This document contains all about principles of accounting and finance in detail., Summaries of Accounting

Download This document contains all about principles of accounting and finance in detail. and more Summaries Accounting in PDF only on Docsity! AMBO UNIVERSITY FACULTY OF BUSINESS & ECONOMICS SCHOOL OF CONTINUING AND DISTANCE STUDIES DISTANCE EDUCATION MODULE FOR PRINCIPLES OF ACCOUNTING PART II (ACCT 202) Prepared By: NajiMohammed(BA]                          DR SHANKAR KUMAR SINGH JHA (Ph.D)   MR M.P. NAIDU [BA, MCOM] 1 June 20, 2009            J imma, Ethiopia MODULE CONTENTS PAGE 1. UNIT ONE: Accounting for Inventories ..............................1 (BY AREGA SEYOUM) 2. UNIT TWO: Determining The Cost Of Inventory.............18 (BY AREGA SEYOUM) 3. UNIT THREE: Additional Valuation Problems for Inventories..................................................................32 (BY AREGA SEYOUM) 4. UNIT FOUR: Accounting for Plant Assets and Depreciation 43 (BY DR SHANKAR KUMAR SINGH JHA) 5. UNIT FIVE: Disposal of Plant Assets ..........................63 (BY AREGA SEYOUM) 6. UNIT SIX: Accounting System for Payroll and Payroll Tax Liabilities ................................................................78 (BY AREGA SEYOUM) 7. UNIT SEVEN: Fundamental of Accounting Concepts and Principles ..........................................................99 (BY DR SHANKAR KUMAR SINGH JHA) 8. UNIT EIGHT: Accounting for Partnership ....................113 (BY MR M.P. NAIDU) 9. UNIT NINE: Accounting for Corporations ....................143 (BY MR M.P. NAIDU) 2 1. Raw material inventory is the cost assigned to goods and materials on hand but not yet placed–– into production. Raw materials include the wood to make a chair or other office furniture, the steel to make a car etc. 2. Work in process inventory –– is the cost of raw material on which production has been     started but not completed, plus the direct labor cost applied specifically to this material  and allocated manufacturing overhead costs. 3. Finished goods inventory –– is the cost identified with the completed but unsold units on hand at the end of each period. In this unit only the determination of the inventory of merchandise purchased for resale commonly called merchandise inventory will be discussed. 1.1 Importance of Inventories Dear students, we believe that from the above discussion you have acquired some concepts regarding inventories. In the operation of wholesale and retail businesses the determination of inventories plays a significant role. What do you think are some of the important roles that inventory determination plays? Merchandise, being continually purchased and sold is one of the most active elements in merchandising business, i.e. in wholesale and retail type of businesses. This is due to the following reasons: 1. The sale of merchandise provides for the principal source of revenue for them. 2. The cost of merchandise sold is the largest deductions from sales. 3. Inventories (ending inventories) are the largest of the current assets of such firms. Inventory determination plays an important role in matching expired costs with revenues of the period. An error in the determination of the inventory figure at the end of the period will cause an equal misstatement of gross profit and net income, and the amount reported for both assets and owners equity in the balance sheet will be incorrect by the same amount. Because of the’’ above reasons inventories have effects on the current and the following periods financial’’ statements. If inventories are misstated (understated of overstated), the financial statements will be distorted. 5 Check Your Progress: Exercise -1.1 1. Describe the three types of inventories for a manufacturing business ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 2. Why do we consider inventories the most active elements in the operation of a merchandising business? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 1.2 Effects of Inventories on Financial Statements 1.2.1 Effect of Ending Inventory on Current Periods’’  Financial Statements Ending inventory is the cost of merchandise on hand at the end of the accounting period. Let us see its effect on current periods financial statements.’’ Income Statement a.. Cost of goods (merchandise) sold =Beginning inventory + Net purchase Ending inventory–– As you see, ending inventory is a deduction in the computation of cost of merchandise sold. So, it has an indirect (negative) relationship to cost of merchandise sold, i.e. if ending inventory is understated, the cost of merchandise sold will be overstated, and if ending inventory is overstated, the cost of merchandise sold will be understated. b.. Gross Profit = Net sales Cost of merchandise sold –– Here, the cost of merchandise sold had indirect relationship to gross profit. So, the effect of ending inventory on gross profit is the opposite of the effect on cost of merchandise sold. That is, if ending inventory is understated, the gross profit will be understated and if ending inventory is overstated, the gross profit will be overstated. This is a direct (positive) relationship. c. Operating income = Gross Profit Operating Expenses–– Gross profit and operating income have direct relationships. Thus, the effect of ending inventory on net income is the same as its effect on gross profit, i.e. direct (positive) effect (relationship). 6 Balance Sheet a.. Current assets – Ending inventory is part of current assets, even the largest. So, it has a direct (positive) relationship to current assets. If ending inventory balance is understated (overstated), the total current assets will be understated (overstated). Since current assets are part of total assets, ending inventory has direct relationship to total assets. b.. Liabilities – No effect on liabilities. Inventory misstatement has no effect on liabilities. c.. Owners equity’’ The net income will be transferred to the owners equity at the end of– ’– ’ accounting period. Closing income summary account does this. So, net income has direct relationship with owners equity at the end of accounting period. The effect of ending’’ inventory on owners equity is the same as its effect on net income, i.e. if ending’’ inventory is understated (overstated), the owners equity will be understated (overstated).’’ 1.2.2 Effects of Beginning Inventory on Current Periods Financial Statements’’ Beginning inventory is inventory balance that was left on hand in the previous period and transferred to the current period. Its effect is summarized below: Income Statement a.. Cost of merchandise sold = Beginning inventory + Net Purchases Ending inventory –– As you see, beginning inventory is an addition in determining cost of goods sold. It has direct effect on cost of merchandise sold. That is, if the beginning inventory is understated (Overstated), the cost of merchandise sold will be understated (Overstated) b.. Gross Profit = Net Sales Cost of merchandise sold–– The effect of beginning inventory on gross profit is the opposite of the effect on cost of merchandise sold, i.e. indirect (negative) relationship. If the beginning inventory is understated, the gross profit will be overstated and if it is overstated, the gross profit will be understated. c.. Net income = Gross Profit Operating expenses–– The effect of beginning inventory on net income is the same as its effect on gross profit. Balance Sheet a.. Current assets The inventory included in current assets is the ending inventory. So,–– beginning inventory has no effect on current assets. b.. Owners equity ’’ – If the effect comes from the previous year, the beginning inventory will not have an effect on ending owners equity since the positive or negative effect of the’’ previous year will be netted off by the negative or positive effect of the current year. But if the error is made in the current period, it will have indirect effect on ending owners ’’ equity. 7 1.. Why does an error in ending inventory affect two accounting periods? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 1.3. Inventory Systems: Dear students! What are the two basic types of inventory systems? There are two principal systems of inventory accounting: periodic and perpetual. 1.3.1 Periodic Inventory System Under this system there is no continuous record of merchandise inventory account. The inventory balance remains the same throughout the accounting period, i.e. the beginning inventory balance. This is because when goods are purchased, they are debited to the purchases account rather than to the merchandise inventory account. The revenue from sales is recorded each time a sale is made. At the time of sale no entry is made to record the cost of goods sold. Consequently, a physical inventory must be taken periodically (usually at the end of each fiscal period) to determine the cost of inventory on hand and goods sold. In the periodic inventory system merchandise purchased is recorded or accumulated in the ‘‘Purchases ’’ account. The periodic inventory system is less costly to maintain than the perpetual inventory system, but it gives management less information about the current status of merchandise. This system is often used by retail enterprises that sell many kinds of low unit cost merchandises such as groceries, drugstores, hardware etc. The journal entries to be made are: 1.. At the time of purchase of merchandise: Purchases XX at cost Accounts payable or cash XX 2.. At the time of sale of merchandise: Accounts receivable or cash XX at retail price  Sales XX 10 3.. To record purchase returns and allowances: Accounts payable or cash XX Purchase returns and allowances XX 4.. To record adjusting entry or closing entry for merchandise inventory: Income Summary XX Merchandise inventory (beginning) XX To close beginning Merchandise inventory Merchandise inventory (ending) XX Income Summary XX To record ending Merchandise inventory       1.3.2 Perpetual Inventory System In contrast to the periodic inventory system, the perpetual inventory system uses accounting records that continuously disclose the amount of inventory. A separate account for each type of merchandise is maintained in a subsidiary ledger. So, the inventory balance will not remain the same in the accounting period. All increases are debited to merchandise inventory account and all decreases are credited to the same account. The balances of accounts are called book inventories of the items on hand. Irrespective of the case with which the perpetual inventory records are maintained, their accuracy must be tested by taking physical inventory of each type of merchandise at least once in a year. The records are then compared with the actual quantities on hand and any differences are corrected. There are no purchases and purchase returns and allowances accounts in this system. At the time of sale, the cost of goods sold is recorded in addition to journal entry for the sale. So, we can determine the cost of inventory as well as goods sold from the accounting records. No need of physical counting to determine their costs. Companies that sell items of high unit value, such as appliances, fur garments or automobiles, tended to use the perpetual inventory system. Given the number and diversity of items contained in the merchandise inventory of most businesses, the perpetual inventory system is usually more effective for keeping track of quantities and ensuring optimal customer service. Management must choose the system or combination of systems that is best for achieving the company's goal. Journal entries to be made are: 11 1.. At the time of purchase of merchandise Merchandise inventory XX at cost Accounts payable/cash XX To record cost of Merchandise purchased 2.. At the time of sale of merchandise Accounts receivable or cash XX   at retail price Sales XX To record the sale Cost of goods sold XX Merchandise inventory XX at cost To record the cost of merchandise sold or cost of sale 3.. To record purchase returns and allowances Accounts payable or cash XX Merchandise inventory XX 4.. No adjusting entry or closing entry for merchandise inventory is needed at the end of each accounting period. Illustration 1.2–– In its beginning inventory on Jan 1, 2008, Ziquala Trading Company had 280 units of merchandise that cost Br. 10 per unit. The following transactions were completed during 2008. January 17 Purchased 200 units of merchandise on account at Br. 12 per unit. 24 Returned 50 defective units from the January 17 purchases to the     supplier (payment for the entire invoice was not made). April 19 Purchased 300 units of merchandise for cash at Br 15 per unit. August 26 Sold 480 units of merchandise for cash at a price of Br. 17 per unit. These goods are: 230 units from the beginning inventory and 100 units                             from January 17 purchase and the rest from the April 19 purchases. December 31  248 units are left on hand, 50 units from January 1 inventory, another 50 units from the January 17 purchase, and the rest from the last                             purchase. Required: Prepare general journal entries for Ziquala Trading Company to record the above transactions and adjusting or closing entry for merchandise inventory on December 31, 2008 (the end of the current fiscal period) under: 12 4. In which of the following types of businesses would a periodic inventory system commonly be used: (i) spare part store, (ii) drugstore, (iii) fur garment shop, (iv) automobile dealer store, (v) supermarket, (vi) office and home appliance store. In which of the above types of businesses would a perpetual inventory system suitable? 5. The merchandise inventory at the end of Year 1 was inadvertently overstated by Br.15,000. (a) Did the error cause an overstatement or understatement of the net income for the same year? Why? (b) Assuming there was no error in the following fiscal year, did the error cause an overstatement or understatement of the (i) cost of goods sold, (ii) gross profit (and net Income), (iii) total assets in Year 2? 1.4. Determining Actual Quantities in the Inventory Dear students! How can and when a business enterprise determines the quantities of the inventories on hand? When does title to merchandise pass from the seller to the buyer? Is there any agreement between the seller and the buyer that determines ownership right of the goods? Give your answer in writing before you read the discussion below. The first stage in the process of taking inventory is to determine the quantity of each kind of merchandise owned by an enterprise. The physical count of inventory is needed under both inventory systems. Under periodic inventory system, it is needed to determine the cost of inventory and goods sold. When the periodic system is used, the counting, weighting, and measuring should be done at the end of the accounting period. To accomplish this, the inventory crew may work during the night or business operations may be stopped until the count is finished. The inventory account under a perpetual inventory system is always up to date. Yet events can occur where the inventory account balance is different from inventory on hand. Such events include theft, loss, damage, and errors. The physical count (some times called taking an““ inventory) is used to adjust the inventory account balance to the actual inventory on hand.”” We determine a Birr (dollar) amount for physical count of inventory on hand at the end of a period by: 15 (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 to the buyer when the goods are shipped (when the goods are loaded on the means of transportation, i.e. at the sellers ’’ 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 buyers point.’’ So, in general, goods in transit purchased on FOB shipping point terms are included in the inventories of the buyer and excluded from the inventories of the seller. And goods in transit purchased on FOB destination terms are included in the inventories of the seller and excluded from the inventories of the buyer. There is also a problem with goods on consignment at the time of taking an inventory. Goods on consignment to another party (agent) called the consignee. A Consignee is to sell the goods for the owner usually on commission are included in the consignors inventories and excluded from’’ the consignees inventories.’’ Check Your Progress: Exercise 1.3 Aba Jifar Company, found in Jimma, purchased goods from Zumra Trading, found in Gondar, on FOB Destination terms. 1. Who will cover transportation charges? Why? 16 ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 2. Assume these goods are in transit at the end of the accounting period. In which Companys’’ inventories do we include these goods? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 2.. A manufacturer ships merchandise to a wholesaler on a consignment basis. If the merchandise is not sold at the end of the period, in whose inventory should the merchandise be included? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ Model Examination Questions A. Short answer questions 1.. Define inventories 2.. From the two inventory systems, which method is better considering internal controls? 3.. If ending inventory is misstated, it will not have an effect in the owners equity of the ’’ following period. Why? B. Workout questions 1. Omo Nada Company reported annual net income as follows 2000 Br. 210,000 2001 280,000 2002 315,000 Analysis of its inventories shows that the following incorrect inventory amounts were used (the correct amounts are also shown) Incorrect inventory Correct inventory Amount Amount December 31, 2004 Br. 160,000 Br. 152,000 December 31, 2005 172,000 177,000 17 UNIT TWO: DETERMINING THE COST OF INVENTORY Contents:  Unit Objective  Introduction 2.1. Inventory Costing Methods Under Periodic Inventory System 2.1.1. . Specific Identification Method 2.1.2. . First-in, First-out Method 2.1.3. . Last-in, First-out Method 2.1.4. . Weighted Average Method 2.2. Comparison of Inventory Costing Methods 2.3. Inventory Costing Methods Under Perpetual Inventory System 2.3.1. . First-in, First-out Method 2.3.2. . Last-in, First-out Method 2.3.3. . Weighted Average Method 2.4. Unit Summary 2.5. Model Examination Questions  List of References Unit Objective This unit aims at discussing inventory cost determination and inventory costing methods. After going through this unit, you will be able to:  describe the determination of the cost of inventory  understand the most common inventory costing methods under a periodic system  compare the effect of the methods on operating results  describe the accounting for inventory under the perpetual system, etc. 20 Introduction Dear students, after having determined the actual quantities of the inventories unsold at the close of the period, we have to assign relevant cost to the quantities on hand to determine total cost of the inventories. How can we assign costs to the actual quantities on hand? Which costs are to be included in the inventory cost, and which ones are not included? Give your answer in writing before you go through the following discussion. In the previous unit you were acquainted with the meaning and concepts of inventories in general and merchandise inventory in particular. In unit one, you were also learned the effect that inventory misstatement would have on the current and following periods financial statements.’’ This unit is the continuation of the previous unit. In this unit, you will discuss the determination of the cost of inventory. Costs included in merchandise inventory are those expenditures necessary, directly or indirectly, to bring an item to a salable condition and location. In other words, cost of an inventory item includes its invoice price minus any discount, plus any added or incidental costs necessary to put it in a place and condition for sale. Added or incidental costs can include import duties, transportation-in, storage, insurance against losses while the goods are in transit, and costs incurred in an aging process(for example, aging of wine and cheese). Minor costs that are difficult to allocate to specific inventory items may be excluded from inventory cost and treated as operating expenses of the period. This is based on materiality principle or the cost - to - benefit constraint. Check Your Progress: Exercise 2. 1 1.. An art gallery purchases a painting for Br. 11,400 on terms FOB shipping point. Additional costs in obtaining and offering the artwork for sale include. 130 for transportation-in, Br. 150 for import duties, Br. 100 for insurance during shipment, Br. 180 for advertising, Br. 400 for training, and Br. 800 for sales salaries. For computing inventory, what cost is assigned to the painting? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 21 2.1 Inventory Costing Methods under Periodic Inventory System Dear students! How do we determine the cost of the merchandise sold and the inventory cost at the end of the period? What costs should be included in the cost of inventories? What objectives are considered in deciding what costs are to be included in inventories? Attempt the question by your own before you go through the following discussion. One of the most important decisions in accounting for inventory is determining the per unit costs assigned to inventory items. When all units are purchased at the same unit cost, this process is simple since the same unit cost is applied to determine the cost of goods sold and ending inventory. However, when identical items are acquired at different unit costs, a question arises as to what amounts are included in the cost of merchandise sold and what amounts remain in inventory. When such is the case, it is necessary to determine the unit cost of the items still on hand. A periodic inventory system determines cost of merchandise sold and inventory at the end of the period. How we assign these costs to inventory and cost of merchandise sold affects the reported amounts for both systems. The assumed flow of costs to be used in the assignment of costs to inventories and to goods sold need not conform to the physical flow of goods. Cost flow assumption relate to the flow of costs, rather than to the physical flow of goods. The question of which physical units of identical goods were sold and which remain in inventories is not relevant to income measurement and inventory valuation. All methods of inventory valuation are based on the cost principle; no matter which method is selected, the inventory is stated at cost. In general, a major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenue. There are four methods commonly used in assigning costs to inventory and cost of merchandise sold. These are: I) Specific identification II) First-in first-out(FIFO) III) Last-in first-out (LIFO) IV) Weighted average 22 This method of assigning cost requires computing the average cost per unit of merchandise available for sale. That means the cost flow is an average of the expenditures. The weighted average unit cost is determined by dividing the total cost of the identical units of each commodity available for sale during the period by the total number of units of merchandise. Average cost per unit = Cost of goods available for sale Total units available for sale Once the average unit cost is determined, then it is multiplied by units on hand (unsold) at the end of the period to calculate the cost of ending inventory. Also, the same average unit cost is applied in the computation of cost of goods sold. Once again, using the previous illustration the costs of ending inventory and goods sold for Ghibe Trading would be computed as follows: Weighted average unit cost = Br. 190,070 = Br. 49.24 3860 units ® Ending inventory cost = Br. 49.24 x 800 = Br. 39,392 ® Cost of Goods Sold = Br. 190,070 - Br. 39,392 = Br. 150,678 2.2. Comparison of Inventory Costing Methods If the cost of units and prices at which they are sold remains stable, all the four methods yield the same results. But if prices change, the three methods usually yield different amounts for: Ending inventory, cost of merchandise sold, and gross profit or net income.  During periods of rising (increasing) prices (or if there is inflationary trend): FIFO Yields: ––  higher ending inventory  Lower cost of goods sold  Higher gross profit (net income) 25 LIFO Yields: ––  Lower ending inventory  Higher cost of goods sold  Lower gross profit (net income)  Weighted average yields the results between the two.  In periods of declining (decreasing) prices (or if there is deflationary trend): FIFO Yields: ––  Lower ending inventory  Higher cost of goods sold  Lower gross profit (net income) LIFO Yields: ––  Higher ending inventory  Lower cost of merchandise sold  Higher gross profit (net income)  Weighted average yields the results between the two. Check Your Progress: Exercise 2.2 1.. Which of the methods of inventory costing will in general yield an inventory cost nearly approximating current replacement cost? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 2.. Do the terms FIFO and LIFO refer to techniques employed in determining quantities of various merchandise on hand? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 2.3 Inventory Costing Methods under Perpetual Inventory System The use of perpetual inventory system provides the most effective means of control over this important asset. Although it is possible to maintain a perpetual inventory memorandum records 26 only or to limit the data to quantities, a complete set of records integrated with the general ledger is preferable. As you learned in Part I, the basic feature of this system is recording all merchandise increases and decreases in a manner similar to the recording of increases and decreases in cash. That means, all purchases of merchandise are debited to the Merchandise Inventory account and sales and other reductions of merchandise are credited to the Merchandise Inventory account. Thus, the balance of merchandise inventory reflects the amount of merchandise inventory assumed to be on hand. Under perpetual inventory system we will apply the inventory costing methods each time sale of merchandise is made. We calculate the cost of goods (merchandise) sold and inventory on hand at the time of each sale. This means the merchandise inventory account is continually updated to reflect purchase and sales. Illustration 2.2 The beginning inventory, purchases and sales of Shebe Business Group Ltd for the month of December are as follows: Units Cost Dec. 1 Inventory 21 Br. 60.00 5 Sale 8 13 purchase 12 Br. 64.00 17 Sale 15 24 purchase 25 Br. 69.00 26 Sale 19 28 purchase 20 Br. 72.00 30 Sale 6 31 Sale 15 2.3.1 First-in First-out Method The assignment of costs to goods sold and ending inventory using FIFO is the same for both the perpetual and periodic inventory systems. Because each withdrawal of goods is from the oldest stock on hand. The oldest is the same whether we use periodic inventory system or perpetual inventory system. Using the data above, let us calculate the cost of goods sold and ending inventory in each of the inventory costing methods under perpetual inventory system. 27 Cost of ending inventory = Br. 60 x 15 = Br. 900.000 30 Cost of merchandise sold = Cost of goods available for sale cost of ending inventory–– = Br. 5193.00 Br. 900.00–– = Br. 4293.00 As you see, the results are different under periodic & perpetual inventory systems. 2.4.3 Weighted Average Cost Method. Under this method, the average unit cost is calculated each time purchase is made to be applied on the sales made after the purchases. The results may be different under periodic and perpetual inventory systems. Let us calculate the cost of merchandise sold and ending inventory using the average cost method from the previous illustration under perpetual inventory system. Average Cost Method (Moving Average) Date Purchase Cost of merchandise sold Inventory Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost Dec. 1 21 Br. 60.00 Br. 1260.00 5 8 Br. 60.00 Br. 480.00 13 60.00 780.00 13 12 64.00 Br. 768.00 25 61.92 = 780+768 13+12 1548.00 17 15 61.92 928.80 10 61.92 619.20 24 25 69.00 1725.00 35 66.98 619.20+1725 10+25 2344.20 26 19 66.98 1272.51 16 66.98 1071.63 28 20 72.00 1440.00 36 69.77 1071.63+1440 16+20 2511.63 30 6 69.77 418.61 30 69.77 2093.00 31 15 69.77 1046.51 15 69.77 1046.51 63 Br. 4146.43 15 Br. 69.77 Br 1046.51 So, the cost of goods sold and ending inventory under perpetual inventory system are Br. 4146.43 and Br. 1046.51, respectively. 31 The results under periodic inventory system are: Weighted average unit cost = Br. 5193 = Br. 66.58 78 Ending inventory cost = Br. 15 @ Br. 66.58 = Br. 998.65 Cost of goods sold = Merchandise available for sale cost of ending inventory–– = Br. 5193.00 Br. 998.65 = –– Br. 4194.35 So, the result is different under periodic and perpetual inventory systems. Check Your Progress: Exercise 2.3 1. What are the advantages of perpetual inventory system over the periodic inventory system? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 2. In periods of steadily rising prices, which inventory method will give the highest i) inventory cost _______________________ ii) lowest inventory cost__________________ iii) highest net income, ___________________ iv) lowest net income? ___________________ 3.. Do the FIFO and LIFO inventory methods result in different quantities of ending inventory? Model Examination Questions I. Short Answer Questions. 1.. What is the difference between goods flow and cost flow? 2.. What are the relative advantages and disadvantages of FIFO and LIFO methods of inventory costing? 3.. Why do you think it is more expensive to maintain a perpetual inventory system? 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. 32 UNIT THREE: ADDITIONAL VALUATION PROBLEMS                          FOR INVENTORIES Contents  Unit Objective  Introduction 3.1. Valuation of Inventories at Lower of Cost or Market [LCM] Method 3.2. Estimating Inventory Cost 3.2.1. . Retail Method of Inventory Costing 3.2.2. . Gross Profit Method of Inventory Costing 3.3. Answers to Check Your Progress 3.4. Model Examination Questions  Unit Summary  List of Reference Materials Unit Objective This unit aims at discussing various valuation methods like lower of cost or market, retail method and gross profit method. After studying this unit, you would be able to: ۞ explain the valuation of inventory at other than cost, including valuation at the lower of cost or market ۞ understand the various methods of estimating cost of an inventory, such as retail       method and gross profit method Introduction 35 Dear students, so far you have discussed with examples the basic cost flow assumptions in valuating the inventories and in determining the cost of goods sold. In all of the cost flow assumptions discussed in unit 2 the cost principle is strictly followed. Under certain circumstances, however, inventory is valued at other than cost. Under what conditions, if any, is it appropriate to use non-cost methods of valuing inventories? Attempt the question before you go through the following discussion. As discussed in the preceding sections, cost is the primary basis for the valuation of inventories. Under certain circumstances, however, inventory is valued at other than cost. Two such circumstances arise when (1) the cost of replacing items in inventory is below recorded cost, and (2) the inventory is not salable at normal sales prices because of imperfections, shop wear, style changes, or other causes. An attempt has been made in this unit to explain other methods of inventory valuation and the problems such as valuation at lower of cost or market, retail method and gross profit method of estimating an inventory cost. 3.1 Valuation of Inventories at Lower of Cost or Market [LCM] Method Dear students, how do you valuate the inventory unsold at the end of the fiscal period, if the replacement cost of the inventory on the balance sheet date is less than its acquisition cost? In the phrase lower of cost or market what does market represent? Give your response in writing“ ” “ ”“ ” “ ” before you read the following discussion. 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 36 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 (3) To the inventory as a whole The less similar the items are that make up inventory, the more likely it is that companies apply LCM to individual items. Advances in technology further encourage the individual item application. Illustration 3.1 The following are the inventory of Ghibe Trading Company, a retailer. Inventory Units Per Unit     Items on hand Cost Market Men Suits Jacket 300 Br 600 Br 570 Trousers 500 300 340 Women Suits Shirt 1000 200 220 Miniskirt 2000 150 100 37 3) When we want to test the validity of cost data. To estimate the cost of inventory, two methods are commonly used. These are retail method and gross profit method. 3.2.1 Retail Method of Inventory Costing This method is mostly used by retail businesses. The estimate is made based on the relationship between the cost and the retail price of merchandise available for sale. The steps to be followed are: (1) Calculate the cost- to-retail ratio = Cost of merchandise available for sale Retail Price of merchandise available for sale (2) Calculate the ending inventory at retail price Ending inventory at retail price = retail price of merchandise available for sale ––           Sales (3) Calculate the estimated cost of ending inventory Estimated cost of ending inventory = Cost to retail ratio X Ending inventory at retail Illustration 3.2 Cost Retail Dec. 1, beginning inventory Br. 160,000 Br. 200,000 Purchases in December (Gross) 620,000 780,000 Purchase Returns and Allowances 15,000 Purchase Discounts 5,000 Sales in December (net) 740,000 (1) Cost-to-retail ratio = Br. 160,000 + Br. 620,000 [15,000 + 5000]–– = 0.7755 or        77.55% Br. 200,000 + Br. 780,000 (2) Ending inventory at retail = (Br. 200,000 + Br. 780,000) Br. 740,000 = Br–– . 240,000 (3) Estimated ending inventory at cost = 0.7755 x Br. 240,000 = Br. 186,120 40 Check Your Progress: Exercise 3.2 1.. An enterprise using the retail method of inventory costing determines the merchandise inventory at retail is Br. 300,000. If the ratio of cost-to-retail price is 70%, what is the estimated cost of inventory? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 2.. Does the retail inventory method mean that inventories are measured at retail value on the balance sheet? Explain. ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 3.2.2 Gross Profit Method of Inventory Costing This method uses an estimate of the gross profit realized during the period to estimate the cost of inventory. The gross profit rate may be estimated based on the average of previous periods gross’’ profit rates. The steps are as follows: (1) The gross profit rate is estimated and then estimated gross profit is calculated: Estimated gross profit = Gross profit rate x Current period Sales (2) Cost of goods sold is estimated: Estimated cost of goods sold = Current period Sales Estimated gross profit–– (3) Calculate the estimated cost of ending inventory: Estimated cost of ending inventory = Cost of goods available for sale Estimated cost of goods sold.–– Illustration 3.3 Jan. 1, beginning inventory (cost) Br. 120,000 Purchases during January (cost) 490,000 Purchase Returns and Allowances 10,000 Net sales during January 580,000 Estimated gross profit rate is 30% 41 The ending inventory is estimated as follows: (1) Estimated gross profit = 0.30 x 580,000 = Br. 174,000 (2) Estimated cost of goods sold = Br. 580,000 Br. 174,000–– = Br. 406,000 (3) Estimated cost of ending inventory = [Br. 120,000 + (490,000 10,000) Br. 406,000]– –– – = Br. 600,000 Br. 406,000–– = Br. 194,000 Check Your Progress: Exercise 3.3 1.. Cost of goods available for sale is Br. 420,000 and net sales for the period is Br. 400,000. If the cost of goods sold percentage of sales is 75%, what is the estimated cost of the inventory to be reported on the balance sheet? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 2.. For what purposes may the retail method of inventory estimation be used? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ Model Examination Questions A. Short answer questions 1.. What is the lower of cost or market and why are inventories valued at lower of cost or market? 2.. From the three ways of applying lower of cost or market, which one results in minimum value of inventory? 3.. What uses can be made of the estimate of the cost of inventory determined by the gross profit method? 4.. Describe the procedure required to estimate inventories on the retail method 5.. Describe the procedure required to estimate inventories on the gross profit method 42 At Cost At Retail Beginning Inventory, January 1 Br. 472,132 Br. 622,800 Purchase 750,000 1,008,400 Freight In–– 8,350 Purchases Returns and Allowances (25,200) (34,800) Sales 1,060,000 Sales Returns and Allowances (28,000) January 31, Physical Inventory 508,200 Required: a) Prepare a schedule to estimate the amount of Sanete Company's January 31 inventory using the retail method. b) Use the Company's cost ratio to reduce the retail value of the physical inventory to cost. c) Calculate the estimated amount of inventory shortage of cost and at retail. List of Reference Materials 1.  Introduction to Accounting, 21st Century 2. Fess and Warren, Accounting Principles, 16th edition, South Western publishing–– Company. 3. Fess and Warren, Accounting Principles, 18th edition, South Western publishing–– Company. 4.    Weygandt, Kieso, Kimmel, Accounting Principles, 5th edition, John Wilily and Sons, Inc. 5.     Mosich A. N. Intermediate Accounting, 6th edition, McGraw Hill Book Company. –– 45 UNIT FOUR: ACCOUNTING FOR PLANT ASSETS AND DEPRECIATION  Unit Objectives  Introduction 4.1 Meaning of Long-Term Assets (Plant Assets) 4.2 Cost of Long Term Assets (Plant Assets) 4.3 Nature of Depreciation 4.4 Factor in Computing Depreciation 4.5 Methods of Computing Depreciation 4.5.1 Straight Line Method 4.5.2 Accelerated Method 4.5.2.1 Written down Value Method or (Diminishing Balance Method) 4.5.2.2 Annuity Method 4.5.2.3 Sum-of-the-Years Digits Method 4.5.2.4 Double Declining Method. 4.5.2.5 Depletion Method 4.6 Capital and Revenue Expenditures 4.6.1 Capital Expenditures 4.6.2 Revenue Expenditures  Unit Summary  Model Exam Questions  List of Reference Materials Unit Objectives This unit aims at discussing the meaning of long term assets (like plant, Building, land, Machinery), accounting for depreciation of plant assets. In this unit we also discuss the periodic depreciation of plant asset is credited to the accumulated depreciation account, instead of the asset account. At the end of the life of the plant asset the accumulated depreciation account balance should equal to the depreciable cost of the asset. After successfully going through this chapter, you are able to understand:  Describe plant assets and issues in accounting for them  Explain depreciation and the factors affecting its computations 46  Explain depreciation for partial years and changes in estimates  Compare and analyze depreciation for different methods.  Apply cost principle to compute the cost of plant assets  Distinguish between revenuer and capital expenditures, and account for these expenditures Introduction Dear students! Have you heard of the term plant asset before? If so, what do you understand by the term plant asset? What do you think about the purpose of plant assets? Give your answer in writing before you go through the discussion below. Before taking up depreciation, it should be understood that the costs relating to the use of long- term assets should be properly calculated and matched against the revenue earned so that periodic net income can be determined. These use costs or expense or periodic write off are known by different names for different category of assets given as under: Types of Long-Term Assets (Plant Assets) Term of expenses or write off or use costs 1. Tangible Assets: (i) Land None (ii) Plant, Building, Equipments Tools, Furniture, Fixtures, and Vehicles Depreciation (iii) Natural Resources such as Oil, Timber, Coal, Minerals Deposits Depletion 2. Intangible Assets such as Patents, Copyrights,   Trademarks, Goodwill Amortization 4.1 Meaning of Long-Term Assets (Plant Assets) Long-term assets are tangible assets that are used in the operations of a company and have a useful life of more than one accounting year. These types of assets are land, building, structures of all types, machinery, equipments, furniture etc. Among these assets, land is a tangible asset that has an indefinite or unlimited useful life. Therefore, it is not subject to depreciation or periodic write off to expenses. Natural Resources: 47 Cost of Self Construction: When a business constructs its own buildings, the cost includes all reasonable and necessary expenditures such as those for materials, labour; some related overhead and indirect costs, architects fees, and insurance during construction and interest on construction loans during the’ period of construction, lawyers fees. If outside contractors are used in the construction, the net’ contract price plus other expenditures necessary to put the building in usable condition are included. Group Purchases: Sometimes, basket purchases (also known as group purchases, package purchases) of assets are made by the purchaser wherein two or more types of long term assets are acquired in a single transaction and for a single lumpsum. In basket or package purchases, cost of each asset acquired must be measured and recorded separately. For example, assume that a purchaser has purchased land and the building situated on the land for a lumpsum of payment of Birr 850,000. The total purchase price can be divided between these two assets on the basis of relative market or appraisal values, as shown below. Assets Estimated Market Percent of Total Allocation of Estimated Value price Purchase Price Useful Life (Birr) (%) (Birr) Land 100,000 10 85,000 Indefinite Building 900,000 90 765,000 30 Years. 10,00,000 100 850,000 When a long term asset is purchased and a non-cash consideration is included in part or in full payment for it, the cash equivalent cost is measured as any cash paid plus current market value of the non-cash consideration given. Alternatively, if the market value of the non-cash consideration given cannot be determined, the current market value of the asset purchased is used for measurement purposes. As a general rule, long term assets are recorded at cost due to the basic criterion of objectivity. However, there could be some exceptions to this rule of cost basis. For example, if an asset acquired by donation or pays substantially less than the market value of the asset, the asset is recorded at its fair market value. 50 Check Your Progress: Exercise 4.2 1. What are the accounting policies for the acquisition (cost) of long-term assets (plant assets)? ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 2. Identify the costs included in the initial valuation of land, building and equipment. ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 3. Describe the accounting problems associated with interest capitalization. ___________________________________________________________________________ ___________________________________________________________________________ __________________________________________________________________________ 4. Describe the accounting problems associated with self-constructed assets. ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 4.3 Nature and Meaning of Depreciation Dear students! Having discussed the concepts about the cost of plant assets, we feel that now you have the clear idea about what is to be included in the cost of plant assets and what is not to be included to the cost of plant assets. Have you heard about deprecation of plant asset? Will you try to give some ideas about deprecation of plant assets? As plant assets are used in the operations of a business, their value to provide service decreases through usage and the passage of time. 51 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 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. Check Your Progress: Exercise 4.3 1. What do you understand by Depreciation? _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ 4.4 Factors Affecting the Computation of Depreciation Dear students! Having discussed the concepts about the deprecation of plant asset we feel that now you have the clear idea about what is to be discussed about depreciation. Have you heard about the factors affecting the computation of depreciation? Will you try to give some ideas about the factors affecting the computation of depreciation? Four factors affect the computation of depreciation. They are: (1) Cost (2) Residual value (3) Depreciable cost, and (4) Estimated economic (useful) life. 52 The depreciation to be reported for each of the four years would be as follows: Depreciation Method- Straight-Line Method Year Cost Yearly Depreciation Accumulated Depreciation Carrying value (Book Value) Beginning of first year Br. 6000 - - Br. 6000.00 End of first year 6000 Br. 1250.00 Br. 1250.00 4750.00 End of second year 6000 1250.00 1250.00 3500.00 End of third year 6000 1250.00 3750.00 2250.00 End of fourth year 6000 1250.00 5000.00 1000.00 NB. There are three important points to note from the depreciation schedule for the straight-line depreciation method. First, the depreciation is the same each year. Second, the accumulated depreciation increases uniformly. Third, the carrying (Book) value decrease uniformly until it reaches the estimated residual value. 4.5.2 Units of Production/Activity Method The production method of depreciation is based on the assumption that depreciation is mainly the result of use and that the passage of time plays no role in the depreciation process. If we assume that the office equipment from the previous illustration has an estimated useful life of 10,000 hours, the depreciation cost per hour would be determined as follows:              Hourly depreciation = Cost Salvage value–– = Br. 6000.00 1000–– = Br. 0.50 Estimated units of useful life 10,000 operating hrs. If we assume that the use of the equipment was 2800 hours for the first year, 3600 hours for the second, 2400 hours for the third, and 1200 hours for the fourth, the depreciation schedule for the office equipment would appear as follows: Depreciation Schedule Production/Activity Method–– Year Cost Hours Depreciation Per Hour Yearly Deprn. Accum. Deprn. Carrying value (Book value) Beginning of the First year Br. 6,000 - Br. 0.50 - - Br. 6,000.00 End of first year 6,000 2,800 0.50 Br. 1,400.00 Br. 1,400.00 4,600.00 End of second year 6,000 3,600 0.50 1,800.00 3,200.00 2,800.00 End of third year 6,000 2,400 0.50 1,200.00 4,400.00 1,600.00 End of fourth year 6,000 1,200 0.50 600.00 5,000.00 1,000.00 55 Under the production method, there is a direct relation between the amounts of depreciation each year and the units of output or use. Also, the accumulated depreciation increases each year indirect relation to units of output or use. Finally, the carrying amount decreases each year in direct relation to units of output or use until it reaches the estimated residual value. Under the production method, the units of output or use that is used to measure estimated useful life for each asset should be appropriate for that asset. For example, for one machine number of units produced may be an appropriate measure, for another number of hours may be a better measure. The production method should be used only when the output of an asset over its useful life can be estimated with reasonable accuracy. 4.5.3 Declining Balance Method This method of depreciation results in relatively large amount of depreciation in the early years of an assets life and smaller amounts in later years. This method is based on the assumption of the passage of time. Since most kinds of plant assets are most efficient when new, and so they provide more and better service in the early years of useful life. It is consistent with the matching rule to allocate more depreciation to the early years than to later years if the benefits or services received in the early years are greater. The declining-balance method is the most common accelerated method of depreciation. Under this method depreciation is computed by applying a fixed rate to the book value of the asset, resulting in higher depreciation charges during the early years of the assets 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 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 assets 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: 56 57 The production method of depreciation provides for periodic charges to depreciation expense that may vary considerably, depending upon the amount of usage of the asset. The production method does not generate a regular pattern because of the random fluctuation of the deprecation from year to year. The major limitation of the production method is that it is not appropriate in situation in which depreciation is a function of time instead of activity. Another problem in using the production method is that an estimate of units of output or service hours received is often difficult to determine. Both the declining balance and the sum of the years digits methods are referred to as accelerated depreciation methods, because they provides (report) relatively higher depreciation expense in the earlier uses of the life of the asset and a gradually declining periodic expense thereafter. The main justification for this approach is that more depreciation should be charged in earlier years because the asset suffers its greatest loss of services in those years. Accelerated depreciation method also recognizes that changing technologies make some equipment lose their capacity to yield services rapidly. Thus, it is appropriate to allocate more to depreciation in the early years, than in later years. Another argument in favor of an accelerated method is that repair (maintenance) expense is likely to be greater in later years than in early years. Thus, the reduced amounts of depreciation reported in later years of the assets life are offset to some extent by increased repair’’ (maintenance) expense. Check Your Progress: Exercise 4.7 1. Discuss straight line, accelerated method of deprecation? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 2.  Identify the factors involved in the depreciation process? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 60 Composite Depreciation Methods Many business enterprises find it means to account for depreciation of certain kinds of plant assets on a composite or group basis, to minimize the record keeping for individual assets. Composite or group depreciation is a process of averaging the economic lives of a number of plant assets and computing depreciation on the entire class of assets as if it were an operating unit. The term composite generally refers to a collection of somewhat dissimilar plant assets; the term group usually refers to a collection of similar assets. The procedures for the computation of periodic depreciation are essentially the same in either case. Several methods may be used to develop a composite or group depreciation rate to be applied to the total cost of a group of plant assets. The computation of a straight-line composite depreciation rate for a group of machines owned by XYZ Company is illustrated as follows: XYZ Company Computation of Straight-Line Composite Depreciation Rate for Machinery Machine Cost Net Residual Value Deprn. Est. Life Annual Deprn. A Br 60,000 - Br 60,000 5 Br 12,000 B 100,000 12,000 88,000 8 11,000 C 150,000 10,000 140,000 10 14,000 D 190,000 10,000 180,000 12 15,000 Total Br 500,000 Br 32,000 Br 468,000 Br 52,000 Composite Depreciation Rate based on Cost: Br 52,000 / 500,000 =10.4% Composite Economic Life of Machines: Br 468,000 / Br 52,000 = 9 Years. The composite depreciation rate is 10.4%, and the composite rate to the cost of $ 5,00,000 will reduce the composite net residual value of the machines to $ 32,000 in exactly 9 years [Br 5,00,000 (52,000 X 9) = Br 32,000}.– Once the composite depreciation rate is computed, it is continued in use until a material change occurs in the composition of plant assets or in the estimate of their economic lives. The assumption underlying the use of composite depreciation methods are (1) plant assets are regularly retired near the end of their economic lives (2) retired plant assets are regularly replaced with similar assets, and (3) proceeds on retirement are approximately equal to the net residual value for the computation of the composite depreciation rate. If the assets are not replaced, for example, the use of 10.4% rate computed above eventually would result in the recording of excessive depreciation. 61 In the determination of yearly depreciation, the 10.4% rate is applied to the balance of the Machinery ledger account at the beginning of the year, which balance excludes the original cost of all machines retired prior to the beginning of the year. Thus, for each of the first five years, annual depreciation is Br 52,000; and in the sixth year (assuming machine X was replaced at the end of the fifth year with a similar machine costing Br 90,000), depreciation would be Br 55,120 [Br 5,00,000 Br 60,000 + Br 90,000) X 10.4% = Br 55, 120]. The composite depreciation rate is– not revised when plant assets are replaced with comparable assets, and the asset group should not be depreciated below net residual value at any time. When composite depreciation procedures are employed, a record is not maintained for accumulated depreciated or individual plant assets. When an asset is retired from use or sold, a journal entry is required to remove the original cost from the plant asset account, and any difference between original cost and the proceeds received is debited to Accumulated depreciation; a gain or loss is not recognized because gains or losses are assumed to offset over time. As for example: If machine were sold at the end of the fourth year for Br 15,000, the journal entry to record the sale would be as follows: Cash A/c ………………………………………… 15,000 Accumulated Depreciation of Machinery………… 45,000 To Machinery Account .………………… 60,000 To record sale of machine XYZ Company depreciation method is used; therefore, no gain or loss is recognized. The primary advantage of the composite depreciation method is that the averaging procedure may obscure significant variations from average. The accuracy of the straight line composite depreciation rate may be verified by recomputing depreciation on the straight line basis for individual plant assets. Any significant discrepancies between the two results require a change in the composite depreciation rate. The advantages claimed for the composite method are simplicity, convenience, and a reduction in the amount of detail involved in plant asset records and depreciation computations. The availability of computers has reduced the force of this argument. In many cases unit plant asset records are now feasible, although composite methods previously were considered a necessity. 62 Revenue Increase Operating Increase Efficiency or Adds to capacity Useful     Expenditure (Additions and Betterment)? Life debit expense (Extraordinary account Repairs                   for                                                    Ordinary Maintenance and Repairs Capital Expenditure Capital Expenditure Debit plant asset Debit accumulated Account depreciation account Check Your Progress: Exercise 4.9 1. Distinguish between the capital and revenue expenditure? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 2. Discuss the concepts of Additions, Betterment, and Extra ordinary repairs? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ Model Examination Questions PART I Multiple Choice Questions 1. An example of an accelerated depreciation method is: (a) Units-of-production (b) Sum-of-the-years-digits (c) Straight-Line (d) None of the above. 2. Which of the example is an example of an intangible asset? (a) Copyrights (b) Patents (c) Goodwill (d) All of the above 3. Which of the following expenditure incurred in connection with the acquisition of machinery is a proper charge to the asset account? (a) Installation costs (b) Transportation charges (c) Neither A nor B. (d) Both A and B 65 Expenditure NO Y E S Y E S NO 4.    If a plant asset with a ten year economic life is sold during the second year, how would you use of the sum-of-the-years-digits method of depreciation instead of the straight-’ line method of depreciation affect the gain or loss on disposal of the asset? Gain Loss (a) Decrease Increase (b) Increase Decrease (c) No Effect No Effect (d) No Effect Decrease 5. The composite depreciation method: (a) Is applied to a group of homogeneous plant assets (b) Is an accelerated method of depreciation (c) Does not involve the recognition of a gain or loss on the retirement of an individual plant asset of the group (d) Disregards net residual value in the computation of the depreciation base. PART II Short Answer Questions 1. What do you understand by depreciation accounting? Which policy of charging‘ ” depreciation should be adopted by the management in the period of rising prices? 2. Distinguish between Declining Balance and Double Declining Balance methods of‘ ’ ‘ ’ depreciation. Which of these methods is recognized for financial reporting purposes? 3. Is a company allowed to change its method of depreciation for reporting purposes? If so, cant be made effective with retrospective effect. Explain briefly. ’ 4. Depreciation is a systematic allocation cost or other value over the service life of an“ asset in systematic and rational pattern. Explain. ” 5. Mention the factors influencing the selection of a depreciation method. List of Reference Materials 1. APB Statement No. 4, Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enterprise, 1970, Para 159. 2. International Accounting Standard Committee, IAS 4, Depreciation Accounting, March 1976 3. Sidney Davidson, et al., Financial Accounting, The Dryden Press, 1988, p.367. 4. The Institute of Chartered Accountant of England and Wales, SSAP 12, Accounting for Depreciation, London: ICAEW, Dec 1977, Para 15. 66 UNIT FIVE: DISPOSAL OF PLANT ASSETS Contents  Unit Objective  Introduction 5.1 Disposal of Plant Assets 5.1.1 Recording Discarding of Plant Assets 5.1.2 Recording the Sale of Plant Assets 5.1.3 Recording Exchanges of Plant Assets 5.2 Accounting for Intangible Assets and Natural Resources  Unit Summary  Answer to Check Your Progress  Model Examination Questions  List of Reference Materials Unit Objective This unit aims at discussing the meaning of disposing of plant assets, the different ways of disposing plant assets, and the accounting procedures involved in recording transactions relating to the discarding, sale and exchange of plant or (fixed) assets. Thus, after going through this unit, you will be able to;  understand the concept of disposing of plant assets  examine the different ways of disposing of plant assets  Analyze the transactions involving the discarding, sale, and exchange of plant assets  Record the transactions involving the discarding, sale, and exchange of plant assets, and  differentiate accounting for financial reporting from accounting for income tax with respect of exchange of plant assets Introduction So far you have seen how to account for property, plant, and equipment assets, from calculating acquisitions cost to depreciating this cost up to the end of the assets useful life. Plant assets, such’’ as equipment, delivery trucks, or machineries cannot be used forever. The assets may wear out or 67 The entry to record the sale of an asset for cash is similar to the one illustrated above except that the receipt of cash should also be recorded. The following entries show how to record the sale of equipment under three assumptions about the selling price. In the first case, the Br. 3,500 cash received is exactly equal to the book value of the equipment (which is equal to Br. 3,500). Case 1. Sold at an amount equal to Book Value, Br. 3,500, no gain or loss results: 2008 June 30. Cash …………………………………… 3,500.00 Accumulated Depreciation, Equip ...…… 17,500.00 Equipment …………………………… 21,000.00 Sale of equipment at an amount equal to book value Case 2. Sold at Br. 2,500 cash; Loss of Br. 1000, (BV = Br. 3,500) 2008 June 30. Loss on sale of equipment .………………… 1000.00   Accumulated Depreciation………………… 17,500.00   Cash .……………………………………… 2,500.00 Equipment .………………………… 21,000.00 Sale of equipment at less than the book value, Loss of Br. 1000 Case 3. Sold at Br. 4000 cash; gain of Br. 500, cash received through Sale less book value of the asset (Br. 4000 Br. 3,500)–– 2008 June 30. Cash .……………………………………… 4000.00    Accumulated Depr, Equipment 17,500.00…………… Equipment ..………………………        21,000.00 Gain on sale of plant asset .. 500.00……… Sale of equipment at more than the book value; gain of Br. 500, (Br. 4000 Br.3, 500) recorded–– 5.1.3. . Recording Exchange of Plant Assets Businesses also dispose of plant assets by trading them in on the purchase of other plant assets. Exchanges may involve similar assets, such as an old machine traded-in on a newer model, or dissimilar assets, such as a machine traded-in on a truck. In either case, the purchase price is reduced by the amount of the trade-in allowance. 70  The basic accounting for exchanges of plant assets is similar to accounting for sales of plant assets for cash. If the trade-in allowance received is greater than the carrying value of the assets surrendered, there has been a gain. If the trade-in allowance is less than the carrying value, there has been a loss. There are special rules for recognizing these gains and losses, depending on the nature of the assets exchanged. Exchange Losses Recognized Gains Recognized For Financial Reporting Purposes:  Of Similar Assets  Of Dissimilar Assets Yes Yes No Yes For Income Tax Purposes:  Of Similar Assets  Of Dissimilar Assets No Yes No Yes Both Gains and Losses are recognized when a company exchanges dissimilar assets. Assets are dissimilar when they perform different functions; assets are similar when they perform the same function. For financials reporting purposes, gains on exchanges of similar assets are not recognized because the earning lives of the asset surrendered are not considered to be completed. When a company trades-in an older machine on a newer machine of the same type, the economic substance of the transaction is the same as that of a major renovation and upgrading of the older machine. Accounting for exchange of similar assets is complicated by the fact that neither gains nor losses are recognized for income tax purposes. Loss Recognized on the Exchange A loss is recognized for financial reporting purposes on all exchange in which a material loss occurs. 71 Illustration 5.2–– To illustrate the recognition of a loss, assume that the business exchange equipment with a cost of Br. 21,000, and accumulated depreciation of Br. 17,500 for a newer more modern equipment on the following terms: Cost of new equipment Birr 23, 000………………………………………… Trade-in Allowance for old equipment……………………………… (2,500) Cash payment required (Boot) ... Birr ……………………………… 20,500. Solution In the illustration above, the trade-in allowance (Br. 2,500) is less than the carrying value (Br. 3,500) of the old machine. The loss on the exchange is Br. 1000, (Br. 3,500 Br. 2,500).–– Therefore, the journal entry required to record the exchange of assets would be as follows: 2008 June 30. Equipment (New) .……………………… 23,000.00 Accum. Depreciation-Equip ..…………… 17,500.00 Loss on Exchange of plant assets .……… 1000.00 Equipment (old)……………………… 21,000.00 Cash . .…………………………… …… 20,500.00 Check Your Progress: Exercise 5.1 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. 23,000 and a loss of Br. 1000 was recognized. If the transaction is for similar assets and is to be recorded for income tax purpose, the loss should not be recognized. In this case, the cost basis of the new asset will reflect the effect of the unrecorded loss. The cost basis for the new asset, therefore, is computed by adding the cash payment to the carrying value of the old asset: 72 To record exchange of Equipment to remove the cost of old equipment and the related accumulated depreciation. of old assets; new equipment recorded at a cost equal to BV of old asset plus cash paid. As with the no recognition of losses, the no recognition of the gain on exchanges is, in effect, a postponement of the gain. Since depreciation will be computed on the cost basis of Br. 22,500, the unrecognized gain is reflected in less deprecation each year on new equipment than if the“ ”“ ” gain had been recognized. Check Your Progress: Exercise 5.3 1.. In what sections of the income statement are gains and losses from the disposal of plant assets presented? ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 2.. Assuming that a plant asset priced at Br 75,000 is acquired by trading in a similar asset. Assume further that the trade-in allowance given on old asset is Br 17,500, (a) what is the amount of boot given? (b) Assuming the book value of the asset traded-in is Br 16,000, what is the cost-basis the new asset for financial reporting purposes? (c) What is the cost basis of the new asset for income tax purposes? ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ Illustrative Problem Zola Company acquired Asset A for Br. 168,000 on January 3, 2002. Asset A had an estimated useful life of six years with no salvaged value. The asset was depreciated on the basis of Sum-of- the-years-digits method. On April 30, 2005, Asset A was exchanged for another similar asset ’ –’ – Asset B. The new asset had a cash price of Br. 190,000. In addition to Asset A, cash of Br. 50,000 and three notes for Br. 90,000 was given up in the exchange. Asset B has an estimated useful life of seven years and salvage value of Br. 4000. Asset B is to be depreciated using the straight-line method. The Company had the experience of recording the exchange for financial reporting purposes. Required: With reference to the above information: 1.. Compute the cost-basis for Asset B in line with Company experience. 2.. Pass the journal entry made by Zola Company to record the exchange of the asset. 75 3.. Compute the depreciation expense to be made on Asset B for 2005 fiscal year ending Dec. 31 for financial reporting purposes. 4.. Compute the cost-basis of Asset B for income tax regulation. 5.. Pass the journal entry to record the exchange for purposes of income tax regulation. Solution to Illustrative Problem 1. Depreciation for the year 2002, on Asset A is: n(n + 1) = 6(6 + 1) = 21 2 2                                6 x 168, 000 = 48,000.00……………………………………                                 21  Depreciation for 2003, 5/2 x 168,000 . 40,000.00………………………………  Depreciation for 2004, 4/21 X 168,000 . 32,000.00……………………………  Depreciation for 2005 (for four months only) 3/12 x 168,000 x 4/12       14,000.00  Total Accumulated Depreciation as of April 30, 2005, Br. 134,000.00 Old Equipment Traded-In (Asset A) Cost………………………………………………………… Birr 168,000 Accumulated Depreciation, April 30, 2005 .………………… 134,000 Book Value .………………………………………………… Birr 34,000 New Equipment Traded-In (Asset B) Purchase (List) price ..……………………………………… Birr 190,000 Trade-in Allowance on old Asset [Asset A]……………… 50,000 Boot Given (cash + Notes)………………………………… Birr 140,000 Therefore, the cost-basis of Asset B can be obtained by adding the Book Value and the amount of Boot given which is ; Br. 34,000 + 140,000 = Br. 174,000. There unrecognized gain on the exchange. (2) 2005 April 30. Asset B ..………………………………… 174,000.00    Accumulated Depreciation .………………… 134,000.00 Asset A ...168, 000.00…………………………………………… Cash 50, 000.00………………………………………………… 76 Notes payable 90, 000.00……………………………………… 3. Depreciation Expense on Asset B for year ending Dec. 31, 2005 by the straight line method is: Annual Depreciation. = Br. 174,000.00 Br. 4000.00 –– = Br. 24,285.71 7 Years  Since the Asset is employed in service after four months had been elapsed, the depreciation for 8 months, (May through Dec. 31) would be: Br. 24,285.71 x 8/12 = Br. 16,190.48 4. The cost-basis for Asset B for income tax regulation is:  Since gains and losses resulting from the exchange of similar assets are not recognized for income tax purposes, the cost basis of the Asset B is the same, that is, Br. 174,000. 5. Journal entry to record the exchange of Asset B for purposes of income tax regulation would be: 2005 April 30. Asset B………………………………………… 174,000    Accumulated Depreciation, Asset A…………… 134,000 Asset A .……………………………… 168,000 Cash .………………………………… 50,000 Notes Payable………………………… 90,000 5.2 Accounting for Intangible Assets and Natural Resources Dear students, up to this point you have discussed in detail the accounting for plant assets, depreciation and disposal. Have you heard of intangible assets? What are intangible assets? Give possible examples of intangible assets. Intangible Assets: 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. 77 Check Your Progress: Exercise 5.4 1. Distinguish between amortization and depletion. ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ Model Examination Questions TYPE A –– Answer the Following Questions: 1.. Explain the accounting procedures for discarding of plant assets. 2.. Explain the entries required in selling a plant asset for cash. 3.. Distinguish between amortization and depletion. 4.. What is meant by Intangible Asset? TYPE B –– Choose the best answer for the following questions: 1.. If plant asset is retired before it is fully depreciated, and no salvage value or scrap value is received. A) a gain on disposal will be recorded B) Loss on disposal will be recorded C) Neither gain nor loss on disposal will be recorded D) All of the foregoing E) None of the foregoing 2.. One of the following is not an example of intangible assets. A) Patents B) Franchise C) Trademarks D) Organization cost E) None of the foregoing 3.. A plant asset priced at Br. 100,000 is acquired by trade-in a similar asset that has a book value of Br. 25,000. Assuming that the trade-in allowance is Br. 30,000 and that Br. 70,000 cash is paid for the new asset. What is the cost basis for the new assets for financial reporting purpose? A) Br. 100,000 B) Br. 70,000 C) Br. 30,000 D) Br. 125,000 E) None of the foregoing 80 4.. Good will in the amount of Br. 60,000 was purchased on January 15, the first month of the fiscal year. It is decided to amortize over the maximum period allowable. The current amortization expense would be: A) Br. 5000 C) Br. 1,500 B) Br. 6000 D) Br. 10,000 E) None of the foregoing TYPE C- Work out the following problem: 1.. On June 30 sold a truck for Br. 950.00. The truck had been purchased two years ago on January 2 for Br. 2300.00.The amount of depreciation is Br. 400.00 a year. Accumulated depreciation for that amount was recorded at the end of the two previous years. A) Record the depreciation for the current year to June 30. B) Record the sale of the truck. 2.. Discarded office equipments for which there was no further use and which could not be sold. The office equipment cost Br. 290.00 and had a book value of Br. 60.00 at the time it was discarded. List of Reference Materials 1.  Introduction to Accounting, 21st Century 2. Fess and Warren, Accounting Principles, 16th edition, South Western publishing–– Company. 3. Fess and Warren, Accounting Principles, 18th edition, South Western publishing–– Company. 4.    Weygandt, Kieso, Kimmel, Accounting Principles, 5th edition, John Wilily and Sons, Inc. 5.     Mosich A. N. Intermediate Accounting, 6th edition, McGraw Hill Book Company. –– 81 UNIT SIX: ACCOUNTING SYSTEM FOR PAYROLL AND PAYROLL TAX LIABILITIES Contents  Unit Objective  Introduction 6.1 Importance of Payroll Accounting 6.2 Definition of Payroll Related Terms 6.3 A Payroll Register [Sheet] and its Components 6.4 Activities Involved in Accounting for Payroll 6.5 Illustration of Payroll Accounting 6.6 Model Examination Questions  Unit Summary  List of Reference Materials Introduction Dear students! Are you familiar with the term payroll? What does it mean to you? Please give your response in writing before you go through the discussion. Accounting systems for payroll and payroll taxes are concerned with the records and reports associated with the employer-employee relationship. It is important that the accounting system provide safeguard to ensure that payments are in accord with managements general plans and its’ specific authorizations. 82 b. The Pay Period: A pay period refers to the length of time covered by each payroll payment. c. The pay day: The payday is the day on which wages or salaries are paid to employees. This is usually on the last day of the pay period. d. A Payroll Register (sheet): is the list of employees of a business along with each employees gross earnings; deductions, and net pay (take home pay) for a particular pay’ period. The payroll register (sheet) is prepared based on attendance sheets, punched (clock) cards or time cards. e. Pay Check: A business can pay payroll by writing a check for the net pay. A check is prepared in the name of each employee and handed to employees. Alternatively, a check for the total net pay can be prepared for employees to be paid by cash at the organization. f. Gross Earnings: is the total earnings of the employees for a given pay period before deductions. g. Withholding Taxes: are taxes collected from the earnings of employees by the employer organization as per the regulations of the government. These have to be remitted (paid) to the government because employer organization is only acting as an agent of the government in collecting these taxes from employees. h. Payroll Deductions: are deductions from the gross earnings of an employee such as employment income taxes, employee pension contributions (withholding taxes), labor union dues, fines, credit association pays etc. i. Net Pay: Net Pay is the earning of an employee after all deductions have been made. This is the take home pay amount collected by an employee on the payday. 6.3 A Payroll Register and its Components Dear students! What does it mean by a payroll register? What do you think are some of the possible components that make up a payroll register? Try to give your answer in writing before you go through the following discussion. a. Employee Number: Number assigned to employees for identification purpose when a relatively large number of employees are involved in a payroll register. It could be an identification card of the employees or a simple serial number. b. Name of Employees: this column lists names of employees of the organization. c.   Earnings: Money earned by an employee from various sources. This may include. 85 (1) Basic Salary: a flat monthly salary of an employee for carrying out the normal work of employment and subject to change when the employee is promoted. (2) Allowances: money paid monthly to an employee for special reasons, like: i. Position allowance a monthly allowance paid to an employee for bearing a– particular office responsibility. ii. Housing allowance a monthly allowance given to cover housing costs of the– individual employee when the employment contract requires the employer to provide housing but the employer fails to do so. iii. Hardship allowance/or disturbance allowance a sum of money given to an– employee to compensate for an inconvenient circumstance caused by the employer. For example, unexpected transfer to a different and distant work area or location. iv. Desert allowance a monthly allowance given to an employee because of– assignment to a relatively hot region. v. Transportation (fuel) allowance a monthly allowance to an employee to cover– cost of transportation up to his/her workplace if the employer has committed itself to provide transportation service. (3) Overtime Earning: Overtime work is the work performed by an employee beyond the regular working hours. Overtime earnings are the amount paid to an employee for overtime work performed. Article 33 of proclamation No. 64/1975 discussed the following about how overtime work should be paid: A worker shall be entitled to be paid at a rate of i. One and one-quarter (1¼) times his ordinary (regular) hourly rate for overtime work performed before 10:00 P.M. in the evening.[11:00 Afternoon 4:00– Evening, Local Time] ii. One and one half (1½) times his ordinary (regular) hourly rate for overtime work performed between 10:00 P.M. and Six (6:00 AM) in the morning. [4:00 Evining- 12:00 Mornings, Local Time] iii. Two times the ordinary (regular) hourly rate for overtime work performed on weekly rest days. iv. Two and one half (2½) times the ordinary (regular) hourly rate for overtime work performed on a public holiday. 86 All in all, the gross earnings of an employee may include the basic salary, allowance and overtime earnings. Check Your Progress: Exercise 6.1 – 1. What term is frequently used to refer to the total amount paid to employees for a certain period? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 2. Distinguish between salaries and wages? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ 3. An employee earns Br. 120 per hour with one and quarter (1¼) times the regular hourly rate for all hours in excess of 40 per week. If the employee worked 52 hours during the current week, what were the gross earnings for the week? ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ d. Deductions: are subtractions made from the earnings of an employee required either by the government or permitted by the employee himself. Some of the common types of deductions in Ethiopia are discussed hereunder. i. Employment Income Tax: Every citizen is required to pay employee tax to the government in almost all countries. In Ethiopia also, income tax is charged on the gross earnings of the employee at the rates indicated under Schedule A of the Proclamation No. 286/2002-Income Tax Proclamation. The tax rates under Schedule A are presented below: Employment Income (per month) Income Tax Rate * In computing and withholding tax, the income tax proclamation dictates that income attributable to the month of Nehassie and Pagumen shall be aggregated (added) and treated as the income of one month. 0 150 Exempt (Free from Tax) 151 650 10% 651 1400 15% 1401 2350 20% 87 Proclamation No. 286/2002 states that the following are not taxable. 1. Income from employment received by causal employees who are not regularly employed provided that they do not work for more than one month for the same employer in any twelve months period. 2. Pension contribution, provident fund and all forms of retirement benefits contributed by employers in an amount that doesnt exceed 15% of the monthly salary of the employee. ’ 3. Payments made to (an employee) as a compensation or gratitude in relation to:  personal injuries suffered by that person  the death of another person The Council of Ministers Regulation No. 78/2002 Regulations issued pursuant to the income tax proclamation further exempt the following from income tax. 1. Amounts paid by employers to cover the actual cost of medical treatment of employees. 2. Allowance in view of means of transportation granted to employees under contract of employment, i.e., transportation allowance. 3. Hardship allowance (Disturbance allowance). 4. Amounts paid by employee in reimbursement of traveling expenses incurred on duty. ii. Pension Contribution Permanent employees of a governmental organization in Ethiopia are expected to pay or contribute 4% of their basic salary to the governments pension trust fund.’ This amount is withheld by the employer from each employee on every payroll and later be paid to the respective government body. The employer is also expected to contribute towards this same fund 6% of the basic salary of every permanent government employee. Therefore, the total contribution to the pension fund of the Ethiopian government is equal to 10% of the basic salary of all of its permanent employees. That is, 4% comes from the employees and 6% comes from the employer. For militaries, the employer (government) contributes 16% and the employee contributes 4% of his/her basic salary towards his/her pension trust fund. 90 This enables a permanent employee of a government organization to be entitled to the pension pay when retired provided that the employee satisfies the minimum requirements to enjoy the benefits. Businesses and non-governmental not-for-profit organizations (NGOs) also have this’ kind of scheme to benefit their employees with some modifications. A fund known as provident fund is established and both the employer and the employee contribute towards this fund monthly. When an employee retires or leaves employment, a lump sum amount is paid to him/her. iii. Other Deductions A part from the above two kinds of deductions, employees may individually authorize additional deductions such as deductions to pay life insurance premiums, to repay loan from the employer, to pay for donation to charitable organization, contributions to “idir ” etc. Check Your Progress: Exercise 6.3 – 1. Identify the federal and state taxes that most employers are required to withhold from employees? ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 2. What is the employers share of pension contributions for a government permanent’ employee whose regular monthly salary of Br. 5400? ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________        e. Net Pay Net pay represents the excess of gross earnings over total deductions of an employee.        f. Signature The payroll sheet should have a column for signature of the employee to be taken when the employee collects the net pay. 91 6.4 Activities Involved In Accounting For Payroll Dear students! Would you list some of the activities that must be undertaken in the payroll department of the organization in relation to payroll preparation? List them in writing before you go through the following discussion. i. Gathering the necessary data All the relevant information about every employee –        should be gathered. This requires reviewing various documents such as attendance sheets and doing some arithmetic work. ii. Entering the names of employees along with the gathered data such as earnings, deductions and net pays in the appropriate columns of the payroll register. iii. Totaling and proving the payroll register the grand total for earnings must be checked if– it is equal to the sum of the grand totals of deductions and net pays. iv. The accuracy and authenticity of the information summarized in the payroll should be verified by a different person from the one who prepared it. v. The payroll should be approved by authorized personnel (individual) vi. Paying the payroll either in cash or by writing a check. vii. The payment of the payroll and income taxes withheld from employees (withholding tax liability) should be recorded in journal entry form. viii. The withholding tax must be paid to the relevant government authority in time (promptly) and this is recorded in journal entry form. Check Your Progress: Exercise 6.3 – 1. How is Net Pay computed? ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 2. Assume an employees regular hourly pay is Br. 30, with a time and a half for every hour’ worked in excess of 48 during a week. The following data are available: Hours worked during current month 204 hrs Regular monthly salary Br. 5760 Allowance (transportation) Br. 700 Assume that according to Company policy transportation allowance in excess of Br. 400 is subject to employment income tax. 92 2. BEKUMA:  Gross Earnings = Br. 1020 + Br. 102 = Br. 1122  The Gross Total Earnings of Bekuma consists of the Br. 1020 basic salary plus the overtime earnings of Br. 102, which is Br. 1122. 3. MEYMUNA:  Gross Total Earnings = Br. 5300, which include the basic salary alone 4. TEWODROS:  Gross Total Earnings = Br. 1470, which is the basic salary 5. YETIMWORK:  Gross Total Earnings = Br. 950 + Br. 89.06 = Br. 1039.06 C. Deductions and Net Pay 1. ABRAHAM:  Gross Total Earnings .………………………………… Br. 952.81  Gross Taxable Income (Br. 952.81 Br. 200) ..– ……… 752.81 i. Employee Income Tax: Earnings X Income Tax Rate = Income Tax 0 150 Br. 150– 0 Br. 00.00 151 650 on Br. 500– 10% 50.00 651 752.81 on Br. – 102.81 15% 15.42 Total Br. 752.81 Br. 65.42 ii. Pension Contribution: Basic salary x 4% = Br. 730 x 0.04 …………………………………… 29.20  Total Deduction (Br. 65.42 + Br. 29.20) ……… Br. 94.62 NB. The income tax would be computed using the short-cut method as follows: = (Taxable Income x 15%) Br. 47.5– = (Br. 752.81 x 0.15) Br. 47.5 = – Br. 65.42 95 2. BEKUMA:  Gross Total Earnings ……………………………… Br. 1122 i. Employee Income tax: Earning X Income Tax Rate = Income Tax 0 150 Br. 150– 0 Br. 00.00 151 650 on Br.500– 10% 50.00 651 1122 on Br. – 472 15%        70.80 Total Br. 1122 Br. 120.80 ii. Pension Contribution: (Br. 1020 x 0.04) Br. 40.80………………………………………………… iii. Credit Association ……………………………………………………… 300.00  Total Deductions . ……………………………………………… Br. 461.60 3. MEYMUNA: Gross Total Earnings . Br. 5300.00…………………………………………………… i. Employee Income tax: Earning X Income Tax Rate = Income Tax 0 150 Br. 150– 0 Br. 00.00 151 650 on 500– 10% 50.00 651 1400 on 750– 15% 112.50 1401 2350 on 950– 20% 190.00 2351 3550 on 1200– 25% 300.00 3551 5000 on 1450– 30% 435.00 Over 5000 on 300 35% 105.00 TOTAL Br. 5300.00 ----------------------------- Br. 1192.50 ii. Pension contribution (Br. 5300 x 0.04) ------------ 212.00  Total Deductions ------------------------------------ Br. 1404.50 4. TEWODROS: Gross Total Earnings ………………………………………………… Br. 1470.00 Gross Taxable Income .……………………………………………… 1470.00 96 i. Employee Income Tax: Earning X Income Tax Rate = Income Tax 0 150 Br. 150– 0 Br. 00.00 151 650 on 500– 10% 50.00 651 1400 on 750– 15% 112.50 1401 1470 on – 70 20% 14.00 TOTAL Br. 1470 ----------------------------------- Br. 176.50 NB. No pension contribution because he is not permanent employee of the organization. Therefore, total deduction is the same as Employee Income Tax, Br. 176.50. 5. YETIMWORK: Gross Total Earnings ……………………………………………… Br. 1039.06 i. Employee Income Tax: Earnings X Income Tax Rate = Income Tax 0 150 Br. 150– 0 Br. 00.00 151 650 on Br. 500– 10% 50.00 651 1039.66 on Br. – 389.06 15% 112.50 TOTAL Br. 1039.06 -------------------------------- Br. 108.36 NB. Pension contribution should not be computed for Yetimwork because she is not permanent employee of the enterprise. Thus, the only deduction from Yetimworks earnings is the employee’ income tax. NB. It is also possible to compute income tax using the short-cut method: Total Income Tax = (Taxable Income x 15%) 47.5– = (Br. 1039.06 x 0.15) 47.5– = Br. 108.30 NET PAY: 1. ABRAHAM: Net pay = Br. 952.81 Br. (94.62)– Net pay = Br. 858.19 97 Net pay = Gross Total Earnings Total Deductions–