MicroLink Information Technology and Business College

Department of Accounting and Finance

Handout for

Principles of Accounting II

March, 2018

Mekelle

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 Chapter 9

Inventories

9.1. Definition of Inventories

Inventories: are Stocks of goods held by businesses for further processing or for sale.

Another definition...

Inventories: are merchandises that are purchased and/or produced and stored for eventual sale.

9.2. Importance of Inventories

Inventory systems meet the needs of a business by providing information regarding inventory
quantities and birr values. Many inventory systems provide information regarding the specific
warehouse location of the inventory and the quantity held in that location. Plant employees and
managers use this information to locate specific items for shipping to customers or to determine
if the company needs to reorder a specific inventory item because the available inventory has
decreased. Inventory also provides information to the accounting department regarding the total
inventory value owned by the company.

9.3. Inventory Systems

There are two systems to account for inventory:

1. The perpetual Inventory System

With the perpetual system, the inventory account is updated after every inventory purchase or
sale. Before computers became widely available, only companies that sold a relatively small
number of high-priced items used this system

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The Perpetual Inventory Method keeps a running, continuous record that tracks the
Inventories and the cost of Goods Sold on a day to day basis.

A perpetual inventory system updates each time the warehouse receives inventory from vendors
as well as each time the warehouse ships inventory to a customer. The perpetual inventory
system provides the inventory balance at any point in time. This balance continually updates

2. The periodic system.

Under the periodic system, a careful evaluation of inventory occurs only at the end of each
accounting period. At that time, each product available for sale is counted and multiplied by its
per unit cost, and the total of all such calculations equals the value of inventory.

The periodic inventory system, unlike the perpetual inventory system does not involve a day to
day record of Inventories or of the cost of goods sold.

Physical Inventory

A physical inventory consists of manually counting each inventory item and comparing it to the
quantity recorded in the inventory system. Some companies separate employees into two groups,
with one group counting each item and the second group recounting each item. This allows the
company to compare the two counts to the quantity recorded in the system and identify potential
inventory problems. A physical inventory count allows the company to correctly determine
inventory quantities, identify necessary inventory adjustments and investigate variances.

Inventory Adjustment

Sometimes companies discover discrepancies between the actual quantities in the inventory and
the recorded inventory. When this occurs, the company records an inventory adjustment to
correct the inventory balance in the system. Adjustment quantities arise from comparing the
actual quantity to the system quantity. The purpose of the inventory adjustment is to make the
inventory system equal the actual inventory owned by the company.
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Inventory Variance
After performing a physical inventory, a company investigates the quantity variances discovered
to determine the reason for the variances. Variances typically arise as a result of employee errors,
theft or destruction

9.3. Determining the actual quantities in the inventory

 Inventory is a significant asset and for many companies the largest asset.
 Inventory is central to the main activity of merchandising and manufacturing companies.
 Mistakes in determining inventory cost can cause critical errors in financial statements.
 Inventory must be protected from external risks (such as fire and theft) and internal fraud
by employees.

The actual quantity of an inventory is determined by conducting a physical count. The physical
count may be undertaken continually or once a year.

Example: XYZ Company has the following data

Units Cost per unit Price per unit

Jan.1 beginning inventory 10 20
4 sale 7 30
10 purchase 8 21
22 sale 4 31
28 sale 2 32
30 purchase 10 22

Required: Determine the actual quantity of inventory on January 31

Beginning inventory …………………………………. 10 units

Add: purchase: (8units+10 units)……………………….. 18 units

Number of units available for sale……………………… 28 units

Less: Number of units sold (7units+4units+2units)…….. 13 units

Actual quantity of ending inventory on January 31 …. 15 units

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Effect of Inventory Errors on Financial Statements

If merchandise inventory is . . . . . . . Understated

Cost of merchandise sold is . . . . . . Overstated

Gross profit and net income are . . . Understated

Ending owner’s equity is . . . . . . . . . Understated

9.4. Determining the cost of inventory

The Cost of Inventory

The cost of inventory includes the cost of purchased merchandise, less discounts that are taken,
plus any duties and transportation costs paid by the purchaser. If the merchandise must be
assembled or otherwise prepared for sale, then the cost of getting the product ready for sale is
considered part of the cost of inventory. Technically, inventory costs include warehousing and
insurance expenses associated with storing unsold merchandise. However, the cost of tracking
this information often outweighs the benefits of allocating these costs to each unit of inventory;
so many companies simply apply these costs directly to the cost of goods sold as the expenses
are incurred.

9.5. Inventory costing Methods

First In, First Out

The first in, first out method most closely approximates the real-world purchasing cycle and
parallels the actual flow of inventory from purchase to sale in a wide range of businesses. Under
the FIFO method, the oldest costs are assigned to inventory items sold, regardless of whether the
sold items were actually purchased at that cost. When the number of inventory items purchased
at the oldest cost is sold, the next oldest cost is assigned to sales.

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Last in, First Out

The last in, last out method is the exact opposite of the FIFO method, assigning the most recent
inventory costs to items sold. Last in, last out is less practical in most businesses, but there are a
few specific situations in which LIFO more closely approximates the actual flow of inventory.

Average Cost Method

The average cost method assigns inventory costs by calculating a moving average of all
inventory purchase costs. This method can be ideal for companies that sell non-perishable
inventory in a non-sequential manner, such as video game retailers. The average cost method can
also provide a more steady, reliable cost recognition structure than other methods, assuming
costs do not swing wildly up and down for inventory items.

9.5.1. Inventory Costing Methods under Periodic Inventory System

A. FIFO Periodic

Example:

Jan. 1 Beginning Inventory 200 units @ 9 birr

Mar. 10 Purchase 300 units @ 10 birr

Sept. 21 Purchase 400 units @ 11 birr

Nov. 18 Purchase 100 units @ 12 birr

Assume: A physical count on December 31 reveals that 700 of the 1,000 units have been sold

Required: Determine:-

1. The number of units available for sale

2. The number of units on hand (ending inventory units)
3. The cost of goods available for sale
4. The cost of ending inventory
5. The cost of goods sold

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B. LIFO Periodic

Example:

Jan. 1 Beginning Inventory 200 units @ 9

Mar. 10 Purchase 300 units @ 10

Sept. 21 Purchase 400 units @ 11

Nov. 18 Purchase 100 units @ 12

Assume: A physical count on December 31 reveals that 700 of the 1,000 units have been sold

Required: Determine:-

1. The number of units available for sale

2. The number of units on hand ( ending inventory units)
3. The cost of goods available for sale
4. The cost of ending inventory
5. The cost of goods sold

C. Average Cost Periodic

Example:

Jan. 1 Beginning Inventory 200 units @ 9

Mar. 10 Purchase 300 units @ 10

Sept. 21 Purchase 400 units @ 11

Nov. 18 Purchase 100 units @ 12

Assume: A physical count on December 31 reveals that 700 of the 1,000 units have been sold

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Required: Determine:-

1. The number of units available for sale

2. The number of units on hand ( ending inventory units)
3. The cost of goods available for sale
4. The cost of ending inventory
5. The cost of goods sold

9.5.1. Inventory Costing Methods under Perpetual Inventory System

A. FIFO - Perpetual

Item 127B Units Cost per unit Price per unit

Jan. 1 Inventory 10 20

4 Sale 7 30

10 Purchase 8 21

22 Sale 4 31

28 Sale 2 32

30 Purchase 10 22

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Item 127B

Date Purchases Cost of Mdse. Sold Inventory Balance

Qty Unit Total Qty Unit Total Qty Unit Total

Cost Cost Cost Cost

Jan. 1 10 20 200
4 7 20 140 3 20 60
10 8 21 168 3 20 60
8 21 16
22 3 20 60
1 21 21 7 21 147
28 2 21 42 5 21 105
30 10 22 220 5 21 105
10 22 220
Totals 18 388 13 263 15 325
B. LIFO Perpetual

Item 127B Units Cost per unit Price per unit

Jan. 1 Inventory 10 20

4 Sale 7 30

10 Purchase 8 21

22 Sale 4 31

28 Sale 2 32

30 Purchase 10 22

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Item 127B

Date Purchases Cost of Mdse. Sold Inventory Balance

Qty Unit Total Qty Unit Total Qty Unit Total

Cost Cost Cost Cost

Jan. 1 10 20 200
4 7 20 140 3 20 60
10 8 21 168 3 20 60
8 21 168
22 4 21 84 3 20 60
4 21 84
28 2 21 42 3 20 60
2 21 42
30 10 22 220 3 20 60
2 21 42
10 22 220
Totals 18 388 13 266 15 322

9.6. Valuation of inventories at other than cost

9.6.1. Valuation at lower of cost or market

Lower of Cost or Market

Compare the Cost and Market

Cost per Market per Lower of Cost or

Item Units LCM Inventory
unit unit Market (LCM)
1 65 68 65 500 32,500
2 80 72 72 300 21,600
3 90 102 90 400 36,000
4 38 36 36 700 25,200
5 20 22 20 900 18,000
6 55 48.5 48.5 600 29,100
Total 162,400

 Inventory valuation at Cost, Market and LCM

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 Item Units Inventory at Cost Inventory at Market Inventory at LCM
1 500 32,500 < 34,000 32,500
2 300 24,000 > 21,600 21,600
3 400 36,000 < 40,800 36,000
4 700 26,600 > 25,200 25,200
5 900 18,000 < 19,800 18,000
6 600 33,000 > 29,100 29,100
Total 170,100 < 170,500 162,400
Total inventory at cost < Total inventory at market

9.8. Presentation of Merchandise Inventory on the Balance Sheet

Dawit Company
Balance Sheet
December 31, 2007

Assets

Current assets:

Cash 19, 400 00

Accounts receivable 80 000

Less allowance for doubtful accounts 3 000 77,000 00

Merchandise inventory 216 300 00

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9.9. Estimating Inventory Cost

9.9.1. Retail Method of Estimating Inventory Cost

 Retail method is based on relationship between cost of merchandise available for sale and
the retail price.
 Retail prices of all merchandise must be accumulated and totaled.
 Inventory at retail is calculated at retail price of merchandise available for sale less net
sales at retail.
 Ratio is calculated as cost divided by retail price.
 Inventory at retail price times cost ratio equals estimated cost of inventory.

Step 1: Determine the ratio of cost to the retail price

Retail Inventory Method

Cost Retail

Merchandise inventory, Jan. 1 19,400 36,000

Purchases in January (net) 42,600 64,000

Merchandise available for sale 62,000 100,000

Ratio of cost to retail price = 62,000 = 62%

100,000

Step 2: Determine the ending inventory at retail.

Retail Inventory Method

Cost Retail

Merchandise inventory, Jan. 1 19,400 36,000

Purchases in January (net) 42,600 64,000

Merchandise available for sale 62,000 100,000

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Sales for January (net) 70,000

Merchandise inventory, January 31, at retail 30,000

Step 3: Calculate the estimated inventory at cost.

Merchandise inventory, January 31, at cost

(30,000 x 62%) 18,600

9.9.2. Gross Profit Method of Estimating Inventory Cost

1. A gross profit percentage rate is estimated based on previous experience adjusted for known

changes.

2. Estimated gross profit is calculated by multiplying the estimated gross profit rate times the

actual net sales.

3. Estimated cost of merchandise sold is calculated by subtracting the gross profit from actual
sales.

4. The cost of merchandise sold estimate is deducted from actual merchandise available for sale

to determine the estimated cost of merchandise inventory.

Gross Profit Method

Merchandise inventory, January 1 $ 57,000

Purchases in January (net) 180,000

Merchandise available for sale 237,000

Sales in January (net) 250,000

Less: Estimated gross profit

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 (250,000 x 30%) 75,000

Estimated cost of merchandise sold 175,000

Estimated merchandise inventory, January 31 62,000

The gross profit method is useful for estimating inventories for monthly or quarterly financial
statements in a periodic inventory system.

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 Chapter 10

Plant Assets and Intangible Assets

10.1. Acquisition of Plant Assets

Plant Assets are tangible assets that are used in the operation of the company and have a useful
life of more than one accounting period. We observe that plant assets are tangible assets in the
sense they can be touched with our hands, and seen with our eyes. They are used in operations
for a period of more than a year. Plant assets are also called fixed assets or long term assets.

Plant assets are distinguished from other assets in two important features,

1. They are used in operation

If we take inventories, they are held for sale and not used in operations. But plant assets are
held for use in operations.

2. The useful lives of plant assets are more than one year. This makes plant assets different
from current assets such as supplies. Supplies are usually consumed in a short time.

10.1.1. Initial cost of plant assets

Plant assets are recorded at cost when purchased. The cost of acquiring a plant asset includes
all expenditures necessary to get it in place and ready for use. These includes:-

1. Purchase price
2. Sales tax
3. Transportation charges
4. Insurance while in transit
5. Assembling costs

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The four major plant assets are land, building, machinery and equipments.

Land

The cost of land includes:

1. Purchase price
2. Fee paid to real estate commission
3. Legal fees
4. Title investigation
5. Accrued property taxes paid by the purchaser
6. Costs of surveying, clearing, grading, draining, the landscaping
7. Assessments of local of local government for items such as roadways, sewers, and sidewalk
if they are expected to last as long as the building

Buildings

The cost of building includes:-

1. Purchase price
2. Brokerage
3. Taxes
4. Uses for building such as wiring, lighting, flooring and etc.

Machinery and Equipment

The cost of machinery and equipment are:-

1. The purchase price of machinery and equipment

2. Taxes
3. Transportation charges
4. Insurance cost while in transit

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10.2. Nature of Depreciation

As time passes, all plant assets with the exception of land lose their capacity to yield services.
Accordingly, the cost of such assets should be transferred to the related expense accounts in an
orderly manner during their expected useful life. This periodic cost expiration is called
depreciation.

Factors contributed to a decline in usefulness may be divided into two categories.

1. Physical depreciation: this includes wear from the use and deterioration from the action
of the elements, and
2. Functional depreciation: This includes inadequacy and obsolescence. A plant asset
becomes inadequate if its capacity is not sufficient to meet the demands of increased
production. A plant asset is obsolete if the commodity that it produces is not longer in
demand or if a new machine can produce a commodity of better quality or a great
reduction in cost.

10.3. Accounting for Depreciation

10.3.1. Depreciation Methods

There are many depreciation methods for allocating the cost of a plant asset over the accounting
periods in its useful life. The most common ones are:-

1. Straight line method

2. Units of Production Method
3. Double declining balance method
4. Sum-of-the- years digits method

Example: Assume that equipment has original cost of Br. 25,000, expected useful life of 5 years
(or produces 44,000 units) and estimated salvage value of Br. 3,000. The accounting period runs
from January 1 to December 31. The equipment was placed in operation on January 1, year 1.

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1. Straight Line Method
Straight line method charges the same amount of depreciation to expense for each period of
the asset’s useful life.

Depreciation in straight line method is computed as follows

Annual Depreciation = Original Cost – Salvage Value
Estimated useful life

25,000-3,000 = Br. 4,400

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Thus depreciation for each of the five years is Br. 4,400.

Once depreciation is computed for the year, it has to be recorded in the ledger using the
following entry

Depreciation expense………………………………..…4400
Accumulated Depreciation-Equipment………………..4400

Entry for year 2, year 3, year 4, and year 5 are the same for straight –line method.

Depreciation expense account is a temporary account that is closed at the end of the period. But
Accumulated Depreciation is a contra plant asset account, and thus reported in the balance sheet.

Depreciable cost = Original cost-salvage value

Book Value: a portion of the cost of a plant asset that is not depreciated by the end of the period.

Based on the ongoing example, book value is computed at the end of each year

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Book value at the end of:

Year 1=25,000-4,400 = 20,600

Year 2=25,000-8,800 = 16,200
Year 3=25,000-13,200 =11,800
Year 4=25,000-17,600 = 7,400
Year 5=25,000-22,000 = 3,000

Note that the book value of the asset should equal to its salvage value at the end of its useful life.
In the illustration under consideration, salvage value is Br. 3,000, which is also equal to book
value at the end of year 5.

Another way to calculate depreciation under straight line method is to first compute straight line
depreciation rate, which is computed as 100% divided by the useful life of the asset, i.e

Straight line depreciable rate= 100

Useful life
100 = 20%
5

In the illustration under consideration, straight line rate is 20%. This rate is applied to the
depreciable cost.

For example depreciation for year 1 is equal to:

22,000x20%= Br. 4400

Points to remember

1. Under straight line method, depreciation expense is the same each period
2. The balance of accumulated depreciation increases each year
3. Book value declines each period until it equals salvage value at the end of its useful life
4. Straight line method is appropriate when the asset usage remains constant
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2. Units of Production Method

Units of production method charge a varying amount to expense each period of asset’s useful life
depending on its usage. It is appropriate when the use of asset varies from period to period.

To apply the units of production method, the length of life the asset is expected in terms of
productive capacity, such as hours, miles, or number of units.

Under unit of production method, two steps are followed to compute depreciation expense.

Step 1. Compute depreciation per unit, hour, or mile

Depreciation per unit= original cost-salvage value

Total estimated productive capacity

From the on-going illustration,

Depreciation per unit is = 25,000-3,000 = 0.5

44000 units

Step 2. Compute depreciation expense for the period

Depreciation expense=depreciation x usage in a year

Assume that production in each of the five years is as follows:

Year 1: 8,000 units,

Year : 14,000 units.

Year 3: 10,000 units,

Year : 5,000 units.

Year 5: 7,000 units

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Depreciation for each of the five years is shown below

year Depreciation usage Depreciation Accumulated Book value

per unit
Depreciation
0 - - - - Br. 25,000
1 0.5 8000 units Br. 4000 Br. 4000 Br. 21,000
2 0.5 14,000 units 7,000 11,000 14,000
3 0.5 10,000 units 5,000 16,000 9,000
4 0.5 5,000 units 2,500 18,500 6,500
5 0.5 7,000 units 3,500 22,000 3,000

Journal entry to record depreciation under units of production method is:-

Year 1 Year 2

Depreciation expense………… 4000 7000

Accumulated Depreciation 4000 7000

The same journal entry, except the amount, can be made for year 3, 4, and 5

A unit of production method is more logical than the straight line method when the amount of
usage of a plant asset changes from year to year.

3. Declining Balance Method

The declining balance method yields a declining periodic depreciation charges over the estimated
life of the asset. Declining balance method is an accelerated depreciation method of that yields
larger depreciation expenses in the early years of an asset’s life and smaller charges in later
years.

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To compute depreciation in double declining method, we need to use the following steps:

Step 1: compute the straight line depreciation rate

Formula: Straight line depreciable rate = 100

Useful life

Assume useful life of the asset is 5 years; therefore straight line rate is 100 = 20%
Useful life

Step 2: Compute double-declining balance rate

= 20%x2=40%

Step 3: compute depreciation expense

Depreciation expense=Double declining balance rate x beginning period book value

year Depreciation for the period

Book value Depreciation Depreciation Accumulate End period
for rate expense depreciation Book value
beginning
period
1 25000 40% 10,000 10,000 15,000
2 15,000 40% 6000 16,000 9.000
3 9,000 40% 3,600 19,600 5,400
4 5,400 40% 2,160 21,760 3,240
5 3240 240 22,000 3,000
Note: 3240-3000=240

Note that the salvage value is not used in the computation of depreciation under the double
declining balance method, except for the last year.

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4. Sum of the years digits method

Sum of the years digits method yield, like double declining balance method, a declining periodic
depreciation charge over the estimated life of the asset. Sum of the year’s digits method is an
accelerated depreciation method. Under the sum of the year’s digits method is an accelerated
depreciation method. Under sum of the year’s digits method, depreciation declines steadily over
the estimated life of the asset.

To compute depreciation under the sum of the year’s digits method, we need to use the following
steps.

Step 1: establish depreciation rate, or depreciation fraction

Depreciation fraction = n (n+1), where n=useful life of the asset

2

Assume the useful life of the of the asset is 5 years

For the illustration question, the denominator of the fraction is equal to 15. i.e

Depreciation fraction= 5 (5+1) = 15

The denominator (15) does not change for each year. Only the numerator will be changing i.e. it
is declining from year to year. Thus depreciation fraction for each of the five years is shown
below:

Year 1 = 5/15 Year 2 = 4/15 year 3= 3/15 year 4= 2/15 year 5 = 1/15

Step 2: compute depreciable cost

Depreciable cost = original cost – salvage value

25,000-3,000= 22,000

Step 3: compute depreciable expense for the year

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Depreciation expense = depreciable cost X depreciation fraction

year Depreciable Fraction rate Depreciation End period

cost expense Accumulated Book value
depreciation
1 22,000 5/15 7333 7333 17,667
2 22,000 4/15 5867 13200 11,800
3 22,000 3/15 4400 17600 7,400
4 22000 2/15 2933 20533 4,467
5 22000 1/15 1467 22000 3,000

10.3.2. Capital and Revenue Expenditure

Capital expenditures: are expenditures used for acquiring plant assets or for additions to plant
assets and expenditures that add to the utility of plant assets for more than one accounting period.

Revenue expenditures: are expenditures for ordinary maintenance of a recurring nature.

Example: the cost of repainting a building.

10.3.3. Disposal of plant assets

Plant assets are no longer useful may be discarded, sold or applied toward the purchase of other
plant assets.

There are three methods to dispose a plant asset. These are:-

1. Discarding plant assets

When plant assets are not longer useful to the business and have no market value, they are
discarded.

2. Sales of Plant assets

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If the plant asset has a market value it is disposed by selling it.

3. Exchange of plant asset

Old equipments are often traded in for new equipments having a similar use.

10.3.4. Depletion

The periodic allocation of the cost of metal cores and other minerals removed from the earth us
called depletion

10.3.5. Intangible assets

Patents

Manufacturers may acquire exclusive rights to produce and sell goods with one or more unique
feature. Such rights are evidenced by patents, which are issued to investors by the federal
government. They continue in effect for 17 years. An enterprise may purchase patent rights from
others or it may obtain patents on new products developed in its own research laboratories.

Copyrights
The exclusive right to publish and sell a literary, artistic or musical composition is obtained by a
copyright. Copyrights are issued by the federal government and extended for 50 years beyond
the author’s death.

Good will

In the sense that it is used in business, good will in intangible asset that attaches to a business as
a result of favorable factors as location of product superiority, reputation, and managerial skill.
In existence is evidenced by the ability of the business to earn a rate of return on the investment
that is in excess of the normal rate for other firms in the same line of business.

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 CHAPTER 11

The payroll system in Ethiopian context

3.1. Introduction

Understanding payroll procedures and keeping adequate payroll reports and records is essential
to the success of a company. Accounting for payroll is important because payroll represents the
largest expense that a company incurs.

3.2. The importance of payroll accounting

The concept of payroll is often referred to the total amount paid to employees of a firm as a
compensation for the service rendered to a firm in a given period of time. The payroll accounting
of a firm has to be given emphasis of significance for the following reason:

 Employers are sensitive to payroll errors and irregularities and maintaining good
employer moral requires that the payroll be paid on a timely, accurate basis.
 Payroll expenditures are subject to various government regulations
 The payment for payroll and related taxes has significant effect on the net income of most
business enterprise.
3.3. Definition of Payroll related terms

Salary or wage

Salary and wages are usually interchangeable. However, the term wages is more correctly used
to payments for manual labor that are paid on the number of hours worked or the number of units
produced.

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The pay period

The pay period is the length of time covered by each payroll payment pay period for wage
workers are usually made, on weekly or biweekly. On the other hand, salaried employees pay
periods are monthly or semimonthly.

The pay day

The day on which wages or salaries are paid to employee, usually the last day of the pay period
is known as the pay day.

Basic records of a payroll accounting system includes:-

A payroll register (sheet)

The entire list of employees of a business along with each employee’s gross earnings, deductions
and net pay for a particular payroll period. The basis for the preparation of the payroll register
can be the attendance sheets, punched (clock) cards or time cards.

Employee earnings record

It is a summary of each employee’s earnings, dedications, and net pay for each payroll period
and of cumulative gross earnings during the year. It is a separate record kept for each employee.

Pay check

An instrument for paying salary if the firm makes payment via writing a check in the name of
each employee for the net pay or a check for the total net pay.

Gross earning

The total pay to an employee before deductions for the pay amount.

Payroll taxes

Are taxes levied against the employee on the payroll of the firm. It is an additional payroll
related expense to and employee.
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Withholding taxes

These are taxes levied against the earnings of employees of an organization and with held by the
employer per regulations of the concerned government.

Payroll deductions

All the reductions from the gross earnings of an employee such as withholding taxes, union dues,
fines credit association pays etc,

Net pay

The gross earnings after subtracting all the deductions. It is sometimes known as take home pay
the amount collected by an employer on the pay day.

Overtime earnings

Overtime work is the work performed by an employee beyond the regular working hours or days.
Overtime earnings is the amount payable to an employee for overtime work done.

Deductions

These are subtractions made from the earnings or an employee that is because it is required by
government or permitted by the employee himself/herself. These include:-

1. Employee income tax

In Ethiopia every citizen is required to pay something in the form of income tax from his/her
earnings or employment. In this case a progressive income tax system that charges higher rates
for higher earning is applied on the gross earnings or each employee save to pay income tax in
and exemption.

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 Taxable monthly income (in birr) Tax rate Deductions
1 Up to 600 is tax free
2 601-1,650 10% 60
3 1,651-3,200 15% 142.50
4 3,201-5,250 20% 302.50
5 5,251-7,800 25% 565
6 7,801-10,900 30% 955
7 Over 10,900 35% 1500
2. Pension contribution

The Ethiopian Permanent employees of an organization are expected to pay pension

contribution from their monthly salary.

Signature

Unless some other document is used, the payroll register may be designed to allow a column for
signature of the employees after collection of the net pay.

Example:

The basic salary of Ato Abebe is Br. 4500. He has also a monthly taxable allowance of Br. 500
and an overtime income of Br. 500

Based on the Ethiopian income tax system determine the following

1. Gross income
2. The amount of income tax deducted from Ato Abebe’s income
3. Amount of pension contribution. Assume the pension contribution rate is 6%
4. Total deductions
5. The net pay.

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 CHAPTER 12

Accounting concepts and Principles

Accounting is a mean of providing financial information for interested parties so that they will
make sound decisions.

Objectives of financial reporting for business enterprises

The three broad objectives of financial reporting are:-

1. To provide financial information that are useful in making rational investment, credit, and
similar decisions.
2. To provide financial information to enable users to predict cash flows to the business and
subsequent to themselves.
3. To provide financial information about business resources (assets), claims to these
resources (liabilities and owner’s equity, and changes in these resources and claims.

The major accounting concepts and principles are:-

1. Business entity

The business entity concept assumes that a business enterprise is separate and distinct from the
persons who supply its assets.

2. Going Concern

Only in rare 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.

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3. Objective evidence

Entries in the accounting records and data reported on financial statements must be based on
objectively determined evidence. If this principle is not followed the confidence of the users of
the financial statements could not be maintained.

4. Unit of Measurement

All business transactions are recorded in terms of money.

5. The Matching Principle

This principle states that to determine the income of an entity for an accounting period, the entity
computes the total expense involved in obtaining the revenue of the same period and relate these
expenses to match against the total revenue so as to determine net income or net loss

6. Adequate disclosure

Financial statements and their accompanying footnotes or other explanatory materials should
contain all of the pertinent data believed essential to the reader’s understanding of the
enterprise’s financial status.

7. Consistency

The accounting system an organization should be consistent from year to year. If the principles
are not applied consistently, the trends indicated could be the result of change in the principles
used rather than the result of changes in business conditions or managerial effectiveness.

8. Materiality

Absolute accuracy in accounting and full disclosure in reporting are not possible. Therefore, it
is important to consider only material errors.

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 Chapter 13

Partnership formation, income division and liquidation

13.1. Definition and characteristics of a partnership

Partnership is an association of two or more persons to carry on as co-owners of a business for a

profit. The partnership form of business organization is widely used for comparatively capital,
managerial talent, and experience of two or more persons.

13.2. Characteristics of a partnership

Partnerships have several characteristics that have accounting implication. The principal
characteristics of the partnership form of business organization are described below.

A. limited life

Partnership has limited life. It continuance as a going concern rests in the partnership contract. A
partnership may be ended voluntarily at any time through the acceptance of a new partner into
the form or withdrawal of the partner. A partnership may be ended in voluntarily by the death or
incapacity or a partner.

B. unlimited liability

Each partner is personally and individually liable for all partnership liabilities. The claims of the
creditors attach first to partnership assets and then to personal assets of nay partner, regardless of
that partner’s equity in the company.

C. Voluntary Association of Individuals

A partnership is a voluntary association of two or more individuals based on a legally binding

contract. The contract may be written or oral. A partnership may be divided into two namely
general partnership and limited partnership.

General partnership is a partnership in which partners have unlimited liability. While limited
partnership is a partnership with limited liability.
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D. Mutual Agency

Mutual agency means that each partner acts on behalf of the partnership when engaging in
partnership business. The act of any partner is binding on all other partners, even when partners
act beyond the scope of their author, as long as the act appears to be appropriate for the
partnership.

E. Non taxable entity

The income of a partnership is not taxed as a separate entity. However, a partnership is required
to file an information tax return showing partnership net income and each partner’s share of net
income. Each partner’s share is taxable at personal tax rates, regardless of the amount of net
income withdrawn from the business during the year.

F. co-ownership of property

Partnership assets are co-owned by the partners. Once assets have been invested in the
partnership they are owned jointly by all the partners. Moreover, if the partnership is terminated,
the assets don not legally revert to the original contributor.

13.3. Advantages and disadvantages of a partnership

The advantage if a partnership includes:

1. A partnership is relatively easy and inexpensive to establish. It is relatively free from

government regulations and restrictions.
2. A partnership enables to bring more capital, more skills, and more experience as compared to
sole proprietorship.
3. The combined income taxes paid by the individual partners may be lower than the income
taxes that would be paid by a corporation.
4. Decisions can be made quickly on substantial matters affecting the firm. Whereas in a
corporation formal meetings with the board of directors are often needed. That is ease of
decision making.

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The disadvantages of a partnership include:-

1. Partnership has limited life

2. Partnership has unlimited liabilities
3. One partner can bind a partnership to contracts (i.e. mutual agency)
4. Raising large amount of capital is more difficult for a partnership that for corporation

13.4. Accounting for partnership

Most of the day-to-day accounting for a partnership is the same as the accounting for any other
form of business organization.

13.5. Recording investment

A separate entry is made for the investment of each partner in a partnership.

13.6. Division of Net income or Net Loss

As in the case of sole proprietorship the net income of a partnership may be said to include a
return for the services of the owners, for the capital invested, and for economic or pure profit.
Partners are not legally employees of the partnership, nor are their capital contribution a loan.
The division of net income or net loss is made using the agreement between the partners.

13.7. Partnership Dissolution

One of the basic characteristics of the partnership form of organization is its limited life. Any
charge in the personnel of the ownership results in the dissolution of the partnership. Thus,
admission of a new partner dissolves the old firm. Similarly, death, bankruptcy, or withdrawal of
a partner causes dissolution. Dissolution of the partnership of the partnership is not necessarily
followed by the winding up of the affairs of the business.

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13.8. Liquidation (bankruptcy) of partnership

When a partnership goes out of business, it usually sells the assets, pays the creditors, and
distributes the remaining cash or other asset to the partners according to their claims. The
winding up process may generally be called liquidation. Although liquidation refers specially to
the payment of liabilities, it is often used in a broader sense to include the entire winding up
process.

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 Chapter 14

Corporation: organization and operation

14.1. Introduction

On the basis of ownership, an organization is divided into three namely sole proprietorship,
partnership, and corporation.

14.2. Definition and characteristics of a corporation

14.2.1. Definition of a corporation

Corporation is a legal entity; distinct and separate from the individuals who create and operate it.
As a legal entity, a corporation may acquire, own and dispose of property in its own name. it
may also in liabilities and enter into contracts.

14.2.2. Characteristics of a corporation

As legal entity, the corporation has certain characteristics that make it different from other types
of business organization. The most important characteristics are:

A. Separate legal existence

A corporation has a separate legal existence in the sense that it may acquire, own and dispose of
property in its corporate name. It may also incur liabilities and enter into other types of contracts
according to the provision of this charter. The charter is also called articles of incorporation. A
charter is a contract by which a corporation is formed.

B. Transferability of ownership

The ownership in a corporation is represented by transferable shares of capital stock.

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C. Limited liability

The stockholders of a corporation have limited liability. This means that stakeholders have no
personal liability for the debts of the corporation. The creditors cannot look for the personal
assets of the shareholders. A corporation is responsible for its own acts and obligations. If the
corporation is insolvent (unable to pay its creditors) the most that a shareholder can lose is the
amount of his/her equity investment in the corporation.

D. Indirect control of the operation

The shareholders exercise control over the management of corporate affairs indirectly by electing
a board of directors. The board of directors assumes the responsibility to determine the
corporation policies and to select the officers who manage the corporation.

The organizational structure of a corporation may look like the following

Shareholders

Board of Directors

Officers

Employees

E. Double taxation

As a separate legal entity, a corporation is subject to double taxation. The earnings of a

corporation are subject to the federal income tax. When the remaining earnings are distributed to
shareholders as dividends, they are again taxed as income to the individuals receiving them.

F. Freedom of Action

A Corporation has less freedom of action than a sole proprietorship and partnership because it is
created by law and owned by stakeholders.

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14.3. Advantages and Disadvantages of a corporation

14.3.1. Advantages of a corporation

Forming a corporate of organization has many advantages. The major advantage of a corporation
includes:-

1. Shareholders have no personal liabilities for the debts of the business

Shareholders are not personally liable for the debts of a corporation. This is cited as the greatest
advantage of a corporation.

2. Transferability of ownership

Ownership of a corporation is evidenced by transferable shares of stock, which may be sold by

one investor to another. Investors may easily convert their corporate ownership into cash by
selling their shares.

3. Professional Management

The stakeholders own a corporation, but they do not manage it on daily basis. To administer the
corporation, the shareholders elect a board of directors. The directors, in turn, hire professional
managers to run the business. And individual shareholders have no right to participate in
management unless his/her has been hired by the directors as a corporate manager.

4. Continuity of existence

Changes in the name and identities of shareholders do not directly affect the corporation.
Therefore, the corporation may continue without disruption, despite the retirements or death of
individual shareholders.

5. Capital advantage

A corporate form of organization may be established to get more capital to expand the business
through sale of shares to investors: as compared to partnership and sole proprietorship.

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14.3.2. Disadvantages of a corporation

The major disadvantages of the corporation are: -

1. Heavy taxation

Corporate earnings are subject to double taxation. First, the corporation must pay corporate
income taxes on its earnings. Second, stockholders must pay personal income taxes on any
portion of these earnings, which they receive as dividends.

2. Greater regulation

Corporation is affected by state and federal laws to a greater extent than are sole proprietorship
and partnership. For instance, the owners’ ability to remove business assets from a corporation is
restricted by law. Corporations are required to disclose their financial affairs to the public.

3. Cost of formation

A sole proprietorship and partnership can be formed at little or no cost. However, in order to
form a corporation, one needs the services of attorney, which is the cost of formation.

4. Separation of ownership and management

In many cases, the separation of ownerships and management is advantageous, but may be a
disadvantage in other cases. If stockholders do not approve of the manner in which management
runs the business, they may find it difficult to take the united action necessary to remove that
management group.

14.4. Stockholder equity

The owners’ equity in a corporation is commonly called stockholders equity, shareholders

equity, shareholders investment or capital. The two main sources of stockholders’ equity are

1. Investments contributed by the stockholders, called paid-in-capital or contributed capital

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2. Net income retained by the business called retained earnings. As shown in the following
illustration, the stockholders equity section of a corporation balance sheet is divided into
subsections based on these two sources.
Stockholders’ equity
Paid-in-capital
Common stock……………………….500, 000
Retained earnings ……………………100, 000
Total stockholders’ equity…………… 600,000

14.5. Characteristics of capital stock

The general term applied to the shares of ownership of a corporation is capital stock. The number
of shares that a corporation is authorized to issue is set forth in its chatter. The term issued is
applied to the shares issued to the stockholders.

Classes of stock

The two classes of stock are common and preferred stock. If a corporation issues only common
stock each shares generally has an equal right. In order to appeal to a broader investment market
a corporation may provide for one or more classes of stock with various preferential rights. The
preference usually relates to the right to share in distributions of earnings. Such stock is generally
called preferred stock.

The board of directors has the sole authority to distribute earnings to the stockholders. When
such action is taken the directors are said to declare a dividend. A cannot guarantee that its
operation will be profitable and hence it cannot guarantee dividends to its stockholders.

A corporation with both preferred stock and common stock may declare dividends on the
common only after it meets the requirements of the stated dividends on the preferred.

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To illustrate, assume a corporation has 1,000 shares of birr 10 preferred stock (that is the
preferred has a prior claim to an annual birr 10 per share dividend) and 4,000 shares of common
stock outstanding. Assume also that in the first years of operation, net income was birr 30,000,
55,000, and 10,000 respectively. The directors’ authorize the retention of a portion of each year
earnings and the distribution of the remainder. Details of the dividend distribution are presented
in the following tabulation.

First Second Third

Year year year

Net income…………………… 30,000 55,000 100,000

Amount retained ……………. 10,000 20,000 40,000
Amount Distributed………… 20,000 35,000 60,000
Preferred Dividend (1,000 shares) 10,000 10, 000 10,000
Common Dividend (4,000 shares) 10,000 25,000 50,000

Dividend per share:

Preferred ………………………….. 10 10 10
Common…………………………… 2.5 6.25 12.5

14.6. Issuing capital stock

The entries to record investments of stockholders in a corporation are like those for investments
by owners of other types of business organizations, in that cash and other assets received are
debited and any liabilities assumed are credited. The credit to stockholders equity differs,
however, in that there are accounts for each class of stock.

To illustrate, assume that a corporation, with an authorization of 10,000 shares of preferred stock
of birr 100 par and 100,000 shares of common stock of birr 20 par, issues one half of each
authorization at par for cash. The entry to record the stockholders investment and the receipt of
the cash is as follows:-

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 Cash…………………………………….3, 000,000

Preferred stock……………………. 1,000,000

Common stock……………………... 2,000,000

Paid in capital in excess of par

When capital stocks at a premium, case or other assets are debited for the amount received. The
stock is the credited for the paramount and an account generally called paid in capital in excess
of par is credited for the amount of the premium.

For example, if Mearon Company issues 2,000 shares of birr 50 par preferred stock for cash at
$55, the entry to record the transaction would be as follows.

Cash…………………………110,000

Preferred stock……………………………………..100,000

Paid in capital in excess of par-preferred stock…….10, 000

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