of scarce resources in an efficient and effective
manner.
Identify the users and uses of accounting. (a) Management uses accounting
information in planning controlling and evaluating business operations. (b)
Investors (owners) judge the wisdom of buying, holding, or selling their
financial interests on the basis of accounting data, i.e. to see how their
investment is doing. (c) Creditors evaluate the risks of granting credit or lending
money. Other groups of users include taxing authorities, regulatory agencies,
customers, labor unions, and economic panniers. These users are grouped in to
two: 1- Internal users and ii- External users.
Explain the meaning of generally accepted accounting principles: Generally

accepted accounting principles are a common set of standards used by
accountants.
Explain the meaning of business entity assumption, cost principle and the monetary unit
assumption. The business entity concept states the economic events of a particular business
should be identified separate from other entities and the owner‟s personal records. The cost
principle requires properties acquired by business enterprises to be recorded at actual amounts
paid and /or assumed in acquiring the properties. The monetary unit assumption requires only
transactions capable of being expressed in terms of money be included in the accounting
records of the business enterprise.
37
State the basic accounting equation and explain the meaning of assets, liabilities,
and owner‟s equity. The basic accounting equation is:
Assets = Liabilities + Owner‟s Equity.
Assets are resources owned by a business, liabilities represent the claim of

creditors on the total assets, and owner‟s equity is the ownership claim on the
total assets. It is often referred to as residual equity.
Analyze the effects of business transactions on the basic accounting equation.

Each business transaction must have a dual effect on the accounting equation.
For example, if an asset is decreased, there must be a corresponding (1)
Increase in another asset, or (2) decrease in a specific liability, or (3) decrease in
owner‟s equity. After each transaction, the equality of assets to the sum of
liabilities and Owner‟s equity must be maintained.
Prepare an income statement, owner‟s equity statement, and balance sheet. An

income statement presents the revenues and expenses of a company for a
specific period of time. An owner‟s equity statement summarizes the changes in
owner‟s equity that have occurred for a specific period of time. A balance sheet
reports the assets, liabilities, and owner‟s equity of a business at a specific date.
1.10 ANSWERS TO CHECK YOUR PROGRESS EXERCISES
Check Your Progress Exercise - 1
1) Accounting is the process of identifying, measuring, recording and

communicating economic events to permit informed decisions and decisions
by the users of the information.
2) Accounting as an information system helps others to make informed
decisions about the use of scarce resources.
38
3) Bookkeeping is the recording part of accounting. Accounting includes
analytical interpretation phases in addition to the recording phase.
Check Your Progress Exercise –2
1) i )internal users ii) external users.

2) Financial Accounting
3) Management Accounting
4) i) Public accounting
ii) Private accounting
iii) Not –for- profit accounting

1. Generally Accepted Accounting Principles.
2. GAAP, are open for change whenever better methods are developed or as
circumstances change.
3. It is the only common unit of measurement to all business enterprises. That
is, why comparison of two unrelated business enterprises is possible.
4. The Cost Principle
1. Based on the number of people who own them and the style of ownership.
2. Unlimmitted Liability refers to the fact that the liability of the owners of a sole
proprietorship and a partnership is not limited to the extent of their investment, but it
extends to their personal properties.
3. Only corporations
4. Owner‟s Equity
5. Liability=Asset –Owner‟s Equity =>Liabilities=60,000-45,000=15,000
39
6. Though it is mathematically correct; it doesn‟t reflect the practical fact that capital is what
is left after deducting liabilities from assets as creditor‟s claims take precedence over
those of owners. Therefore, liability is not what is left after owners take their shares.
7. When the assets of a business are not sufficient to satisfy all the claims of both owners and
creditors, first creditors are paid in full and owners take whatever remains (i.e. the residue)
even if this means they will not be fully paid.
8. A transaction is an event that has to be recorded by accountants because it affects the
economic status of the business. The purchase of equipment, the consumption of supplies,
the collection of money from debtors, payment to creditors, and the provision of service to
customers are common examples of transactions that accountants have to record daily.
1. Supplies
2. It is not advisable for owners to withdraw in kind (such as a vehicle or
furniture) because this may interrupt the business's operation for sometime
until the withdrawn assets are replaced.
3. Factor Effect on owners equity

Revenues In c re a s e
Expenses Decrease
Investment In c re a s e
Drawings Decrease
4. The income statement, the balance sheet, statement of owner‟s equity and
statement of cash flows.
- Name of company
- Name of report (statement)
- Period covered by financial statement
1.11 MODEL EXAMINATION QUESTIONS
40
1. Guji company had the following amounts of assets and liabilities at the
beginning and end of last year:
Assets Liabilities
Beginning of the year………………Br.75,000 Br. 30,000
End of the year….……………………120,000 46,000
Determine the net income or net loss of Guji for the year under each of the
following unrelated assumptions:
a) Owner made no additional investment and withdrew no amount during
the year
b)Owner made no additional investment but withdrew Br.17,500 to pay
for her personal expenses
c) Owner withdrew no amount during the year but made additional
investment of Br. 32,500 cash.
d)Owner withdrew Br.17,500 and invested Br.25,000 cash during the
year.
2. For each of the following give an example of a transaction that creates the described
effects:
a) Decreases a liability and decreases an asset
b) Increases an asset and decreases another asset
c) Decreases an asset and decreases owners equity
d) Increases a liability and decreases owners equity
e) Increases an asset and increases a liability
f) Decreases an asset and decreases a liability
Mimi started a new business called Omo Company and completed the following
transactions during November:
41
Nov.1 Mimi transferred 56,000 out of a personal savings bank account to a
checking account she in the name of the business.
1. Rented office space and paid cash for the month‟s rent of 800
3. Purchased electrical equipment for 14,000 by paying 3,200 and agreeing
to pay the remaining balance in six months
5. Purchased office supplies by paying 900 cash.
6. Completed electrical work and received 1,000 cash for doing the work.
3. Purchased 3,800 of office equipment on credit
15. Completed electrical work on credit in the amount of 4,000
20. Paid for the office equipment purchased on Nov.9
24. Billed a customer for electrical work completed 600
28. Received 4,000 for the work completed on Nov.15
30. Paid salary of employees 1,200
30. Paid the monthly utilities bill 440
30. Withdrew 700 from the business for personal use
Required:
1. Arrange the following asset, liability and owner‟s equity titles in a table just
like illustrated in this unit: Cash, Accounts Receivable, Office Supplies,
Office Equipment, Electrical Equipment, Accounts Payable and Mimi
Capital.
2. Use additions and subtractions to show the effect of each transaction on the
items in the equation. Show new totals after each transaction. Next to each
change in owners equity state whether the change was caused by an
investment, revenue, expense or withdrawal.
42
3. Prepare an income statement, a statement of owner‟s equity, and a balance
sheet
1.12 GLOSSARY OF TERMS

Accounting - the process of identifying measuring, recording, and
communicating the economic events of an organization to interested users of the
information.
Assets – Resources owned by a business.
Auditing – the examination of financial statements by a certified public

accountant in order to express an opinion as to the fairness of presentation.
Balance Sheet – A financial statement that reports the assets, liabilities, and
owner‟s equity on a specific date.
Basic Accounting Equation - Assets=Liabilities + owner‟s equity
Bookkeeping – A part of accounting that involves only the recording of

economic events.
Corporation – a business organized as a separate legal entity under state

corporation law having ownership divided into transferable shares of stock.
Cost Principle – an accounting principle that states the assets should be

recorded at their actual cost .
Drawings – Withdrawals of cash or other assets from the business for the
owner‟s personal use.
43
Economic (Business) Entity Assumption – An assumption that states a
business enterprise must be given separate and distinct existence from the
owners, creditors, customers and any other party.
Expenses - the cost of assets consumed or services used in the process of

earning revenue.
Income statement – A financial statement that presents the revenues and

expenses and resulting net income or net loss of a company for a specific period
of time.
Investment by owner – the assets put in to the business by the owner.
Liabilities – Represents the claim of creditors on the assets of the business.
Monetary unit assumption– An assumption stating that only transactions that

can be expressed in terms of money be included in the accounting records of the
business.
Net Income – the amount by which revenues exceed expenses.
Net loss – the amount by which expenses exceed revenues.
Owner’s Equity Statement – A financial statement that summarizes the

changes in owner‟s equity for a specific period of time.
Partnership – An association of two or more persons to carry on a business as

co-owners for profit.
Private accounting – An area of accounting with in a company that involves

such activities as cost accounting, budgeting, and accounting information
systems.
44
Public Accounting – An area of accounting in which the accountant offers
expert service to the general public on a fee bases.
Revenues – the gross increase in Owner‟s equity, resulting form business

activities entered in for the purpose of earning income. It is the amount charged
to customers for services sold or goods delivered to them.
Tax Accounting - an area of public accounting involving tax advice, tax

planning, and preparing tax returns.
Transactions – The economic events of the business recorded by the

accountant.
45
UNIT .2 THE ACCOUNTING CYCLE
CONTENTS
2.1 Introduction
2.2 Nature of an Account
2.3 Classification of Accounts
2.4 Chart of Accounts
2.5 Rules of Debits and credits
2.6 Journalizing Business Transactions
2.7 Posting From the Journal to the Ledger
2.8 The Trial Balance
2.8.1 Proof provided by the Trial Balance
2.8.2 Limitations of the Trial Balance
2.9 Adjustments
2.9.1 The Accrual Basis and Cash Basis of Accounting
2.9.2 The Matching Principle
2.10 Worksheet for Financial Statements
2.11 Financial Statement Preparation
2.12 The Closing Process
2.13 Post Closing Trial Balance
2.14 Summary
2.15 Answers to Check Your Progress Questions
2.16 Model Exam Questions
46
2.0 aims & Objectives
By the time you have finished this unit you should be able to:
- explain the meaning and nature of an account.
- apply debits and credits to record business transactions
- define the terms journal, ledger, journalizing, posting, trial balance etc.
- complete the accounting cycle
2.1 INTRODUCTION
In unit 1, you have learned the relationship between the accounting equation and
business transactions. Every business transaction affects the elements of the
accounting equation. This accounting procedure will be discussed in detail. The
different and interrelated stages of the accounting cycle will be presented. The
chapter is lengthy, but essential for the remaining chapters in this course and
other accounting courses. Therefore, you are advised to study the chapter
carefully.
2.2 NATURE OF AN ACCOUNT

In order to provide the necessary information to users, accountants maintain
separate records on each element of the financial statements. For example, to
report the balance for cash at the end of a year, a record regarding cash should
be kept. The record includes beginning cash balance, cash payments & cash
collections during the period. This record is called an account.
Definition: An account is a subdivision under the three elements of the

accounting equation used to record the changes over a single element in the
financial statements. An account has three parts, Title, Debit, and credit. For
illustration purposes an account can be represented in the form of capital letter
„T‟.
47
Example
Title
Debit Credit
Dr Cr
2.3 CLASSIFICATIONS OF ACCOUNTS

Accounts are classified into five: assets, liabilities, capital, revenue and,
expenses. The first three are called balance sheet accounts and the other two
are called income Statement accounts. Balance Sheet accounts are those
reported on the balance sheet at the end of the reporting period and Income
Statement accounts are reported on the Income Statement.
The five groups of account are discussed below
1. Assets: Resources owned by a business or individual are called assets.

Assets could be tangible or intangible. Tangible assets are assets having
physical existence, like cash, land, computer, stationery materials. Intangible
assets do not have physical existence. Example: Goodwill, Copyright, patent
right.
On the balance sheet assets are classified into two current assets and non –
current assets.
Current Assets – are those assets, which can be used, sold, or converted into
cash within one accounting year. Example: cash, supplies, prepayments,
receivables etc.
Non-current Asset: All assets other than current assets are called non-current
assets. Example: land, patent right, office equipment, vehicles.
48
2. Liabilities: Creditors‟ claims to the assets of a business; amounts owed to
creditors are called liabilities. Like assets, liabilities are classified in to two as
current liabilities and non – current liabilities
Current liabilities: The liabilities that are payable within the next (one)
accounting year are known as current liability. Example: Accounts Payable,
Rent Payable, Salary Payable.
Non – Current Liabilities: Debts that are not required to be paid within the next
accounting period. Example long term notes payable.
3. Capital: The excess of the assets of a business over its liabilities is referred to
as capital. It is the equity of the owner in the business.
4. Revenue: Are increases in owner‟s equity resulting from the main operations
of the business.
Examples of revenue accounts are sales, interest income, tuition fee, and sales
commission.
5. Expenses: are decreases in owner‟s equity in the process of earning revenue.

For example, a hotel has to pay salary to its workers for the services rendered to
clients in order to get the income form customers (revenue) the Hotel has pay
salary to the employees (expense).
Example of expenses: Salary, insurance, depreciation, supplies, utilities, rent etc.
2.4 CHART OF ACCOUNTS

The number and name of accounts used by an organization depends on the
nature of its operation. The list of accounts used by an organization and their
49
codes is called the chart of accounts. Look at the following chart of accounts of
Bati Transport.
Bati Transport
Chart of Accounts
Asset Account number
Cash--------------------------------------------------------------------------11
Accounts Receivable------------------------------------------------------ 12
Supplies----------------------------------------------------------------------13
Prepaid Insurance-----------------------------------------------------------14
Equipment------------------------------------------------------------------- 15
Accumulated Depreciation –Equipment---------------------------------16
Truck--------------------------------------------------------------------------17
Accumulated depreciation – Truck----------------------------------------18
Liabilities
Accounts Payable-------------------------------------------------------------21
Notes Payable-----------------------------------------------------------------22
Owners Equity
Yimer Adem, Capital----------------------------------------------------------31
Yimer Adem Drawing-------------------------------------------------------32
Income Summary-------------------------------------------------------------33
Revenue
Service income----------------------------------------------------------------41
Expense
50
Salaries Expense --------------------------------------------------------------51
Rent Expense ------------------------------------------------------------------52
Utilities Expense---------------------------------------------------------------53
Supplies Expense--------------------------------------------------------------54
Insurance Expense-------------------------------------------------------------55
Maintenance Expense---------------------------------------------------------56
Depreciation Expense---------------------------------------------------------57
Truck Expense-----------------------------------------------------------------58
Miscellaneous expense--------------------------------------------------------59
In the chart of accounts, the asset accounts are listed according to their liquidity.
Liquidity is the ease with which an asset can be converted in to cash. Cash is
the most liquid asset so it is listed first. Accounts other than cash will be listed
in their frequency of use or in alphabetical order.
The account number is a code to identify accounts. The number could be a two
digit, three digit or more digits. In the above example a three – digits code is
used.
When the chart of accounts is prepared in an organization we say the ledger is

opened.
2.5 RULES OF DEBITS AND CREDITS

As shown above every account has three parts. These parts are discussed below:
Title – The name of the account. This is written at the top of the account.
Debit – is the left hand side of an account –Debit is abbreviated as „Dr.‟. When
an amount is entered on the left side of an account we say the account is debited
or charged.
51
Credit – is the right hand side of an account. Credit is abbreviated as Cr. An
account is said to be credited when an amount is entered on the right hand side
of the account.
An account may increase or decrease on the debit side or on the credit side depending on the
nature of the account. In general, accounts appearing on the left hand side of the accounting
equation increase on their left side (Dr. side) and decrease on their right side (Cr. Side);
whereas accounts on the right side of the equation increase on their right side and decrease on
their left side.
The above general rule will be expanded as follows
Debit Credit
-Increase in assets -Decrease in assets
-Increase in expenses -Decrease in expenses
-Decrease in capital -Increase in Liabilities
-Decrease in liabilities -Increase in liabilities
-Decrease in revenue -Increase in revenue.

1. Unlike other accounts on the right hand side, expenses increase on the debit
side and decrease on the credit side. Explain the reason.
……………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
……
The normal balance of an Account

Normal balance refers to the side of an account (Dr. or Cr.), which will have
greater entries than the other. The increasing side will be the normal balance for
accounts.
52
Example: The normal balance of all asset accounts is debit
2.6 JOURNALIZING BUSINESS TRANSACTIONS

When a business transaction takes place, source documents will be obtained and
recorded. The accounting record in which a transaction is initially recorded is
known as a journal. The journal is therefore referred to as “The book of
original entry”.
The process of recording a business transaction in the accounting record is

called journalizing.
The Journal commonly used to record all types of transactions is the General
Journal. This Journal includes the following parts, entered step by step.
1. The date of the transaction
2. The title of the account debited
3. The title of the account credited
4. The amount of debit and credit
5. Brief explanation of the entry or reference to the source document.
Look at the following General Journal and notice where each of the above
information is found.
Journal page
Date Description P.R Debit Credit
Year
Month day Debited account title XX
XXX
Credited account title X XX
XX
53
Explanation
There are also other types of Journals like, known as special journals that are
used to record specific types of transactions. The cash Journal, for instance, is
used to record only transactions affecting cash. The General Journal is used for
illustrations in this chapter. Special journals are discussed in unit 5.
STEPS IN JOURNALIZING A TRANSACTION

The following steps should be followed in recording a transaction in the journal.
1. Record the date - Insert the year, the month, and the date as shown above.
2. Record the Debit- Insert the account debited in the description column
and the amount of debit in the debit column.
3. Record the credit- Insert the account credited below the debited account
and indented to the right in the description column and the amount of
credit in the credit column.
4. Explanation- Write a brief explanation or reference to source document in
the description column, when necessary.
Each one set of debits and credits for a transaction is called a journal entry.
In recording a business transaction answer the following questions based on the transaction to
be recorded may help you.
a) Which accounts are affected?

b) Is each account increased or decreased?
c) Which account is debited and which is credited?
d) Prepare the complete journal entry.
Example. On January 10,2003 Tamget P.L.C paid Birr 6,000 to its employees
as a salary for the first week of the year.
54
This business transaction will be analyzed and recorded as follows.
a) Which accounts are affected? Answer: Cash and Salary Expense.
b) Is each account increased or decreased? Answer: cash is decreased and
salary expense is increased.
c) Which account is debited and which is credited? Answer: Salary Expense
is debited because increase in expenses is recorded on the debit side. And
cash is credited because decrease in assets is recorded on the debit side.
d) Prepare the complete Journal entry.
2003 Description
J an . 10 Salary expense 00
6000
Cash 6000 00
Payment of salary
Note: A journal entry is the complete presentation of the record in the journal.
CHECK YOUR PROGRESS EXERCISE - 2

Journalize the following transaction by answering 4 questions suggested above.
 On January 11, 2003 Tamget bought a building for Birr 150,000 on credit.
ILLUSTRATION
To illustrate the complete accounting cycle, we will consider the following list
of selected transactions. The transactions were completed by Bati Transport in
the month of January 2003.
January 1. Ato yimer took Birr 450,000 from his personal savings and deposited
it in the name of Bati transport.
January 2. Bati Transport purchased two used trucks for Birr 150,000 each, on
cash.
55
January 4. Bati Transport received a check for Birr 650 for services given to
Alem
Trading.
January 4. Received an invoice for truck expenses Birr 90.
January 11. Paid Birr 600 for Awash Insurance Company to buy an insurance
policy for its trucks.
January 16. Ato Yimer issued a check for Birr 9,400 to the workers as a salary
fo r
two weeks.
January 20. Bati trading Billed Muradu Supermarket for goods transported from
Djibouti to Gondar Birr 2,650
January 21. Ato Yimer wrote a check for birr 450 to have one of the trucks
repainted
January 21. Bati trading purchased stationary materials and other supplies of
Birr 740 on
account
January 22. Office equipment of Birr 11,600 is bought on account.
January 23. Purchased an additional truck for Birr 250,000 paying birr 100,000
in cash
and issuing a note for the difference.
January 23. Recorded services billed to customers on account birr 14,600.
January 25. Received cash from customers on account Birr 15,000.
January 27. The owner withdrew Birr 500 in cash for his personal use.
January 28. Paid Birr 9,400 to workers as a salary for the last two weeks of the
month.
56
January 30. Paid telephone expense of Birr 95 and electric expenses of Birr 125
for the
month.
January 30. Paid other miscellaneous expenses Birr 50.
January 31. Paid Birr 4,000 as a rent for a building used for office space.
These transactions are journalised as follows:
Date Description Debit Credit

2003 Cash 450,000
Jan.1 Yimer Capital 450,000
To record investment by
owner
2 Truck 300,000
Cash 300,000
Purchase of trucks
4 Cash 650
Service Income 650
Cash received fro m
customers
4 Truck Expenses 90
Accounts Payable 90
Service received in
advance
11 Prepaid Insurance 600
Cash 600
Purchase of insurance policy
16 Salary Expense 9,400
Cash 9,400
Payment of salary
20 Accounts Receivable 2,650
Service Income 2,650
Provision of service
21 Truck Expense 450
Cash 450
Cash paid to repaint truck
21 Supplies 740
57
Accounts Payable 740
Purchase of supplies of
account
22 Office Equipment 11,600
Accounts Payable 11,600
Purchase of equipment
23 Truck 250,000
Cash 100,000
Notes Payable 150,000
Purchase of truck
23 Accounts Receivable 14,600
Service Income 14,600
Provision of service on
account
25 Cash 15,000
Accounts Receivable 15,000
Collection of cash
27 Drawings 500
Cash 500
Owner withdrawals
28 Salary Expense 9,400
Cash 9,400
Payment of salary
30 Utilities Expense 220
Cash 220
Payment for telephone,
electricity
30 Miscellaneous Expenses 50
Cash 50
Payment fo r various
expenses
31 Rent Expense 4,000
Cash 4,000
Payment of Rent
2.7 POSTING FROM THE JOURNAL TO THE LEDGER
58
After the information about a business transaction has been journalized, that
information is transferred to the specific accounts affected by each transaction.
This process of transferring the information is called posting.
An account could be of two types; the two-column account and the four-column account. We
will use the four-column account for our illustration. The two forms of accounts are given
below.
The two-column account:

Account Account number
Date It e m P.R Debit Date It e m P.R Credit
The four-column account:

Account Account number
Date It e m P.R Debit Credit Balance

Debit Credit
The steps in posting are given below:

1. Record the date and amount of Dr. and Cr. Entry to the account
59
2. Insert the Journal page number in the P.R (Post Reference) column of the
account.
3. Insert the account number in the P.R column of the journal.
Note. The P.R Column is used for reference purposes. The P.R column of the
journal shows whether the entry is posted and the account to which it is posted.
In the account, the P.R Column shows the Journal page number from which the
entry was brought.
The group of accounts used by an organization is called ledger.
Illustration. As mentioned above, to illustrate the posting process the four

column account is used and the entries to the cash account are posted as follows.
Account Cash Account Number

Balance
Date It e m P.R Debit Credit Debit Credit
200 450,00 00 450,00 00
3 1 0 0
J an
2 300,00 00 150,00 00
0 0
4 650 00 150,65 00
0
11 600 00 150050 00
16 9,400 00 140650 00
21 450 00 140200 00
23 100,00 00 40200 00
0
25 15,000 00 55200 00
27 500 00 54200 00
28 9,400 00 45300 00
30 220 00 45,080 00
30 50 00 45,030 00
31 4,000 00 41,030 00
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Note. The item column is usually left blank. In some cases the word balance is
written when the account is carried foreword to a new page.

Rule the other accounts used by Bati Transport and post the respective Dr. & Cr. entries (Hint
17 accounts, including cash, are used by Bati Transport). Don‟t continue without doing this
because the following discussion assumes you have done this exercise!
2.8 THE TRIAL BALANCE

After the posting phase is completed, we have to verify the equality of the debit and credit
balances. This is done through the use of the „Trial Balance‟. A trial balance is a two column
listing of the accounts in the ledger and their balance to make sure that the total of debit
balances equals the total of credit balances.
The trial balance for our illustration, Bati Transport is presented bellow. The
amounts are taken from the balances of the accounts after all the transactions
have been posted. Therefore, after posting the above transactions, you should get
the final balances shown on the trial balance in the end.
Bati Transport
Trial Balance
January 31, 2003
Cash 41,030 00
Accounts Receivable 2,250 00
Supplies 740 00
Prepaid Insurance 600 00
Office equipment 11,600 00
Truck 550,000 00
Accounts payable 12,430 00
Notes payable 150,000 00
Yimer capital 450,000 00
Yimer drawing 500 00
61
Service income 17,900 00
Salary expense 18,800 00
Rent expense 4,000 00
Utilities expense 220 00
Maintenance expense 450 00
Truuck expense 90 00
Miscellaneous expense 50 00
Total 630,330 00 630,330 00
2.8.1 Proof Provided by the Trial Balance

The trial balance debit totals and credit totals are equal implies that the
accounting work is more likely to be free from any one or more of the following
errors.
1. Error in preparing the trial balance including

-Addition error
-The amount of an account balance was in correctly listed on the trial
balance
- A debit balance was recorded as a credit or vice versa
- A balance was entirely omitted.
2. Error in posting, including

- An erroneous amount was posted to the account.
- A debit amount was posted as a credit or vice versa
- A debit or credit posting was omitted
2.8.2 Limitations of the Trial Balance

The trial balance amounts are equal doesn‟t mean that the accounting work is
free from error. That is, there are errors that may take place without affecting
the trial balance totals. Some examples are mentioned below:
- Failure to record a transaction or to post a transaction
62
- Recording the same erroneous amount for both the debit and the credit
parts of a transaction.
- Recording the same transaction more than once.
- Posting part of a transaction to the correct side but the wrong account.
Note: All these errors have the same affect (increasing or decreasing) on the
debit totals and credit totals
2.9 ADJUSTMENTS
All the transactions recorded above in the journalizing step are the result of daily
transactions. Other transactions result from the passage of time or from the
internal operations of the business. For example, insurance premiums are paid
for a certain period of time and expire during that time period. Another example
is office supplies such as paper, pens & pencils.
At the end of the period the balances in accounts such as supplies and prepaid
insurance must be brought up to date. The supplies account balance, for
example, must be credited by the consumed part of the supplies, debiting
supplies expense.
Example. Stationary materials totaling Birr 1,900.00 were purchased and

recorded during the year. At the end of the year, only Birr 150 of the supplies
are left in hand.
The adjusting entry prepared at the end of the year to adjust the supplies account
will be
1990 Supplies expense 1,750

Dec31 Supplies 1,750
63
Note: 1. Adjustments are dated as the last day of the year.
2. The accounting year here – we assume, runs from January 1- December
31.
Additional examples on adjustments will be given below under the topic

„worksheet‟
2.9.1 The Accrual Basis and the Cash Basis of Accounting
1. The cash basis of accounting – In this basis of accounting revenues are

reported in the period in which cash is received and expenses are reported in
the period in which cash is paid. Net in come will, therefore, be the
difference between the cash receipts (Revenues) and cash payments
(expenses). This method will be used by organizations that have very few
receivables and payables. For most businesses, however, the cash basis is
not an acceptable method.
2. The accrual basis of accounting – Under this method revenues are reported
in the period in which they are earned, and expenses are reported in the
period in which they are incurred. For example, revenue will be recognized
as services are provided to customers or goods sold and not when cash is
collected. Most organizations use this method of accounting and we will
apply this method in this course.
2.9.2 The Matching Principle

We have discussed three concepts and principles in accounting in unit one. Now
we will see one more principle, the matching principle. This principle states that
the expense of a period have to be matched with the revenue of that period
regardless of when payment is made. In order to do this, the accrual basis of
64
accounting requires the use of an adjusting process at the end of the period so
that revenues and expenses of the period will be determined properly.
2.10 WORKSHEET FOR FINANCIAL STATEMENTS

Most of the data required to prepare the accounting reports (financial
statements) is now gathered. The data will now be presented in a convenient
form. The worksheet is a large columnar sheet prepared to arrange in a
convenient form all the accounting data required to prepare financial statements.
The worksheet has a heading and a body.
The heading has three parts:

i) Name of the Organization
ii) Name of the form (worksheet)
iii) Period of time covered.
The body contains five main parts each of them with two main columns. These
parts are
1. The trial balance
2. The adjustment
3. The adjusted trial balance
4. The income statement
5. The balance sheet.
The worksheet for Bati Transport is given below. The five parts of the body are
discussed as follows. You are advised to read and understand the discussions
before you look at the respective columns of the worksheet.
Bati Transport
Work Sheet
65
For th3e month ended jan.31,2003
Account Title Trial Balance Adjustment Adjusted Trial Income Balance sheeet
balance statement
1 Cash 41,030 41,030 41,030
©
2 Accounts receivable 2 ,2 5 0 7 ,4 0 0 9 ,6 5 0 9 ,6 5 0
(a )
3 Supplies 740 340 400 400
(b)
4 Prepaid Insurance 600 450 150 150
5 Office equipment 11,600 11,600 11,600
6 Truck 550,000 550,000 550,000
7 Accounts payable 12,430 12,430 12,430
8 Notes payable 150,000 150,000 150,000
9 Yimer Capital 450,000 450,000 450,000
10 Yimer drawing 500 500 500
©
11 Service income 17,900 7 ,4 0 0 25,300 25300
12 Salary expense 18,800 18,800 18,800
13 Rent expense 4 ,0 0 0 4 ,0 0 0 4 ,0 0 0
14 Utilities expense 220 220 220
15 Maintenance expense 450 450 450
16 Truck expense 90 90 90
17 Miscellaneous 50 50 50
Expense
18 630,330 630,330
(a )
19 Supplies expense 340 340 340
(b)
20 Insurance expense 450 450 450
21 7290 7290 636,830 636,830
22 Net income
23 25300 25300 613,330 613,330
1. The trial balance column – this is the same trial balance we have prepared
before. The trial balance column of the work sheet can be brought direct from
the ledger or from a separate trial balance.
2. The Adjustment column – As mentioned previously, some account balances

have to be adjusted at the end of the year.
The accounts in the ledger of our illustration that require adjustment and the
adjusting entry for the accounts are presented below.
66
a) Supplies – The supplies account has a debit balance of Birr 740. The cost of
supplies in hand on July 31 is determined to be Birr 400. The following
adjusting entry is required to bring the balance of the account up to date:
Supplies expense…………………………….340
Supplies……………………………………..340
b) Prepaid insurance – Analysis of the policy showed that three – fourth of the
policy is expired. That is only Birr 150 of the policy is applicable to future
periods. The adjusting entry to transfer the expired part of the insurance to
expense will be.
Insurance expense ……………………….450

Prepaid insurance………………………..450
c) Service Income – At the end of the month unbilled fees for services
performed to clients totaled Birr 6,500.
This amount refers to an income earned but to be collected in the future. The
journal entry to record it will be
Accounts receivable………………………….6,500
Service income………………………………6,500
All the above adjusting entries will be inserted in the adjustment column of the
worksheet in front of the accounts affected.
Note – The letters a, b & c are used to cross-reference the debits and credits to
help future review of the worksheet.
3. The Adjusted Trial Balance Column – The accounts that require

adjustment are now adjusted. Transferring the trial balance column amounts
67
combined with the adjustment column amounts will complete the adjusted trial
balance column of the worksheet.
4. The income statement and the balance sheet columns – Transfer the
income statement account balances (revenue &expenses) to the income
statement and balance sheet account balances (Asset, Liability &owners equity)
to the balance sheet columns. Note that what we have to transfer is the adjusted
trial balance column amounts, to the corresponding columns.
Look at the 22nd row. It shows the net income for the month and it is added to
the two columns (Income statement Dr. and balance sheet cr.) as a balancing
figure.
2.11 FINANCIAL STATEMENT PREPARATION

After the work sheet is completed financial statements could be prepared easily.
In chapter one we have discussed four basic financial statements prepared by
most organizations. Here, we will prepare three of these statements for Bati
Transport form the worksheet.
1. Income statement All the data required to prepare the income statement is
brought
from the worksheet.
Bati Transport
Income statement
For the month ended. Jan 31, 2003
Service Income …………………………………………………………Birr

25,300
Operating expenses
68
Salary expense………………………..Birr 18,800
Rent “…………………………………….4,000
Maintenance expense ……………………… 450
Insurance “ ……………………………450
Supplies “ …………………………….340
Utilities “……………………………..220
Truck “ …………………………….. .90
Miscellaneous “………………………………50
Total operating
expense………………………………………24,400
Net Income…………………………………………………Birr
900
2. Statement of owner’s equity – This statement shows the beginning balance

of capital and the changes that affected it.
The balance of the owners equity account (Yimer capital) in the worksheet may not be the
beginning one. Therefore, the ledger has to be reviewed to see if there was an additional
investment during the priod or not. In our illustration there is no additional investment.
Bati Transport
Statement of Owner’s equity
FOR THE MONTH ENDED JANUARY 31, 2003
Yimer capital January 1, 2003………………………………Birr

450,000
Net income for the month………………….birr 900
Less: Withdrawal…………………………………...500
400
69
Yimer capital, January 31, 2003……………….…………….Birr
450,400
3. Balance sheet – The data to prepare this statement will be taken from the
worksheet and the other financial statements. Note that assets and liabilities are
classified as current and non – current.
Bati Transport
Balance sheet
JANUARY 31, 2003
Assets
Current Assets:
Cash…………………………………………Birr 41, 030

Accounts Receivable…………………………….. 9,650
Supplies…………………………………………… 400
Prepaid insurance…………………………………….150
Total current assets……………………………………………Birr 51,230
Plant Asset (None-Current Assets):
Office equipment……………………………..Birr 110,600

Truck………………………………………………550,000
561,600
Total asset………………………………………………………Birr
612,830
70
Liabilities
Current liabilities
Accounts payable……………………………..Birr 12,430
Non-current liabilities
Notes payable……………………………………..150,000
Total liabilities……………………………………………………Birr
162,430
Owner’s equity
Ato Yimer Capital……………………………………………………………..

450,400
Total liability and owners equity………………………………………….Birr
612,830
2.12 THE CLOSING PROCESS

Some of the accounts in the ledger are temporary accounts used to classify and
summarize the transactions affecting capital (owners equity). These accounts
will be closed after financial statements are prepared. That is, their balances will
be transferred to the Capital account. The temporary accounts that have to be
closed are revenue, expense and withdrawal accounts.
Steps in closing:
1. Closing revenue accounts - Debit each revenue account by its balance and
credit the „Income Summary‟ account by the total revenue for the period.
71
Note: Income summary is an account used to close revenue and expense
accounts. This account will immediately be closed to the capital account at the
end of the closing process.
2. Closing expense accounts – Debit the income summary account by the total
of expenses for the period and credit each expense account by its balance.
3. Closing the income summary account – Income summary will be closed to

the capital account. The balance of his account depends on the nature of
operation; credit if result is profit and debit if result is loss.
4. Closing Withdrawal – Debit the owners equity account by the total of

drawings for the period and credit the drawing account.
The temporary accounts of Bati transport are closed as follows.
2003 Income summary………………….25,300

January Service income…………………………………25,300
31 Closing revenue
31 Salary expense………………………..18,800
rent expense……………………………4,000
Maintenance expense………………….. 450
Insurance expense………………………..450
Supplies expense…………………………340
Utilities expense………………………….220
Truck expense …………………………… 90
Miscellaneous expense…………………….50
Income expense…………………………………24,400
72
Closing expenses
2003 Income summary………………900

January 31 Yemer Capital………………………..900
Closing income summary
31 Yimer capital…………………...500
Yimer drowing………………………..500
Closing with drowal
The above closing entries have transferred the balance of the temporary
accounts to the permanent capital account.

Post all the above closing entries and recompute the balance of all the accounts
affected.
2.13 POST CLOSING TRIAL BALANCE

After the closing entries have been journalized and posted, a trial balance is
prepared to prove the equality of the general ledger before recording the new
year’s transactions. It should be noted that this trial balance includes only
balance sheet accounts. This is because the temporary income statement
accounts are closed during the closing process. This trial balance is called the
post – closing trial balance.
In practice the ledger balance after closing may be checked by a simple

calculator print out rather than a formal trial balance. The post closing trial
balance for Bait Transport is presented below.
73
Bati Transport
Post – Closing trial balance
JAN 31, 2003
Cash……………………………………………Birr 41,030
Accounts Receivable ………………………………...9,650
Supplies…………………………………………………400
Prepaid insurance……………………………………….150
Office equipment……………………………………11,600
Truck……………………………………………….550,000
Accounts payable…………………………………………………….Birr 12,430
Nots payable……………………………………………………………..150,000
Yimer capital……………………………………………………………..450,400
Total……………………………………Birr 612,830 Birr 612,830
2.14 SUMMARY
Accountants go through a number of step-by-step procedures to record
transactions and to summarize the records in to useful repotrs in a systematic
manner. These procedures that accountants go through from the time a
transaction is identified until the time financial statements are prepared are
together called the accounting cycle. The accounting cycle is summarized
below:
74
Input Process Output
1. When a transaction 2. Transactions are recorded in the jour7n.P
alreparing financial statements
happens, source documents
are prepared. 3.Posting to individual accounts
4.Preparing a trial balance after

determining the balance of each
ledger account
6.preparing and completing the

work sheet with adjustments
8.Adjustments are journalized and

posted
9.Closing entries are journalized

and posted
10.A post closing trial balance is

prepared
2.15 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

Expenses are found on the right hand side of the accounting equation; they are
elements of the owners equity account. When expenses increase capital will
decrease and vice versa. Because of this reverse effect of expenses on capital
they increase on the Dr. sided and decrease on the Cr. side, unlike other right
hand side accounts.
a) Building and Accounts payable
75
b) Both accounts are increased.
c) Building is debited and accounts payable is credited
d) Journal entry:
2003, Building……………………………150,000
Jan 11 Accounts
payable…………………………..150,000
Purchase of building on credit.
Prepare a four – column account for each account and post the respective entries
to the accounts. Compare the ending balance of each account in your answer
with their balance in the trial balance.
After all the closing entries are posted all temporary accounts will have zero
balances. On the other hand, permanent accounts will have non- zero balances.
Example: Yimer Capital = Birr 450,400, supplies Birr 400.
A complete list of the permanent accounts and their balances is given on the post
– closing trial balance.
2.16 MODEL EXAM QUESTIONS
1. Indicate whether each of the following items below is an asset, liability,

revenue, expense, gain or loss account and whether it appears in the balance
sheet or income statement.
a) Office furniture
76
b) Income from services
c) Salaries paid to workers
d) Supplies on hand
e) Salary payable to workers
f) Cash
g) Income form sale of a used truck
h) Goods damaged by fire in the store
2. Given below is a list of selected transactions performed by John Décor

during the month of September 2002, the first month of operation.
a) Record the transactions in General Journal

b) Post each entry to the perspective account. Use the four – column
account.
c) Prepare a trial balance
d) Prepare a worksheet. Assume the following adjustment for the accounts and
journalize them.
e) Prepare a Balance sheet, Income statement and statement of owner‟s
equity
f) close the temporary accounts.
Sept. 10 Mr. John transferred cash form his personal account to be used in the
business,
Birr 10,000.
“ 10 Paid rent for the month, Birr 500
“ 11 Purchased a truck for Birr 12,000 by paying Birr 3,000 Cash and
giving a notes payable for the difference.
“ 12 Purchased equipment on account Birr 1,460.
77
“ 13 Purchased supplies on account Birr 240.
“ 14 Paid insurance premiums of Birr 170 (Dr. prepaid insurance)
“ 15 Received cash for services completed Birr 360.
“ 16 Purchased Supplies on account Birr 240.
“ 18 Paid salaries of Birr 900.
“ 21 Paid its liabilities for the purchase of equipment
“ 24 Recorded sales on account Birr 2,080
“ 26 Received an invoice for truck expense Birr 115
“ 27 Paid utilities expense Birr 205.
“ 27 Paid miscellaneous expenses Birr 73.
“ 28 Received cash from customers on account birr 1,420
“ 30 Paid salaries to employees Birr 950
“ 30. The owner withdrew Birr 1, 750 for personal use.
3. The trial balance of Betty Beauty Saloon does not balance. The errors in the
accounting work are given below. Determine the correct balance of each
account and prepare the corrected trial balance.
Betty Beauty Saloon

Trial balance
APRIL 30
Cach 5,902.00
Accounts Receivable 6,300.00
78
Supplies 1,600.00
Equipment 5,200.00
Accounts payable 4,300.00
Betty capital 10,000.00
Service income 4,700.00
Operating expenses 1,980.00
Total 20,982.00 19,200.00
The errors are the following:
 Cash received form a customer on account was recorded (both debit and
credit) as birr
 1,400 instead of Birr 1,120
 The purchase on account of an equipment costing Birr 780 was recorded

as a debit to
 operating expense and credit to accounts payable.
 Service was performed to clients Birr 1,780 for which accounts

Receivable was
 debited birr 1,780 and service income was credit birr 178
 A payment of Birr 80 for telephone charges was debited to Operating

Expense and it was also debited to cash
 The ledger balance of the service income account is birr 4,700 rather than
Birr 4,720.
79
4. As of Sene 30 1994, the end of the current fiscal year, the accountant for
Abay General Trading completed the worksheet before journalizing and
posting the adjustments.
Required: (a) Compare the adjusted and unadjusted trial balances and prepare
the eight journal entries that were required to adjust the accounts.
(b) Prepare the journal entries that were required to close temporary accounts.
Abay General Trading

TRIAL BALANCE
SENE 30, 1994
Un adjusted Adjusted
Cash 12,825.00 12,825.00
Supplies 8,950.00 3,635.00
Prepaid rent 19,500.00 1,500.00
Prepaid insurance 3,750.00 1,250.00
Equipment 92,150.00 92,150.00
Accumulated depreciation 53,480.00 66,270.00
equipment
Automobile 56,500.00 56,500.00
Accumulated depreciation 28,250.00 36,900.00
automobile
Accounts payable 8,310.00 8,730.00
Salary payable 3,400.00
Tax Payable 1,225.00
Ato Abay capital 41,245.00 41,245.00
Ato Abay drawing 18,600.00 18,600.00
Service income 261,200.0 261,200.0
0 0
Salary Expense 172,300 175,700.0
0
Rent Expense 18,000.00
80
Supplies Expense 5,315.00
Depreciation Expense 12,790.00
Equipment
Depreciation Expense 8,650.00
Automobile
Utilities Expense 4,700.00 5,120.00
Taxes Expense 1,500 2,725.00
Insurance Expense 2,500.00
Miscellaneous Expense 1,710.00 ___ 1,710.00 ___
_ _
Total 392,485.0 392,487.0 418,970.0 418,970.0
0 0 0 0

Account –a record showing separately the increases and decreases of a financial
statement item during a period.
T account- the simplest format of an account, which resembles the letter „T‟.
Chart of Accounts- a list of the account s used by an organization and their

codes.
Debit- the left side of an account.
Credit- the right side of an account.
Source Documents- documents such as an invoice or a cash receipt voucher

that evidence the occurrence of a transaction.
Journal- a book or record where a transaction‟s full debits and credits and other
details are first recorded.
Journal Entry-the debits and credits recorded in the journal for one transaction.
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Ledger- a book, where increases and decreases in each account are separately
recorded. It is therefore the collection of the individual accounts of an
organization.
Trial Balance – a form showing the final balance of each ledger account. It is
used to somehow check if any errors were made during the period.
Work Sheet –a working paper that accountants use to collect adjustment data
and to easly prepare the financial statements.
Adjustments – entries required to up-date some accounts before preparing

financial statements.
Post Closing Trial Balance- a trial balance prepared after all the accounts have
been closed.
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UNIT 3. ACCOUNTING FOR MERCHANDISING BUSINESSES
Contents
3.1 Introduction
3.2 Nature of a Merchandising Business
3.2.1 What is a Merchandising Business
3.2.2 Comparison of Financial Statements for Merchandising and
Service Businesses
3.3 The Periodic and the Perpetual Inventory Systems
3.3.1 The Periodic Inventory System
3.3.2 Perpetual Inventory Systems
3.4 Recording Purchase and Sales Transactions
3.4.1 Recording Sales
3.4.2 Recording Purchases
3.5 Completing the Worksheet for a Merchandising Business
3.6 Preparing Financial Statements for Merchandising Businesses
3.7 Summary
3.9 Model Examination Questions

After reading this unit, you will be able to:
- describe what a merchandising business is and compare it to a service
giving business.
- describe the difference between the two alternative systems of recording
inventory (periodic and the perpetual inventory systems)
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- record journal entries for merchandising transactions such as the purchase
and sale of merchandise
- complete the worksheet of a merchandising business and record
adjustment journal entries related to the Merchandise Inventory account
- prepare financial statements for a merchandising business
3.1 INTRODUCTION
In the previous chapters, you saw how to record transactions of a service
business. The steps that we go through to prepare the financial statements of
other types of businesses (such as a merchandising business) are basically the
same. Transactions are first journalized, and then posted to the ledger; a
worksheet is prepared and completed…. But, there are some transactions in
merchandising companies that you don‟t find in a service giving business, like
the purchase of goods for sale and the sale of those goods. The first section of
this chapter, therefore, discusses the nature of a merchandising business and
how to record merchandising transactions. The next section discusses about the
preparation of financial statements for merchandising companies.
SECTION-ONE: RECORDING MERCHANDISING TRANSACTIONS

3.2 NATURE OF A MERCHANDISING BUSINESS
3.2.1What is a Merchandising Business?
A merchandising business buys goods in finished form for resale to customers.
A merchandising business sells tangible goods to its customers. When we say

goods it can be anything that has physical characteristics that you can see and
touch (i.e., tangible). These can be goods ranging from television sets, cars,
office table and chair (furniture), to chewing gums, toothbrushes and various
stationery. These goods that a merchandising company sells to its customers are
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called merchandise inventory. (A customer is an individual or a firm to whom
a business sells its products.)
One final thing that you should know about a merchandising business is that a
merchandising company does not produce the goods that it sells. Instead, it
buys these goods from manufacturers, which produce the goods using raw
materials.
The following diagram can help you to better visualize the flow of goods from a
manufacturer to the final consumer:
sells Merchandising companies
Manufacture wholesale sell Retail final

rs rs er consumer
goods goods
A wholesaler is a trader, which buys goods from manufacturers and sells them
to a retailer or another wholesaler. It is the retailer who sells the goods to the
final consumer by buying them from wholesalers (or sometimes from a
manufacturer).
When you want to buy a soap to wash your clothes, where do you buy it? Who
is the manufacturer of the soap? Are there any wholesalers of that soap in your
area? Can the wholesaler be taken as the customer of the manufacturer? And
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finally, can we say the shop from which you buy the soap is a merchandising
business?
3.2.2 Comparison of Financial Statements for Merchandising and Service

Businesses
Income Statement
A model income statement for a merchandising business and another one for a
service business are shown below. Compare them carefully.
ABC service company XYZ merchandising

Income statement Income statement
For the year ended Dec.31, 200x For the year ended Dec.31, 200x
Revenue: Revenue:
Service fee………………….Birr Net Sales…………………Birr 360,000
23,200 Cost of goods
sold…………….(256,000)
Gross Profit
…………………….104,000
Expenses: Various Operating
Various Operating Expenses (7120) Expenses……………………….(79,400)
Net Income 16080 Net Income ……………………..24,600
As you can see from the above Income Statements, merchandising companies
have to pay to buy the goods that they sell. Therefore, they have to deduct this
cost of goods sold in addition to other operating expenses from their sales
revenue to determine their net income.
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The difference between sales revenue and cost of goods sold is referred to as
gross profit. Why „gross‟? Because other expenses have yet to be deducted to
arrive at the net profit or net income of the business.
Balance Sheet
The Balance Sheet of a service business and that of a merchandising business
are similar in every aspect except one thing. The current assets section of the
Balance Sheet of a merchandising business includes one asset that service
companies do not have. That is merchandise inventory. Merchandise inventory
refers to goods bought by a merchandising business for resale to customers. So,
if a merchandising business has some unsold goods (merchandise) on hand at
the end of the year this would be reported as one asset on the Balance Sheet.
3.3 THE PERIODIC AND THE PERPETUAL INVENTORY SYSTEMS

The value of goods (merchandise) on hand at the end of the year for resale
would be reported on the Balance Sheet as one asset as described above. This
means that we need to open a separate ledger account in which to record
merchandise inventory information.
The two alternatives in dealing with this account are:

1. To up date this account every time goods are bought and sold
(continuously = perpetually) or
2. To up date this account only at the end of the period (periodically).
3. 3.1 The Periodic Inventory System

Under this system, as the name periodic suggests, the inventory account is
updated only periodically i.e., only at the end of a period.
When goods are bought, a temporary purchases account is debited instead of the
inventory account itself. Likewise, when goods are sold revenue is recorded,
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but the fact that there is a reduction in merchandise inventory is not recognized.
This is because the Merchandise Inventory account is not credited every time
goods are sold.
Therefore, if one wants to know the cost of goods on hand, it is a must that a
physical inventory be conducted first. The account doesn‟t reflect the value of
goods on hand because it was not up dated when merchandise was bought and
sold. Physical inventory means counting the quantity of goods on hand. Once
the quantity of goods on hand has been determined, it is multiplied by the unit
price of those goods to determine the cost of goods on hand.
In conclusion, under the periodic system, since the merchandise inventory account is not
continually updated, the cost of merchandise on hand is determined only at the end of the
period after carrying out a physical inventory.
Companies such as department stores or „super markets‟, which sell small items,
use periodic systems.
3.3.2 Perpetual Inventory Systems

A perpetual inventory system continuously records the amount of inventory on
hand (perpetual =continuous). Under this system, the merchandise inventory
account is debited or credited every time (goods) are bought or sold. When an
item is sold, its cost is recorded in a separate cost of goods sold account in
addition to recording sales.
The cost of merchandise on hand can be looked up from the merchandise

Inventory account any time, without conducting a physical inventory.
Check Your Progress Exercise-1

If you have a supermarket business, would you use the perpetual or periodic
system? What if your system is computerized? Explain.
88
3.4 RECORDING PURCHASES AND SALES TRANSACTIONS
The following discussions in the remainder of this chapter all assume the use of
a periodic inventory system. The perpetual system will be discussed in part two
of this course.
3.4.1 Recording Sales

When a merchandising company transfers goods to the buyer, in exchange for
cash or a promise top at a later date, revenue is produced to the company. This
revenue is recorded in a Sales account. However, the sales revenue, which is
reported on the Income Statement is Net Sales. That is,
Net Sales = Gross Sales – Sales Discounts- Sales Returns and Allowances
RECORDING GROSS SALES

The gross sales amount is obtained from sales invoices. An invoice is a
document, prepared by the seller of merchandise to notify to the buyer the
details of the sale. These details can include number of items sold, unit price of
items, total price, terms of sale and manner of shipment. When goods are
delivered to the customer, the Sales account is credited because revenues are
increased by credits.
A company can sell goods either for cash or on account.
Recording Cash Sales

When merchandise is sold on cash, the Cash account is debited and the revenue account Sales
is credited.
Example – Ika Company based in Bahir Dar, buys and sells used commodities.
On January 14. 2001. Ika sold goods for Birr 20,000. Record the transaction.
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Answer:
January 14, Dr. Cash………………………………..20,000.00
Cr. Sales……………………………………20,000.00
Recording Credit Sales
The Accounts Receivable account is debited when goods are sold on account
(for credit).
Example -
Ika sold goods worth Birr 35,000 on account on January 15, 2001. Record the
transaction.
Solution
January 15. Accounts Receivable…………………..35,000.00

Sales…………………………………………35,000.00
Determining Gross Sales when there are trade discounts
A trade discount is a percentage deduction from the specified list price or

catalogue price of merchandise.
Trade discounts allow us:
- To avoid publishing a new catalogues every time prices change.

- To grant quantity discounts
- Quotation of different prices to different types of customers.
Trade discounts are not recorded in the seller‟s accounting records; they are only
used to calculate the gross selling price.
Example: IKA sold 500 T.V. sets, each with a list price of Birr 80, on January
17, 2001 for cash. It gave the customer a 30% trade discount, as the customer
was a very loyal one. Record the sale.
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Answer:
List price of goods ( 80 X 500) Birr 40,000
Less: Trade discount (30 % of 40,000) (12,000)
Invoice price 28,000
Journal entry:
Cash……………………..28,000
Sale………………………28,000

1. Record the journal entry if IKa Company above sold goods with a list price
of Birr 52,000 to a customer on account. Ika offered the customer a trade
discount of 20% for purchases above Birr 40,000 as it usually does.
Recording Deductions from Gross Sales

Go back to illustration 1- and have a look at the model Income Statement of a
merchandising company. You will see that the sales reported on the income
statement is net sales, i.e., after deduction of sales discounts and sales returns
and allowances.
Gross sales (from invoice)…………………..XXX

Less: Sales discounts…………………………….(XX)
Sales returns and allowances ………….…..(XX)
Net sales……………………………….XX
Sales Discounts
Sales Discounts are deductions from invoice price to customers who pay early
when goods are sold on credit.
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As a seller, you would usually want to be paid as soon as possible. This is because, as
you can imagine, you can use the money for various purposes once you have been
paid. If you want your customers to pay you early the customary practice is to offer
them a (deduction) discount from the invoice price if they pay early.
How much discount is given usually depends on the credit terms. These terms
(agreements) are usually stated on the invoice. The most frequently used terms
are stated below:
- “n/30” or “Net 30” – means there is no discount even if the customer

pays before the payment date.
- 2/10, n/30 –means the due date of the payment is after 30 days of the
sale. But if the customer pays with in 10 days she will get a 2% discount.
- 2/EOM, n/60- means the normal due date is with in 60 days of the sale
but the customer will get a 2% discount if she pays before the end of
month of sale.

1. What do the credit terms 1/15,n/60; 2/10, n/EOM; and n/60 mean?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
Sales discounts are purchase discounts from the side of the buyer. Sales
discounts and purchase discounts are the same thing seen from different sides.
They are generally called cash discounts together. A cash discount is, therefore,
deduction from original invoice price for early payment when goods are sold on
credit (on account).
Example:
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On January 21, 2001 IKA Company sold merchandise for birr 20,000 on
account. The credit terms are 2/30, n/30. The customer paid on January 31, (10
days after invoice date).
A. How much would IKA Company collect from this sale?
B. Record the necessary journal entries on January 21 and January 31.
Solution:
A- Since the customer paid with in the discount period, i.e., with in 10 days,
she will get a 2% discount. Therefore,
Invoice price……………………..20,000
Less: Sales Discount (2% X 20,000)………(400)
Cash collected …………. 19,600
B- Journal Entries:
January 21 A/R…………………..20,000
Sales……………………..20,000
January 31, Cash………………….19600

Sales Discounts ………...400
A/R………………..20,000
You might initially have thought of debiting the Sales account for Birr 400 on
January 31, since the actual cash collected from the sales of those goods is birr
400 less than what was recorded as Sales on January 21. But it is better to
record the reduction in sales in a separate contra Sales account. A contra
account reduces another account. In this case, the amount in the Sales Discount
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account will be deducted from (Gross) Sales on the income statement. That way,
we can disclose how much sales discount was offered and taken during the year
on the income statement, separately.

IKA Company sold goods worth Birr 120,000 on account to Gizu company
terms 1/10, n/60 on January 18, 2001. Gizu Company paid on January 28, 2001.
A- How much would IKA Company collect from this sale?

B- Record the necessary journal entries on January 18 and on January
28.
Sales Returns and Allowances
Customers can return merchandise they have bought if they find it to be

defective or of the wrong model, or unsatisfactory for a variety of reasons. A
sales return is merchandise returned by a buyer. The buyer would be paid back
her money if she has already paid.
A sales allowance is a deduction from the original invoice price when the
customer keeps the merchandise but is dissatisfied. If, for example, a customer
buys an item worth birr 100 and finds it to be of the wrong color after receiving
it, she may still want to retain the item even if she is dissatisfied with its color.
In that case the seller may let her pay only, say, Birr 95 by giving her an
allowance of Birr 5.
Example:
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IKA Company sold merchandise worth Birr 15, 000 on February 3, 2001 on
account terms 2/10, n/30. On February 5, the buyer returned a portion of the
goods worth Birr 5,000 as they were found to be of the wrong model. The buyer
then paid on February 13, 2001.
Record the necessary journal entries on February 3,5 and 13.
Solution:
February 3 A/R…………………….15,000
Sales …………………….15,000
February 5 Sales Returns and Allowances ………5,000

A/R………………………………….5,000
February 13 Cash…………………………………..9800
Sales Discount ……………………….. 200
A/R…………………………10,000
Here, the buyer paid with in the discount period. Therefore, the amount that
would be collected is:
15,000 – 5,000 = 10,000

Deduct: 2% Cash discount (200)
Cash collected 9800

Assume the customer in the above example returned the goods on February 15
instead of February 5, after paying with in the discount period on February 13.
Record the relevant Journal entries on February 3, 13 and 15.
95
Go back to illustration (1) once again on page and you will see that we have so
far been dealing with what net sales is composed of. You should by now be able
to figure out how the net sales figure on the income statement is arrived at.
In the following section, we will see how to record purchase transactions. Keep
in mind that a merchandising company both buys and sells goods.
3.4.2 Recording Purchases
Under the periodic inventory system a merchandising company uses the

Purchases account to record the cost of goods bought for resale to customers.
Example:
IKA Company bought goods worth Birr 43,000 from Saba Co., which is based
in Addis Ababa, on account on January 4, 2001, terms 20/10, n/30. Record the
transaction.
Solution:
January 4 – Purchases …………………..43,000
Accounts payable………………………..43,000

Record the same transaction for IKA Company if the merchandise were bought
for cash.
…………………………………………………………………………………………………
………………………………………………………………………………………………….
Deductions from Purchases
Purchase Discounts
A merchandising company can buy goods under credit terms that permit it to get
a discount if it pays with in a specified period of time. The deduction from the
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original purchase price is recorded in a separate contra Purchase account called
Purchase Discounts.
Example:
IKA Company bought goods worth Birr 50,000 from Gibir Company on account
on January 14, 2001, terms 1/10,n/60. Ika Company paid on January 24, 2001.
Record the transactions on both dates.
Solution:
J an . 1 4 . Purchases………………..50,000
A/P………………………50,000
J an . 2 4 . A/P…………………… …50,000
Purchase Discounts …….......500
Cash…………………….. 49,500
Check your Progress Exercise -7

1. What would Gibir Company record on January 14, and January 24?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
Purchase Returns and allowances

A purchase return occurs when a buyer returns merchandise to a seller.
A purchase allowance is a reduction on the price of goods bought for

dissatisfaction on the side of the buyer.
Both purchase returns and purchase allowances are recorded in a contra

purchase account called Purchase Returns and Allowances.
97
Example:
In the previous example for IKA Company, a portion of the goods worth birr
5,000 bought on January 14 from Gibir Company were of the wrong size. Gibir
Company acknowledged this and gave IKa Company a 5% price allowance on
January 17.
What should IKA Company record on January 17?
Solution:
January 17 A/P…………………………………250
Purchase Returnes and Allowance…………250
Check your Progress Exercise - 8
1. What would Gibir Co. record on January 17?

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
When both purchase discounts and purchase returns and allowances are
deducted from purchases what is obtained is called Net purchase. That is,
Gross Purchase…………………………XX
Less: Purchase discounts…………………….(XX)
Purchase returns and allowances………(XX)
Net Purchases…………………….XX
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TRANSPORTATION COSTS
Once merchandise has been bought it has to be moved from the seller‟s place to
the buyer‟s place. A third party comes in to the scene here: the transportation
company who moves the goods between the two places.
That is:
Seller Goods goods goods

Buyer
Freighter
So, the question is, who is going to pay to the freighter (transportation)
company. Who covers the transportation costs depends, as you might have
guessed, on the agreement between the buyer and seller. The agreements are
usually stated in the either of these two terms:
- FOB Destination – means “free on board at destination “. That is, since

the destination of the goods is the buyer‟s place, it is free at destination
means transportation cost is paid when the goods are loaded. It simply
means the seller pays transportation cost. FOB Destination means goods
are shipped to their destination (to the buyer) with out transportation
charge to the buyer.
- FOB shipping Point –means “ free on board at shipping point”. That is,
goods are loaded (on a truck or train) or shipped free of charge. It is,
therefore, the buyer, which pays to the transportation company when the
goods reach the buyer (their destination) Briefly, when the terms are FOB
Shipping Point the buyer pays transportation costs.
99
Transportation costs paid by a buyer of merchandise increase the cost of merchandise. They
are recorded in a separate Transportation-In account that is used to record freight costs
incurred in the acquisition of merchandise.
Example
IKA Company bought goods worth Birr 85,000 on account, terms 2/10,n/60
FOB shipping point on March 2, 2001.Transportoin cost of Birr 1,500 was paid
on March 2. Ika Company paid on March 31, 2001. Record the necessary
journal entries
Solution:
Here, since the terms are FOB Shipping Point, the buyer (Ika) pays
transportation.
March 2 -Purchase…………………..85,000
A/P………………………..85,000
-Transportation In……….....1500
Cash………………………1500
March 31 A/P…………………………85,000
Cash………………………..85,000
1. What would have been recorded by IKA, if it paid on March 12, 2001? What
if the terms were FOB destination?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
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Example:
IKA Company sold goods worth Birr 135,000 terms 1/15, n/EOM on February
1, 2001. FOB Destination. It also paid transportation costs of Birr 800 on Feb.
1. The customer paid IKA on February 16, 2001. Record the relevant Journal
entries.
Answers:
Feb 1 A/R…………………………..135,000
Sales…………………………..135,000
Feb 16 Sales discount ………………….1,350
Cash………………………….133,650
A/R…………………………135,000
Delivery Expense…………………800
Cash……………………………800
The Delivery Expense account shows how much was incurred to deliver goods
sold to customers. It is, therefore, shown on the income statement as a selling
expense.

1. What would the customer (buyer) recorded, in the above example, on
February 1, and 13, 2001?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
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Sometimes, the seller prepays the freight as a convenience to the buyer and later
collects it on the due date of the invoice even though the terms are FOB
shipping Point.
Example
Raey Co. sold goods worth Birr 40,000 on April 1, 2001 to IKA company terms
2/10, n/30 FOB Shipping Point. It also paid Birr 2,500 to Ergib Movers for
transporting the goods and added the amount to the invoice. What would each of
these companies record assuming IKA paid on April 31, 2001
Raey Co. (seller) IKa Co (Buyer)

April 1- A/R…………….40,000 April 1-Purchases …………40,000
Sales………………40,000 A/P………………….40,000
A/R…………….2500 Transport-in ………2500
Cash…………….2500
April 31-Cash……………42,500 A/P………………2500
April 31- A/P…………………42,500
A/R………………42500
Cash…………………42,500
Check Your Progress Exercise – 11

1. What would have been recorded on the above dates if IKa Co. Paid on April
11, 2001?
……………………………………………………………………………………
……………………………………………………………………………………
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……………………………………………………………………………………
………………………………………
If the buyer pays the transportation costs for the seller (when the terms are FOB
Destination) the buyer simply deducts the freight paid from the amount to be
paid to the seller.
Example:
X Company bought merchandise worth Birr 14,000 terms FOB destination from
Y Co. on account. It paid Birr 350 transportation costs. What would be recorded
on the books of the buyer and seller on the date of the sale?
Buyer (X Co) Seller Y Co.
-Purchase……….14,000 -. A/R……………….14,000
-A/P………………14,000 Sales………………….14,000
-A/P……………350 -Delivery exp……….350

Cash………..350 A/R………………350
Transfer of Title
Shipping terms determine not only determine who pays for transportation. They
also determine at what point ownership title of the goods sold transfers to the
buyer. Put briefly, whose property is it when merchandise is in transit?
1. When terms are FOB Destination we have seen that the seller covers
transportation costs. By implication the seller takes the responsibility of safely
moving and delivering the goods to the buyer. The buyer is not responsible for
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any damage that can happen to these goods in transit. Therefore, the goods
become the buyer‟s property only when they are delivered to him /her.
Conclusion: Ownership title of the goods transfers to the buyer at destination

when the terms are FOB destination.
2. When the terms are FOB shipping point the buyer pays freight costs. The
buyer takes the responsibility of safely moving these goods to his /her own
place. The merchandise, therefore, becomes his/her property as soon as they are
loaded on a truck or a train.
Conclusion: Ownership title of goods transfers to the buyer at shipping point

when terms are FOB shipping point.
The following table summarizes it all.
Sipping terms Transportation paid Title Transfers

by When goods
a re
Delivered to
FOB Destination Seller Buyer
FOB shipping Buyer Freighter
point (transportation
company)
Summary of Section One

Lets once again present the model Income Statement that we saw at the
beginning of this chapter. This time around, however, it is a bit detailed. Please
study the relationship between each item on the Income Statement carefully.
104
Also try to remember how each item was recorded in journal entry form when
the transactions affecting these accounts happened.
XYZ Merchandising Co.

Income statement
For the year ended Dec. 31,2001
Gross Sales …………………………………………………

400,000
Less: Sales Discounts (15,000)
Sales Ret &All (25,000)……… …………………….
(40,000)
Net
sales………………………………………………………….360,000
Cost of goods sold:

Beginning merchandise inventory (January 1, 2001)…10,000
Add: Purchases…………………..210,000
Less: Purchase Disc………..(5,000)
Purchase Ret & All…(5,000)
Net purchase…………………………..200,000
Add: Transportation –In……………………….66,000
Total cost of goods Available for sale………………...276,000
Less: Ending M.I (Dec. 31,2001)………………………(20.000)
Cost of goods sold………………………………………………
(256,000)
Gross profit………………………………………………………………
104,000
105
Less: Various Selling and Administrative Expenses
………………………(79,400)
Net Income…………………………………………………
24,600
Note:
Under a periodic inventory system, the cost of goods sold during a period is
determined only indirectly after comparing what was on hand at the beginning
of the period, and the cost of goods purchased during the period with what is left
on hand at the end of the period. That is, Beg inventory + Total cost of purchase
–Ending inventory=Cost of Goods Sold.
Under periodic inventory procedures no attempt is made to determine the cost of
goods sold at the time of each sale. Instead, the cost of all the goods sold during
the accounting period is determined at the end of the period.
Summary of Important Relationships on the Income Statement

1. Net sales = Gross sales- (Sales Discounts + Sales Returns and
allowances)
2. Net purchases = Purchases – (Purchase Disc. + Purchase Ret. &
allowance)
3. Total cost of Purchase = Net purchase + Transportation –In
4. Cost of goods sold = Beg inventory + Total cost of purchase –Ending
inventory
5. Gross profit = Net sales – Cost of goods sold
6. Net Income = Gross Profit – operating (i.e., selling & administrative)
expenses.
SECTION TWO: REPORTING MERCHANDISING TRANSACTIONS
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In the previous section, we saw how purchase and sales transactions are
recorded.
In this section, we will see how those transactions are summarized and reported
on the financial statements.
3.5 COMPLETING THE WORKSHEET FOR A MERCHANDISING

COMPANY
The use of a worksheet, as you remember, assists in preparing adjusting and
closing entries. In addition it contains all of the information needed for the
preparation of the financial statements. Except for the merchandise – related
accounts, the work sheet for a merchandising Co. is the same as for a service
company.
The following illustration, therefore, assumes that all selling and administrative
expenses have been adjusted. That accomplished, the only account, which
remains to be adjusted, is the Merchandise Inventory account.
Illustration
The following is the trial balance of Hard Works, a merchandising business owned by
Yibeltal. All accounts have been adjusted except the Merchandise Inventory account.
Hard Works
Trial Balance
December 31, 2002
Account title Dr CR
Cash 19,663
Account Receivable 1,880
Merchandise Inventory 7,000
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Accounts Payable 700
Yibeltal, Capital 25,000
Yibeltal,Drawings 2,000
Sales 14,600
Sales Discounts 44
Sales Returns and Allowances 20
Purchases 6,000
Purchase discounts 82
Purchase Returns and allowances 100
Transportation –In 75
Selling expenses 2,650
Administrative expenses 1,150
________
40,482 40,482
 A physical inventory of merchandise carried out on December 31, 2002

showed Birr 10,000 of goods on hand.
Required:
A- Prepare a worksheet for Hard Works.

B- Prepare financial statements from the worksheet
C- Record the necessary adjustment journal entry in relation to
merchandise
inventory
D- Record closing entries
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Hard Works Co.
Worksheet for the year ended December 31,2002
Trial Balance Adjustment Adjusted Trial balance Income statement Balance sheet
Account title Dr . Cr. Dr . Cr. Dr . Cr. Dr . Cr. Dr . Cr.
Cash 19,663 19,663 19,663
Account 1 ,8 8 0 1 ,8 8 0 1 ,8 8 0
Receivable
Merchandise 7 ,0 0 0 10,000 7 ,0 0 0 10,000 10,000
Inventory
Accounts Payable 7 00 700 700
Yibeltal, Capital 25,000 25,000 2,5000
Yibeltal, Drawings 2 ,0 0 0 2 ,0 0 0 2 ,0 0 0
Income summery 7 ,0 0 0 10,000 7 ,0 0 0 10,000 7 ,0 0 0 10000
Sales 14,600 14,600 14600
Sales Discounts 44 44 44
Sales Returns and 20 20 20
Allowances
Purchases 6 ,0 0 0 6 ,0 0 0 6 ,0 0 0
Purchase discounts 82 82 82
Purchase Returns 1 00 100 100
and allowances
Transportation –In 75 75 75
Selling expenses 2 ,6 5 0 2 ,6 5 0 2 ,6 5 0
Administrative 1 ,1 5 0 1 ,1 5 0 1 ,1 5 0
expenses
40,482 40,482 17,000 17,000 50,482 50,482 16,939 24782 33,543 25,700
7 ,8 4 3 7 8 ,4 3
24,782 24782 33,543 33,543
Note:
The merchandise inventory account before adjustment shows the inventory on
hand at the beginning of the period. This is because, since purchases and sales
of merchandise have not been debited or credited to the merchandise inventory
account, this account would still show the beginning inventory amount at the
end of the period.
Therefore, an adjustment journal entry is needed to update this account. At the end of the
period, a physical inventory would be conducted to determine the amount of inventory on
hand.
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The adjustment journal entry removes beginning inventory amount from the
merchandise inventory account and replaces it with the (ending) actual value of
merchandise inventory on hand as determined by the physical inventory.
The adjustment is:
 Income summary (beginning inventory)…………..XXX

Merchandise amount inventory……………………XXX
 Merchandise Inventory…………………………….XXX
Income Summary…………………………………..XXX
An adjustment journal entry for Hard Works is presented latter in (c).
3.6 PREPARING FINANCIAL STATEMENTS FOR MERCHANDISING

BUSINESSES
We will discuss financial statements as we work on requirement (b) of our illustration.
Once the worksheet has been completed, the financial statements are prepared.
Next, any adjusting and closing entries are entered in the journal and posted to
the ledger.
Income Statement
There are two widely used formats of the income statement. These are:
The single – Step Income Statement

This format is shown below for Hard Works Co. It shows cost of goods sold
and operating expense but has only one subtotal for total expenses.
Hard Works Co.

Income statement
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For the year ended December 31, 2002
Net sales…………………………………………………..Br.14536
Expenses:
Cost of goods sold………………………2893
Operating Expenses …………………….3800 (6693)
Net Income……………………………………….7843
The Multiple –Step Income Statement
Hard Works Co.

Income statement
For the year ended December 31, 2002
Revenue:
Gross Sales……………………………………………… Br. 14600
Less: Sales Discounts ………..44
Sales Returns &All……20……………… (6 4 )
Net Sales 14536
Less: Cost of goods sold:

Beg. Inventory (Jan 1)…………………..7,000
Add: Purchase………………………6,000
Less: Purchase.……………….(82)
Purchase Ret & all…….(100)
Net Purchases……………..5818
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Add: Transportation –In ……………75
Total cost of purchase……..5893
Total cost of Goods Available for sale……………..12,893

Less: ending Inventory (Dec.31)…………………………(10,000)
Cost of Goods sold…………………………………………..(2893)
Gross Profit……………………………………………11,643
Operating Expenses:
Selling Expenses……………….2,650
Admin. Exp…………………….1,150
Total operating expenses……………….. (3800)
Net Income……………………………… 7,843
Hard Works Co.

Statement of Owner’s Equity
For the year Ended December 31, 2002
Yibeltal Capital Jan1,2002………………………Br..25,000

Add: Net Income for the year…………………………7843
Deduct: Owner‟s withdrawal during the year………....2,000
Yibeltal Capital December 31, 2002…………………30843
Hard Works Co.

Balance sheet
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For the year Ended December 31, 2002
Assets: Liabilities & capital

Liabilities:
Cash…………………..19663 A/P……………………700
A/R…………………… 1880 Owner‟s Equity:
Merch. Inventory…….10,000 Yibeltal Capital …
30843
Total Assets………….31,843 Total Liab. &
O/E……31,843
C. Adjustment Journal entry
-Income summary…………………..7,000
Merchandise Inventory………………7,000
-Merchandise Inventory…………….10,000
Income Summary…………………….10,000
D. Closing entries
-Sales………………………………..14,600
Income summary……………………..14,600
-Income summary………………………66
Sales discount………………………………44
Sales Returns and Allowances…………… 20
-Income summary………………………………6,075
Purchases…………………………………………….6,000
Transportation-In………………………………………..75
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- Purchase Discounts………………………………..82
Purchase Ret. &All……………………………...100
Income Summary……………………………………….182
- Income summary……………………………….3,800
Selling Expenses…………………………………2650
Administrative expense…………………………..1150
- Income summary………………………………….7,843
Yibeltal Capital……………………………………7,843
- Yibeltal Captal……………………………………..2,000
Yibeltal Drawings……………………………………2,000
3.7 SUMMARY
Even though the steps and procedures that we go through to prepare the
financial statements of merchandising companies are the same with that of
service businesses, there are transactions peculiar to merchandising companies.
These include the purchase and sale of merchandise. You should be able to
record these transactions by now. Go back and study the relationships between
financial statement items summarized at the end of section one of this unit.
3.8 ANSWERS TO CHECK YOUR PROGRESS EXERCISE

List price of goods……………………………….52,000

Less: Trade discount (20% X [52,000-40,000]) ……… (2400)
Invoice Price……………………..49,600
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Journal entry:
- A/R……………………49,600
Sales…………………………49,600

- 1/15, n/60 – 1% discount if customer pays with in 15 days, otherwise
amount is due with in 60 days with out any discount.
- 2/10, n/EOM – 2% discount if paid with in 10 days, otherwise the whole
amount due at the end of the month of sale
- n/60 – No discount – amount is due in 60 days
A – since the customer paid with in the discount period, i.e., with in 10 days,
amount collected would be:
120,000 – 1% (120,000) = 118,800
B– J an . 1 8 A/R………………………..120,000
Sales………………………….120,000
Jan. 28 Cash……………………….118800
Sales Discount……………….1200
A/R…………………………….120,000
Feb 3 - A/R …………………………….15,000

Sales …………………………….15,000
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Feb 13- Cash……………………………..14,700
Sales Discount……………………...300
A/R……………………………….15,000
Feb 15- Sales Returns &Allowances……5,000

Cash……………………………….4900
Sales Discount………………………100
January 4 Purchase ………………………….43,000

Cash……………………………….43,000
Jan 14. A/R……………………………….50,000

Sales………………………………50,000
Jan 24. Cash………………………………49,500

Sales Discounts……………………… 500
A/R………………………………..50,000
Jan 17. Sales Returns & Allowances………250

A/R…………………………………..250

FOB shipping point
March 12. A/P……………………………………85,300

Cash……………………………………..83,300
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Purchase Discounts……………………. 1,700
FOB Destination
March 2 - Purchase……………………………….85,000
A/P……………………………………..85,000
March 31- A/P…………………………………….85,000

Cash……………………………………85,000

Feb 1- Purchase………………………………..135,000
A/P……………………………………….135,000
Feb 13- A/P……………………………………..135,000

Cash………………………………………133,650
Purchase Discounts………………………… 1,350

Seller Buyer
April 1-A/R……………40,000 Purchase……………40,000

Sales…………………40,000 A/P……………………40,000
A/R………………2,500 Transportation-In……..2,500
Cash…………………..2,500 A/P……………2,500
April 11- Cash (39200 + 2500)…41,700 April 11-A/P…………42,500
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Sales Discount…………...800 Cash…………….41,700
A/R (40,000 Purchase Discounts...800
+2500)…….42,500

1. You are provided with the following data from the records of three
merchandising companies:(a), (b) and (c). Determine each of the missing
numbers for each company.
a b
c
Invoice cost of merchandise purchase Br.90, 000 Br.40, 000
Br.30, 500
Purchase discounts 4000 ?
650
Purchase returns and allowances 3,000 1,500
1,100
Transportatiln-In ? 3,500
4,000
Merchandise inventory (beginning of period) 7,000 ?
9,000
Total cost of merchandise purchases 89,400 39,500
?
Merchandise inventory (end of period) 4,400 7,500
?
Cost of goods sold ? 41,600
34,130
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2. Prepare journal entries to record the following merchandising transactions of
Shiach Company. The company uses the periodic inventory system.
July 1 Purchased merchandise form Gizhy Company for $6,000 under credit
terms of 1/15, n/30, FOB shipping point.
2 Sold merchandise to Terra Co. for $800 under credit terms of 2/10,
n/60, FOB shipping point.
3 Paid $100 for freight (transportation) charges on the purchase of July
1.
8 Sold merchandise for $1,600 cash.
9 Purchased merchandise from Chilalo Co. for $2,300 under credit terms
of 2/15, n/60, FOB destination.
12 Received a $200 credit memorandum acknowledging the return of
merchandise purchased on July 9.
12 Received the balance due from Terra Co. for the credit sale dated July
2, net of the discount.
16 Paid the balance due to Gizhy Company within the discount period.
19 Sold merchandise to Urban Co. for $1,250 under credit terms of 2/15,
21 Issued a $150 credit memorandum to Urban Co. for an allowance on
goods sold on July 19.
22 Received a debit memorandum from Urban Co. for an error that
overstated the total sales invoice by $50.
24 Paid Chilalo Co. the balance due after deducting the discount.
30 Received the balance due from Urban Co. for the credit sale dated July
19, net of the discount.
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31 Sold merchandise to Terra Co. for $5,000 under credit terms of 2/10,
3. The following unadjusted trial balance was prepared at the end of the fiscal
year for Tenkir Company:
TENKIR COMPANY
UNADJUSTED TRAIL BALANCE
July 31, 2000
Cash……………………………………………….. $ 4,200
Merchandise Inventory…………………………… 11,500
Store supplies…………………………………….. 4,800
Prepaid Insurance………………………………… 2,300
Store equipment………………………………….. 41,900
Accumulated deprecation-Store Equipment… $ 15,000
Accounts payable…………………………………. 9,000
Gidey Tinker, capital…………………………….. 35,200
Gidey Tenkir, withdrawals ………………………. 3,200
Sales……………………………………………….. 104,000
Sales discounts…………………………………… 1,000
Sales returns and allowances…………………… 2,000
Cost of goods sold………………………………... 37,400
Depreciation expense – Store equipment…….. -
Salaries expense………………………………… 31,000
Insurance expense………………………………. -
Rent expense…………………………………….. 14,000
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Store supplies expense…………………………. -
Advertising expense…………………………….. 9,900
.
Totals……………………………………………...$163,200 $163,200
Rent and salaries expense are equally divided between the selling and the
general and administrative functions. Tenkir Company uses the periodic
inventory system.
Required:
1. Prepare adjusting journal entries for the following:
a. Store supplies on hand at year-end amount to $1,650.
b. Expired insurance, an administrative expense, for the year is
$1,500.
c. Depreciation expense, a selling expense, for the year is $1,400.
d. A physical count of the ending merchandise inventory shows
$11,100 of goods on hand.
2. Prepare a multiple-step income statement.

3. Prepare a single-step income statement.
4. Prepare all the necessary closing entries.

A Merchandising Business- a business that buys and sells goods at a profit.
Merchandise- anything that a merchandising company buys in order to resale it

to its customers.
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Periodic Inventory System- a system of recording inventories that updates
inventory records only once in an accounting period.
Perpetual Inventory System- a system of recording inventories that

continuously shows the balance of inventory on hand as the records about
inventory are continuously updated.
Physical Inventory- the act of counting (measuring, weighing, etc)

merchandise in order to determine the quantity of goods on hand on a particular
date.
Trade Discount- deduction from the normal selling price (list price) to
determine the invoice price of goods.
Cash Discount- deduction from the invoice price of goods for early payment
when goods are sold on credit. Cash discounts are called sales discounts for the
seller whereas they are referred to as purchase discounts by the buyer.
Purchase (or Sales) Returns- merchandise returned to the seller after it has
already been sold or bought.
Purchase (or Sales) Allowance- a deduction from the invoice price of goods
when the goods bought or sold are agreed to be of defective or unsatisfactory for
any reason.
Contra Account- if an account is a contra account; its balance would be

deducted from another account when it is presented in the financial statements.
FOB Destination- an agreement that requires the seller of the goods to cover
transportation costs. It is read as free on board at destination.
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FOB Shipping Point- an agreement that requires the buyer of merchandise to
cover transportation costs. It is read as free on board at shipping point.
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Unit 4. Accruals and Deferrals
CONTENTS
4.1 Introduction
4.2 Types of Adjusting Entries
4.3 Accounting for Deferrals
4.3.1 Accounting Treatment for Prepayments (Deferred Expenses)
4.3.1.1 The Asset Method
4.3.1.2 The Expense Method
4.3.1.3 Effect of Overlooking Adjustments for Deferred Expenses
4.3.2 Deferred Revenues
4.3.2.1 The Liability Method
4.3.2.2 The revenue Method
4.3.2.3 Effect of Overlooking Adjustments for Deferred Revenues
4.4 Accounting for Accruals
4.4.1 Adjustment for Accrued Expenses
4.4.2 Effect of Overlooking Adjustments for Accrued Expenses
4.4.3 Adjustment for Accrued Revenues
4.5 Reversing Entries
4.6 Summary
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After reading this unit you should be able to:
- define accruals and deferrals
- record adjustment journal entries for accruals and deferrals under
various alternatives
- tell the effect of overlooking adjustment journal entries for accruals
and deferrals
- understand and record reversing entries
4.1 INTRODUCTION
The realization principle, as explained in unit 2 requires that revenue be
recognized and recorded in the period it is earned. And the matching principle
stresses that in order to measure income; expenses incurred to produce revenues
must be matched (associated) with the revenue generated in the same accounting
period.
At the end of an accounting period, adjusting entries are needed so that all
revenues earned are reflected in the financial statements regardless of whether
they have been collected or not. Adjusting entries are also needed for expenses
to ensure that all expenses incurred are matched against the revenues of the
current period regardless of when cash payment of the expense occurs.
Thus, adjusting entries help in achieving the goals of accrual accounting – which
states recording revenues when it is earned and recording expenses when the
related goods and services are used, i.e. when expenses are incurred.
Accountants use adjusting entries to apply accrual accounting to transactions

that span more than one accounting period. That is, adjusting entries are needed
whenever transactions affect the revenues or expenses of more than one
accounting period.
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4.2 TYPES OF ADJUSTING ENTRIES
A business may need to make a dozen or more adjusting entries at the end of
each accounting period. The exact number of adjustments will depend up on the
nature of the company‟s business activities. But, all adjusting entries fall in to
two general categories:
1. Adjusting entries to apportion deferrals

2. Adjusting entries to record accruals
4.3 ACCOUNTING FOR DEFERRALS

Definition: - The word “defer” means to delay or post pone. In accounting,
Deferrals are the delay (or post ponment) in the recognition of an expense
already paid or revenue already received.
Deferred items consist of adjusting entries involving data previously recorded in

accounts. These entries involve the transfer of data already recorded in asset and
liability accounts to expense and revenues accounts.
Types of Deferrals
Deferred items could be grouped into two major types:
i. Deferrals to apportion prepayments
ii. Deferrals to apportion advance receipts
4.3.1 Accounting Treatment for Prepayments (Deferred Expenses)

Companies often make advance expenditures that benefit more than one period,
before receiving the service. Such expenditures that are made before receiving
the service are called Prepaid Expenses or Deferred Expenses. At the initial
point of payment, the total advance payment is an asset not an expense to the
business enterprise paying in advance. This is because, according to the accrual
126
basis of accounting, the recognition of expense is not related to the payment of
cash. Rather it is related to the receiving of the service; that is, incurring of the
expense. As far as the company has not received the service the total advance
payment remains to be an asset to the business enterprise.
However, each time the company receives the service, the asset will be
converted to an expense. That is, the part of the advance expenditure that has
benefited current operations is treated as an expense of the period in which the
service is received as you can see, each time the service is received (expense
incurred) no payment will be made, because the payment has already been made
in advance.
And the part of the advance payment that has not been consumed or has not
been expired (used) is treated as an asset applicable to future operations. It is
through the use of adjusting entries that we apportion (divide) the prepayment in
to used and unused portion. The adjusting entry for the adjustment of
prepayments uses an asset and expense accounts.
There are two alternative methods of recoding prepayment at the initial point of
payment.
1. The asset method
2. The expense method
We have tried to discuss the asset method of recording prepayments in the previous
chapters. In this chapter, we will see both methods to help you understand the
alternative methods of recording prepayments.
To illustrate the alternative methods of recording prepayments, assume on Jan.

1,2002 CHAMO ADVERTIZMENT COMPANY paid Br. 36,000 for rent for
the coming three years for office it has rented from SHALA COMPANY. Also,
127
assume that the fiscal year of CHAMO ADV. COMPANY ends on December
31.
4.3.1.1 Recording Prepayments (Deferred Expenses) Initially in an Asset

Account (The Asset Method)
The total advance payment is debited to an asset account, in CHAMO ADV. CO.S’ case
to a Prepaid Rent Account. Recording the total advance payment in an asset account
does not imply that it will remain to be an asset. As we mentioned earlier, at the initial
point of payment, the total amount paid in advance is an asset. However, as each day
passes, part of the asset expires and becomes an expense. In accounting, we don’t
transfer the expired portion each day from the asset to an expense account. Rather we
delay it until the end of the accounting period.
The adjusting entry used in this case, debits an expense account and credit an
asset for the amount that has expired i.e. the portion for which service has been
received.
Lets see these for CHAMO ADV. CO., On Jan. 2, 2002 the following journal
entry will be made by CHAMO ADV. CO.
 Prepaid Rent ………………………… 36,000
Cash ………………………………… 36,000
To record advance payment of rent for 3 years.
As you can notice, the total advance payment was debited to an asset account,
and obviously as cash was paid the cash account is credited.
After one year on Dec. 31, 2002, the company has used the office for one year.
We say from the total advance payment, Br. 12,000 (= Br. 36,000/3 Br. 12000)
has expired. But until adjustment, the used portion Br. 12000 remains in the
asset account; it is through adjustment that we transfer the used portion to an
expense account.
128
The adjusting entry that transfers the used portion to the expense account for
CHAMO ADV. CO. made on Dec. 31,2002 is:
Rent Expense ……………… Br. 12,000
Prepaid Rent ………… ………….. Br. 12,000
After the adjusting entry has been posted, the Rent Expense account will have a balance
of Br. 12,000 and prepaid Rent now shows the correct balance of Br. 24,000 (The
portion that has not expired or used). This relationship can be shown using a “T”
account as follows:
Prepaid Rent Rent Expense
Dr. Cr. Dr.
Cr.
Jan. 1,2002 36,000 12,000 Dec. 31, 2002 Dec. 31,2002 12,000
(Payment) (Adjusting) (Adjusting)
Balance Br. 24000
The used portion Br. 36000 = Br. 12000

3
is transferred from the asset to an expense account
If CHAMO ADV.CO. decides to leave the office it rented on Dec.31,2002, do

you think that it will be refunded the amount it paid of Jan. 1,2002? No, because
it has already used the office for one year. As a result, the amount it should be
refunded is the unused portion of the prepayment. But in our case, CHAMO
ADV. CO. has not decided to leave the office.
129
4.3.1.2 Recording Prepayments Initially in an Expense Account (The Expense
Method)
In our illustration for CHAMO ADV. CO., advance payments for rent that will
benefit three years operation were recorded by a debit to an asset account,
Prepaid Rent. However, each time the service is used (i.e. stay in the office) it is
obvious that the asset will be converted to an expense account. As a result some
companies follow an alternative practice of recording prepayments directly to an
expense by the assumption that the prepayment will be finally converted to an
expense. Remember that, though the pre payment is recorded initially (directly)
in an expense account, it still remains to be an asset to the company as far as the
service is not received.
In CHAMO ADV.CO.‟S case the following journal entry will be made on Jan.
1,2001, the date of advance payment.
Rent Expense ………………….. 36,000

Cash …………………………36,000
To record advance payments made for rent for three years.
Recording the prepayment directly in an expense account doesn‟t necessarily

indicate that the total advance payment will expire during the year. That is, part
of the prepayment might remain unexpired (unused) at the end of the year.
When there is unused portion, an adjustment is needed to transfer the unused
portion from the expense account to the asset account. The adjusting entry will
debit an asset account and credit an expense account for the amount for which
no service is received (unexpired petition).
On Dec. 31,2002, the following adjusting entry is made by CHAMO ADV.

Company.
130
Prepaid Rent…………………………. 24000
Rent Expense………………………..24000
To record the adjustment that transfer the unexpired portion from an expense to
asset account.
The unexpired amount is computed as:
36,000
Yearly expiration = = Br. 12,000 per year. There fore, after one year
only
3Yea
rssss
ss
1/3 (12,000) expires, the remaining balance Br. 24,000 (=Br. 36,000 – 12,000) is
unexpired and reported as an asset.
This alternative method leads to the same results in the balance sheet and
income statement, as does the asset method of recording. Here also, the balance
of prepaid rent that will appear on the balance sheet is Br. 24,000 and the
amount of rent expense for the year is Br. 12,000.
4.3.1.3 Effect of Overlooking Adjustments for Deferred Expenses

What is the effect of over looking the adjustment on the financial statements?
Income Statement:
 The expenses would be over stated by Br. 24,000. Because it is
through the adjusting entry that we apportioned the unexpired portion
from the expense account and transferred to the asset account.
 The overstatement of expense leads to an understatement of net
income (or overstatement of net loss if there is net loss).
Balance sheet:
131
 The understatement of net income will be reflected on the owners
equity (capital) that is capital will be understated. Because through the
closing process the understated income balance will be transferred to
the capital account, hence the understatement of capital.
 The assets (Prepaid Rent) would be affected and understated, if the
adjustment was over looked. Because it is through adjustment that we
transfer the unexpired portion to the asset account. But if no
adjustment, the unexpired portion remains in the expense account than
being in the asset account.
Therefore, we say never, never over look an adjustment, for failing to do so will
misstate all financial statements. And misstated financial statements will lead to
WRONG DECISIONS.

Anbessa Co. purchased supplies worth br.5000 on March 12,20x2.At the
beginning of the fiscal year the company had br.3500 worth of supplies on hand.
A physical count at the end of the year December31, 20x2 showed that there is
br.1500 worth of supplies on hand. Record the necessary adjustment journal
entry on December31, 20x2 if
A. The company has a policy of recording supplies as an expense initially

when they are bought.
B. The company has a policy of recording supplies as an asset initially when
they are bought
4.3.2 Deferred Revenues (Unearned Revenues)
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Just as expenses can be paid before they are used, revenues can be received
before they are earned, i.e., before the service has been given. Unity University
College collected money from you in advance of giving service. Such advance
collections made before giving service are called Unearned Revenues.
When cash is received in advance, the company enters in to an obligation to

deliver goods or perform services. Therefore, unearned revenues are shown in a
liability account, and will appear on the Balance Sheet.
Unearned Revenues differ from other liabilities because unlike Accounts

payable, they are usually settled by rendering services, than payment in cash.
We can say it is a work off rather than a paid off liability. Of course, if the
company fails to deliver the services as promised it must refund the customers
their money for the portion it has not rendered the service.
Each time the company renders services it is earning the revenues. No cash
collection will be made at this point, why? Because the cash has already been
collected in advance.
Concerning the recording of Deferred Revenues, we have two alternative

methods:
1. Recording advance collections directly in a liability account
2. Recording advance collection directly in a revenues account
The financial statements prepared using these two methods are one and the
same. It is like two roads leading to the same place.
To help us understand the difference between the alternative methods, consider

the following illustration:
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On January 1,2001, Oceanic Advertisement Company collected Br. 18,600 in
advance from ZOOM Company by promising to advertise the products of
ZOOM Co. on Ethiopian Television and on one of the local news papers for the
coming 20 months. Assume advertisement services given each month are equal.
4.3.2.1 The Liability Method: Recording Unearned Revenues Directly (initially)

in a Liability Account
Amounts that are collected in advance from customers are not revenues of the
business enterprise, as far as service is not provided. As a result, one approach to
record the advance collections is to record them directly in a liability account;
even if part or all of it might be earned during the period.
On Jan. 1, 2001, Oceanic Advertisement Company will record the advance

collection as:
Cash ………………………………………18,600
Unearned Advertisement Revenues
………………………18,600
Remember that the unearned advertisement Revenues is a liability account, not a

revenue account. The Advertisement Revenues will be earned gradually as
Ocean Co. gives the services as promised. Because it will not be practical to
record weekly or monthly earnings of revenues, what we do is to delay weekly
or monthly earning until the end of the fiscal period. By which time we will
transfer the amount of Advertisement Revenues earned for the year from the
liability account to the revenue account. The adjustment journal entry for this
debits the liability account and credits the revenues account for the earned
portion (the portion for which service has been rendered).
134
On Dec. 31,2001, the following adjusting entry will be made in the case of
Oceanic Advertisement Company:
Unearned Advertisement Revenues ………………….11,160

Advertisement Revenues ……………………..11,160
To record adjustment
The amount that is earned can be computed as:

Monthly = Br. 18,600/20months = Br. 930 per month earnings.
i.e. each month the company earns Br. 930.00. Therefore, for the period from
Jan.1,2001, to Dec.31,2001, Br. 11,160 (=12 x 930) is earned by Oceanic
Advertisement Company.
After the adjusting entry has been posted, unearned Advertisement Revenue will
have a Br. 7440 end balance and Advertisement Revenue will have a Br. 11,160
balance. The balance in unearned Advertisement represents the obligation of the
company to render advertisement services in the future periods. This can be
stated using a “T” account as follows:
Unearned Advertisement Revenue Advertisement Revenue

Br. 18,600 Jan. 1, 2001
Br. 11, 160 Br.7, 440 Br. 11, 160
To transfer the earned portion Br. 11,160

from the liability to the revenue account
What would be the effect of over looking the adjustment?
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On the income statement:
- Revenues would be understated. This is because; it is through
adjustment that we transfer the earned portion from the liability to
the revenue account.
- Net income would be understated; or net loss would be
overstated. Because there would be an understatement of revenue.
On the balance sheet
- Capital would be understated, because the understated net income

would be closed finally to the capital account.
- The liability would be overstated in the Balance sheet because the
adjustment has transferred out from the liability account to the
revenue account the portion that is earned. But, if there was no
adjustment this earned portion remains in the liability account and
overstates it.
4.3.2.2 The Revenue Method: Recording Advance Collections Initially in a Revenue Account
We have stressed that amounts collected from customers in advance are

liabilities not revenue because according to the revenue realization principle,
revenue is earned when service is given to the customer.
However, we know that each time service is given we earn revenue. As a result,
some companies prefer to record advance collections initially in a revenue
account though it is not earned.
Here, the expectation is that, in the future all of the advance collections will be
earned and be converted into revenue. Notice that, even if we record the advance
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collection in revenue accounts it doesn‟t mean that it is revenue. It still remains
to be a liability as far as service is not given.
On Jan. 1, 2001, the date of advance collection, Oceanic Advertisement

Company will record the following journal entry:
Cash -----------------------------------------------18,600
Advertisement Revenue ---------------------------18,600
To record advance collections for advertisement
for 20 months
RECORDING THE ADVANCE COLLECTION IN REVENUE ACCOUNT DOES NOT

NECESSARILY IMPLY THAT IT WILL BE EARNED TOTALLY IN THE PERIOD.
A portion of it might remain unearned. When there is unearned revenue at the end of
the year an adjustment is necessary to transfer this unearned portion from the revenue
account to the liability account.
In year 2001, Oceanic Advertisement Company rendered services only for 12

months from the total 20-month services it promised to give. Since the 8 months
service is not rendered it should NOT be reported as revenue. As a result, using
an adjusting entry, which debits the revenue account and credits the liability
account, we transfer the unearned portion to the liability account.
On Dec. 31, 2001, the following adjusting entry is necessary for oceanic
advertisement company:
Advertisement Revenue -------------------------------- 7440

Unearned Advertisement Revenue-------------------------------
-----7440
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After the adjusting entry is posted, the Advertisement Revenue account will
have a balance of Br. 11,160 and unearned Advertisement Revenue will have a
balance of Br. 7,440. Notice that, it is one and the same to the balance that
resulted in the previous alternative.
4.3.2.3 Effect of Overlooking Adjustments for Deferred Revenues

What would be the effect of overlooking the adjustment?
On the income statement

- Revenues would be overstated by the amount of the adjustment, because it
is through the adjustment that the unearned portion is apportioned from
revenue account.
- Net income would be overstated
On the Balance Sheet:
- Liability (= unearned Advertisement Revenue) would have been under

stated because it is through the adjusting entry that we transfer the
unearned portion to the liability account. That is, if no adjustment, nothing
would have been transferred to the liability account.
- Overstatement of owner‟s equity thus results from the over statement of
revenue or net income.

Nebir Publishing Co. received br.5600 in advance from customers who
subscribe to the magazine that the company publishes. At the beginning of the
fiscal year the company had br.3200 of unearned revenues. And at the end of the
current fiscal year December31, 20x2 there were still br.4300 unearned revenues
from magazine subscriptions received in advance.
Record the necessary adjustment journal entry on December31, 20x2 assuming
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A-The company records advance receipts as a liability when they are
collected
B- The company records advance receipts as a revenue when they are
collected
4.4 Accounting for Accruals
Definition: an accrual is the recognition of revenue or an expense that has arisen

but has not yet been recorded.
The word “accrue” means to accumulate or grow in size. In accounting, an

accrual is the recognition of revenue or an expense that has accumulated
overtime but has not yet been recorded. In order to report a company‟s financial
position and profitability accurately, the accruals should be recognized
(recorded) in the accounting period in which they occur.
As you can notice from the definition, we have basically two types of accruals in
accounting. These are:
1 – Accrued Expense / Accrued Liability/
2 – Accrued Revenue /Accrued Assets/
4.4.1 Accrued Expenses /Accrued Liability/
Accrued expenses refer to expenses that are incurred but are both unpaid and
unrecorded. When we say the expense is incurred; it means, “ the service has
been received but the payment for it has not yet been made.” Since the incurred
expense is not paid there is a sense of a liability, hence the name accrued
liability.
Most expenses in accounting are paid whenever they are incurred. There are,
however, some business expenses that accrue (accumulate) daily but are usually
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recorded when they are paid. Such expenses include, salary and wages paid to
employees, and interest paid on borrowed money. As you know, employees
work on a day-to-day basis but they are not paid on a daily basis. Rather there is
an interval on which the payment is made. Therefore, we say these expenses
accrue, that is, grow or accumulate over time.
Accrual (both accrued expenses and accrued revenues) in general need an

adjusting entry when the end of the fiscal period comes before the date on which
the expense is to be paid.
ILLUSTRATION
Mamush Bakery pays the salaries of its employees every Friday, for a five
working days from Monday to Friday. (That is, the employees are paid on every
Friday for the work they perform from Monday to Friday. The salary for five
working days amounts to Br. 2500.
For the year 1998, the end of the fiscal year, Dec. 31, falls on Wednesday. What
adjustment is needed on December 31 in relation to salary expense.
ANSWER:
By the end of Dec. 31, 1998, the employees have already worked for three days
(Monday, Tuesday, and Wednesday) but they will not be paid until the regular
pay day on Friday, which lies on Jan. 2, 1999 in another fiscal period.
The salaries for the three days are rightfully an expense for 1998. As a result, the
expense must be recorded and reported in 1998, in the year in which it is
incurred (According to the expense recognition principle).
Since it is not paid on Dec. 31, 1998, there is a liability that the company owes
to pay. The salary rate is Br. 2,500 for the workdays, then, the rate per day will
be Br. 500 (= Br. 2500/5). Therefore, the expense for the three days is Br. 500 x
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3 = Br. 1,500.f and the following adjusting entry should be made to recognize
the accrued expense on Dec. 31, 1998:
Salary Expense -----------------1500

Salary Payable ------------------------------ 1500
The balance in salaries payable that will be reported as a liability on Mamush

Baker‟s balance sheet is Br. 1,500. And the Salary Expense of the three days Br.
1500 will be reported together with the salary expenses of the year on the
income statement.
4.4.2 Effect of Overlooking Adjustment of Accrued Expenses

As we stated earlier, adjustment is a mandatory step in the accounting cycle
because failing to do so will affect the amounts reported on the financial
statements. As a result, the adjustment for recognizing accrued expenses must be
made always by the end of the fiscal year.
In our case, if the adjustment on Dec. 31, 1998 was overlooked, the following
will be reflected on the financial statements:
On the Income Statement

- Expenses would have been understated, because in the adjustment an
expense account has been increased.
- Understatement of expense leads to an overstatement of net income (or an
understatement of net loss, if there is net loss)
On the Balance Sheet

- Capital would have been overstated because of the overstatement of net
income.
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- Liability (salaries payable) would have been understated, because in the
adjusting
entry a labiality account has been increased.
4.4.3 Accrued Revenues (Accrued Assets)

Accrued revenues are revenues for which a service has been performed or goods delivered but
for which no entry has been recorded.
That is, the revenues have been earned but not both yet recorded and received.
Any revenues that have been earned but not recorded during the accounting
period call for an adjusting entry that debits an asset account (= specifically a
receivable) and credits a revenue account.
4.5 Reversing Entries: The Optional First Step in the Next Accounting Period
At the end of each accounting period, adjusting entries are made to bring
revenues and expenses into conformity with the matching rule. That is, using
adjusting entries at the end of the accounting period, we try to update the
accounts of the business enterprise.
A reversing entry is a general journal entry made on the first day of the new
accounting period that is the exact reverse of an adjusting entry made at the end
of the previous period. Unlike adjusting entries, reversing entries are optional,
i.e., without the use of reversing entries we can prepare correct financial
statements.
A reversing entry, as the name implies, is the exact reverse of the adjusting entry
made at the end of the previous period. It contains the same account titles and
dollar amounts as the related adjusting entry, but the debits and credits are the
reverse of those in the adjusting entry and the date is the first day of the next
accounting period.
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Reversing entries simplify the recording of certain routine cash receipts and
payments and minimize the possibility of making errors.
Not all adjusting entries can be reversed. In accounting, when the policy of
using reversing entries is adopted the adjusting entries to record the following
adjustments can be reversed:
- Adjustments to record both types of accruals can be reversed.

- Prepaid expenses initially recorded as an expense can be reversed
- Unearned revenues initially recorded as a revenue can be reversed
N.B Deferrals that are recorded initially as an asset and as revenue cannot be
reversed.
To show how reversing entries can be helpful, consider the following example.
- SAMRA COMPANY pays the salary of its employees each Friday for a
five-day workweek. Assume salary per day is Br. 300.00, or Br. 1500 for
a five-day week. Through out the year, the company‟s accountant makes a
journal entry each Friday as follows:
Salary Expense ---------------- 1500
Cash ------------------------------ 1500
To record payment of salary for the week.
Next, let us assume that December 31, end of the year 2002 falls on Wednesday.
All expenses of the year must be recorded before the accounts are closed and
financial statements are prepared on December 31. Therefore an adjusting entry
must be made to record the salaries expense and the related liability for the three
days (Monday to Wednesday) they have worked. The adjusting entry for $
900.00 (computed as 3 x 300 daily salary expenses) is:
Dec. 31, 2002
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Salary Expense 900
Salary Payable 900
To record accrued salary for the three days worked
in December
The reversing entry would be:
Jan.1, 2003 Salary Payable 900
Salary Expense 900
To reverse adjustment made at the end of previous year.
After the reversing entry salary payable will have zero balance and salary
expense will have a credit balance of 900 birr. Open T-accounts for both the
salary expense and salary payable accounts and record adjustment, closing and
reversing entries in the T-accounts ;you would get the fore mentioned balances.
The payment of salary on the following Friday would simply be recorded as

follows:
January 2 Salary Expense…………..1500
Cash…………………………….1500

How would the payment have been recorded if the adjustment were not
reversed?
The Choice of Method of Recording Deferrals

As you can recall, for both types of deferrals there are two methods of recording.
That is, in the case of prepaid expenses the asset and expense methods and in the
case of unearned revenues the liability and revenue methods of recording. Both
alternative methods of recording deferrals result in the same effects on the
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financial statements. Then, the next logical question to ask is which method of
recording to use.
The choice between the two methods of recording prepaid expenses and
unearned revenues depends up on which method would normally result in fewer
entries and would be least likely to create errors in the recording process.
It is better to record those prepaid expenses that will be used (consumed) during
the accounting period initially as an expense. This way, only one entry would be
required, and no adjusting entry is necessary. On the other hand, those prepaid
expenses that will not be totally used or consumed during the accounting period
are usually recorded initially as assets and an adjusting entry is made at the end
of the period for the amount consumed.
Recording prepaid expenses that last for more than one period requires only an
adjusting entry, but recording it initially as an expense would normally require
both an adjusting entry and reversing entry.
Similarly, for unearned revenues that will be earned in the current accounting
period, the revenue method of recording is preferable. In contrast, for unearned
revenues that will be earned in more than one period the labiality method of
recording is preferable.
4.6 SUMMARY
Accountants have to update some of the accounting records or accounts before
preparing the basic financial statements. The journal entries made at the end of the year
to update the accounting records are called adjustment journal entries.
These can be adjustments for deferrals and adjustments for accruals.
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Deferred expenses can initially be recorded either as assets or expenses. In any
case, the accounts usually need adjustment. After adjustment the accounts reflect
the same correct balance whichever method is followed. The same is true with
deferred revenue. It can be recorded as a liability or as revenue when initially it
is received.
The use of reversing entries is optional in all cases but it is recommended, as it

will simplify matters in the following period.

A- December 31,20x2 Supplies………….1,500
Supplies Expense………1,500
B- December 31,20x2 Supplies Expense………7,000
Supplies………….7,000

A- December 31,20x2 Unearned Subscription Revenue………4,500
Subscription
Revenue……………4,500
B- December 31,20x2 Subscription Revenue …………..4,300
UnearnedSubscriptionRevenue………4,300

January2 SalaryExpense……………….600
Salary Payable………………..900
Cash…………………………….1,500
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Part I. Multiple Choice
1. Revenues which are earned but not collected resulting:

A. Accrued Assets
B. Accrued Liabilities
C. Accrued Revenues
D. Differed Revenues
E. “A” and “C”
2. Reversing entries are
A. made at the beginning of the new accounting period
B. direct reverse of the adjusting entries made at the end of the previous
year.
C. are optional
D. All
E. None
3. The adjusting entry to record accrued expenses will:
A. debit an asset account and credit a liability account
B. debit a liability account and credit a revenue account
C. debit an expense account and credit a liability account
D. debit an expense account and credit an asset account.
E. None
3. Unearned revenues are classified as:
A. liability
B. an asset
C. a revenue
D. an expense
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E. None
Part II. Exercise
MAMO GASHA Company pays the salary of its employees on every Saturday for a six
working days from Monday to Saturday. The total salary for the six days amount to Br.
4,200.
For the year 2002, the fiscal year ended on Thursday, Dec. 31, 2002.
Instruction: On the basis of the above data:

1- Record the adjustment needed on 1 Thursday Dec. 31, 2002.
2- Record the payment of salary on Saturday, Jan. 2, 2002. (Assume the
company follows the policy of using reversing entries)
3- Repeat instruction “2” assuming the company does not use reversing
entries.
On July 1, 2000
SELAM CONPANY rented Office rooms from BUDENA plc for 4 years by paying Br.
72000. The SELAM COMPANY agreed to use the office rooms as a show room for its
products it manufactures at its factory around kality.
Both Companies use a fiscal year that ends on Dec. 31.
Instruction:
1. Pass the journal entry to record
a) The payment of cash by Selam company on July 1,2000,
assuming the company records pre payments as an asset.
b) The adjusting entries entry repaired on Dec. 31, 2000 and 2001
in the records of
SELAM COMPANY.
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2. Pass the journal entry in the records of BUDENA Company to record:
a) The cash collection made on July 1, 2000, assuming the company records
advance collections as a liability.
b) The adjusting entry required on Dec. 31, 2000 and 2001 in the
records of Budena company
c) What is the effect of failing to pass the adjustment on Dec. 31,
2000

Accrued Expenses (Accrued liabilities)- expenses which are incurred but are
unrecorded and unpaid at the end of the period.
Accrued Revenues (Accrued assets) – Revenues which have been earned (i.e.
service given or goods sold) during the accounting period but has not been
record or collected at the end of the period.
Adjusting entries – Entries required at the end of the period to update the
accounts before financial statements
Prepaid Expenses (Deferred Assets, Deferred Expenses) – Advance

payments which are made before receiving the service.
Reversing Entries – An optional procedure made on the first day of a new

accounting period
which is the direct reverse of the adjusting entry made at the end of the previous period.
Unearned Revenues (Deferred Revenues) – Advance collections made before

rendering the service or selling the goods. Unearned revenues represent an
obligation to render services or deliver goods in the future.
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UNIT 5: ACCOUNTING SYSTEMS
CONTENTS
5.1 Introduction
5.2 Components of Accounting Systems
5.2.1 Source Documents
5.2.2 Input Devices
5.2.3 Information Processors
5.2.4 Information Storage
5.2.5 Output Device
5.3 Fundamental Principles of Accounting Systems
5.3.1 Control Principle
5.3.2 Relevance Principle
5.3.3 Compatibility Principle
5.3.4 Flexibility Principle
5.3.5 Cost-Benefit-Principle
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5.4 Special Journal and Subsidiary Ledgers
5.4.1 Subsidiary Ledgers
5.4.2 Special Journals
5.4.2.1 Advantages of Using Special Journals
5.4.2.2 Sales Journal
5.5 Computer Technology and Accounting Systems
5.6 Summary
5.7 Answer to Check your Progress Questions

After completing this unit, you should be able to:
- understand principles of accounting information systems
- list out the components of accounting information systems
- explain the purpose and use of special journals and subsidiary ledgers
- explain the impacts technology on accounting information systems.
5.1 INTRODUCTION
This unit introduces you to the components and principles of accounting
systems.
A system is a way of doing something. There are various ways of doing things.
Let‟s say you decided to go home when you go out of your office. There are
many ways to do that: You can either take a taxi or you can walk the whole
distance home; you can take the main road, or you may wish to use a short cut
and so forth.
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In accounting also, it is true that almost all business record, process and report
business transactions. However, the speed and efficiency of the processing
depends on which accounting system they use.
5.2 COMPONENTS OF AN ACCOUNTING SYSTEM

There are five basic elements of an accounting system. These are:
5.2.1 Source Documents

Source documents provide the basic information to be processed by the
accounting system. Invoices from suppliers, bills sent to customers, and payroll
records are some examples of source documents. You have already seen their
meaning and importance in previous chapter.
5.2.2 Input Devices

Input devices capture information from source documents and enable its transfer
to the information-processing component of the system. Journal entries, both
paper based and electronic are a type of input devices.
5.2.3 Information Processors

An information processor is a system that interprets, transforms and summarizes
information for use in analysis and reporting. The information processing in an
accounting system can be manual or computerized.
Now a days, computer are being increasingly used to process information.

Many businesses in Ethiopia, for example, use the Peachtree accounting
software to process accounting information.
5.2.4 Information Storage

After being input, processed data are usually saved for use in future analysis or
report. Information storage is the component of an accounting system that keeps
data in a form accessible to information processors.
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5.2.5 Output Device
Output devices are the means to take information out of an accounting system
and make it available to users. Output devices include printers, and monitors,
which provide such outputs as financial statements, bills to customers and
internal reports.
Give one example of an information storage device.

…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
5.3 FUNDAMENTAL PRINCIPLES OF ACCOUNTIG SYSTEMS

5.3.1 Control Principle
Any accounting information system should allow managers to control and
monitor business activities. To achieve this, accounting system must have
internal control as an element.
Internal controls are methods and procedures that direct operations to one goal,
ensure reliability of financial reports and safeguard business assets. Internal
controls are discussed separately and at a greater detail in the next chapter.
5.3.2 Relevance Principle

The information that an accounting system provides should be relevant to
decision makers. This means, an information system should be designed to
capture data that make difference in decision. To ensure this, it is important that
all decision makers, be considered when identifying relevant information for
disclosure.
5.3.3 Compatibility Principle
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The compatibility principle requires that an accounting system conform to the
company‟s activities, personnel and structure. The system must also be
customized to the unique characteristics of the company.
All in all, accounting systems must be consistent with the aims of the company,
i.e., they should work in harmony with company goals.
5.3.4 Flexibility Principle

Accounting information systems must be flexible to adjust to changes in the
company, in the business environment and needs of decision makers. These
changes can be technological developments, consumer tastes or company
activities.
A system must be designed to adapt to these and other changes.
5.3.5 Cost-Benefit-Principle
You wouldn‟t do anything in your daily life with out first weighing the costs and
the benefits. Likewise, the benefits of performing an activity in an accounting
system should be greater than its costs.
For example, when you decided whether or not to report certain information,
you have to compare the benefits (its usefulness to decision making) and the
costs (of computing, personnel and other indirect costs).
5.4 SPECIAL JOURNALS AND SUBSIDIARY LEDGERS

5.4.1 Subsidiary Ledgers
When a business has so many customers and suppliers, a control account for Accounts
Receivable and a control account for Accounts Payable are established in the general ledger.
But in addition to these, subsidiary ledger for receivables and payables may be added to the
accounting system to show the balances for each individual customer and supplier separately.
A control account is an account in the general ledger that shows the total
balances of all the subsidiary accounts related to it.
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Subsidiary ledger accounts show the details supporting the related general ledger control
account balance. For example, the subsidiary (supporting) accounts for accounts Receivable
may be used to send out to each customer statements showing the balance they owe the
company.
A subsidiary ledger is therefore, a group of related accounts showing the details

of the balance of general ledger accounts.
Subsidiary ledgers are used to relieve the general ledger of a mass of detail. Thereby, the
general ledger trial balance is shortened. What‟s more, having separate ledgers promotes the
division of labor as one employee can handle the control account while its subsidiary can be
assigned to another employee.
The relationship between a control account in the general ledger and its
subsidiary accounts can be illustrated as follows in T- account form.
Control account in Subsidiary accounts in the

the Accounts Receivable
General Ledger subsidiary
Ledger
Accounts Receivable Customer A
Customer B
2001 2001 2001
Dec. 31 Dec. 31 Dec. 31
Bal. 10,000 Bal. 1,000 Bal. 4,000
Customer C Customer D
2001 2001
Dec. 31 Dec. 31
Bal. 2,000 Bal 3,000
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As you can see the sum of all balances in the subsidiary accounts (1,000 + 2,000
+ 4,000 + 3,000) on December 31, 2001 is equal to the balance in the control
account (10,000).
When a transaction is recorded as a journal entry, it must indicate which of the subsidiary
ledger accounts is affected. Posting will be made to both the control account and the
subsidiary ledger account.
Example
A Br. 450 sale was made on account to Gome Balcha on January 2, 20X2. The
journal entry would be:
Jan. 2 Accounts Receivable-Gome 450
Sales 450
The Br. 450 would be posted as a debit to both the Account Receivable control
account in the general ledger and G.Balcha‟s account in the subsidiary ledger.
The credit would, of course, be to the Sales account in the general ledger.
The following can be a summary of what‟s discussed above:
General ledger
Control Account Subsidiary ledger
Accounts Receivable Accounts Receivable
subsidiary
Accounts Payable Ledger (account for each
customer)
Office Equipment, Accounts Payable subsidiary
Delivery Equipment, Ledger (account for each
Office Furniture supplier)
Equipment subsidiary ledger
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(Account for each item of
equipment).
1. What factors would affect a company‟s decision to set up subsidiary ledger accounts for
the general ledger accounts?
……………………………………………………………………………………
…………………
……………………………………………………………………………………
…………………
5.4.2 Special Journals
A general journal is an all-purpose journal where we can record any transaction.
However, as the transactions of a company increase, it is better to use special
journals along with the general journal to record transactions of similar type in
one, such as sales on account or cash payments. Special journals record
transactions of a similar nature.
Special journals are designed to systematize the original recording of major

transactions, which occur very repeatedly.
The number and format of special journals used by a company depends on the
nature and size of the company‟s business transactions.
The following are some of the typical examples of special journals used by most
merchandising businesses.
1. Sales Journals 2. Cash Receipt journal

for recording credit for recording cash
sales. receipts.
3. Purchase journal
4. Cash payment 157
for recording credit
journal
purchases.
5.4.2.1 advantages of using special journals
A- Time is saved in journalizing. The amount of writing is reduced because it is not
necessary to repeat the account titles printed already at the top of the special columns
for every debit and credit.
B- Time is saved in posting- many amounts are posted as column totals rather than
individually.
C- Detail is eliminated from the general ledger column. Totals are posted to
the ledger means that detail is left in the special journals.
D- Division of labor is promoted. Several persons can work simultaneously on the
accounting records. This allows management to fix responsibility and quickly locate
errors.
E- Management analysis is aided. The special journal can be useful to

management in analyzing classes of transactions, such as sales, because
similar transactions are in one place.
5.4.2.2 Sales Journal

The sales journal is used to record sales of merchandise on credit; sales on cash are
recorded in a cash receipts journal. Sales of assets other than merchandise on credit are
recorded in the general journal.
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159
Each transaction recorded in the sales journal has a debit to Accounts
Receivable and a credit to Sales. Therefore, only one column is needed for these
two accounts. The posting reference (P/R) column is not used when transactions
are recorded; instead this column is used when posting.
Posting
Sales journal entries are posted as shown with the arrow line in the illustration.
Individual transactions in the sales journal are posted regularly (daily) to
subsidiary customer accounts in the accounts receivable subsidiary ledger. These
postings keep customer accounts up to date.
The sales journals amount column is totaled at the end of the period. The total is debited to
accounts Receivable and credited to sales.
The other special journals are illustrated below. Their operation is almost similar to the sales
journal
160
o.
161
5. 5 COMPUTER TECHNOLOGY AND ACCOUNTING SYSTEMS
Computer technology can be divided into two broad categories: hardware and
software.
Computer hardware-is the physical equipment in a computerized accounting

information system. The physical equipment includes processing units, hard
drives, modems, monitors, printers, etc.
Computer software- is the program that directs the operation of computer

hardware. Peachtree and Sun system are some example of accounting software
that help to process information.
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Computer technology reduces the time and effort devoted to record keeping
tasks. Accountants can now concentrate on analysis and managerial type
decisions and work with less effort directed at record keeping tasks.
One added advantage of a computerized accounting system (as opposed to a

paper-based manual system) is that various computers in an organization can be
networked. Networking means linking or connecting computers with each other
to give different users and different computers access to a common database and
programs.

1. “ With the increase in the computerization of accounting systems of many
organizations in Ethiopia, the demand for accountants would fall (decrease).
This is because accountants are going to be replaced by computers.” Do you
agree with this statement? If not, Why?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
5.6 SUMMARY
Although accounting systems vary from business to business the broad
principles discussed in this unit apply to all systems.
These principles are the control, relevance, compatibility, flexibility and cost -
benefit principle.
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Ledgers, either manual or electronic, can be examples of information storage
devices.

The nature and size of its transactions determine to what accounts subsidiary
ledgers should be set up. In addition the cost- benefit factor should be
considered.

Computers are never going to replace accountants. Of course, they make the
processing of data efficient and help reduce errors. However, there needs to be
accounting professionals who design how the computers work and who analyze
and interpret the output of the computers (financial statements).
1. Assuming the use of a two-column general journal, a purchase journal and a

cash payments journal, indicate the journal in which each of the following
transactions should be recorded:
a) Payment of cash on account to creditor

b) Purchase of office supply on account
c) Purchase of merchandise for cash
d) Return of portion of merchandise bought in „c‟
e) Purchase of store equipment on account
f) Withdrawal of cash by owner
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5.9 GLOSSARY
General ledger -the principal ledger that contains all the balance sheet and
income statement accounts.
Controlling Account- a summarizing account in the general ledger, which

represents a summary of subsidiary accounts.
Subsidiary ledger - a group of accounts, which contain detail regarding a

controlling, account.
Purchaser journal - a special journal for recording purchase of merchandise or
other items on account.
Cash payment journal- a special journal for recording payments of cash for
any purpose.
Sales journal - a special journal for recording sale of merchandise on account.
Cash Receipts journal- a special journal for recording receipt of cash from any
source.
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UNIT 6. INTERNAL CONTROL
Content
6.1 Introduction
6.2 The Purpose of Internal Control
6.3 Components of Internal Control
6.3.1 The Control Environment
6.3.2 The Accounting System
6.3.3 Control Procedures
6.3.3.1 Requiring Authorization
6.3.3.2 Establishing Responsibility
6.3.3.3 Maintaining Adequate Records
6.3.3.4 Insuring Assets and Bonding Key Employees
6.3.3.5 Separating Record Keeping From Custody of
Assets
6.3.3.6 Dividing Responsibility for Related Tasks
(transactions)
6.3.3.7 Rotating Duties
6.3.3.8 Applying Technical Controls
6.3.3.9 Performing Regular and Independent Reviews
6.4 Technology and Internal Control
6.5 Limitations of Internal Control
6.6 Summary
6.7 Answer to Check Your Progress Exercise
6.9 Glossary
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After you have read this unit, you should be able to:
- explain the purpose of internal control
- identify components of internal control
- describe how technology impacts internal control and,
- list out the limitations of internal control
6.1 INTRODUCTION
A company‟s internal control structure consists of the policies and procedures
established to insure that the company‟s goals will be achieved.
As a company grows in size, it becomes difficult to maintain control over all

phases of operation. Therefore, management needs to delegate authority and rely
on the control structure in order to achieve adherence to enterprise goals.
6.2 THE PURPOSE OF INTERNAL CONTROL

Managers use an internal control system to monitor and control business
operations. An internal control system is all the policies and procedures
managers use to:
 Protect business assets from theft and misuse. For example, what can be
done to protect cash from theft and misuse?
 Ensure reliability of accounting records. That is, how reliable and accurate
are our records and reports regarding Accounts Receivable, for instance.
 Promote efficiency of operation. Efficiency means achieving
organizational goals by using as minimum resources as possible.
 And make employees adhere to company policy.
6.3 COMPONENTS OF INTERNAL CONTROL
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The internal control structure can be divided in to three elements?
6.3.1 The Control Environment

The control environment of an organization represents the overall attitude and
awareness of both management and employees about the importance of controls.
The control environment is influenced by such factors as management‟s

philosophy & operating style, the organizational structure of the business and
personnel policies.
6.3.2 The Accounting System

The accounting system consists of the methods and records established by
management to identify, record, process and report a company‟s transactions,
and to provide assurance that the objectives of internal control are being met.
6.3.3 Control Procedures

Internal control procedures vary from company to company. They depend on the
nature of the business and of its size.
The following are common procedures that you find in the internal control of
many organizations.
6.3.3.1 Requiring Authorization

Management should properly authorize all transactions and activities before they
take place.
For example, selling on credit requires management‟s approval.
6.3.3.2 Establishing Responsibility
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Proper internal control requires responsibility for each task to be clearly
established and assigned to one person. Otherwise, if responsibility is not
identified, it is difficult to say who is at fault (responsible) when a problem
occurs.
For example, if we allow two sales clerks to share access to (use) the same cash
register, it would be difficult to take which sales clerk accountable when and if
there is a cash shortage.
6.3.3.3 Maintaining Adequate Records

Reliable records are a source of information that management uses to monitor
company operations. For example, when detailed records of office equipment
are kept, items are unlikely to be lost or stolen with out the discrepancy being
noticed.
6.3.3.4 Insuring Assets and Bonding Key Employees

Good internal control dictates that assets be adequately insured against causality.
In addition, employees handling cash should be bonded. Bonding an employee
means buying an insurance policy against losses from theft by that employee.
6.3.3.5 Separating Record Keeping From Custody of Assets

A person who controls or has access to an asset must not keep that asset‟s
accounting records. This prevents the loss of the asset from theft because the
person who has control over the asset knows that another person keeps records
of the asset. The record keeper doesn‟t have access to the asset and therefore,
has no reason to falsify records.
For a fraud to be committed in such a system, the two people must agree (-this is
called collusion). Collusion is usually less likely to occur.
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6.3.3.6 Dividing Responsibility for Related Tasks (transactions)
In order to ensure that the work of one employee serves as a check on another,
responsibility for a series of related transactions should be divided between two
or more individuals (or employees) or departments.
This is usually referred to as segregation of duties.
For example, no one individual should be authorized to order merchandise, to

receive merchandise, and to pay the supplier. If one employee is allowed to do
these all by herself (alone), she can place orders with a supplier on the basis of
friendship rather than price and quality; convert goods to her personal use; pay
false invoices; and so forth.
6.3.3.7 Rotating Duties

It is advisable to rotate clerical personnel periodically from job to job. This
would help them broaden their understanding of the system. In addition and
more importantly, they know that others would in the future perform their jobs
(when rotated). This discourages them to deviate from prescribed procedures
because they fear that the employee who takes up their job will discover it.
6.3.3.8 Applying Technical Controls

Cash register, check protectors, time clocks, mechanical counters, and personal
identification scanners are examples of control devices that can improve internal
control.
A cash register has a locked in tape or electronic file, which makes record of
each cash sale.
A check protector perforates the amount written on a check in to its face and
makes it difficult to change the amount.
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A time clock registers the exact time an employee arrives and leaves from the
job.
Mechanical change and currency counters quickly and accurately count

amounts.
Personal scanners limit access to some places only to authorized individuals.
6.3.3.9 Performing Regular and Independent Reviews

Regular reviews of internal control systems are needed to ensure that procedure
are followed. Internal auditors who are not directly involved in the operations
of the business usually perform these reviews. This encourages an evaluation on
the efficiency and effectiveness of the internal control system.

1. Give one set of related tasks as an example, that you think is desirable to
divide and to rotate employees.
…………………………………………………………………………………………………
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6. 4 TECHNOLOGY AND INTERNAL CONTROL

Technology impacts an internal control system in many important ways. Some
of these are:
 Technologically advanced systems allow saving time in processing

information.
 They allow a regular review and more extensive testing of records as
information can be easily and rapidly accessed.
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 Technologically advanced systems reduce the number of errors in
processing information provided the software and data entry are correct.
 They are so efficient these days that they require fewer employees. This
makes separation of crucial responsibilities difficult. The duties of these
employees, therefore, must be monitored to minimize the risk of error or
fraud.
6.5 LIMITATIONS OF INTERNAL CONTROL

No internal control system is perfect. The most serious limiting factors are
human error and human fraud.
Human error can occur from negligence, fatigue or confusion. Human fraud involves a
deliberate act by employees to defeat internal controls for personal gains.
Another important limiting factor of an internal control system is the cost-

benefit consideration. This means that the cost of an internal control system
must not exceed its benefits.
We can‟t employ an internal control system simply because it is good. We have

to weigh its costs against its benefits.
For instance, not all companies need to computerize their accounting system if
the cost of automating the system is greater than the benefits.

1. Can collusion be taken (seen) as a limitation of internal controls? Explain.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
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6.6 SUMMARY
172
Internal control consists of the control environment, the accounting system
and control procedures that work in line with the company‟s policy to:
 Protect assets from fraud and misuse
 Ensure completeness and reliability of financial statements
 Ensure efficiency of operations and
 Ascertain every employee adheres to the company‟s policies
6.7 ANSWER TO CHECK YOUR PROGRESS EXERCISES

One employee shouldn‟t be allowed to issue goods, to collect cash and keep the
records when merchandise is sold in a merchandising company.
Yes, in every internal control the system works only if two employees do not
agree (collude) to break the system. Therefore, every system has the inherent
limitations of collusion.

1. Write brief answers for the following questions.
a. What are the main objectives of internal controls and how are these
objectives achieved?
b. Why should record keeping for assets be separated from custody over the
assets?
2. Musina is a government owned public enterprise that is growing rapidly. The

organization‟s bookkeeper left town suddenly after the manager discovered
that a large sum of money has disappeared over the past 18 months. An audit
showed that the bookkeeper has written and signed several checks in the
name of his fiancé and then recorded the payments as salary expense. His
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fiancé, who cashed the checks but never worked for Musina, also left town
with the bookkeeper.
Evaluate Musina‟s internal control system. Which principles (procedures) of

internal control seem to have been ignored?

Collusion - agreement between two or more employees to commit fraud.
Segregation of duties - assigning responsibility of related tasks to various

employees.
Control procedures- the various ways through which an organization tries to

protect fraud and achieve other internal control objectives.
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UNIT 7. CASH
Contents
7.1 Introduction
7.2 Meaning of Cash
7.3 Characteristics of Cash
7.4 Management of Cash
7.5 Internal Control of Cash
7.5.1 Control of Cash Through Bank Accounts
7.5.1.1 Reconciliation of Bank and Book cash Balances
7.5.1.2 Steps in Preparing Bank Reconciliation
7.5.1.3 Illustration of Bank Reconciliation
7.5.2 Petty Cash Fund
7.5.2.1 Establishment of Petty Cash
7.5.2.2 Replenishment of Petty Cash
7.5.3 Voucher System
7.5.4 Change Fund
7.5.5 Cash Short and Over
7.6 Summary
7.7 Answer to Check Your Progress Exercise
7.9 Glossary
In this unit, internal control of cash, the accounting for cash transactions and other aspects
will be discussed. After you have studied this unit, you should be able to:
- define cash
- identify the with composition of cash
- explain the objectives of cash management
- prepare a bank reconciliation
- understand the internal control of cash
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7.1 INTRODUCTION
Since cash is the asset most likely to be used improperly by employees, exposed for
embezzlement and many business transactions either directly or indirectly affect it, it is
therefore necessary to have effective control of cash.
7.2 MEANING OF CASH
Cash includes money on deposit in banks and other items that a bank will accept for
immediate deposit. Money on deposit in banks includes checking and saving accounts. Other
items such as ordinary checks received from customers, money orders, coins and currency and
petty cash also are included as cash. Banks do not accept postage stamps, travel advances to
employees, notes receivable or post-dated checks as cash.
7.3 CHARACTERISTICS OF CASH
The following are some of the characteristics of cash:

a) Cash is used as medium of exchange
b) Cash is the most liquid asset
c) Cash is mostly affected by business transactions
d) Cash is used to measure the value of other assets
e) Cash is mostly exposed to embezzlements
7.4 MANAGEMENT OF CASH
Cash management refers to planning, controlling and accounting for cash transactions and
cash balances. Efficient management of cash is essential to the survival and success of every
business organization. Managing cash requires planning wisely so that there will not be
excess cash held on hand at any point in time; or there is no shortage of cash at any point in
time to meet the business‟s needs.

1. Define cash as it is used for accounting purpose.
…………………………………………………………………………………………………
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2. Which of the following items should not be included as cash?

a) Ordinary checks
b) Post-dated checks
c) Cash deposited in saving accounts
d) Postage stamps
e) Deposits in checking accounts
7.5 INTERNAL CONTROL OF CASH
The need to safeguard cash is crucial in most businesses because cash is mostly exposed to
embezzlement. Firms address this problem through the internal control system. An internal
control system is a set of policies and procedures designed to protect assets, provide accurate
accounting records and evaluate performances.
A sound internal control system for cash increases the likely hood that the reported values for
cash are accurate.
Internal control for cash should include the following procedures:

a) The individuals who receive cash should not also disburse (pay) cash
b) The individuals who handle cash should not access accounting records
c) Cash receipts are immediately recorded and deposited and are not used directly to
make payments.
d) Disbursements are made by serially numbered checks, only upon proper authorization
by someone other than the person writing the check
e) Bank accounts are reconciled monthly.
The following are the most common elements of cash control and managements: bank
account system, petty cash fund, voucher system, change fund, and cash short and over.
7.5.1 Control of Cash Through Bank Accounts

Bank accounts are one of the most important means of controlling cash that provide several
advantages such as:
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- Cash is physically protected by the bank,
- A separate record of cash is maintained by the bank,
- And customers may remit payments directly to the bank.
If a company uses a bank account, monthly statements are received from the bank showing
beginning and ending balances and transactions occurring during the month including checks
paid, deposits received, and service charges. These monthly statements (reports) received
from the bank are called bank statements. Bank statements generally are accompanied by
checks paid and charged to the accounts during the month, debit and credited memos, which
inform the company about changes in the cash accounts. For a bank, the depositor‟s cash
balance is a liability, the amount the bank owes to the firm. Therefore, a debit memo describes
the amount and nature of decrease is the company‟s cash accounts. A credits memo indicates
an increase in the cash balance of the depositor that it has with the bank.
7.5.1.1 Reconciliation of Bank and Book Cash Balances

Monthly reconciling of the bank balance with the depositor‟s cash accounts balance is
essential cash control procedure. To reconcile a bank statement means to verify that the bank
balance and the accounting records of the depositor are consistent. The balance shown in a
monthly bank statement seldom equals the balance appearing in the depositor‟s accounting
records. Certain transactions recorded by the depositor may not have been recorded by the
bank and vice versa.
The most common examples that cause disparity between the two balances are:
a) Outstanding checks:
Checks issued and recorded by the company, but not yet presented to the bank for
payment.
b) Deposits in transit:
Cash receipts recorded by the depositor, but not reached the bank to be
included in the bank statement for the current month.
c) Service charges:
Banks often charge a fee for handling checking accounts. The amount of this charge is
deducted by the bank form bank balance and debit memo is issued for the depositor.
d) Charges for depositing NSF- checks:
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NSF stands for “Not Sufficient Funds.” When checks are deposited in an account,
the bank generally gives the depositor immediate credit. On occasion, one of these
checks may prove to be uncollectible because the maker of the check does not
have sufficient funds in his or her account. In such a case, the bank will reduce the
depositor‟s account by the amount of this uncollectible item and return the check
to the depositor marked “NSF”.
e) Notes collected by bank:
If the bank collects a note receivable on behalf of the depositor, it credits the
depositor‟s account and issues a credit memorandum for the depositor.
When the depositor prepares bank reconciliation, the balances shown in the bank statement
and in the accounting records both are adjusted for any unrecorded transactions. Additional
adjustments may be required to correct any errors discovered in the bank statements or in the
accounting records.
7.5.1.2 Steps in Preparing Bank Reconciliation

A bank reconciliation is a schedule prepared by the depositor to bring the balance shown in
the bank statement and the balance shown in the depositor‟s accounting into agreement.
The steps to prepare a bank reconciliation are:

a) The deposits listed on the bank statement are compared with the deposits shown in the
accounting records. Any deposits not yet recorded by the bank are deposits in transit
and should be added to the balance shown in the bank statements.
b) The paid and received checks from the bank are compared with the check stubs. Any
checks issued but not yet paid by the bank are outstanding checks and should be
deducted from the balance reported in the bank statements.
c) Any credit memorandums issued by the bank that have not been recorded by the
depositor, are added to the balance per depositor‟s record.
d) Any debit memorandums issued by the bank that have not been recorded by the
depositor are deducted from the balance per depositor‟s record.
e) Any errors in the bank statement or depositor‟s accounting records are adjusted.
f) The equality of adjusted balance of statement and adjusted balance of the depositor‟s
record is compared.
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g) Journal entries are prepared to record any items delayed by the depositor.
7.5.1.3 Illustration of Bank Reconciliation
The January bank statement sent by Awash Bank to RAM Company shows Br. 4,262.83.
Assume also that on January 31, 2000, the Cash account of RAM Co. shows a balance of Br.
5,000.17. The accountant of RAM Company has identified the following items:
1. A deposit of Br. 410.90 made after banking hours on Jan. 31 does not appear on the
bank statement.
2. Two checks issued in January have not yet been paid by the bank:
Check No. 301 Br. 110.25
Check No. 342 607.50
3. A credit memorandum was included in the bank statement, which was for proceeds
from collection of a non-interest bearing note receivable from MAN company Br.
524.74.
4. Three debit memorandums accompanied the bank statement: Fee charged by bank for
handling collection of notes receivable Br.5; a check of Br. 50.25 received from a
customer, RON company, and deposited by RAM company was charged back as NSF;
and service charge by bank for the month of January amounts to Br. 12.00.
5. Check No. 305 was issued by RAM Company for payment of telephone expense in the
amount of Br. 85 but was erroneously recorded in the cash payments journal as Br. 58.
The January 31 bank reconciliation for RAM Company is shown below:
RAM Company
Bank Reconciliation
January 31, 2000
Balance per bank statement, Jan. 31,2000 Br. 5,000.17

Add: Deposit of Jan. 31 not recorded by bank 410.90
Subtotal Br. 5,411.07
Deduct: outstanding checks:
No. 301 Br. 110.25
No. 342 607.50 117.75
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Adjusted cash balance Br. 4,693.32
Balance per depositor‟s record, Jan. 31,2000 Br. 4,262.83

Add: Note Receivable collected by bank 524.74
Subtotal Br. 4,787.57
Deduct: collection fee Br. 5.00
NSF check of Ron Co. 50.25
Service charge 12.00
Error on check stub No. 305 27.00 94.25
Adjusted cash balance Br. 4,693.32
The following are journal entries related to the bank reconciliation.
2000
Jan. 31 cash 524.74
Notes Receivable 524.74
To record collection of Note Receivable
collected by bank
31 Miscellaneous Expense 17.00
Accounts Receivable-RON Co. 50.25
Utilities Exp. 27.00
Cash 94.25
To record bank service charges,
NSF check and error in recording
Check No. 305
1. Briefly explain the basic purpose of a bank reconciliation.

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…………………………………………………………………………………………………
2. Define the following terms related to the accounting for cash:

a) Outstanding checks
……………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
……
b) Deposit in transit
……………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
……
c) NSF- check
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
3. Which of the reconciling items necessitate an entry in the depositor‟s accounts?

a) Deposit in transit
b) Outstanding checks
c) Note collected by bank
d) Bank service charge
7.5.2 Petty Cash Fund

Petty cash fund, which is part of the total cash balance, is used to handle many types of small
payments such as employee transportation costs, purchase of office supplies, purchase of
postage stamps, and delivery charges. Many businesses find it convenient to make minor
expenditures instead of writing checks. The petty cash amount various from Br. 50 or less to
more than Br. 1,000, which will cover small expenditures for a period of two or three weeks.
7.5.2.1 Establishment of Petty Cash
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To establish a petty cash fund a check is issued to a bank. This check is cashed and the money
is kept on hand in a petty cash box. One employee is designated as custodian of the fund. The
issuance of the check for establishment is recoded by debiting petty cash account and
crediting cash.
7.5.2.2 Replenishment of Petty Cash

During the period, the custodian makes small payments form the petty cash fund and obtains a
receipt or prepares a petty cash voucher. This petty cash voucher explains the nature and
amount of every expenditure and is kept with the fund. When the fund runs low or at the end
of the company‟s fiscal period, a check is issued to reimburse the fund for the expenditures
made during the period. The issuance of this check is recorded by debiting the appropriate
expense accounts and crediting cash or vouchers payable.
7.5.3 Voucher System

One method to control cash disbursements is a voucher system. A voucher is a special form,
which contains relevant data about a liability and its payment.
In a voucher system, a voucher is prepared for each expenditure and approved by the
designated officials. Each approved voucher represents liability and recorded in a voucher
register, which is similar to purchases journal. Those registered vouchers are filed according
to their payment date in an unpaid vouchers file. The vouchers and supporting documents then
are sent to the treasure or other official is the finance department before issuing checks. When
the checks are signed, the paid vouchers are recorded in a check register which is similar to
cash payments journal. Those paid vouchers are filed in paid vouchers file according to their
serial number for future reference.
7.5.4 Change Fund

Some businesses that receive cash directly from customers should maintain a fund of currency
and coins in order to make change (Amharic=>”zirzir”). This fund, which is part of the total
cash balance, is called change fund. A change fund is established by issuing a check to the
bank and transferring the cash to the custodian. The issuance of a check to establish a change
fund is recorded by debiting cash on hand and crediting cash or voucher payable.
Once a change fund is established, there will be no change in its balance unless there is a
decision by management to increase or decrease the fund balance.
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7.5.5 Cash Short and Over
In handling cash receipts from daily sales, a few errors in making changes will occur. These
errors may cause a cash shortage or overage at the end of the day. The account cash short and
over is debited if there is shortage and credited if there is overage. At the end of the period if
the account had a debit balance, it appears in the Income statement as miscellaneous expense;
if it has a credit balance, it is shown as miscellaneous revenue.
For example, assume that the total cash sales recorded during the day amounts to Br. 12,420.
However, the cash receipts in the cash register drawer (actual cash count) total Br. 12,415.
The following entry would be made to adjust the accounting records for the shortage in the
cash receipts:
Cash Short and Over 5.00

Cash 5.00
To record a Br. 5.00 (Br. 12,420 – 12,415)
Shortage in cash receipts for the day
1. The petty cash account has a debit balance of Br. 200. At the end of the accounting period,
there is Br. 160 in the petty cash fund along with petty cash receipts totaling Br. 40.
Should the fund be replenished as of the last day of the period? Why?
…………………………………………………………………………………………………
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2. In what order are vouchers ordinarily filed

A) In the unpaid voucher file
B) In the paid voucher file
3 In which section of the Income statement would a credit balance in cash short and over be
reported?
7.6 SUMMARY
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1. Cash includes only those items immediately available to pay obligations.
2. The objectives of cash management are accurate accounting for cash transactions, the
prevention of losses through theft or fraud, and maintaining adequate cash balances.
3. The bank reconciliation adjusts the cash balance per book and the cash balance per bank
statement for any unrecorded items such as outstanding checks and bank service charges.
4. Bank reconciliation produces the correct amount of cash to be included in the balance
sheet at the end of the month.
5. A company may use a petty cash fund to make small payments that occur frequently, as
payment by check would cause delay and excessive expense of maintaining records.
6. One of the best systems for establishing control of cash payments is the use of a voucher
system. A voucher system uses vouchers, a voucher register, a file for unpaid vouchers, a
check register and a file for paid vouchers.
7.7 ANSWER TO CHECK YOUR PROGRESS EXERCISES
1. Cash includes all the items that are accepted for deposit by a bank, notably paper
money and coins, money orders, and checks.
2. a) Post-dated checks
b) Postage stamps
1. The basic purpose of a bank reconciliation is to achieve the control inherent in the
maintenance of two independent records of cash transactions; one record maintained
by the depositor and the other by the bank. When these two records are reconciled
(brought into agreement), we gain assurance of a correct accounting for cash
transactions.
2. a) Checks issued that have not been paid by the bank.

b) Deposits not recorded by the bank.
c) A customer‟s check which was deposited but returned because of a lack of funds in
the account on which the check was drawn (in the customer‟s bank account).
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d) Note collected by bank
e) Bank service charge

1. Yes. To record the unrecorded expenditures of Br. 40 at least by the end of the fiscal
period
2. a) According to the earliest date
b) In numerical order
3. In miscellaneous revenue section of Income statement
Part I. Short answer questions

1. In general terms, in which section does cash, appear on the balance sheet?
2. Explain some measures that strengthen internal control over cash receipts and payments.
3. What is the basic control feature in a voucher system?
4. List two items often encountered in reconciling a bank account that may cause cash per the
bank statement to be larger than the balance of cash shown in the depositor‟s accounting
records.
Part II. Work Out Questions
1. Shown below is the information needed to prepare a bank reconciliation for MITE
company at December 31.
a) At December 31, cash per the bank statement was $ 15,981; cash per the
company‟s records was $ 17,445.
b) Two-debit memorandum accompanied the bank statement: service charges for
December of $ 24, and a $ 600 check drawn by RAMI marked „NSF‟.
c) Cash receipts of $ 4,353 on December 31 were not deposited until January.
d) The following checks had been issued in December but were not included
among the paid checks returned by the bank: no. 620 for $ 978, no. 630 for $
2,052, and no. 641 for $ 483.
Required:
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i) Prepare a bank reconciliation at December 31
ii) Prepare the necessary journal entry or entries to update the accounting records
based on the reconciliation.
2. RAM Company maintains its checking account with the Commercz Bank. The company
is ready to prepare its December 31 bank reconciliation. The following data are available:
a) The November 30 bank reconciliation showed the following:
1) Cash on hand (held by RAM company for day to day minor
expenses), Br. 400 (included in RAM‟s cash account)
2) Deposit in transit, Br. 2,000, and
3) Checks outstanding: N0. 121 Br. 1,000
No. 130 2,000
No. 142 3,000
b) Bank Statement, December 31:
 Balance, December 31 Br. 67,600
 Deposits: 188,500
 Checks: No. 130, Br. 2,000; N0. 142, Br. 3,000;
N0. 143 – 176, Br. 191,000 (196,000)
 Note collected for RAM company (including
Br. 720 interest) 16,720
 NSF check, customer Binda (250)
 Bank service charges (20)
 Balance, December 31 Br. 76,550
Required:
i) Determine deposit in transit and checks outstanding
ii) Prepare the December 31 Bank reconciliation
iii) Based on your bank reconciliation, give all journal entries that should be made at
December 31.
Bank reconciliation: a schedule that explains the difference between the balance of cash
shown in the bank statement and the balance of cash shown in the depositor‟s records.
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Cash: money on deposit in banks and other items that a bank will accept for immediate
deposit.
Cash management: planning, controlling, and accounting for cash transactions and cash
balances.
Petty cash: small amount of cash, which is used to make small payments that occur
frequently.
Voucher: a written authorization used in approving a transaction for recording and payment.
Voucher system: an accounting system designed to provide strong internal control over cash
disbursements.
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UNIT 8. ACCOUNTING FOR RECEIVABLES
Contents
8.1 Introduction
8.2 Classification of Receivables
8.3 Internal Control Over Receivables
8.4 Characteristics of Notes Receivables
8.5 Accounting for Notes Receivable
8.6 Converting Receivables to Cash Before Maturity
8.7 Accounting for Uncollectibles
8.7.1 Allowance Method
8.7.2 Estimating Uncollectibles
8.7.2.1 Estimate Based on Sale
8.7.2.2 Estimate Based on Analysis of
Receivables
8.7.3 Direct-write-off method
8.8 Summary
8.9 Answer to Check your Progress Exercises
After you have studied this unit, you will be able to:
- list the common classification of Receivables
- explain internal Control procedures that apply to receivables
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- describe the nature of and the accounting for uncollectibles and,
- explain how receivables can be converted to cash before maturity.
8.1 INTRODUCTION
In this unit, we emphasize on how companies account for and report receivables.
We have discussed the importance of estimating uncollectibles in order to
determine the reasonable balance of receivables on the balance sheet.
Most of the companies sell goods and services on credit in order to earn more
profits. Receivables represent claims for money, goods, services, and non-cash
assets from other firms. Receivables may be current or non-current depending
on the expected collection date.
8.2 CLASSIFICATION OF RECEIVABLES
Receivables can be broadly classified into Trade Receivables and Non-trade

Receivables. Trade Receivables describe amounts owed to the company for
goods and services sold in the normal course of business. Non-trade Receivable
arise from many other sources, such as advance to employees, interest
receivables, rent receivables and loan to affiliated companies. Unless we
indicate otherwise, we will assume that all receivables in this unit are trade
receivables.
Based on the above broad classification, receivables can be further classified

into Account Receivable and Notes Receivables. Account Receivable refers to
amounts due from customers for credit sales. These receivables are supported by
sales invoices or other documents rather than any formal written promises. Such
Account Receivables are normally expected to be collected within relatively
short period, such as 30 or 60 days. They are classified on the balance sheet as a
current asset. On the other hand, Notes Receivable refers to amounts that
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customers owe, for which a formal, written instrument of credit has been issued.
Notes are usually used for credit periods of more than sixty days and for
transactions of relatively large value. Notes may also be used in settlement of an
open account and in borrowing or lending money.
8.3 INTERNAL CONTROL OVER RECEIVABLES
The principles of internal control that we saw in chapter 5 are required by

organizations to safeguard their assets from any kind of error and misconduct.
These control procedures should apply on receivables because they are one of
the asset elements for the organization. For example, the individual responsible
for sales should be separate from the individual accounting for the receivables
and approving credit. By doing so, the accounting and credit approval functions
serve as independent checks on sales. Separation of responsibility for related
functions reduces the possibility of errors and misuse of funds.
Adequate control over Accounts Receivable begins with the approval of the
sales by a responsible company official or the credit department, after the
customer‟s credit rating has been reviewed. Likewise, adjustments of Account
Receivable, such as for sales return and allowance, and sales discount, should be
authorized or reviewed by a responsible party. Effective collection procedure
should also be established to ensure timely collection of receivables and to
minimize losses from uncollectible accounts.

1. Why is Account Receivable classified as a current asset?
……………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………
2. Why is segregation of duties required for related activities related to

receivables?
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……………………………………………………………………………………………
…………………………………………………………………………………………………
………………………………………………………………………………
8.4 CHARACTERISTICS OF NOTES RECEIVABLE
A claim supported by a note has some advantages over a claim in the form of an
Account Receivable. By signing a note, the debtor recognizes the debt and
agrees to pay according to the terms listed. A note is therefore a strong legal
claim if there is a court action.
A promissory note is a written promise to pay a sum of money on demand or at

a definite time. It is payable to the order of a person or firm or to the bearer or
holder of the note. The person or firm that makes the promise signs it. The one
to whose order the note is payable is called the payee, and the one making the
promise is called the maker.
Notes have several characteristics that affect how they are recorded and reported in the
financial statements. The characteristics are described in the following paragraphs: -
 Due Date
The date a note is to be paid is called the Due Date or Maturity date. The
period of time between the issuance date and the due date of a short-term note
may be stated in either days or months. When the term on a note is expressed in
days, the maturity date is the specified number of days after the note‟s date. As
an example, a five-day note dated January-1 matures and is due on Jannuary-6.
A 90-day notes dated March-10, matures on Jun-8. This due date, June-8, is
computed as below: -
Term of the Note--------------------------------------------90

Days in March---------------------------31
Minus the date of the note-------------10
Days remaining in March------------------------21
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Add days in April---------------------------------30
Add days in May----------------------------------31
82
Number of days remaining to equal 90-days
(90 – 82 = 8)------------------------------------------------8
Therefore, Due date is June-8.
The period of a note is sometimes expressed in months. When months are used, the note
matures and is payable in the month of its maturity on the same date of the month as its
original date
A three-month note dated March-10, for instance, is payable on June-10.
 Interest Computation
Interest is the cost of borrowing money for the borrower. It is the profit from
lending money for the lender. The interest rate on notes is normally stated in
terms of per year, regardless of the actual period of time involved.
The formula for computing interest is as follows: -
Interest = Principal X Annual X Time

(Face Amount interest Rate
of the Note)
To illustrate the formula, the interest on a Br. 10,000, 12%, 60 day note is
computed as:-
Br. 10,000 X 12% X 60/360 = 200
N.B. To simplify interest computations for notes with periods expressed in days,
it is common to treat a year as having 360 days.
 Maturity Value
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The amount that is due at the maturity or due date is called the maturity value.
The maturity value of a note is the sum of the face amount and the interest. In
the above example, the maturity value is Br. 10,200 (which is Br. 10,000 face
amount plus Br. 200 interest)
I.e. MV = FV + I where MV= Maturity value
FV = Face value
I = Interest
8.5 ACCOUNTING FOR NOTES RECEIVABLE
Notes Receivable are usually recorded in a single note Receivable account to

simplify record keeping. We need only one account because the original notes
are kept on file. This means the maker; rate of interest, due date, and other
information can be learned by examining the actual note.
To illustrate the recording of the receipt of a note, assume that on Jannuary-10,

Nile Co. sales merchandise on account to Tana Co. and receive a Br. 5,000, 90-
day, 12% promissory note.
This transaction is recorded as: -

Jan. 10. Notes Receivable ------------------------5000
Sales--------------------------------------5000
The maker of the note usually honors the note and pays it in full. The entry
required to record the receipt of cash by Nile Co. from Tana Co. is as follows:
April-10 Cash------------------------------5150
Notes Receivable-----------------------5000
Interest Revenue (500 X 12/100 X 90/360)----150
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Companies can sometimes accept a note for an overdue customer as a way of
granting a time extension on a past-due account Receivable. To illustrate,
assume that a 60-day, 10% note dated September 5, 20x1 is accepted by Awash
Co. in settlement of the account of Happy co, which is past due and has a
balance of 10,000. The entry to record the transaction is as follows:
September 5 N/R---------------------------------------------10, 000
A/R ----------------------------------------------10,000
Received a note to settle account
Recording a dishonored note

When a note‟s maker is unable or refuses to pay at maturity, the note is dishonored. The act of
dishonoring a note doesn‟t relieve the maker of the obligation to pay. The payee should use
every legitimate means to collect. But how do companies report this event? The balance of the
Notes Receivable account normally includes only those notes that have not matured. When a
note is dishonored, we therefore remove the amount of this note from the Notes Receivable
account and charge it back to an Accounts Receivable from its maker. Assume for instance
Nile Co., holds a Br. 1000, 12%, 30-day note of Ato Alemu. At maturity, Alemu dishonored
the note. Nile Co. records this dishonoring of its N/R, on Oct. 25, as follows:
Oct.25, A/R---------------Ato Alemu 1010

N/R---------------------------1000
Int. Rev.-------------------------10
To record dishonored note & interest of 1000 X
12% X
30/360 =10
The above entry records interest of Br. 10, which has been earned, even though
the note has been dishonored.
End-Of-Period interest Adjustment
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When notes receivable are outstanding at the end of an accounting period,
accrued interest is computed and recorded. For example, on December 20, 20x1,
Nile Co. accepted a Br. 2000, 60-day, 12% note from a customer in granting an
extension of a past-due account. Assuming that the accounting period ends on
Dec. 31, the entries to record the receipt of the note, accrued interest, and
payment of the note at maturity are shown below: -
Dec. 19. N/R -------------------------------------2000

A/R- customer-X --------------------------------2000
Received note in settlement of A\R
Dec. 31. Interest Receivable-------------------------8
Int. Revenue------------------------------------8
Adjusting entry for ace need
Interest, Br. 2000 X 12% X 12/360 = 8
Feb. 17. Cash----------------------------------2040
N/R---------------------------------------------2000
Int. Rec.--------------------------------------------8
Int. Revenue-------------------------------------32
Received pyt of note & interest at maturity
The adjusting entry above on Dec. 31, 20X1,was required to show the interest
earned for the period on the Income Statement.
8.6 Converting Receivables to cash before Maturity
Sometimes, companies convert receivables to cash before they are due. Reasons for this
include the need for cash or a desire not to be involved in collection activities. Converting
receivable is usually done either (1) by selling them, or (2) by using them as security for a
loan. The topic of using notes as security for a loan will be discussed in future courses. Notes
Receivable can be converted to cash by discounting them at a financial institution such as a
Bank. The process has three steps as indicated in the following diagram. In the first step, the
maker receives goods, service or cash from the payee in exchange for the note. In the second
step, the payee discounts the note with a bank and receives the maturity value of the note less
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a discount (a fee) charged by the bank. In the third step, the maker pays the bank at the
maturity of the note.
Maker Goods (1) Payee

Note (2)
Cash (3) cash less discount
Ba n k
Note (2)
Notes Receivable are discounted with or without recourse. When a note is

discounted without recourse, the bank assumes the risk of a bad debt loss and
the original payee doesn‟t have a contingent liability. A contingent liability is an
obligation to make a future payment if and only if an uncertain future event
occurs. A note discounted without recourse is like an outright sale of an asset. If
a note is discounted with recourse and the original maker of the note fails to pay
the bank when it matures, the payee of the note must pay for it. This means a
company discounting a note (an endorser) with recourse has a contingent
liability until the bank is paid. A Co. should disclose contingent liabilities in the
accompanying notes to its financial statements.
To illustrate, assume that a 90-day, 12%, Br. 20,000 N/R from Hiwot Co. dated
Jan.1, 20x2 is discounted at the payee‟s bank on February 12, 20x2 at
thediscount rate of 15%. The steps to determine the proceeds (-the amount to be
received by the payee from the bank upon discounting) are as follows:
Step 1 – Determine the maturity date & maturity value.

MD = April –1 & MV = FV + I = 20,000 + [20,000 X 12% X 90/360]
= 20,600
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Step 2 – Determine the Bank Discount (Bank discount is an interest that is
charged by
the bank and is computed based on the maturity value of the note for the
discount period. Discount Period is the time the bank must hold the
note) before it becomes due.
 Bank Discount = MV X DR X DP where MV = Maturity value ( 20,600)

DR = Discount Rate (15%)
Discount = 20,600 X 15% X 48/360 DP = Discount period ( from
February12 to April 1)
= 412
Step 3- Determine proceed (proceed is the amount of cash paid to the endorser
a ft e r
deducting discount)
i.e. proceed = MV – D
= 20,600 – 412 = 20188
Step 4 – Record the necessary journal entry at the date of discount. (Here, record
interest
revenue which is the excess of proceeds from the face value or record
interest expense when the proceed is less than the face value of the
note)
Feb 12. Cash---------------------------------20,188
N/R -----------------------------------------
20,000
I. R ev . --------------------------------------
188.00
Discounted Br. 20,000, 90-day, 12% note at 15%
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The length of the discount period and the difference between the interest rate
and the discount rate determine whether interest expense or interest revenue will
result from discounting.
When a discounted Notes Receivable is dishonored, the bank notifies the

endorser and asks for payment if there is no statement that limits the
responsibility of the endorser. In some cases, the bank may charge a protest fee
of notifying the endorser that a note has been dishonored. The entire amount
paid to the bank by the endorser, including the interest and protest fee, should be
debited to the A/R of the maker. For example, assume that the maker, Hiwot Co,
dishonored the above discounted note at maturity. The bank charges a protest
fee of Br. 25. The endorser‟s entry to record the payment to the bank is as
follows:
April 2. A/R Hiwot Co----------------- 20,625

Cash-----------------------------------20, 625
Paid dishonored, discounted note
1.Chilallo Co. issued a 60-day, 12% note for Br. 40,000, dated February-12, to
Garra Muleta Co. an account.
a) Determine the due date of the note

b) Determine the maturity value of the note
c) Present entries required to record the following
 Receipt of the note by the payee.
 Receipt by payee of payment of the note at maturity.
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2. Record the following transaction in the account of Axumite Co.
May-1. Received a Br. 15,000, 60-day, 12% note from Adama Co. on
account.
May-21. Discounted the note at Mekele Bank at 14%
June-30. The note is dishonored, paid the bank the amount due on the note
plus a protest fee of Br. 30.
July-20. Received the amount due on the dishonored note plus interest for
20-days, at 12% on the amount charged to Adama Co. on April-30.
8.7 Accounting for uncollectible Accounts Receivable
When credit is extended, some amount of uncollectible receivables is generally

inevitable regardless of the care taken in granting credit and the control
procedures used. The operating expense incurred because of the failure to collect
receivables is called Uncollectible Accounts Expense or Bad Debts Expense or
Doubtful Accounts Expense.
When does an account as a note become uncollectibles? There is no general rule

for determining when an account receivable becomes uncollectible. The fact that
a debtor fails to pay an account receivable according to a sales contract or fails
to pay a note on the due date does not necessarily mean that the account
receivable will be uncollectible. The debtor‟s bankruptcy is one of the most
significant indications of partial or complete uncollectibility. Other indications
include the closing of the customer‟s business and the failure of repeated
attempts to collect.
There are two methods of accounting for uncollectible receivables. The

allowance method, which provides an expense for uncollectible receivables in
advance of their write-off (removal from the ledger) and the direct write-off
200
method, which recognizes the expense only when accounts receivable are
judged to be worthless. We will discuss each of these methods next.
8.7.1 ALLOWANCE METHOD

The allowance method of accounting for bad debts matches the expected loss
from uncollectibles A/R against the sales they helped produce. We must use
expected losses since management can‟t exactly identify the customers who
won‟t pay their bills at the time of sale. This means at the end of each period the
allowance method requires us to estimate the total bad debts expected to result
from that period‟s sales. An allowance is then recorded for this expected loss.
This method has two advantages over the direct write-off method:
(1) Bad debt expense is charged to the period in which the related sales are recognized, and
(2) A/R is reported on the Balance Sheet at the estimated amount of cash to be
collected.
The allowance method estimates bad debt expense at the end of each accountig
period and records it through an adjusting entry. To illustrate this method,
assume the A/R account has a balance of Br. 50,000 and based on careful study
of the experience of other companies, Nile Co. estimates that a total of Br. 2000
will be uncollectibles.
This estimated expense is recorded through the following adjusting entry.

Dec. 31 Uncollectibles Accounts Expense 2000
Allowance for Doubtful Accounts
2000
To record estimated bad debts
201
The amount Br. 2000 is an estimated reduction in A/R;but it cannot be credited
to specific customer accounts or to the A/R controlling account. Instead, a contra
asset account entitled Allowance for Doubtful Accounts is credited.
As with all periodic adjustments the above entry serves two purposes. First, it
reduces the value of the receivable to the amount of cash expected to be realized
in the future. This amount, which is Br. 48,000 (Br. 50,000 – Br. 2,000), is
called the Net Realizable value of the receivables. Second, the adjusting entry
matches the Br. 2000 expense of uncollectibles account with the related
revenues of the period.
Write-off to the Allowance Account
When specific accounts are identified as uncollectibles, they are written-off

against the Allowance for Doubtful Accounts. Assume after spending some time
trying to collect from Shalla Co., Nile Co. decides that Shalla‟s Br. 200 accounts
receivable is uncollectible and makes the following entry to writ-it off.
J an . 2 5 Allowance for Doubtful Accounts 200

A/R-Shalla Co. 200
To write-off uncollectible accounts.
Note two aspects of this entry and its related accounts

Before Write-off After
Write-off
A/R 50,000 49,800
202
Less Allowance for D. a/cs 2,000
1,800
NRV 48,000 48,000
Neither total assets nor net income are affected by the Write-off of a specific
account. But both total assets and net income are affected by the recognized bad
debts expense for the year in the adjusting entry.
Recovery of Uncollectibles Accounts
When a customer fails to pay and the account is written-off as uncollectibles, his
or her credit standing is jeopardized. To help restore credit standing, a customer
may later choose to voluntarily pay all or part of the amount owed. A company
makes two entries when collecting an account previously written-off. The first is
to reverse the original write-off and reinstate the customer‟s account. For
example, assume the amount written-of in the preceding entry is later collected
on February 15.
On Feb. 15- The entries to record this recovery are:

Feb. 15- A/R Shalla Co. 200
Allowance for Doubtful Accounts 200
To reinstate accounts previously written-off
Feb. 15- Cash 200
A/R-Shalla Co. 20 0
To record full payment of account
8.7.2 ESTIMATING UNCOLLECTIBLES

The allowance method of accounting for bad debts requires an estimate of bad
debts expense to prepare the adjusting entry at the end of each accounting
203
period. How does a company estimate bad debts expense? There are two
common methods. One is based on the Income Statement relationship between
bad debts expense and sales. The second is based on the Balance Sheet
relationship between A/R and the Allowance for Doubtful Accounts. Both
methods require an analysis of past experience.
8.7.2.1 ESTIMATING BASED ON SALES
Accounts receivable are created by credit sales. The amount of credits sales
during the period may therefore be used to estimate the amount of uncollectible
accounts expense. The amount of this estimate is added to whatever balance
exists in Allowance for Doubtful Accounts. To illustrate, assume Wonji Co. has
credit sales of Br. 500,000 in 20X2. Based on past experience and the
experience of other Cos, Wonji Co. estimated 0.007% of credit sales are
uncollectible. Using this prediction, the adjusting entry for uncollectible
accounts at the end of the period, 20X2 is as follows.
Dec. 31 Uncollectibles Accounts Exp. (500,000 X 0.007%) 3500

Allowance fo r Doubtful Accounts
3500
To record estimated Uncoll. Exp.
This entry doesn‟t mean that the Dec. 31, 20X2, balance of Allowance for
Doubtful Accounts will be Br. 3500. A Br. 3500 balance results only if the
account had a zero balance prior to posting the adjusting entry. For example,
assume that Allowance for Doubtful Accounts has a credit balance of Br. 1000
before adjustment. Now, what will be the balance of Allowance for Doubtful
Accounts be at the end of 20X2 ? It will be Br. 4500. If there had been a debit
balance of Br. 500 in the Allowance for Doubtful Accounts before the year-end
adjustment, and the amount of adjustment. would still have been Br. 3500. What
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will have been the end balance of Allowance for Doubtful Accounts at the end
of 20X2? (Find by your own!)
8.7.2.2 ESTIMATE BASED ON ANALYSIS OF RECEIVABLES
The longer an A/R remains outstanding, the less likely that it will be collected.
Thus, we can base the estimate of uncollectibles accounts on how long the
accounts have been outstanding. For this purpose, we can use a process called
Ageing receivables which examines each A/R to estimate the amount of
uncollectibles. Receivables are classified by how long they are past their due
date. Then, estimates of uncollectibles are made assuming the longer an amount
is past due the more likely it is to be uncollectible. After the outstanding
amounts are classified and analyzed in the Aging schedule the expected balance
for the Allowance for Doubtful Accounts will be estimated. Let‟s assume the
amount estimated is Br. 5000. So, do you think this is the adjustment amount
required for the current period? NO!
Because, this estimated amount is the expected balance of the Allowance for
Doubtful Accounts after adjustment rather than the current year provision for
Uncollectible Accounts Expense. Therefore, to determine the current year
provision we must take in to account the balance before adjustment in the
Allowance for Doubtful Accounts. To illustrate, assume there is as credit
Balance of Br. 1300 in the allowance account before adjustment. The amount to
be added to this balance is therefore Br. 3800 (B.r 5000 – Br. 1200) and the
adjustment entry is as follows:
Dec. 31 Uncollectible Accounts Expense 3800

To record Uncollectible expense.
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Alternatively, if the Allowance for Doubtful Accounts had an unadjusted debit
balance of Br. 700, then the required adjustment is Br. 5700. (Br. 5000 + 700)
and the adjustment entry is as follows:
Dec. 31 . Uncollectible Accounts Expense 5700

To record Uncollectible expense .
8.7.3 THE DIRECT- WRITE-OFF METHOD

The Direct Write-off method of accounting for bad debts records the loss from
an uncollectible A/R at the time it is determined to be uncollectible. No attempt
is made to predict uncollectible accounts expense. Bad debt expense is recorded
when specific accounts are determined to be worthless. If Wonji Co. uses a
direct write-off method and determines on Feb. 20, it can‟t collect from a
customer- Home Co.- Br. 500. The entry to write-off the customer‟s account is
as follows
Feb. 20 Uncollectible Accounts Expense 500

A/R- Home Co. 500
To write-off Uncollectible accounts
Some times an amount previously written off is later collected. This can be due
to factors such as continual collection efforts or the good fortune of a customer.
If the account of Home Co. that was written-off directly to Bad Debit Expense is
later collected in full, the following two entries record this recovery.
Mar. 5 - A/R- Home Co. 5 00
Uncollectible Accounts Expense 500
To reinstate account
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Mar. 5 - Cash 500
A/R- Home Co. 500
To record full payment of account
If the recovery is in the year following the writ- off, there is no balance in the
Uncollectible Accounts Expense account related to the previous year‟s write-off
and no other write-offs are expected. So the credit portion of the entry recording
the recovery can be made to a Bad Debts Recoveries revenue account.
To conclude this part companies must weigh at least two principles when
considering use of the direct write-off method:
(1) Matching principle, & (2) Materiality principle
1. Record the following transactions in the accounts of Dashen P/c., which uses
the allowance method of accounting for uncollectibles receivables.
Sep. 5- Sold merchandise on account to Hirut Co. Br. 5000

Oct. 20- Received Br. 3000 from, Hirut Co. and Writes-off the remainder owed
on the sale of September 5 as uncollectibles.
Dec. 10- reinstated the account of Hirut Co. that had been written-off on
October-20 and received Br. 2000 cash in full payment.
8.8 Summary
Receivables are money claims against other entities, including people, business
firms and other organizations. These receivables as other assets of the business
207
organization need to be properly handled otherwise they might be exposed for
different type of error and fraud.
Based on the nature of the account, there are different accounting treatments
required for recording transactions made on credit and for the related risk of
uncollectibles that arise when customers default to make payment according to
their agreement. The common methods used to treat uncollectibles accounts in
the book of the payee are the allowance method and the direct-write-off method.
If a company selects the allowance method to treat uncollectibles, estimation is

required either based on sales or analysis of receivables.
8.9 Answers to check your progress questions
CHECK YOUR PROGRESS EXERCISE -1

a. Account Receivable is classified as current asset because it is normally
expected to be collected within a relatively short period or time.
b. Segregation of duties for related activities is required in order to decrease
the possibility of inefficiency, error and fraud.

1.
a. April-13
b. Br. 40,800 MV = FV + I = [40,000 + (40,000 X 12/100 X 60/360 )]
c. 1- Notes Receivables----------------40,000
A/R- Garra Muleta Co.----------------40,000
2- Cash-----------------------40,800
N/R------------------------------40,000
Interest Revenue-------------------800
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2.
May-1. Note Receivable 15,000
A/R-Adama Co. 15, 000
May-21. Cash (15300 – 238) 15062

N/R 15,000
Interest Revenue 62
June-30. A/R-Adama Co. (15300 + 30) 15330

Ca s h 15330
July-20. Cash 15432.20

A/R-Adama Co. 15,330
Interest Revenue (15330 x 12/100 x 20/360) 102.20

Sep. 5 A/R-Hirut Co. 5000
S al e 5000
Oct.20 Cash 3000

A/R-Hiruit Co. 3000
Allowance for Doubtful account 2000
A/R-Hirut Co. 2000
Dec. 10 A/R-Hiruit Co. 2000

Allowance for D.a/c 2000
Cash 2000
A/R Hiruit Co. 2000
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1. Prepare journal entries to record the following transactions entered in to by

Meskel Company during the year 20X2.
September 1- Received a Br. 10,000, 12%, 60-day note from Yasin Co. as full
settlement of his open account.
October 20- Sold merchandise on account to Heaven Co. for B.r 25,000 by
receiving a
90-day, 10% note.
October 31- Received full payment from Yasin Co. for notes received on
September 1.
December 31- Record the adjusting entry required for accrued interest from
October 20.
Transaction. (assume that the Accounting period ends on
December 31.)
2. Nazareth cosmetics Co. is undecided about which base to use in estimating

uncollectibles accounts. On December 31, 20X2, the balance in Account
Receivable was Br. 800,000 and net credit sales amounted to Br. 1,500,000
during 20X2. An aging analysis of the account receivable indicated that Br.
12,000 in accounts receivable are expected to be uncollectible. Past
experience has shown that about ½ of 1% of net credit sales eventually are
uncollectibles.
Prepare the adjusting entries to record estimated bad debit expense using the
(1) Percentage of sales basis, and
(2) The percentage of receivable basis under each of the following
independent assumptions
210
a) Allowance for Doubtful Accounts has a credit balance of
Br. 2000 before adjustment.
b) Allowance for Doubtful Account has a debit balance of Br.
600 before adjustment
3. The Lasta Co. uses the allowance method for estimating uncollectibles
accounts. Prepare journal entries to record the following transactions.
January 02- Sold merchandise to Nile Co. for Br. 30,000, term n/15.
February 15- Received Br. 20,000 from Nile Co. on account.
April 20- Written-off as uncollectible the remaining balance of Nile Co. account
when the business declared bankruptcy.
June 1- unexpectedly received a check for Br. 6000 from Nile Co.
4. Compute the missing amounts for each of the following notes.

Principal Interest Rate Time Total
Interest
(a) Br. 60,000 10 % 1.5 years ?
(b) Br. 200,000 ? 9 months Br. 17,250
(c ) ? 12 % 60 days Br. 1,500
(d) Br. 85,000 7% ? 1,487.50
5. Meskerem Co. holds a 90-day, 10% note for Br. 100,000 dated June-12, that
was received from a customer on account. On June 30, the note is discounted
at Borena Bank at the rate of 12.5 %.
a) Determine the maturity value of the note.

b) Determine the number of days in the discount period
211
c) Determine the amount of the discount.
d) Determine the amount of the proceeds
e) Present the journal entry required to record the discounting of the note on
June 30.
8.11 Glossary of terms
Account Receivable: - A claim against a customer for services rendered or

goods sold on credit.
Aging the receivable: - The process of analyzing the account receivable and
classifying them according to various age groupings, with the due date being the
base point for determine age.
Allowance method: - A method of accounting for uncollectible receivables,

whereby advance provision for the uncollectibles is made.
Current asset: - Cash or other assets that are expected to be converted to cash or sold or used
up, usually within a year or less, through the normal operations of business.
Direct write-off method: - A method of accounting for uncollectibles

receivables, whereby an expense is recognized only when specific accounts are
judged to be uncollectible.
Dishonored note receivable: - A note that the maker fails to pay on its due
date.
Notes Receivable: - A written promise to pay by the maker, representing an

amount to be received by the payee.
Uncollectibles accounts Expense: - The operating expense incurred because of

the failure to collect receivables.
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UNIT 1. INVENTORIES
CONTENTS
1.0Aims and Objectives
1.1 Introduction
1.2 Importance of Inventories
1.3 Effects of Inventories on Financial Statements
1.3.1 Effects of Ending Inventory on Current Period‟s Financial
Statements
1.3.2 Effects of Beginning Inventory on Current Period‟s Financial
Statements
1.3.3 Effects of Ending Inventory on the Following Period‟s
Financial Statements
1.4 Inventory systems
1.4.1 Periodic Inventory System
1.4.2 Perpetual Inventory System
1.5 Determining Actual Quantities in the Inventory
1.6 Summary
1.7 Answers to Check Your Progress
1.9 Glossary
1.0AIMS AND OBJECTIVES
This unit aims at discussing the meaning, importance and effects of inventories.
It also discusses the inventory systems and determining actual quantities in
inventories. After studying this unit, you will be able to:
- explain the meaning of inventories
213
- describe the effect of inventory on the financial statements of the
current period and the following period
- identify and describe the two principal inventory systems
- identify the procedures for determining the actual quantities in
inventory.
214
1.1INTRODUCTION
In the last section of Principles of Accounting I, you have learned about the
principles and practices of accounting for receivables – one of the current asset
items in the balance sheet of a retail business. In this unit you will learn and
discuss the concepts in accounting for inventories.
Inventories are asset items held for sale in the ordinary course of business or
goods that will be used or consumed in the production of goods to be sold. They
are mainly divided into two major:
 Inventories of merchandising businesses
 Inventories of manufacturing businesses
i. Inventories of merchandising businesses are merchandise purchased

for resale in the normal course of business. These types of inventories
are called merchandise inventories.
ii. Inventories of manufacturing businesses manufacturing businesses are
businesses that produce physical output. They normally have three
types of inventories. These are:
 Raw material inventory

 Work in process inventory
 Finished goods inventory
1. Raw material inventory -is the cost assigned to goods and materials on hand
but not yet placed into production. Raw materials include the wood to make a
chair or other office furniture‟s, the steel to make a car etc.
2. Work in process inventory- is the cost of raw material on which production
has been started but not completed, plus the direct labor cost applied specifically
to this material and allocated manufacturing overhead costs.
215
3. Finished goods inventory- is the cost identified with the completed but
unsold units on hand at the end of each period.
In this unit only the determination of the inventory of merchandise purchased for
resale commonly called merchandise inventory will be discussed.
1.2 IMPORTANCE OF INVENTORIES
Merchandise purchased and sold is the most active elements in merchandising

business, i.e. in wholesale and retail type of businesses. This is due to the
following reasons:
1.The sale of merchandise is the principal source of revenue for them.

2.The cost of merchandise sold is the largest deductions from sales.
3.Inventories (ending inventories) are the largest of the current assets or
those firms.
Because of the above reasons inventories, have effects on the current and the
following period‟s financial statements. If inventories are misstated (understated
of overstated), the financial statements will be distorted.
1. List the four types of inventories

………………………………………………………
………………………………………………………
………………………………………………………
………………………………………………………
216
2.Why do we consider inventories the most active elements merchandising
businesses?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
1.3 THE EFFECTS OF INVENTORIES ON CURRENT AND

FOLLOWING PERIOD’S FINANCIAL STATEMENTS.
1.3.1 Effect of ending inventory on current period’s financial statements
Ending inventory is the cost of merchandise on hand at the end of accounting

period. Let us see its effect on current period‟s financial statements.
Income statement
a. Cost of goods (merchandise) sold =Beginning inventory + Net purchase –

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

Here, the cost of merchandise sold had indirect relationship to gross profit. So,
the effect of ending inventory on gross profit is the opposite of the effect on cost
of merchandise sold. That is, if ending inventory is understated, the gross profit
217
will be understated and if ending inventory is overstated, the gross profit will be
overstated. This is a direct (positive) relationship.
c. Operating income = Gross Profit – Operating Expenses

Gross profit and operating income have direct relationships. Thus, the effect of
ending inventory on net income is the same as its effect on gross profit, i.e.
direct (positive) effect (relationship).
Balance Sheet
1. Current assets - Ending inventory is part of current assets, even the
largest. So, it has a direct (positive) relationship to current assets. If
ending inventory balance is understated (overstated), the total current
assets will be understated (overstated). Since current assets are part of
total assets, ending inventory has direct relationship to total assets.
2. Liabilities- No effect on liabilities. Inventory misstatement has no effect

on liabilities.
3. Owners’ equity – The net income will be transferred to the owners‟ equity
at the end of accounting period. Closing income summary account does
this. So, net income has direct relationship with owners‟ equity at the end
of accounting period. The effect-ending inventory on owners‟ equity is
the same as its effect on net income, i.e. if ending inventory is understated
(Overstated), the owners‟ equity will be understated (Overstated).
1.3.2 Effects of beginning inventory on current period’s financial
statements
Beginning inventory is inventory balance that was left on hand in the previous
period and transferred to the current period. Its effect is summarized below:
218
Income Statement
1. Cost of merchandise sold= Beginning inventory + Net Purchases –
Ending inventory
As you see, beginning inventory is an addition in determining cost of
goods sold. It has direct effect on cost of merchandise sold. That is, if the
beginning inventory is understated (Overstated), the cost of merchandise
sold will be understated (Overstated)
2. Gross Profit= Net Sales – Cost of merchandise sold

The effect of beginning inventory on gross profit is the opposite of the
effect on cost of merchandise sold, i.e. indirect (negative) relationship. If
the beginning inventory is understated, the gross profit will be overstated
and if it is overstated, the gross profit will be understated.
3. Net income = Gross Profit – Operating expenses

The effect of beginning inventory on net income is the same as its effect
on gross profit.
Balance sheet
1. Current assets – The inventory included in current assets is the ending
inventory. So, beginning inventory has no effect on current assets.
2. Owners’ equity- If the effect comes from the previous year, the beginning
inventory will not have an effect on ending owners‟ equity since the
positive or negative effect of the previous year will be netted off by the
negative or positive effect of the current year. But if the error is made in
the current period, it will have indirect effect on ending owners‟ equity.
219
1.3.3 Effect of ending inventory on the following period’s financial
statements
The ending inventory of the current period will become the beginning inventory
for the following period. So, it will have the same effect as beginning inventory
of the current period. Let us summarize it.
Income statement of the following period
Cost of merchandise sold direct relationship

Gross profit indirect relationship
Net income indirect relationship
Balance sheet of the following period
The ending inventory of the current period will not have an effect on the
following period‟s balance sheet items.
Illustration - 1
The following amounts were reported in Belay Company‟s financial statements
for three consecutive fiscal year ended December 31.
2000 2001 2002

a) Cost of merchandise sold Br. 130,000 Br. 154,000 Br.
140,000
b) Net income 40,000 50,000
42,000
c) Total Current assets 210,000 230,000
200,000
220
d) Owner‟s equity 234,000 260,000
224,000
In making the physical counts of inventory, the following errors were made:
 Inventory on December 31,2000, under stated by Br. 12,000
 Inventory on December 31, 2001, overstated by Br. 6000
Required:
Determine the correct amount of the items listed above.
Solution
2000 2001 2002
a) Cost of merchandise sold:
Reported Br. 130,000 Br. 154,000 Br.
140,000
Adjustment of
2000 error (12,000) 12,000 _
2001 error _ 6,000
(6,000)
Corrected Br. 118,000 Br. 172,000 Br.
136,000
b) Net income:
Reported Br. 40,000 Br. 50,000 Br.
42,000
Adjustment of
2000 error 12,000 (12,000)
_
221
2001 error _ (6,000)
6,000
48,000
c) Total current assets:

Reported Br. 210,000 Br. 230,000 Br.
200,000
Adjustment of
2000 error 12,000 _ _
2001 error _ (6,000) _
200,000
d) Owner’s equity:
Reported Br. 234,000 Br. 260,000 Br.

224,000
Adjustment of
2000 error 12,000 _ _
2001 error _ (6,000) _
224,000
1. Why does an understated ending inventory understate net income for the
period by the same amount?
222
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
2. Why does an error in ending inventory affect two accounting periods?

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
1.4 INVENTORY SYSTEMS: PERIODIC VS PERPETUAL
There are two principal systems of inventory accounting periodic and perpetual.
1.4.1 Periodic inventory system
Under this system there is no continuous record of merchandise inventory

account. The inventory balance remains the same through out the accounting
period, i.e. the beginning inventory balance. This is because when goods are
purchased, they are debited to the purchases account rather than merchandise
inventory account.
The revenue from sales is recorded each time a sale is made. No entry is made
for the cost of goods sold. So, physical inventory must be taken periodically to
determine the cost of inventory on hand and goods sold.
The periodic inventory system is less costly to maintain than the perpetual
inventory system, but it gives management less information about the current
status of merchandise.
This system is often used by retail enterprises that sell many kinds of low unit
cost merchandise such as groceries, drugstores, hardware etc.
223
The journal entries to be prepared are:
1. At the time of purchase of merchandise:
Purchases XX at cost
Accounts payable or cash XX
2. At the time of sale of merchandise:
Accounts receivable or cash XX at retail
price
S al es XX
3. To record purchase returns and allowance:
Purchase returns and allowance XX
4. To record adjusting entry or closing entry for merchandise inventory:

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

Merchandise inventory (ending) XX
Income summary XX
To record ending inventory
1.4.2 Perpetual inventory system
Under this system the accounting record continuously disclose the amount of
inventory. So, the inventory balance will not remain the same in the accounting
period. All increases are debited to merchandise inventory account and all
decreases are credited to the same account.
224
There are no purchases and purchase returns and allowances accounts in this
system. At the time of sale, the cost of goods sold is recorded in addition to
Journal entry for the sale. So, we can determine the cost of inventory as well as
goods sold from the accounting record. No need of physical counting to
determine their costs.
Companies that sell items of high unit value, such as appliances or automobiles,
tended to use the perpetual inventory system.
Given the number and diversity of items contained in the merchandise inventory
of most businesses, the perpetual inventory system is usually more effective for
keeping track of quantities and ensuring optimal customer service. Management
must choose the system or combination of systems that is best for achieving the
company's goal.
Journal entries to be prepared are:

1. At the time of purchase of merchandise
Merchandise inventory XX at cost
Accounts payable/cash XX
To record cost of goods sold
2. At the time of sale of merchandise

Accounts receivable or cash XX at retail
price
Sales XX
To record cost of goods sold
To record the sales
225
Cost of goods sold XX
Merchandise inventory XX at cost
To record the cost of merchandise sold
3. To record purchase returns and allowances

Merchandise inventory XX
4. No adjusting entry or closing entry for merchandise inventory is

needed at the end of each accounting period.
Illustration – 2
In its beginning inventory on Jan 1, 2002, NINI Company had 120 units of
merchandise that cost Br. 8 Per unit. The following transactions were completed
during 2002.
February 5 Purchased on credit 150 units of merchandise at Br. 10 per unit.
9 Returned 20 detective units from February 5 purchases to the
supplier.
June 15 Purchased for cash 230 units of merchandise at Br 9 per unit.

September 6 Sold 220 units of merchandise for cash at a price of Br. 15 per
unit. These
goods are: 120 units from the beginning inventory and 100
units for February
Purchases.
December 31 260 units are left on hand, 30 units from February 5 purchases.
226
Required: Prepare general journal entries for NINI Company to record the
above transactions and adjusting or closing entry for merchandise inventory on
December 31,
a) Periodic inventory system
b) Perpetual inventory system
Solution
a) February 5 Purchases (150 x Br.10) 1,500
Account payable 1,500
9 Accounts payable (20 x Br. 10) 200
Purchase returns and allowances
200
June 15 Purchases (230 x Br. 9) 2,070
Cash 2,070
September 6 Cash (220 x Br. 15)
3,300
Sales 3,300
December 31 To record or close the merchandise inventory account
Income summary (120 x Br. 8) 960
Merchandise inventory (beginning) 960
_To close the beginning inventory
Merchandise inventor (ending) 2,370
Income summary [(30 x Br. 10) + (230 x Br. 9)]
2,370
_ To record the ending merchandise inventory
227
b) February 5 Merchandise inventory 1,500
Accounts payable 1,500
9 Accounts payable 200
Merchandise inventory 200
June 15 Merchandise inventory 2,070
C as h 2,070
September 6 i) To record the sales
C as h 3,300
Sales
3,300
ii) To record cost of merchandise sold
= (120 x Br. 8) + (100 x Br. 10)
= Br. 960 + Br. 1,000 = Br. 1,960
Cost of merchandise sold 1,960
Merchandise inventory 1,960
December 31 No entry is needed to record or close merchandise inventory
account.
1.5 DETERMINING ACTUAL QUANTITIES IN THE INVENTORY
The physical count of inventory is needed under both inventory systems. Under
periodic inventory system, it is needed to determine the cost of inventory and
goods sold.
The inventory account under a perpetual inventory systems is always up to date.
Yet events can occur where the inventory account balance is different from
inventory on hand. such events include theft,, loss, damage, and errors. The
228
physical count (some times called “taking an inventory”) is used to adjust the
inventory ac count balance to the actual inventory on hand.
We determine a birr (dollar) amount for physical count of inventory on hand at

the end of a period by:
(1) Counting the units of each product on hand
(2) Multiplying the count for each product by its cost per unit
(3) Adding the cost for all products
At the time of taking an inventory, all the merchandise owned by the business
on the inventory date, and only such merchandise, should be included in the
inventory. The merchandise owned by the business may not necessarily be in the
warehouse. They may be in transit.
The legal title to the merchandise in transit on the inventory date is known by
examining purchase and sales invoices of the last few days of the current
accounting period and the first few days of the following accounting period.
This legal title depends on shipping terms (agreements).
There are two main types of shipping terms. FOB shipping point and FOB
destination
(1) FOB shipping point- the ownership title passes too the buyer when the
goods are shipped (when the goods are loaded on the means of
transportation, i.e. at the seller‟s point). The purchaser is responsible for
freight charges.
(2) FOB destination – the title passes to the buyer when the goods arrive at
their destination, i.e. at the buyer‟s point.
229
So, in general, goods in transit purchased on FOB shipping point terms are
included in the inventories of the buyer and excluded from the inventories of the
buyer and excluded from the inventories of the seller. And goods in transit
purchased on FOB destination terms are included in the inventories of the seller
and excluded from the inventories of the buyer.
There are also a problem with goods on consignment at the time of taking and
inventory. Goods on consignment to another party (agent) called the consignee.
A Consignee is to sell the goods for the owner usually on commission are
included in the consignor‟s inventories and excluded from the consignee‟s
inventories.
ABC Company, found in Addis, purchased goods from XYZ Company, found in
Mekele, on FOB shipping point terms.
1.Who will cover transportation charges? Why?

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
2. Assume these goods are in transit at the end of accounting period. In which
company‟s inventories do we include these goods?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
230
1.6 SUMMARY
Inventories are goods held for sale in the ordinary course of business or goods
that will be used or consumed in the production of goods to be sold. They are
included in the current asset section of the balance sheet.
Goods purchased and sold are the most active elements in the merchandising
businesses due to many reasons. Because of this reason, they have significant
effects on the current and the following period‟s financial statements.
There are two principal systems of inventory accounting periodic and perpetual.
In the periodic system, only the revenue from sales is recorded at the time the
sale is made no entry is made until the end of the period to record the
merchandise inventory and the cost of goods sold. In the perpetual inventory
system, sales and cost of merchandise sold are recorded at the time each sale is
made. In this way, the accounting records continuously disclose the amount of
inventory on hand.
The first step in “taking an inventory” is to count the merchandise on hand. To

this count is added merchandise in transit that is owned. Therefore, it is
normally necessary to examine purchases and sales invoices of the last few days
of the accounting period and the first few days of the following period to
determine who has legal title to merchandise in transit on the inventory date.
1.7 ANSWERS TO CHECK YOUR PROGRESS
Check Your Progress Exercise 1

1. - Merchandise inventory
231
- Raw material inventory
- Work in process inventory
- Finished goods inventory
2. - It is due to many reasons including the following

- The sale of merchandise is the main source of revenue
- The major deduction from sales is cost of merchandise sold
- Inventories are the largest of the current assets.
1. Ending inventory has direct effect on net income of the current period. So, if
ending inventory is understated, the net income will be understated by the
same amount. In other way round, if ending inventory is understated, cost of
goods sold will be overstated, resulting in an understatement of gross margin
and net income.
2. Because the ending inventory for the current period will become beginning
inventory for the following period.
1. The buyer (ABC Company). The title to the goods is passed to ABC
Company at the seller‟s point. So, while in transit, they are the properties
of ABC company.
2. In ABC Company
A. Short answer questions

1. Define inventories
232
2. From the two inventory systems, which method is better considering
internal controls?
3. If ending inventory is misstated, it will not have an effect in the
owners‟ equity of the following period. Why?
B. Workout questions
2. Abera Company reported annual net income as follows
2000 Br. 151,400
2001 152,400
2002 128,120
Analysis of its inventories shows that the following incorrect inventory amounts
were used (the correct amounts are also shown)
Incorrect inventory Correct

inventory
Amount
Amount
December 31,2001 Br. 24,000 Br.
28,000
December 31,2001 27,000
23,000
Compute the annual net income for each of the three years assuming the correct
inventories had been used.
3. Condensed income statement for FANTU Supermarket for two years are
shown below:
233
19 x 4 19 x
3
Sales (net) Br. 126,000 Br. 105,000
Cost of Goods Sold 75,000
54,000
Gross Margin Br. 51,000 Br.

51,000
Operating Expenses 30,000
30,000
Net Income Br. 21,000 Br. 21,000
After the end of 19 x 4 it was discovered that an error had resulted in a Br. 9000
understatement of 19 x 3 ending inventory.
Required: Compute
a) the corrected net income for 19 x 3
b) the corrected cost of goods sold for 19 x 4
c) the corrected net income for 19 x 4
d) what effect will the error have on net income and ending owner's equity
for 19 x 5?
4. MAMO Co. engaged in the following transactions in Megabit 1995:
Megabit 1- Sold merchandise to Belew Co. on credit, terms n/30, FOB

shipping point, Br. 2100 (cost br. 1260)
3 – Purchased merchandise on credit from Semi Co., terms n/30,
FOB shipping point, Br. 3800
234
5 – Paid Express Transit for freight charges on merchandise
received, Br. 290
6 – Purchased store supplies on credit from Hadiya Trading, terms
n/20, Br. 636
8 – Purchase merchandise on credit from Semi Co., terms n/30,
FOB shipping point, Br. 3600, which includes Br. 200 freight
costs paid by Semi Co.
12 – Returned some of the merchandise received on Megabit 3 for
credit, Br. 600
Refer to the following exercise in order to answer questions a – f.
The following information is related to the business for three consecutive fiscal
years.
19 x 3 19 x 2
19 x 1
Net sales Br. 430,000 Br. 425,000 Br.
400,000
Cost of goods sold 240,000 243,000
240,000
Gross Profit 189,200 182,000
160,000
Operating Expenses 96,800 92,400
86,500
Assume that you have found everything in order except for the following:
i. The ending inventory was understated by Br. 15,000 and Br. 3000 at the
end of 19 x 1 and 19 x 2 respectively.
235
ii. The ending inventory was overstated by Br. 20,200 at the end of 19 x 3
The business enterprise uses the periodic inventory system and the above errors
had not been brought to attention prior to your investigation.
a. What was the correct amount of cost of goods sold for 19 x 1?

b. What was the correct amount of cost of goods sold for 19 x 2?
c. What was the correct amount of cost of goods sold for 19 x 3?
d. What was the correct amount of Net income for 19 x 2?
e. What was the correct amount of Net income for 19 x 3?
f. Compute the correct gross profit percentage for 19 x 1?
Megabit 15 – Sold merchandise on credit to MERON Trading, terms n/30, FOB

shipping point, Br. 1200 (cost Br. 720)
16 – Returned some of the store supplies purchased in Megabit 6 for
credit, Br. 200
17 – Sold merchandise for cash Br. 1000 (cost, Br. 600)
18 – Accepted for full credit a return from Belew Company and
returned merchandised to inventory, Br. 200 (Cost Br. 120)
24 – Paid Semi Company for purchase of Megabit 3 loss return of
Megabit 12
25 – Received full payment from Belew Company for his Megabit 1
purchase less the return on Megabit 18
Required:
1. Prepare general journal entries to record the transactions, assuming use of
the periodic inventory system.
236
2. Prepare general journal entries to record the transactions, assuming use of
the periodic inventory system.
3. Compute the cost of goods sold and net sales during Megabit.
4. Compute the Gross Profit on sale for the month of Megabit.
1.9 GLOSSARY
1. Cost of merchandise sold- The cost of the merchandise purchased by a

merchandise enterprise and sold
2. Current asset- Cash or another asset that may reasonably be expected to be
realized in cash or sold or consumed, usually within a year or less, through
the normal operations of a business.
3. Finished goods inventory- The cost of finished products on hand that have
not been sold
4. FOB destination- Terms of agreement between buyer and seller where by
ownership passes when merchandise is received by the buyer, and the seller
absorbs the transportation costs.
5. FOB shipping, point-Terms of agreement between buyer and seller,
whereby ownership passes when merchandise is delivered to the shipper, and
the buyer absorbs the transportation costs.
6. Gross profit- The excess of net revenue from sales over the cost of
merchandise sold.
7. Net income- The final figure in the income statement when revenues exceed
expenses.
8. Purchases returns and allowances- Reduction in purchase, resulting from
merchandise returned to the vendor or from the vendor‟s reduction in the
original purchase price; a contra account to purchases.
237
9. Work in process inventory- The direct materials costs, the direct labor
costs, and the factory overhead costs, which have entered into the
manufacturing process, but are associated with products that have not been
finished.
238
UNIT 2: DETERMINING THE COST OF INVENTORY
Contents
2.0 Aims and Objectives
2.1 Introduction
2.2 Inventory Costing Methods Under Periodic Inventory system
2.2.1 Specific Identification Method
2.2.2 First-in First-out Method
2.2.3 Last-in First-out Method
2.2.4 Weighted Average Method
2.3 Comparison of Inventory Costing Methods
2.4 Inventory Costing Methods Under Perpetual Inventory System
2.4.1 First-in First-out Method
2.4.2 Last-in First-out Method
2.5 Summary
2.8 Glossary
2.0 AIMS AND OBJECTIVES
This unit aims at discussing inventory cost determination and inventory costing
methods.
After going through this unit, you will be able to:
1. describe the determination of the cost of inventory
2. aware of the most common inventory costing methods under a
periodic system
239
3. compare the effect of the methods on operating results
4. describe the accounting for inventory under the perpetual system.
2.1 INTRODUCTION
This chapter is the continuation of the previous chapter, in which we have

discussed the meaning and concepts of inventory. In this chapter, we will
discuss the determination of the cost of inventory.
Costs included in merchandise inventory are those expenditures necessary,
directly or indirectly, to bring an item to a salable condition and location. In
other words, cost of an inventory item includes its invoice price minus any
discount, plus any added or incidental costs necessary to put it in a place and
condition for sale. Added or incidental costs can include import duties,
transportation-in, storage, insurance against losses while the goods are in transit,
and costs incurred in an aging process(for example, aging of wine and cheese).
Minor costs that are difficult to allocate to specific inventory items may be
excluded from inventory cost and treated as operating expenses of the period.
This is based on materiality principle or the cost-to –benefit constraint.
1. An art gallery purchases a painting for Br. 11,400 on terms FOB shipping
point. Additional costs in obtaining and offering the artwork for sale include.
130 for transportation-in, Br. 150 for import duties, Br. 100 for insurance
during shipment, Br. 180 for advertising, Br. 400 for training, and Br. 800 for
sales salaries. For computing inventory, what cost is assigned to the painting?
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240
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2.2 INVENTORY COSTING METHODS UNDER PERIODIC

INVENTORY SYSTEM
One of the most important decisions in accounting for inventory is determining

the per unit costs assigned to inventory items. When all units are purchased at
the same unit cost, this process is simple since the same unit cost is applied to
determine the cost of goods sold and ending inventory. But when identical items
are purchased at different costs, a question arises as to what amounts are
included in the cost of merchandise sold and what amounts remain in inventory.
A periodic inventory system determines cost of merchandise sold and inventory
at the end of the period. We must record cost of merchandise sold and
reductions in inventory as sales occur using a perpetual inventory system. How
we assign these costs to inventory and cost of merchandise sold affects the
reported amounts for both systems.
There are four methods commonly used in assigning costs to inventory and cost
of merchandise sold. These are:
 Specific identification
 First-in first-out(FIFO)
 Last-in first-out (LIFO)
 Weighted average
Let us see these costing methods under periodic inventory system based on the
following illustration
241
Illustration:
Beza Company began the year and purchased merchandise as follows:
Jan-1 Beginning inventory 80 units@ Br. 60 = Br. 4,800
Feb. 16 Purchase 400 units@ 56 = 22,400
Sep.2 Purchase 160 units @ 50 = 8,000
Nov. 26 Purchase 320 units@ 46 = 14,720
Dec. 4 Purchase 240 units@ 40 = 9,600
Total 1200 units Br.59, 520
The ending inventory consists of 300 units, 100 from each of the last three
purchases.
2.2.1 Specific Identification Method
When each item in inventory can be directly identified with a specific purchase
and its invoice, we can use specific identification (also called specific invoice
pricing) to assign costs. This method is appropriate when the variety of
merchandise carried in stock is small and the volume of sales is relatively small.
We can specifically identify the items sold and the items on hand.
Example
From the above illustration, the ending inventory consists of 300 units, 100 from
each of the last purchases. So, the items on hand are specifically known from
which purchases they are:
Cost of ending inventories under specific identification method

Br. 40 x 100 = Br. 4,000
Br. 46 x 100 = 4,600
242
Br. 50 x 100 = 5,000
300units Br. 13,600
 Cost of Ending inventory cost = Br. 13,600

 The cost of merchandise sold = Cost of goods available for sale - Ending
inventory
= Br. 59,520 – Br. 13,600
= Br. 45,920
2.2.2 First-in, First-out (FIFO)

This method of assigning cost to inventory and the goods sold assumes
inventory items are sold in the order acquired. This means the cost flow is in the
order in which the expenditures were made. So, to determine the cost of ending
inventory, we have to start from the most recent purchase and continue to the
next recent. Because the first purchased items (old purchases) are the first to be
sold they are used (included) in the computation of cost of goods sold.
For example, easily spoiled goods such as fruits, vegetables etc., must be sold
near the time of their acquisition. So, the inventory on hand will be from the
recent purchases. As an example, consider the previous illustration on page 21.
The cost of ending inventory under FIFO method

= Br. 40 x 240 Br. 9,600
= Br. 46 x 60 2,760
300 units Br. 12,360
 Cost of Ending inventory Br. 12,360

 Cost of merchandise sold = Br. 59,520 – Br. 12,360
243
Br. 47,160
2.2.3 Last-in first-out (LIFO)
This method of assigning cost assumes that the most recent purchases are sold
first. Their costs are charged to cost of goods sold, and the costs of the earliest
purchases are assigned to inventory. The cost flow is in the reverse order in
which expenditures were made.
In calculating the cost of goods sold, we will start from the earliest purchases.
As an example, take the previous illustration

The cost-ending inventory under FIFO method
=Br.60 x 80 = Br. 4,800
=Br. 56 x 220 = 12,320
300 units
Ending inventory cost = Br. 17,120
Cost of merchandise sold = Br. 59,520 – Br. 17,120
= Br. 42,400
This method of assigning cost requires computing the average cost per unit of
merchandise available for sale. That means the cost flow is an average of the
expenditures.
244
To calculate the cost of ending inventory, we will calculate first the cost per unit
of goods available for sale
Average cost per unit = Cost of goods available for sale

Total units available for sale
Then the weighted average unit cost is multiplied by units on hand at the end of
the period to calculate the cost of ending inventory. Also, the same average unit
cost is applied in the computation of cost of goods sold.
As an example, take the previous illustration

Weighted average unit cost = Br. 59,520 = Br. 49.60
1,200
 Ending inventory cost = Br. 49.60x 300

= Br. 14,880
 Cost of merchandise sold = Br. 59,520-Br. 14,880

= Br. 44,640
2.3 COMPARISON OF INVENTORY COSTING METHODS
If the cost of units and prices at which they are sold remains stable, all the four
methods yield the same results. But if prices change, the three methods usually
yield different amounts for:
- Ending inventory
- Cost of merchandise sold
- Gross profit or net income
245
In periods of rising (increasing) prices: (or if there is inflationary trend):
FIFO yields – higher ending inventory

_ Lower cost of merchandise sold
_ Higher gross profit (net income)
LIFO yields _ Lower ending inventory

_ Higher cost of merchandise sold
_ Lower gross profit (net income)
 Weighted average yields the results between the two.
In periods of declining (decreasing) prices:
FIFO yields _ Lower ending inventory

_ Higher cost of merchandise sold
_ Lower gross profit or net income
LIFO yields_ higher ending inventory

_ Lower cost of merchandise sold
_ Higher gross profit or net income
 Weighted average- between the two
1. Which of the methods of inventory costing will in general yield an inventory

cost nearly approximating current replacement cost?
246
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2. Does the terms FIFO and LIFO refer to techniques employed in determining
quantities of various merchandise on hand?
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2.4 INVENTORY COSTING METHODS UNDER PERPETUAL

INVENTORY SYSTEM
Under perpetual inventory systems we will apply the inventory costing methods
each time sale of merchandise is made. We calculate the cost of goods
(merchandise) sold and inventory on hand at the time of each sale. This means
the merchandise inventory account is continually updated to reflect purchase and
sales.
Illustration:
The beginning inventory, purchases and sales of Nesru Company for the month
of January fare as follows:
Units Cost
J an . 1 Inventory 12 Br. 10.00
6 Sale 5
10 purchase 10 Br. 12.00
20 Sale 8
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27 Sale 10
2.4.1 First-in first-out Method
The assignment of costs to goods sold and inventory using FIFO is the same for
both the perpetual and periodic inventory systems. Because each withdrawal of
goods is from the oldest stock on hand. The oldest is the same whether we use
periodic inventory system or perpetual inventory system.
Let us calculate the cost of goods sold and ending inventory under perpetual
inventory system from the above illustration.
Perpetual - FIFO
Date Purchase Cost of merchandise Inventory
sold
Qty Unit Total Qt Unit Total Qty Unit Total
. cost cost y cost cost cost cost
J an . 1 15 Br. Br.
10.00 150.00
6 5 B r. Br. 10
10.00 50.00 10.00 100.00
248
10
10 10 Br. Br.120.0 10 10.00 100.00
12.00 0
12.00 120.00
20 8 10.00 80.00 2
10 10.00 20.00
12.00 120.00
2
25 8 12.50 100.00 10 10.00 20.00
8
12.00 120.00
12.50 100.00
27 2 10.00 20.00 2
8 12.00 96.00 8 12.00 24.00
12.50 100.00
2
30 15 14.00 210.00 8 12.00 24.00
5
12.50 100.00
14.00 210.00
249
23 Br. 25 Br.
246.00 334.00
So, the cost of merchandise sold and ending inventory under perpetual- FIFO
method are Br. 246 and Br. 334 respectively.
Let us see them under periodic - FIFO method:
Units on hand = units available for sale – units sold
= (15 + 10 + 8 + 15 ) – ( 5+ 8 + 10 )
= 48 - 23 = 25
Cost of ending inventory = Br. 14 x 15 = Br. 210

Br. 12.50 x 8 = 100
Br. 12 x 2 = 24
Br. 334
Cost of goods available for sale = Br. 120 + Br. 100 + Br. 210 = Br. 580
Cost of goods sold = Br. 580 – Br. 334
Br 246
So, the same results of cost of gods sold and ending inventory under both
periodic inventory systems.
2.4.2 Lasting, First-Out method

Unlike FIFO method, different results may occur under periodic and perpetual
inventory system. The most recent purchases change when new purchase occurs.
250
Let us calculate first the cost of goods sold and ending inventory for the above
illustration under perpetual inventory system. Then, we will see the results under
periodic inventory system.
Perpetual - LIFO
Date Purchase Cost of merch. Sold Inventory
Qty Unit Total Qty Unit Total Qty Unit cost Total
cost cost cost cost cost
J an . 1 15 Br. 10.00 Br.
150.00
6 5 B r. Br. 10 10.00 100.00
10.00 50.00
10 10 Br. Br. 10 10.00 100.00
12.00 120.00 10 12.00 120.00
20 8 B r. Br. 10 10.00 100.00
12.00 96.00 2 12.00 24.00
25 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
8 12.50 100.00
27 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
30 15 14.00 210.00 10 10.00 100.00
15 24.00 210.00
23 Br. 25 Br.
270.00 310.00
251
So, the cost of merchandise sold and ending inventory under perpetual inventory
system are Br. 270 and Br. 310 respectively.
The results under periodic inventory system are:
Cost of ending inventory = Br. 10 x 15 = Br. 150
Br. 12 x 10 = 120
25
Br. 270
Cost of merchandise sold = Br. 580 - 270

= Br. 310
As you see, the results are different under periodic & perpetual inventory
systems.
2.4.3 Weighted average cost method.
Under this method, the average unit cost is calculated each time purchased is
made to be applied on the sales made after the purchases. The results may be
different under periodic and perpetual inventory system.
Let us calculate the cost of merchandise sold and ending inventory comes out
from the previous illustration under perpetual inventory system.
252
Average Cost Method (Moving Average)
Purchase Cost of merchandise sold Inventory
Dat Qty Unit Total Qty Unit Total cost Qty Unit Total cost
e cost cost cost cost
J an . 15 Br. Br. 150.00

1 10.00
6 5 Br. Br. 50.00 10 10.00 100.00
10.00
20 11.00 220.00
10 10 12.00 Br. =
100+120
120.00
10+10
20 8 11.00 88.00 12 11.00 132.00
20 11.60 + 232.00
25 8 12.00 100.00 132+100
12+8
27 10 11.60 116.00 10 11.60 116.00

30 15 14.00 210.00 15 13.04 326.00
116+210
10+15
23 Br. 254.00 25 Br. Br 326.00
13.04
So, the cost of goods sold and ending inventory under perpetual inventory
system are Br. 254.00 and Br. 326.00, respectively.
253
The results under periodic inventory system are:
Weighted average unit cost = Br. 580 = Br. 12.08
48
Ending inventory cost = Br. 12.08 x 25
= Br. 302
Cost of merchandise sold = Br. 580 – Br. 302
= Br. 278
So, the result is different under periodic and perpetual inventory systems.
1. What are the advantages of perpetual inventory system over the periodic
inventory system?
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2. In periods of steadily rising prices, which inventory method will give the
highest,
i) inventory cost,
ii) lowest inventory cost
iii) highest net income, and
iv) lowest net income?
254
3. Do the FIFO and LIFO inventory methods result in different quantities of
ending inventory?
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2.5 SUMMARY
The cost of merchandise inventory is made up of the purchase price and all
expenditure incurred in acquiring such merchandising including transportation,
customs duties, and insurance against losses in transit.
Under periodic inventory system, in determining the cost of merchandise sold

and the inventory at the end of the period, it is customary to use an assumption
as to the flow of costs of merchandise through an enterprise. The four methods
of costing an inventory are specific identification, FIFO, LIFO and weighted
average of which the last three are the cost flow assumptions. The FIFO method
of costing inventory is based on the assumption that costs should be charged
against revenue in the order in which they were incurred. The LIFO method is
based on the assumption that the most recent costs incurred should be charged
against revenues. The weighted average method is based on the assumption that
costs should be charged against revenue according to the weighted average unit
costs of the goods sold.
If the cost of units and the prices at which they are sold remain stable, all three
inventory costing methods will yield the same results. However, during a period
of rising prices, the use of FIFO method will result in a higher amount of gross
255
profit than the other two methods. In a period of declining prices, the use of
LIFO method will result in a higher amount of gross profit than the other two
methods. The average cost method is often viewed as a compromise between the
FIFO and LIFO methods.
Under a perpetual inventory system, costs are assigned to the cost of

merchandise sold account each time a sale occurs. Specific identification assigns
a cost to each item sold by referring to its actual cost. Weighted average
assigned a cost to items sold by taking the current balance in the merchandise
inventory account and dividing it by the total items to determine the weighted
average cost per unit.
Check Your Progress 1

1. Total c cost is Br. 12,180, computed as: Br. 11,400 + 130 + Br. 150 + Br.
100 + Br. 400.
Br. 180 for advertising and Br. 800 for sales salaries are not added to cost
of the inventory. They are included in operating expenses

1) First-in, First-out (FIFO) method
2) No, They are the methods of determining cost of the inventory.

1) For internal c control purpose. This is by comparing the perpetual
inventory record and inventory amount through physical count; we can
determine the inventory shortage or overage.
256
For preparation of interim financial statements, there is no need of
counting the inventory. Frequent comparisons of balance with
predetermined maximum and minimum levels facilitate the timely
recording of merchandise to avoid both excess inventory and the cost of
sales.

1. When costs and prices are rising, does LIFO or FIFO report higher net
income?
2. In periods of declining prices, which method are not preferable income
tax purposes?
B. Workout question
Tale Company had the following beginning inventory and purchases during
2002:
I te m X
Date Unit’s Unit cost
J an . 1 Inventory 400 B r. 1 4
March 10 Purchase 200 15
May 9 Purchase 300 16
Sep. 22 Purchase 250 20
Nov. 28 Purchase 100 21
At December 31, 2002, there were 550 units of X on hand.
Sales of units were as follows:

Jan.15 200 units at Br. 30
257
April 1 200 units at Br. 30
Nov. 1 300 units at Br. 35
Additional data for use in applying the specific identification method

(1) Jan. 15 sale - 200 units@ Br. 14
(2) April 1 Sale - 200 units@ Br. 15
(3) Nov. 1 Sale - 200 units@ Br. 20
Required:
a. Calculate the cost of merchandise available for sale
b. Apply the four different methods of inventory costing to calculate
ending inventory & Cost of merchandise sold under:
i) Periodic inventory system

ii) Perpetual inventory system
1. What is the difference between goods flow and cost flow?

2. What are the relative advantages and disadvantages of FIFO and LIFO
methods of inventory costing?
3. Why do you think it is more expensive to maintain a perpetual inventory
system?
4. What are the three most important advantages of the perpetual inventory
system?
5. A company using a perpetual inventory system sells merchandise to a
customer on account for Br. 1250; the cost of the merchandise was Br. 1000.
a) What entries would be made on the general ledger accounts as a
result of the transaction?
b) What is the amount of gross profit realized from this specific sale?
258
II. Choose the best answer from the given alternatives
1. The inventory system that does not attempt to record the cost of goods sold
each time sale is made is;
a) FIFO b) Periodic c) Perpetual d) Physical
e) b and d f) c and d
2. If merchandise inventory is being valued at cost and the price level is

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

a) If the FIFO method of inventory costing is selected by a company the
method shall be used for all inventory items.
b) Under the average cost method, the same unit cost is used to compute
both the cost of goods sold and the cost of inventory.
c) One of the major drawbacks of LIFO is that it does not attempt to
match current costs with current revenues.
d) All of the above
e) None of the above
4. Identify the wrong statement:

a) The FIFO method in periods of rising prices causes businesses to report
more than their true profit resulting in the payment of excess income
taxes.
259
b) Over a period of rising prices a business that use LIFO method may
report the value of inventory at a cost figure far below what it currently
pays for the same item.
c) Pricing the inventory and cost of goods sold using the specific
identification method is the same under both periodic and perpetual
systems.
d) The FIFO method of inventory costing is not the best measure of the
current balance sheet value of inventory.
e) None of the above.
5. In which method of inventory costing the flow of cost and income

determination is given due consideration?
a) Average cost b) FIFO c) LIFO
d) Gross profit e) None of the above
III. Problems
1. Eyassu Furniture Company sold 2200 doors during 19 x 5 at Br. 320 per
door. Its beginning inventory on January 1 was 130 doors at Br. 112.
Purchases made during the year were as follows:
February 225 doors @ Br. 124

April 350 doors @ Br. 130
June 700 doors @ Br. 140
August 300 doors @ Br. 132
October 400 doors @ Br. 136
November 250 doors @ Br. 144
260
The company's selling and administrative expenses for the year were Br.
202,000, and the company uses the periodic inventory system.
Required:
1. Prepare a schedule to compute the lost of goods available for sale.
2. Prepare an income statement under each of the following assumptions:
(a) costs are assigned to inventory using the average cost method
(b) costs are assigned to inventory using the FIFO method
(c) costs are assigned to inventory using LIFO method
2.8 GLOSSARY
6. Cost-to-benefit constraint- it is a concept that says accounting information

is used disclosed if the cost perceived to be associated with it is balanced
against the benefits perceived to be associated with it.
7. First-in, First-out (FIFO) method- method of inventory costing based on

the assumption that the costs of merchandise sold should be charged against
revenue in the order in which the costs were incurred.
8. Last-in, First-out (LIFO) method- a method of inventory costing based on

the assumption that the most recent merchandise costs should be charged
against revenue.
261
UNIT 3: ADDITIONAL VALUATION PROBLEMS FOR
INVENTORIES
Contents
Aims and Objectives
Introduction
Valuation at Lower of Cost or Market
Estimating Inventory Cost
Method of Inventory Costing
Retail Gross Profit Method
Summary
Answers to Check Your Progress
Model Examination Questions
Glossary
3.0AIMS AND OBJECTIVES
This chapter aims at discussing various valuation methods like lower of cost or
market, retail method and gross profit method.
After studying this chapter, you would be able to:

1. explain the valuation of inventory at other than cost, including valuation
at the lower of cost or market.
2. acquaint yourself with various methods of estimating cost of an inventory,
including retail method and gross profit method.
3.1 INTRODUCTION
262
an attempt has been made in this unit to explain valuation of inventory valuation
and the problems such as valuation at lower of cost or market, retail method and
gross profit method of estimating an inventory cost.
3.2 VALUATION AT LOWER OF COST OR MARKET (LCM)
It was explained how costs are assigned to ending inventory and cost of goods
sold using one of four costing methods (FIFO, LIFO, Weighted average, or
specific identification). Yet, the cost of inventory is not necessarily the amount
always reported on a balance sheet. Accounting principles require that inventory
be reported at the market value of replacing inventory when market is lower
than cost. Merchandise inventory is then said to be reported on the balance sheet
at the lower of cost or market (LCM).
In applying LCM, cost is the acquisition price of inventory computed using one
of the historical cost methods - specific identification, FIFO, LIFO, and
Weighted average; market is defined as the current market value (cost) of
replacing inventory. It is the current cost of purchasing the same inventory items
in the usual manner. It is important to know that market is not defined as the
sales prices. A decline in market cost reflects a loss of value in inventory. This is
because the recorded cost of inventory is higher than the current market cost.
When this occurs, a loss is recognized. This is done by recognizing the decline
in merchandise inventory from recorded cost to market cost at the end of the
period.
LCM is applied in one of three ways:

(1) Separately to individual item
(2) To major categories of items
263
(3) To the whole of inventory
The less similar the items are that make up inventory, the more likely it is that
companies apply LCM to individual items. Advances in technology further
encourage the individual item application.
Illustration
The following are the inventory of ABC motor sports, retailer.
Inventory units per unit
Items on hand co s t market
Cycles:
Roadster 50 Br. 15,000 Br. 14,000
Sprint 20 9,000 9,500
Off Road:
Trax-4 10 10,000 11,200
Blaz’m 6 16,000 14,500
Let us see LCM computation under the three ways:
(1) Separately to each individual item
Inventory items Total cost Total market LCM
Roadster Br. 750,000 Br. 700,000 Br. 700,000

Sprint 180,000 190,000 180,000
Categories sub total Br. 930,000 Br. 890,000
Trax-4 100,000 112,000 100,000
Blaz‟m 96,000 87,000 87,000
264
Categories sub total Br. 196,000 Br. 199,000
Totals Br.1,126,000 Br. 1,089,000 Br.
1,1,067,000
(2) Major categories of items
Inventory Categories Categories LCM

categories total cost total market
Cycles Br. 930,000 Br. 890,000

Br. 890,000
Off. Road 196,000 199,000
199,000
Totals Br. 1,126,000 Br. 1089,000 Br.
1,086,000
When LCM is applied to the whole of inventory, the market cost is Br.
1,089,000. Since this market cost is Br. 37,000 lower than Br. 1,126,000
recorded cost, it is the amount reported for inventory on the balance sheet. When
LCM is applied to individual items of inventory, the marked cost is Br.
1,067,000. Since market is again less than Br. 1,126,000 cost, it is the amount
reported for inventory. When LCM is applied to the major categories of
inventories, the market is Br. 1,086,000 which is also lower than cost.
1. In the phrase lower of cost or market, what is meant by “market”?

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265
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2. Blen Trading value its inventory, shown below, at the lower of cost or
market. Compute Blen's inventory value using (i) item – by – item method,
and (ii) the major category method.
Per Unit
Quantity Cost Market
Category I
It e m A 200 Br. 5.00 Br. 4.00
It e m B 300 4.00 4.00
It e m C 400 10.00 8.60
Category II
It e m X 500 8.00 9.20
It e m Y 300 14.00 14.50
3.3 ESTIMATING INVENTORY COST
In practice, an inventory amount is estimated for some purposes. When it is

impossible to take a physical inventory or to maintain perpetual inventory
records.
Example
266
1) Monthly income statements are needed. It may b e too costly, to take
physical inventory. This is especially the case when periodic inventory
system is used.
2) When a catastrophe such as a five has destroyed the inventory. In such case,
to ask claims from insurance companies, the is a need of estimated inventory.
To estimate the cost of inventory, two methods are used. These are retail method
and gross profit method.
3.3.1 Retail method of inventory costing
This method is mostly used by retail business. The estimate is made based on
the relation ship between the cost and the retail price of merchandise available
for sale.
The steps to be followed are:

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

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

Estimated cost of ending inventory = Cost to retail ration X Ending
inventory at retail
Example
267
Cost Retail
Sep. 1, beginning inventory Br. 25,000 Br. 40,000
Purchases in September (net) 125,000 160,000
Sales in September (net) 140,000
(1) Cost retail ration = Br. 25,000 + Br. 125,000 = 0.75

Br. 40,000 + Br. 160,000
(2) Ending inventory at retail = (Br. 40,000 + Br. 160,000) – Br. 140,000 =
Br. 60,000
(3) Estimated ending inventory at cost = 0.75 X Br. 60,000
= Br. 45,000
1. Enterprises using the retail method of inventory costing determine the

merchandise inventory at retail is Br. 300,000. If the ratio of cost of retail
price is 65%, what is the estimated cost of inventory?
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2. Does the retail inventory method mean that inventories are measured at retail
value on the balance sheet? Explain.
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3.3.2 Gross profit method
268
This method uses an estimate of the gross profit realized during the period to
estimate the cost of inventory. The gross profit rate may be estimated based on
the average of previous period‟s gross profit rates.
The steps are as follows:

(1) The gross profit rate is estimated and then estimated gross profit is
calculated.
Estimated gross profit = Gross profit rate X Sales
(2) Cost of merchandise sold is estimated

Estimated cost of merchandise sold = Sales - Estimated gross profit
(3) Calculate the estimated cost of ending inventory

Estimated cost of ending inventory =
Cost of merchandise available for sale – Estimated cost of merchandise
sold.
Example
Oct. 1, beginning inventory (cost) – Br. 36,000

Net purchases during October (cost) 204,000
Net sales during October 220,000
Estimated gross profit rate is 40%
The ending inventory is estimated as follows:

(1) Estimated gross profit = 0.4 X 220,000
= Br. 88,000
269
(2) Estimated cost of merchandise sold
= Br. 220,000 – Br. 88,000
= Br. 132,000
(3) Estimated cost of ending inventory

= (Br. 36,000 + 204,000) – Br. 132,000
= Br. 240,000 – Br. 132,000
= Br. 108,000
1. Cost of merchandise available for sale is Br. 200,000 and net sales for the
period is Br. 180,000. If the cost of merchandise sold percentage of sales is
60%, what is the estimated cost of the inventory to be reported on the
financial statements?
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2. What are some of the reasons that may cause management to use the gross
profit method of estimating inventory?
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3.4 SUMMARY
270
If the market price of an item of inventory is lower than its cost, the lower of
cost or market method is used to value inventory. Market, as used in the phrase
lower of cost or market; is interpreted to mean the cost to replace merchandise
on the inventory date. It is possible to apply the lower of cost or market basis to
each item in the inventory, to major classes or categories, or to the inventory as
a whole.
When it is impractical or impossible to take a physical inventory or to maintain

perpetual inventory records, two commonly used methods of estimating
inventory would be applied:
1) the retail method and
2) the gross profit method
The retail method of inventory estimation is based on the relation ship of the
cost of merchandise available for sale to the retail prices of the same
merchandise. The inventory at retail is determined by deducting net sales for the
period from the retail price of the goods that were available for sale during the
period. The inventory at retail is then converted to cost on the basis of the ratio
of cost to selling price of the merchandise available for sale.
The gross profit method of estimating inventory is based upon the historical
relationship of the gross profit to the sales. The rate of gross profit is multiplied
by the sales to determine the gross profit. To determine the cost of merchandise
sold, the gross profit is then subtracted from sales. The estimated cost of ending
inventory is computed by subtracting the cost of merchandise sold from cost of
merchandise available for sale.
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1. The cost to replace merchandise on the inventory date
2. (i) Item – by – item method:
Category I Total Cost Total Market LCM

It e m A Br. 1000 Br. 800 Br. 800
It e m B 1200 1320 1200
It e m C 4000 3440 3440
Category II Total Cost Total Market LCM

It e m X Br. 4000 Br. 4600 Br. 4000
It e m Y 4200 4350 1200
Inventory of LCM Br.
13,640
(ii) The Major Category Method

Category I Total Cost Total Market LCM
It e m A Br. 1000 Br. 800
It e m B 1200 1320
It e m C 4000 3440
Totals Br. 6200 Br. 5560 Br. 5560
Category II Total Cost Total Market LCM

It e m X Br. 4000 Br. 4600
It e m Y 4200 4350
Totals Br. 8200 Br. 8950 Br. 8200
Inventory of LCM Br. 13,760
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1. It is Br. 195,000 computed as 0.65 X Br. 300,000
2. No, the inventory at retail is converted to cost on the basis of the ratio of cost
to retail. Therefore, it is reported on the balance sheet at its estimated cost.
1. It is Br. 92,000 computed as follows

Cost of merchandise sold = Br. 180,000 X 0.60 = Br. 108,000
Estimated cost of ending inventory = Br. 200,000 – Br. 108,000
= Br. 92,000
2. To replace the retail method when records of the retail prices of beginning
inventory and purchases are not kept.
To prepare interim financial statements, and to estimate the inventory lost or
destroyed by theft, fire, or other hazards.

1. From three ways of applying lower of cost or market, which one results in
minimum value of inventory?
2. When do we use the inventory estimation methods to determine the cost
of inventory?
B. Work out questions

1. Crystal Corporation‟s ending inventory includes the following items.
273
Product Units on hand Unit cost Replacement cost per
unit
W 40 Br. 30 B r. 3 4
X 50 48 40
Y 60 26 24
Z 44 20 20
Replacement cost is determined to be the best measure of market. Calculate

lower of cost or market for the inventory
a. As a whole b. Applied separately to each products
2. The records of the unlimited provided the following information for the year
ended December 31:
At cost At retail
Jan. 1 beginning inventory Br. 160,450 Br.
264,900
Purchases 1,100,140 1,828,200
Purchases returns 17,600 34,100
Sales _ 1,570,200
Sales returns _ 15,600
Transportation in 13,000 _
Required: calculate the estimated cost of ending inventory

a. By retail method
b. By gross profit method if the gross profit rate is 30%
274
3. Rahel Company's Dress shop had net retail sales of Br. 1,000,000 during the
current year. The following additional information was obtained from the
accounting records:
At Cost At Retail
Beginning Inventory Br. 160,000 Br. 240,000
Net Purchase 560,000 880,000
Transportation – In 41,600
Required:
a) Estimate the company's ending inventory at cost using the retail method.
b) Assume that a physical inventory taken at year-end revealed an inventory
on hand of Br. 72,000 at retail value. What is the estimated amount of
inventory shrinkage (loss due to theft, damage, and so forth) at cost?
4. Fantu and his family is a large retail furniture company that operates in two
adjacent warehouses. One warehouse is a showroom, and the other is used to
store merchandise. On the night of March 13, a fire broke out in the storage
warehouse and destroyed the merchandise stored there.
Fortunately, the fire did not reach the showroom, so all the merchandise on
display was saved.
Although, the company maintained a perpetual inventory system, its records

were rather had hazard, and the last reliable physical inventory was taken on
December 31. In addition, there was not control of the flow of the goods
between the show room and the warehouse.
275
Thus, it was impossible to tell what goods should be in either place. As a
result, the insurance company required an independent estimate of the
amount of loss. The insurance company examiners were satisfied when they
were provided with the following information.
1. Merchandise Inventory on December 31 Br. 1,454,800

2. Purchase, January 1 to March 13 2,412,200
3. Purchase Returns, Jan. 1 to March 13 (10,706)
4. Freight – In, Jan 1 to March 13 53,100
5. Sales, January to March 13 3,959,050
6. Sales Returns, Jan 1 to March 13 (29,800)
7. Merchandise Inventory in Showroom March 13 402,906
8. Average gross Margin 44%
Required:
Prepare a schedule that estimates, the amount of the inventory lost in the fire.
5. Sanete Trading Company switched recently to the retail inventory method

to estimate the cost-ending inventory. To test this method, the company took
a physical inventory one month after its implementation. Cost, retail, and the
physical inventory data are as follows:
At Cost At Retail
Beginning Inventory, January 1 Br. 472,132 Br. 622,800
Purchase 750,000 1,008,400
Freight – In 8,350
Purchases Returns and Allowances (25,200)
(34,800)
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Sales 1,060,000
Sales Returns and Allowances (28,000)
January 31, Physical Inventory 508,200
Required:
a) Prepare a schedule to estimate the amount of Sanete Company's January

31 inventory using the retail method.
b) Use the company's cost ratio to reduce the retail value of the physical
inventory to cost.
c) Calculate the estimated amount of inventory shortage of cost and at retail.
277
UNIT 4: ACCOUNTING FOR PLANT ASSETS AND DEPRECIATION
Content
4.1Introduction
4.2Nature and Meaning of Long-Term Assets
4.3Determination of The Accusation cost of Plant Assets
4.4Natures and Meaning of Depreciation
4.5Factors That Affect the Computation of Depreciation
4.6Methods of computing Depreciation
4.6.1 The Straight-Line Method
4.6.2 Units of Production Method
4.6.3 Double-Declining Balance Method
4.6.4 The Sum-of-The-Years-Digits Method.
4.7 Comparison of Depreciation Methods
4.8 Recording Depreciation
4.9 Special Depreciation Methods
4.9.1 Group and Composite-Rate Depreciation Methods
4.10 Revision of Depreciation Rates
4.11 Capital and Revenue Expenditures
4.12 Summary
4.13 Answer to Check Your Progress
278
4.15 Reference Books
4.16 Glossary
This unit aims at discussing the meaning and nature of plant assets, acquisition
costs, and the related cost allocation (depreciation) of plant assets. The units also
discuss the different methods of computing depreciation and the accounting
procedures involved in recording the transactions relating to disposal of plant
assets.
After having studied and worked through this unit, you will able to be:
 determine the acquisition c cost of tangible assets
 compute depreciation for plant assets using various depreciation methods
 record depreciation expense in the accounting records
 distinguish expenses from expenditures that should be capitalized
 differentiate depreciation for financial reporting from depreciation for
income tax
4.1 INTRODUCTION
In the previous chapter you have learnt about the accounting for current assets
(i.e. accounting for cash, receivables and inventories). In this chapter you will
learn about the issues of plant assets and its related depreciation.
Most business enterprise holds such major assets as land, buildings, equipments,
furnitures, tools, and etc. These assets help produce revenue over many periods
by facilitating the production and sale of goods or services to customers.
279
Because these assets are necessary in a company‟s day-to-day operations,
companies do not sell them in the ordinary course of business. Keep in mind,
though; one company‟s long-term asset might be another company‟s short-term
asset. For example, a delivery truck is a long-term asset for most companies, but
a truck dealer would regard a delivery truck as a current asset merchandise
inventory.
4.2 NATURE AND MEANING OF LONG-TERM ASSETS
Assets that can be used by a business enterprise for relatively long period
(usually more than one year) are called Long-Term Assets.
Long-term assets are divided into tangible and intangible categories.
Tangible assets (also called plant assets or fixed assets) are assets with physical
substance that can be charged in the operations of business for a relatively
longer period of time, usually more than one year or one operating cycle
whichever is longer. Examples are land, buildings, equipments and machineries,
trucks, etc.
In contrast, intangible assets are assets without a physical feature that can be
charged in the operations of business for long period of time. They generally
consist of rights or advantages held such as goodwill, patents, copyrights,
franchise, trade marks, organization costs, etc.
4.3 DETERMINATION OF THE ACQUISITION COST OF PLANT

ASSETS
280
The acquisition cost of plant (fixed) assets is the cash or cash-equivalent
purchase price, including incidental costs required to complete the purchase, to
transport the asset, and to prepare it for use.
For example, expenditures related to the acquisition of a plant asset such as

freight, insurance while in transit, and installation are included in the cost of the
asset because they are necessary if the asset is to function. According to the
matching principle, therefore, such costs are allocated to the economic life of the
asset rather than charged as expenses in the current period.
Land
The acquisition cost of land includes the negotiated cash price plus other costs
such as the cost of land surveys, legal fees, title fees, broker‟s commissions,
co9st of preparing the land to build on, and even the demolition costs of old
structures that might be torn down to get the land ready for its intended use.
Under the historical cost assumption, land is reported in the balance sheet at its
original cost. Land is not subjected to depreciation because land does not have a
limited useful life.
The following illustration will help us how to determine the cost of land.
Illustration-1
A business enterprise acquires a piece of land for future site. It pays a cash price
of Br. 210,000, pays brokerage fees of Br. 7500 and title fees of Br. 3000, pays
Br. 5000 to have unwanted building removed, and pays, Br. 1500 to have the
site graded. The business receives
281
Br. 2000 salvage from the old building. The cost of the land is determined as
follows:
Cash prices (negotiated price)…………………………………………Br.
210,000.00
Title
Fees……………………………………………………………………..3,0
00.00
Brokerage
Fees………………………………………………………………...7,500.0
0
Cost of
Grading……………………………………………………………..…1,50
0.00
Cost of removing (demolition) unwanted building Br. 5000
Less: Salvage
received……………………………….(2000)…………………3,000.00
Total cost of land……………………………………………………
.….Br. 225,000.00
Generally, land is part of property, plant and equipment. If the major purpose of
acquiring and holding land is speculative, it is more appropriately classified as
an investment. If the land is held on a real estate concern for resale, it should be
classified as inventory. When the land has been purchased for the purpose of
constructing a building, all costs incurred up to the excavation for the new
building are considered land costs. Removal of old buildings clearing, grading
and filling are considered land costs because these costs are necessary to get the
land in condition for its intended purpose. Any proceeds obtained in the process
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of getting the land ready for its intended use, such as salvage receipts on the
demolition of an old building are treated as reductions in the price of the land.
Cost of buildings
When an existing building is purchased its cost includes, the purchase price plus
all repairs and other expenses required to put it in a usable conditions. On the
other hand, when a business constructs a new building, the cost includes all
reasonable and necessary expenditures, such as those for materials, labor, part of
the overhead and other indirect costs, engineers and architects‟ fees, insurance
during construction, interest incurred on construction loans during the period of
construction, lawyers' fees, and building permits. If outside contractors are used
in the construction, the net contract price plus other expenditures necessary to
put the building in usable condition are included.
Cost of equipment
The term “ equipment” in accounting includes office equipment, store

equipment, factory equipment, delivery equipment, machinery, furnitures and
fixtures, and similar fixed assets. The cost of such assets includes the invoice
(purchase) price, transportation and handling charges, insurance on the
equipment while in transit, assembling and installation costs, and costs of
conducting trail runs. As indicated earlier, all costs of getting an asset ready for
its intended use are costs of that asset.
4.4 NATURE AND MEANING OF DEPRECIATION
As plant assets are used in the operations of a business, their value to provide
service decreases through usage and the passage of time.
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This cost allocation of plant asset, called depreciation, is recorded in the
accounting books periodically.
Depreciation is frequently misunderstood. The term depreciation, as used in

accounting, does not refer to the physical deterioration of an asset or the
decrease in market value of an asset overtime.
Depreciation means the allocation of the cost of a plant asset to the periods that
benefit from the services of the asset.
The term depreciation is used to describe the gradual conversion of the cost of
the asset into an expense.
Depreciation is not a process of valuation. Ac counting records are kept in

accordance with the cost principle; they are not indicators of changing price
levels. It is possible that, through an advantageous buy and specific market
conditions the market value of a building may rise. Nevertheless, depreciation
must continue too be recorded because it is the result of an allocation, not a
valuation process.
4.5 FACTORS THAT AFFECT THE COMPUTATION OF

DEPRECIATION
Four factors affect the computation of depreciation. They are:

(1) Cost
(2) Residual value
(3) Depreciable cost, and
(4) Estimated economic (useful) life.
284
Cost- is the net purchase price plus all reasonable and necessary expenditures to
get the asset in place and ready for use.
Residual value- also known as salvage value, disposal value, scrape value, or
trade-in value represents the estimated market value of the asset at the time of its
retirement.
Depreciable cost - represents the difference between the asset cost and its
estimated residual value. For example, an item of equipment that costs Br. 5000
and has a residual value of Br. 500 would have a depreciable cost of Br. 4500,
(Br. 5000 - Br. 500). The depreciable costs must be allocated over the estimated
economic life of the asset.
Estimated economic (useful) life- the estimated economic life of an asset is the
total number of service units expected from the asset. Service units may be
measured in terms of years the asset is expected to be used, units expected to be
produced, miles or kilometers expected to be driven, or similar measures. In
determining the estimated useful life of an asset, the accountant should consider
all relevant information, including (1) past experience with similar repair assets,
(2) the asset‟s present condition, (3) the company‟s repairs and maintenance
policy, (4) current technological and industry trends, and (5) local conditions
such as whether.
4.6 METHODS OF COMPUTING DEPRECIATION
Depreciation methods differ primarily in the amount of cost allocated to each

period. A list of depreciation amounts for each year of an asset‟s useful life is
called depreciation schedule.
285
The most common methods of computing depreciation for plant assets are:
(1) The straight line method
(2) The units of production method
(3) The double-declining balance method, and
(4) The sum-of- the years-digits method.
4.6.1 Straight-Line Depreciation
When this method is used to allocate depreciation, the depreciable cost of the
asset is spread evenly (uniformly) over the useful life of an asset. The straight-
line method is based on the assumption that depreciation depends only on the
passage of time. The depreciation expense for each period is computed by
dividing the depreciable cost by the number of accounting periods in the asset‟s
estimated useful life. The depreciation expense to be reported is the same in
each year. The following illustration will help us to understand the Straight-Line
method of computing depreciation.
Illustration - 2
Suppose, for example a business enterprise acquires a new computer (office
equipment) at a cost of Birr 6000. It is estimated that the computer has an
estimated residual value of Birr 1000 at the end of its estimated useful life of 4
years. The yearly (annual) depreciation would be Birr 1250m computed as
follows:
Annual depreciation = Cost - Salvage value

Estimated useful life
= Birr 6000 – Birr 1000 = Birr 1250

4 years
The depreciation to be reported for each of the four years would be as follows:
Depreciation Method- Straight-Line Method
286
Year Cost Yearly Accumulated Carrying
Depreciation Depreciation value (Book
Value)
Beginning of first Br. 6000 - - Br. 6000.00
year
End of first year 6000 Br. 1250.00 Br. 1250.00 4750.00
End of second year 6000 1250.00 1250.00 3500.00
End of third year 6000 1250.00 3750.00 2250.00
End of fourth year 6000 1250.00 5000.00 1000.00
NB. There are three important points to note from the depreciation schedule for
the straight-line depreciation method. First, the depreciation is the same each
year. Second, the accumulated depreciation increases uniformly. Third, the
carrying (Book) value decreases uniformly until it reaches the estimated
residual value.
4.6.2 Units of Production Method
The production method of depreciation is based on the assumption that

depreciation is mainly the result of use and that the passage of time plays no role
in the depreciation process. If we assume that the office equipment from the
previous illustration has an estimated useful life of 10,000 hours, the
depreciation cost per hour would be determined as follows:
Hourly depreciation = Cost – Salvage value = Br. 6000.00 –

1000 = Br. 0.50
Rate Estimated units of useful life 10,000 operating
h rs .
If we assume that the use of the equipment was 2800 hours for the first year,
3600 hours for the second, 2400 hours for the third, and 1200 hours for the
fourth, the depreciation schedule for the office equipment would appear as
follows:
287
Depreciation Schedule – Production Method
Year Cost Hours Depreciation Yearly Accum. Carrying

Per Hour Depr. Depr. value (Book
value)
Beginning of Br. - Br. 0.50 - - Br. 6,000.00
6,000
the
First year
End of first 6,000 2,800 0.50 Br. Br. 4,600.00
1,400.00 1,400.00
year
End of second 6,000 3,600 0.50 1,800.00 3,200.00 2,800.00
year
End of third 6,000 2,400 0.50 1,200.00 4,400.00 1,600.00
year
End of fourth 6,000 1,200 0.50 600.00 5,000.00 1,000.00
year
Under the production method, there is a direct relation between the amounts of
depreciation each year and the units of output or use. Also, the accumulated
depreciation increases each year indirect relation to units of output or use.
Finally, the carrying amount decreases each year in direct relation to units of
output or use until it reaches the estimated residual value.
Under the production method, the units of output or use that is used to measure
estimated useful fife for each asset should be appropriate for that asset. For
example, for one machine number of units produced may be an appropriate
measure, for another number of hours may be a better measure. The production
288
method should be used only when the output of an asset over its useful life can
be estimated with reasonable accuracy.
4.6.3 Declining Balance Method
This method of depreciation results in relatively large amount of depreciation in

the early years of an assets life and smaller amounts in later years. This method
is based on the assumption of the passage of time. Since most kinds of plant
assets are most efficient when new, and so they provide more and better service
in the early years of useful life. It is consistent with the matching rule to allocate
more depreciation to the early years than to later years if the benefits or services
received in the early years are greater.
The declining-balance method is the most common accelerated method of

depreciation. Under this method depreciation is computed by applying a fixed
rate to the book value of the asset, resulting in higher depreciation charges
during the early years of the asset‟s life. Though any fixed rate might be used
under the method, the most common rate is a percentage equal to twice the
straight-line percentage. When twice the straight-line rate is used, the method is
usually called the double-declining balance method.
Referring to the previous example, the equipment had an estimated useful life of
four years. Consequently, under the straight-line method, the depreciation rate
for each year was 25 percent, (100/ estimated useful life of the asset for 100/ 4
years).
Therefore, under the double-declining balance method, the fixed rate is 50

percent (2X 25 percent). This fixed rate of 50 percent is applied to the remaining
289
carrying value at the end of each year. Estimated residual value is not taken into
account in computing depreciation except in the last year of an asset‟s useful
life, when depreciation is limited to the amount necessary to bring the carrying
value down to the estimated residual value. The depreciation schedule for this
method is as follows:
Depreciation Schedule, Double-Declining Balance Method
Year Cost Fixed Yearly Accumulated Carrying

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

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

Cost Depreciation Depreciation Value
Date of purchase Br6000 - - - Br. 6000
End of first year 6000 4/10 Br. 2200 Br. 2200 3800
End of second 6000 3/10 1650 3850 2150
year
End of third year 6000 2/10 1100 4950 1050
End of fourth 6000 1/10 550 5500 500
year
1. What happens if the estimated economic life of the asset is, let say, 25 years?
How would you calculate the sum-of-years-digits?
291
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
NB. The above illustration for the sum of year‟s digit method is based on the
assumption that the first use of the asset concide with the beginning of the fiscal
period. When the first use of the asset does not concide with the beginning of a
fiscal year, it is necessary to allocate each full year‟s depreciation b/n the two
fiscal years benefited. Assuming that the asset in the example was placed in
service after four months of the fiscal year had been elapsed, the depreciation for
that fiscal year would be Br. 1466.67 computed as follows:
First year depreciation = 4/10 X (6000 – 500) X 8/12…………………. Br.

1466.67
Therefore, the depreciation for the second year would be ….Br.
1833.33
Computed as follows:
= 4/10 X (6000 – 500) X 4/12……………….. Br.

733.33
= 3/10 X (6000 – 500) X 8/12…………………….
1100.00
Total, second fiscal year depreciation…………………………… Br.

1833.33
4.7 COMPARISON OF DEPRECIATION METHODS
292
The straight-line depreciation provides a uniform or equal depreciation charges
to expense throughout the service life of the asset.
The production method of depreciation provides for periodic charges to

depreciation expense that may vary considerably, depending upon the amount of
usage of the asset. The production method does not generate a regular pattern
because of the random fluctuation of the deprecation from year to year.
The major limitation of the production method is that it is not appropriate in

situation in which depreciation is a function of time instead of activity. Another
problem in using the production method is that an estimate of units of output or
service hours received is often difficult to determine.
Both the declining balance and the sum of the years digits methods are referred
to as accelerated depreciation methods, because they provides (report) relatively
higher depreciation expense in the earlier uses of the life of the asset and a
gradually declining periodic expense thereafter.
The main justification for this approach is that more depreciation should be
charged in earlier years because the asset suffers its greatest loss of services in
those years.
Accelerated depreciation method also recognizes that changing technologies
make some equipment lose their capacity to yield services rapidly. Thus, it is
appropriate to allocate more to depreciation in the early years, than in later
years.
Another argument in favor of an accelerated method is that repair (maintenance)

expense is likely to be greater in later years than in early years. Thus, the
293
reduced amounts of depreciation reported in later years of the asset‟s life are
offset to some extent by increased repair (maintenance) expense.
A visual comparison may provide a better understanding of the three-

depreciation methods disc ribe above. Figure 4-1 compares the yearly
depreciation under the four methods.
300
Graphical Comparison of three
methods of
Yearly 2500 determining depreciation
Depreciation
2000
1500 SLD
1000
SYD
500
DDB
D
1 2 3 4
In the above graph that shows yearly depreciation, straight-line depreciation is

uniform at Birr 1375 per year over the four years period. However, the declining
balance method begins at an amount greater than straight line (Br.3000) and
decreases each year to amounts that are less than straight line (ultimately, Br.
250). The production method does not generate a regular pattern because of the
294
random fluctuation of the depreciation from year to year. In general companies
use different methods of deprecation for goods reason. The straight-line method
can be advantageous for financial reporting because it can produce the highest
net income, and the accelerated depreciation method can be beneficial for tax
purposes because it can result in lower income taxes.
CHECK YOUR PROGRESS EXERCISE -3

1. Under what situation is the production method of depreciation appropriate?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
2. State and describe the draw back of the production method of depreciation?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
4.8 RECORDING DEPRECIATION
The amount by which a fixed asset decreases is an expense of the business. The
amount of depreciation expense should be recorded each fiscal period. If
depreciation expense is not recorded, the income statement will not contain all
the expenses of the business. This will cause the net income to be reported
higher than it should be. Income tax laws allow a business to deduct
depreciation as an expense in determining net income. If depreciation expenses
are not included on the income tax reports, the business will pay more income
taxes than it should be.
295
Depreciation may be recorded by an entry a t the end of each month, or the
adjustment may be delayed until the end of the year.
To record the periodic cost expiration (allocation) of plant asset, the expense
account, depreciation expense is debited and the part of the entry that records the
decrease in the plant asset is credited to a contra asset account entitled
Accumulated Depreciation or Allowance for Depreciation. The use of this
contra asset account permits the original cost to remain unchanged in the plant
asset account. This facilitates the computation of periodic depreciation, the
listing of both cost and accumulated depreciation on the balance sheet, and
reporting required for property and income tax purposes.
NB. An exception to the general procedure of recording depreciation monthly or
annually is often made when a plant asset is sold, traded-in, or discarded.
1. What would be the journal entry to record the depreciation expense of a

machine that costs Br? 3000, with no salvage value and has an estimated
economic life of 10 years if the straight-line method is applied? Assuming
that the machine was placed in service after two months had been elapsed in
the current period
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
ILLUSTRATIVE PROBLEM
296
TORA-BORA Construction Company acquired a new crane for Birr 360,500 at
the beginning of year 1. The crane has an estimated residual value of Birr 35,000
and an estimated useful life of five years. The crane is expected to last 10,000
operating hours. It was used 1800 hours in year 1, 2000 hours in year 2. and
2500 hours in year 3. Based on the information given above:
1) Compute the annual depreciation and the carrying value for the crane for
each of the first three years under each of the following methods:
a) Straight line method,
b) Units of production method,
c) Double-declining-balance method, and
d) Sum-of-the-years-digits method.
2) Prepare the adjusting entry that would be made each year to record the
depreciation calculated under the straight line method.
Solution:
1) a) Straight Line Method:
Annual depreciation = original cost – estimated salvage value
Estimated Economic life
= Br. 36,500 – Br. 35,000

5 years
= Br. 325,500 = Br. 65,100

5
297
Therefore, deprecation for the first year, second year, and for the third year, is
uniformly
Br. 65,100.
b) Units of Production Method:

Hourly Depreciation Rate = Original Cost – Salvage value
Estimated Operating Hours
= Br. 360,500 – 35,000

10,000 operating hours
= Br. 32.55
During the first year the crane has been in operation for 1800 hours. Therefore,
the depreciation for the first year is Br. 58,590, computed as follows:
Br. 32,55 X 1800 hours = Br. 58,590
Second year deprecation = Br. 32.55 X 2000 hours = Br. 65,100
Third year depreciation = Br. 32.55 X 2500 hours = Br. 81,375
c) Double-declining- balance Method:

To proceed with the double-declining-balance method, first we have to
determine the rate. The double-declining rate for the asset can be obtained by the
following formula:
Rate = 100 X2
Estimated
Life
298
Rate = 100 2 = 40%
5 years
Unlike the other methods, in the declining-balance method the salvage value is
not deducted in computing the depreciation base. The declining balance rate is
multiplied b y the book value of the asset at the beginning of each period.
Therefore,
First year depreciation = 40/100 X 36,500 = Br. 144,200
Second year deprecation = 40/100 X (360,500 – 144,200)

= 40/100 X 216,300 = Br. 86,520
Third year depreciation = 40/100 (360,500 – 230,720)

= 0.4 X 129,780 = Br. 51,912
d) Sum-of-the-years-digits Method
To work with this method, we must determine the denominator of the fraction,
The denominator or the fraction for an asset with an estimated economic life of
5 years is 5+4+3+2+1 = 15
 Depreciation for year 1 is therefore, 5/15 x (OC – Salvage value)

 Which is 5/15x (325,500) = Br. 108,500
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 Second year depreciation = 4/15 x (325,500) = Br. 86,800
 Third year depreciation= 3/15 x 325,500 = Br. 65,100
4.9 SPECIAL DEPRECIATION METHODS
Some times each of the four depreciation methods discussed so far may not b e
suitable because the assets involved have unique characteristics, or the nature of
the industry requires that a special depreciation method be use of these methods,
the group and composite methods are discussed below:
4.9.1 Group And Composite Methods

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.
300
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
(1) computing the annual depreciation for each asset, (2) determining the annual
depreciation, and (3) dividing the sum thus determined by the total cost of the
assets.
Illustration - 3
TANA Transport share Co. depreciates its group of cars, buses, and trucks on
the basis of composite-depreciation method. The composite-rate depreciation is
computed in the following manner:
Original Residual Depreciable Estimated
Annual Dep.
Asset Cost Value Co s t Life (straight line
method)
Cars Br.400,000 Br. 80,000 Br. 320,000 8
years Br. 40,000
Buses 2,400,000 240,000 2,160,000 10 years
216,000
Trucks 1,500,000 150,000 1,350,000 9 years
150,000
Br. 4,300,000 Br. 470,000 Br. 3,830,000
Br. 406,000
Composite depreciation rate = Br. 406,000 = 9.44%

Br. 4,300,000
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If no change exists in the asset account, the group of assets will be depreciated
to the residual or salvage value at the rate of Br. 406,000 (Br. 4,300,000 x
9.44%) a year.
The composite depreciation rate may be applied against total asset cost on a
monthly basis, or some reasonable assumption may be made regarding the
timing of increases and decreases in the group. A common practice is to assume
that all additions and retirements have occurred uniformly throughout the year.
The composite rate is then applied to the average of the beginning and ending
balances of the account. Another acceptable averaging technique is to assume
that all additions and retirements during the first-half of the year occurred as of
the first day of the year, and that all additional and retirements during the second
half of the year occurred on the first day of the following year.
NB. If an asset within the composite group is retired before, or after, the average
service life of the group is reached, the resulting gain or loss should not be
recognized. This practice is justified because some assets will be retired
(disposed) before the average service life of the group and others after the
average life. For this reason, the debit to Accumulated Depreciation is the
difference between original costs and cash received.
Illustration - 4
Suppose that TANA Transport share Co. in the previous example, sold one of
the trucks with the cost of Br. 75,000, at a selling price of Br. 40,000, at the end
of the fourth year. Therefore, the entry to record the disposal would be:
Solution:
302
Original cost of the asset………………………………………..Birr 75,000
Less: cash receipts from sale of asset………………………………..40,000
Accumulated Depreciation of the asset…………………………Birr 35,000
Accumulated Depreciation……………35,000
Cash…………………………………...40,000
Cars, Buses, and Trucks……………….75,000
4.10 REVISION OF DEPRECIATION RATES
When a plant asset is acquired, depreciation rates are carefully determined based
on past experience with similar assets and other relevant information. The
provisions for depreciation are only estimates, however, and it may be necessary
to revise the estimated economic life and that of salvage value during the life of
the asset. Unexpected physical deterioration or unforeseen obsolescence may
make the useful life of the asset less than originally estimated. Good
maintenance procedures, revision of operating procedures, or similar
improvements may prolong the life of the asset beyond the original estimate.
Illustration - 5
Assume that a delivery truck originally acquired for Br. 75,000 is estimated to
have a 16-year life with a residual value of Br. 3000. However, after 10 years of
intensive use, it is determined that the delivery truck will last only 4 more years,
(instead of 6 years) but its estimated residual value at the end of the four years
will be Br. 6000, (instead of Br. 3000).
Solution:
303
Before the revision of the estimated life and the residual value of the asset at the
beginning of the 11th year, the asset ac count and its related accumulated
depreciation account would appear as shown below:
Delivery Trucks Accumulated Depr- Delivery
Truck
Cost 75,000
45,000 Balance at the
end of the 10th Year
After the revision, at the beginning of the 11th year, the remaining depreciable
cost and the revised annual depreciation by the straight-line method are
computed as follows.
Original Cost of the truck…………………………………………….Birr

75,000
Less: Accumulated depreciation already taken…………………………………
45,000
Remaining cost of the delivery truck…………………………………Birr
30,000
Less: Revised estimated salvage
value…………………………………………...6,000
Revised annual depreciation 30,000 - 6000
4 years …………………….Birr 6,000
The new annual periodic depreciation expense is computed by dividing the

revised depreciable cost of Br. 24,000 by the remaining revised useful life of 4
304
years. Therefore, the new periodic depreciation charge is Br. 6000. The annual
adjusting entry for depreciation for the next two years would be as follows:
Year 11
Dec. 31, Depreciation Expense - Delivery Truck………………..6000
Accumulated Depreciation - Delivery
Truck………………6000
Year12
Dec. 31 Depr. Expense-Truck…………………………….6000
Accum. Depreciation-Truck……………………………60000
Depreciation of partial years

So far, the illustrations of the depreciation methods have assumed that the plant
assets were purchased at the beginning or end of the accounting period.
However, business does not often buy assets exactly at the beginning or end of
the accounting period. In most cases, they acquire the assets when they are
needed and sell or discard them when they are no longer useful or needed. The
time of year is normally not a factor in the decision. Thus, it is often necessary
to calculate depreciation for partial years.
Illustration - 6
Assume that a piece of equipment is purchased for Br. 5000 and that it has an
estimated useful life of five years, and an estimated residual value of Br. 500.
Assume further that the equipment is purchased on October 2 and that the yearly
accounting period ends on December 31. Depreciation must be recorded for
three months, October through December, or 3/12 of a year. This factor is
applied to the calculated depreciation for the entire year. The three months‟
depreciation under the straight-line method is calculated as follows:
Solution:
Annual depreciation = Original cost – Estimated Salvage value
Estimated useful life
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= Br. 5000 – Br. 500 = Birr 900
5 years
Depreciation for partial year (Oct – Dec. 31) is therefore, Br. 900 x 3/12 = Br.
225
If the company used the double declining balance method on the above
equipment, the depreciation on the asset would be: Br. 5000 x 40/100 x 3/12, =
Br. 500, depr. For three months,
If the company used the sum-of-years-digits method, the depreciation on the

asset would be:
Birr (5000 – 500) x 5/15 x 3/12 = Birr 375, and the depreciation for the second
year would be:
(5000 – 500) x 5/15 x 9/12 = Br. 1125

(5000 – 500) x 4/15 x 3/12 = 300
Therefore, total 2nd year depreciation Br. 1425
NB. In this specific example depreciation was recorded from the beginning of
October. If the equipment had been purchased on October 16, or thereafter,
depreciation would be calculated beginning November 1, as if the equipment
were purchased on that date.
4.11 CAPITAL AND REVENUE EXPENDITURES
Capital Expenditures- are expenditures that improve the operating efficiency

(or capacity) or costs incurred to achieve greater future benefits.
306
In addition to the acquisition of plant assets, capital expenditures included
additions and betterments.
An addition is an enlargement to the physical layout of a plant asset. Suppose

for example, if a new wing is added to a building, the benefits from the
expenditure will be received over several years, and the amount paid for it
should be debited to the asset account.
A betterment, on the other hand, is an improvement that does not add to the
physical layout of the asset. Installation of an air conditioning system is an
example of betterment, Replacement of a concrete floor for a wooden floor is
also betterment that will provide benefits over a number of years, so its cost
should be charged (debited) to an asset account.
Another types of capital expenditures include extraordinary repairs.

Extraordinary repairs are repairs of amore significant nature. They affect the
estimated residual value or estimated useful life of an asset. For example, a
boiler for heating a building may be given a complete overhaul, at a cost of Br.
3000 that will prolong its economic life by 5 years.
Extraordinary repairs are recorded by debiting the accumulated depreciation

account, under the assumption that some of the depreciation previously recorded
has now been eliminated. The effect of this reduction in the accumulated
depreciation account is to increase the book value of the asset by the cost of the
extraordinary repair. As a result, the new book value of the asset should be
depreciated over the new estimated useful life.
Illustration - 7
307
Suppose for example, a machine costing Br. 35,000 had no estimated residual
value and an original estimated useful life of ten years, has been depreciated for
7 years. At the very beginning of the 8th year, the machine was given a major
overhaul costing Br. 3000. This expenditure extended the useful life of the
machine 3 years beyond the original estimate. The computation of the new book
value and the entry for the extraordinary repair would be as follows:
Solution
To record extraordinary repair
Jan. 4. Accumulated Depreciation – Machinery……………3000.00
Cash
…………………………………………………………3000.00
Extraordinary repair to machinery
The revised annual depreciation for each of the six years remaining in the
machine‟s useful life would be calculated as follows:
Cost of Machine……………………………………… Birr 35,000
Accum. Depreciation before extraordinary repair Br. 24,500
Less: extraordinary repair (Debited to Accum. Depr.)….3000 21,500
Book value (carrying value) after extraordinary repair… Br.13,500
Revised Annual periodic depreciation= 13500……………………….2,250
6 years
Revenue expenditures
Revenue expenditures are expenditures incurred in order to maintain the normal

operating efficiency of the asset.
308
Among the more usual kinds of revenue expenditures for plant asset are the
repairs, maintenance, lubrication, Cleaning and inspection necessary to keep an
asset in good working condition.
Ordinary repairs are expenditures that are necessary to keep an asset in good
operating conditions. Trucks must have tune-ups, their tires and batteries must
be replaced regularly, and other routine repairs must be made. Offices and halls
must be painted regularly, and broken tiles or woodwork must be replaced. Such
repairs benefits only the current period and therefore must be charged against
the revenue in the current fiscal period.
1) Discuss the difference between ordinary repairs and extraordinary repairs?

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4.12 SUMMARY
Almost all business enterprises of any size or activity use assets of a durable
nature. Such assets, commonly refereed to as property, plant, and equipment,
plant assets, or fixed assets, support the operating activities in every business
organization, instead of being a part of the operating activities. Such assets
include land, building, and equipments (machinery, furniture, tools).
309
The major characteristics of plant (or fixed) assets are:
1) they are acquired for use in the operations of a business, they are not
intended for resale purpose. If the business holds them for resale they are
categorized under the caption 'Inventories', in the balance sheet.
2) they are long-term in nature and usually subject to depreciation long-term
assets are capable of repeated usage in the operating activities of the
business, and
3) they posse‟s physical features.
One of the big issues in accounting for plant assets is the determination of cost.
The acquisition cost of a plant asset includes the cash or cash equivalent
purchase price of obtaining the asset and bringing it to the location and
condition necessary for its intended use.
Cost of Land: Includes the negotiated cash price plus other costs such as the
cost of land surveys, legal fees, broker‟s commissions, title fees, cost of
preparing the land to build on, and the cost of tearing-down (or razing) old
building, and any expenditures associated with the acquisition of land that are
necessary to get the land ready for its intended use.
Cost of buildings: Includes the purchase price plus all repairs and other
expenses requited to put it in a usable condition. When a business constructs a
new building, the cost includes all reasonable and necessary expenditures, such
as materials, labor, part of the overhead and other indirect costs, engineers and
architects‟ fees, insurance during construction period, lawyers fees, and building
permits.
310
Cost of Equipments: Includes the invoice price, transportation and handling
costs, insurance on the equipment while in transit, assembling and installation
costs, and costs of conducting test (trail) runs.
As plant assets are used in the operation of a business, their value to provide
services decreases through usage and the passage of time. This cost allocation of
plant asset through usage and the passage of time are called depreciation.
Depreciation is frequently misunderstood. The term doesn‟t refer to the decrease

in market value of an asset overtime; no it is a process of valuation. Instead, the
term is used to describe the gradual conversion of the cost of the asset into an
expense account. Four factors affect the computation of depreciation. They are:
(1) cost, (2) residual value, (3) depreciable cost, and (4) estimated useful
life of the asset. Business may be different methods to compute
depreciation
The most common methods of computing depreciation for plant assets are (1)
straight line method, (2) production method, (3) double-declining balance
method, and (4) sum-of-years-digits method.
After the determination of periodic depreciation, the amount of depreciation

expense should be recorded each fiscal period by debiting the depreciation
expense and crediting a contra asset account called Accumulated Depreciation.
The use of this contra asset account permits the original cost to remain
unchanged in the plant asset account.
Sometimes each of the four depreciation methods may not be appropriated

because the assets involved have unique characteristics or the nature of the
311
industry requires that a special depreciation method be used. Of these methods,
the group and composite methods are often used by business enterprises.
When a plant asset is acquired, deprecation rates area carefully determined

based on past experience with similar assets and other relevant information,
however, it may be necessary to revise the estimated economic life and that of
salvage value during the life of the asset. Unexpected physical deterioration or
unforeseen obsolescence may make the useful life of the asset less than
originally estimated. Good maintenance procedures, revision of operating
procedures, or similar improvements may prolong the life of the asset beyond
the originals estimate.
After plant assets are acquired and ready for use, additional costs are incurred
that range from ordinary repairs to significant additions. The major problem is
allocating these costs to the proper time periods. These costs are divided into
two major categories: capital, and revenue expenditures.
Capital expenditures are expenditures that improves the operating capacity (or
efficiency) or expenditure that increases the useful life of the asset beyond the
original estimate. The most common capital expenditures are (1) additions, (2)
betterments, and (3) extraordinary repairs.
Revenue expenditures, on the other hand, are expenditures incurred in order to

maintain the normal operating efficiency of the asset. The most usual kinds of
revenue expenditures for a plant asset are the repairs, maintenance, lubrication,
cleaning, and inspection necessary to keep an asset in good working condition.
Such expenditures benefits only the current period and therefore must be
charged against the revenue in the current fiscal period.
312

1. The justification for using the production method is that, it assumes that
depreciation is a function of use or productivity instead of the passage of
time. Moreover, under the production method there is a direct relation
between the amounts of depreciation each year and the units of output or use.
1. There is an easy means of computing the denominate of the fraction.

It is: n(n + 1) = 25 (25 + 1) = 325
2 2

(1) Where loss of services is a result of activity or productivity, the production
method will be best match costs and revenues. And, when the units of output or
use that is used to measure estimated useful life for each asset is reasonably
determined.
(2) The major limitation (or drawback) of the production method is that it is not
appropriate in situations in which depreciation is a function of time instead of
activity. For example a building is subject to a great deal of steady deterioration
from the elements (time) regardless of its use. Another drawback in using the
production method is that an estimate of units of output or service hours
received is often difficult to determine.
313
1. Annual deprecation = original cost - salvage value
Estimated life
Since the asset had been placed in service after two months had been elapsed,
only depreciation for 10 months will be recognized.
Therefore, 10 x 300 = Br. 250.00

2
Depreciation Expense……….. 250.00
Accumulated Depreciation……250.00
1. Ordinary repairs: are expenditures made to maintain plant assets in normal

operating condition, they are charged to an expense account in the period in
which they are incurred on the basis that is benefits on one accounting
period. Ordinary repairs affect the expenses of one accounting period only.
Extra ordinary repairs - on the other hand, are repairs of a more significant
nature. They affect the estimated residual value or estimated useful life of the
asset. Extraordinary repairs increase the life of the asset beyond the original
estimate. Hence, it benefits the operating activity of the business for several
years. Extraordinary repairs should be debited to the Accumulated Depreciation
account instead of debiting to an expense account.
TYPE A: Answer the following questions:

1. Explain the meaning of deprecation
2. Describe in detail the major characteristics of plant (fixed) assets.
3. Briefly describe the factors that affect the computation of depreciation.
314
4. Distinguish between an addition to plant assets and a betterment.
5. What accounting treatment is normally given to the following items in
accounting for plant assets?
a) Additions
b) Extraordinary (major) repairs.
c) Betterments.
TYPE B: For each of the following questions choose the best answer from
the given
alternatives.
1. Which of the following statements best describe the purpose of accounting
fo r
depreciation?
A) Depreciation is an attempt to measure the decrease in market value
of an asset during a period of time.
B) Depreciation is the allocation of the cost of a natural resource over
its useful life as it is used up.
C) Depreciation is the allocation of an equal amount of cost of a
tangible asset to each year of its economic life.
D) Depreciation is the allocation of the cost of a tangible asset over its
useful life.
E) None of the above
1. Which of the following expenditures incurred in connection with the

acquisition of equipment is not a proper charge to the asset account?
A) Freight or transportation costs.
B) Cost of test runs to ready the machine for operation
315
C) Taxes and tariffs
D) Cost of vandalism
E) B and D
2. If the Double-declining depreciations rate of a plant asset is 50%, then its

estimated life will be:
A) 50 years. B) 10 years C) 5 years D) 4 years E) None of
the above
3. Which of the following methods will yield the highest deprecation

expense during the first year of an asset‟s life?
A) Straight line method
B) Sum-of-years-digits method
C) Double-declining balance method
D) All of the above
4. If the adjusting entry to record depreciation expense was overlooked,

then:
A) Total assets will be understated
B) Liabilities would be overstated
C) Owner‟s capital would be overstated
D) Net income would be overstated
E) C and D
TYPE C: Work out the following questions:
On October 5, 2001, NOON C. acquired a new machine at a cost of Birr

250,000. the machine has a useful life of 5 years and scrape value of Br. 10,000.
316
it is estimated that the equipment will produce 2,000,000 units of products
throughout its life. The equipment produced 95,000 units and 300,000 units of
products during the fiscal periods ending December 31, 2001 and December
31,2001 respectively. On the basis of the above date, compute deprecation
expense to be recorded on Dec. 31, 2002.
1) Under the units of production method.

2) Under the declining-balance method.
3) Under the sum-of-years-digits method
4) Under the straight-line method.
4.15 RECOMMENDED (REFERENCE) BOOKS
1. Fees and Warren : Principles of Accounting,

16th
Edition.
2. Horngren, Sundem, and Elliot. : Introduction to Financial
Accounting,
8 th Edition. Pearson
Educational Inc.
New Delhi, 2002
3. Roger H. Hermanson, :
Jems D, Edwards and : Accounting principles 4th
Edition,
R.F Salmonson (1989) IRWIN Inc.
4.16 GLOSSARY
317
1. Accumulated Depreciation: The cumulative sum of all depreciation
recognized since the date of acquisition of the particular assets.
2. Book Value, (net book value): The balance of an account shown on the
book, net of any contra accounts. For example the book value of
equipment is its acquisition cost minus accumulated depreciation.
3. Capitalized: A cost that is added to an asset account, as distinguished
from being expensed immediately.
4. Contra account: A separate but related account that offsets or is a
deduction from a companion account. An example is accumulated
depreciation.
5. Depreciable Value: The amount of the acquisition cost to be allocated as
depreciation over the total useful life of an asset. It is the difference
between the total acquisition cost and the predicted residual value.
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UNIT 5. DISPOSAL OF PLANT ASSETS
Contents
5.1 Introduction
5.2 Disposal of Plant Assets
5.2.1 Recording Discarding of a plant asset
5.2.2 Recording The Sale of Plant Assets
5.2.3 Recording Exchanges of Plant Assets
Accounting for Intangible Assets and Natural Resources
Summary
Answer to Check Your Progress
Model Examination Questions
Reference Books
Glossary
This unit aims at discussing the meaning of disposing of plant assets, the
different ways of disposing plant assets, and the accounting procedures involved
in recording transactions relating to the discarding sale and exchange of plant or
(fixed) assets.
After going through this unit, you will be able to;

- understand the concept of disposing of plant assets.
- examine the different ways of disposing of plant assets.
- analyze and record the transactions involving the discarding,
sale, and exchange of plant assets.
319
- differentiate accounting for financial reporting from
accounting for income tax with respect of exchange of plant
assets.
5.1 INTRODUCTION
So far we have seen how to account for property, plant, and equipment assets,
from calculating acquisitions cost to depreciating this cost up to the end of the
asset‟s useful life. Plant assets, such as equipment, delivery trucks, or
machineries cannot be used forever. The assets may wear out or the business
may replace them with newer model. When a plant asset is no longer useful to a
business the asset may be disposed of either through discarding, sale, or traded-
in with similar) or dissimilar) assets. This chapter therefore, is presented this
concept in detail.
5.2 DISPOSALS OF PLANT ASSETS
A plant asset rarely lasts exactly as long as its estimated life. If it lasts longer
than its estimated life, it is not depreciated past the point at which its carrying
value equals its residual value. The purpose of depreciation is to spread the
depreciable cost of the asset over the economic life of the asset. Thus, the total
accumulated depreciation should never exceed the total depreciable cost. If the
asset is still used in the business beyond the end of its estimated life, its cost and
accumulated depreciation remain in the ledger accounts. Proper records will thus
be available for maintaining control over plant assets. If the residual value is
zero, the book value of a fully depreciated asset is zero until the asset is disposed
off. If such an asset is discarded, no gain or loss results. A plant asset may be
disposed by:
320
(1) Discarding it as worthless; (2) Selling it; or (3) Trading it in on a new asset
5.2.1 Recording Discarding of a Plant Asset
If a plant asset is of no further use to the business and cannot be sold or traded,
then the plant asset is discarded. If the asset has no book value. (i.e., if it is fully
depreciated), the plant asset account is credited for the amount of the original
cost of the item being discarded. At the same time, the accumulated depreciation
account is debited for the amount of the total accumulated depreciation of the
item being discarded. In this case neither gain nor loss is realized. On the other
hand, if a plant asset has a book value (if not fully depreciated) at the time it is
discarded, the business incurs a loss.
Illustration - 1
Suppose for example, on July 5, year 5, equipment that was acquired On Jan 10,
year 1, at a cost of Br. 11,000, is discarded as worthless. The discarded
equipment has a carrying value of Br. 2000 at the time of disposal. The carrying
value is computed as the difference between the cost of asset Br. 11,000 and
accumulated deprecation, Br. 9000. A loss equal to the carrying value should be
recorded when the equipment is discarded.
Solution:
The journal entry required to discard the plant asset as of July 5, year 5, is:
Year 5
July 5. Accumulated Deprecation, Equipment …………9000.00
Loss on disposal of plant Asset…………………2000.00
Equipment ……………………………….11000.00
Discarding Equipment no longer used in the business.
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5.2.2 Recording the Sale of Plant Asset
The entry to record the sale of an asset for cash is similar to the one illustrated
above except that the receipt of cash should also be recorded. The following
entries show how to record the sale of equipment under three assumptions about
the selling price. In the first case, the Br. 2000 cash received is exactly equal to
the book value of the equipment (which is equal to Br. 2000).
Case 1. Sold at an amount equal to Book value, Br. 2000, no gain or loss results.
Year 5
July 5. Cash ……………………………………2000.00
Accumulated Depreciation, Equip……...9000.00
Equipment
………………………………..11000.00
Sale of equipment at an amount equal to
book value
Case 2. Sold at Br. 1500 cash; Loss of Br. 500, (BV = Br. 2000)
Year 5
July 5. Loss on sale of equipment………………….500.00
Accumulated Depreciation……………………… 9000.00
Cash ……………………………………………….1500.00
Equipment…………………………………11000.00
Sale of equipment at less than the book value. Loss of Br.
500
Case 3. Sold at Br. 3000 cash; gain of Br. 1000, cash received through
Sale less book value of the asset (Br. 3000 – Br. 2000)
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Year 5
July 5.
Cash ……………………………………….3000.00
Accumulated Depr, Equipment……………9000.00
Equipment……………………………………………..11000.00
Gain on sale of plant asset……………………………...1000.00
Sale of equipment at more than the book value; gain of Br.
1000,
(Br. 3000 – Br.2000) recorded
5.2.3 Recording Exchange of Plant Assets
Businesses also dispose of plant assets by trading them in on the purchase of

other plant assets. Exchanges may involve similar assets, such as an old machine
traded-in on a newer model, or dissimilar assets, such as a machine traded-in on
a truck. In either case, the purchase price is reduced by the amount of the trade-
in allowance.
The basic accounting for exchanges of plant assets is similar to accounting for
sales of plant assets for cash. If the trade-in allowance received is greater than
the carrying value of the assets surrendered, there has been a gain. If the trade-in
allowance is less than the carrying value, there has been a loss.
There are special rules for recognizing these gains and losses, depending on the
nature of the assets exchanged.
Exchange Losses Gains
Recognized Recognized
For Financial Reporting Purposes:
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 Of similar assets…………………………
Yes……………………………….No
 Of Dissimilar assets………………………..
Yes…………………………….. Yes
For Income Tax purposes:
 Of similar assets……………………………
No………………………….. No
 Of dissimilar assets………………………… Yes………………………
Yes
Both Gains and Losses are recognized when a company exchanges dissimilar
assets. Assets are dissimilar when they perform different functions; assets are
similar when they perform the same function.
For financials reporting purposes, gains on exchanges of similar assets are not
recognized because the earning lives of the asset surrendered are not considered
to be completed.
When a company trades-in an older machine on a newer machine of the same

type, the economic substance of the transaction is the same as that of a major
renovation and upgrading of the older machine.
Accounting for exchange of similar assets is complicated by the fact that neither
gains nor losses are recognized for income tax purposes.
Loss Recognized on the Exchange
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A loss is recognized for financial reporting purposes on all exchange in which a
material loss occurs.
Illustration-2
To illustrate the recognition of a loss, assume that the business exchange a

machine with a cost of Br. 11,000, and accumulated depreciation of Br. 9000 for
a newer more modern machine on the following terms:
Cost of new machine ………………………Birr 12000.

Trade-in Allowance for old machine……………(1500)
Cash payment required (Boot)……………..Birr 10500.
Solution
In the illustration above, the trade-in allowance (1500) is less than the carrying
value (Br. 2000) of the old machine. The loss on the exchange is Br. 500, (Br.
2000 – Br. 1500). Therefore, the journal entry required to record the exchange of
assets would be as follows:
Year 5.
July 5. Equipment (New)……………………..120,00.00
Accum. Depreciation-Equip…………………...9,000.00
Loss on Exchange of plant assets………………. 500.00
Equipment (old)……………………………………11,000.00
Cash…………………………….…………………. 10,500.00
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1. What is the justification for the non-recognition of gains? That results from
the exchange of similar assets?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
Loss Not Recognized on the Exchange
In the previous illustration, in which a loss was recognized, the new asset was
recorded at the purchase price of Br. 12000 and a loss of Br. 500 was
recognized. If the transaction is for similar assets and is to be recorded for
income tax purpose, the loss should not be recognized. In this case, the cost
basis of the new asset will reflect the effect of the unrecorded loss. The cost
basis for the new asset, therefore, is computed by adding the cash payment to the
carrying value of the old asset:
Carrying (Book) value of old Equipment……………………..Birr

2,000.00
Cash paid (Boot given)…………………………………………
10,500.00
Cost-basis of new Equipment ……………………………… Birr
12,500.00
Note that no loss is recognized in the entry to record this transaction.

Year 5.
July 5. Equipment (New)……………………………….12,500.00
Accumulated Depreciation……………………… 9,000.00
Equipment (old)……………………………11,000.00
Cash……………………………………….. 10,500.00
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To record exchange of Equipments - cost of old
Equipments
and its related Accumulated Depreciation removed
from the
accounts; new equipment recorded at amount equal to
book
value of old equipment plus boot given.
NB. The new equipment is recorded (reported) at a purchase price of Br. 12000
plus the unrecognized loss of Br. 500. the post postponement of the loss. Since
depreciation of the new equipment will be computed based on a cost of Br.
12500 instead of Br. 12000, the “unrecognized” loss results in more depreciation
each year on a new equipment than the loss had been recognized.
Gain Recognized on the Exchange
Gains on exchanges are recognized for financial reporting purposes when

dissimilar assets are exchanged. To illustrate the recognition of a gain, assume
the following terms in which the machines being exchanged serve different
functions:
Price of new machine………………………………Birr 12,000.00

Trade-in Allowance for old machine………………….(3000)
Cash payment required (Boot given)……………….Birr 9,000.00
Here the trade-in allowance (Br. 3000) exceeds the carrying value (Br. 2000) of
the old machine by Br. 1000. thus, there is a gain on the exchange, if the trade-in
allowance represents the fair mark value of the old machine. Assuming that this
condition is true, the entry to record the transaction is as follows:
Years 5
July 5. Equipment (New)……………………………12,000
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Accumulated Depreciation…………………….9,000
Equipment (old)………………………….11,000
Cash ……………………………………… 9,000
Gain on exchange of Equip………………..1,000
To record the exchange of Equipments to
remove
cost of old equipment and the related
accumulated
depreciation, new equipment recorded at cost
price;
gain recognized.
Gain Not Recognized on the Exchange:

A gain on an exchange should not be recognized in the accounting records if the
assets perform similar functions. The cost basis for the new equipment must
indicate the effect of the unrecorded gain. This cost basis is computed by adding
the cash payment to the carrying value of the old asset:
Carrying value of old equipment …………………………..Birr 2,000.00
Cash paid (Boot Given)………………………………………… 9,000.00
Cost basis of new Equipment……………………………. Birr 11,000.00
The entry to record the transaction is as follows:
YEAR 5
July 5. Equipment (New)……………………………..11,000.00
Accumulated Depreciation…………………… 9,000.00
Equipment (old)…………………………………..11,000.00
Cash…………………………………………………9,000.00
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To record exchange of Equipment to remove the cost of old
equipment and the related accum. depr. of old assets; new
equipment recorded at a cost equal to BV of old asset plus
cash paid.
As with the no recognition of losses, the no recognition of the gain on exchanges

is, in effect, a postponement of the gain. Since depreciation will be computed on
the cost basis of Br. 11,000, the “unrecognized” gain is reflected in less
deprecation each year on new equipment than if the gain had been recognized.
Illustrative Problem:
ABC Corporation acquired machine X for Br. 84,000 on January 10.1999.

Machine X had an estimated useful life of six years with no salvaged value. The
machine was depreciated on the basis of Sum-of-the-years-digits‟ method. On
May 5, 2002, machine X was exchanged for another similar machine Y. The
new machine had a cash price of Br. 95,000. In addition to Machine X, cash of
Br. 25,000 and three notes for Br. 45,000 was given up in the exchange.
Machine Y has an estimated useful life of seven years and salvage value of Br.
1000. Machine Y is to be depreciated using the straight-line method. The
corporation had the experience of recording the exchange for financial reporting
purposes.
Required: With reference to the above information:

1. Compute the cost-basis for Machine Y in line with corporation
experience.
2. Pass the journal entry made by ABC Corporation to record the exchange
of the machine.
3. Compute the depreciation expense to be made on Machine Y for 2002
fiscal year ending Dec. 31 for financial reporting purpose.
4. Compute the cost-basis of Machine Y for income tax regulation.
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5. Pass the journal entry to record the exchange for purposes of income tax
regulation.
Solution to Illustrative Problem:

1. Depreciation for the year 1999, on Machine X is:
n(n + 1) = 6(6 + 1) = 21
2 2
6 X 84,000 = …………………………………………24,000.00
21
 Depreciation for 2000, 5/2 X 84,000……………………………….

20,000.00
 Depreciation for 2001, 4/21 X 84,000…………………………….
16,000.00
 Depreciation for 2002 (for four months only) 3/12 X 84,000 X 4/12 .
4,000.00
 Total Accumulated Depreciation as of May 5, 2002, Br.
64,000.00
Old Equipment Traded-In (Machine X)

Cost…………………………………………………………Birr 84,000
Accumulated Depreciation, May 5, 2002………………………..64,000
Book Value………………………………………………… Birr 20,000
New Equipment Traded-In (Machine Y)

Purchase (List) price…………………………………….Birr
95,000
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 Trade-in Allowance on old
Machine…………………………25,000
Boot Given (cash + Notes)……………………………… Br
70,000
Therefore, the cost-basis of Machine Y can be obtained by adding the Book

Value and the amount of Boot given which is ; Br. 20,000 + 70,000 = Br.
90,000. There is unrecognized gain on the exchange.
(2) 2002
May 5. Machine Y…………………………………..90,000.00
Accumulated Depreciation ………………….64,000.00
Machine
X……………………………………………...84,000.00
Cash…………………………………………………….25,000.00
Notes
payable…………………………………………..45,000.00
3. Depreciation Expense on Machine Y for year ending Dec. 31,2002 by the

straight line method is:
Ann. Depr. = Br. 90,000.00 – Br. 1000.00 = Br. 12714.29, since the Machine
is employed in
7 Years
service after four months had been elapsed, the depreciation for 8 months, (May
through
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Dec. 31) would be:
Br. 12714.29 X 8/12 = Br. 8476.20
4. The cost-basis for Machine Y for income tax regulation is:

Since gains and losses resulting from the exchange of similar assets are not
recognized for income tax purposes, the cost basis of the Machine is the same
that is Br. 90,000.
5. Journal entry to record the exchange of machine Y for purposes of income tax
regulation would be:
2002
May 5. Machine Y………………………………………………90,000
Accumulated Depreciation, Machine X…………………64,000
Machine X…………………………………………. 84,000
Cash …………………………………………………25,000
Notes Payable……………………………. …………45,000
5.3 ACCOUNTING FOR INTANGIBLE ASSETS AND NATURAL

RESOURCES
Intangible Assets: are long-term assets that do not have physical substance and
in most cases relate to legal rights or advantages held.
Intangible assets include patents, copyrights, trademarks, franchises,
organization costs, leaseholds, leasehold improvements, and goodwill. The
allocation of intangible assets to the periods they benefits is called amortization.
Intangible assets are accounted for at acquisition cost, that is, the amount paid
for them. Some intangible assets such as goodwill and trademarks may be
acquired at little or no cost. Even though they may have great value and be
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needed for profitable operations they should not appear on the balance sheet
unless they have been purchased from another party at a price established in the
market place.
The, Accounting Principles Board (APB) has decided that a company should
record as assets the costs of Intangible assets acquired from others. However, the
company should record as expenses the cost of developing intangible assets.
Also, intangible assets that have a determinable useful life such as patents,
copyrights, and leaseholds, should be written off through periodic amortization
over that useful life in much the same way that plant assets are depreciated.
Even though some intangible assets, such as goodwill and trademarks, have no
measurable limit on their lives, they should also be amortized over a reasonable
length of time (not to exceed forty years).
Illustration - 3
Assume that on Jan 2,2002 MOHA Soft Drink Bottling company purchased a
patent on a unique bottle cap for Br. 54,000.
The entry to record the patent would be as follows:
2002
Jan 2. Patent……………………………..54,000
Cash……………………………………..54,000
To record the purchase of Bottle cap patent
Assume that MOHA‟s management determines that, although the patent for the
bottle cap will last for seventeen years, the product using the cap will be sold
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only for the next six years. The entry to record the annual amortization would be
as follows:
Amortization Expense………………………..9,000.00
Patent……………………………………………9,000.00
To record annual amortization of patent (Br. 54000/ 6 years)
Note that the patent account is reduced directly by the amount of the
amortization expense. This is in contrast to other long-term asset accounts in
which depreciation or depletion is accumulated in a separate contra account.
If the patent becomes worthless before it is fully amortized, the remaining

carrying value is written off as a loss. For instance, assume that after the first
two years MOHA soft Drink Bottling Company‟s chief competitor‟s offers a
bottle with a new type of cap that makes MOHA‟s cap obsolete. The entry to
record the loss is:
Loss on patent……………………………36,000.00
Patent……………………………………36,000.00
To record the loss resulting from patents becoming
worthless.
Depletion of Natural Resources
We now turn our attention to another group of long-lived assets natural

resources, such as minerals, oil, and timber or lumber. These natural resources
are extracted from the earth.
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Depletion is the accounting measure used to allocate the acquisition cost of
natural resources. Depletion differs from depreciation because depletion focuses
specifically on the physical use and exhaustion of the natural resources, while
depreciation focuses more broadly on any reduction of the economic value of a
plant or fixed asset. The costs of natural resources are usually classified as long-
terms assets.
Depletion expense is the measure of that portion of long-term assets that is used
up in a particular period.
Illustration - 4
Suppose for example, MIDROC Construction has acquired the right to use
10,000 acres of land in Kibre-Mengist territory to mine for gold at a total cost
of, Br. 10,000.000. The Company estimated that the mine will; provide
approximately 500,000 grams of gold. The depletion rate established is
computed in the following manner.
Total cost – Salvage value = Depletion cost per unit.
Total estimated units available
Br. 10,000,000 = Br. 20 per gram

500,000 units
If 100,000 grams are extracted in the first year, then the depletion for the year is
2000.000 (1000,000 x Br. 20.00). The entry to record the depletion is therefore:
Depletion Expense…………………..2,000,000
Accumulated Depletion……………………….2,000,000
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1. Distinguish between amortization and depletion.
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
5.4. SUMMARY
Plant assets, such aw equipments, trucks, or machineries, cannot be used

forever. The assets may wear out or the business may replace them with newer
models. When a fixed asset is no longer useful to a business, the asset may be
disposed of by: (1) discarding it as worthless; (2) selling it: or (3) trading it in on
a new asset.
If a plant asset is of no further use to the business and cannot be sold or traded,
then the plant asset is discarded. If the asset is fully depreciated, no loss or gain
is recognized. Otherwise, if the asset is not fully depreciated at the time of
disposal, the business incurs a loss.
Another means of disposing of a plant asset is sale of plant asset. While selling
plant assets, if the selling price exceeds the book (carrying) value of the asset,
there is a gain, and the gain should be reported in the income statement for the
period under other income section because it results from no operating activities.
On the other hand, if the cash received through sales of plant asset is less than
the book (carrying) value of the asset sold, there is a loss, and this loss is
reported among the other expense section on the income statement. If the
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amount of cash received through sale of a plant assert is exactly equal to the
book value of the asset, neither gain nor loss is realized.
Business also dispose of plant assets by trading them in on the purchase of other
plant assets- Exchanges may involve similar assets that serves the same
function, or it may involve dissimilar assets that serve different functions.
The basic accounting for exchanges of plant assets is similar to accounting for
sales of plant assets for cash. If the trade-in allowance received on old asset is
greater than the carrying (book) value of the asset surrendered, there has been a
gain. In contrast, if the trade-in allowance is less than the carrying (book) value,
there has been a loss.
There are special rules for recognizing these gains and losses, depending on the
nature of the assets exchanged.
If the assets exchanged are dissimilar (perform different functions), both gains
and loses are recognized. If the assets exchanged are similar (perform the same
function), loss on exchanges is recognized, but if the exchange results in a gain,
the gain should not be recognized for financial reporting purposes.
For income tax purposes, neither gain nor loss is recognized from the exchange
of similar assets. However, income tax law allows the recognition of both gains
and losses from the exchange of dissimilar assets.
The chapter also discussed accounting for intangible assets and natural
resources. Intangible assets are long-term assets without a physical substance,
and inmost cases related to legal rights or advantages held. Intangible assets
include patents, copyrights, trademarks, franchising, organization costs,
337
leaseholds, leasehold improvements, and goodwill. The cost allocation of
intangible assets to the periods they benefit is called amortization.
Natural resources are another group of long-term assets that are extracted from
the earth such as minerals, oils, (or petroleum), and timber (or lumber). The
periodic cost allocation of these natural resources is referred to as depletion.
Unlike plant assets, natural resources are consumed physically over the period of
use and do not maintain their physical characteristics.

1. Gains on exchanges of similar assets are not recognized for financial
reporting purposes because the earning lives of the asset surrendered are
not considered to be completed.

1. Amortization is the periodic cost allocation of intangible assets to the
periods that benefit from the assets.
Whereas, depletion is the process of allocating the cost of natural resources

tot he periods in which the resources are used.
TYPE A – Answer the Following Questions:

1. Explain the accounting procedures for discarding of plant assets.
2. Explain the entries required in selling a plant asset for cash.
338
3. Distinguish between amortization and depletion.
4. What is meant by Intangible Asset?
TYPE B – Choose the best answer for the following questions:

1. If plant asset is retired before it is fully depreciated, and no salvage value
or scrap value is received.
A) a gain on disposal will be recorded
B) Loss on disposal will be recorded
C) Neither gain nor loss on disposal will be recorded
D) All of the above.
2. One of the following is not an example of intangible assets.

A) patents B) Franchise C) Trademarks
D) Organization cost E) None
3. A plant asset priced at Br. 100,000 is acquired by trade-in a similar asset

that has a book value of Br. 25,000. Assuming that the trade-in allowance
is Br. 30,000 and that Br. 70,000 cash is paid for the new asset. What is
the cost basis for the new assets for financial reporting purpose?
A) Br. 100,000 B) Br. 70,000 C) Br. 30,000
D) Br. 125,000 E) Non
4. Good will in the amount of Br. 60,000 was purchased on January 15, the
first month of the fiscal year. It is decided to amortize over the maximum
period allowable. The current amortization expense would be:
A) Br. 5000 C) Br. 1,500
B) Br. 6000 D) Br. 10,000 E) None
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TYPE C- Work out the following problem:
1. Sold a truck for Br. 950.00. The truck had been purchased two years ago
on January 2 for Br. 2300.00.The amount of depreciation is Br. 400.00 a
year. Accumulated depreciation for that amount was recorded at the end
of the two previous years.
A) Record the depreciation for the current year to June 30.
B) Record the sale of the truck.
2. Discarded office equipments for which there was no further use and
which could not be sold. The office equipment cost Br. 160.00 and had a
book value of Br. 20.00 at the time was discarded.
5.7 RECOMMENDED (REFERENCE) BOOKS
1. Fees and Warren : Principles of Accounting, 16 Edition

2. Horngren, Sundem : Introduction to Financial Accounting and
Elliot 8th Edition, (2002) Parson
Education Inc.
3. Roger H. Hermanson, : Accounting Principles, 4th Edition ,1989,
Jems D, Edwards and: IRWIN Inc.
4. R.F. Salmonson : Principles of Accounting , 14th Edition.
5. Kieso and Weygandt : Intermediate Accounting, 9th Edition,
(998) John Wiley & sons ,Inc.
5.8 GLOSSARY
1. Amortization: When referring to long-lived assets, it usually means the

allocation of the costs of intangible assets to the periods that
benefits from these intangible assets.
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2. APB Opinions: A series of thirty-one opinions of the accounting principles
Board, many of which are still the “accounting law of the land.”
3. Depletion: The process of allocating the cost of natural resources to the

periods in which the resources are used.
4. Franchises (Licenses): Privileges granted by a government, manufacturer, or

distributor to sell a product or service in accordance with
specified conditions.
5. Goodwill: The excess of the cost of an acquired company over the sum of the
fair market value of its identifiable individual assets less the liability.
6. Leasehold: The right to use a fixed asset for a specified period of time,
typically beyond one year.
7. Leasehold Improvement: Investments by a lessee in items that are not

permitted to be removed from the premises when a
lease expires, such as installation of new fixtures,
panels, walls and air-condition equipment.
8. Patents: Granted by the federal government to an invent bestowing (in the

united states) the exclusive right for 17 years to produce and sell the in
invention.
9. Trademarks: Distinctive identification of a manufactured product or of a

service taking the form of a name, a sign, a slogan, a logo, or an
emblem.
341
342
UNIT 6. ACCOUNTING SYSTEMS FOR PAYROLL AND PAYROLL
TAXES
Contents

6.1 Introduction
6.2 Importance of Payroll Accounting
6.3 Definitions of Payroll Related Terms
6.4 Possible Components of A Payroll Register
6.5 Major Activities Involved In Accounting For Payroll
6.6 Illustration Of A Payroll Register
6.7 Summary
6.8 Answer to Check Your Progress Questions
6.10 Glossary
This unit aims at discussing the accounting for payroll and payroll tax liabilities.
The techniques and procedures used in computing personal income tax, pension
contributions, and other deductions are discussed in detail. Also, the journal
entries and other records necessary in accounting for payroll will be explained
and illustrated based on examples. After reading and covered this unit you
would be able to:
 understand the importance of payroll accounting

 define payroll related terms
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 describe the components of a payroll register
 calculate income taxes, pension contribution and other deductions and net
p ay
 record journal entries related to payroll and payroll taxes
 prepare a payroll register
6.1 INTRODUCTION
In the previous chapter you have discussed the basic accounting principles and
practices that are useful in accounting for the acquisition, use, and disposal of
plant assets, as well as the accounting for intangible assets and natural
resources have also been discussed briefly.
In this chapter you will be acquainted with the basics of accounting for payroll
and payroll taxes. Accounting systems for payroll and payroll taxes are
concerned with the records and reports associated with the employer-employee
relationship. It is important that the accounting system provide safeguard to
ensure that payments are in accord with management‟s general plans and its
specific authorizations.
All employees of an organization expect and are entitled to receive their

remuneration at regular intervals following the close of each payroll period.
Regardless of the number of employees and the difficulties in computing the
344
amounts to be paid, the payroll system must be designed to process the
necessary data quickly and assure payment of the correct amount to each
employee.
The system must also provide adequate safeguards against unauthorized

payments to employees and other misappropriations of funds.
Various federal, state, and local laws requires employers to keep accurate
payroll records and to prepare reports and submit to the appropriate
governmental units. The law also require employers t remit the amounts
withheld from its employees and for taxes imposed on itself. These records must
be kept for specified periods of time and be available for inspection by those
responsible for enforcement of the laws. Besides, payroll data may be useful in
negotiations with labor unions, in settling employee grievances, and in
determining rights to vacations, sick leaves, and retirement pensions.
Here, in this chapter, you are going to learn intensely and worked through the
major concepts that are common to most payroll systems such as the employee‟s
earnings record, payroll sheet (or register), and journal entries related to payroll.
Each of these concepts is illustrated and discussed by taking into account the
current tax law of the country. As much as possible the chapter attempts to give
you adequate knowledge about payroll systems in Ethiopia, however, if you
come across any confusion or difficulties you can consult the authorities in the
Ministry of Finance or Inland Revenue Administration in your locality, or refer
the various proclamations especially; Proclamation No. 286 / 2002, the council
of ministers regulation No. 78 / 2002. And Article 33 or proclamation No. 64 /
1975
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6. 2 IMPORTANCE OF PAYROLL ACCOUNTING
Accounting for payroll is particularly important because:

1- Payroll often represents the largest expense that a company incurs.
2- Both federal and state governments require that detailed payroll records
be kept and
3- Employees are sensitive to payroll errors or irregularities. To maintain
good employee morale payroll must be paid on a timely and accurate
basis.
6. 3 DEFINITION OF PAYROLL RELATED TERMS
1. Salary and Wages: Salary and wages are usually used interchangeably.
However, the term wages is more correctly used to refer to payments to
unskilled-manual labor. It is usually paid based on the number of hours worked
or the number of units produced. Therefore, wages are usually paid when a
particular piece of work is completed or weekly.
On the other hand, salaries refers to payments to employees who render

managerial, administrative or similar services, and they are usually paid to
skilled labor on a monthly or yearly basis.
Both wages and salaries related to an „employee‟ is an individual who works

primarily to one organization and whose activities are under the direct
supervision of employer.
A self-employed person on the other hand works (gives her services) on a fee
basis to various firms.
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2. The Pay Period: A pay period refers to the length of time covered by each
payroll payment.
3 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.
4. A Payroll Register (sheet): is the list of employees of a business along with

each employee‟s gross earnings; deductions and net pay (take home pay) for a
particular pay period. The payroll register (sheet) is prepared based on
attendance sheets, punched (clock) cards or time cards.
5. Pay Check: A business can pay payroll by writing a check for the amount of
the net pay. A check is prepared in the name of each employee and handed to
employees. Alternatively a check for the total net pay can be prepared for
employees to the paid by cash at the organization.
6. Gross Earnings: are taxes collected from the earnings of employees by t he

employer organization as per the regulations of the government. These have to
be submitted (paid) to the government because3d employer organization is only
acting as an agent of the government in collecting these taxes from employees.
7. Payroll Deductions: are deductions from the gross earnings of an employee

such as employment income taxes (with holding taxes), labor union dues, fines,
credit association pays etc.
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8. Net Pay: Net Pay is the earning of an employee after all deductions have been
deducted. This is the take home pay amount collected by an employee on the
payday.
6.4 POSSIBLE COMPONENTS OF A PAYROLL REGISTER
1 Employee Number
Number assigned to employees for identification purpose when a relatively large
number of employees are involved in a payroll register.
2 Name of Employees
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 employee is
promoted.
b. Allowances- money paid monthly to an employee for special reasons,
like:
- Position allowance- a monthly paid to an employee of earning a
particular office responsibility.
- Housing allowance- a monthly allowance given to cover housing
costs of the individual employee when the employment contract
requires the employer to provide housing but the employer fails to do
so.
- Hardship allowance- a sum of money given to an employee to
compensate for an inconvenient circumstance caused by the
348
employer. For instance, unexpected transfer to aw different and
distant work area or location.
- Desert allowance- a monthly allowance given to an employee
because of assignment to a relatively hot region.
- Transportation (fuel) allowance- a monthly allowance to an
employee to cover cost of transportation up to her workplace if the
employer has committed itself to provide transportation service.
C. Overtime Earning: Overtime work is the work performed by an employee

beyond the regular working hours.
Overtime earnings are the amount paid to an employee for overtime work
performed.
Article 33 of proclamation No. 64/1975 discussed the following about how

overtime work should be paid:
A worker shall be entitled to the paid at a rate of

i. one and one-quarter (1 ¼) times his ordinary hourly rate for overtime
work performed before 10:00 P.M in the evening.
ii. One and one half (1 ½) times his ordinary hourly rate for overtime work
performed between 10:00 P.M and six (6:00 A.M) in the morning.
iii. Two times the ordinary hourly rate for overtime work performed on
weekly rest days
iv. two and one half (2 ½ ) times the ordinary hourly rate for overtime work
performed on a public holiday.
349
All in all, the gross earnings of an employee may include the basic salary,
allowance and overtime earnings.

1. What term is frequently used to refer to the total amount paid to employees
for a certain period?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………
2. Distinguish between salaries and wages?

…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………
3. An employee earns Br. 50 per hour with one and quarter (1 ¼) times than
regular hourly rate for all hours in excess of 40 per week. If the employee
worked 50 hours during the current week, what was the gross earning for the
week?
…………………………………………………………………………………
…………………………………………………………………………………
…………………………………………………………………………………
………………………………………
4 Deduction: are subtractions made from the earnings of employees required by

the government or permitted by the employee himself.
350
a. Employment Income Tax: Every citizen is required to pay employee tax
to the government in almost all countries. In Ethiopia also, income tax is
charged on the gross earnings of the employee at the rates indicated under
schedule A of the Proclamation N. 286/2002- Income tax proclamation.
The tax rates under schedule A are Presented below:
Employment Income Income

(per month) Tax rate * In computing and
Over Birr To Birr withholding tax, the income

0 150 Exempt (Free t ax proclamation dictates
from Tax)
151 650 10% that income attributable to
651 15% the month of Nehassie and
1400
Pagumen shall be aggregated
1401 20%
2350 (added) and treated as the
2351 25%
income of one month.
3550
3551 30%
5000
Over 5,000 35%
Taxable income includes any payment or gains in cash or I n kind received from
employment by an individual, including income from former employment or
otherwise or from prospective employment.
351
1. What is the total amount deducted as income tax for an employee who earns
a basic montly salary of Br. 1800, a monthly non taxable allowance of Br.
300, and an overtime earning of Br. 400?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
2. Describe (i) Basic (regular) pay, (ii) Overtime pay

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
Short cut to Income Tax Calculation

Employment Income Income
(per month) Tax Payable
Over Birr To Birr
0 150 No tax
151 650 (10% X EI) – 15
651 1 400 (15% X EI) – 47.5
1401 2 350 (20% X EI) – 117.5
2351 3 550 (25% X EI) – 235
3551 5 000 (30% X EI) – 412.5
Over 5,000 (35% X EI) – 662.5
EI = Employment Income or taxable income
352
15 = (150 X 0.1) – 0
47.5 = [(150 X .15) – 0] + [(500 X 0.15) – (500 X 0.1)]and so forth
Proclamation No. 286/2002 states that the following are not taxable.
1- income from employment received by casual employees who are not
regularly employed provided that they do not work for more than one
month for the same employer in any twelve months period.
2- Pension contribution, provident fund and all forms of retirement benefits
contributed by employers in an amount that doesn‟t exceed 15% of the
monthly salary of the employee.
3- Payments made to---- (an employee) as a compensation or gratitude in
relation to:
o personal injuries suffered by that person
o the death of another person
The council of ministers regulation No. 78/2002

Regulations issued pursuant to the income tax proclamation further exempts the
following from income tax.
1- Amounts paid by employers to cover the actual cost of medical treatment

of employees.
2- Allowance in view of means of transportation granted to employees under
contract of employment, i.e., transportation allowance.
3- Hardship allowance
4- Amounts paid by employee in reimbursement of traveling expenses
incurred on duty.
4.b. Pension Contribution
353
Permanent employees a governmental organization in Ethiopia is expected to
pay or contribute 4% of their basic salary to the governments‟ pension trust
fund.
This amount is withheld by the employer from each employee on every payroll
and later be paid to the respective government body.
The employer is also expected to contribute towards this same fund 6% of the
basic salary of every permanent government employee.
Therefore, the total contribution to the pension fund of the Ethiopian

government is equal to 10% of the basic salary of all of its permanent
employees.
That is, 4% comes from the employees and 6% comes from the employer.
This enables a permanent employee of a government organization to be entitled

to the pension pay when retiring provided the employee satisfies the minimum
requirements to enjoy the benefits.
Business and non-governmental not-for profit organization (NGO‟s) also have

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

Apart from the above two kinds of deductions, employees may individually
authorize additional deductions such as deductions to pay life insurance
354
premiums, to repay loan from the employer, to pay for donation to charitable
organization, contributions to "ldir" etc.

1. Identify the federal and state taxes that most employers are required to
withhold from employees?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………..
2. What is the employer share of pension contributions for a government
permanent employee whose regular monthly salary of Br. 2400?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………..
5 Net Pay
Net pay represents the excess of gross earnings over total deductions of an
employee.
Signature
The payroll sheet should have a column for signature of the employee to be
taken when the employee collects the net pay.
6.5 MAJOR ACTIVITIES INVOLVED IN ACCOUNTING FOR

PAYROLL
355
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 the gathered data such as
earnings, deductions and net pays in the appropriate columns of the payroll
register.
3 Totaling and proving the payroll register -the grand total for earnings must be
checked if its 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 personnel (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
(withhold doing tax liability) should be recorded in journal entry form.
8 The withholding tax - must be paid to the relevant government authority in
time (promptly) and this is recorded in journal entry form.

1. How is Net Pay computed?
……………………………………………………………………………………
……………………………………………………………………………………
356
……………………………………………………………………………………
………………………………………
2. Assume an employee's regular hourly pay is Br. 16, with a time and a half for
every hour worked in excess of 48 during a week. The following data are
available:
Hours worked during current month Br. 200
Regular monthly salary Br. 3072
Allowance (transportation) Br. 300
Assume that according to company policy transportation allowance in excess of
Br. 200 is subject to employment income tax.
Based on the above data, compute the amount of the employee's:

i. net pay for the current month;
ii. employment income tax,
iii. total deductions, assuming the employee is permanent civil servant.
6.6 ILLUSTRATION OF A PAYROLL REGISTER
Godanaye is a government agency recently organized 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 Yekatit,
1995.
Serial Name of Employee Basic Transp. Overtime

Duration of
No. __________________ Salary Allowance worked(hr)
OT Work
01 Aregash Shewa Br. 730 200 4 6:00-10:00
P.M
357
02 Paulos Chala 1020 ___ 8
Sunday(8:30-5:30)
03 Mohammed Modesir 5300 ___ ___ ___
04 Tensay Belay 1470 ___ ___ ___
05 Haile Olango 950 ___ 6 Public
Holiday
Additional Information
- The management of the agency usually expects a worker to work 40 hours
in a week and during Yekatit there are four weeks.
- There were no absentees during the month
- All employees are permanent except Tenssay and Haile
- Paulos agreed to contribute monthly Br. 300 from his salary as a monthly
saving in the credit association of the agency.
Required
1. Prepare a payroll register (sheet) for the agency for the month of Yekatit,
1995.
2. Record the payment of salary as of yekatit 30,1995 using check stub No.
0123.
3. Record the payment of the claim of the credit Association of their agency
on Megabit 1, 1995 use check stub No. 0124.
4. Record the payment of the withholding taxes and pension contribution to
the concerned government body on Megabit 7,1995.
5. Compute and recognize the total payroll tax expense for the month of
Yekatit, 1995.
358
Computation of Earnings, Deductions and Net Pay
Gross Earnings = Basic salary + Allowance + Overtime Earning
Overtime Earning
Overtime earning = OT hrs worked X (ordinary hourly rate X relevant OT rate)
1. AREGASH:
 OT Earning = 4 hours X br. 730 X 1.25 = br. 22.81
160 hours
NB Every employee is expected to work 160 hours per month
(i.e. 40 hours x 4 weeks)
 You should compute the regular hourly rate first:
Regular Hourly Rate = Monthly salary (Basic Salary)
Total Hours worked in the Month
= br. 730
160 Hours
 Therefore, the regular Hourly payment = br. 4.56
The regular hourly payment must be multiplied by the appropriate OT rate
as
follows:
br. (4.56 x 1.25) x 4 hours-------------------br. 22.81
2. PAULOS
 OT Earning = 8 hours X br. 1020 x 2 ----------------br. 102.00
160 hours
3. HAILE
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 OT Earnings = 6 hours X br. 950 x 2.5 -------------br. 89.06
160 hours
GROSS EARNINGS
Gross Earnings = Basic salary + Allowance + OT Earnings
1. AGEGASH
 Gross Earnings = br. 730 + br. 200 + br. 22.81 = br. 952 .81
 Remember taxable income in this case is br. 752.81 because the
transportation allowance of br. 200 is not subject to taxation.
2. PAULOS
 Gross Earning = br. 1020 + br. 102 = br. 1122
 The Gross Total Earnings of Paulos consists of the br. 1020 basic
salary plus the overtime earnings of br. 102, which is br. 1122.
3. MOHAMMED
 Gross Total Earnings = br. 5300, which include the basic salary
alone
4. TENSAY
 Gross Total Earnings = br. 1470, which is the basic salary.
5. HAILE
 Gross Total Eanings = br. 950 + 89.06 = br. 1039.06
DEDUCTIONS AND NET PAY
1. AREGASH:
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 Gross Total Earnings-----------------------------------------br. 952.81
 Gross Taxable Income (br. 952.81 – br. 200)-----------------752.81
Employee Income Tax:
Earnings X Income Tax Rate = Income Tax

0 – 150---------150 0 br. 00.00
151 – 650 on 500 10% 50.00
651 – 752.81 on 102.81 15% 15.42
TOTAL br. 752.81-----------------------------------------------br. 65.42
Pension contribution:
Basic salary x 4%
= br. 730 x 0.04-------------------------------------------------29.20
 Total Deduction (br. 65.42 + br. 29.20)-----------------br. 94.62
NB. The income tax to be deducted from the employee could have been
computed by using the short-cut method as follows:
= (Taxable Income x 15%) – br. 47.5
= (br. 752.81 x 0.15) – br. 47.5 = br. 65.42
2. PAULOS:
 Gross Total Earning-----br. 1122.
 Employee Income tax
Earning X Income Tax Rate = Income

Tax
0 – 150 (150) 0 br. 00.00
361
151 – 650 on 500 10% 50.00
651 – 1122 on 472 15% 70.80
TOTAL br.1122---------------------------------------------br. 120.80
 Pension Contribution (br. 1020 x 0.04)---------------------40.80
 Credit Association--------------------------------------------300.00
 Total Deduction---------------------------------------------br. 461.60
3. MOHAMMED:
 Gross Total Earnings------------------------------------br. 5300.00
 Employee Income Tax
Earning X Income Tax Rate = Income

Tax
0 – 150-------150 0 br. 00.00
151 – 650 on 500 10% 50.00
651 – 1400 on 750 15% 112.50
1401 – 2350 on 950 20% 190.00
2351 – 3550 on 1200 25% 300.00
3551 – 5000 on 1450 30% 435.00
Over 5000 on 300 35% 105.00
Total br. 5300.00-----------------------------------------------br. 1192.50
 Pension contribution (br. 5300 x 0.04)---------------------- 212.00
 Total Deductions------------------------------------------br. 1404.50
4. TENSAY:
 Gross Total Earnings------------------------------------br. 1470.00
 Gross Taxable Income--------------------------------------1470.00
362
Earning X Income Tax Rate = Income Tax

0 – 150-----150 0 br. 00.00
151 – 650 on 500 10% 50.00
651 – 1400 on 750 15% 112.50
1401 – 1470 on 70 20% 14.00
Total br. 1470---------------------------------------------------- br. 176.50
NB. No pension contributions because she is not permanent employee of the

organization. Therefore, total deduction is the same as Employee Income Tax,
br. 176.50.
5. HAILE:
 Gross Total Earnings--------------------------------------br. 1039.06
Earnings X Income Tax Rate = Income
Tax
0 – 150----150 0 br. 00.00
151 – 650 on 500 10% 50.00
651 – 1039.66 on 389.06 15% 58.36
Total br. 1039.06----------------------------------------------------br. 108.36
 Pension contribution should not be computed for Haile because he is
not permanent employee of the agency. Thus, the only deduction
from Haile‟s earnings is the employee income tax.
NB. It is also possible to compute income tax by using the short-cut method:
363
Total Income Tax = (Taxable Income x 15%) – 47.5
= (br. 1039.06 x 0.15) – 47.5
= br. 108.36
NET PAY:
Net pay = Gross Total Earnings – Total Deductions
1. AREGASH:
Net pay = br. 952.81 – br. (94.62)
Net pay = br. 858.19
2. PAULOS:
Net pay = br. 1122 – br. (461.60)
3. MOHAMMED:
Net pay = br. 5300 – br. (1404.50)
Net pay = br. 3895.50
4. TENSAY:
Net pay = br. 1470 – br. (176.50)
Net pay = br. 1293.50
5. HAILE:
Net pay = br. 1039.06 – br. 108.36
PROVING THE PAYROLL:
364
Total Earnings:
Basic salary-----------------------------------------------br. 9470.00
Allowances-----------------------------------------------------200.00
Overtime--------------------------------------------------------213.87
Grand Total---------------------------------------br. 9883.87
Deductions:
Employee Income Taxes--------------------------------br. 1663.58
Pension Contributions----------------------------------------282.00
Other Deductions----------------------------------------------300.00 =
Total Deductions------------------------------br. 2245.58
Net Pay Total------------------------------------------------------br. 7638.29
Total Deductions plus Net pay----------------------------------br. 9883.87
The payroll register (or sheet) for Godanaye Rehabilitation Agency prepared for
the Month of Yekatit, 1995 is shown below.
6.7 SUMMARY
The term payroll is used to refer to the total amount paid to employees for a
certain period. Payroll includes amounts paid for salaries to managerial or
administrative employees as well as wages paid for manual labor.
Accounting systems for payroll and payroll taxes are concerned with the records
and reports associated with the employer-employee relationship. It is important
that the accounting system provide safeguards to ensure that payments are
accord with management‟s general plans and its specific authorizations.
Various federal, state, and local laws require employers to keep accurate payroll
records and to prepare reports and submit to the appropriate governmental units.
The law also requires employees and for taxes imposed on itself. These record
365
must be kept for specified periods of time and be available for inspection by
those responsible for enforcement of the laws.
Payroll data may also be useful in negotiations with labor unions, in settling
employee grievances, and in determining rights to vacations , sick leaves, and
retirement pensions.
Salary and wages are usually used interchangeably. However, the term wage is
more correctly used to refer to payments to unskilled manual labor. It is usually
paid based on the number of hours worked or the number of units produced.
Therefore, wages are usually paid when a particular piece of work is completed
or on a weekly basis. On the other hand, salaries refer to payments to employees
who render managerial, administrative, or similar services. Salaries are usually
paid to skilled labor on a monthly or yearly basis.
A payroll register is the list of employees of a business along with each

employee‟s gross earnings, deductions, and net pay (take-home-pay) for a
particular pay period. The payroll register (sheet) is prepared based on
attendance sheets, punched (clock) cards or time cards.
Components of a payroll register include Employee number, Employee name,

Earnings (usually Basic or regular salary, Allowances, and overtime),
Deductions, Net pay, and Signature.
Earnings are money earned by an employee of an organization from various

sources. It may include: (1) the basic salary which is a flat monthly salary of an
employee that is paid for carrying out the normal work or employment, (2)
allowances which represents money paid monthly to an employee for special
366
reasons, which may include: position allowance, housing allowance, hardship
allowance, desert allowance, and transportation (or fuel) allowance, etc, and (3)
overtime earnings – the amount payable to employees for overtime work
performed.
Deductions are subtractions made from the earnings of employees. Deductions

are either required by law or permitted by the employee himself. The principal
deductions in Ethiopia are: Employee Income tax, pension contribution, and
other deductions like deductions to pay life insurance premiums, to repay loans
from the employer, for credit association, to pay for donation to charitable
organization, contribution to „Idir‟, etc.
Net pay or take-home-pay represents the excess of gross earnings over total
deductions of an employee.
The payroll sheet should have a column for signature of the employee to be
taken when the employee collects the net pay. In general, a payroll register
(sheet) should at least show the total earnings of each employee, deductions, and
the net pay together with the names and signatures of employees.
Todanaye
Payroll Register(sheet)
For the month of Yekatit,1995
Ser Name of Earnings Deductions
. Employee Bas Allo Over Gros Inco Pensi Other Total Net Sig
No ic - Time s me on Dedu Dedu Pay n.
. sala wan Earni Tax Contr. c. c.
ry ce ng
367
01 Aregash 730 200 22.8 952.8 65.42 29.2 ___ 94.62 858.1
Shewa 1 1 9
02 Paulos 102 ___ 102 1122 120.8 40.8 300 461.6 660.4
Chala 0
03 Mohammed 530 ___ ___ 5300 1192. 212 ___ 1404. 3895.
Mudesir 0 5 5 5
04 Tensay 147 ___ ___ 1470 176.5 ___ ___ 176.5 1293.
Belay 0 5
05 Haile 950 ___ 89.0 1039. 108.3 ___ ___ 108.3 930.7
Olango 6 06 5 5 1
Totals 947 200 213. 9883. 1663. 282 300 2245. 7638.
0 87 87 57 57 3
Prepared by_______________Checked by________________Approved

by___________
Check Your progress Exercise - 1

1. Payroll
2. (a) Salaries – represent payment for employees who are paid at a monthly or
yearly rate. Salary is usually applied to payment for managerial,
administrative, or similar services.
368
(b) Wages – represent payment for services of employees at an hourly rate or
on a piece work basis. Wage is usually applied payment for a manual
labor.
(c) Gross Earnings = Basic Salary + Overtime earning for the week
Weekly Basic Salary = regular hourly rate x weekly regular working

hours.
= br. 50 x 40 hrs. = br. 2000
 Therefore, weekly regular salary of the employee is br. 2000

 Overtime Earning = Overtime Hours worked x (Regular Hourly
rate x OT rate)
OE = 16 x (br. 50 x 1.25)
OE = 16 x (62.50)
Overtime Earning = br. 1000.
 Thus, total earnings of the week = br. 2000 + Br. 1000 = br. 3000
Check Your progress Exercise – 1
1. Gross total Earnings of the employee = Basic Salary + Allowance +

Overtime earning
Gross total Earnings = br. 1800 + br. 300 + br. 400
Gross Total Earnings = br. 2500
Taxable Income of the employee = br. 2200, which does not include the
allowance of br. 300, because it is non-taxable.
Earnings X Income Tax Rate = Income Tax

0 – 150 150 0 00.00
369
151 – 650 on 500 1 0% 50.00
651 – 1400 on 750 1 5% 112.50
1401 – 2200 on 800 2 0% 160.00
Total br. 2200 322.50
 Total Employee Income Tax is therefore, br. 322.50
(b) (i) Basic (Regular) pay – is a flat monthly salary of an employee

that is paid
for carrying out the normal work of employment and subject to
change
when the employee is promoted.
(ii) Overtime pay – is the amount payable to an employee for
overtime work
d o n e.
Check Your progress Exercise - 3

1. Employee income tax
- employee pension contribution (if any)
2. Pension contribution is the amount of money that each government permanent
employee contributes towards a fund which up on the employees retirement, will
be drawn upon to finance the participant‟s welfare.
 The employer‟s share of pension contribution is 6% of the regular
monthly salary of the permanent civil employee. Thus; 0.06 x br. 2400 =
br. 144.00
Check your progress Exercise - 4
1. Net pay is computed using the following formula:
370
Net pay = Gross total Earnings – Total Deductions
2. Gross Total Earnings = Basic Salary + Allowance + Overtime earning

Gross Total Earning = br. 3072 + br. 300 + (8 hrs x (br. 16 x
1.50)
= br. 3072 + br. 300 (8 x br. 24)
= br. 3072 + br. 300 + br. 192
= br. 3564.00
 Net pay = Total Earnings – Total Deductions

 Total Deductions = Income Tax + pension contribution
 Income Tax: Taxable Income (br. 3564 – br. 200) ---br. 3364.
Earnings X Income Tax Rate = Income

Tax
0 – 150 on 150 0 00.00
151 – 650 on 500 10% 50.00
651 – 1400 on 750 15% 112.00
1401 – 2350 on 950 20% 190.00
235 – 3364 on 1014 25% 253.50
Total br. 3364--------------------------------------------------- br. 606.00
 Pension contribution = 4% of basic salary
Pension contribution = 0.04 x br. 3072 = br. 122.88
Total Deductions -----------------------------br. 728.88
 (i) Net pay = br. 3564 – br. 728,88
Net pay = br. 2835.12
 (ii) Employee Income Tax = br. 606.00
 (iii) Total Deductions = br. 606 + br. 122.88 = br. 728.88
371
PROBLEM – 1
CHILALO Retail Enterprise, a government owned business, pays its employees
salaries according to the Ethiopian calendar Month. The following data relate to
the month of Meskerem, 1995 E.C.
S.No Employee Name Basic Salary

001 Animut Anley birr 2500
002 Nebiyat Girma 1880
003 Erecha Megersa 1790
004 Bekuretsion G/Tensae 1565
Additional information
 All workers are expected to work 40 hours per week and during
Meskerem there are 4 weeks. The workers have done as they have been
expected.
 Nebiyat Girma has worked 10 hours of overtime during Meskerem: 3
hours during „Meskel‟ and the other 7 hours before 10 p.m.
 Erecha Megersa has also worked 5 hours of overtime: 2 hours during
weekly rest days and 3 hours between 10 p.m. – 6 a.m.
 Animut and Nebiyat received a monthly position allowance of br. 350 and
br 300 respectively which are both taxable.
 Animut Anley agreed to have a monthly deduction of br. 250 for credit
association.
 All workers are permanent except Bekuretsion G/Tesnae.
372
Required:
1. Compute the total deductions and net pay for each employee.
2. Compute (calculate) the total:
a) Withholding Taxes
b) Payroll Tax
c) Record the payment of salary as of Meskerem 30,1995.
3. Pass the entry to pay the withholding taxes to the appropriate government
unit.
PROBLEM – 2
HABESHA Trading co. is a private business enterprise. The company pays the
salary of its employees according to the Ethiopian calendar month. The
following data relates to the month of Hidar, 1995.
Serial No. Name Basic Salary

A 101 Abeje Belew br. 2710
P 102 Haragua Delelegn 2500
P 103 Zeleke Belayneh 1800
M 104 Zinash Manahlot 4200
Additional information
 The organization expects every worker to work 48 hours in a week and
during Hidar there are four weeks and all workers have done as they have
been expected.
 Ato, Abeje Belew and W/r, Haregua Delelegn are entitled to get a
monthly allowance of birr 500 and br. 400 respectively.
373
 All workers are permanent except W/t, Zinash Manahlot, and they are
entitled to a total of 15% provident fund of which 10% from the employer
and 5% from the employee.
 Ato Zeleke Belayneh and W/t Zinash Manahlot have worked 12 hours of
overtime each on public holidays.
 According to the company rule, any allowance more than birr 200 is
subject to income tax.
Required: based on the information given above:

1. Compute the income tax for each employee.
2. Compute the total deductions for each employee.
3. Determine the net pay (take-home-pay) for each employee.
4. Compute the total withholding tax for the month.
5. Compute the total payroll tax expense.
6. Pass the journal entry to record the payment of salary as of Hidar 30,1995.
PROBLEM – 3
The following data relates to the payroll of the employees of a privately owned
business organization known as”ALAZAR Retail Enterprise”, for the month of
Megabit, 1995 E.C.
Serial Name Basic Overtime Worked

No. Salary Hours Duration
01 Aleme T. br. 4300 4 up to 10 PM
02 Banchayehu S. 960 12 b/n 10PM to
6 AM
03 Chemdessa N. 1450 8 weekly rest
days
374
04 Deniel T. 632 10 public
holiday
05 Leilena A. 2000 ___ ____
Additional Information
 The management of the business organization usually expects a woker to
work 40 hours in a week.
 There were no absentees during Megabit.
Required:
1. Prepare a payroll sheet for the month of Megabit
2. Record the payment of salary as of Miazia 1, 1995
3. Record the recognition of the payroll tax expense as of Miazia 1, 1995
4. Record the payment of withholding taxes to the proper government units
as of Miazia 15, 1995
6. 10 GLOSSARY
Payroll- total amount paid to employees for a certain period.
Salary – amount paid to work performed for skilled labor
Wages – amount paid to a piece of work by unskilled labor
Payroll Register (sheet) – a list of employees of a business along with their

earnings, deductions and net pay.
375
UNIT 7. CONCEPTS AND PRINCIPLES
Contents
7.0. Aims and Objectives

7.1. Introduction
376
7.2. Generally Accepted Accounting Principles (GAAP)
7.3. Summary
7.4. Answers to Check Your Progress Exercises
7.5. Model Examination Questions
7.6. Reference Books
7.7. Glossary
This unit aims at discussing the basic accounting concepts and procedures used
in the preparation of finical reports. It also discusses in detail the Generally
Accepted Accounting Principles.
After studying this unit, you will be able to:
- describe the development of accounting concepts and principles

- dentify and illustrate the application of basic accounting concepts and
principle
- sol e exercises and problems.
7.1 INTRODUCTION
The historical development of accounting practice has been closely related to

economic developments. In the earlier periods, a business enterprise was very
often managed by its owner, and the accounting records and reports were used
mainly by the owner – manager in conducting the business. Bankers and other
lenders often relied on their personal relationship with the owner rather than on
financial statements as the basis for making loans for business purposes. If a
large amount was owed to a bank or supplier, the creditor often participated in
management decisions.
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As business organizations grew in size and complexity, “management” and
“outsiders” became more clearly differentiated. From the later group, which
includes owners (stock holders), creditors, government, labor unions, customers
and the general public, came the demand for accurate financial information for
use in judging the performance of management.
In addition, as the size and complexity of the business unit increased, the
accounting problems involved in the preparation of financial statements became
more and more complex. With these developments came an awareness of the
need for a framework of concepts and generally accepted accounting principles
to serve as guidelines for the preparation of the basic financial statements.
Accounting concepts and principles include conventions, axioms, standards,

rules, guidelines and procedures that are necessary to have accounting practice
at a particular period of time. The word “principles” as used in the context of
generally accepted accounting principles does not have the same
authoritativeness as universal principles or natural laws relating to the study of
astronomy, physical or other physical sciences.
Accounting principles have been developed by individuals to help make

accounting data more useful in an ever-changing society. They represent the
best possible guides, based on reason observation, and experimentation, to the
achievement of the desired results. These principles are continually re examined
and revised to keep pace with the increasing complexity of business operations.
General acceptance among the members of the accounting profession is the
criterion for determining an accounting principle.
Responsibility for the development of accounting principles has rested primarily

on practicing accountants and accounting educators, working both
independently and under the sponsorship of various accounting organization.
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These principles are also influenced by business practice and customs, ideas and
beliefs of the users of the financial statements, governmental agencies, stock
exchanges and other business groups.

1. Accounting principles and concepts are needed due to different reasons.
What are they?
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7.2 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
1. Business Entity Concept
The business entity concept assumes that a business enterprise is separate and
distinct from the persons who supply its partial or all assets and from every other
business. Businesses are perceived and treated as a distinct separate entities
regardless of the legal concept because in so far as a specific business is
concerned, the purpose of accounting is to record its transactions and
periodically report its financial positions and profitability. Consequently, the
records and reports of the business should not include either the transactions of
another business or the personal assets or transactions of its owner or owners.
To include either would distort the financial position and profitability of the
business.
The accounting equation, Assets = Equities, or Assets = Liabilities + Owners

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

expenses as assets, even though they may not be salable.
Doubt as to the continued existence of a firm may be disclosed in a note to the

financial statements.
If a business enterprise is to be sold or liquidated, financial statements should be

prepared from the “quitting concern” or liquidating point of view rather than
from a “going concern” point of view. That is, in such cases, the cost principle
and the going concern would not be applied in preparing the financial
statements. Instead the estimated market values become more useful and
informative.
3. (Historical) Cost Principle
Under this principle, which is a fundamental principle in accounting, all goods

and services purchased are recorded at cost, where costs are measured on a cash
or equivalent basis. If the consideration given for an asset or service is cash,
cost is measured at the entire cash outlay made to secure the asset or the service.
Otherwise, cost is measured at the cash equivalent value of the consideration
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given or the cash equivalent value of the thing received whichever is more
clearly evident.
For example, if a business paid Birr 15,000 for a lot of land to be used in
business operation, the land should be recorded at a cost of Birr 15,000. It does
not make any difference if the buyer or any other competent outside appraiser
think that the land worth more or less than Birr 15,000. Therefore, the journal
entry would be recorded in the buyer‟s book as follows:
Land-------------------------------------15,000
Cash--------------------------------------15,000
4. Objectivity Principle
This principle requires that entries in the accounting records and data reported
on financial statements be based on objectively determined evidence. This
principle answers the question why assets and services are recorded at cost
rather than some other amount such as estimated market value. As a rule, costs
are objective since normally are established by buyers and sellers, each striking
the best possible bargain for themselves. If this principle is not followed, the
confidence of the many users of the financial statements could not be
maintained. For example, objective evidence such as invoices and vouchers for
purchass, bank statements for the amount of cash in bank, and physical counts
for merchandise on hand supports much of the accounting. Such evidence is
completely objective and can be verified.
Evidence is not always conclusively objective, for there are many cases in
accounting in which judgments, estimates, and other subjective factors must be
taken into account. In such situations, the most objective evidence available
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should be used. For example, the provision for doubtful accounts is an estimate
of the losses expected from failure to collect sales made on account. The
estimation of this amount should be based on such objective factors as past
experience in collecting accounts receivable and reliable forecasts of future
business activities. To provide accounting reports that can be accepted with
confidence, evidence should be developed that will minimize the possibility of
error, intentional bias, or fraud.
1. What does the objectivity principle require for information presented in

financial statement?
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2. A business shows office stationery on the balance sheet at its cost Birr
430 cost, although it cannot be sold for more than Birr 10 as scrap paper.
Which accounts principle require this treatment?
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5. Stable Monetary Unit Concept /Unit of measurement
Accounting transactions are measured, recorded and reported in terms of

monetary unit. In the process of measuring, recording and reporting the
monetary unit is treated as a stable unit of measure like a gallon, a kilometer etc.
However, the monetary unit is not a stable unit of measure nevertheless;
accountants use a monetary unit as a standard unit of measurement in their
reports. Money is both the common factor of all business transactions and the
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only feasible unit of measurement that can be used to achieve uniform financial
data.
The generally accepted use of the monetary unit for accounting for and reporting
the activities of an enterprise has got two major limitations: First, it limits the
scope of accounting reports. The scope of the report will be on information
which can be quantifiable and measurable interims of monetary unit. What so
ever the information is useful to the user, unless it is measurable interims of
monetary unit, it cannot be reported on the financial statements. Secondly, as it
is stated above, any monetary unit in the world is not stable due to economic
changes. Therefore, the accountants report could be highly criticized for not
being fully informative.
To consider the above two limitations, accountants usually prepare reports

which accompany the financial statements. These reports try to inform relevant
unquantifiable information and reflect the effects of change in purchasing power
of the monetary unit.
6. The Periodicity Concept /Accounting period Concept/
According to this concept, the life of a business entity should be broken into
segment periods for accounting purposes. A complete and accurate, picture of
an enterprise‟s success or failure cannot be obtained until it discontinues
operations, converts its assets into cash, and pays off its debts. Then, and only
then is it possible to determine its true net income. But many decisions
regarding the business must be made by management and interested outsiders
during its existence. Therefore, it is essential to stop the operation of the
business artificially at frequent intervals so as to produce periodic reports on
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operations, financial position, and cash flows. These reports reduced will help
the user how well or bad the business was operating during those periods. These
periods are timely and provide a consistent frame of reference to measure the
business activities and compare those measurements with previous periods and
other companies.
Reports may be prepared when a certain job or project is completed, but more
often they are prepared at specific time intervals. For a number of reasons,
including custom and various legal requirements, the longest interval between
reports is one year.
This element of periodicity creates many of the problems of accountancy. The

basic problem is the determination of periodic net income. For example, the
need for adjusting entries, problems of inventory costing, problems of
recognizing the uncollectibilty of the receivables, and problem of selecting
depreciation methods are directly related to the periodic measurement process.
What are the two major limitations of stable monetary unit concept on the
accounting reports?
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7. The Matching Principle
How well or bad the company is doing is reflected to users on the income
statement prepared for a period of time. The income statement tries to measure
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the business‟s earnings by comparing the revenue with expenses of that period
which is covered by the income statement.
The matching principle means that after the revenues for an accounting period
have been determined, the costs associated with those revenues must be
deducted in order to determine net income. The term matching refers to the
close relationship that exists between certain costs and the revenue realized as a
result of incurring those costs.
Thus, the use of matching as a pervasive principle in the income measurement

offers another practical reason for the widespread use of cost principle. For
example, the expenditure for advertising is a cost to be matched against the sales
that is promoted. The recognition of uncollectible accounts is also supported by
the matching principle. Uncollectibles arise from credit sales to customers who
fails to pay their bills. To match this expense (uncollectible amount) , it
becomes important to estimate what part of the credit sales is to be uncollectible
in the future. The use of estimate is necessary in order to carry the matching
principle.
8. Revenue Realization Principle
States that revenue from business transactions is recorded when goods or

services are sold. Some business sell goods or services on one date but receive
payment on a later date. In such cases, the revenue is recorded on the date of
sale, not necessarily when the cash is received.
9. Adequate Disclosure Principle
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All financial statements and accompanying statements should include the
necessary data that helps to facilitate the user‟s understanding. Thus, all
relevant information to the users must be disclosed. However, full disclosure
does not mean that everything must be disclosed. That would be too costly. A
balance must be maintained between the cost of disclosing information and its
relevance to users. Basically, if the information will make a difference in
investors‟ or creditors‟ decisions it should be disclosed. Therefore, the criterion
for disclosure is based on value judgment rather than objective facts.
Financial statements are made more useful by the use of headings and
subheading, and by merging items in significant categories. Although all
essential data should be disclosed with in these categories, judgments must be
exercised by excluding non-essential information to avoid clutter. For example,
detailed information as to the amount of cash in various special and general
funds, the amount on deposit in each of several banks, and the amount invested
in various marketable government securities is not needed by the reader of
financial statements. Such information displayed on the balance sheet would
hinder rather than aid understanding.
In most cases, all of the pertinent data needed by the reader cannot be presented
in the financial statements themselves. The statements therefore normally
include essential or explanatory information in accompanying notes. Adequate
disclosures are necessary for both historical facts and subsequent events to the
issuance of financial statements. The following are some examples:
 Summary of significant accounting policies.

 Change in accounting methods used by the business
 Contingent liabilities and commitments.
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 Events subsequent to the date of statements
 Replacement cost of inventiories and plant assets etc.
10. The Consistency Principle
The amount and direction of change in net income and financial position from
period to period is very important to readers and may greatly influence their
decisions. Therefore, interested person should be able to assume that successive
financial statements of an enterprise are based on consistently on the same
generally accepted accounting principles. If the principles are not applied
consistently, the trends indicated could be the result of changes in the principles
used rather than the result of changes in business conditions or managerial
effectiveness.
Consistency principle requires that the same generally accepted accounting

principles are used from period to period for the same accounting events.
Therefore, once an accounting method or principle is adapted, it should be used
for reasonable period of time. This is because accounting information is more
useful if it can be compared with similar information for the same company
from time to time. However, consistency principle does not prohibit switching
from one accounting method to another. Changes are permissible when it is
believed that the uses of a different principle will more fairly state net income
and financial position. Examples of change in accounting principles include a
change in the method of inventory pricing, a change in depreciation method for
previously recorded assets and a change in the method of accounting for long-
term construction contracts. Consideration of changes in accounting principles
must be accompanied by consideration of the general rule for disclosure of such
changes, which is as follows:
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The nature of and justification for a change in accounting principle and its
effects on income should be disclosed in the financial statements of the period in
which the change is made. The justification for the change should explain
clearly why the newly adopted accounting principle is preferable.
There are various methods of reporting the effect of a change in accounting

principle on net income. The cumulative effect of the change on net income
may be reported on the income statement of the period in which the change is
adopted. In some cases the effect of the change could be applied retroactively to
past periods by presenting revised income statements for the earlier years
affected.
The application of the consistency principle does not require that a specific
method be used uniformly throughout an enterprise. For example, it is not
unusual for large enterprises to use different costing methods and pricing
methods for different segments of their inventories.
11. The Materiality Concept
In following generally accepted accounting principles, the accountant must

consider the relative importance of any event, accounting procedure or change in
procedure that affects items on the financial statements. The concept of
materiality is relative. What is material for one firm may be immaterial for
another firm. The determination of what is important and what is not requires
the exercise of judgments. Precise criteria cannot be formulated. Some factors
do help to identify events as being material or immaterial. This is done by
comparing the size and nature of an item or event with the size and nature of
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other events or items. For example, the erroneous classification of a Birr 10,000
asset on a balance sheet exhibiting total assets of Birr 10,000,000, would
probably be immaterial. If the assets total only Birr 100,000, however, it would
certainly be material. If the Birr 10,000 represented a note receivable from an
officer of the enterprise, it might well be material even in the first assumption.
The concept of materiality may be applied to procedures used in recording

transactions. For example, small expenditures for plant assets may be treated as
an expense of the period rather than as an asset. The saving in clerical costs is
justified if the practice does not materially affects the financial statements.
Customs and practicality also influence the criteria of materiality. For example,
corporate financial statements seldom report the cents amount or even the
hundreds of dollars. A common practice is to round to the nearest thousands.
For large corporations, there is an increasing tendency to report the financial
data in terms of millions, carrying figures to one decimal.
12. The conservatisms (prudence) concept
Accountants follow methods and procedures that yield the lesser amount of net
income or net asset value. Of an accountant faced two methods of handling a
particular event, he /she tends to use the method which understate the net
income or net asset. This is done to protect the firm from uncertain risk of loss.
Thus, conservatism is usually expressed by the statement “anticipate no profit
but provide for all losses”. Such an attitude of pessimism has been due in part to
the need for an offset to the optimism of business management.
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Current accounting thought has shifted somewhat from this philosophy of
conservatism. Conservatism is no longer considered to be a dominant factor in
selecting among alternatives.
N.B: the concepts and principles of objectivity disclosure, consistency and

materiality are more important than conservatism and the latter should be a
factor only when the others don’t play a significant role in the decisions to be
made by users of financial statements.
7.3 SUMMARY
The accounting profession is guided by basic accounting concepts and

principles. In recording business transactions and in preparing financial
statements, accountants apply these principles and concepts.
Accounting principles differ from the principles related to the physical sciences.
Accounting principles are developed by individuals to help make accounting
data more useful in an ever – changing society. These principles are continually
reexamined and revised to keep pace with the increasing complexity of business
operations.
1. Accounting principles and concepts are needed because of the following

facts:
i) The development of business firm in size and form.

ii) The complexity of business transactions.
iii) The need for separation of management and owners
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iv) The demand for accurate, timely and relevant information by users.
2. i) the objectivity principle requires that accounting records be based on

verifiable events
such as business transactions between independent parties.
ii) the historical cost principle.
3. The two major limitations of stable monetary unit concept are:

a) The scope of the report will be on information, which can be
quantifiable and measurable in terms of money.
b) Any monetary unit in the world is not stable due to economic
changes.
7.5 MODEL EXAMINATION QUESTIONS.
A) Discussion Questions
1. For accounting purposes, what is the nature of the assumption as to the length
of life of an enterprise?
2. Why should the most objective evidence available be used as the basis for
data reported on financial statements?
3. If a complete and accurate picture of an enterprise‟s success or failure is

desired, what accounting period must be used to report on operations?
4. Is revenue from sales of merchandise on account more commonly recognized

at the time of sale or at the time of cash receipt?
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5. When there are several acceptable alternative accounting methods that could
be used, the method used by an enterprise should be disclosed in the financial
statements. Give examples of accounting methods that fall in this category.
6. If significant changes are made in the accounting principle applied from one
period to the next, why the effect of these changes should be disclosed in the
financial statements?
7. You have just been employed by a relatively small merchandising business

that records its revenues only when cash is received and its expense only
when cash is paid you are aware of the fault that the enterprise should
record its revenues and expenses on the accrual basis. Would changing to the
accrual basis violate the principle of consistency? Discuss.
8. The accountant for a large department store charged the acquisition of a

pencil sharpener to an expense account, even though the asset had an
estimated useful life of 10 years. Which accounting concept supports this
treatment of the expenditure?
9. Why do the financial statements of a business present its activities separate

from its owner‟s activities?
10.The monetary principle assumes that money is a useful standard measuring

unit for reporting the effects of business transactions. State and explain two
major criticism or limitations of this accounting principle.
B) Exercises
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1. Each of the following statements represents a decision made by an
accountant. State whether or not you agree with the decision. Support your
answer with reference to generally accepted accounting principles that are
applicable in the circumstance.
a) In preparing the balance sheet, detailed information as to the amount due

from hundreds of customers was omitted. The total amount was
presented under the captain “Accounts Receivable”
b) Used computer equipment, with an estimated useful life of 5 years and

no salvage value, was purchased early in the current fiscal year for Birr
150,000. Since the company planned to purchase new equipment,
costing Birr 250.000, to replace this equipment at the end of five years,
depreciation expense of Birr 50,000 was recorded for the current year.
The depreciation expense thus provided for one fifth of the cost of the
replacement.
c) All minor expenditures for office equipment are charged to an expense

account.
d) Merchandise transferred to other parties on a consignment basis and not

sold was included in merchandise inventory.
e) Land, used as a parking lot, was purchased 10 years ago for Birr 50,000.
Since its market value is now Birr 90,000, the land account is debited
for Birr 40,000 and a gain account is credited for a like amount. The
gain is presented as an “other income” item in the income statement.
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f) Thirty days before the end of the current year, sales catalogs were acquired
for birr 45,000. Although the catalogs are not salable the unused portion is
included as an asset in the balance sheet at the end of the year.
g) Merchandise inventory at the end of the current year was estimated by the
general manager, who “eye balled”, the inventory on hand and then
determined its cost, based on the estimate of current costs. The accountant
used the general manager‟s estimate for recording the cost of the inventory in
the accounts.
h) Financial statements adjusted to eliminate the effects of inflation (using the

current cost method) were presented as supplementary financial data.
i) Net income for the current year is expected to be larger than normal.
Therefore the accountant used the declining – balance method for
determining depreciation for the current year to reduce the net income to a
more normal amount. The accountant plans to return its future years to the
use of the straight-line method that has been used in all past years for
determining income.
7.6 REFERENCE BOOKS
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1. Fees and Warren : Principles of Acconting, 16th
Edition.
2. Horngren, Sundem, and Elliot : Introduction to Financial

Accounting, 8th
Edition, (2002) Pearson Education Inc.
3. Roger H. Hermanson, : Accouonting Principles, 4th Education

(1989)
Jems D. Edwards and R.F Salmonson IRWIN Inc.

(1998)
John Wiley and Sons, Inc.
7.7 GLOSSARY
1. Adequate disclosure – the concept that financial statements and their

accompanying footnotes should contain all of the pertinent data believed
essential to the reader understands of an enterprises financial status.
2. Business Entity concept – the concept that assumes that accounting applies
to individual economic units and each unit is separate and district from the
persons who supply its assets.
3. Conservatism – the concept that dictates that in selecting among

alternatives, the method or procedure that yields the lesser amount of net
income or asset values should be selected.
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4. Consistency – the concept that assumes that the same generally accepted
accounting principles have applied in the preparation of successive financial
statements.
5. Cost Principle – the principle that assumes that the monetary records for
properties and services purchased by a business should be maintained in
terms of its cost.
6. Going Concern Concept – the concept that assumes that a business entity
has a reasonable expectation of continuing in business at a profit for an
indefinite period of time.
7. Matching – the principle of accounting that all revenues should be matched

with the expenses incurred in earning those revenues during a period of time.
8. Materiality – the concept that recognizes the practicality of ignoring small

or insignificant deviations from generally accepted accounting principles.
9. Periodicity concept – the concept that states that the life of a business entity
should be broken into segment periods for accounting purposes.
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UNIT 8. ACCOUNTING FOR PARTNERSHIPS
Contents

8.1 Introduction
8.2 Partnership And Their Characteristics
8.3 Advantages And Disadvantages of A Partnership
8.4 Recording The Formation of A Partnership
8.5 Division of Partnership Income And Losses
8.6 Financial Statements For A Partnership
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8.7 Dissolution of A Partnership
8.7.1. Admission of A New Partner
8.7.2. Withdrawal of A Partner
8.8 Liquidation of A Partnership
8.9 Summary
8.10 Answers To Check Your Progress
8.12 Reference Books
8.13 Glossary
The unit aims at discussing the accounting for partnerships such as recording
investments, computing each partner‟s share of income or losses using different
techniques, and recording them to the respective capital accounts. Also, the
accounting implications of dissolution and liquidation of a partnership will be
described. Having studied and worked through this chapter you would be able
to:
 define partnerships and explain their characteristics.

 describe the advantages and disadvantages of a partnership
 record the investments made by the partners in forming a partnership.
 understand and apply the various methods of dividing the income or lass
of a partnership.
 Record the admission and withdrawal of a partner(s)
 Understand and apply the steps in the liquidation of a partnership.
8.1 INTRODUCTION
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In your previous course you have studied the three most dominant forms of
business organization: sole proprietorship, partnership, and corporation. For
accounting purposes, each form should be viewed as an economic unit separate
from its owners, though legally only the corporation is considered separate from
its owners. In the previous section you have also studied the basic accounting
principles and practices used in accounting for a sole proprietorship form of
business organization. The accounting for corporate form of businesses will be
explained in the next unit. Therefore, the main focus of this chapter is to
acquaint the learns with the basics of accounting for partnerships. As will be
explained later in this section, the same accounting principles that are used in
accounting for a sole proprietorship are applied in partnership form of
businesses. However, there are accounting practices that are unique to
partnerships. These unique accounting features relate to the partners‟ capital
and drawing accounts, division of income (or loss), and changes in ownership of
the partnership.
8.2 PARTNERSHIPS AND THEIR CHARACTERSTICS
A partnership is an association of two or more persons to carry-on as co-owners

of a business for profit. This association is based on a partnership agreement or
contract known as the articles of a partnership.
The partnership agreement should specify the name location, and purpose of the
business; the capital contributions and duties of each partner; the methods of
income and loss division; the rights of each partner upon liquidation (winding
up) of a partnership, etc.
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The partnership agreement should be in writing to avoid any misunderstandings
about the formation, operation, and liquidation of a partnership.
Characteristics of a partnership
For purposes of accounting, partnerships are treated as separate economic

entities. The next paragraphs describe some of the important features of a
partnership.
A) Voluntary Association
A partnership is a voluntary association of individuals rather than a legal entity

in itself. Therefore, a partner is responsible under the law for his or her
partner‟s business actions with in the scope of the partnership. A partner also
has unlimited liability for the debts of the partnership. Because of these
potential liabilities, an individual must be allowed to choose the people who join
the partnership.
B) Limited Life
Because a partnership is formed by the consent of two or more partners, it has a

limited life. This means that, anything that ends the contract dissolves the
partnership.
A partnership can be dissolved when (1) a new partner is admitted; (2) a partner
withdraws, retires, dies or becomes bankrupt. At this point, the remaining
partners should sign a new contractual agreement to continue the affairs of the
business. In place of the old partnership a new partnership is formed. Thus, a
partnership is said to have a limited life.
C) Unlimited Liability
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Each partner is liable for all the debts of the partnership. When and if the
partnership fails to pay its debts, creditors can seize (take) each partner‟s
personal assets to satisfy their claims. Therefore, partnerships creditors claims
are not limited to the assets of the business, but is extends to the personal
property of the partners. Each partner, then, could be required by law to pay all
the obligations (debts) of the partnership.
Suppose, for example, the liabilities of ABC company (a partnership business)

as of a certain date is birr 600,000, however, the total properties (assets) of ABC
company could only be sold for birr 450,000. Thus, to settle creditors claims
fully, the house or personal assets of the partners may have to be sold.
D) Mutual Agency
Each partner is an agent of the partnership within the scope of the business.
This means that partner‟s act to any contract is binding on the remaining
partners as long as it is with in the apparent scope of the business‟ operations.
For example, a partner in a public accounting firm can bind the partnership
through the delivery of accounting services. redundent. But this partner cannot
bind the partnership to a contract for delivering (or providing) cars because it is
out of the scope of the business.
E) Co ownership of partnership property

Once invested, the properties contributed by the partners become the property of
the partnership and is owned jointly by all the partners. Upon liquidation of the
partnership and distribution of assets, the partner‟s claim on the assets is
measured by the amount of the balance in his/her capital account.
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8.3 ADVANTAGES AND DISADVANTAGES OF PARTNERSHIP
Advantages:
A partnership form of business ownership has the following advantages:
1. Easy and inexpensive to form than a corporation. A partnership is easy to

form. It only requires the consent of two or more parties. Two or more
competent persons simply agree to be partners in some common business
purpose.
2. Advantageous to raise a large amount of capital and managerial skill (talent)

than a sole proprietorship. Because a partnership is formed by two or more
persons, it is possible to raise a large amount of capital and managerial skill
than a single owner.
3. Not subject to separate taxation as a case in a corporation because each

partner reports his/her own share of partnership income and is individually
taxed, and
4. Not required to observe on many restrictive laws unlike a corporation.
DISADVANTAGES
Partnership has the following disadvantages:

1. Partners assume unlimited liability. The liability of the partners is not
limited to what they have in the partnership, but it goes to the extent of their
personal properties (assets).
403
2. Disadvantageous if each partner does not exercise his/her good judgment
because one partner‟s act can bind a partnership into a contract.
3. Limited life. Partnerships are subject to possible termination due to many

uncontrollable circumstances such as the death of a partner.
4. The transfer of ownership from one partner to another person is difficult

unless the remaining partners approve of this
8.4 RECORDING THE FORMATION OF A PARTNERSHIP
A separate capital account is maintained for each partner in a partnership. Each

partner‟s capital account is credited for the value of their investment upon
formation of the partnership.
Illustration
Dr. Teklay and Dr.Mamo decided to form a partnership business, which would
provide medical services. They have been in business separately before they
form the partnership. The partnership assumed the liabilities of their separate
business. The assets were valued and recorded at their current fair market value.
Shown below are the assets contributed and the liabilities assumed by the
partnership at their fair market value.
Dr. Teklay Dr. Mamo

Cash Birr 6.500 Cash Birr
3,300
Accounts Receivable 8,600 Accounts Receivable
4,300
404
Supplies 21,000 Supplies
12,000
Medical Equipment 3,000 Medical Equipment
150,000
Accounts Payable (2,300) Accounts Payable
(3,200)
The journal entry on January 1, 2002 to record the investment of each partner
and the formation of the partnership would be:
2002, Jan.1. Cash 6,500

A/R 8,600
Supplies 21,000
Medical Equipment 3,000
A/p 2,300
Teklay Capital 36,800
2002, Jan.1. Cash 3,300

A/R 4,300
Supplies 12,000
Building 150,000
Accounts Payable 3,200
Mamo, Capital 166,400
1. On February 2, 2oo2, Dr. Teklay and Dr. Mamo made additional

investments of cash Birr 4,200 and 4300 respectively. Show the entry to
record the investments by the owners.
405
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2. What is the meaning of unlimited liability when applied to a partnership?

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3. What characteristics of a partnership could be interpreted as disadvantages?

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8.5 DIVISION OF PARTNERSHIP INCOME AND LOSSES
A partnership‟s income and losses can be distributed according to whatever

method the partners specifies in the partnership agreement. The agreement
should be specific and clear, to avoid later disputes.
If a partnership agreement does not mention the distribution of income and

losses, the law requires that they be shared equally by all partners. Also, if a
partnership agreement specifies only the distribution of income, but is silent as
to losses, the law requires that losses be distributed in the same ratio as income.
The Income of a partnership normally has three components:
(1) return to the partners for the use of their capital – called interest on
partners‟ capital,
406
(2) compensation for direct services the partners have rendered – called
partners‟ salaries, and
(3) other income for any special characteristics individual partners may bring
to the partnership or risks they may take.
The breakdown of total income into its three components helps clarify how
much each partner has contributed to the firm.
Income can be shared among the partners in one of the following ways:
1. Net income divided in a stated ratio such as:

A) equally
B) agreed upon ratio (other than equally)
C) ratio based on beginning capital balances
2. Net Income divided by allowing interest on the capital investments,

salaries, or both with the remaining net income divided in an agreed ratio.
Example
Assume that Dr. Teklay and Dr. Mamo partnership had a net income of Birr
60,000
1. A. Assume that the articles of a partnership provides equal share of Net

Income or
Loss.
- In this case the capital accounts of each partner will be credited for Birr.
30,000
Income Summary-------------------------------60,000
407
Dr. Teklay capital-----------------------------------30,000
Dr. Mamo capital------------------------------------30,000
B. Net income is divided in ratio of 3.2 to Dr. teklay and Dr. Mamo
respectively.
- Income summary-------------------------------------60,000
Dr. Teklay capital (3/5 X 60,000) --------------------------
36,000
Dr. Mamo capital (2/5 X 60,000) ---------------------------
24,000
C. Net income is divided in a ratio of partners‟ capital account balances at the

beginning
of the fiscal period.
Income summary ------------------------------- 60,000
 36800 
Dr. Teklay capital  203200  60,000 -----------------------------
 
 
10,860
 166400 
Dr. Mamo capital  203200  60,000 ------------------------------
 
49,134
 36800 + 166400 = 203200
408
2. Net income is divided by allowing 5% interest on their beginning capital
balances, a
salary of Birr. 5,000 to Dr. Teklay and the remainder is divide equally.
Net Income Division
Income to be
Dr. Teklay Dr.Mamo Total
Distributed
Net income Birr, 60,000

Interest (5%) 1,840 8,320 10,160
49,840
Salary 5,000 -- 5,000 44,840
Remainder 22,420 22,420 44,840
-- 0 –
Distribution 29,260 30,740 60,000
Journal entry
Income summary ---------------------------- 60,000
Dr. Teklay capital ---------------------------- 29,260
Dr. Mamo capital ---------------------------- 30,740
1. Assume the same agreement as in number “2” above but the net income for
the year was Birr. 10,000. Determine the amount to be distributed to each
partner and record the distribution in journal entry form -------------------------
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409
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8.6 FINANCIAL STATEMENTS FOR A PARTNERSHIP
The income statement of a sole proprietorship and that of a partnership are the
same. At the end of the period a statement of partners‟ capital is prepared which
summarizes the effect of transactions on the capital account balances of each
partner. The statement of owners equity for Teklay and Mamo using assumed
data and the income division shown above is illustrated below:
Dr. Teklay and Dr Mamo
Statement of partners’ Capital
For the year Ended Dec, 31, 2002
Dr. Teklay Dr. Mamo

Capital Bal. January 1, 2002 Br. 36,800 Br. 166,400
Add: Additional investment 4,200
4,300
Total Br. 41,000 Br. 170,700
Net income distribution 29,260
30,740
70,260 201,440
Deduct: Withdrawals during the year 5,000
5,000
Capital Bal. Dec. 31, 2002 Br. 65260 Br. 196,440
NB- The balance sheet of a partnership is different from that of a sole

proprietorship only
410
in the owner‟s equity section. In the partnership business since two or
more persons
owns the business, there are two or more capital accounts whereas for a
sole
proprietorship there will always be one capital account.
1. Hilina and Meron agreed to form a partnership. Hilina contributed Br.

200,000 in cash , and Meron contributed assets with a fair market value of
Br. 400,000. The partnership, in its initial year, reported net income of Br.
120,000.
Prepare the journal entry to distribute the first year‟s income to the partners
under each of the following condition.
 Hilina and Meron failed to include stated ratio in the partnership

agreement.
 Hilina and Meron agreed to share income and losses in a 3:2 ratio.
 Hilina and Meron agreed to share income and losses in the ratio of their
original investments.
 Hilina and Meron agreed to share income and losses by allowing 10
percent interest on their original investments and sharing any remainder
equally
2. What accounts are debited and credited to record the division of net income
at the end of the fiscal period?
411
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3. What accounts are debited and credited to record the division of net loss
among the partners‟ at the end of the fiscal period?
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8.7 DISSOLUTION OF A PARTNERSHIP
 Dissolution of a partnership occurs whenever there is change in the original

association of partners. When a partnership is dissolved, the partners lose
their authority to continue the business as a going concern. This does not
mean that the business operation necessarily is ended or interrupted, but it
does mean – from a legal and accounting standpoint – that the separate entity
stops to exist.
 The remaining partners can act for the partnership in finishing the affairs of
the business or in forming a new partnership that will be a new accounting
entity.
 A partnership is legally dissolved (terminated) when a new partner is

admitted or an existing partner withdraws.
8.7.1. Admission of a New Partner:
The admission of a new partner dissolves the old partnership because a new
association has been formed.
412
Dissolving the old partnership and creating a new one require the consent of all
the old partners and the ratification of a new partnership agreement.
When a new partner is admitted, a new partnership agreement should be

prepared.
 A new partner can be admitted into a partnership in one of two ways:
(1) by purchasing ownership right from one or more of the original

partners, or
(2) by investing assets in the partnership.
1. Admission by Purchase of Ownership Right
When an individual is admitted to a firm by purchasing ownership right from an

old partner, each partner must agree to the change. A journal entry is needed in
the partnership to transfer the ownership right purchased from the capital
account of the selling partner to the capital account of the new partner. The
partnership‟s assets and liabilities remain unchanged.
Suppose, for example, Sister Helen joins the partnership of Dr. Teklay and Dr.
Mamo by buying ownership right of Br. 8000 from Dr. Mamo. The entry to
record the admission of Sister Helen and the transfer of the ownership right from
the capital account of Dr. Mamo to the capital account of Sister Helen in the
partnership books shown below
Journal entry
Dr. Mamo---------------------------------- 8,000
413
Sr. Helen --------------------------------------8,000
The price that sister Helen paid to Dr. Momo can be more or less than Br. 8,000
but that is irrelevant as it wouldn‟t be reflected in the record (books) of the
partnership.
2. Admission by Investing Assets
Assume that instead of purchasing ownership right from the existing partners,
Sister Helen invested cash of Br. 80,000 into the partnership. In this case both
partnership assets and total owners‟ equity are increase. The journal entry must
record such an investment and the increase in partnership assets.
Consider the following scenarios as an example:

1- Sister Helen receives a 50% ownership right in the partnership. Assume also
that Dr. Teklay and Dr. Mamo‟s capital balance were Br. 25,000 and Br.
55,000 respectively. Dr. Teklay and Dr. Mamo share income in a ratio of 2:1
respectively.
Journal Entry
Sister Helen‟s capital account would be credited for Br. 80,000 i.e., (55,000 +
25,000 + 80,000) X ½.
Cash------------------------------------------80,000
Sister Helen, Capital------------------------80,000
2- Sister Helen receives a one –fourth ownership right upon admission.
Assume everything else as above. In this case Sister Helen‟s capital account
would be
credited for birr 40,000 ie, (Birr 25,000 + Birr 80,000) X ¼.
414
The difference Br. 40,000, (80,000 – 40,000) would be shared between the
remaining two partners with the income-sharing ratio.
Journal entry
Cash----------------------------80,000
Helen capital ------------------------40,000
Dr. Teklay capital --------------------- 26,667
Dr. Mamo capital --------------------- 13,333

1. Assume the same as above except that sister Helen received ¾ ownership
right upon admission as she was thought to bring goodwill to the partnership.
Record the admission.
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8.7.2. RETIREMENT OR WITHDRAWAL OF A PARTNER
When an existing partner withdraws he/she can sell his/her ownership right or
he/she can withdraw assets from the partnership. Both options are considered
below:
1. Sale of Ownership Right to the Existing Partner
415
When ownership right is sold by a withdrawing partner to an existing partner,
the entry on the partnership‟s books transfers the retiring partner‟s capital
balance to the buyer‟s capital account.
Example:
Dr. Mamo withdraws from the partnership because of a disagreement. He sells

his Br. 38,333 ownership right to Dr. Teklay.
Journal entry
Dr. Mamo Capital----------------------------- 38,333

Dr. Teklay Capital ----------------------------- 38,333
The amount paid by Dr. Teklay is not recorded on the partnership books,
because the transaction involves no flow of assets to or from the partnership.
2. Withdrawal of Assets From the Partnership
When a partner withdraws he/she may be paid above or below the amount
shown in his/her capital balances.
Example:
a. Assume Dr. Mamo was paid Br. 50,000 cash when he withdraws from the
partnership of T,M&H. The capital balances of each partner were as follows
as of that date:
Dr. Teklay capital ---------------------------Br. 100,000

Dr. Mamo capital --------------------------- --- 50,000
Sister Helen capital ----------------------------- 35,000
416
Total Equities Birr 185,000
Journal entry
Dr,Mamo capital -------------------------------- 50,000

Cash -----------------------------------------------------------50,000
b. Assume Dr. Mamo was paid Br. 56,000 instead of Br. 50,000, the excess
amount of Birr 6,000 is charged to the remaining partner‟s capital accounts
based on the income- sharing ratio. (Assume a 3:2:1 income-sharing ratio
between Dr Teklay Dr. Mamo and Sister Helen respectively).
Journal entry
Dr. Mamo capital ------------------------------50,000

Sister Helen capital ---------------------------- 1,500
Dr. Teklay capital ------------------------------ 4,500
Cash ----------------------------------------------------56,000
 The Birr 6,000 excess is shared on the basis of a 3:1 ratio, i.e., Dr. Teklay
would be charged for 6,000 X c/4 = birr 4500, and Sister Helan would be
charged for
Birr 6000 X ¼= Birr 1500.
1. Assume everything else as in # b above except that Dr. Mamo was paid Br.
45,000 upon withdrawal. Record the dissolution.
417
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Attempt the following questions:
1. The partnership agreement for Kebede and Lema partnership does not
disclose how they will share income and losses. How would the income and
losses be shared in this partnership?
2. In January 19X1, Sisay Hailu and Gelane Jalene agreed to produce and sell
Soaps. Sisay contributed br. 240,000 in cash to the business. Gelane
contributed the building and equipment, valued at Br. 220,000 and Birr.
140,000, respectively. The partnership had an income of Birr 84,000 during
19X1 but was less successful during 19X2, when income was only Br.
40,000.
(a) Prepare the journal entry to record the investment of both partners in the
partnership
(b) Determine the share of income for each partner in 19X1 under each of the
following conditions:
 The partners agreed to share income equally.

 The partners failed to agree on an income- sharing arrangement.
418
 The partners agreed to share income according to the ratio of their capital
investments
 The partners agreed to share income by allowing interest of 10% on their
original investments and dividing the remainder equally.
 The partners agreed to share income by allowing salaries of Birr 40,000
for Sisay and Br. 28,000 for Gelane, and dividing the remainder equally.
3. Nadew, Tezera, and Woliyi have equity in a partnership of Birr 80,000, Birr
80,000, and Birr 120,000, respectively, and they share income and losses in a
ratio of 20%, 20%, and 60%. The partners have agreed to admit Equbay to
the partnership.
Instruction: prepare journal entries to record the admission of Equbay to the

partnership under the following conditions:
(a) Equbay invests Birr 50,000 for 20% interest in the partnership, and a
bonus is recorded for the original partners.
(b) Equbay invests Birr 60,000 for a 40% interest in the partnership, and a
bonus is recorded for Equbay.
8.8 LIQUIDATION OF A PARTNERSHIP
Liquidation of a partnership is the process of ending the business, of selling

enough assets to pay the partnership‟s liabilities and distributing any remaining
assets among the partners.
Liquidation is a special form of dissolution. When a partnership is liquidated,

the business will not continue.
419
 A partnership may be liquidated if:
A. the objectives sought in forming the partnership has been achieved.

B. the time period for which the partnership was formed expires (ends)
C. newly enacted laws have made the partnerships activities illegal,
D. the partnership becomes bankrupt.
The partnership agreement should indicate the procedures to be followed incase

of liquidation. Usually, the books (records) are adjusted and closed, with the
income or loss distributed to the partners and the assets are sold.
The sale of the assets at the time of liquidation of a partnership is known as

realization.
As the assets of the business are sold, any gain or loss should be distributed to
the partners according to the income and loss sharing ratio.
As cash is realized, it must be applied first to outside creditors. Finally, the

remaining cash is distributed to the partners in accordance with the balance of
their capital accounts.
Illustration
The partnership of Resom, Sultan, and Tassew is liquidated on September

1,2002. The income and loss sharing ratio of the partners is: Resom 40%,
Sultan 35%, and Tassew 25%. After discontinuing the ordinary business
operations of their partnership and closing the accounts, the following summary
of a trial balance is prepared:
420
R, S And T
Trial Balance
Septamber 1, 2002
Debit Credit
Cash 10,000
Other assets 90.000
Liabilities 10,000
R. Capital 30,000
S. Capital 30,000
T. Capital ________ 30,000
Total 100,000 100,000
Based on the information on the trial balance, accounting for liquidation of R,S,
and T partnership will be illustrated using different selling prices for the non
cash assets.
Case One: Gain On Realization
Assume that Resom, Sultan, and Tassew sell all noncash assets for Birr 95,000,
realizing a gain of birr 5000, (Birr 95,000 – Birr 90,000). The gain is divided
among Resom, sultan and Tassew in the income and loss sharing ratio of 40%
35%, and 25% respectively. Then, the liabilities are paid, and the remaining
cash is distributed to the partners according to the balances in their capital
accounts. The entries to record the steps in the liquidation of a business are as
follows:
Cash………………………………95,000
421
Other assets………………………….90,000
Gain on sale of assets……………….. 5,000
Entry to record the sale of non cash assets

and the recognition of gain on realization
- Gain on sale of assets…………… 5,000

R Cap. (5,000 X 40%)………………… 2.000
S Cap. (5,000 X 35%)…………………. 1,750
T Cap. (5000 X 25%)…………………...1,250
To distribute gain on realization
- Liabilities……………………….10,000
Cash………………………………..10,000
To record the settlement of partnership liabilities.
After the above entries are posted, the partners‟ capital accounts shows:
R‟s Beg Bal. 30,000 + 2,000 = Birr 32,000

S‟s Beg Bal. 30,000 + 1,750 = Birr 31,750
T‟s Beg Bal. 30,000 + 1,250 = Birr 31,250
The cash account now shows a balance of Birr 95,000 (10,000 + 95,000 –
10,000). The entry recorded upon distribution of this cash among the partners
would, therefore, be
R, capital……………………… Birr 32,000

S, capital……………………… Birr 31,750
422
T, capital……………………… Birr 31,250
Cash-------------------------------------95,000
To record the distribution of cash

among the partners.
Case two: Loss on Realization: No capital Deficiencies
Assume that Resom, Sultan, and Tassew sell all non cash assets for Birr 70,000,
instead of Birr 95,000, incurred a loss of birr 20,000,(Birr 90,000 – Birr 70,000)
Journal entry
-Cash --------------------------------------70,000
Loss on realization-----------------------20,00
Other Assets-------------------------------------90,000
To record the sale of the assets
-R capital---------------------- (40% X 20,000) -----------------8,000

S capital----------------------- (35,000 X 20,000) --------------7,000
T capital ---------------------- (25% X 20,000) --------------- 5,000
Loss on Realization -------------------------------------
20,000
To distribute the loss on realization
- Liabilities ---------------------------------- 10,000
423
Cash -----------------------------------10,000
To record the settlement of partnership
liabilities
After the above entries have been posted; the accounts show cash 70,000 R, cap.
Birr22,000 S,cap. Birr 23,000 and T, cap. Birr 25,000. The entry to record the
cash distribution to the partners would, therefore, be as follows:
R cap --------------------------------- 22,000

S cap ----------------------------------23,000
T cap --------------------------------- 25, 000
Cash -------------------------------------- 70,000
Entry to record the distribution of cash to partners.
Case three: Loss on Realization with Deficiency in one Partner Capital
- Assume the non-cash assets of R,S and T partnership are sold for only Birr
10,200, incurring a loss of Birr 79,800,( Birr 90,000 – Birr 10,200). The
entries to record the division of loss among the partners and the liquidation to
this point are shown below:
Cash -------------------------------- 10,200

Loss on sale of Assets ----------- 79,800
Other Assets-------------------------- 90,000
To record the sale of assets
R capital (79800 X 40%) ----------------------31,920
424
S capital (79800 X 35%) ---------------------- 27,930
T capital (79800 X 25%) ---------------------- 19,950
Loss on sale of Assets ---------------------------- 79,800
To distribute loss on realization
- Liabilities ----------------------------------- 10,000

Cash ------------------------------------------------10,000
To record settlement of liabilities
At this stage of the liquidation the capital accounts of the partners have the
following balances
R capital = 30,000 – 31920 = 1,920

S capital = 30,000 – 27930 = 2,070
T capital = 30,000 – 19950 = 10,050
Only Birr 10,200 cash is available (10,000 + 10200 – 10,000) for distribution to
S and T while the combined balances of their capital accounts is Birr 12,120.
Therefore, additional Birr 1,920, (12120 – 10200) is needed which is the amount
owed by R to the partnership.
Therefore, either R will have to pay this amount first and the cash will be
distributed to S and T, or S and T will have to share the Birr 1920 loss in their
income and loss-sharing ratio of 35:25.
Let‟s assume, the loss was distributed since R couldn‟t pay the amount
immediately.
425
Journal Entries
S capital (35/60 X 1920) -------------- 1,120.00

T capital (25/60 X 1920) -------------- --800.00
R capital -------------------------------------1,920
To charge R’s capital deficiency to S and T
S, capital -----------------------------------950.00
T, capital -----------------------------------9,250.00
Cash ----------------------------------------------10,200
To record the final cash distribution to partners.
The various entries in the liquidation of R,S, and T partnership are summarized
in the following statement.
R, S, T partnership
Statement of Partnership Liquidation
For period Sept. 1-15,2002
Non cash = Liabilities + Capital

Cash + Asset
R(40%) S(35%
T(25%)
426
Bal.before realization Birr 10,000 90,000 10,000 30,000 30,000
30,000
Sales of Assets &

Division of loss +10,200 -90,000 --- -31,920 -27,930
19,950
Bal.after realization 20,000 -0- 10,000 (1920) 2,070

10,050
Payment of Liab. – 10,000 --- -10.000 --- ---

---
Bal. After payment

Of liab. 10,200 - 0- -0 - (1920) 2,070
10,050
Division of deficiency --- --- --- 1920

(1120) 800
Bal. After division of

Deficiency – 10,200 -0- -0- -0 - 950
9,250
Dist.of cash 10,000 --- --- --- -950

-9250
Balance -0 - -0 - -0 - -0 - -0 -
-0 -
427
8.9 SUMMARY
A partnership is an association of two or more persons to carry on as co-owners

of a business for profit. This association is based on a partnership agreement or
contract known as the articles of a partnership.
A partnership form of business ownership has several characteristics. From

among them are: voluntary association, limited life, unlimited liability, mutual
agency, and co- ownership of partnership property.
The advantages of partnerships include: easy of formation, possible to raise

large amount of capital than a single owner, not subject to separate taxation, and
the absence of many restrictive laws unlike a corporation, etc.
Partnerships have also the following disadvantages: unlimited liability, mutual

agency, limited life, etc.
In accounting for partners‟ investment, it is necessary to maintain separate

capital and withdrawals accounts for each partner and to divide the income and
losses of the company among the partners. When recording the investments of
the partners, all noncash assets must be recorded at their fair market value at the
time they are transferred to the partnership.
A partnership income and losses can be distributed according to whatever

method the partner specifies in the partnership agreement. The agreement
should be specific and clear, to avoid later disputes.
If a partnership agreement does not mention the distribution of income and

losses, the law requires that they be shared equally by all partners. If a
428
partnership agreement specifies only the distribution of income, but is silent as
to losses, the law requires that losses be distributed in the same ratio as income.
The income of a partnership normally has three components: (1) return to the
partners for the use of their capital, (2) compensation for direct services the
partners have rendered, and (3) other income for any special characteristics
individual partners may bring to the partnership or risks they may take.
At the end of each fiscal period financial statements are prepared for a
partnership business. Most of the financial statements of a partnership are the
same as that of a sole proprietorship with the exception of the owners equity
section of a balance sheet.
Dissolution of a partnership occurs whenever there is a change in the original

association of partners. When a partnership is dissolved, the partners lose their
authority to continue the business as a going concern. This does not mean that
the business operation necessarily is ended or interrupted, but it does mean -
from a legal and accounting stand point - that the separate entity stops to exist.
A partnership is legally dissolved when a new partner is admitted or an existing
partner withdraws.
Liquidation of a partnership is the process of ending the business, of selling

enough assets to pay the partnership‟s liabilities and distributing any remaining
assets among the partners. Liquidation is a special from of dissolution. When a
partnership is liquidated, the business will not continue.
A partnership may be liquidated if: (a) the objectives sought in forming the
partnership has been achieved, (b) the time period for which the partnership was
429
formed expires (or ends), (c) newly enacted laws have made the partnership‟s
activities illegal, (d) the partnership becomes bankrupt.
The partnership agreement should indicate the procedures to be followed incase

of liquidation. Usually, the records are adjusted and closed, with the income or
loss distributed to the partners, and the assets are sold. The sale of the assets at
the time of liquidation of a partnership is known as realization. As the assets of
the business are sold, any gain or loss should be distributed to the partners
according to the income and loss sharing ratio. As cash is realized it must be
applied first to outside creditors. Finally, the remaining cash is distributed to the
partners in accordance with the balance of their capital accounts.

Journal entry
Cash-----------------------------8500
Dr. Teklay capital-------------------------- 4200
Dr. Mamo capital--------------------------- 4300

Net income division
Income to be
Dr. Beklay Dr. Mamo Total
Distributed
Net income 15,000
430
Interest (5%) 1,840 8,320 10,160
4,840
PART I. Choose The Best Answer:
____________ 1. The term unlimited liability when used in connection with a

partnership refers to the fact that:
A) A contract entered into by one partner is binding on all
partners.
B) Creditors can look beyond the partnership assets to the
individual assets of the partners for satisfaction.
C) The partnership has an unlimited obligation to provide
professional services.
D) The partnership is liable for all actions of the partners even
when conducting personal business.
E) All except D.
____________ 2. A and B agree to form a partnership. A is to contribute birr

60,000 in cash and to spent one – half time to the partnership. Bi is agreed to
contribute birr 40,000 and to devote full time to the partnership. How will A and
B share in the division of net income or net loss?
A) 1:2 C) 3:2 E)None of the above
B) 2:1 D) 1:1
431
Refer to the following information which is related to XYZ partnership and
answer questions 3 and 4.
The capital account and income sharing ratios of the three partners after
realization of non – cash assets and settlement of all liabilities are as follows:
Partner Balance in Capital Income – Sharing

Account Ratio
X Birr 45,000 2
Y (15,000) 3
Z 36,000 3
________ 3. If partner Y is unable to pay any part of his deficiency to the

partnership,
how much cash will be given to partner Z from the liquidation?
A) Birr 30,375 C) Birr 13,500 E) None of the above.

B) Birr 27,000 D) Birr 30,000
________ 4. If partner Y pays two – third of the deficiency to the partnership,

how much
cash will be given to partner X?
A) Birr 33,000 C) Birr 43,000 E) None of the above.
B) Birr 47,000 D) Birr 45,000
_________ 5. Which of the following is not a characteristic of a partnership?
432
A) each partner can act as an agent of a partnership
B) Unlimited life.
C) Easy of formation
D) It is not legally separate from its owners.
PART II – Attempt the Following Questions
1. What are the disadvantages of the partnership over the corporation as a form
of organization for a profit making business enterprise?
2. Explain the difference between the admission of a new partner to a
partnership (a) by purchase of an interest from another partner and (b) by
contribution of assets to the partnership.
3. When a new partner is admitted to a partnership and goodwill is attributable

to the old partnership, how should the amount of the goodwill be allocated to
the capital accounts of the original partners?
4. Why might partnership attribute goodwill to a newly admitted partner?
5. Paulos, Kebede, and Abeje are partners sharing income 3:2:1. After the
firm‟s loss from liquidation is distributed, Paulos‟s capital account has a
debit balance of Birr 30,000. If Paulos is personally bankrupt and unable to
pay any of the birr 30,000, how will the loss be divided between Kebede and
Abeje?
Exercise
433
Dagnachew and Firdu formed a partnership. Dagnachew invested Birr 90,000
and Firdu invested Birr 60,000. Dagnachew is to devote one-half time to the
business while Firdu is to devote full time.
The following plans for the division of income are being considered:
1. equally
2. in the ratio of original investments
3. in the ratio of time devoted to the business
4. Interest of 12% on original investments and the reminder equally.
5. Interest of 12% on original investments, salaries of Birr 10,000 to
Dagnachew and Birr 20,000 to Firdu, and the remainder equally.
6. The same as in #5 except that Dagnachew is also to be allowed a bonus equal
to 25% of the amount by which net income exceeds salary allowances.
Required:
Determine the division of income to Dagnachew and Firdu under each plan
assuming the partnership of Danagnachew and Firdu earned a net income of:
a) Birr 32,000
b) Birr 150,000
Problem 1
The following balance sheet is related to YOGA partnership
YOGA Partnership
Balance sheet
Meskerm 10,1995
434
Assets: Liabilities and Capital
Cash-------------------------Birr 20,000 Liabilities--------------Birr

30,000
Other assets--------------------- 80,000 Capital:
Y.capital-------------------- 40,000
G. capital------------------- 21,000
_______ A. capital------------------- 9,000
Total Liabilities and
Total Assets---------------- Birr 100,000 Capital-----------------------
100,000
The partners agreed to liquidate the business enterprise by selling other assets
and dividing any remaining cash available in the partnership after settling the
debt of the partnership as of the date of liquidation. All the partners are general
partners. Partner Y, G and A share income or loss in the ratio of 20%, 40%, and
40% respectively.
Required:
A. prepare a liquidation statement assuming that the other assets were

realized for:
i) Birr 80,000
ii) Birr 100,000
iii) Birr 60,000
iv) Birr 50,000
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B. Journalize the necessary entries for the business enterprise on the basis of
the liquidation statement prepared for each case.
8.12 REFERENCE BOOKS
1. Fees and Warren : principles of Accounting, 16th Edition.
2. Horngrn, sundem, : Introduction to Financial Accounting:

8th Edition,
(2002) Pearson Education Inc.,
3. Roger H. Hermanson, : Accounting Principles, 4th Edition,

(1989) IRWIN
Jems D. Edwards INC.
And R.F. Salmonson

(1998) John
wiley and sons, Inc.
8.13 GLOSSARY
Partnership : a business owned by two or more

individuals as
co-owners based on a partnership
agreement.
Partners : owners of a partnership
436
Dissolution : formation of a new partnership because of
the
retirement‟s admission or death of a
partner.
Liquidation : the winding up of operation and sale of

business
assets.
Realization : sale of business assets for cash
UNIT 9. ACCOUNTING FOR CORPORATIONS
CONTENTS
9.1 Introduction
9.2 Definition of Corporation
9.3 Characteristics of Corporation
9.4 Advantages of Corporate form of Organization
437
9.5 Disadvantages of Corporate form of Organization
9.6 Formation of a Corporation
9.6.1 Organization Costs
9.6.2 Rights of Stockholders
9.7 Authorization and Issuance of Stocks
9.7.1 Types of Stocks / Shares
9.7.2 Issuance of Par-value Stocks
9.7.2.1 Authorization
9.7.2.2 Par-value Stock issued for cash
9.7.2.3 Par-value Stock issued on a subscription basis
9.7.2.4 Non cash issuance of Capital Stock
9.7.2.5 Issuance of No-par Stock
9.8 Accounting for Retained earnings and Dividends
9.8.1 Nature of Retained Earnings
9.8.2 Nature of Dividends
9.8.3 Relevant Dividends dates
9.8.4 Dividends and Characteristics of Preferred Stock
9.8.4.1 Participating and Non participating preferred stock
9.8.4.2 Cumulative and Non cumulative preferred stock
9.9 Accounting for Treasury Stocks
9.9.1 Reasons to acquired Treasury Stocks
9.9.2 Recording and Reporting Treasury Stock Transactions
9.10 Equity Per Share
9.11 Summary
9.14 Glossary
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This unit aims at discussing different issues related to a corporate form of

organization such as the characteristics of a corporation, accounting and
reporting practical for the issuance of stocks. Treasures stocks and equity per
share. After studying this chapter, you will be able to:
- describe the characteristics, advantages and disadvantages of the
corporate form of business organization
- explain the rights of stockholders and the role of corporate directions.
- differentiate among authorized, issued and outstanding shares.
- Account for the issuance of capital stock
- understand the nature of retained earnings and dividends
- account for treasury stock transactions
- know how to calculate earnings per share.
9.1 INTRODUCTION
Assume that you are planning to start a new business. Would you choose a sole
proprietorship, a partnership or a corporation? In principles of accounting 1 and
previous chapter of principles of accounting you have studied about the first two
forms of business organizations. In this chapter the importance of corporate
form of organization will be discussed.
9.2 DEFINITION OF CORPORATION
A corporation is a legal entity having an existence separate and distinct from

that of its owners. In the eyes of the law there are two persons and a corporation
is an „artificial person‟ having many of its own rights and responsibilities.
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9.3 CHARACTERISTICS OF CORPORATION
Among the characteristics of a corporation are:

a) A corporation is a separate legal entity. According to the law a
corporate entity may own property in its own name, may enter into
contract and responsible for its own debts.
b) A corporation has a legal status in court. According to the law a
corporation may sue and be sued as if it were a real person.
c) A corporation has its own charter. A corporation is created by obtaining
charter from the state in which the company is to be incorporated.
d) A corporation pays income taxes on its earnings. The income of a
corporation is subject to income taxes, which must be paid by the
corporation.
9.4 ADVANTAGES OF THE CORPORATE FORM OF

ORGANIZATION
A corporate entity has many advantages not available in other forms of

organization. Among the advantages are the following:
a) Continuous existence: A corporation has perpetual existence in that its

continuous existence is not dissolved by the death on retirements of any of its
members.
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b) No personal liability for owners: Since a corporation is a separate legal
entity, the creditors of a corporation have a claim against the assets of the
corporation, not the personal property of the owners.
c) Separation of managements from ownership: the owners of a corporation

(called stock holders or shareholders) own the corporation but they do not
manage it on a daily basis. To administer the affairs of the corporation,
president and other officers are hired for it. Thus, individual stockholder has
no rights to participate in the management's activity of the corporation unless
the stockholder has been hired as a corporate officer.
d) Easily transferable ownership shares: ownership of a corporation is

evidenced by transferable shares of stocks. These shares of stocks may be
sold by one investor to another without dissolving or disrupting the business
organization.
9.5 DISADVANTAGES OF CORPORATE FORM OF ORGANIZATION
Some of the disadvantages of the corporation are:

a) Double taxation: corporate earnings are taxed two times. The earnings
are taxed first as a corporate income taxes and again as personal income
taxes if the corporation. Distributes its earnings to stockholders.
b) Difficulties to control: since ownership is usually separated from

managements, owners are unable to exercise active control over
management actions.
441
c) Greater regulation: since a corporation comes into existence according to
the law of the state, the law may provide for considerable regulation of the
corporation‟s activities. For example, the withdrawal of funds from a
corporation is subjects to certain limits sets by law.
9.6 FORMATION OF A CORPORATION
A corporation is created by obtaining a corporate charter. The charter is given

from the states in which the corporation is to be incorporated. To obtain a
corporate charter an application called articles of incorporation are prepared by t
he organizers called incorporators and submitted to the state corporations
commissioner or other designated officials. These articles of incorporation
specify the purpose of the business, its location, the names of the organizers, the
classes and numbers of shares of capital stock authorized, and the consideration
to be paid in by the organizers for their respective shares. The article of
incorporation is approved by the state and charter is issued. Once a charter is
obtained a board of directors is elected. The directors in turn hold meetings at
which officers of the corporation are appointed.
9.6.1 Organization costs

In the process of incorporation, the organizers must pay for necessary costs such
as payment of an incorporation fee to the state, payment of fees to attorneys for
their services in drawing up the articles of incorporation, payment to promoters
and variety of other outlays necessary to bring the corporation into existence.
These costs are charged to an asset account called organization costs. In the
balance sheets, organization costs appear under the „other assets‟ caption.
9.6.2 Rights of Stockholders

The stockholders who are the owners of a corporate entity have the following
basic rights:
a) The rights to votes: the common stockholders have the right to elect the
board of directors, and thereby to be represented in the management of the
business.
442
b) The rights to participate in the earnings of a corporation: Stockholders
in corporations may not make withdrawal of company assets. However,
the earnings of a profitable corporation may be distributed to stockholders
is the form of cash dividend. The payment of a dividend always requires
formal authorization by the board of directors.
c) The rights to share in the distribution of assets upon liquid action: when
a corporation ends its existence, the creditors of the corporation must first
be paid is full; any remaining assets are dividend among stockholders in
proportion to the number of shares owned.
d) Pre-emptive rights: the current stockholders has the right to purchase the
shares of the corporation on a prorate basis when new stocks are offered
for sale. This preemptive rights is designed to provide each stockholder
the opportunity to maintain a proportional ownership in the corporation.

1. When a business is organized as a corporation:
a) Stockholders are liable for the debts of the business
b) Stockholders do not have to pay personal income taxes
on dividend received.
c) Each stockholder has the rights to make managerial decision.
d) Owners cannot withdraw assets from the business at will.
2. Explain the meaning of the term double taxation at it applies to corporate

profits.
……………………………………………………………………………………
……………………………………………………………………………………
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……………………………………………………………………………………
………………………………………
9.7 AUTHORIZATION AND ISSUANCE OF STOCKS
The state officials approve the articles of incorporation, which specify the
number of shares a corporation is authorized to issue. The total number of shares
that may be issued is known as the authorized shares. When the corporation
receives cash is exchange for stock certificates, which represents the number of
shares issued, the shares become issued shares. Shares that are issued and held
by the stockholders are called outstanding shares. Sometimes a corporation
requires shares from its own shareholders. These shares are called treasury
stocks, which reduce the number of outstanding shares.
A corporation may choose not to issue immediately all the authorized shares
even though it is customary to have a large number of authorized shares than
presently needed. If more capital is needed, the previously authorized shares will
be readily available for issue. A corporation can apply to the state for permission
to increase the number of authorized shares.
9.7.1 Types of Stocks/Shares

Many corporations issue several classes of capital stock, each providing
investors with different rights and opportunities. The basic types of stock issued
by every corporation is called common stock. Common stock possessed the
traditional rights of ownership such as voting rights, participation residual
dividends, and residual claim to assets in the event of liquidation. When any of
these rights is modified, the term preferred stock is used. Preferred stock
specifies different rights that distinguish it from common stock. Some of the
distinctive features for preferred stocks are priority claims on dividends,
cumulative dividend rights, priority as to assets is the event of liquid action of a
corporation and no voting power.
444
Stocks according to their nature are classified into par value and no-par stocks.
Par value stocks with a designated dollar amount per share as stated in the
corporate charter and printed on the stock certificates. On the other hand, some
states allow corporations to issue stocks without designating a par value. Such
stocks are called no-par stocks. When no par stocks are issued by a corporation,
the entire issuance price is viewed as a legal capital, which is subject to
withdrawal. Sometimes some states authorize the issuance of no-par stock with a
stated, or assigned, value per share that is established permanently by the
corporate directors and is in the laws. Most corporations use a stated value for
no par stock.
9.7.2 Issuance of Par-value Stocks

9.7.2.1 Authorization
Authorization of par value stocks, specified in the unit may be recorded as a
memo entry in the general journal and in the ledger accounts. Most states require
the total number of shares authorized be shown on each stock certificate, in
addition to the number of shares represented by that particular stock certificates.
9.7.2.2 Par value stock issued for cash
When stocks are issued to various investors, a stock certificate specifying the
number of shares represented is prepared for each investor/or stockholder. When
par value stock is issued for cash, the capital stock account is credited with the
par value of the shares issued regardless of whether the issuance price is more or
less than par. If par value stock is issued for more than par value (at premium),
paid in capital in excess of par account is credited for the excess of selling price
over par. This paid in capital is excess of par does not represent a profit to the
corporation rather it is part of the invested capital. If par value stock is sold by
445
corporation for less than par (at discount), a negative stockholders‟ equity
accounts, Discount on common (or preferred) stock, is debited for the amount of
the discount.
For example, assume that 50,000 shares of Br. 2 par value common stock have
seen authorized and that 10,000 of these authorized shares are issued at a price
of Br. 10 each. The entry would be:
Cash………………………………………………………100.000
Common
Stock…………………………………..20,000
Paid-in-capital is excess of par…………………
80,000
9.7.2.3 Par value stock issued on a subscription basis
During the start-up of a corporation, prospective investors may sign a contract to

purchase a specified number of shares on credits with payments due at one or
more specified future dates. One reason for this procedure is to attract small
investors. Another reason is to appeal to investors who prefer not to invest cash
until the corporation is ready to start business operations. A corporation may
also sell its capital stock on credit after incorporation.
When stock is subscribed, the company debits stock subscription receivable for
the subscription price, credits capital stock subscribed for the par value of the
subscribed shares, and credits paid in capital in excess of the subscription price
over par value. Later, as cash is collected, the entry is a debit to cash and a credit
to stock subscription receivable. When the entire subscription price is collected,
the stock certificates are issued for the subscribers. The issuance of stock is
recorded by debiting capital stock subscribed and crediting capital stock. The
following illustration demonstrates the accounting procedures for stock
subscriptions.
446
Assume that 120,000 shares of RAM corporation common stock, par br. 10, are
subscribed for at Br. 12 by Misrak Binda. The total is payable in three
installments. The following entries are processed by RAM Corporation.
Common stock subscription Receivable 1,440,000

Common stock subscribed
1,200,000
Paid-in-capital in excess of par
240,000
To record receipt of subscription for 120,000 shares
Cash 480,000
Common stock subscription receivable
480,000
To record receipt of 1st payment
Cash 480,000
Common stock subscription Receivable
480,000
To record receipt of final payment
Cash 480,000
Common stock subscription Receivable
480,000
To record receipt of final payment
Common stock subscribed 1,200,000
Common stock 1,200,000
To record issuance of stock
9.7.2.4 Non Cash Issuance of Capital Stock
447
Corporations sometimes issue capital stock for non-cash assets such as in
exchange for real estate. The current markets value of the stock issued or the
non-cash consideration received, whichever is must reliable, determinable, is
used to record the transaction. If the market value of either capital stock issued
or the no cash items are not reliable, the value are established by the
corporation‟s board of directors.
9.7.2.5 Issuance of No-par Stock
Some states allow corporations to issue stock without designating a par or stated
value. When this no par stock is issued, the entire issuance price is credited to
the capital stock account and is viewed as legal capital not subject to
withdrawal.
9.8 ACCOUNTING FOR RETAINED EARNINGS AND DIVIDENDS
9.8.1 Nature of Retained Earnings
Capital provided to a corporation by stockholders in exchange for shares of

either preferred or common stock is called paid in capital or contributed
capital. The second major type of stockholders‟ equity is a retained earnings.
The amount of the retained earnings account at any balance sheet date represents
the accumulated earnings (net income) of the company since the date of
incorporation, less any losses and all dividends distributed to stockholders.
9.8.2 Nature of Dividends

A dividend is a distribution of earnings to stockholders is the form of assets or
shares of the issuing company‟s stock. Type of dividends includes the following.
a) Cash dividend
Cash disbursed
448
b) Property Dividend
Non cash assets disbursed
c) Stock Dividend
Corporations own stock disbursed
d) Liquidating Dividend
Return of contributed capital
e) Scrip Dividend
Creation of a liability by declaring a dividend to be paid at a specific
future date.
9.8.3 Relevant dividend dates
Prior to payment, dividends must be declared by the board of directors of the

corporation. The important dividend dates are:
a) Date of Declaration: on this date, the corporation‟s board of directors
formally approves and announces the dividend to be distributed. The
declaration is recorded on this date as a debit to dividends and a credit to
dividends payable.
b) Date of payment: this date is determined by the board of directors and is

usually stated is declaration. At the date of payment the liability recorded at
the date of declaration is debited and the appropriate asset account is
credited.
9.8.4 Dividend and Characteristics of preferred stock
A corporation with both preferred stock and common stock may declare
dividends on the common only after it meets the requirements of the stated
dividend on the preferred. The preferred dividend may be stated in monetary
terms or as a percent of par.
449
9.8.4.1 Participating and non-participating preferred stock
A participating preferred stock receives a minimum dividend but also receives
higher dividend when the company pays substantial dividends on common
shares. The preferred stockholders‟ right may be to receive dividend only a
stated amounts. Such stock is said to be nonparticipating.
To illustrated, assume the following information
 Common stock issued 4,000

 Preferred stock issued 2,000
 Dividend per share of preferred stock Br. 10
The corporation reported net income of Br. 150,000 for the third year and the
BOD declared both of the net income as dividend. If the preferred stock issued
by the corporation is participating, the preferred stockholders will receive. Br.
30,000 (Br. 20,000 + Br. 10,000), and the common stockholders will receive Br.
60,000 (Br. 40,000 + Br. 20,000).
9.8.4.2 Cumulative and Non-cumulative preferred stock

Cumulative preferred means that if the company fails to pay a preferred
dividend, its obligation accumulates and all omitted dividends must be paid in
the future before any common dividends are paid. The cumulative preferred
stockholders would receive all accumulated unpaid dividends (called dividend in
arrears) before the holders of common shares receive anything. Preferred stock
not having this cumulative rights is called no cumulative.
For example, assume the following information
 Cumulative preferred, 10% of Br. 100 par (10,000 shares issued)

 Common stock of Br. 90 par (40,000 shares issued)
 The Board of Directors (BOD) did not declare dividend in year 2
 Year 3 dividend declared by the BOD amounts to Br. 320,000.
450
 Year 1 dividend declared and distributed amounts to Br. 200,000.
If the preferred stock is cumulative, the preferred stockholders will receive Br.
200,000 (Br. 100,000 + Br. 100,000), and the common stock holders will receive
Br. 120,000 (Br. 320,000 – Br. 200,000).
1. State the classification (assets, liability, stockholders‟ equity, revenue or

expense) of each of the following accounts
a) subscription receivable
b) organization costs
c) paid in capital is excess of par value
d) retained earnings
e) preferred stock
2. If a corporation has outstanding 1,000 shares of Br. 9 cumulative preferred

stock of Br. 100 par and dividends have been passed for the preceding three
years, what is their amount of preferred dividends that must be declared is the
current year before a dividend can be declared on common stock?
a) Br. 9,000 c) Br. 36,000
b) Br. 27,000 d) None
9.9 ACCOUNTING FOR TREASURY STOCKS
Treasury stock is a corporation‟s own stock (preferred or common) that has been
issued and required by the issuing corporation. A corporation may also accept
shares of its own stock in payment of a debits owed by a stockholder or as a
donation from a stockholder.
Treasury stock does not reduce the number of shares issued, but does reduce the
number of outstanding shares. The purchase of treasury stock decreases both
451
assets and stockholders‟ equity. Moreover, treasury stock does not carry voting,
dividend, preemptive, or liquidating rights and is not assets.
9.9.1 Reasons to acquire Treasury Stocks

In general treasury steps are to acquire for the following reasons:
a) to support (increase) the markets price of the stock
b) to I increase earnings par share by reducing the number of shares
outstanding.
c) To reduce dividend payment payments by reducing the number of shares
outstanding.
d) To provide shares for reassurance to employees as a bonus
e) To use the share acquired for stock dividend
f) To reissue with a higher price
9.9.2 Recording and reporting Treasury stock Transactions

There are several methods of accounting for the purchase and the resale of
treasure stock. A commonly used method is the cost basis. When the stock is
purchased by the corporation, treasury stock account is debited for the price paid
for it. The par and the price at which the stock was originally issued are ignored.
When the stock is resold, treasury stock is credited at the price paid for it, and
the difference between the price paid and the selling price is debited or credited
to an account entitled paid in capital from sale of treasury stock.
To illustrate the cost method, assume that Harambe Corporation had 50,000
shares of Br. 10 par common stock outstanding at the beginning of the current
year. The company purchased 500 shares for cash and received 500 shares in
settlement of a debt from stockholders. The markets price of stocks was Br.
30/share. The following entry is required involving the transactions.
452
Treasury stock 30,000
Cash 15,000
Notes Receivable 15,000
If the company sells 600 shares of the treasury stock for Br. 31 each, the entry
would be:
Cash 18,600
Treasury stock 18,000
Paid in capital from sale of 600
Treasury stock
Paid in capital from sale of treasury stock is reported in the paid in capital
section of the balance sheet. Treasury stock is deducted from the total of the
paid in capital and Retained earnings.
9.10 EQUITY PER SHARE
The amount appearing on the balance sheet as total stockholders‟ equity can be
stated in terms of the equity per share. When there is only one class of stock, the
equity per share is determined by dividing total stockholders‟ equity by the
number of shares outstanding. For a corporation with both preferred and
common stock, it is necessary first to allocate the total equity between the two
classes. To illustrate, consider the following statements of stockholders‟ equity
at December 31, 19x1.
- 9 to preferred stock, Br. 50 par value, authorized 20,000 shares, issued and
Outstanding 12,000 share
Br. 600,000
- Common stock, no par, stated value Br. 2 per share,
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authorized 500,000 shares, issued 400,000 shares of which 25,000
shares are held is the treasury
800,000
- Paid in capital is excess of per

-Preferred Br. 50,000
-Common 1,000,000 1,050,000
- Retained earnings
2,000,000
Subtotal Br.
4,450,000
- Less cost of 25,000shares of common stock

Reacquired and held in treasury
250,000
- Total stockholders‟ equity Br.
4,200,000
If the preferred stock is entitled to receive Br. 105 per share upon liquidation
and if there is no preferred dividend in arrears, the computation of earnings per
share are as follows:
Preferred EPS = Equity allocated to preferred stock

Number of o/s shares of preferred stock
= 105 X 12,000
12,000
= Br. 105/share
Common EPS = Equity allocated to common stock
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Number of o/s shares of common stock
= 2,940,000
375,000
= Br. 7.84 /share
1. A corporation reacquired 1,000 shares of its own Br. 50 par common stock
for Br. 75,000 recording it at costs. What effects does it has on stockholders‟
equity?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
2. If the Retained Earnings account has a debit balance, how is it presented in

the balance sheet and what is it called?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
3. How is book value per share of common stock computed when a company
has only one class of stock?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
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9.11 SUMMARY
 A Corporation has the following most important characteristics:

 Separate legal existence, limited liability, and transferable units of stocks.
 The primary advantages of a corporation are no personal liability of

stockholders for the debts of the business, the transferability of ownership
shares, continuity of existence and ability to hire professional managements.
 Stockholders in a corporation normally have the rights to elect the board of

directors, to share in dividends declared by the directors, to share is the
distribution of assets if the corporation is liquidated, and to subscribe to
additional shares if the corporation decides to increases the number of shares
outstanding.
 Common stock represents the true residual ownership of a corporation. These

share have voting rights and cannot be called. Preferred stock has preference
over common stock with respects to dividends and to distributions in the
events of liquidation.
 When capital stock is issued, appropriate asset accounts are debited for the
market price of stock. A capital stock account is credited for the par value of
the issued shares. The difference between the market value received and the
par value of the issued shares is credited or debited to additional paid in
capital accounts.
 The stockholders; equity sections are classified into two: paid-in-capital and
retained earnings.
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 Any treasury stock held at the end of an accounting period is deducted from
the total of the paid-in-capital and retained earnings of the corporation.
 To determine the equity per share, the equity allocated to each class is
divided by the number of shares outstanding of the respective class.
9.12 ANSWER TO CHECK YOUR PROGRESS

1. D
2. According to double taxation concept corporate income is taxed two
times; when earned to the corporation and then again taxed to the
stockholders when distributed as dividends.
1. a) Assets
b) Assets
c) Stockholders‟ equity
d) Stockholders‟ equity
e) Stockholders‟ equity
2. C

1. The stockholders‟eq2uity decrease for Br. 375,00
2. The debit balance is deducted from paid in capital and is called defects.
3. EPS = Total stockholders‟ equity
Number of shares outstanding
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9.13 MODEL EXAM QUESTIONS
Part 1. Short answer questions

1. When a corporation issues stock at a premium, does the premium constitute
income? Explain.
2. What type of expenditure is charged to the organization costs accounts?
3. When stock is issued by a corporation is exchange for assets other than cash,
accounts face the problem of determining the dollar amounts at which to
record the transaction. Discuss the factors to be considered and explain their
significance?
PART 2. WORKOUT QUESTIONS
1. Early in the year Yetimwork Demissie and several friends organized a

corporation called mobile communications, Incorporation. The corporation
was authorized to issue 50,000 of Br. 100 per value, 10% cumulative
preferred stock and 400,000 shares of Br, 2 par value common stock. The
following transactions occurred during the year.
Jan. 6 Issued for cash 20,000 shares of common stock at Br. 14 per
share. The shares were issued to Binda and 10 other investors.
Jan. 7 Issued an additional 500 shares of common stock to Binda is

exchange for his services in organizing the corporation. The
stockholders agreed that these services were worth Br. 11,000.
Jan12 Issued 2,500 shares of preferred stock for cash of Br. 250,000.
Jan. 4 acquired land as a building site in exchange for 15,000 shares

of common stock. In view of the appraised value of the land, the
directors agreed that the common stock was to valued for purpose
of this transaction at Br. 15 per share.
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Nov15 The first annual dividend of Br. 10 per share was declared on the
preferred stock to be
Paid December 20.
Dec20 Paid the cash dividend declared on November 15,
Dec31 After the revenue and expenses were closed into the Income summary
account, that
account indicated a net income of Br. 106,500.
Instructions
a) Prepare journal entries in general journal form to record the above
transactions
b) Prepare stockholders‟ equity section of the Mobile communications, Inc.
balance sheets at December 31.
2. Belay publications was organized early in 19x1 with authorization to

issue 20,000 shares of Br. 100 par value preferred stock and 1 million
shares of Br. 1 par value common stock. All of the preferred stock was
issued at par, and 300,000 shares of common stock were sold for Br. 20
per share. The preferred stock pays a 10% cumulative dividend and is
callable at Br. 105. During the first five years of operations, the
corporation earned a total of Br. 4,460,000 and paid dividends of Br. 1 per
share each year on the common stock. In 19X6, however, the corporation
reported a net loss of Br. 1,600,000 and paid no dividends.
Instruction
Prepare the stockholders‟ equity section of the balance sheet at December 31,
19X6.
9.14 GLOSSARY
459
Board of directors: Persons elected by common stockholders to direct the
affairs of a corporation.
Capital stock: Transferable units of ownership is a corporation. A broad term,

which may
refer to common stock, preferred stock, or both.
Common stock: A type of capital stock, which possesses the basic rights of
ownership including the rights to vote.
Corporation: A business organized as a legal entity separate from its owners.
Legal capital: Equal to the par value or stated value of capital stock issued. This
amount
cannot be removed without special legal action.
Paid in capital: the amounts invested in a corporation by its stockholders.
Par value (or stated Value): the minimum amount per share to be invested is
the corporation by its own owners and cannot be
withdrawn except by special legal action.
Preferred stock: a class of capital stock usually having preferences as to

dividends and in the distribution of assets inevents of liquid
action.
Stock certificate: a document issued by a corporation as evidence of the

ownership of the number of shares stated on the certificate.
460
Subscriptions to Capital stock: formal promises to buy shares of stock from a
corporation with payment at a later date.
UNIT 10. DEPARTMENTS AND BRANCHES
Contents:
10.1 Introduction
10.2 Accounting for Departmental Operations.
10.3 Departmental Margin Approach to Income Reporting
10.4 Accounting for Branch Operations
10.4.1 Centralized Accounting System
10.4.2 Decentralized Accounting System
10.5 Financial Statements for Home Office and Branch
10.6 Shipments to Branch Billed at Selling Price
10.7 Summary
10.8 Answers to Check Your Progress Exercises
10.10 Reference books
10.11 Glossary
After studying this unit, you should be able to:

- discuss the need for departmental information;
- discuss accounting reports for departmental operations;
461
- explain Departmental margin Approach to income reporting;
- illustrate system of branch accounting;
- Centralized Vs Decentralized, and
- explain shipment to branch billed at selling price.
10.1 INTRODUCTION
The activities of many business enterprises are performed by separate segments

such as departments, divisions and branches. These units of an operating entity
may be organized as separate corporations, with common ownership of the stock
and common management at the top. Selection of the organization structure and
the segmentation is often affected by size volume of business, diversity of
activity and geographic distribution of operations. In any event, the managers of
segmented enterprises need accounting reports which are designed to aid them
in planning, controlling, and evaluating the performance of the various
segments.
Segmentation may occur in service enterprises as well as in businesses engaged

mainly in merchandising or manufacturing activities. Segmented accounting
reports are useful to management regardless of the type of activity.
10.2 ACCOUNTING FOR DEPARTMENTAL OPERATIONS
Accounting reports for departmental operations are generally limited to income

statements. Although departmental income statements are usually not issued to
stockholders or others outside the management group, the trend is toward
providing more information of this type.
462
Analysis of operations by departments may end with the determination of gross
profits or it may extend through the determination of net income.
Gross Profit by Departments
For a merchandising enterprise, the gross profit is one of the most significant
figures in the income statement. Since the sales and the cost of merchandise
sold are both, to large extent, controlled by departmental management, the
reporting of gross profit by departments is useful in:
 cost analysis and control
 helping management in directing its efforts toward obtaining a mix of
sales that will maximize profits. After studying such reports, management
may decide to change sales or purchases policies, cut back or expand
operations, or shift personnel to achieve a higher gross profit for each
department. Caution must be exercised in the use of such reports to insure
that proposed changes affecting gross profit don‟t have an adverse effect
on net income,
To compute gross profit by departments, it is necessary to determine by

departments each element entering into gross profit. There are two basic
methods of doing this
1. Setting up departmental accounts and identifying each element by

department at the time of the transaction. It is usually used unless the time
required in analyzing each transaction is too great, or
2. maintaining only one account for the element and then allocating it among
the departments at the time the income statement is prepared. This method is
likely to yield less accurate results than the first method but some degree of
accuracy may be sacrificed to obtain a saving of time and expense.
463
The following are elements that must be departmentalized in order to determine
gross profit by departments:
 Merchandise inventory
 Purchases
 Sales, and
 The related cash discounts, and returns and allowances
Some of the above elements may be identifiable directly to each department and
some are not, which must be allocated based on different basis (e.g. based on
quantity purchased).
When departmental accounts are maintained for each element, special

departmental columns for recording transactions may be provided in the proper
columns. For example, in a furniture store that sells furniture and carpeting, the
sales Journal may have a credit column for Furniture sales and a credit column
for Carpet sales. To aid in the journalizing of departmental transactions, the
supporting documents such as sales invoices, vouchers, and cash register
readings must identify the department affected by each transaction.
An income statement showing gross profit by departments for Texas company,

which has two sales departments, appears below.
464
Texas Company
Income Statement
For the year ended December 31,2000.
Department X Department Y Total

Revenue from sales:
Sales 630,0 270,00 900,0
00 0 00
Less: Sales returns and 15,30 7,100 22,40
allowance 0 0
Net sales 614,7 262,9 877,6
00 00 00
Cost of merchandise sold:
Merchandise Inventory
January1,2000 80,15 61,750 141,9
0 00
Purchases 334,5 200,3 534,9
50 50 00
Less: Purchase discount 6200 328,3 2400 197,90 8600 526,3
50 0 00
Merchandise available for 408,5 259,70 668,2
sale 00 0 00
Less: merchandise
Inventory, Dec. 31,2000 85,15 78,950 164,1
465
0 00
Cost of Merchandise Sold 323,3 180,7 504,1
50 50 00
Gross Profit 291,3 82,15 373,5
50 0 00
Operating expenses:
Selling expenses 113,2
00
General Expense 110,2
00
Total operating expenses 223,2
00
Income from operations
Other expense: 150,3
00
Interest expenses 2,500
Income before income tax 147,8
00
Income tax 64,44
4
Net Income 83,35
0
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N.B. Usually the Operating expenses would be listed in detail. But here they are
shown in condensed form for illustrative purpose.
Departmental reporting of income may be extended to the various sections of the

income statement, such as gross profit less selling expenses (gross selling
profit), gross profit less all operating expenses (operating income), income
before income tax, or net income. The underlying principle is the same for all
degrees of departmentalization i.e. to assign each department the related revenue
and that part of the expenses incurred for its benefit.
Some expenses may be easily identifiable with the department benefited. For
example, if each sales person is restricted to a certain sales department, the sales
salaries may be assigned to the proper departmental salary accounts each time
the payroll is prepared. On the other hand, the salaries of company officers,
executives, and office personnel are not identifiable with the specific sales
departments and must therefore be allocated if an equitable and reasonable basis
for allocation exists
Many accountants prefer to apportion all operating expenses to the individual

department only at the end of the accounting period. In this case, there is no
need for departmental expense accounts in the general ledger and fewer postings
are needed. The apportionments may be made on a worksheet, which serves as
the basis for preparing the departmental income statement.
When operating expenses are allocated, they should be apportioned to the

respective departments as nearly as possible in accordance with the cost of
services rendered to them. Determining the amount of an expense chargeable to
467
each department requires the exercise of judgment and considers the cost of
collecting data for use in making an apportionment.
We have different basis of allocation of these costs. The following are common
basis of allocation.
468
Expenses Basis of allocation.
 Sales salary Expense……………………………………Payroll
 Advertising Expense……………………………………Sales
 Depreciation on Store Equipment………………………Average cost of
Equipment
 Depreciation – on Building………………………….…..Floor space
occupied.
 Officers‟ Salaries Expense & Office Salaries ……… ….Relative amount
of time
expense
devoted to each
department
 Rent Expenses, and Heating & Lighting Expense……….Floor space
occupied.
 Property tax Expense & Insurance Expense……………..Average cost of
inventory &
Store
Equipment.
 Uncollectible Accounts Expense…………………………Sales
 Miscellaneous Selling Expense…………………………...Sales
 Miscellaneous General Expense…………………………..Sales
 Delivery Expense…………………………………………Quantity sold.
 Discounts………………………………………………….Purchase
 Commission……………………………………………….Sales
N.B. Basis of allocations may change whenever more reliable and readily
available information is obtained.
469
For example, the apportionment of property tax expense and insurance expense
for Texas co. may be done as follows:
Total Department X Department
Y
Merchandise Inventory:
January 1…………………Birr 141,900 Birr 80,150
Birr 61,750
December 31…………………..164,100 85,150
78,95
Total…………………………...306,000 165,300
140,700
Average …………………………...153,000 82,650
70,350
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Cost of store Equipment:
January 1………………………..28,300 16,400
11,900
December 31……………………31,700 19,600
12,100
Total…………………………….60,000 36,000
24,000
Average…………………………...30,000 18,000
12,000
Total average…………………….183,000 100,650
82,350
Percent…………………………... 100% 55%
45%
Property tax expense………………6,800* 3,740
3,060
Insurance expense…………………3,900* 2,145
1,755
*The total Property tax Expense and Insurance Expense are taken from the
respective accounts of the company for the year.
The apportionment of Uncollectible Accounts Expense, Miscellaneous Selling

Expense and Miscellaneous General Expense are based on sales as indicated
above.
The computation of the apportionment is as follows:
471
Total Department X
Department Y
Sales Birr 900,000 Birr 630,000 Birr
270,000
Percent 100% 70%
30%
Uncollectible Account Expense Br.4,600 Br.3,220
Br.1,380
Miscellaneous Selling Expense 4,700 3,290
1,410
Miscellaneous General Expense 4,800 3,360
1,440
The other operating expenses will be apportioned in a similar manner. An

Income Statement presenting income from operations by departments for Texas
Company appears below.
472
473
1. Ford Company apportions depreciation expense on equipment on the
basis of the combined total of average cost of the equipment and average
cost of the merchandise inventories. Depreciation expense on equipment
amounted to Birr 110,000 and property tax expense amounted to Birr
26,000 for the year. Determine the apportionment of the Depreciation
Expense and the Property tax Expense, based on the following data:
Average cost
Departments Equipment Inventories
Service
R…………………………………….Birr 120,000
M………………………………………….60,000
Sales
100……………………………………….240,000………………Birr
160,000
200……………………………………….420,000……………………360,
000
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300……………………………………….360,000……………………280,
000
Total…………………………………… ..Birr.1,
200,000……………...Birr. 800,000
2. What are the uses of accounting reports by departments?
10.3 DEPARTMENTAL MARGIN APPROACH TO INCOME

REPORTING
Not all accountants agree as to the merits of the type of departmental analysis
discussed in the preceding section (income statement by operating income).
Many cautions against complete reliance on such departmental income
statements on the grounds that the use of arbitrary based in allocating operating
expenses is likely to yield in correct amounts of departmental operating income.
In addition, objection may be made to the reporting of operating income by
departments on the grounds that departments are not independent operating
units, but segments of a single business enterprise, and that therefore no single
department of a business can by itself earn an income. For these reasons, the
format of income statements of segmented businesses may follow a somewhat
different format than the one illustrated previously. The alternative form
emphasizes the contribution of each department to the operating expenses
incurred on behalf of the business as a unified whole. Income statements
prepared in this alternative form are said to follows the departmental margin or
contribution margin approach to income reporting. Departmental margin is the
term used to describe the excess of departmental gross profit over direct
475
departmental expenses i.e. Departmental margin = Departmental sales –
Departmental cost of goods sold - direct departmental expense.
Prior to the preparation of an income statement in the departmental margin

format, it is necessary to differentiate between operating expense that are direct
and those that are indirect.
 Direct expense – Operating expenses directly traceable to or incurred for

the sole benefit of a specific department and usually subject to the control
of the departmental manager.
 Indirect expense – operating expenses incurred for the entire enterprise as
a unit and hence not subject to the control of individual department
managers.
An income statement in the departmental margin format for Texas Company is

presented below.
476
477
Departmental Margin Analysis And Control
The importance of controlling expenses as an essential element of profit

maximization has been emphasized throughout this material. The value of the
departmental margin approach to income reporting derives largely from its
emphasis on the assignment of responsibility for control. An accounting system
that provides the means for such control is sometimes called responsibility
accounting.
With departmental margin analysis, the manager of each department can be held
accountable for operating expense traceable to the department. A reduction in
the direct expenses of a department will have a favorable effect on that
department‟s contribution to the net income of the enterprise.
478
The departmental margin income statement may also be useful to management
in making plans for future operations. For example, this type of analysis can be
used when the discontinuance of a certain operation or department is being
considered. If a specific department yields a departmental margin, it generally
should be retained, even though the allocation of the indirect operating expenses
would result in a net loss for that department. This observation is based on the
assumption that the department in question represents a relatively small segment
of the enterprise. Its termination, therefore, would not cause any significant
reduction in the amount of indirect expenses.
However, the common decision criterion for elimination or retention of a

department is to compare lost revenue with avoidable costs. Lost revenue refers
to the revenue lost by the company if the department is eliminated. Avoidable
costs refer to those costs that can be avoided if the department is eliminated.
Direct expenses are avoidable whereas indirect expenses may be avoidable or
unavoidable.
For example, assume that a company has two departments with the following
data:
Department A Department B
Total
Sales……………………………………Birr 900,000 Birr 600,000
Birr 1,500,000
Cost of sales & operating expenses…………810,000 760,000
1,570,000
Operating income………………………….. ..90,000 Br.(160,000)
(70,000)
Suppose 40% of total cost and operating expenses are unavoidable, should the
company delete department B?
479
To answer this question we have to compare avoidable costs with lost revenues.
If lost revenues greater than avoidable costs, the department should be retained
but if lost revenues less than avoidable costs, the department should be
eliminated. In the above example, avoidable costs are 60% of Birr 760,000 =
456,000 where as lost revenues are Birr 600,000. Lost revenues are greater than
avoidable costs, therefore department B should be retained.
In addition to the above factors, there are others that may need to be considered.
For example, there may be problems regarding the displacement of sales
personnel. Or customers attracted by the least profitable department may make
large purchases in other departments, so that discontinuance of that department
may adversely affect the sales of other departments.
10.4 ACCOUNTING FOR BRANCH OPERATIONS
Branch is a segment of an organization, which is located far geographically. A

business enterprise opens new branches in an effort to increase its sales and
income. Although commonly associated with retailing branch operations are
also carried on by banking institutions, service organizations, and many kinds of
manufacturing enterprises. Regardless of the nature of the business, each branch
ordinarily has a branch manager. Within the framework of general policies set
by top management, the branch manager may be given freedom in conducting
the business of the branch. It is necessary to maintain a record of the assets at
the branch locations and of liabilities incurred by each branch.
There are various systems of accounting for branch operations. The system may
be highly centralized or completely decentralized or between these two
extremes.
480
10.4.1 Centralized Accounting System
A system whereby the accounting for the branch is done at the home office
(head office). The branch may prepare only the basic records of its transactions,
such as sales invoices, time tickets for employees, and vouchers for liabilities
incurred. Copies of all such documents are forwarded to the home office,
where, they are recorded in proper journals in the usual manner. When this
system is used, the branch has no journals or ledgers. If the operating results of
the branch are to be determined separately, which is normally the case, separate
branch accounts for sales, cost of merchandise sold, and expenses must be
maintained in the home office ledger. The principles of departmental
accounting will apply in such cases, with the branch being treated as a
department.
One important result of centralizing the bookkeeping activities at one location

may be substantial savings in office expense. There is also greater assurance of
uniformity in accounting methods used. On the other hand, there is some
likelihood of delays and inaccuracies in submitting data to the home office, with
the result that periodic reports on the operations of a branch may not be
available when needed.
10.4.2 Decentralized Accounting Systems
A system of accounting whereby the branch is responsible for the detailed

accounting and only summary accounts carried for the branch by the home
office. When the accounting for branches is decentralized, each branch
maintains its own accounting system with journals and ledgers. The account
classification for assets, liabilities, revenues and expenses in the branch ledger
481
conforms to the classification used by the home office. The accounting
processes are like those of an independent business, except that the branch does
not have capital accounts. A special account entitled Home Office takes the
place of the capital accounts. The process of preparing financial statements and
adjusting and closing the accounts is substantially the same as for an
independent business. In the remainder of this unit, we will discuss this system
of branch accounting.
1. What are the distinction between centralized and decentralized system of

accounting for branch?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………….
Underlying Principles of Decentralized Branch Accounting
When the branch has a ledger with a full set of accounts except capital accounts,
there must be some tie – in between the branch ledger and the general ledger at
the home office. The properties at the branch are a part of the assets of the
entire enterprise, and liabilities incurred at the branch are liabilities of the entire
enterprise. Although the accounting system at the branch is much like that of an
independent company, the branch is not considered a separate entity but only a
segment of the business.
The tie – in between the home office and the branch is accomplished by the
subsidiary ledger technique, with an added modification that makes the branch
482
ledger a self contained unit. The accounts are Home Office account and
Investment in branch account. These two accounts represent the same item
except their location. Investment at Branch is an asset account which is
maintained at the head office whereas Home Office is a capital account
maintained at the branch. These two accounts have always equal but opposite
balances and are known as reciprocal accounts. The home office account in the
branch ledger replaces the capital accounts that would be used if the branch
were a separate entity. Actually, the account represents the portion of the capital
of the home office that is invested in the branch.
Transactions that are usually made between the Home Office and the Branch
a r e:
1. Transfer of assets from head office to branch. The assets may be cash,
equipment etc.
2. Transfer of assets from branch to head office.
3. Reporting of operation income or loss by branch.
When the home office sends assets to the branch, it debits investment in branch
account for the total and credits the proper asset accounts. Upon receiving the
assets, the branch debits the proper asset accounts and credits Home office.
When the branch transfers assets to the home office, it debits the Home Office
account and credits the proper asset accounts. Upon receiving the assets, the
head office, debits the proper asset accounts and credits Investment in branch
account.
As the branch incurs expenses and earns revenue, it records the transactions in
the usual manner. Although such transactions affect the amount of the home
office investment at the branch recognition of the change is delayed until the
483
accounts are closed at the end of the accounting period. At that time, the
Income Summary account in the branch ledger in closed to the account Home
Office. If the operations have resulted in an operating income, the account
Home Office will be credited and Income Summary will be debited.
In the Home Office, an operating income at the branch is recorded by a debit to

Investment in Branch and a credit to Branch Operating Income. For an
operating loss, the entries would be just the reverse.
Illustration:
1. July 1,2002 ABC. Co. (the home office) sent Birr 8000 to Bahir Dar
Branch.
2. July 22,2002 the branch sent Birr 5000 to the home office.
3. July 31, 2002 the branch reported an operating income of Birr 3000.
Record the above transactions in the Branch and head Office books.
Solution:
Head office Book Branch Book

2002 Investment in branch –Bahir Dar…….8000
July
cash………….8000
1
July 1 Cash……………………………..8000 Head
office……8000
(Home
office)
2002
July
22 484
2000 Cash………………………………..5000 Head
Office…….5000
July 22 Investment in Branch –Bahir Dar…….5000
Cash……………….5000
22000002 Investment in branch –Bahir Dar….3000 Income

July
su3m 1 mary …….3000
July 31 Branch Operating income………..3000 Head
office……………3000
In a merchandising business, the branch can get assets either from transfer of
merchandise from head office or purchase from local supplier.
When the branch purchase items from outside suppliers no journal entry is
necessary at head office and the branch record the purchase as if it is a separate
But when the branch obtains assets from head office the journal entries depend
on whether perpetual or periodic inventory system is used.
When perpetual inventory system is used, a shipment of merchandise from the

home office is recorded by the home office by debiting Investment in Branch
and crediting Merchandise Inventory. The branch records the transactions by
debiting merchandise inventory and crediting Home Office.
When periodic inventory system is used a shipment of merchandise from the

home office is recorded by the home office by debiting Investment in Branch
and crediting shipments to Branch. The branch records the transaction by
485
debiting Shipments from Home Office and crediting Home Office. The two
shipments accounts are also reciprocal accounts.
The account Shipments to Branch is a contra account representing a reduction in

merchandise inventory and purchases in the home office ledger. A Shipment
from Home Office, in the branch ledger, is like a purchase account. Both
accounts are temporary in nature and are periodically closed to the respective
Income Summary accounts.
Illustration of Decentralized Branch Accounting
Home office Entries Branch

Entries
Transactions
1. The home office established Branch #1 near the end of the fiscal year,
sending Birr 20,000 in cash and Birr 40,000 in merchandise.
Investment in Branch #1…..60,000

Cash……………………….20,000
Cash…………………………20,000 Shipments from Head
Office….40,000
Shipments to Branch #1…….40,000 (Merchandise
Inventory)
Head
Office……………...60,000
2. The branch purchased on account Birr 20,000 of merchandise, Birr

30,000 of equipments, and Birr 1,500 of Prepaid Insurance.
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Purchases……………….20,000
(Merchandise Inventory)
No need
Equipment……………..30,000
Prepaid
Insurance…….....1500
Accounts
payable……….51,500
*Only entries and accounts affecting Branch #1 are presented.
3. The branch sold merchandise for Birr 36,000 in cash and Birr 21,000 on
account
Cash……………..36,000
Account
Receivable…21,000
No need
Sales…………………..57,000
4. The branch paid operating expenses of Birr 11,300.
Operating expenses………..11,300
No need Cash………………………...11,300
5. The branch collected Birr 12,000 on accounts receivable.
487
Cash ………………..12,000
No need Account Receivable……..12,000
6. The branch paid Birr 32,000 on accounts payable.
Account Payable……..12,000
No need Cash ………………..12,000
7. The branch sent Birr 10,000 in cash to the home office.
Cash……………10,000 Home Office………..10,000

Investment in Branch # 110,000 Cash……………..10,000
Adjusting Entries.
a) To record the branch ending merchandise inventory

Merchandise Inventory………………22,000
Income
Summary…………………..22,000
N.B. if perpetual inventory system is
used no need of adjustment.
b) To record the branch Insurance and Depreciation expense.
488
Operating expenses………700
Prepaid Insurance……...........200
Accumulated Depreciation….500
c) to close the branch sales account.
Sales……………………57,000
Income Summary………….57,000
d) To close the branch cost and expense accounts.
Income summary………………..72,000
Shipments from Head office……….40,000
Purchases…………………………..20,000
Operating expenses…………………12,000
e) To close the branch Income Summary account and to record the operating
income of the branch in the accounts of the home office.
Investment in Branch #1……….7,000 Income summary

……7,000
Branch # 1 operating income…..7,000 Home
office…………7,000
After the foregoing entries have been posted, the Home Office accounts affected
and the Branch ledger accounts appear as shown below.
489
Home office ledger Branch
ledger.
Cash Cash
(7) 10,000 (1) 20,000 (1) 20,000 (4)
11,300
(3) 36,000 (6)
32,000
(5) 12,000 (7)
10,000
68,000
53,300
Bal. 14,700
Accounts
Receivable
(3) 21,000 (5)
12,000
Bal. 9,000
Home office ledger Branch ledger

Merchandise
Inventory
(a) 22,000
490
Prepaid Insurance
(2) 1500
(b) 200
Bal. 1300
Equipment
(2) 30,000
Accumulated
Depreciation
(b) 500
Investment in Branch #1 Accounts

Payable
(1) 60,000 (7) 10,000 (6)32,000
(2) 51,500
(e) 7,000 Bal.
19,500
Bal.57,000
Bal. 15,500
491
Home
Office
(7) 10,000 (1)
60,000
(e )
7,000
Branch #1 operating income
Bal. 57,000
(e) 7,000
Income
Summary
(d ) 72,000
(a) 22,000
* Branch operating income will (e) 7,000 (c) 57,000
be closed to the Income summary
account.
Sales
(c ) 57,000 (3)
57,000
Shipment to Branch#1 _ _
(1) 40,000
Shipments from
Home office
(1 ) 40,000
(d) 40,000
*Shipments to Branch #1 is _
_ deducted from the sum of the
beginning inventory an d Purchases
purchases. It will be closed to

492
the Income Summary account.
(d ) 20,000 (1 )
20,000
_ _
Operating
expense
(4) 11,300 (d)
12,000
(b) 700
_ _
10.5 FINANCIAL STATEMENTS FOR HOME OFFICE AND BRANCH
Branch financial statements differ from those of a separate business entity in two
major respects. In the Branch Income Statement, Shipments from the Home
Office appear in the cost of merchandise sold section following Purchases. In
the Branch Balance Sheet, the account Home Office takes the place of capital
accounts.
The Home Office Income Statement reports details of sales, cost of merchandise
sold, and income or loss from Home Office operations in the usual manner. The
operating income and loss of each branch is then Listed, and the operating
results for the entire enterprise are reported. The asset section of the balance
sheet prepared from the Home Office ledger will include the controlling
accounts for the various branches. The various asset and liabilities at the branch
locations will not be disclosed.
493
The home office statements, together with financial statements for each
individual branch, serve a useful purpose for management. They are not usually
issued to stockholders and creditors. Accordingly, it is necessary to combine the
data on the income statements of the home office and the branches to form one
overall income statement. The data on the balance sheet of the home office and
of the various branches are also combined to form one balance sheet for the
enterprise. The preparation of the combined statements is made easier by the
use of worksheets. The worksheets are similar in that each has a column for the
home office account balance, a column for the account balances of each branch,
a set of columns headed “Eliminations” and a final column to which the
combined figures are extended.
The combined income statement and the related worksheet for Kelles
Corporation are as follows:
Keller Corporation
Worksheet for Combined Income statement
For the year ended December 31,2002.
Home Branch Eliminations Combined
office #1 Income
statement
494
Debit Credit
Sales 897,000 57,000 954,000
Merchandise inventory January 141,000 141,000
1,2002
Purchases 652,000 20,000 672,000
Shipments from Home Office 40,000 40,00
0
Less: shipments to Branch#1 40,000 ______ 40,00 __________
_ 0 __
Merchandise available for sale 753,000 60,000 813,000
Less: merchandise Inventory
December 31, 2002 150,000 22,000 172,000
Cost of merchandise sold 603,000 38,000 641,000
Gross Profit 294,000 19,000 313,000
Operating expenses 150,500 12,000 162,500
Income before income tax 143,500 7,000 40,00 40,00 150,500
0 0
Income tax 66,740
Net income 83,700
Keller Corporation
Income Statement
For the Year ended December 31,2002
Sales 54,000
Merchandise Inventory, January 1,2002 141,000
Purchases 672,000
Merchandise available for sale 813,000
Less: Merchandise Inventory, December 31,2002 172,000
Cost of merchandise sold 641,000
Gross profit 313,000
Operating expense 162,500
Income before income tax 150,500
Income tax 66,740
Net income 83,760
495
The account Shipments from Home Office is canceled by a Credit in the
Elimination Column, and the account Shipments to Branch # 1 is canceled by a
Debit in the Elimination Column. These eliminations are necessary in the
preparation of a combined statement reporting the Home Office and the branch
as a single operating unit. The two account, merely record a change in location
of merchandise within the company.
The combined balance sheet and the related worksheet for Keller Corporation
are presented below. The reciprocal account Investment in Branch # 1 is
canceled by a credit elimination; the reciprocal accounts Home Office is
canceled by a debit elimination.
Killer Corporation
Worksheet for combined Balance Sheet
December 31,2002
Home Branch #1 Eliminations Combined
Office Balance
sheet
Debit Credit
Debit Balances
Cash 62,000 14,700 76,700
Accounts Receivable 81,000 9,000 90,000
Merchandise Inventory 150,000 22,000 172,000
Prepaid Insurance 8,200 1300 9,500
Investment in Branch #1 57,000 57,000
Equipment 195,000 30,000 225,000
Total 553,200 77,000 573,000
Credit Balance
Accumulated depreciation 87,000 500 87,500
Accounts Payable 110,000 19,500 129,500
Home Office 57,000 57,000
Common stock 200,000 200,000
Retained Earnings 156,200 156,200
496
Total 553,200 77,000 57,000 57,000 573,200
Keller Corporation
Balance sheet
December 31,2002
Assets Liability and Capital

Cash……………………………………76,700 Accounts
payable……………………..129,500
Accounts Receivable………….. ……...90,000
Merchandise Inventory……………... Capital
172,000
Prepaid Insurance……………………….9,500 Common stock, Birr 10
per………….208,000
Equipment………………..225,000 Retained
earning……………………..156,200
Less: Accumulated depn‟….87,500 Total
capital…………………………356,200
Total assets………………………… 485,700 Total liabilities &
497
capital……………485,700
10.6 SHIPMENTS TO BRANCH BILLED AT SELLING PRIES
In the foregoing discussion and illustrations, the billing for merchandise shipped
to the branch has been assumed to be at cost price. When all or most of the
merchandise handled by the branch is supplied by the home office, billings are
usually made at selling price. An advantage of this procedure is that it provides
a convenient control over inventories at the branch. The branch merchandise
inventory at the beginning of the period (at selling price), plus shipments during
the period (at selling price), less sales for the period yields the ending inventory
(at selling price). Comparison of the book amount with the physical inventory
taken at selling prices discloses any difference. A significant difference between
the physical and book inventories indicates a need for remedial action by the
management.
When shipments to the branch are billed at selling prices, no gross profit will be
reported on the branch income statement. The merchandise inventory on the
branch balance sheet will also be stated at the billed (selling) price of the
merchandise on hand. In combining the branch statements with the home office
statements, it is necessary to convert the data back to cost by eliminating the
markup form both the Shipments accounts and the Inventory accounts.
Check Your Process Exercise -3
498
Area Company has established two branches Branch #1 and Branch #2. The
transfer of assets(cash) among Home Office, Branch 1 and Branch 2 is as
indicate below:
Home Office
Movement 1
Branch #1 __________________ Branch #2.
Movement 1: Transfer of cash by the home office to branch #1.

Movement 2: Transfer of cash by branch #1 to branch #2.
Required: Record movement 1 and movement 2 in the books of the Home

Office, Branch #1
and Branch #2 assuming that Decentralized Accounting system is
used (5 journal
entries are necessary)
…………………………………………………………………….………………
………
……………………………………………………………………………………
………
……………………………………………………………………………………
………
10.7 SUMMARY
Departmental accounting is more likely to be used by a large business than by a

small one, but some degree of departmentalization may be used by a small
499
enterprise. Accounting reports for departmental operations are generally limited
to income statements although departmental income statements are not usually
issued to external users.
In an effort to increase its sales and income a business enterprise may also open
new branches (stores). Regardless of the nature of the business each branch
ordinary has a branch manager. Within the framework of general policies set by
top management, the branch manager may be given freedom in conducting the
business of the branch.
There are various systems of accounting for branch operations. The system may
be highly centralized, with the accounting for the branch done at the home
office. Or the system may be almost completely decentralized, with the branch
responsible for the detailed accounting.
10.8 ANSWERS TO CHECK YOUR PROGRESS EXERCISE

i) a) Apportionment of depreciation expense:
Total Services Department Sales

Department
R S 100
200 300
Average cost of Equipment…1,200,000 120,000 60,000 240,000
420,000 360,000
Percent……………………… 100% 10% 5% 20%
35% 30%
500
Depreciation Expense……….110,000 11,000 5,508 22,000
38,500 33,000
b) Apportionment of property tax expense
Total Services Department Sales

Department
R S 100
200 300
Average cost of Equipment
& inventory…………Br.2,000,000 120,000 60,000 400,000
780,000 640,000
Percent………………………….100% 6% 3% 20%
39% 32%
Property tax expense………. 26,000 2,160 1,080 5,200

10,140 8,320
ii) The uses of Accounting reports by departments are

a) for planning and allocating of resources.
b) For controlling of operations.
c) For evaluating performance

In centralized system of accounting, the accounting for the branch is done at the
head office. The branch is limited to business activities but in decentralized
system of accounting, the detailed accounting activities are done by the branch.
501
Branch #1 Book Branch #2 Book Home o ffi c e /Area
Co/book
Moment 1. Cash……….XX Investment in branch

#1…XX
Home Office…XX ___
Cash……………XX
Movement 2 Home Office…XX Cash…………XX Investment

in
Cash………….XX Home office…XX
Branch #2….XX
Investment
in
Branch #1…..XX
Part A. Multiple Choices
1. Which of the following would be the most appropriate basis for allocating
rent expense
for use in arriving at operating income by department?
A. Departmental Sales C. Cost of inventory
B. Physical space occupied D. Time devoted to departments.
502
2. On the income statement departmentalized through departmental margin,
sales commission expense would be reported as:
A. a direct expense C. as other expense
B. an indirect expense C. none of the above.
3. In accounting for a firm with a colony west branch, the home office and
colony west branch accounts are known as
A. home office ledger accounts C. reciprocal accounts
B. branch ledger accounts D. none of the above.
4. In the worksheet for a combined income statement for the Home Office and
its North side Branch what item is eliminated as an offset to Shipments to
North side Branch?
A. Home office C. Shipments from Home office
B. North side Branch D. None of the above.
Part B. Exercises
1. Describe the underlying principle of apportionment of operating expenses to
departments for income statements departmentalized through income from
operations.
2. Differentiate between a direct and an indirect operating expense.
3. What is the nature of reciprocal accounts employed in branch accounting?
4. a) What Home Office accounts are debited and credited to record the
operating income of the Columbus Branch?
503
b) What branch accounts are debited and credited to close the Columbus
Branch Income Summary account
5. Where are the journals and ledgers detailing the operations of a branch
maintained in
a) a centralized system for branch accounting?
b) A decentralized system?
6. During the year, the Home Office shipped to the Branch merchandise that
had cost Birr 300,000. The branch was billed for Birr 420,000, which was
the selling price of the merchandise. No merchandise was purchased from
any outside sources. Branch net sales for the year totaled Birr 380,500. All
sales were made at the billed price. Merchandise on hand at the beginning of
the period totaled Birr 68,300 at the billed price. Merchandise on hand at the
end of the period as determined by physical count was Birr 101,470 at the
billed price. Determine the amount, at the billed price, of any discrepancy
between the book amount and the physical count of inventory.
10.10 REFERENCE BOOKS
1. Fees and Warren: Principles of Accounting, 16th Edition

2. Fees and Warren: Principles of Accounting, 14th Edition.
Part C. Work out
504
Branch # 1 Book (Area Co.) Home office
book
Movement 1. Cash…………..XX Investment in Branch

#1…XX
Home Office……XX
Cash………………….XX
Movement 2. Home office……XX Investment in

branch#2…XX
Cash…………..XX Investment in
branch#1….XX
Branch # 2 book
Movement 1. No need of journal entry.
Movement 2. Cash……………………………..XX
Home office………………………XX
10.11 GLOSSARY
1. Branch: Segment of an organization, which is located far geographically.
2. Centralized accounting system: a system of accounting whereby the

accounting for the branch is done at the
head office.
505
3. Decentralized accounting system: a system of accounting whereby the
branch is responsible for the detailed
accounting and only summary accounts
carried for the branch by the home office.
4. Departmental margin: departmental gross profit less direct departmental

expense.
5. Direct expense: an expense directly traceable to or incurred for the sole

benefit of a specific department and ordinarily
subject to the control of the department
manager.
6. Shipment to branch accounts – a contra account representing a reduction in

merchandise inventory and purchases in the
home office.
506

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PRINCIPLES OF ACCOUNTING I Acct.

BLOCK I. STRUCTURE OF ACCOUNTING

BLOCK II. ACCOUNTING CONTROL SYSTEMS

BLOCK III. ACCOUNTING FOR CURRENT ASSETS

1.0 Aims & Objectives

1.0 AIMS & OBJECTIVES

But to take advantage of these, we need knowledge of information systems.

The kind of information processed in accounting is financial i.e. of a monetary

Therefore, a study of accounting helps people make better and informed

But the use of accounting information is not limited to accountants or people in

This course discusses the fundamental principles involved in processing

Understanding these fundamental principles is very important because

Let‟s take a closer look at the activities involved in the process:

A Vital element in communicating economic events is the accountant‟s ability

As accounting plays an important role in the decision making process of

1.2.2 Importance of Accounting and Users of Accounting Information

1.3 BOOKKEEPING VERSUS ACCOUNTING

People often fail to understand the difference between accounting and

A person might become a reasonably proficient bookkeeper in a few weeks or

Check Your Progress Exercise -1

Users of Accounting Information

1) External Users: External Users of accounting information are parties, which

- The area of accounting aimed at serving external users is called Financial

Creditors lend money or other resources to an organization. Lenders include

b) Share- holders (Stockholders)

c) Employees and labour Unions

The Inland Revenue Authority requires organizations to prepare financial

The area of accounting aimed at serving the decision-making needs of internal

 What are manufacturing costs per product?

1.4 THE ACCOUNTING PROFESSION

ii) Private Accounting

2. Budgeting: Assisting management in quantifying goals concerning

3. General Accounting: recording daily transactions and preparing

4. Accounting information systems: designing both manual and

6. Internal Auditing: reviewing a company‟s operations to determine

iii) Not for Profit Accounting

Check your Progress Exercise -2

1. What are the basic categories of the users of accounting information?

2. _____________is the area of accounting aimed at serving external users of

3. _____________ is the area of accounting aimed at serving the decision-

4. What are the three major fields of engagement for accountants?

1.5. ACCOUNTING PRINCIPLES AND CONCEPTS

In this unit, we will discuss three of the generally accepted accounting

i) Business Entity Concept

ii) The cost principle

For example, Modern Advertising Company is considering the purchase of a

Monetary Unit Assumption

Check Your Progress Exercise -3

1. The abbreviation GAAP stands for ____________________________.

4. What is the principle that says properties acquired by business enterprises

1.6 FORMS OF BUSINESS ORGANIZATIONS

A sole proprietorship is a separate entity for accounting purposes (Business

1.7 BUSINESS TRANSACTIONS AND THE ACCOUNTING EQUATION

A transaction can be an exchange (such as the purchase or sale of property, payment or

For a given transaction to qualify to be recorded it has:

(i.e. it should not be a mere promise or intention; it must be at least partially

1.7.1 Assets, Liabilities and Owner’s Equity

Economic Resources = claims over the

It is customary to place “liabilities“ before “Owners equity” in the accounting equation

Check Your Progress Exercise -4

1 Business organizations are classified in to three, based on what?

2 What do we mean by the term „unlimited liability‟?

5 Assume total asset of Br 60,000, and owner‟s equity of Br 45,000.