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UNIT ONE
Charter one: Financial reporting and accounting standards
1.1 The Environment of Accounting
The environment of accounting refers to all those surroundings, forces, and influences that
affect the development of accounting. These are professional organizations, government
agencies, legislative acts, information users, and the like which will be discussed hereafter.
Financial accounting (FA) is the information accumulation, processing and communication
system designed to satisfy the investment and creditors’ decision-making information needs
to users. FA information is communicated through financial statements and constrained by
the pronouncements of several policy making groups
Financial accounting is the process that culminates in the preparation of financial reports
relative to the enterprise. The financial statements are:
• • The Balance sheet
• • The Income statement
• • The Statement of cash flows and
• • The Statement of changes in owners’ or stockholders’ equity
Accounting objectives and practices are changing because of the changes in accounting
theory to meet changing demands and influences. Thus modern financial accounting is the
product of many influences and conditions. Conditions or Factors that Influence Financial
Accounting and reporting, one Capital Allocation
Resources are limited. As a result, people try to conserve them and ensure that they are
used effectively. Efficient use of resources often determines whether a business thrives. This fact
places a substantial burden on the accounting profession. Accountants must measure
performance accurately and fairly on a timely basis, so that the right managers and companies
are able to attract investment capital. For example, relevant financial information that faithfully
represents financial results allows investors and creditors to compare the income and assets
employed by such companies. An effective process of capital allocation is critical to a healthy
economy. It promotes productivity, encourages innovation, and provides an efficient and
liquid market for buying and selling securities and obtaining and granting credit.
Unreliable and irrelevant information leads to poor capital allocation, which adversely
affects the securities markets.
The above factors or conditions constitute the environment of accounting thereby influencing it.
Most companies of today produce goods. They also exchange goods and services with the
objective of maximizing the economic welfare of the owners of the company. With the
emergence of different forms of business organizations such as partnership, corporate and
multinational companies, most investors and creditors are far away from the companies’ day-

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to-day activities. Similarly creditors use financial information to make decisions about
whether to the conceptual framework should increase financial statement users’
understanding of and confidence in financial reporting.
The conceptual framework should enhance comparability among the financial statements of
different companies. Similar events should be similarly accounted for and reported;
dissimilar events should not be.
The conceptual framework is used to help the new and emerging practical problems should be
solved more quickly by referring to an existing framework of basic theory enter into a lending
agreement with a potential borrower and to ascertain their ability to repay the debt.
Thus these investors and creditors rely on financial accounting data as a principal source of
information when making decisions about buying, selling or holding investments in the
company. Accounting is a service activity whose major function is to provide useful financial
information about economic entities to interested parties. Fair presentation of financial affairs
becomes the essence of accounting theory and practice. The usefulness of accounting
information in turn depends on effective measurement and communication of the economic
activities of entities to users of that information. Therefore, the responsibility placed on
accountants is greater today than ever before.
Financial statements and reports prepared by accountants are important to the successful working
of a society. The securities market reacts to the financial accounting information in a
sophisticated manner. Moreover, financial accounting information also plays a role in other
resource allocation decisions such as employee wage negotiations, management
compensations, bonus agreements, pension funding decisions, post retirement benefits and
for forecasting future economic trends, etc. Various Federal government units often use
financial accounting information to monitor the activities of regulated companies and later policy
makings.
Financial reporting
» General purpose financial reporting » aims to provide useful financial information about
the reporting entity to primary users who cannot require the reporting entity to provide
information directly to them.
» Special purpose financial reporting » responds to the requirements of users that have the
authority to require the reporting entity to provide the information that they need for their
purposes directly to them. Examples include: » prudential regulation reporting requirements
» tax reporting requirements
International Financial Reporting Standards (IFRS)*
» Designed for general purpose financial reporting by profit-oriented entities » might be found
to be appropriate for not-for-profit activities too
» Focused on information needs of (primary users) existing and potential investors, lenders
and other creditors who cannot require information from the entity » information to enable
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primary users to make their own assessments of the reporting entity’s prospects for future net
cash inflows
» as a basis for their decisions to buy, hold, sell equity and debt instruments or to provide a loan
or to require settlement of a loan
1.2 Need for High-Quality Standards
To facilitate efficient capital allocation, investors need relevant information and a faithful
representation of that information to enable them to make comparisons across borders. A
single, widely accepted set of high-quality accounting standards is a necessity to ensure
adequate comparability and Investors are able to make better investment decisions
Globalization demands a single set of high-quality international accounting standards. But
how is this to be achieved? Here are some elements:
1. Single set of high-quality accounting standards established by a single standard setting body.

2. Consistency in application and interpretation.

3. Common disclosures.

4. Common high-quality auditing standards and practices.

5. Common approach to regulatory review and enforcement.

6. Education and training of market participants.

7. Common delivery systems (e.g., extensible Business Reporting Language—XBRL).

8. Common approach to corporate governance and legal frameworks around the world.
1.3 International standard setting organization
For many years, many nations have relied on their own standard-setting organizations. For
example, Canada has the Accounting Standards Board, Japan has the Accounting Standards
Board of Japan, Germany has the German Accounting Standards Committee, and the United
States has the Financial Accounting Standards Board (FASB). The standards issued by these
organizations are sometimes principles-based, rules-based, tax-oriented, or business-based.
In other words, they often differ in concept and objective.
The main international standard-setting organization is based in London, United Kingdom,
and is called the International Accounting Standards Board (IASB). The IASB issues
International Financial Reporting Standards (IFRS), which are used on most foreign
exchanges.
IFRS has the best potential to provide a common platform on which companies can report and
investors can compare financial information. As a result, our discussion focuses on IFRS and
the organization involved in developing these standards—the International Accounting Standards

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Board (IASB). (A detailed discussion of the U.S. system is provided at the book’s companion
website, www.wiley.com/college/kieso.) The two organizations that have a role in international
1.3.1. International Organization of Securities Commissions (IOSCO)
Standard-setting are the International Organization of Securities Commissions (IOSCO) and the
IASB.
The International Organization of Securities Commissions (IOSCO) is an association of
organizations that regulate the world’s securities and futures markets. Members are
generally the main financial regulator for a given country. IOSCO does not set accounting
standards. Instead, this organization is dedicated to ensuring that the global markets can
operate in an efficient and effective basis. The member agencies (such as from France,
Germany, New Zealand, and the United States) have resolved to:
• • Cooperate together to promote high standards of regulation in order to maintain just,
efficient, and sound markets.

• • Exchange information on their respective experiences in order to promote the development

of domestic markets.

• • Unite their efforts to establish standards and an effective surveillance of international

securities transactions.

• • Provide mutual assistance to promote the integrity of the markets by a rigorous

application of the standards and by effective enforcement against offenses.
1.3.2. International Accounting Standards Board (IASB)
IOSCO supports the development and use of IFRS as the single set of high-quality international
standards in cross-border offerings and listings. It recommends that its members allow
multinational issuers to use IFRS in cross-border offerings and listings, as supplemented by
reconciliation, disclosure, and interpretation where necessary to address outstanding substantive
issues at a national or regional level. (For more information, go to http://www.iosco.org/.)
The standard-setting structure internationally is composed of the following four organizations:
1. The IFRS Foundation provides oversight to the IASB, IFRS Advisory Council, and IFRS
Interpretations Committee. In this role, it appoints members, reviews effectiveness, and helps in
the fundraising efforts for these organizations.
2. The International Accounting Standards Board (IASB) develops, in the public interest, a
single set of high-quality, enforceable, and global international financial reporting standards for
general-purpose financial statements.
3. The IFRS Advisory Council (the Advisory Council) provides advice and counsel to the IASB
on major policies and technical issues.

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4. The IFRS Interpretations Committee assists the IASB through the timely identification,
discussion, and resolution of financial reporting issues within the framework of IFRS.
In addition, as part of the governance structure, a Monitoring Board was created. The purpose of
this board is to establish a link between accounting standard-setters and those public authorities
(e.g., IOSCO) that generally oversee them. The Monitoring Board also provides political
legitimacy to the overall organization.
Due Process
In establishing financial accounting standards, the IASB has a thorough, open, and transparent
due process. The IASB due process has the following elements: (1) an independent standard-
setting board overseen by a geographically and professionally diverse body of trustees; (2) a
thorough and systematic process for developing standards; (3) engagement with investors,
regulators, business leaders, and the global accountancy profession at every stage of the process;
and (4) collaborative efforts with the worldwide standard-setting community.
Types of pronouncements
The IASB issues three major types of pronouncements:
1. International Financial Reporting Standards.

2. Conceptual Framework for Financial Reporting.

3. International Financial Reporting Standards Interpretations.

International Financial Reporting Standards. Financial accounting standards issued by the
IASB are referred to as International Financial Reporting Standards (IFRS).
Conceptual Framework for Financial Reporting. As part of a long-range effort to move away
from the problem-by-problem approach, the IASB uses an IFRS conceptual framework. This
Conceptual Framework for Financial Reporting sets forth the fundamental objective and
concepts that the Board uses in developing future standards of financial reporting. The intent of
the document is to form a cohesive set of interrelated concepts a conceptual framework that will
serve as tools for solving existing and emerging problems in a consistent manner.
International Financial Reporting Standards Interpretations. Interpretations issued by the
IFRS Interpretations Committee are also considered authoritative and must be followed. These
interpretations cover (1) newly identified financial reporting issues not specifically dealt with in
IFRS and (2) issues where unsatisfactory or conflicting interpretations have developed, or seem
likely to develop, in the absence of authoritative guidance. The IFRS Interpretations Committee
applies a principles-based approach in providing interpretative guidance.
The IFRS Interpretations Committee can address controversial accounting problems as they
arise. It determines whether it can resolve .In essence, it becomes a “problem filter” for the
IASB.

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Hierarchy of IFRS
Because it is a private organization, the IASB has no regulatory mandate and therefore no
enforcement mechanism. As a result, the Board relies on other regulators to enforce the use of its
standards. For example, the European Union requires publicly traded member country companies
to use IFRS.
Any company indicating that it is preparing its financial statements in conformity with IFRS
must use all of the standards and interpretations. The following hierarchy is used to determine
what recognition, valuation, and disclosure requirements should be used. Companies first look
to:
1. International Financial Reporting Standards, International Accounting Standards (issued by
the predecessor to the IASB), and IFRS interpretations originated by the IFRS Interpretations
Committee (and its predecessor, the IAS Interpretations Committee);

2. The Conceptual Framework for Financial Reporting; and

3. Pronouncements of other standard-setting bodies that use a similar conceptual framework

(e.g., U.S. GAAP).
1.4. IASB Conceptual Framework for Financial Reporting 1.4.1. Need for a Conceptual
Framework
A conceptual framework establishes the concepts that underlie financial reporting. A
conceptual framework is a coherent system of concepts that flow from an objective. The
objective identifies the purpose of financial reporting. The other concepts provide guidance on
(1) identifying the boundaries of financial reporting; (2) selecting the transactions, other events,
and circumstances to be represented; (3) how they should be recognized and measured; and (4)
how they should be summarized and reported
Why do we need a conceptual framework? First, to be useful, rule-making should build on
and relate to an established body of concepts. A soundly developed conceptual framework
thus enables the IASB to issue more useful and consistent pronouncements overtime, and
a coherent set of standards should result. Second, as a result of a soundly developed
conceptual framework, the profession should be able to more quickly solve new and
emerging practical problems by referring to an existing framework of basic theory.
Overview of the IASB’s Conceptual Framework for Financial Reporting
The first level identifies the objective of financial reporting—that is, the purpose of financial
reporting.
The second level provides the qualitative characteristics that make accounting information
useful and the elements of financial statements (assets, liabilities, and so on).Is called
Fundamental concept.

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The third level identifies the recognition, measurement, and disclosure concepts used in
establishing and applying accounting standards and the specific concepts to implement the
objective. These concepts include assumptions, principles, and a cost constraint that describe the
present reporting environment.
1.4.2. First level: basic objective
The objective of financial reporting is the foundation of the Conceptual Framework. Other
aspects of the Conceptual Framework—qualitative characteristics, elements of financial
statements, recognition, measurement, and disclosure flow logically from the objective. Those
aspects of the Conceptual Framework help to ensure that financial reporting achieves its
objective.
The objective of general-purpose financial reporting is to provide financial information about the
reporting entity that is useful to present and potential equity investors, lenders, and other
creditors in making decisions about providing resources to the entity. Those decisions involve
buying, selling, or holding equity and debt instruments, and providing or settling loans and other
forms of credit. Information that is decision-useful to capital providers may also be helpful to
other users of financial reporting who are not capital providers.
General-purpose financial reporting helps users who lack the ability to demand all the
financial information they need from an entity and therefore must rely, at least partly, on the
information provided in financial reports

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1.4.3. Second level: fundamental concepts

The objective (first level) focuses on the purpose of financial reporting. What is the purpose of
the second level? The second level provides conceptual building blocks that explain the
qualitative characteristics of accounting information and define the elements of financial
statements. That is, the second level forms a bridge between the why of accounting (the
objective) and the how of accounting (recognition, measurement, and financial statement
presentation).
A. Qualitative Characteristics of Accounting Information
How does a company choose an acceptable accounting method, the amount and types of
information to disclose, and the format in which to present it? The answer: By determining
which alternative provides the most useful information for decision making purposes
(decision-usefulness). The IASB identified the qualitative characteristics of accounting
information that distinguish better (more useful) information from inferior (less useful)
information for decision-making purposes. In addition, the IASB identified a cost constraint as
parts of the Conceptual qualitative characteristics are either fundamental or enhancing
characteristics, depending on how they affect the decision-usefulness of information.
Regardless of classification, each qualitative characteristic contributes to the decision-usefulness
of financial reporting information. However, providing useful financial information is limited by
a pervasive constraint on financial reporting—cost should not exceed the benefits of a reporting
practice.
Fundamental Quality—Relevance
Relevance is one of the two fundamental qualities that make accounting information useful for
decision-making. Relevance and related ingredients of this fundamental quality are shown
below.
To be relevant, accounting information must be capable of making a difference in a decision.
Information with no bearing on a decision is irrelevant. Financial information is capable of
making a difference when it has predictive value, confirmatory value, or both
Financial information has predictive value if it has value as an input to predictive processes
used by investors to form their own expectations about the future
Relevant information also helps users confirm or correct prior expectations; it has confirmatory
value
Materiality is a company-specific aspect of relevance. Information is material if omitting it or
misstating it could influence decisions that users make on the basis of the reported financial
information. An individual company determines whether information is material because both

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the nature and/or magnitude of the item(s) to which the information relates must be considered in
the context of an individual company’s financial report.
Fundamental Quality—Faithful Representation
Faithful representation is the second fundamental quality that makes accounting information
useful for decision-making. Faithful representation and related ingredients of this fundamental
quality are shown below
Faithful representation means that the numbers and descriptions match what really existed or
happened. Faithful representation is a necessity because most users have neither the time nor the
expertise to evaluate the factual content of the information Completeness. Completeness means
that all the information that is necessary for faithful representation is provided Neutrality.
Neutrality means that a company cannot select information to favor one set of interested parties
over another
Free from Error. An information item that is free from error will be a more accurate (faithful)
representation of a financial item
Enhancing Qualities
Enhancing qualitative characteristics are complementary to the fundamental qualitative
characteristics. These characteristics distinguish more-useful information from less-useful
information. Enhancing characteristics, shown below, are comparability, verifiability, timeliness,
and understandability.
Comparability. Information that is measured and reported in a similar manner for different
companies is considered comparable. Comparability enables users to identify the real
similarities and differences in economic events between companies.
Verifiability. Verifiability occurs when independent measurers, using the same methods, obtain
similar results. Verifiability occurs in the following situations
Timeliness. Timeliness means having information available to decision-makers before it loses
its capacity to influence decisions. Having relevant information available sooner can enhance its
capacity to influence decisions, and a lack of timeliness can rob information of its usefulness
Understandability is the quality of information that lets reasonably informed users see its
significance. Understandability is enhanced when information is classified, characterized, and
presented clearly and concisely.
B. Basic Elements
An important aspect of developing any theoretical structure is the body of basic elements or
definitions to be included in it. Accounting uses many terms with distinctive and specific
meanings. These terms constitute the language of business or the jargon of accounting.
Elements of financial statements

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The elements directly related to the measurement of financial position are assets, liabilities, and
equity. These are defined as follows.
ASSET. A resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity.
LIABILITY. A present obligation of the entity arising from past events, the settlement of which
is expected to result in an outflow from the entity of resources embodying economic benefits.
EQUITY. The residual interest in the assets of the entity after deducting all its liabilities.
The elements of income and expenses are defined as follows.
INCOME. Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants.
EXPENSES. Decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrence’s of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants.
1.4.4. Third level: recognition, measurement, and disclosure concepts
The third level of the Conceptual Framework consists of concepts that implement the basic
objectives of level one. These concepts explain how companies should recognize, measure, and
report financial elements and events. Here, we identify the concepts as basic assumptions,
principles, and a cost constraint. Not everyone uses this classification system, so focus your
attention more on understanding the concepts than on how we classify and organize them.
These concepts serve as guidelines in responding to controversial financial reporting issues.
Basic Assumptions
The five basic assumptions in turn: (1) economic entity,
(2) Going concern, (3) monetary unit, (4) periodicity, and (5) accrual basis.
Economic Entity Assumption
The economic entity assumption means that economic activity can be identified with a
particular unit of accountability. In other words, a company keeps its activity separate and
distinct from its owners and any other business unit. Thus, the entity concept does not
necessarily refer to a legal entity. A parent and its subsidiaries are separate legal entities, but
merging their activities for accounting and reporting purposes does not violate the economic
entity assumption
Going Concern Assumption
Most accounting methods rely on the going concern assumption—that the company will have
a long life. Despite numerous business failures, most companies have a fairly high continuance

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rate. As a rule, we expect companies to last long enough to fulfill their objectives and
commitments.
Monetary Unit Assumption
The monetary unit assumption means that money is the common denominator of economic
activity and provides an appropriate basis for accounting measurement and analysis. That is, the
monetary unit is the most effective means of expressing to interested parties changes in capital
and exchanges of goods and services
Periodicity Assumption
To measure the results of a company’s activity accurately, we would need to wait until it
liquidates. Decision-makers, however, cannot wait that long for such information. Users need to
know a company’s performance and economic status on a timely basis so that they can evaluate
and compare companies, and take appropriate actions. Therefore, companies must report
information periodically. The periodicity (or time period) assumption implies that a company
can divide its economic activities into artificial time periods. These time periods vary, but the
most common are monthly, quarterly, and yearly
Accrual Basis of Accounting
Companies prepare financial statements using the accrual basis of accounting. Accrual basis
accounting means that transactions that change a company’s financial statements are recorded in
the periods in which the events occur
Basic Principles of Accounting
There are four basic principles of accounting to record and report transactions: (1)
measurement, (2) revenue recognition, (3) expense recognition, and (4) full disclosure. We
look at each in turn
Measurement Principles
The most commonly used measurements are based on historical cost and fair value. Selection
of which principle to follow generally reflects a trade-off between relevance and faithful
representation.
Historical Cost. IFRS requires that companies account for and report many assets and liabilities
on the basis of acquisition price. This is often referred to as the historical cost principle. Cost
has an important advantage over other valuations: It is generally thought to be a faithful
representation of the amount paid for a given item.
Fair Value. Fair value is defined as “the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the measurement
date.” Fair value is therefore a market-based measure. Recently, IFRS has increasingly called for
use of fair value measurements in the financial statements. The IASB believes that fair value

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Information is more relevant to users than historical cost. Fair value measurement, it is argued,
provides better insight into the value of a company’s assets and liabilities (its financial position)
and a better basis for assessing future cash flow prospects
Revenue Recognition Principle
When a company agrees to perform a service or sell a product to a customer, it has a
performance obligation. When the company satisfies this performance obligation, it recognizes
revenue. The revenue recognition principle therefore requires that companies recognize
revenue in the accounting period in which the performance obligation is satisfied
Expense Recognition Principle
Expenses are defined as outflows or other “using up” of assets or incurring of liabilities (or a
combination of both) during a period as a result of delivering or producing goods and/or
rendering services. It follows then that recognition of expenses is related to net changes in assets
and earning revenues. In practice, the approach for recognizing expenses is, “Let the expense
follow the revenues.” This approach is the expense recognition principle. To illustrate,
companies recognize expenses not when they pay wages or make a product, but when the work
(service) or the product actually contributes to revenue.
Full Disclosure Principle
In deciding what information to report, companies follow the general practice of providing
information that is of sufficient importance to influence the judgment and decisions of an
informed user. Often referred to as the full disclosure principle, it recognizes that the nature and
amount of information included in financial reports reflects a series of judgmental trade-offs. These
trade-offs strive for (1) sufficient detail to disclose matters that make a difference to users, yet (2)
sufficient condensation to make the information understandable, keeping in mind costs of
preparing and using it. Users find information about financial position, income, cash flows, and
investments in one of three places: (1) within the main body of financial statements, (2) in the notes
to those statements, or (3) as supplementary information.
Cost Constraint
In providing information with the qualitative characteristics that make it useful, companies
must consider an overriding factor that limits (constrains) the reporting. This is referred to as
the cost constraint. That is, companies must weigh the costs of providing the information
against the benefits that can be derived from using it. Summary of the Structure:
Referrer page 47 your text book, Kieso 2014 2nd IFRS edition.
1.5. Cash flow and income measurement
Most companies use accrual-basis accounting: They recognize revenue when the performance
obligation is satisfied and expenses in the period incurred, without regard to the time of receipt
or payment of cash. Some small companies and the average individual taxpayer, however, use a

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strict or modified cash-basis approach. Under the strict cash basis, companies record revenue
only when they receive cash, and they record expenses only when they disperse cash.
Determining income on the cash basis rests upon collecting revenue and paying expenses. The
cash basis ignores two principles: the revenue recognition principle and the expense recognition
principle. Consequently, cash-basis financial statements are not in conformity with IFRS.
The modified cash basis is a mixture of the cash basis and the accrual basis. It is based on the
strict cash basis but with modifications that have substantial support, such as capitalizing and
depreciating plant assets or recording inventory. This method is often followed by professional
services firms
Conversion from cash basis to accrual basis
Not infrequently, companies want to convert a cash basis or a modified cash basis set of financial
statements to the accrual basis for presentation to investors and creditors
Service Revenue Computation
To convert the amount of cash received from customs to service revenue on an accrual basis, we
must consider changes in accounts receivable and unearned service revenue during the year
Examples.
Revenue Cash Receipts from Customers xxxx
-Beginning Accounts Receivable xxx
On an +Ending Accounts Receivable xxx
Accrual Basis + Beginning Unearned service revenue xxx
- Ending Unearned Service Revenue xxx
Service revenue (accrual) xxxx

Operating Expense Computation

To convert cash paid for operating expenses during the year to operating expenses on an accrual
basis we must consider changes in prepaid expenses and accrued liabilities
Expenses Cash paid for operating expenses xxx
On an + Beginning prepaid expense xxx
Accrual Basis - Ending prepaid expense xxx
- Beginning accrued liabilities xxx
+ Ending accrued liabilities xxx
Operating expenses (accrual) xxx

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UNIT TWO
ACCOUNTING CYCLE IN SIMPLEST FORM
2.1 Accounting Information System
An accounting information system collects and processes transaction data and then disseminates
the financial information to interested parties. Accounting information systems vary widely from
one business to another. Various factors shape these systems: the nature of the business and the
transactions in which it engages, the size of the firm, the volume of data to be handled, and the
informational demands that management and others require.
2.2 Double-entry rules: Debits and Credits
The terms debit (Dr.) and credit (Cr.) mean left and right, respectively. These terms do not
mean increase or decrease, but instead describe where a company makes entries in the recording
process. That is, when a company enters an amount on the left side of an account, it debits the
account. When it makes an entry on the right side, it credits the account. When comparing the
totals of the two sides, an account shows a debit balance if the total of the debit amounts
exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits.
If a company records every transaction with equal debits and credits, then the sum of all the
debits to the accounts must equal the sum of all the credits.
2.3 Accounting Cycle
The sequence of accounting procedures completed during each accounting period is called
the accounting cycle. A broad summary of the accounting processes of the accounting cycle
include:
include
1. Processes that are performed through out the fiscal year
2. Year end processes and
3. Accounting process during the beginning accounting period of the next fiscal year
The following sections discuses each steps followed during the three accounting processes.
processes
2.4: Processes that are performed Throughout the Fiscal Year
The accounting processes that cover the entire accounting year can be discussed into the
following three main headings;
headings;
1. Recording Transactions
The recording process in the accounting cycle involves the following steps;
a) Identification of business transactions
The purposes of this step are to identify transactions and events that cause the changes the
firm’s resource or obligations and to collect the relevant economic date about those
transactions. These, events or transactions can be categorized into three categories;
 Transactions that involve exchange of resources or obligations with other external
parties such as sales of goods, payment of dividend, receipts of donations etc.
 Transactions that occur with in the firm: these are internal events that affect the firm’s
resource or obligation. For example, recognitions of depreciation, amortizations etc
can be included in this category. These events of economic nature require a journal
entry. However, other events such as increase in the value of assets resulted from
superior management quality and similar factors are not recorded.

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 External economic and environmental events that are beyond the control of the
company like for example, casualty of losses and changes in market value asset and
liabilities.
b) Journalizing business transactions. This step measures and records the economic effect
of the transactions in an accounting record called Journal. Accounting principles that
guide measurement, recognition and classification of accounts are applied at this stage.
A journal entry consists of date, the account and the amount involved and a brief
description about the journal entry.
A journal is the first book of entry because; transactions are first recorded in this record in
the form of Journal entry.
c) Posting to the ledger: Posting is the process of transferring transaction data recorded in a
journal to the accounts in the ledger. A ledger is a group of individual accounts that are
used to summarize the effect of business transactions on a specific category of resources
or obligations of the company. Accordingly, accounting system usually have two types
of ledgers.
 General Ledger: General Ledger holds accounts grouped into seven account types (i.e.
Assets, Liabilities, owner’s Equity, Revenues, Expenses, gains and Loss accounts).
These category of ledger composed of accounts that are reported on the financial
reports of a company.
company.
 Subsidiary Ledger: Subsidiary ledger are supporting the General Ledger accounts
reported on the financial reports. For example, Account Recievable subsidiary ledger
2.5 Year end processes
The year end accounting processes are accounting processes performed at the end of
accounting period. At the end of the accounting period, the steps in the accounting process
starts with summarizing balances of accounts in general and subsidiary ledgers and ends
with the preparation of post closing trial balance. The year end accounting process involves;
i. Preparing Unadjusted Trial Balance:
The purpose of this step is primarily to check the accuracy of the recording processes you
have seen in the above section. Trial balance is a working paper used at year end to check
the total Debit and total credit of the ledger are equal or in conformity with the fundamental
accounting equation-
equation ASSETS = Liabilities + Owner’s equity. Recall your course principles of
accounting II during your previous study for the errors that can be located using a Trial
Balance. These errors may take different forms, but they all make the Trial Balance Total
Debit and Total Credit amount columns not to be equal. A trail balance is not the only tool for
accountants to insure the accuracy of transaction data before preparation of financial
reports. There are also other accuracy insuring tools in manual accounting system such as;
 Checking the cash balance
 Schedule of Account Receivables
 Schedule of Account payables
ii. Journalizing and Posting Adjusting journal entries
Many changes in a firm’s economic resources and obligations occur continuously. For
example, interest accrues daily on the debts as does Rent Expenses on an office Building.
Other resources and obligations such as employee salaries, originate as service rendered,
with the payment to follow at specified dates. The end of accounting period does not
consider with receipts or payment of cash associated with these types of resource changes.

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Accrual Basis of Accounting requires the recording of these changes in economic

resources and obligations at the end of accounting period under the Revenue, Historical
Cost and matching principles. Adjusting journal entries are used to record such resource
changes to ensure the accuracy of the Financial Statements.
Adjusting journal entries are usually planed on a working paper called ‘Work sheet’ in the
‘Adjustment Columns’. The work sheet in addition to planning adjusting entries, the
amount of profit of net loss for the period is determined before income statement is
prepared. Adjusting entries can be categorized into the following classes;
1) DEFERRALS are for cash flows that occurs BEFORE REVENUE AND EXPENSE RECOGNITION . These
adjusting journal entries are normally recorded when cash is paid for expenses that apply
to more than one accounting period or cash is received for revenues that apply for more
than one accounting periods. The portion of the Expense or the Revenue that applies for
the future period s is deferred as PREPAID EXPENSE (ASSET) OR UNEARNED REVENUE (LIABILITY).
The adjusting journal entries for deferrals depend on the method accounting used to
record routine operational cash payments and receipts that PRECEDE EXPENSE OR REVENUE
RECOGNITION . These methods would be discussed below for deferred expenses and
deferred revenues;
Deferred Expenses recorded initially as Prepayments (Asset).
This method records an Asset on payment of cash before goods and services are received.
These adjusting journal entries at year-end require recognizing expenses and the expiration
of the assets or prepayments.
EXAMPLE1: Assume that Yam rot Plc, paid cash Br 12,000.00 as a prepayment for the rent of
its Office Building on August 1, 2003 to cover six month rent. The journal entries including
adjusting entry under this method are given below;
Payment of Cash for Rent on August 1, 2003
Date Account Title Debit Credit
Aug. 1 Prepaid Rent 12,000.00
Cash 12,000.00
Adjusting journal entry on December 31, 2003 the end of accounting period recognizes 5
month rent service received [(Br 12,000.00/6 month) x 5 months]= Br 10,000.00;
Date Account Title Debit Credit
Dec.31 Rent Expense 10,000.00
Prepaid Rent 10,000.00

Deferred Expenses recorded initially as Expense.

This method records prepayments as Expense initially when cash is paid before goods
and services are received. These adjusting journal entries at year-end require recognizing
unexpired Asset or prepayments applicable for the coming accounting period.
Example; Assume that Yam rot Plc, paid cash Br 12,000.00 as a prepayment for the rent
of its Office Building on August 1, 2003 to cover six month rent. The journal entries
including adjusting entry under this method are given below;
 Payment of Cash for Rent on August 1, 2003
Date Account Title Debit Credit
Aug. 1 Rent Expense 12,000.00
Cash 12,000.00

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Adjusting journal entry on December 31, 2003 the end of accounting period recognizes 1
month prepaid rent that will be service to received in the coming accounting year [(Br
12,000.00/6 month )x 1 months]= Br 2,000.00;

Date Account Title Debit Credit

Dec.31 Prepaid Rent 2,000.00
Rent Expense 2,000.00
Note that the standard method of recording a prepayment in example 1 above, the adjusting
entry debits expense and credits an asset/prepaid expense account at the amount of expired
portion during the accounting period. However, the second method given in example 2
Debits the asset/prepaid expense and credits the expense accounts at the unexpired amount
applicable for the next accounting period. In both methods, the expense applicable for the
period is the same.
In the second treatment of deferred expenses initially recorded as expense before goods and
services are received by the firm, the adjusting journal entry transfers the amount of
prepayment applicable to the future period from expense to an asset account otherwise; the
expense of the period is closed overstated. When this method is used, there should be an
optional journal entry called Reversing.

A. Deferred Revenue initially recorded as Liability/Unearned Revenue

Deferred Revenue represents revenue received in cash before goods and services provided
to a customer or it is earned. Such advance collection of revenue is liabilities to the
business until goods and services are provided to the customer.
Example 3: Assume that TG printing received cash Br 36,000.00 to provide three years
advertising service on one of its monthly magazine to Tana Trading on March 1, 2005. The
initial recording and the related adjustment using a standard method are given below;
 Collection of cash on March 1, 2005 as a liability on Unearned subscription revenue
account take the form;
Date Account Title Debit Credit
Mar. 1, 2005 Cash 36,000.00
Unearned subscription revenue 36,000.00
The unearned subscription revenue is liability at the time collected but it will be earned
when advertising service provided each month for the coming three years to come. At year
end, on December 31, 2005, this amount is partially earned and the remaining will be earned
in the coming years. Part of it earned during the year 2005 10 month service is provided.
Thus, this amount should be recorded on December 31, 2005 as revenue through an
adjusting entry.
 Adjusting journal entry on December 31, 2005 the end of accounting period
recognizes 10 month Subscription Revenue for service provided during 2005 would
be [36,000.00/(3x12 months) x 10 = Br 10,000.00 is records as given below;
Date Account Title Debit Credit
Dec.312005 Unearned Subscription Revenue 10,000.00
Subscription Revenue 10,000.00
B. Deferred Revenue initially recorded as Revenue on Subscription Revenue account
Under this method of recording Deferred Revenue, the cash received before providing
advertising service on March 1, 2005 is credited on the revenue account- ‘Subscription

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Revenue’ rather than a liability account’ unearned Subscription Revenue’ account. Thus
the above journal entries on March 1 and December 31 2005 given as Example 3 will be;
a) Collection of cash on March 1, 2005 recorded as a Revenue on Subscription Revenue
Date Account Title Debit Credit
Mar. 1, 2005 Cash 36,000.00
Unearned subscription revenue 36,000.00
b) Adjusting journal entry on December 31, 2005 the end of accounting period recognizes 2
years and 2 month Unearned Subscription Revenue for service provided during 2005
would be [36,000.00/(3x12 months) x 26= Br 26,000.00 is transferred to a liability
account Unearned Subscription Revenue as given below;

Date Account Title Debit Credit

Dec.312005 Unearned Subscription Revenue 26,000.00
Subscription Revenue 26,000.00
2. Accruals are for cash flows that occurs after expense and revenue recognitions. These
adjusting entries are recorded when cash is paid or received in the future accounting
period but all or a portion of the future cash flow applies to expense or revenue of the
current accounting period.
period.
Accrued expenses are expenses incurred for goods and services received but not yet paid
and recorded during the period. This adjusting entry records an accumulated expenses
and the related liability during the period, because it is nit yet paid in cash in the current
accounting period.
Example 4: Assume that Safi retails singed a lank loan of 12%, Br 10,000.00 6 month
note on November 1, 2005. The journal entries at year end and on December 31, 2005
are given below;
On Nov 1, 2005 the Bank Loan is recorded as;
Date Account Title Debit Credit
Nov 1, 2005 Cash 10,000.00
Note Payable 10,000.00
Adjusting journal entry on December 31, 2005 to accrue a two month interest expense is
recognized with the related interest payable during the period of 2005;
Interest expense accrued is computes as;
I=PIT
I = 10,000.00 x 12% x 2/12= 200.00
Date Account Title Debit Credit
Dec3 1, 2005 Interest Expense 200.00
Expense Payable 200.00
Accrued Revenue: Are revenues earned for goods and services provided but not yet paid
in cash and records. These will be records in the coming accounting period but a portion
of it or all are earned and not received in cash during the current accounting period.
Thus, the adjusting entry for accrued Revenues record the accrued revenue earned and
the related asset receivable account because it will be received in cash the future period.
Example5: Assume that AD Company received Br 18,000.00; 12%; 1 3 month note from
TK Store as a settlement of on account this year on November 30, 2008. The journal
entries on November 30 and the adjusting entry to accrue interest income for one month
are given below;
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On November 30, 2008

Date Account Title Debit Credit
Nov 1, 2005 Note Receivable 18,000.00
Account Receivable 18,000.00
Adjusting journal entry on December 31, 2005 to record one month Interest Income on
Notes Receivable is;
Interest income=Principal Rate X Period
= 18,000.00 x 12%x 1/12
= Br 180.00
Date Account Title Debit Credit
Dec31, 2005 Interest Receivable 180.00
Interest Income 180.00
3. Other Adjusting Entries
A. Depreciation Expenses:: property, plant and equipment (plant Assets) are balance sheet
accounts used to account for many productive assets with a useful economic life
exceeding one year. The capital expenditure made for these productive assets- Cost; is
allocated to their economic life as Depreciation Expense to match against to the
Revenues the Assets help to produce during the accounting period. Depreciation is a
systemic and rational allocation of Plant Asset costs over its estimated useful life.

Example 6: Assume that Building with a cost of Br 560,000.00 and estimated economic
life of 28 years was acquired on January 1, 2003 to be used as Head Office for AD
Company. The company uses a straight line method of depreciation, the adjusting entry
at the end of 2003is shown below;
Annual Depreciation expense = Cost/ Estimated economic life
= Br 560,000.00/28 years
= Br 20,000.00
Date Account Title Debit Credit
Dec31, 2003 Depreciation Expense 20,000.00
Accumulated Depreciation 20,000.00
This adjusting entry for depreciation expense reduces the net book value of the Building
account. Accumulated Depreciation account is a Contra Account. A Contra Account has
a balance opposite of the account to which it relates.

B. Bad Debt Expense:: Often goods and services are sold on credit. Some accounts that
never been collected from customers result Bad Debt Expenses. Bad Debt Expenses are
recorded at the end of accounting period using an Adjusting entry that Debits Bad Debt
Expense and Credit Allowance for doubtful Accounts (Allowance for uncollectible
Accounts- a contra Account Receivable Account) accounts.
The estimate of Bad Debts Expense accounts are made based on the total credit sales or
the balance of Accounts receivable at year end.

Example 7: Assume that Hope Retail Store has made Br 420,000.00 credit sales of
merchandise of during 2004. Prior experience indicated that expected uncollectible
Accounts as 2 percent of the total sales. The adjusting entry to record, the Bad Debts
Expense of the year 2004; Br 8,400.00 [Br 420,000.00 x 0.02] is given below;

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Date Account Title Debit Credit

Dec31, 2004 Bad Debts Expense 8,400.00
Allowance for doubtful Accounts 8,400.00
The Br 8,400.00 Allowance is the part of 2004 credit sales not expected to be collected. The
Net Realizable value of account Receivable is the difference between the balance of
Account Receivable and Allowance for doubt full Account is an estimate value of the cash
ultimately expected to be collected from credit sales.

C. Inventory account under periodic inventory system

Under Periodic inventory system, the Inventory accounts are updated after a physical count
of inventory on hand at year end using adjusting entry that records the Ending inventory
balance and transfers the beginning balance to Income summary account to determine the
Cost of Goods Sold during the accounting period.

Example 8: Assume that Hope Retail Store that uses Periodic inventory system. The
Balance of Inventory account on unadjusted amount column shows Br 23,450.00. The
inventory of goods on December 31, 2005 resulted Br 15,950.00 was on hand. The adjusting
entries on December 31, 2005 are given below;

Date Account Title Debit Credit

Dec31, 2005 Income Summary 23,450.00
Inventory 23,450.00
Date Account Title Debit Credit
Dec31, 2005 Inventory 15,950.00
Income Summary 15,950.00
iii. Preparing Adjusted Trial Balance Adjusted Trail Balance is usually part of a working paper
called work sheet. ‘Adjusted Trail balance’ is prepared when completing a worksheet.
The adjusted trial balance lists all the account balances that will appear on the financial
statements with the exception of Retained Earnings which does not reflect the current
year’s net income or Dividend. The purpose of adjusted trial balance is to confirm the
equality of total Debit-Credit of the ledger after taking all the adjusting journal entries into
consideration. The account balances in the adjusted trial balance reflects the effect of the
adjusting entries.
The adjusted trial balance is prepared from the data obtained from unadjusted trial balance
and adjustment columns of a worksheet.
worksheet.
iv. Preparing financial Statements
As discussed above, the ultimate objective of accounting information system of any
organization; is to provide financial information in the form of financial reports. Financial
reports are prepared for a period of any duration. However, monthly, quarterly and annual
financial reports are the most common.
The common financial reports of business enterprises are;
 Balance sheet that shows the position of assets, liabilities and owner’s equity on the
statement date.
 Income Statement shows the result of business operations.
 Statement of Owners equity and
 Statement of cash flows

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v. Journalizing and Posting Closing journal entries

Closing the accounts in the ledger is also year end accounting process primarily aimed at
transferring systematically the result of operations-Net income or lose to the owner’s equity
account. The main purpose of closing entries is;
 Increase or decrease the Retained Earnings by the net income or the net loss of the
period.
 To close the balances of Temporary Accounts related to earnings and dividends.
Those accounts in the ledger used only for one accounting period are closed at year end
after financial statements are prepared. These, category of ledger accounts are called
Temporary/Nominal Accounts. The nominal accounts include Revenues/sales, purchases
and related accounts [contra purchase accounts] and freight in, expenses etc which are
reported on the income statement.
Example 9: Assume that the adjusted trial balance on December 31, 2009 of ASHE Plc
show below;
ASHE Plc
Adjusted Trial Balance
December 31, 2009
Accounts Debit Credit
Sales Br 425,600.00
Net purchases Br 125,500.00
Dividends 75,450.00
Selling expenses 97,500.00
Administrative expenses 45,500.00
The following are closing journal entries for income statement accounts and dividend for
ASHE Plc;
A) Closing sales/Revenue
Date Account Title Debit Credit
Dec31, 2009 sales 425,600.00
Income Summary 425,600.00
B) Closing Purchases and operating expenses
Date Account Title Debit Credit
Dec31, 2009 Income Summary 293,500.00
Purchases 125,500.00
Selling expenses 97,500.00
Administrative expenses 45,500.00
C) Closing Dividend
Date Account Title Debit Credit
Dec31, 2009 Retained Earning 75,450.00
Dividend 75,450.00
d) CLOSING INCOME SUMMARY
Assuming that the net income of the period is Br 65,750.00
Date Account Title Debit Credit

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Dec31, 2009 Income Summary 65,750.00

Retained Earnings 65,750.00
After these closing entries are journalized and posted to the accounts in the ledger, the
account balances of revenue, expenses, purchases and dividend accounts are reduced to
zero. These accounts by nature serve to summarize the effect of net income/loss and
dividend for one accounting period.
period.

vi. Preparing Post Closing Trail Balance

Post closing trial balance is the final lists only the balances of the permanent/ Balance sheet
accounts. The purpose of this process is to check the equality of total debits and total Credit
part of the ledge after Temporary/ income statement accounts are closed. The number of
accounts the firm finds this as a voluble checking procedure because the chance of errors
increase with the number of accounts and postings.
2.6: Processes at the beginning of the next accounting period
Reversing entries are journal entries optionally made at the beginning of the next accounting
period. Depending on the accounting policies of a firm, Reversing journal entries are
required to simplify certain journal entries in the next accounting period.

Reversing entries are optional that:

Are dated the first day of the next accounting period
Use the same accounts and amounts as adjusting entries but with the debits and the
credits reversed.
Are posted to the ledger
Reversing entries are requires under the following situations;
Defer the recognition of revenues or expenses are recorded initially as Revenue or
expense respectively.
Accrue revenue or expenses adjusting entries increase an asset or a liability accounts
respectively.
Consider the following examples, as of December 2004;
Assume that 3F company is paid Br 12,000.00 for Rent to cover rent expense for the coming
6 months on November 1, 2004.

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On November 1, 2004, original entry;

Date Account Title Debit Credit
Nov 1, 2004 Rent Expense 12,000.00
Cash 12,000.00
 On December 31, 2004, Adjusting entry records two month rent expense for service
received from November1 to December 31, 2004[12,000.00/6months] x 2= 4,000.00 but
the reaming applicable for the future period will be 12,000.00 – 4,000.00 = 8,000.00;
Date Account Title Debit Credit
Dec31, 2004 Prepaid Rent 8,000.00
Rent Expense 8,000.00
On January 1, 2005, the beginning of 2005;
Jan1, 2005 Rent Expense 8,000.00
Prepaid Rent 8,000.00

a) Assume that the last wages was paid on December 28, 2003. Wages are usually paid on
Friday for 5 working days. The total weekly wage is Br 5,000.00. the adjusting entry to
accrue two days wage and the related Reversing entries are given below;
On December 31, 2003 adjusting entry
Date Account Title Debit Credit
Dec31, Wages Expense 2,000.00
2004
Wages Payable 2,000.00
On January 1, 2004, the beginning of 2004;
Jan1, 2004 Wages Payable 2,000.00
Wages Expense 2,000.00
 On January 4, 2004, the payment of wages for the week ;
Jan4, 2004 Wages Expense 5,000.00
Cash 5,000.00
Note that with out reversing entry on the above journal entry on January 4, 2004 the
payment of wages would have been recorded as given below;
Jan4, 2004 Wages Expense 3,000.00
Wages Payable 2,000.00
Cash 5,000.00

UNIT THREE
Income statement and Related Information
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1.1. Income statement and Limitations of the Income Statement

The income statement is the report that measures the success of company operations for a given
period of time. (It is also often called the statement of income or statement of earnings. The
business and investment community uses the income statement to determine profitability,
investment value, and creditworthiness. It provides investors and creditors with information that
helps them predict the amounts, timing, and uncertainty of future cash flows.
Usefulness of the Income Statement
The income statement helps users of financial statements predict future cash flows in a number
of ways. For example, investors and creditors use the income statement information to:
1) Evaluate the past performance of the company. Examining revenues and expenses
indicates how the company performed and allows comparison of its performance to its
competitors.
2) Provide a basis for predicting future performance. Information about past performance
helps to determine important trends that, if continued, provide information about future
performance.
3) Help assess the risk or uncertainty of achieving future cash flows. Information on the
various components of income—revenues, expenses, gains, and losses—highlights the
relationships among them. It also helps to assess the risk of not achieving a particular
level of cash flows in the future.
In summary, information in the income statement—revenues, expenses, gains, and losses—helps
users evaluate past performance. It also provides insights into the likelihood of achieving a
particular level of cash flows in the future.
Limitations of the Income Statement
Because net income is an estimate and reflects a number of assumptions, income statement users
need to be aware of certain limitations associated with its information. Some of these limitations
include:
1) Companies omit items from the income statement that they cannot measure reliably.
2) Income numbers are affected by the accounting methods employed. One company may
depreciate its plant assets on an accelerated basis; another chooses straight-line
depreciation. Assuming all other factors are equal, the first company will report lower
income.
3) Income measurement involves judgment. For example, one company in good faith may
estimate the useful life of an asset to be 20 years while another company uses a 15-year
estimate for the same type of asset.
In summary, several limitations of the income statement reduce the usefulness of its information
for predicting the amounts, timing, and uncertainty of future cash flows.
1.2. Elements of the Income Statement
Net income results from revenue, expense, gain, and loss transactions. The income statement
summarizes these transactions.
Revenue: Inflows or other enhancements of assets of an entity or settlements of its liabilities
during a period from delivering or producing goods, rendering services, or other activities that
constitute the entity’s ongoing major or central operations.
Expenses: Outflows or other using-up of assets or incurrence of liabilities during a period from
delivering or producing goods, rendering services, or carrying out other activities that constitute
the entity’s ongoing major or central operations.
Gains: Increases in equity (net assets) from peripheral or incidental transactions of an entity
except those that result from revenues or investments by owners.
Losses: Decreases in equity (net assets) from peripheral or incidental transactions of an entity
except those that result from expenses or distributions to owners
Format of the income statement
 Single-Step Income Statements
In reporting revenues, gains, expenses, and losses, companies often use a format known as the
single-step income statement. The single-step statement consists of just two groupings:

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revenues and expenses. Expenses are deducted from revenues to arrive at net income or loss,
hence the expression “single-step.”
The primary advantage of the single-step format lies in its simple presentation and the
absence of any implication that one type of revenue or expense item has priority over
another. This format thus eliminates potential classification problems.
 Multiple-Step Income Statements
Some contend that including other important revenue and expense classifications makes the
income statement more useful. These further classifications include:
1. A separation of operating and non operating activities of the company. For example,
companies’ often present income from operations followed by sections entitled “Other
revenues and gains” and “Other expenses and losses.” These other categories include such
transactions as interest revenue and expense, gains or losses from sales of long-term
assets, and dividends received.
2. A classification of expenses by functions, such as merchandising (cost of goods sold),
selling, and administration. This permits immediate comparison with costs of previous
years and with other departments in the same year.
When a company uses a multiple-step income statement, it may prepare some or all of the
following sections or subsections.
1) Operating section-A report of the revenues and expenses of the company’s principal
operations.
a) Sales or Revenue Section. A subsection presenting sales, discounts, allowances, returns,
and other related information. Its purpose is to arrive at the net amount of sales revenue.
b) Cost of Goods Sold Section. A subsection that shows the cost of goods that were sold to
produce the sales.
c) Selling Expenses. A subsection that lists expenses resulting from the company’s efforts
to make sales.
d) Administrative or General Expenses. A subsection reporting expenses of general
administration.
2) Non operating section- A report of revenues and expenses resulting from secondary or
auxiliary activities of the company. In addition, special gains and losses that are infrequent or
unusual, but not both, are normally reported in this section. Generally these items break
down into two main subsections:
a) Other Revenues and Gains. A list of the revenues earned or gains incurred, generally
net of related expenses, from non operating transactions.
b) Other Expenses and Losses. A list of the expenses or losses incurred, generally net of
any related incomes, from non operating transactions.
3) Income tax- A short section reporting federal and state taxes levied on income from
continuing operations.
4) Discontinued operations- Material gains or losses resulting from the disposition of a
segment of the business.
5) Extraordinary items- Unusual and infrequent material gains and losses.
6) Earnings per share
Illustration: The adjusted trial balance of New Company contained the following information:
Administrative expense;
Officers’ salaries Br4, 900
Depreciation of office furniture and equipment 3,960
Cost of goods sold 63,570
Rental revenue 17,230
Selling expense;
Transportation-out 2,690
Sales commissions 7,980
Depreciation of sales equipment 6,480

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Sales 96,500
Income tax 7,580
Interest expense 1,860
Instructions
a) Prepare an income statement for the year 2010 using the multiple-step form. Common shares
outstanding for 2010 total 40,550 (000 omitted)
b) Prepare an income statement for the year 2010 using the single-step form.
NEW COMPANY
Income Statement
For the Year Ended December 31, 2012
Sales revenues:
Sales............................................................... Br96, 500
Cost of goods sold.......................................... 63,570
Gross profit .................................................... 32,930
Operating expenses:
Selling expenses
Transportation-out.................... Br2, 690
Sales commissions........................ 7,980
Depreciation of sales equipment.. 6,480 17,150
Administrative expenses
Office salaries................................ 4,900
Depr.of office furn. and equip............... 3,960 8,860 26,010
Income from operations.................. 6,920

Other revenues and gains:

Rental revenue............................................. 17,230
24,150
Other expenses and losses:
Interest expense............................................ 1,860
Income before tax......................................... 22,290
Income tax………………………………… 7,580
Net income………………………………… 14,710
Earnings per share (14710/40,550shares) Br0.36
1.3. Retained Earnings Statement
Net income increases retained earnings. A net loss decreases retained earnings. Both cash and
stock dividends decrease retained earnings. Changes in accounting principles (generally) and
prior period adjustments may increase or decrease retained earnings. Companies charge or credit
these adjustments (net of tax) to the opening balance of retained earnings. This excludes the
adjustments from the determination of net income for the current period.

Prepare statement of retained earnings for ABC Corporation from the following information.
Retained earnings January 1, 2012 290,000
Dividend declared 29,000
Income before tax 162,000
Income tax 48,600

ABC Corporation
Retained earnings
For the year ended December 31, 2012

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Retained earnings January 1, 2012 290,000

Add: Net income 113,400
Deduct: 29,000
Net increase in retained earnings 84,400
Retained earnings December 31, 2012 Br374,400
1.4. The Concept of Revenue and Expense and the Recognition Process
To understand the conceptual issues related to income measurement, it is necessary first to recall
the definitions of Revenues and Expenses.
 Revenues are inflows or other enhancement of assets of an entity or settlement of its
liabilities (or a combination of both) during a period from delivering or producing goods,
rendering service or performing other activities that constitute the entity’s ongoing major
or central operations.
 Expenses are out flows or other using up of assets or incurrence of liabilities (or a
combination of both) during a period from goods received or service rendered or carrying
out other activities that constitutes the entity’s ongoing major or central operation.
The above definitions of revenues and expenses contain asset and liabilities. This is because the
concept of revenues and expenses are derived from Assets and Liabilities. Therefore, it would be
necessary to have a clear understanding of Assets and Liabilities.
 Assets are probable future economic benefits obtained or controlled by a firm as a result
of past transactions or events.
 Liabilities are probable future sacrifice of economic benefits arising from present
obligations of an entity to transfer assets or provide service to other entities in the future
as a result of past transactions or events.
The earning process may involve longer time and costly efforts for some companies. However;
the company is required to provide periodic reports on earnings even when the earning process
extends over several accounting period. Such situations force one to raise the question how mach
revenue and expenses should be recognized and reported during each accounting periods must be
resolved.
resolved
AFAC No. 5, defines Recognition as the recording of an item in the accounts and financial
statement as an Asset, Liability, Revenue, Expense, Gain or Loss. There are four fundamental
criteria must be met before an item can be recognized. These are;
1. Definition: the item or event must meet the definition of one of the financial statement
elements. (Asset, Liability, Revenue, Expense, Gain or Loss )
2. Measurability:
Measurability: The item or event must be quantified in reliable measure fro example,
historical cost, current cost, market value, net realizable value and net present value.
3. Relevance: the information about the item or event is capable of making a difference in uses
decisions. Relevant information about the item or event has the quality of timeliness, and
predictive and feedback vales.
4. Reliability: The information about the item or event representational faithful, verifiable and
neutral.
The above four recognition criteria apply to all items to be recognized in the financial
statements. However, AFAC No. 5 sets more stringent requirements for recognizing components
of earnings than for recognizing other changes in assets or liabilities.
liabilities
1.5. Revenue Recognition

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The objective of any business enterprise is to generate income that will provide owners with a
return on their investment. The major source of income for most enterprises is from its operation
- the process of generating revenue by providing goods and services to outsiders. Operations
involve the incurring of costs and expenses, and unless a satisfactory level of revenue is
generated a loss or a low level of income will result, no matter how carefully costs and expenses
are controlled.
Revenues are said earned when the company has substantially accomplished all that it must do to
be entitled to receive the associated benefits of the revenue. In general, revenue is recognizable
when the earning process is completed or virtually completed.
Revenue is realized when cash is received for the goods or services sold. Revenue is considered
realizable when claims to cash (for example, non cash assets such as accounts or notes
receivable) are received that are determined to be readily convertible into known amount of cash.
In addition, revenue to be recognized collection of the claims from customers and clients who
have purchased goods and services should be reasonably assured.
Stages in Revenue Recognition
The delivery of goods or services to a customer is a significant event that occurs in virtually all
revenue – generating transitions. Revenue from sale of goods and services can be recognized;
1. On delivery of the product or service (the point of sale)
2. Before delivery of the product or service.
3. After delivery of the product or service.
1.5.1. Revenue Recognition Methods
The above timing at which revenues are recognized can be the methods of revenue recognition.
The following are the revenue recognition methods;

a) Revenue at delivery/Point of sale method

The conditions for revenue recognition are usually met at the time goods or services are
delivered. Thus, revenue from the sale of goods is usually recognized at the date of sale, which
is the date the goods are delivered to the customer. Revenue from services rendered is likewise
recognized when the services have been performed. This is the point – of – sale method,
sometimes called the sales method or the delivery methods of revenue recognition.
Some costs associated with servicing a product or service sold with a guarantee or warranty may
be incurred after delivery. When this cost can be reasonably estimated, revenue is still
recognized at the date of sale, with a provision made for future warranty cost. In this case,
revenue is considered earned and realizable.
Shipment of goods on consignment does not constitute sales. In a consignment, goods are
transferred to another party (the consignee), who acts as an agent for the owner of the goods (the
consignor). Title to the goods remains with the owner until the agent sells the goods to ultimate
customers, at which time a sales transaction takes place and revenue is recognized by the
consignor.
b) Revenue Recognition Before Delivery
In some instances the earning process extends over several accounting periods. Delivery of the
final products may occur years after the initiation of the product. Examples are construction of
large ships, bridges, office buildings, and development of space exploration equipment.
Contracts for these projects often provide for progress billings at various points in the
construction process. GAAP provides two methods of accounting for revenue on long – term
constructs:
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A. Percentage – of – completion method: Under this method revenue, expenses and gross profit are
recognized each accounting period based on the estimate of the percentage of completion of the
construction project.
The percentage-of-completion method recognizes revenue on a long – term project as the
contract is being completed, thus timely information is provided. However, it contains estimates
and is not as reliable as information in the completed – contract method.
Measuring progress toward completion of a long – term construction project is accomplished
with input measures or out put measures.
measures
I. In- put measures:
B. The effort devoted to a project to date is compared with the total effort expected to be required in
order to complete the project. Examples are cost incurred to date compared with total estimated
costs for the project and labor hours worked compared with total estimated labor required to
complete the project. Among input measures, the cost – to – cost method is the most common.
The cost – to - cost method measures the percentage completed by the ratio of the costs incurred
to date to the current estimate of the total cost required to complete the project:
Total costs incurred to date
Percentage completed =
Most recent estimate of total costs of the project
The Most Recent Estimate of Total Project Costs is the sum of the total costs incurred to date
plus the estimated costs yet to be incurred to complete the project. Once the percentage completed
has been computed, the amount of revenue to be recognized in the current period is determined as:
Revenue Current = [Percentage Completed x Total Revenue] – Prior year Revenue
II. Output measures:
Results to date are compared with total results when the project is completed. Examples are
number of stories to be built and miles of highway completed compared with total miles to be
completed.
completed
C. Completed – contract method: under these method revenues, expenses, and gross profit are
recognized only when the contract is completed. As construction costs are incurred they are
accumulated in an inventory account (construction in progress). Progress billings are not
recorded as revenues but are accumulated in a contra inventory account (billings on construction
progress. At the completion of the contract, all the accounts are closed and the entire gross profit
from the construction project is recognized.
Illustration: Addis Construction Company engaged into contract with a municipality to
construct a 20 kilometer highway. Total contract price is Br. 800,000.00.
Additional data: Year 1 year 2 year 3
Construction costs during the year Br.125, 000.00 Br. 495,000.00 Br. 145,000.00
Estimated cost to complete the project Br.625, 000.00 Br. 155,000.00 0
Operating costs incurred Br. 5,000.00 Br. 2,000.00 2,500.00
Using the above data compute the realized profit on contract revenue for each year under the
following methods of accounting for construction – type contracts:
a) Percentage - of –completion method (cost – to cost)
Total costs incurred to date
Percentage completed =
Most recent estimate of total costs of the project
Percentage completed year 1 = Br 125,000.00/750,000.00
= 17%
Revenue Year1 = 17% x 800,000.00= 136,000.00
Gross profit Y 1= 136,000.00 – 125,000.00= Br 11,000.00
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Y1 Net income = 11,000.00 – 5,000.00= Br 6,000.00

Percentage completed year 2 = (Br 125,000.00+ 495,000.00)/770,000.00
= 80%
Revenue Year 2 = (80% x 800,000.00) - 136,000.00 = 504,000.00
Gross profit Y 2= 504,000.00- 495,000.00 = Br 9,000.00
Net income Y 2 = 9,000.00 – 2,000.00= Br 7,000.00
Revenue year 3 = 800,000.00 – (504,000.00+ 136,000.00)
= 160,000.00
Gross profit Y 3= 160,000.00- 145,000.00 = Br 15,000.00
Net income Y3 = 15,000.00 – 2,500.00= Br 12,500.00
Comparative income statement for three years for Addis Constriction- Percentage - of –
completion method (cost – to cost);
Y1 Y2 Y3
Contract Revenue Br. 136,000.00 Br. 504,000.00 Br. 160,000.00
Costs Incurred 125,000.00 495,000.00 145,000.00
Realized Gross Profit Br. 11,000.00 Br. 9,000.00 Br. 15,000.00
Operating Expenses 5,000.00 2,000.00 2,500.00
Net Income Br. 6,000.00 Br 7,000.00 Br 12,500.00
b) Completed – Contract method.
Y1 Y2 Y3
CONTRACT REVENUE BR 0 BR 0 BR 800,000.00
Construction costs incurred.................0 0 765,000.00
Gross profit Br. 0 Br. 0 Br 35,000.00
Operating expenses Br. 11,000.00 Br. 3,000.00 Br.2,500.00
Net income (loss) Br. (11,000.00) Br. (3,000.00) Br 32,500.00

The recognition of revenue prior to delivery generally is viewed as a departure from the revenue
realization principle. Recognition of revenue on construction – type contracts under the
percentage – 0f completion or on completion of “special order” goods has considerable
theoretical and practical support.
In general, when a sale of goods is not considered to result in revenue realization, the revenue
might be recognized at the following stages of the productive (earning) process prior to delivery
of goods to customers:
Prior to production
During production
on competition of production
At some other stage based, for example, on production, accumulation, discovery, receipt of
orders from customers, or billing of customers.
D. Revenue Recognition After Delivery
Under some circumstances the revenue recognition criteria are not met until some time after
delivery of the goods or service to the customer. Such is the case when:
 The substance of the transaction if different from the form, such as in product – financing
arrangements.
 There is a right to return the product
 The ultimate collectability of the sales price is highly uncertain, such as with some long –
term installment sales

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Revenue recognition when there is right to return exists;

 Some industries such as book publisher and machinery manufacturers, the sales terms
allow customers the right to return the goods under certain circumstances and over longer
period of time. Thus, when the goods are delivered it not known what amount of the
revenue will ultimately becomes realizable.
 According to SFAS no.48, if an enterprise sells its product but givers the buyer the right
to return, the revenue from such sales can be recognized at the time of sales only if the
following criteria are met;
 The seller’s price to the buyer is substantially fixed or determinable at the time of sale
 The buyer has paid or obliged to pay the seller
 The buyer’s obligation to the seller does not be changed in an event of theft or damages.
 The buyer acquired the product for resale
 The seller does not have any significant obligation to the future performance
 The amount of future returns can be reasonably estimated.
I. Installment Method of Revenue Recognition:
The installment method is widely used for income tax purposes because it postpones the payment
of income taxes until installment receivables are collected. However, the installment method is not
acceptable for financial accounting unless considerable doubt exists as to the collectibles of the
receivables and a reasonable estimate of doubtful accounts expense can’t be is made.
Under the installment method, the seller recognizes gross profit on sales in proportion to the cash
collected. If the rate of gross profit on installment sales is 40%, each birr of cash collected on the
installment receivables represents 40 cents of gross profit and 60 cents of cost recovery.
Repossessions are common under the installment sales method because this method is used only
when there is substantial uncertainty of collection.
To illustrate: Assume that Beko Company has the following data for the year 2003 regarding
contract sales and cost of goods sold to be accounted using the installment sales method.
Year 2003
Installment sales Br 80,000.00 100%
Cost of goods sold 60,000.00 75%
Gross Margin 20,000.00 25%
Cash collections
Year 2003 Br 10,000.00
Year 2004 52,000.00
Year 2005 18,000.00
Total Br 80,000.00
The journal entries to record the above installment sales and customer collections are given
below;
 To record installment sales Br 80,000.00 and the related cost of goods sold Br 60,000.00
under perpetual inventory system;

Date Debit Credit

2003 Installment Accounts Receivable 80,000.00
Installment sales revenue 80,000.00

Cost of installment sales 60,000.00

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Inventory 60,000.00
 Collection of Br 10,000.00 during 2003
Date Debit Credit
2003 Cash 10,000.00
Installment Accounts 10,000.00
Receivable
 On December 31, 2003, to defer gross margin on installment sales Br 20,000.00 is recorded
Date Debit Credit
2003 Installment sales revenue 80,000.00
Cost of installment sales 60,000.00
Deferred Gross margin on installment sales 20,000.00
 On December 31, 2003, on cash collection recognizes gross margin which is 25% Br
10,000.00.
Date Debit Credit
2003 Deferred Gross margin on 2,500.00
installment sales
Realized Gross margin 2,500.00
on installment sales
The realized gross margin on installment sales account is an income statement account and
closed using income summary account. But the Installment account Receivables and the deferred
gross margin - a contra installment sales receivable account; are reported on the balance sheet as
given below;
below
ii. Cost Recovery Method.
The cost recovery method is sometimes called the sunk cost method. Under this method a
company recovers all the related costs incurred (the sunk costs) before it recognizes any profit.
The cost recovery method is used only for highly speculative transactions when the ultimate
realization of revenue or profit is unpredictable. The cost recovery method is also justified when
there is uncertainty regarding the ultimate collectability of an installment sale.
Under the cost recovery method, no profit is recognized until the cost of the products sold is
fully recovered. In the period of sale, the cost of the products is deducted from sales (net of the
deferred gross profit) in the income statement. The deferred gross profit also is deducted from
the related receivable in the balance sheet. Collections of principal reduce the receivable, and
any collections of interest are credited to the deferred gross profit ledger account. Deferred gross
profit subsequently recognized as earned is presented as a separate item of revenue in the income
statement.
iii. Cash Collection Method.
The recognition of revenue may be delayed beyond the point of sale until additional evidence
confirms the sales transaction. For example, a significant degree of uncertainty may exist as to
the collectibles of receivables resulting from revenue transactions, or a sales transaction may be
lacking in economic substance and therefore may after inadequate evidence of revenue
realization. Under these circumstances revenue is recognized as cash is collected, and costs
incurred are either recognized as expense or deferred, as considered appropriate in a specific
situation.
1.5.2. Revenue recognition for sale of service

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For companies that provide services rather than products, revenue recognition follows
procedures similar to those for tangible goods transactions. The following four revenue
recognition methods for sale of services;
1. Specific performance 3. Completed performance
2. Proportional performance 4. Cash Collection method
1. SPECIFIC PERFORMANCE.
The specific performance method is used to account for service revenue that is earned by
performing a single act. For example, a real estate broker earns sales commission revenue on
completion on a real estate transaction, a dentist earns revenue on completion of a tooth filling; a
laundry earns revenue on competition of the cleaning.
cleaning
Franchise revenue: SFAS No 45, “Accounting for Franchise Fee Revenue” deals with a
particular type of service sale, franchises. It prescribes The Specific Performance method to
account for franchise fee, which a franchiser earns by selling a franchise. For revenue
recognition purposes, it is often difficult to determine the point at which the franchisor has
“substantially performed” the service required to earn the Franchise Fee.
To illustrate:
illustrate: Assume that on April 1, 2004, Alpha Corporation (franchisor) sold a franchise to
Asefa Plc (franchisee) for Br. 20,000.00 cash as a down payment and received a note that
required five annual payments of Br. 8,739.00 beginning on March 31, 2005. The interest rate is
14% and the note therefore has a present value of Br. 30,000.00.
Let see the following two assumptions;
assumptions
No additional services are to be performed and collectability is reasonably assured
Additional services to perform for the franchisee
Case A. If no additional services are to be performed and collectability is reasonably assured by
the franchisor and, Alpha Corporation (franchisor) recognizes the entire amount (Br. 20,000.00
the down payment and Br. 30,000.00 note receivable) as revenue on April 1, 2004 as follows:
Date Debit Credit
Apr 1,2004 Cash 20,000.00
Note Receivable 30,000.00
Franchise Fee revenue 50,000.00
Case B.. If Alpha Corporation (franchisor) has additional services to perform for Asefa Plc
(franchisee) such as outfitting the new pizza restaurant, no franchise fee revenue would be
recognized on April 1, 2004;would be rather be;
Date Debit Credit
Apr Cash 20,000.00
1,2004
Note Recievable 30,000.00

Deferred Franchise Fee 50,000.00

Revenue
In addition to the above journal entry on April 1, 2004, the franchisor records an adjusting
entry to accrue interest on the Note Receivable as given below;
Date Debit Credit
Dec Note Receivable 3,150.00
1,2004
Interest 3,150.00
Revenue[30,000.00x.14x9/12]

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Assume that Alpha Corporation completes its obligations to the franchisee in January 5, 2004,
after having spent Br.2, 000.00 in the process. The entry to record this expenditure and
recognize revenue would be:
Date Debit Credit
Dec ,2004 Deferred Franchise Fee Revenue 50,000.00
Franchise service Expense 2,000.00
Franchise Fee revenue 50,000.00
Prepaid Expense; Franchise service 2,000.00
Expenditures in 2004 by the franchisor related to the franchise would be deferred as prepaid
expenses until the associated franchise fee is recognizes until the associated franchise fee is
recognized, in conformity with the matching principle.
principle
2. PROPORTIONAL PERFORMANCE METHOD
The proportional performance method is used to recognize service revenue that is earned by
more than a single act and only when the service extends beyond one accounting period.
Under this method, revenue is recognized based on the proportional performance of each act.
The proportional performance method of accounting for service revenue is similar to the
Percentage-of-Completion Method. Proportional measurement takes different forms
depending on the type of service transaction.
a. Similar performance acts: In such cases equal amount of service revenue is
recognized for each such act (for example, processing of monthly mortgage payments
by a mortgage banker).
b. Dissimilar performance acts: acts: Service Revenue is recognized in proportion to the
server’s direct costs to perform each act (for example, providing lessons,
examinations, and grading by a correspondence school)
c. Similar acts with a fixed period of performance:
performance: service revenue is recognized by
the straight line method over the fixed period unless another method is more
appropriate (for example, providing maintenance services on equipment for a fixed
periodic fee)
3. COMPLETED – PERFORMANCE METHOD.
The completed performance method is used to recognize service revenue earned by
performing a services of acts of which the last is so important in relation to the total service
transaction that service revenue is considered earned only after the final act occurs; in similar
manner as to the completed – contract method used for long –term contracts.
4. CASH COLLECTION METHOD
The cash collection method is used to account for service revenue when the uncertainty of
collection is so high or the estimates of expenses related to the revenues are so unreliable that
the requirement of reliability is not satisfied. Revenue is recognized only when cash is
collected. This method is similar to the cost recovery method used for sales of goods.
1.5.3. Expenses Recognition
After the revenue of the accounting period is measured and recognized in conformity with
the revenue principle, the matching principle is applied to measure and recognize the
expenses of that period. The costs of those assets and services used up should be recognized
and reported as expenses of the period during which the related revenue is recognized.
recognized
Expenses can be classified into three categories:
1. Direct expenses are expenses such as cost of goods sold that are associated directly with
revenues. These expenses are recognized based on recognition of revenues that result
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directly and jointly from the same transactions or other events as the expenses. This is an
example of applying the matching principle.
2. Period expenses are expenses such as selling and administrative salaries, which are not
associated directly with revenues. These expenses are recognized during the period in which
cash is spent or liabilities are incurred for goods and services that are used up either
simultaneously at acquisition or soon after.
3. Allocated expenses are expenses such as depreciation and insurance. These expenses are
allocated by systematic and rational procedures to the periods during which the related assets
are expected to provide benefits.
Recognition principles provide the following points into consideration as guide for expense
recognition;
a. Cause and effect: Costs may be recognized as expenses based on a presumed direct
association with specific revenue. Costs that appear to be related to specific revenue are
recognized as expenses concurrently with the recognition of the related revenue. Examples
of costs related to specific revenue include the direct cost of goods sold or service provided,
sales commission, and direct costs incurred in relation to construction – type contracts.
contracts
b. Systematic and Rational Allocation : If a direct means is not available to associate cause
and effect, costs may be recognized as expenses based on an orderly allocation to the
accounting periods in which the costs appear to expire and presumably provide benefits
received, because neither can be objectively measured.
c. Immediate recognition: Expenses are recognized in the current accounting period when
Costs incurred in the accounting period are expected to provide any future benefit costs
deferred as assets in earlier periods no longer provide benefits, and allocation of costs to
revenue or to accounting periods is impractical or is considered to serve no useful purpose.
3.4 Recognition of gains and Losses
Gains and losses are distinguished from revenues and expenses in that they result from
peripheral or incidental transactions, events, or circumstances.
Most gains and losses are recognized when the transaction is completed. Thus, gains and
losses from disposal of operational assets, sale of investments, and early extinguishment of
debt are recognized in the entry made to record the transaction.
For example,
example, an entry to record the disposal of a tract of land for cash would reflect a debit
to cash, a credit to land for cash would reflect a debit to cash, a credit to land (for its
recorded cost), and debit to loss (or a credit to gain) on disposal.
Estimated losses are recognized before their ultimate realization if they are both probable and
can be reasonably estimated. Examples are losses on disposal of a segment of a business,
pending litigation, and expropriation of assets. If both conditions are met, the nature and
estimated amount of the contingent loss must be disclosed in as note to the financial
statements.
In contrast, gains are almost never recognized before the completion of a transaction that
establishes the existence and amount of the gain.
gain
UNIT FOUR
FINANCIAL STATEMENTS AND ADDITIONAL DISCLOSURE
4.1. FINANCIAL STATEMENTS AND OVERVIEW

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Financial statements are the final out put of an Accounting system. As far as financial accounting
is concerned, financial reports basically prepared for external users of accounting information.
The common financial statements for business enterprises are; Income Statement, Balance sheet,
Statement of Owner’s equity and Statement of Cash Flows. There are also supplementary
information added to these financial statements-Additional disclosure; that provides clarification
and information that makes a difference for decision makers. Additional disclosure or notes to
the financial statements provide voluble information about the items reported in the financial
statements. But in this section we are highly emphasize on balance among financial statements.
4.2. BALANCE SHEET
The balance sheet provides economic information about an entity’s resources (assets), claims
against those resources (liabilities) and the remaining claim accruing to the owners (owners’
equity).
If a balance sheet is examined carefully, users can gain a considerable amount of information
related to enterprise liquidity and financial flexibility. Balance sheet is basically a historical
statement, because it shows the cumulative effect of past transactions and events.
Benefits of the Balance sheet
 A balance sheet in comparative form provides valuable information to creditors,
stockholders, management, prospective investor, and the public.
 Individuals with the ability to interpret comparative balance sheets may learn much as to
the short-run solvency of a business enterprise, favorable or unfavorable trends in
liquidity, commitments that must be met in the future, and the relative positions of
creditors and stockholders.
Limitations of Balance sheet
 The inability of accountants to measure the “current fair value” of an enterprise’s net
assets.
 The inability of accountants to foresee future economic events necessitates the
preparation of balance sheets on a different basis.
 Accountants are unable to identify and provide a valuation for many factors that have a
material effect on the financial position of an enterprise.
 The quality, morale, and character of management and other personnel, the market
position of an enterprise and the regulation of its products are subjective and intangible
and are not reported on the balance sheet.

4.3. ELEMENTS OF BALANCE SHEET

A balance sheet shows the financial condition of an accounting entity as of a particular date.
The balance sheet consists of assets, the resources of the firm; liabilities, the debts of the firm;
and stockholders’ equity, the owners’ interest in the firm. The assets are derived from two
sources, creditors and owners. At any point in time, the assets must equal the contribution of
the creditors and owners. The accounting equation expresses this relationship:
relationship

Assets = Liabilities + Stockholders’ Equity

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As a generalization subject to many exceptions, the following classification of balance sheet

items is suggested as representative:
representative
1. Assets
2. Liability and
3. Owner’s Equity
1. ASSETS:
ASSETS: are probable future economic benefits obtained or controlled by a particular entity
as a result of past transactions or events. Assets are subcategorized as follows;
follows
Current assets include cash and other assets that are reasonably expected to be realized in
cash or sold or consumed during the normal operating cycle of the business or within one
year from the balance sheet date. The normal operating cycle of a business is the average
length of time from the expenditure of cash to inventory, to sale, to accounts receivable, and
finally back to cash. Most companies use one year as the time period for classifying items as
current or long-term because either the operating cycle is less than one year or the operating
cycle may be difficult to measure reliably. Five general types of assets generally are included
in the current assets classification:
classification
1. Cash – Money in any form-cash and checks a waiting deposit, balances in checking
accounts, and expendable cash funds.
2. Secondary cash resources – Various short-term investments that are readily
marketable. Any such resources whose availability for current use is restricted by
contract are excluded
3. Short-term receivables – Trade accounts receivable (including installment
receivables collected during the enterprises operating cycle) and notes receivable with
short-term maturities.
4. Inventories – Material, supplies, goods in process, finished goods. This category
includes items held for sale in the ordinary course of operation, items in process of
production of goods or services. Goods held on consignment from others are not
included because title is not held to such goods.
5. Prepaid – The cost of various services, such as insurance, taxes, and rent, which have
been paid for in advance of use. Short-term prepayments sometimes are referred to as
prepaid expenses.
Non Current Assets
A. Tangible Non Current Assets: These are tangible (have physical substance) and are
held for productive use in business operations. Land, natural resources subject to
depletion, buildings, equipment, machines, tools, leased assets under capital leases,
leasehold improvements, and plant assets under construction are included. Long-term
prepayments for the use of physical assets, such as leaseholds, easements, or rights of

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way, also may be included in this category, though some accountants group these in
the next category.
B. Intangible Assets: Long-term property rights of an intangible nature may be of
greater importance to a business enterprise than its tangible assets. Examples of such
assert include patents, goodwill, trademarks, copyrights, organization costs, and
franchise.
C. Other non-current assets /Deferred charges/: Included in this category are items
such as plant assets no longer used in operations and held for disposal costs incurred
in the issuance of long-term debts, deferred start-up and moving costs, and any other
non current assets that is not included in one of the first three categories.
2. LIABILITIES-are
are probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other entities in the
future as a result of past transactions or events. Liabilities also sub categorizes as;
Current liabilities: Are obligations whose liquidation is expected to require the use of
current assets or the creation of other current liabilities. Three main classes of current
liabilities fall within this definition.
definition
Obligations for the acquisition of goods and services that have entered the operating
cycle. This includes trade payables (including notes and accounts payable to
suppliers) and accrued liabilities such as wages, commissions, income taxes, property
taxes etc.
Other debts that may be expected to required payment within the operating cycle or
one year. This includes short-term notes payable to banks and the currently maturing
portions of long-term debt.
Collections received in advance of the delivery of goods or the performance of
services. These advances often are described as “deferred revenue” but it is the
obligation to furnish the goods or services or to refund the payment that requires them
to be classified in the current liabilities section of the balance sheet.
Some liabilities that will be paid shortly after the balance sheet date are excluded
from current liabilities, because of the requirements that a current liability must
involve the use of current assets or the issuance of new short-term debt for its
extinction. The following can be Examples;
obligations due at an early date that will be retired by the issuance of new-long-term
debts, for example, bonds that will be refunded or a loan secured by the cash surrender
value of life insurance policies (the amount of cash that would be received if the policies
were canceled) that will be renewed, and

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Obligations that will be paid from a fund included among non current assets, for
example, a life insurance policy loan that will be liquidated by offset against the cash
surrender value of the policy, or by deduction from the proceeds of the life insurance
policy at maturity.
Non-current liabilities: A non-current liability is an obligation that will not require the use
of current assets or the issuance of short-term debt within the next year or operating cycle,
whichever is longer. They may be classified into the following;
a) Long-term debt based on security issues or related contractual arrangements. Included
in this category are notes and bonds, reported net of unamortized discount and including
any unamortized premium. The distinguishing characteristic is that there is a borrowing
transaction supported by a contractual obligation to pay principal and interest.
b) Other non-current liabilities: This includes all long-term liabilities that do not belong in
the first category. An amount received in advance on a long-term commitment to furnish
goods or services deferred revenue, differed income tax credits, liabilities under capital
leases and non current amount payable under pension plans are examples.
Contingent liabilities:: Liabilities that may or may not come into existence as a result of
transactions or events that have not yet been finalized usually are not reported in birr amount
in the balance sheet. Some examples, of contingent liabilities are possible additional income
tax assessments and pending lawsuits that may result in the payment of damages.
3. OWNERS EQUITIES:: Equity is the residual interest in the assets of an entity that remains
after deducting its liabilities. It represents the net claim of the owners from business Assets.
The owners’ equity in a business enterprise is the residual interest in assets, after liabilities
have been deducted. The amount of owners’ equity thus is directly dependent on the values
assigned to assets and liabilities. Owners’ equity for a corporation is called stockholders’
equity; that for a partnership, partners’ equity, and that for a sole proprietorship, proprietors’
equity. Owners’ equity includes contributed (or paid-in) capital and retained earnings.
Because of legal requirements, owners’ equity is sub classified to reflect detailed sources.
For corporations, the most commonly reported sources are:

1) Capital Stock: It is the firm’s stated or legal capital. It is the par value of the issued or
outstanding preferred and common stock of the corporation and represents the amount
that is not available for dividend declarations. Legal capital is specified by state law and
the articles of incorporation (the charter) of the corporation.
2) Contributed capital in excess of par (or stated value): It reports the value of assets
received by the corporation above the par (or stated value) of the capital stock given in
exchange. These amounts usually arise when the corporation sells its stock above par (or

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the stated amount per share) or issues stock dividends. Sometimes called additional paid-
in capital or premium on stock, it is considered legal capital in most instances.
3) Other contributed capital: It arises from such transactions as the sale of treasury stock
above its acquisition cost and capital arising from recapitalizations. For balance sheet
presentation, there is generally only one additional contributed capital account, which
includes contributed capital in excess of par. The specific underlying sub accounts are
maintained in a subsidiary ledger.
4) Retained Earnings: It is essentially a corporations accumulated net earnings, less
dividends paid out, since the company’s inception. In many corporations, retained
earnings are the largest amount in the owners’ equity section. A negative balance in
retained earnings is called a deficit and usually arises when a company experiences
operating losses.
5) Treasury Stock: Shares that have been issued and then required by the company, but
not retired, are called treasury stock. Treasury stock is not an asset of the issuing firm.
Companies repurchase their own stock for several reasons:
 To meet employee stock purchase or option plan needs
 To increase reported earnings per share
 To stabilize the stock’s price
 To reduce the outstanding shares, perhaps to discourage a hostile takeover attempt
 To contract the firms operations
 To indicate that management believes the stock is under valued
4.4. STATEMENT OF CASH FLOWS
The primary purpose of the statement of cash flows is to provide information about a
company’s cash receipts and cash payments during a period. A secondary objective is to provide
cash-basis information about the company’s operating, investing, and financing activities. The
statement of cash flows therefore reports cash receipts, cash payments, and net change in cash
resulting from a company’s operating, investing, and financing activities during a period. Its
format reconciles the beginning and ending cash balances for the period.
5.

Usefulness of the statement of cash flows

The statement of cash flows provides information to help investors, creditors, and others assess
the following:
1. The entity’s ability to generate future cash flows. A primary objective of financial reporting
is to provide information with which to predict the amounts, timing, and uncertainty of future
cash flows. By examining relationships between items such as sales and net cash flow from
operating activities, or net cash flow from operating activities and increases or decreases in cash,
it is possible to better predict the future cash flows than is possible using accrual-basis data
alone.
2. The entity’s ability to pay dividends and meet obligations. Simply put, cash is essential.
Without adequate cash, a company cannot pay employees, settle debts, pay out dividends, or
acquire equipment. A statement of cash flows indicates where the company’s cash comes from
and how the company uses its cash. Employees, creditors, stockholders, and customers should be
particularly interested in this statement, because it alone shows the flows of cash in a business.
3. The reasons for the difference between net income and net cash flow from operating
activities. The net income number is important: It provides information on the performance of a

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company from one period to another. But some people are critical of accrual-basis net income
because companies must make estimates to arrive at it. Such is not the case with cash. Thus, as
the opening story showed, financial statement readers can benefit from knowing why a
company’s net income and net cash flow from operating activities differ, and can assess for
themselves the reliability of the income number.
4. The cash and noncash investing and financing transactions during the period. Besides
operating activities, companies undertake investing and financing transactions. Investing
activities include the purchase and sale of assets other than a company’s products or services.
Financing activities include borrowings and repayments of borrowings, investments by owners,
and distributions to owners. By examining a company’s investing and financing activities, a
financial statement reader can better understand why assets and liabilities increased or decreased
during the period.
Classification of cash flows
The statement of cash flows classifies cash receipts and cash payments by operating, investing,
and financing activities.1 Transactions and other events characteristic of each kind of activity is
as follows.
1. Operating activities involve the cash effects of transactions that enter into the determination
of net income, such as cash receipts from sales of goods and services, and cash payments to
suppliers and employees for acquisitions of inventory and expenses.
2. Investing activities generally involve long-term assets and include (a) making and collecting
loans, and (b) acquiring and disposing of investments and productive long-lived assets.
3. Financing activities involve liability and stockholders’ equity items and include (a) obtaining
cash from creditors and repaying the amounts borrowed, and (b) obtaining capital from owners
and providing them with a return on, and a return of, their investment.
Operating
Cash inflows
From sales of goods or services
From returns on loans (interest) and on equity securities (dividends) Income Statement
Cash outflows Items
To suppliers for inventory
To employees for services
To government for taxes
To lenders for interest
To others for expenses

Investing
Cash inflows
From sale of property, plant, and equipment
From sale of debt or equity securities of other entities generally
From collection of principal on loans to other entities Long-Term
Cash outflows Asset Items
To purchase property, plant, and equipment

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To purchase debt or equity securities of other entities

To make loans to other entities
Financing
Cash inflows generally
From sale of equity securities Long-Term
From issuance of debt (bonds and notes) Liability
Cash outflows and Equity
To stockholders as dividends Items
To redeem long-term debt or reacquire capital stock
Note the following general guidelines about the classification of cash flows.
1) Operating activities involve income statement items.
2) Investing activities involve cash flows resulting from changes in investments and long-term
asset items.
3) Financing activities involve cash flows resulting from changes in long-term liability and
stockholders’ equity items.
Format of the statement of cash flows
The three activities we discussed above constitute the general format of the statement of cash
flows. The operating activities section always appears first. It is followed by the investing
activities section and then the financing activities section.
Steps in preparation
Companies prepare the statement of cash flows differently from the three other basic financial
statements. For one thing, it is not prepared from an adjusted trial balance.
The cash flow statement requires detailed information concerning the changes in account
balances that occurred between two points in time. An adjusted trial balance will not provide the
necessary data. Second, the statement of cash flows deals with cash receipts and payments. As a
result, the company must adjust the effects of the use of accrual accounting to determine cash
flows. The information to prepare this statement usually comes from three sources:
1. Comparative balance sheets provide the amount of the changes in assets, liabilities, and
equities from the beginning to the end of the period.
2. Current income statement data help determine the amount of cash provided by or used by
operations during the period.
3. Selected transaction data from the general ledger provide additional detailed information
needed to determine how the company provided or used cash during the period.
Preparing the statement of cash flows from the data sources above involves three major steps:
Step 1.Determine the change in cash. This procedure is straightforward. A company can easily
compute the difference between the beginning and the ending cash balance from examining its
comparative balance sheets.
Step 2.Determine the net cash flow from operating activities. This procedure is complex. It
involves analyzing not only the current year’s income statement but also comparative balance
sheets as well as selected transaction data.

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Step 3.Determine net cash flows from investing and financing activities. A company must
analyze all other changes in the balance sheet accounts to determine their effects on cash.
Along with an income statements and balance sheet, a statement of cash flows is included in an
annual reports to stockholders of publicity owned companies and is covered by the auditors’
opinion. The objectives of this statement are:
are
1. To summarize the financing, operating, and investing activities of a business enterprise
during an accounting period, including the amount of cash equivalent obtained from
operations, and
2. To complete the disclosure for changes in financial position during an accounting period
that is not readily apparent in comparative balance sheets.
3. Enable firm’s to generate positive cash flows from operating activities.
4. Enable firm’s to meet its obligations and pay dividends.
5. To know the reasons for the difference between net income and net cash flows.
6. To know the effect of investing and financing on a firm’s financial position.
7. To know both the cash and noncash investing and financing transactions during the period
The statement of cash flows discloses transactions that affect cash directly, as well as significant
investing and financing transactions that do not affect cash.

The statement of cash flows presents cash flows classified into the following sections;

1. Operating cash flows:

flows: includes cash transaction that enters into the determination of net
income. Reported under this classification are both the cash inflows and the cash outflows that
are related to net income. The usual cash flows identified are:

Cash Inflows Cash Outflows

 Collection from customers  Purchase of goods for resale

 Interest on receivables  Interest expense on notes payables

 Dividend income from investment  Income taxes, custom duties and

fines
 Refund from suppliers
 Salaries and wages

Alternative Methods of Operating Cash Flow

There are two acceptable formats for preparing the Cash Flows from Operating Activities: the

Direct Method, and the Indirect Method. While each method uses a different format to arrive at

Net Cash provided (or used) by Operating Activities, the end result is the same. In other words,

they use a different path to arrive at the same answer.

answer

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4.4.1 DIRECT METHOD.

The Direct Method takes accrual-basis revenue and adjusts it for changes in accounts receivable

to arrive at cash received from customers.

If Accounts Receivable decreases during the year, the decrease is added to accrual basis revenue.

A decrease in Accounts Receivable means that customer cash payments on account exceed

customer charges on account during the period. This excess is used to adjust the accrual-based

revenues reported on the income statement to report the total cash received from customers

during the period.

period

Similarly, if Accounts Receivable increases during the year, this increase is subtracted from

revenue. An increase in Accounts Receivable means that customer charges on account exceeded

customer cash payments on account during the period. This excess is used to adjust the accrual

based revenues reported on the income statement to report the total cash received from

customers during the period.

period

Operating Activities Direct Method

+ Cash Received from Customers xx

- Cash paid for inventory xx
- Cash paid for operating expenses xx
- Cash paid for income taxes xx
- Cash paid for interest xx
+ Cash received from dividends and interest xx
= Net cash from operating activities xx

Cash Received from Customers Cash Paid For Inventory

Sales Cost of Goods Sold
- Increase in A/R (receive less cash) OR + End Inventory
+ Decreases in A/R (receive more cash) - Beginning Inventory
- Write-offs (beg allowance + bad debt exp. - = Purchases
ending allowance)
+Increase in unearned revenue (receive more + Beg A/P
cash) OR
- Decrease in unearned revenue (receive less - End A/P
cash)

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= Cash Received from Customers = Cash paid for inventory

Cash Paid for Operating Expenses Cash Paid for Income Taxes

Operating Expenses (do not include interest Income Tax Exp

exp., depreciation exp., nor gains & losses from
sale of investments)
- Beg prepaid + Beg tax payable
+ End prepaid - End tax payable
+ Beg accrued exp
- End accrued exp
= Cash paid for operating expenses = Cash paid for income Taxes

Cash Paid for Interest Cash Received from dividends and interest
Interest Exp Dividend and Interest Income
+ Beg interest payable + Beg interest receivable
- End interest payable - End interest receivable
= Cash paid for interest = Cash Received from dividends and
interest
Direct Method- Example
Emir Company, which began business on January 1, 2010, has the following selected balance
sheet information.
December 31, 2010 January 1, 2010
Cash Br159, 000 –0–
Accounts receivable 15,000 –0–
Inventory 160,000 –0–
Prepaid expenses 8,000 –0–
Property, plant, and equipment (net) 90,000 –0–
Accounts payable 60,000 –0–
Accrued expenses payable 20,000 –0–

Emir Company’s December 31, 2010, income statement and additional information are as
follows.
Revenues from sales Br780, 000
Cost of goods sold 450,000
Gross profit 330,000
Operating expenses Br160, 000
Depreciation 10,000 170,000
Income before income taxes 160,000
Income tax expense 48,000
Net income Br112,000
Additional Information:
(a) Dividends of Br70, 000 were declared and paid in cash.

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(b) The accounts payable increase resulted from the purchase of merchandise.
(c) Prepaid expenses and accrued expenses payable relate to operating expenses.

Under the direct method, companies compute net cash provided by operating activities by
adjusting each item in the income statement from the accrual basis to the cash basis.
Cash Receipts from Customers: The income statement for Emir Company reported revenues
from customers of Br780, 000. To determine cash receipts from customers, the company
considers the change in accounts receivable during the year.
For Emir Company, accounts receivable increased Br15, 000. Thus, cash receipts from
customers were Br765, 000, computed as follows.
Revenues from sales Br780, 000
Deduct: Increase in accounts receivable 15,000
Cash receipts from customers Br765,000
Cash Payments to Supplier: Emir Company reported cost of goods sold on its income statement
of Br450, 000. To determine cash payments to suppliers, the company first finds purchases for
the year, by adjusting cost of goods sold for the change in inventory. When inventory increases
during the year, purchases this year exceed cost of goods sold. As a result, the company adds the
increase in inventory to cost of goods sold, to arrive at purchases.
In 2010, Emir Company’s inventory increased Br160, 000. The company computes purchases as
follows.
Cost of goods sold Br450, 000
Add: Increase in inventory 160,000
Purchases Br610,000
Cash payments to suppliers were Br550, 000, computed as follows.
Purchases Br610, 000
Deduct: Increase in accounts payable 60,000
Cash payments to suppliers Br550,000
Emir Company’s cash payments for operating expenses were Br148, 000, computed as follows.
Operating expenses Br160, 000
Add: Increase in prepaid expenses 8,000
Deduct: Increase in accrued expenses payable (20,000)
Cash payments for operating expenses Br148,000

EMIG COMPANY
STATEMENT OF CASH FLOWS (PARTIAL)
Cash flows from operating activities
Cash received from customers Br765, 000
Cash payments:
To suppliers Br550, 000
For operating expenses 148,000
For income taxes 48,000 746,000

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Net cash provided by operating activities Br 19,000

If Emir Company uses the direct method to present the net cash flows from operating activities,
it must provide in a separate schedule the reconciliation of net income to net cash provided by
operating activities.
EMIG COMPANY
RECONCILIATION
Net income Br112, 000
Adjustments to reconcile net income to net cash
Provided by operating activities:
Depreciation expense Br 10,000
Increase in accounts receivable (15,000)
Increase in inventory (160,000)
Increase in prepaid expenses (8,000)
Increase in accounts payable 60,000
Increase in accrued expense payable 20,000 (93,000)
Net cash provided by operating activities Br 19,000

4.4.2 INDIRECT METHOD

The Indirect Method starts with accrual-based net income and makes certain adjustments to
arrive at Cash Flows from Operating Activities. Adjustments to accrual-based net income
include adding back any noncash items that were included to arrive at net income, such as
depreciation and amortization. This basically cancels out that they were originally subtracted to
arrive at net income. Since these items do not represent cash outlays, they should not be included
in the Statement of Cash Flows.
Flows

Gains and losses are other items on the income statement to consider. They result from the sale
of an asset. Gains are added and losses are subtracted on the income statement to arrive at net
income. Since gains and losses do not represent operating cash flows, gains are canceled out by
subtracting and losses are canceled out by adding to net income in the operating section.
section

Appropriate adjustments should also be made on the income statement to reflect the change from
accrual-based revenues reported to cash-based. This is done by analyzing the changes in noncash
current assets and current liabilities.
liabilities

Operating Activities Indirect Method

Net Income xx
+ Depreciation exp (noncash exp) xx
+ Losses from sale of assets (full amount of sale already included in investing section) xx

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- Gains from sale of assets (full amount of sale already included in investing section) xx
- Increases in current assets xx
+ Decreases in current assets xx
+ Increases in current liabilities xx
- Decreases in current liabilities xx
= Net cash from operating activities xx
2. Investing cash flows: Includes cash inflows and cash outflows related to the disposing of
or acquiring operating facilities (plant, property, equipment), the sale or purchase of
investments, and other non-operating (investment) assets. Outflows are investments of
cash by the entity to acquire non-cash assets. Inflows under this classification occur only
when cash is received from the sale or disposal of prior investments. The following are
typical cash flows under investing activities:
activities

Cash Inflows Cash Outflows

 Disposal / sale of property  Acquisition/ Purchase property

 Disposal / sale of investment  Long term investment on debt

securities and equity securities.

 Collection of a loan (excluding  Loans to other parties

interest which is an operating  Acquisition of intangible assets
activity)
3. Financing cash flows include both cash inflows and outflows related to the financing
activities (borrowing or issuing stock) used to obtain cash for the business. Outflows occur
when principle amounts are returned to the owners and creditors for their earlier investments.
The usual cash flows under these classifications are:
are

Cash Inflows Cash Outflows

 Owners from issuing equity  Owners for dividends & other cash
securities distributions
 Creditors from issuing debt  Owners for retiring stock
securities or treasury stock purchased
 Collection of a loan (excluding  Creditors for repayment of amounts
interest which is an operating borrowed (excluding interest, which
activity) is
included in operating activities).

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4.5: ADDITIONAL DISCLOSURE

The disclosure principle requires that financial statements include all significant information
needed by users of the statements. Some examples of information disclosed in notes to the
financial statements included in annual reports of publicity owned companies include the
following:
following
1. A summary of significant accounting policies
2. Description of stock option, pension, and employee stock ownership plans
3. Litigation in which the company is a party, loss and gain contingencies, and unusual
commitments.
4. Terms of proposed business combinations and a description of any unusual events or
transactions, such as related party transactions.
5. The amounts of depreciation expense and research and development costs.
6. An analysis of the composition of income taxes expense, including a reconciliation of the
company’s effective income tax rate with the statutory federal income tax rate.
7. Detailed description or summary of receivables, inventories, investments, plant assets,
intangible assets, borrowing arrangements, with banks, long-term debts, and stockholders
equity.
equity

UNIT FIVE
ACCOUNTING FOR CASH, SHORT TERM INVESTMENT AND RECEIVABLES
5.1 CASH AND CASH EQUIVALENTS
Cash, the most liquid of assets, is the standard medium of exchange and the basis for measuring
and accounting for all other items. Companies generally classify cash as a current asset. Cash
consists of coin, currency, and available funds on deposit at the bank. Negotiable instruments
such as money orders, certified checks, cashier’s checks, personal checks, and bank drafts are
also viewed as cash. What about savings accounts? Banks do have the legal right to demand
notice before withdrawal. But, because banks rarely demand prior notice, savings accounts
nevertheless are considered cash. Some negotiable instruments provide small investors with an
opportunity to earn interest. These items, more appropriately classified as temporary investments
than as cash, include money market funds, money market savings certificates, and certificates of
deposit (CDs), and similar types of deposits and “short-term paper.”
5.2 REPORTING CASH

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Although the reporting of cash is relatively straightforward, a number of issues merit special
attention. These issues relate to the reporting of:
1. Cash equivalents.
2. Restricted cash.
3. Bank overdrafts.
1. Cash Equivalents: A current classification that has become popular is “Cash and cash
equivalents.” Cash equivalents are short-term, highly liquid investments that are both;
a) Readily convertible. A variety of “short-term paper” is available for investment. For
example, certificates of deposit (CDs) represent formal evidence of indebtedness, issued by a
bank, subject to withdrawal under the specific terms of the instrument. Issued in various
denominations, they have maturities anywhere from 7 days to 10 years and generally pay
interest at the short-term interest rate in effect at the date of issuance.
b) In money-market funds, a variation of the mutual fund, the mix of Treasury bills and
commercial paper making up the fund’s portfolio determines the yield. Most money-market
funds require an initial minimum investment of a minimum a amount; many allow
withdrawal by check or wire transfer. Treasury bills are government obligations generally
issued with 4-, 13-, and 26-week maturities; they are sold at weekly government auctions.
c) So near their maturity that they present insignificant risk of changes in interest rates.
Generally, only investments with original maturities of three months or less qualify under
these definitions. Examples of cash equivalents are Treasury bills, commercial paper, and
money market funds.
d) Restricted Cash: Petty cash, payroll, and dividend funds are examples of cash set aside for a
particular purpose. In most situations, these fund balances are not material. Therefore,
companies do not segregate them from cash in the financial statements. When material in
amount, companies segregate restricted cash from “regular” cash for reporting purposes.
Companies classify restricted cash either in the current assets or in the long-term assets
section, depending on the date of availability or disbursement. Classification in the current
section is appropriate if using the cash for payment of existing or maturing obligations
(within a year or the operating cycle, whichever is longer). On the other hand, companies
show the restricted cash in the long-term section of the balance sheet if holding the cash for a
longer period of time. Cash classified in the long-term section is frequently set aside for plant
expansion, retirement of long-term debt.
2. Bank overdrafts occur when a company writes a check for more than the amount in its cash
account. Companies should report bank overdrafts in the current liabilities section, adding
them to the amount reported as accounts payable. If material, companies should disclose
these items separately, either on the face of the balance sheet or in the related notes.3Bank
overdrafts are generally not offset against the cash account. A major exceptions when
available cash is present in another account in the same bank on which the overdraft
occurred. Offsetting in this case is required.
5.3 AN OVERVIEW OF SHORT TERM INVESTMENT
Short-term investments are readily marketable securities (stocks and bonds) that are intended
to be sold within the time period of current assets. Logically, short-term investments are
classified as current assets.
Security investments have to meet the following two criteria to be classified as short-term
investments:
The investment is readily marketable

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Management intends to convert the investment into cash within one year or operating
cycle, whichever is longer
Security investments that do not meet both criteria should be classified as long-term. For
example, stocks of privately held corporations are likely to have very limited markets, and as the
result, such equity investments would not meet the first criterion and should be classified as
long-term.
Equity securities and debt securities are other terms used to describe some investments. So what
are equity and debt securities?
1) Equity Securities: An equity security generally represents some form of ownership in
another company, such as owning the common stock of a corporation:
Equity Security = Ownership = Common Stock
2) Debt Securities: A debt security represents a borrower-lender relationship:
Debt Security = Borrowing = Bonds Payable
If you purchase a debt security such as a corporate bond, you are directly or indirectly making a
loan to the company for which it has promised to pay a stated amount of interest, usually
semiannually, and to repay the amount loaned on a specific maturity date, often many years in
the future.
INVESTMENTS IN EQUITY AND DEBT SECURITIES (BALANCE SHEET CLASSIFICATION )
It is important to note that most of these investments could be classified as either current assets
or long-term investments. In part, the distinction between the two classifications is based on the
company’s judgment regarding the nature of these investments.
If the investments are included among the current assets, you generally would conclude that
these are investments of idle cash, with the expectation that the investments will generate
dividends or interest income and/or increase in value and be sold at a profit when the idle cash
later is needed to finance ongoing business activities.
However, if these investments are classified as long-term, the company may be taking a longer-
term view and hoping to maintain an ongoing business relationship with another company
(perhaps a supplier) or to support a joint venture with another company when neither company
can provide adequate financing or assume the full risk of a particular business venture, whether a
domestic or a foreign endeavor.
Investments in marketable securities may be presented in the balance sheet as trading, available
for sale, or held to maturity securities.
1. TRADING SECURITIES: The term trading securities typically is applied to companies which
invest in and actively manage a portfolio of equity and debt security investments, with
frequent purchase and sales transactions (trading), taking advantage of short-term changes in
market price to produce earnings, along with the earnings from dividends and interest.
Those investments are classified as current assets and appear immediately below cash and
cash equivalents because they can be sold readily to generate cash if needed. The dividends
and interest earned, along with the gains or losses from the sale of these investments, are
reported as other income or expense in the income statement.
2. AVAILABLE FOR SALE SECURITIES: Although some companies hold trading security
portfolio investments, a more common purpose for investments in marketable securities is to
generate dividend or interest income or to gain from market price appreciation rather than
carrying excessive cash balances during low points in the business cycle.

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If necessary, such investments can be sold, but they also can be held for months or even years
and are referred to logically as available for sale securities. The current versus the long-term
classification of these investments provides an indication of the company’s purpose and
intent.
3. HELD TO MATURITY SECURITIES : A bond investor (bondholder) is directly or indirectly
making a loan to the corporation in return for a stated amount of interest that typically is paid
semiannually and a stated amount that will be paid back on a specified future date.
When bond investments are classified as trading or available for sale securities, the stated
interest payments the investor receives will be reported as income in the income statement for
the year, the bond investment on the balance sheet will be based on its current market value,
and the change in the value of the bond investment will be reported either in the income
statement or in stockholders’ equity.
However, if the investor intends to hold the bond investment until it matures, it generally will
be classified as a long-term investment, specifically as a held to maturity security. Unlike
trading and available for sale securities, a held to maturity investment is not adjusted to
market value at year end because the company does not expect to sell the investment in the
near term; the current market price of the bond is less relevant than it is for other investments
the company can or intends to sell in the near term
5.3.1. RECOGNITION OF SHORT TERM INVESTMENTS
At acquisition, short Term Investments are recorded at cost plus any costs incident to the
acquisitions, such as brokerage commission and transfer taxes.
Bonds acquired between interest dates are traded on the basis of the market price plus the interest
accrued since the most recent interest payment. The accrued interest is a separate asset acquired
with the bonds. The cost of these two assets should be separated in the accounting records to
achieve a clear picture of the results of the investment in bonds.
When Short Term Investments are sold; the difference between the carrying amount- cost; and
the proceeds are recognized as a Gain or a Loss.
Gain or loss is the result of a change in the market price of bonds, which may have occurred for
a number of reasons. The two most likely causes are the change in;
 The level of interest rates and
 Investor appraisal of bond issue.
Example : Assume that on October 1, 2004, AB Company purchased Br. 3,000.00 par value 6%
bonds of XYZ Corporation at 103 (103%) of face amount plus accrued interest. The bonds were
issued a number of years ago by XYZ Corporation, and interest is paid each February 1, and
August 1. Broker’s fees and other related costs incident to the purchase were Br. 50.00. On May
1, 2005 AB Company sold the above bonds at 103 ½ plus accrued interest for three months. Cost
of sale was Br. 70.00 The journal entries to record the above transactions of AB Company are
given below;
A. Acquisition of short-term investment in bonds is recorded as
B. The cost of the short-term investment is determined as;
= Market price + incidental acquisition costs
= 1.03 x Br. 3,000.00 + Br. 50.00 = Br. 3,090.00 + 50.00 = Br. 3,140.00
The cash paid is equal to cost plus accrued interest i.e.
= Br. 3,140.00 + Br. 3,000.00 x 6/100 x 2/12
= Br. 3,140.00 + Br. 30.00

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= Br. 3,170.00
Oct. 1, 2004 Short Term Investment 3,140.00
Interest Receivable 30.00
Cash 3,170.00
[To
To record acquisition of bond including interest accrued]
accrued

C. To record accrued interest for 3 months at the end of the fiscal period.
Dec. 31, 2004 Interest Receivable 45.00
Interest Income [3,000 x6/100x 3/12] 45.00
[To record interest accrued for 3 months]

D. To closing Interest income;

Dec. 31, 2004 Interest Income 45.00
Income summary 45.00
[To close Interest income]

E. The journal entry to record the cash collection is on February 1 and August 1, 2005;

Feb. 1, 2005 Cash 90.00

Interest Receivable 30.00
Interest Income 60.00
F. The journal entry to record the sale is:
May. 1, 2005 Cash 3,080.00
Loss on sale of short-term investment 105.00
Short Term Investment 3,140.00
Interest Income 45.00
Cash received = Proceed + Accrued interest
= (1.035 x Br. 3,000.00– Br. 70.00) + Br. 45.00
= Br. 3,035.00 + Br. 45.00
= Br. 3,080.00
** Gain/Loss = Proceed – Cost
= Br. 3,035.00 – Br. 3,140.00
= Br. 105.00
1.3.2. INVESTMENT IN COMMERCIAL PAPER AND TREASURY BILLS
Unlike bonds, commercial paper and Treasury bills are non interests bearing. The interest
revenue earned on these investments is measured by the discount (the difference between the
face amount and the issuance price). The discount is accumulated in short-term investment
ledger account and recorded as interest revenue at the end of each accounting period during the
stated term of the commercial paper or Treasury bills.

Example: On Nov. 1, 2003 ABC Company acquired a treasury bill for a face amount of Br. 100,000.00
for Br. 94,000.00 cash for 3 months period. The required journal entries to record the acquisition of
Treasury bill are given below;

A. To record acquisition of Br. 100,000.00 face amount of 3 months Treasury bills;

Nov. 1, 2003 Short Term Investment- Treasury Bill 94,000.00
Cash 94,000.00

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[To acquisition of Treasury Bill]

B. To record accrued interest for two months

Dec 31, 2003 Short Term Investment- Treasury Bill 4,000.00
Interest Income [(100,000-94,000)/3 )x 2] 4,000.00
[To accrued interest for two months of Treasury Bill]

C. To record accrued revenue for one month;

Interest income = 6,000.00 – 4,000.00 = 2,000.00
Jan 31, 2004 Short Term Investment- Treasury Bill 2,000.00
Interest Income[ 6,000.00 – 4,000.00] 2,000.00
[To accrued interest for one months of Treasury Bill]
D. To record receipt of cash at the end of 3rd month (maturity date)
Jan 31, 2004 Cash 100,000.00
Short Term Investment- Treasury Bill 100,000.00
[To cash on Treasury Bill]
The monthly interest revenue can be computed (1) by straight-line method in which the total
discount will be divided by the number of months the short-term investment is outstanding i.e.
equal interest revenue will be recorded each month. For example, in the above example the
amount of discount (Br. 6000 = Br. 100,000 – 94,000) is divided by three months i.e. by the
number of months the short-term investment is outstanding or (2) by interest method in which
the effective rate of interest per period is applied to the carrying amount of the short-term
investment at the beginning of each period.
1.3.3. VALUATION OF SHORT – TERM INVESTMENT
Normally, an asset is recorded at cost, and this cost is associated with the revenue generated
from the use of the asset. If the asset loses its value without generating revenue, the cost is
written off as a loss. The revenue realization principle usually allows recognition of increases in
the value of an asset only when it is sold. Whether realization should be limited to the point of
sale for short-term investments is a question worth considering. By definition, short-term
investments are readily salable at a quoted market price. This same characteristic usually is not
found in inventories or plant assets. This basic difference between these types of assets suggests
that the traditional tests of revenue realization should not control the valuation of short-term
investments.

5.7. VALUATION AT MARKET VALUE

Short term investments can be valued at market value or Lower of cost or Market value. The
use of market price to value short-term investments at the end of an accounting period has some
advantages:
 The income statement will show the results of decisions to hold or sell such investments
period by period (For example, if the market price rises in one accounting period and
falls in the next, the gain from holding short-term investments in the first period and the
loss sustained by failure to sell at the higher price will be disclosed)
disclosed
 Valuation at current market price eliminates the anomaly of carrying identical securities
at different amounts because they were acquired at different prices

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 Market value is more meaningful to creditors who use the current section of the balance
sheet to judge the debt-paying ability of the business enterprise.
enterprise
1.4. NATURE OF RECEIVABLES
Receivables are current assets that results mainly from sale of goods and services to customers on
account. The balance sheet of every business enterprise includes a variety of claims from other parties
that generally provide a future flow of cash. These receivables represent claims for money, goods,
services and non-cash assets from other firms. Trade receivables describe amounts owed the company for
goods and services sold in the normal course of business. Non-trade receivables arise from many other
sources, such as tax refunds, contracts, investors, finance receivables, installment notes, sale of assets,
and advances to employees.
Receivables from customers frequently represent a substantial part of a business enterprise’s current
assets. Poor screening of applicants for credit or an inefficient collection policy may result in large losses.
Consequently, strong accounting controls and effective management of receivables are typical
characteristics of most profitable enterprises. The accounting for Recievables are mainly concerned with
the measurement, valuation, disposal and presentation on the balance sheet are what this section is
dedicated for.
5.4.1. MEASURING ACCOUNTS RECEIVABLE
Accounts receivable are recognized only when the criteria for recognition are fulfilled. Account
Recievables are recognized at face value subjected to adjustments for cash discounts, sales
returns and allowances and trade discounts as per the credit term of sales. Let see the following
items related to credit terms;
a) Trade Discounts: Typically, a single invoice price for a product is published. Then,
several different discounts may apply, depending on customer type and quantity ordered.
These trade discounts reduce the final sales price and are not affected by date of payment.
For accounting purposes, the listed invoice price less the trade discount is treated as the
gross price to which cash discounts apply. Trade discounts are not accounted for
separately, but rather help define the invoice price.
b) Cash Discounts: Companies frequently offer a cash discount for payment received within
a designated period. Cash discounts are used to increase sales, to encourage early
payment by the customer, and to increase the likelihood of collection.
The incentive to pay within the discount period is generally significant although in percentage
terms this does not always appear to be the case.
When goods and services are sold on credit basis that provides cash discount; there are two
alternative methods of recording Recievables where by the sales discount differently;
A. THE GROSS METHOD records sell discounts only if the customer pays within the discount
period.
B. THE NET METHODS: The net amount records sales discounts only if the customer fails to pay
within the discount period.
To illustrate the two methods, On February 2, 2003; assume that TG Company sold merchandise
to E&C Company Br 16,500.00;Term 2/10, n/30. The journal entries to record the sales and
collections under the methods are given below;
The Gross Method
Recording sale of Merchandize on accounts;
Date Accounts Debit Credit
Feb. 2, 2003 Account Recievable 16,500.00
Sales 16,500.00
[To record sale of merchandize on account]

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Entry to record collection within the 10-day discount period:

Date Accounts Debit Credit
Feb. 9, 2003 Cash 16,170.00
Sales Discount[16,500.00 x .02 = 330.00] 330.00
Account Recievable 16,500.00
[To record collection before discount period ]

The Net Method

The above transaction on February 2, 2003 can be recorded under net method as given below;
Recording sale of Merchandize on accounts;
Date Accounts Debit Credit
Feb. 2, 2003 Account Recievable 16,170.00
Sales 16,170.00
[To record sale of merchandize on account]
Entry to record collection within the 10-day discount period:
Date Accounts Debit Credit
Feb. 9, 2003 Cash 16,170.00
Account Recievable 16,170.00
[To record collection before discount period ]
Entry to record collection after the 10-day discount period:
Date Accounts Debit Credit
Feb. 16, 2003 Cash 16,500.00
Sales Discount Forfeited 330.00
Account Recievable 16,170.00
[To record collection after discount period ]

Sales discount is a contra account to sales, reducing net sales by the amount of cash discount
taken. The gross method specifically identifies discounts taken by customers.
Sales Discount Forfeited, a revenue account, is similar to interest revenue. The net method
specifically identifies discounts forfeited by customers. Regardless of the payment date, the net
method reports sales and receivable at the net amount, the amount acceptable to the seller for
compute payment.
SALES AND EXCISE TAXES
Many government units impose sales and Excise taxes on particular products or on sales
transactions. Usually, the seller is responsible for the remittance of these taxes to the
government. An excise tax imposed on the manufacture of a product is a part of the cost of
production, but an excise tax on the sale of the product is imposed on the consumer but collected
by the seller.
If sales and excise taxes are collected as separately disclosed additions to the selling price they
should be credited to a Liability Account t- sales tax/excise tax payable.
For example, if the total credit sales of the week is Br 42,500.00 and it is subjected to 10% sales
tax, the journal entry to record the sales and the related sales tax payable on this sales can be;

Date Accounts Debit Credit

Feb. 16, 2003 Account 46,750.00
Recievable[43,500.00x1.1=46,750.00]

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Sales 42,500.00
Sales tax payable 4,250.00
[To record sales subjected to sales taxes ]
1.4.2. VALUATION OF ACCOUNT RECEIVABLES
When credit is extended, some amount of uncollectible receivables is generally inevitable. Firms
attempt to develop a credit policy neither too conservative (leading to excessive lost sales) nor
too liberal (leading to excessive uncollectable accounts). Past records of payment and the
financial condition and income of customers are key inputs to the credit-granting decision.
Credit sales unless involves complex screening of credit customers to reduce the risk
uncollectable Receivables. Generally, there are two approaches to recognizing the costs of
uncollectable receivables are found in practice.
Allowance method: If uncollectable accounts receivable are both probable and estimable, an
estimate of uncollectible receivables is recognized and net accounts receivables is reduced. The
resulting estimated expenses reflect the likely reduction in the value of recorded receivables.
This approach reduces earnings before specific accounts are known to be uncollectable.
Estimated uncollectable are recorded as Bad Debt Expense, an operating expense, usually
classified as a selling expense. And used widely by most large firms.
Direct-write-off method: If uncollectable accounts are not probable or estimable, no adjustment
to income or receivables is made until specific accounts are considered uncollectable. This
method is usually by those firms smaller in size and relatively lower level of credit sales.
A. ALLOWANCE METHOD
Under this method, the amount of uncollectable Receivables is estimated at the end of the
accounting period based on past experiences recorded through an adjusting entry.
For example, the estimated uncollectable accounts for ABC Company during 2005, is Br
23,450.00 bases on past experience. The journal entry to record the estimated uncollectable
receivable would be;

Date Accounts Debit Credit

Dec. 31, Bad Debt Expense 23,450.00
2005
Allowance for uncollectable accounts 23,450.00
[To record bad debt expense ]
The estimate of this uncollectible under this method can be based on total credit sales or balance
of Receivables.
B. CREDIT SALES ESTIMATION METHOD: this method matches the matching principles and the
income statement. The estimate of bad debt is made on the percentage of credit sales during
the period. This method is simple and forward. For example; is the total credit sale of AShu
Company is Br 245,500.00 during 2006. As experience 2% of these sales are estimated to be
uncollectible. The journal entry under this credit sales estimation method is given below;

Date Accounts Debit Credit

Dec. 31, Bad Debt Expense [.02x245,500.00] 4,910.00
2006
Allowance for uncollectable accounts 4,910.00
[To record bad debt expense ]

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Allowance for doubtful or uncollectable account is a contra account to Accounts Receivable and
are used because the identity of specific uncollectable accounts is unknown at the time of the
above entry. A net account receivable (gross accounts receivable less the allowance account) is
an estimate of the net realizable value of the receivables.
C. THE AGING OF ACCOUNT RECIEVABLE METHOD: under this method, the bad debt expense
for the period is estimated from Balance of Account Recievable. The bad debt expense is
estimated by using the analysis of Receivables- Aging of Receivables.
Example: Assume that ACB Company uses the Aging or Receivables method for uncollectable
and the following is obtained from analysis of Receivables for 2004;

Value Account Estimated Amount of uncollectable

Past Due Recievable uncollectible
1-30 days 45,600.00 2% 912.00
30-90 days 67,240.00 5% 3,362.00
0ver 90 days 23,450.00 10% 2,345.00
Total 136,290.00 6,619.00

The journal entry to record the bad debt expense takes into consideration the balance of
Allowance for Doubt full accounts at year end. Assume that the allowance for doubt full account
has a Credit balance of Br 2,145.00. The adjusting entry to record bad debt expense is;

Date Accounts Debit Credit

Dec. 31, Bad Debt Expense [6,619.00- 2,145.00] 4,474.00
2004
Allowance for Doubtful accounts 4,474.00
[To record bad debt expense ]
Two subsequent events must be considered when using the Allowance method;
1. The write-off of a specific Customer receivable account and
2. Collection of an account previously written off.
THE WRITE-OFF OF A SPECIFIC CUSTOMER RECEIVABLE ACCOUNT
If a specific customer account deemed to be uncollectible under this method; the Account
receivable with related customer account is credited and the Allowance for uncollectible
Account is debited.
For example, Assume that accounts of Merga Retail Br 1,250.00 is deemed to be uncollectable
on February 10, 2006 by SSH Company Credit Manager. The journal entry for the write of this
specific accounts under the allowance method debits Allowance for dough full accounts and
credits the Account receivable accounts including the specific account of the customer as given
below;
Date Accounts Debit Credit
Feb.10, 2006 Allowance for uncollectable accounts 1,250.00
Account Recievable- Merga Retail 1,250.00
[To write off Merga Retail’s Account ]
The write-off entry is recorded only when the likelihood of collection does not support further
collection efforts.
COLLECTION OF AN ACCOUNT PREVIOUSLY WRITTEN OFF

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When amounts are received on account after a write-off, the write-off entry is reversed to
reinstate the receivable and cash collection is recorded.
Example: Assume that SSH Company is able to collect Br 1,250.00 on account on April 12,
2006 from Merga Retail written off on Feb 10, 2006. The following two journal entries are
necessary.
Reinstating the customer account written off: this is the reverse of a journal entry to record the
write off a customer account.

Date Accounts Debit Credit

Apr 12, 2006 Account Recievable- Merga Retail 1,250.00
Allowance for uncollectable accounts 1,250.00
[To reinstate Merga Retail’s Account ]

Date Accounts Debit Credit

Apr 12, 2006 Cash 1,250.00
Account Recievable- Merga Retail 1,250.00
[To record collection from Merga Retail ]

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1.4.3. DIRECT WRITE-OFF METHOD

Companies in the first year of operation or in new lines of business may have no basis for
estimating uncollectable in such cases, and when uncollectable accounts are immaterial and used
by those firms which have smaller credit sales.
GAAP allows receivables to be written of directly as they become uncollectable. No adjusting
entry is made at the end of an accounting period under the direct write-off method.
Example: Assume that BC Company decided to write off a customer account Shola store a
declared bankrupt Br 2,230.00 on March 2, 2005. The journal entry to write of the account under
DIRECT METHOD Debits Bad Debt Expense and Credits Account Recievable account with the
respective customer as given below;

Date Accounts Debit Credit

Mar 2, 2005 Bad Debt Expense 2,230.00
Account Recievable- Shola Store 2,230.00
[To record collection from Shola Store]

1.4.4. DISPOSAL OF ACCOUNT RECEIVABLES

In the normal course of events, companies collect accounts and notes receivable when due and
then remove them from the books. However, the growing size and significance of credit sales
and receivables has led to changes in this “normal course of events.” In order to accelerate the
receipt of cash from receivables, the owner may transfer accounts or notes receivables to another
company for cash.
There are various reasons for this early transfer.
 For competitive reasons, providing sales financing for customers is virtually mandatory
in many industries. In the sale of durable goods, such as automobiles, trucks, industrial
and farm equipment, computers, and appliances, most sales are on an installment contract
basis. Many major companies in these industries have created wholly-owned subsidiaries
specializing in receivables financing.
 The holder may sell receivables because money is tight and access to normal credit is
unavailable or too expensive. Also, a firm may sell its receivables, instead of borrowing,
to avoid violating existing lending agreements.
 Billing and collection of receivables are often time-consuming and costly. Credit card
companies such as MasterCard, Visa, American Express, Diners Club, Discover, and
others take over the collection process and provide merchants with immediate cash.
 Some purchasers of receivables buy them to obtain the legal protection of ownership
rights afforded a purchaser of assets versus the lesser rights afforded a secured creditor.
 Banks and other lending institutions may need to purchase receivables because of legal
lending limits. That is, they cannot make any additional loans but they can buy
receivables and charge a fee for this service.
The transfer of receivables to a third party for cash happens in one of two ways:
1. Secured Borrowing: A company often uses receivables as collateral in a borrowing
transaction. In fact, a creditor often requires that the debtor designate (assign) or pledge10
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receivables as security for the loan. If the loan is not paid when due, the creditor can convert
the collateral to cash—that is, collect the receivables.
2. Sales of Receivables: Sales of receivables have increased substantially in recent years. A
common type is a sale to a factor. Factors are finance companies or banks that buy
receivables from businesses for a fee and then collect the remittances directly from the
customers.
Factoring of receivables may be without recourse or a with recourse basis;
a) Sale without Recourse: When buying receivables without recourse, the purchaser assumes
the risk of collectability and absorbs any credit losses. The transfer of accounts receivable in a
nonrecourse transaction is an outright sale of the receivables both in form (transfer of title)
and substance (transfer of control). In nonrecourse transactions, as in any sale of assets, the
seller debits Cash for the proceeds and credits Accounts Receivable for the face value of the
receivables. The seller recognizes the difference, reduced by any provision for probable
adjustments (discounts, returns, allowances, etc.), as a Loss on the Sale of Receivables. The
seller uses a Due from Factor account (reported as a receivable) to account for the proceeds
retained by the factor to cover probable sales discounts, sales returns, and sales allowances.
b) Sale with Recourse: For receivables sold with recourse, the seller guarantees payment to the
purchaser in the event the debtor fails to pay. To record this type of transaction, the seller uses
a financial components approach, because the seller has a continuing involvement with the
receivable. Values are now assigned to such components as the recourse provision, servicing
rights, and agreement to reacquire. In this approach, each party to the sale only recognizes the
assets and liabilities that it controls after the sale.
1.4.5. PRESENTATION OF RECEIVABLES
The general rules in classifying receivables are:
a) Segregate the different types of receivables that a company possesses, if material.
b) Appropriately offset the valuation accounts against the proper receivable accounts.
c) Determine that receivables classified in the current assets section will be converted into
cash within the year or the operating cycle, whichever is longer.
d) Disclose any loss contingencies that exist on the receivables.
e) Disclose any receivables designated or pledged as collateral.
f) Disclose all significant concentrations of credit risk arising from receivables.
Concentrations of credit risk exist when receivables have common characteristics that may affect
their collection. These common characteristics might be companies in the same industry or same
region of the country.
5.5. RECORDING N OTE RECEIVABLES
May transactions can be the reasons for a company to receive note receivables. Such
transactions may include;
1. SETTLEMENT OF ACCOUNT RECEIVABLES;
Some companies provide goods and services to their customer on open credit – Account
Receivables; for a credit period not more than 60 days. When these receivables are not
collected at the end of the credit period; this account receivables usually settled using a
more formal credit instrument called Note Receivables.

Example: Assume that ASS Company sold Merchandises for Br 30,000.00on account to AD Retail
Store on Sep.20, 2005. Term of sale was 2/10 n/30. On Oct. 21, 2005, after the credit period, AD

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Company singed a 12%, Br 30,000.00, 60 days note for the settlement of its open trade Account.
The journal entry on October 21, 2005 for a note received by ASS Company is recorded as given
below;

DATE ACCOUNT TITLE DEBIT CREDIT

2005 Note Recievable 30,000.00
Oct.21 Account Receivables 30,000.00
To record Note Recievable
2. NOTES EXCHANGED FOR CASH AND OTHER PRIVILEGES
Long-term notes must be recorded at their present value using the appropriate interest rate.
Companies may accept a note with a stated interest rate lower than the market rate in exchange
for cash or other consideration worth the face value of the note. To make this a fair transaction,
other rights or privileges must be received by the party accepting the note, beyond the cash
payments required in the note.
Example: On January 1, 2005, YES company loaned SA Company Br. 100,000.00 and accepted
a Br. 100,000.00 note due December 31, 2006, with 5% interest payable annually each
December 31, beginning 2005. The market interest rate is 12%. SA Company agreed to provide
YES company with agricultural materials at a discount price over the note term. Two-thirds of
the supplies are to be furnished during the first year. The present value of the note itself is
significantly less than Br. 100,000.00.
PRINCIPAL VALUE OF NOTE/THE PRESENT VALUE /:
=Br. 100,000.00 (0.79719) + Br. 100,000.00 (0.05) (1.69005) = Br. 88,170.00.
In this example, YES company would lend only Br. 88,170.00 if the note alone were received in
exchange. The additional Br. 11,830.00 (Br. 100,000.00 – Br. 88,170.00) is a prepayment for
discount pricing. YES company, thus receives two payments of Br. 5,000.00[100,000.00 x .05], one
payment of Br. 100,000.00, and discount pricing on purchases over the note term. The value of the
other privileges should be recorded as an asset equal to the difference between the note’s present
and face values. The entry on the book of YES Company using the gross method on January 1, 2005
is;
DATE ACCOUNT TITLE DEBIT CREDIT
2005 Note Recievable 100,000.00
Jan. 1 Prepaid purchase 11,830.00
Discount on Notes Receivable 11,830.00
Cash 100,000.00
To record Note Recievable
The entries to record receipt of cash and to recognize two-thirds of the discount on
December 31, 2005 are;
DATE ACCOUNT TITLE DEBIT CREDIT
2005 Cash[100,000.00 x .05] 5,000.00
Dec.31 Discount on Notes Receivable 5,580.40
Interest income[88,170.00x.12] 10,580.40
To record interest income.

DATE ACCOUNT TITLE DEBIT CREDIT

2005 Purchases [2/3 x 11,830.00] 7,887.00
Dec.31 Prepaid purchase 7,887.00

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To record 2/3 of the discount.

The remaining prepaid purchases account is now a current asset for 2006. The entries
when the contract is concluded on December 31, 2006 are;
DATE ACCOUNT TITLE DEBIT CREDIT
2006 Cash[100,000.00 x .05] 5,000.00
Dec.31 Discount on Notes Receivable 6,250.00
Interest income[.12(88,170.00 +5,580.40] 11,250.00
To record interest income.
DATE ACCOUNT TITLE DEBIT CREDIT
2006 Purchases [1/3 x 11,830.00] 3,943.00
Dec.31 Prepaid purchase 3,943.00
To record 2/3 of the discount.
DATE ACCOUNT TITLE DEBIT CREDIT

2006 cash 100,000.00

Dec.31
Note Recievable 100,000.00

5.5.1. DISCOUNTING NOTES RECEIVABLE

Negotiable notes receivable may be sold or discounted. The term sale is appropriate when a note
is indorsed to a bank or finance company on a without recourse basis, that is, in the event the
maker of the note defaults, the bank or finance company has no recourse against the seller of the
note. The term discounted applies when an enterprise borrows against notes receivable and
indorses them on a with recourse basis, which means that the borrower must pay the note if the
maker does not.
The process of discounting note involves,
 The payee (the holder of the note) discounts the note with a Factor or a bank and
 Receives the maturity value of the note less a discount (a fee) charged by the bank.
 The maker pays the bank at the maturity of the note.
The proceeds received when a note is discounted are computed by deducting from the maturity
value of the note the amount of interest (discount) charged by the bank or finance company.
Banks usually compute the discount on the maturity value of the note rather than on the proceeds
(amount actually borrowed), which gives the bank a higher effective rate of interest than the rate
of interest used to discount the note.
Notes are discounted with recourse or without recourse and are recorded as a borrowing or a sale
depending on whether the conditions of SFAS No. 125 are met.
 If the note is discounted with recourse and treated as a sale, the payee records a gain or
loss equal to the difference between the proceeds and book value of the note, including
accrued interest, and has a contingent liability until the note is paid by the maker.
 But if the note is discounted with out recourse, the payee has no contingent liability.
If a discounted note is recorded as a borrowing, a liability is recorded and interest expense is
recognized over the term of borrowing. The proceeds to the payee are not affected by the
reporting alternatives and are based on the total of principal value plus interest to maturity,
whether or not the note is interest bearing. The bank charges its discount rate on this total
amount for the period between the date of discounting and the date of maturity of the note.

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EXAMPLE: Assume that On April 1, 2008; Ck Company received a Br. 30,000.00; 10 percent
one-year note for a sale of equipment to Nelly Company. Interest on the note is due at maturity.
On August 1, 2009, Ck Company discounted the note at Dashen Bank with recourse.
CASE 1: Assume that the discounting qualifies as a sale and that the bank charges 15 percent.
The proceeds to Ck Company on August 1, 2008 can be computed as follows:
Principal value ----------------------------------------------------Br. 30,000.00
Interest to maturity (Br. 30,000.00x 0.1) ---------------------------3,000.00
Total maturity value subject to discount ----------------------Br 33,000.00
Less: Bank Interest charged (Br. 30,000.00 x 0.15 x 8/12) (3,300.00)
Proceeds ------------------------------------------------------------Br. 29,700.00

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The bank charges interest on the maturity value a full eight months before, that value is reached,
effectively raising the interest cost to Ck Company, which records the following entries to discount
the note:
DATE ACCOUNT TITLE DEBIT CREDIT
2009 Interest Receivable (Br. 30,000.00 x 0.1 x 4/12) 1,000.00
Aug.1 Interest income 1,000.00
To record interest income accrued on the Note Receivable.

DATE ACCOUNT TITLE DEBIT CREDIT

2009 Cash 29,700.00

Aug.1
Loss on discounting of note 1,300.00

Note Recievable 30,000.00

Interest Receivable 1,000.00

To record the discounting of the note.

A second acceptable method for recording the note discounting by Ck Company on August 1,
2008 is as follows:

DATE ACCOUNT TITLE DEBIT CREDIT

2008 Cash 29,700.00
Aug.1 Interest Expense 300.00
Note Recievable 30,000.00

When the contingency is removed (upon payment of the note by the maker), the following entry is
made:
DATE ACCOUNT TITLE DEBIT CREDIT
2008 Notes Receivable Discounted 30,000.00
Aug.1 Note Recievable 30,000.00

For a note discounted without recourse, the entries are the same (although the notes receivable
discounted account is not used), but no contingent liability exists.

CASE 2: Assume the discounting above does not quality as a sale, Ck Company makes these entries
on August 1, 2008;
DATE ACCOUNT TITLE DEBIT CREDIT
2008 Interest Recievable 1,000.00
Aug.1 Interest Income 1,000.00
To record interest on Note Recievable
DATE ACCOUNT TITLE DEBIT CREDIT
2008 Cash 29,700.00
Aug.1 Interest Expense 1,300.00

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Liability on Discounted Note Receivable 30,000.00

Interest Recievable 1,000.00

When the maker pays the note at maturity, the following entry is made on April 1, 2009;

DATE ACCOUNT TITLE DEBIT CREDIT

2008 Liability on Discounted Note Receivable 30,000.00
Aug.1 Notes Receivable 30,000.00

5.5.2. DISHONORED NOTES

A NOTE RECEIVABLE not renewed or collected at maturity is considered a DISHONORED NOTE.
Interest continues to accrue on the face value plus any previously accrued interest at the interest
rate set by state laws. The payee generally transfers the note to a special receivable accounts and
initiate collection efforts.

EXAMPLE : Assume that On April 1, 2008; Ck Company received a Br. 30,000.00; 10 percent one-
year note for a sale of equipment to Nelly Company. On August 2, 2009, the note from Nelly
Company is dishonored. Ck Company started a collection attempt and incurred Br 1,200.00. The
dishonored note is no more negotiable and changed to receivable including additional expenses
incurred to force collection as given below;
DATE ACCOUNT TITLE DEBIT CREDIT
2009 Account Receivable [33,000.00 + 1,200.00] 34,200.00
Apr.1 Notes Receivable 34,200.00
The accounting for discounted notes dishonored by the maker depends on the discounting
transaction.
 If the note was discounted without recourse and recorded as a sale, no entry is required
and no contingent liability exists to be removed.
 If the note was discounted with recourse (the more likely case) and recorded as a sale, the
payee pays the maturity value, including interest and any fee charged by the bank, and
debits a special receivable account for the amount paid.
EXAMPLE: Assume that the note discounted by Ck Company and recorded as a sale is dishonored.
The bank charges a Br. 150.00 protest fee for the additional task of notifying Ck Company on the
default. Assuming footnote disclosure of the contingent liability, the entry upon notification by the
bank 0n April 2, 2009 is as follows:
DATE ACCOUNT TITLE DEBIT CREDIT
2009 Account Receivable [33,000.00 + 150.00] 33,150.00
Apr.1 Cash 33,150.00

If the account method of disclosing the contingent liability were used, the entry would be the
following:
DATE ACCOUNT TITLE DEBIT CREDIT
2009 Account Receivable [33,000.00 + 150.00] 33,150.00
Apr.1 Notes receivable discounted 30,000.00
Notes receivable 30,000.00
Cash 33,150.00

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This entry removes the contingent liability and establishes the special receivable- Notes
receivable past due or Account Receivable.
Finally, assume that the note cook company discounted is recorded as a liability and is then
dishonored. The entry to record the default, with the Br. 150.00 protest fee, is:
DATE ACCOUNT TITLE DEBIT CREDIT
2009 Notes receivable past due 33,150.00
Apr.1 Liability on Discounted Notes Receivable 30,000.00
Notes receivable 30,000.00
Cash 33,150.00
If efforts to collect the past-due note fail, the accounting for the loss depends on whether
note are included in the bad debt estimation process. If notes are included the account is
closed against the allowance for doubtful accounts at its carrying value. If notes are not
included, the direct write-off method is used. The note is credited for the carrying value
and a loss is debited.
5.5.3. BALANCE SHEET PRESENTATION OF NOTE RECEIVABLES.
In the current asset section of the balance sheet, material amounts of notes receivables arising
from written negotiable contracts that will be due within a year or operating cycle whichever is
longer are reported.
Any discount or premium relating to notes receivable is reported in the balance sheet as s
deduction from or as an addition to the face amount of the note. The description of notes
receivable should include the effective interest rate.
Notes receivable that will not be collected within a year of the operating cycle are excluded from
the current assets category.
UNIT SIX
Accounting for Inventories

Learning Objectives

After studying this chapter, you should be able to:

 Discuss how to classify and determine inventory.

 Explain the accounting for inventories and apply the inventory cost flow methods.
 Explain the financial effects of the inventory cost flow assumptions.
 Explain the lower-of-cost-or-net realizable value basis of accounting for inventories.
 Indicate the effects of inventory errors on the financial statements.
 The Disclosure requirements

Introduction

The accounting for inventories is a major consideration for many entities because of its significance
on both the statement of profit or loss (cost of goods sold) and the statement of financial position.

There are two types of entities for which the accounting for inventories must be considered. The
merchandising entity (generally, a retailer or wholesaler) has a single inventory account, usually

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entitled merchandise inventory. These are goods on hand that are purchased for resale. The other
type of entity is the manufacturer, which generally has three types of inventories: (1) raw
materials, (2) work in process, and (3) finished goods. Raw materials inventory represents goods
purchased that will act as inputs in the production process leading to the finished product. Work in
process (WIP) consists of the goods entered in to production but not yet completed. Finished goods
inventory is the completed product that is on hand awaiting sales.

Accordingly, this chapter deals with costs included in the valuation of inventories, cost flow
assumption used, the basis for valuation of inventories and effects of inventory errors on the
financial statements.

2.1. Importance of Inventories

Merchandise purchased and sold is the most active elements in merchandising business, i.e. in
wholesale and retail type of businesses. This is due to the following reasons:

 The sale of merchandise is the principal source of revenue for them.

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

2.2. Basic Concept of Inventory Costing

According to IAS 2, the primary basis of accounting for inventories is cost. Cost is defined as the sum
of all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to
their present location and condition. This definition allows for significant interpretation of the costs
to be included in inventory.

For raw materials and merchandise inventory that are purchased outright and not intended for
further conversion, the identification of cost is relatively straightforward. The cost of these
purchased inventories will include all expenditures incurred in bringing the goods to the point of
sale and putting them in a salable condition. These costs include the purchase price, import duties
and other taxes (other than those subsequently recoverable by the entity from taxing authority, e.g.,
VAT, GST), transportation costs, insurance, and handling costs. Trade discounts, rebates, and other
such items are to be deducted in determining inventory costs; failure to do so would result in
carrying inventories at amounts in excess of true historical costs. Exchange differences arising
directly on the recent acquisition of inventories invoiced in a foreign currency are not permitted to
be included in the costs of purchase of inventories.

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Borrowing costs will generally not be capitalized in connection with inventory acquisitions, since
the period required to ready the goods for sale will generally not be significant. On the other hand,
when a lengthy production process is required to prepare the goods for sale, the provisions of IAS
23 would be applicable and a portion of borrowing costs would become part of the cost of
inventory. In practice, such situations are rare and IAS 23 allows an exemption for inventories that
are manufactured, or otherwise produced, in large quantities on a repetitive basis.

Conversion costs for manufactured goods should include all costs that are directly associated with
the units produced, such as labor and overhead. The allocation of overhead costs, however, must
be systematic and rational, and in the case of fixed overhead costs (i.e., those which do not vary
directly with level of production) the allocation process should be based on normal production
levels. In periods of unusually low levels of production, a portion of fixed overhead costs must
accordingly be charged directly to operations, and not taken into inventory.

Costs other than material and conversion costs are capitalized only to the extent they are necessary
to bring the goods to their present condition and location. Examples might include certain design
costs and other types of preproduction expenditures if intended to benefit specific classes of
customers. On the other hand, all research costs and most development costs would typically not
become part of inventory costs.

2.3. Owner ship of Goods

Inventory can only be an asset of the reporting entity if it is an economic resource of the entity at
the date of the statement of financial position. In general, an entity should record purchases and
sales of inventory when legal title passes. Although strict adherence to this rule may not appear to
be important in daily transactions, proper inventory cut-off at the end of an accounting period is
crucial for the correct determination of periodic results of operations. Thus, for accounting
purposes, to obtain an accurate measurement of inventory quantity and corresponding monetary
representation of inventory and cost of goods sold in the financial statements, it is necessary to
determine when title passes.

The most common error made in this regard is to assume that title is synonymous with possession
of goods on hand. This may be incorrect in two ways:

1. The goods on hand may not be owned; and

2. Goods that are not on hand may be owned. There are four matters that may cause confusion
about proper ownership:
1. Goods in transit;
2. Consignment sales;
3. Product financing arrangements; and
4. Sales made with the buyer having generous or unusual right of return.

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But for the sake this course as an introduction we will see the first two concepts

2.3.1. Goods in transit

Goods in transit are goods Purchased goods not yet received and sold goods not yet delivered.

Goods in transit should be included in the inventory of the company that has legal title to the goods.
Legal title is determined by the terms of sale

The term FOB stands for “free on board.” If goods are shipped FOB destination, the seller pays
transportation costs and title does not generally pass until the carrier delivers the goods to the
buyer; thus, these goods are part of the seller’s inventory while in transit. If goods are shipped FOB
shipping point, transportation costs are paid by the buyer and title generally passes when the
carrier takes possession; thus these goods are part of the buyer’s inventory while in transit. The
terms FOB destination and FOB shipping point often indicate a specific location at which title to the
goods is transferred, such as FOB Milan. This means that the seller would most likely retain title
and risk of loss until the goods are delivered to a common carrier in Milan who will act as an agent
for the buyer.

In a CIF (cost, insurance and freight) contract, the buyer agrees to pay in a lump sum the cost of the
goods, insurance costs and freight charges. In a C&F contract, the buyer promises to pay a lump sum
that includes the cost of the goods and all freight charges. In either case, the seller must deliver the
goods to the carrier and pay the costs of loading; thus both title and risk of loss generally pass to the
buyer up on delivery of the goods to the carrier.

2.3.2. Consignment sales

There are specifically defined situations where the party holding the goods is doing so as an agent
for the true owner. In consignments, the consignor (seller) ships goods to the consignee (buyer),
who acts as the agent of the consignor in trying to sell the goods. In some consignments, the
consignee receives a commission; in other arrangements, the consignee “purchases” the goods
simultaneously with the sale of the goods to the final customer. Goods out on consignment are
properly included in the inventory of the consignor and excluded from the inventory of the
consignee. Disclosure may be required of the consignee, however, since common financial
analytical inferences, such as days’ sales in inventory or inventory turnover, may appear distorted
unless the financial statement users are informed. However, IFRS does not explicitly address this.

Illustration 1: Consignment arrangement

ABC Company (Manufacturer) which produces Product A wants to attract a new customer XYZ.
Customer XYZ is interested in Product A but doesn’t want to freeze (invest) cash in inventory and
negotiates an inventory consignment arrangement with Manufacturer. Manufacturer will initially
ship 100 tons of Product A to Customer XYZ’s ware house and will replenish this inventory as

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Customer XYZ uses the product. Customer XYZ will not take title to the product until the product is
consumed by Customer XYZ. The selling price for one ton of Product A is set at Birr 100.
Manufacture’s cost of one ton of Product A is Birr 60.

At the beginning of November 2016, Manufacturer ships 100 tons of Products A to Customer XYZ.
The Manufacturer will records the following journal entry

Inventory (Consignments) 6,000

Finished Goods Inventory 6,000

The consignment inventory amount was determined as Br 60x100tons= Birr6, 000.

Note: no journal entries are made by Customer XYZ except for entering entries in an inventory
system to track how much consigned inventory was received and consumed.

During November 2016, Customer XYZ uses 70 tons of Products A and notifies Manufacturer about
this consumption by sending an account statement. Manufacturer uses the account statement to
issue an invoice to Customer XYZ and record the sale of 70 tons along with the related cost of goods
sold as follows:

Account receivable 7,000

Sales 7,000

THE SALES AMOUNT WAS DETERMINED AS BIRR 100X70TONS=

BIRR 7,000

Inventory (Consignments) 4,200

Finished Goods Inventory 4,200

The cost of goods sold amount was determined as Birr 60x70 tons=Birr 4,200.

2.4. Inventory Systems

Inventory system is a system through which we can determine the cost of merchandise sold and
cost of merchandise on hand. Generally, there are two widely accepted inventory system.

1. Periodic Inventory System and

2. Perpetual Inventory System
2.4.1. 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

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inventory balance. This is because when goods are purchased, they are debited to the purchases
account rather than merchandise inventory account.

The revenue from sales is recorded each time a sale is made. No entry is made for the cost of goods
sold. So, physical inventory must be taken periodically to determine the cost of inventory on hand
and goods sold. The periodic inventory system is less costly to maintain than the perpetual
inventory system, but it gives management less information about the current status of
merchandise. It is often used by retail enterprises that sell many kinds of low unit cost merchandise
such as groceries, drugstores, hardware etc.

The journal entries to be prepared are:

1. At the time of purchase of merchandise:

Purchases XX at cost

Accounts payable or cash XX

2. At the time of sale of merchandise:

Accounts receivable or cash XX at retail price

Sales XX

3. To record purchase returns and allowance:

Accounts payable or cash XX

Purchase returns and allowance XX

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

Income Summary XX

Merchandise inventory (beginning) XX

To close beginning inventory

Merchandise inventory (ending) XX

Income summary XX

To record ending inventory

2.4.2. Perpetual Inventory System

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Under this system the accounting record continuously disclose the amount of inventory. So, the
inventory balance will not remain the same in the accounting period. All increases are debited to
merchandise inventory account and all decreases are credited to the same account.

There are no purchases and purchase returns and allowances accounts in this system. At the time of
sale, the cost of goods sold is recorded in addition to Journal entry for the sale. So, we can
determine the cost of inventory as well as goods sold from the accounting record. No need of
physical counting to determine their costs.

Companies that sell items of high unit value, such as appliances or automobiles, tended to use the
perpetual inventory system. Given the number and diversity of items contained in the merchandise
inventory of most businesses, the perpetual inventory system is usually more effective for keeping
track of quantities and ensuring optimal customer service. Management must choose the system or
combination of systems that is best for achieving the company's goal.

Journal entries to be prepared are:

1. At the time of purchase of merchandise

Merchandise inventory XX at cost

Accounts payable/cash XX

To record cost of goods sold

2. At the time of sale of merchandise

Accounts receivable or cash XX at retail price

Sales XX

To record the sales

Cost of goods sold XX at cost

Merchandise inventory XX

To record the cost of merchandise sold

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 – 2

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In its beginning inventory on Jan 1, 2015, Glorious Company had 120 units of merchandise that cost
Br. 8 per unit. The following transactions were completed during 2015.
February 5 Purchased on credit 150 units of merchandise at Br. 10 per unit.
9 Returned 20 detective units from February 5 purchases to the supplier.
June 15 Purchased for cash 230 units of merchandise at Br 9 per unit.

September 6 Sold 220 units of merchandise for cash at a price of Br. 15 per unit. These goods
are: 120 units from the beginning inventory and 100 units for February Purchases.

December 31 260 units are left on hand, 30 units from February 5 purchases.

Required: Prepare general journal entries for Glorious Company to record the above transactions
and adjusting or closing entry for merchandise inventory on December 31,

a) Periodic inventory system

b) Perpetual inventory system
Solution

a) February 5 Purchases (150 x Br.10) 1,500

Account payable1,500

9 Accounts payable (20 x Br. 10) 200

Purchase returns and allowances 200

June 15 Purchases (230 x Br. 9)2,070

Cash 2,070

September 6 Cash (220 x Br. 15) 3,300

Sales 3,300

December 31 To record or close the merchandise inventory account

Income summary (120 x Br. 8)960

Merchandise inventory (beginning) 960

To close the beginning inventory

Merchandise inventor (ending) 2,370

Income summary [(30 x Br. 10) + (230 x Br. 9)] 2,370

(To record the ending merchandise inventory)

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b) February 5 Merchandise inventory 1,500

Accounts payable 1,500

9 Accounts payable 200

Merchandise inventory 200

June 15 Merchandise inventory 2,070

Cash 2,070

September 6 i) to record the sales

Cash 3,300

Sales 3,300

ii) To record cost of merchandise sold

= (120 x Br. 8) + (100 x Br. 10) = Br. 960 + Br. 1,000 = Br. 1,960

Cost of merchandise sold 1,960

Merchandise inventory 1,960

December 31 No entry is needed to record or close merchandise inventory account.

2.5. Inventory Costing Methods

According to IAS2 there are three methods of costing which are applied in valuation of inventory
and they are depicted as follows:

Specific Identification: It is generally not a practical technique, as the product will generally lose
its separate identity as it passes through the production and sales process. Exceptions to this would
generally be limited to those situations where there are small inventory quantities, typically having
high unit value and a low turnover rate. Under IAS 2, specific identification must be employed to
cost inventories that are not ordinarily interchangeable, and goods and services produced and
segregated for specific projects. For inventories meeting either of these criteria, the specific
identification method is mandatory and alternative methods cannot be used.

For the sake of illustration, consider the following ABC company data for 2018

If ABC PLC sold the TVs it purchased on February 3 and May 22, then its cost of goods sold is £1,500
(£700 + £800), and its ending inventory is £750
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Because of the limited applicability of specific identification, it is more likely to be the case that
certain assumptions regarding the cost flows associated with inventory will need to be made. One
of accounting’s peculiarities is that these cost flows may or may not reflect the physical flow of
inventory. Over the years, much attention has been given to both the flow of physical goods and the
assumed flow of costs associated with those goods. In most jurisdictions, it has long been
recognized that the flow of costs need not mirror the actual flow of the goods with which those
costs are associated.

In cases where there are a large number of items of inventory and where the turnover is rapid, the
standard prescribes two inventory costing formulas, namely the first-in, first-out (FIFO) and the
weighted-average methods. A third alternative formerly endorsed by IFRS, the LIFO costing
method, was designated as being unacceptable.

FIFO and weighted-average cost are the only acceptable cost flow assumptions under IFRS. Either
method can be used to assign cost of inventories, but once selected an entity must apply that cost
flow assumption consistently (unless the change to the other method can be justified under the
criteria set forth byIAS8). Furthermore, an entity is constrained from applying different cost
formulas to inventories having similar nature and use to the entity. On the other hand, for
inventories having different natures or uses, different cost formulas may be justified. Mere
difference in location, however, cannot be used to justify applying different costing methods to
other wise similar inventories. Note that where a change in cost formula is made, this is likely to
represent a change in accounting policy rather than a change in accounting estimate and will
therefore need to be retrospectively applied under the requirements of IAS 8.

. Inventory Costing Methods under a Periodic Inventory System

The term cost flow refers to the inflow of costs when goods are purchased or manufactured and to
the outflow of costs when goods are sold. The cost remaining in inventories is the difference
between the inflow and outflow of costs. The problem often faced by an accountant is determining
the cost of merchandise sold and the cost of remaining inventories or ending inventories when
merchandise are purchased at different costs. If identical goods are purchased at different costs
during the period, there should be an arbitrary assumption as to the cost flow of merchandise
through the business such as:

1. FIFO (First In First Out)

2. Average Costing Method
3. Specific Identification see the above illustration

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Illustration 3: You are given the following data for BB Electronics for the year 2018 for one of its
item called CD-RW.

Date Item Quantity Unit Cost Total Cost

January 1, 2015 Inventory 500 Units Br 10.50 Br 5,250

March 31, 2015 Sold 300 Units

April 1, 2015 Purchases 1,800 Units 12 21,600

June 30, 2015 Sold 600 Units

July 1, 2015 Purchases 500 Units 12.50 6,250

September 30, 2015 Sold 700 Units

October 1, 2015 Purchases 200 Units 13 2,600

December 31, 2015 Sold 800 Units

Required: For the CD-RW of BB Electronics compute the cost of inventory on hand as of December
31, 2015 and cost of goods sold under the following two cost flow assumptions:

1. FIFO Cost Flow Assumption

FIFO cost flow is in the order in which the expenditures were made. FIFO assumes that items
acquired first should be sold first to customers. FIFO charges costs against revenue in the order in
which they were incurred. Hence:

 Inventory on hand assumed the most recent costs

 Inventory sold assumed the oldest or earliest costs
Ending Inventory in Units= 3,000- 2,400= 600 units

Cost of Ending Inventory (COEI)

200 Units * Br 13............................................Br 2,600

400 Units * Br 12.50.....................................5,000

COEI.....................................................................Br 7,600

Cost of Goods Sold (COGS)

500 units * Br 10.5........................................ Br 5,250

1800 units * Br 12......................................... 21,600

100 units * Br 12.5........................................1,250

COGS....................................................................Br 28,100

Cost of Goods Sold (The Alternative Method)

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COGS= Cost of Goods Available for Sale (COGAFS) − COEI

COGAS= Br 5,250 + 21,600 + 6,250 + 2,600= Br 35,700

COGS=Br 35,700 − 7,600

COGS=Br 28,100

FIFO-Advantage and Disadvantage

 Advantage-the merchandise inventory to be reported in the balance sheet approximates its

replacement cost
 Disadvantage-it matches old costs with current revenue

2. THE AVERAGE METHOD (Weighted Average Costing Method)

This cost flow is an average of the expenditure. It charges costs against revenue applying the
weighted average unit cost of the goods available for sale.

Weighted Average Unit cost = (U1*C1 + U2*C2 + U3*C3 + U4*C4 + ….) / Total Units

Weighted Average Unit cost = 500*10.5 + 1800*12 + 500*12.5 + 200*13

500 + 1800 + 500 + 200

Weighted Average Unit cost = Br 35,700 /3,000 = Br 11.90

Cost of Ending Inventory

 COEI= Br 11.90* 600 units = Br 7,140

Cost of Goods Sold

 COGS= Br 11.90* 2,400 units = Br 28,560

Cost of Goods Sold (The Alternative Method)

 COGS= COGAFS − COEI

 COGS=Br 35,700 − 7,140 = Br 28,560
Comparison of the two Methods:

Costing Method FIFO AVERAGE

COGAFS 35700 35700

COEI 7600 7140

COGS 28100 28560

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The higher the unit cost of ending inventory, the higher the total cost of ending inventory is, which
means the lesser the COGS. The lesser the unit COEI, the lesser the total COEI is, which means the
higher the COGS.

1.7 Inventory Costing Methods under Perpetual Inventory System

It is customarily to use the inventory cost flow assumption under perpetual inventory system, too.
Illustration4: take the data For BB Electronics above and compute the cost of Ending inventory
and cost of goods sold assuming that the company uses perpetual inventory system under: FIFO,
LIFO and AVERAGE cost flow assumption.

A) FIFO Cost Flow Assumption

Date Purchases Sold Inventory

Qty UC TC Qty UC TC Qty UC TC

Jan.1 500 10.5 5,250

Mar.31 300 10.5 3,150 200 10.5 2,100

Apr.1 1,800 12 21,600 200 10.5 2,100

1,800 12 21,600

June 30 200 10.5 2,100

400 12 4,800 1,400 12 16800

July 1 500 12.5 6,250 1,400 12 16,800

500 12.5 6,250

Sep.30 700 12 8,400 700 12 8,400

500 12.5 6,250

Oct.1 200 13 2,600 700 12 8,400

500 12.5 6,250

200 13 2,600

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Dec. 31 700 12 8,400 400 12.5 5,000

100 12.5 1,250 200 13 2,600

Total Br 28,100 Br 7,600

A) AVERAGE (Moving Average Cost)

Each time a purchase is made, new average cost will be computed and sales after that are made at
this new average unit cost.

Date Purchases Sold Inventory

Qty UC TC Qty UC TC Qty UC TC

Jan.1 500 10.5 5,250

Mar.31 300 10.5 3,150 200 10.5 2,100

Apr.1 1,800 12 21,600 2,000 11.85 23,700

June 30 600 11.85 7,110 1,400 11.85 16,590

July 1 500 12.5 6,250 1,900 12.02 22,840

Sep.30 700 12.02 8,414 1,200 12.02 14,426

Oct.1 200 13 2,600 1,400 12.16 17,026

Dec. 31 800 12.16 9,728 600 12.16 7,298

Total Br 28,402 Br 7,298

Comparison of the two Methods

FIFO Moving Average

COGAFS 35,700 35,700

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COEI 7,600 7,298

COGS 28,100 28,402

 The results of the FIFO method under both the periodic and perpetual inventory systems
produces the same result for cost of EI and Merchandise sold
 The perpetual inventory system provides the most effective means of control over this
important asset-merchandise inventory
2.6. Lower-of-Cost-or-Net Realizable Value (LCNRV)
Inventories are recorded at their cost. However, if inventory declines in value below its original
cost, a major departure from the historical cost principle occurs. Whatever the reason for a decline
—obsolescence, price-level changes, or damaged goods—a company should write down the
inventory to net realizable value to report this loss. A company abandons the historical cost
principle when the future utility (revenue-producing ability) of the asset drops below its
original cost.

Net Realizable Value

Recall that cost is the acquisition price of inventory computed using one of the historical cost-based
methods—specific identification, average cost, or FIFO. The term net realizable value(NRV) refers
to the net amount that a company expects to realize from the sale of inventory. Specifically, net
realizable value is the estimated selling price in the normal course of business less estimated costs
to complete and estimated costs to make a sale.

To illustrate, assume that Mander Corp. has unfinished inventory with a cost of $950, a sales value
of $1,000, estimated cost of completion of $50, and estimated selling costs of $200. Mander’s net
realizable value is computed as follows.

Inventory value—unfinished……………………….……. $1,000

Less: Estimated cost of completion …………..$ 50

Estimated cost to sell …………………………..200 (250)

Net realizable value ………………………………………$ 750

Mander reports inventory on its statement of financial position at $750. In its income statement,
Mander reports a Loss on Inventory Write-Down of $200 ($950 _ $750). A departure from cost is
justified because inventories should not be reported at amounts higher than their expected
realization from sale or use. In addition, a company like Mander should charge the loss of utility
against revenues in the period in which the loss occurs, not in the period of sale. Companies

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therefore report their inventories at the lower-of-cost-or-net realizable value (LCNRV) at each
reporting date.

Illustration 4: LCNRV

As indicated, a company values inventory at LCNRV. A company estimates net realizable value
based on the most reliable evidence of the inventories’ realizable amounts (expected selling price,
expected costs to completion, and expected costs to sell).

To illustrate, Regner Foods computes its inventory at LCNRV, as shown in below

Food cost Net Realizable Finale Inventory

Value Value

Spinach 80,000.00 120,000.00 80,000.00

Carrots 100,000.00 110,000.00 100,000.00

Cut beans 50,000.00 40,000.00 40,000.00

peas 90,000.00 72,000.00 72,000.00

Mixed Vegetables 95,000.00 92,000.00 92,000.00

Total Inventory Value 384,000.00

Final Inventory Value:

Spinach Cost ($80,000) is selected because it is lower than net realizable value.

Carrots Cost ($100,000) is selected because it is lower than net realizable value.

Cut beans Net realizable value ($40,000) is selected because it is lower than cost.

Peas Net realizable value ($72,000) is selected because it is lower than cost.

Mixed vegetables Net realizable value ($92,000) is selected because it is lower than cost.

As indicated, the final inventory value of $384,000 equals the sum of the LCNRV for each of the
inventory items. That is, Regner applies the LCNRV rule to each individual type of food.

2.6.1. Methods of Applying LCNRV

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In the Regner Foods illustration, we assumed that the company applied the LCNRV rule to each
individual type of food. However, companies may apply the LCNRV rule to a group of similar or
related items, or to the total of the inventory. For example, in the textile industry, it may not be
possible to determine selling price for each textile individually, and therefore it may be necessary to
perform the net realizable value assessment on all textiles that will be used to produce clothing for
a particular season.

If a company follows a group of similar-or-related-items or total-inventory approach in

determining LCNRV, increases in market prices tend to offset decreases in market prices. To
illustrate, assume that Regner Foods separates its food products into two major groups, frozen and
canned, as shown in Illustration 5 below

Illustration 5: Methods of Applying LCNRV

Food Cost Net Realizable Methods of LCNRV Applied

Value
Major Individual Major Total
group items groups inventory

Frozen Spinach 80,000.00 120,000. 80,000.0

00 0

Carrots 100,000.00 110,000. 100,000.0

00 0

Cut beans 50,000.00 40,000.0

0
40,000.00

230,000.0 270,000. 230,000.0

0 00 0
Total frozen

peas 90,000.00 72,000. 72,000.0

00 0

Mixed 95,000.00 92,000. 92,000.0

Vegetables 00 0

185,000.0 164,000. 164,000.

0 00 00
Total scanned

Total Inventory 415,000.00 384,000. 415,000.00

Value 434,000.00 00
scanned 394,000.00

If Regner Foods applied the LCNRV rule to individual items, the amount of inventory is $384,000. If
applying the rule to major groups, it jumps to $394,000. If applying LCNRV to the total inventory, it
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totals $415,000. Why this difference? When a company uses a major group or total-inventory
approach, net realizable values higher than cost offset net realizable values lower than cost. For
Regner Foods, using the similar-or related approach partially offsets the high net realizable value
for spinach. Using the total-inventory approach totally offsets it.

In most situations, companies price inventory on an item-by-item basis. In fact, tax rules in some
countries require that companies use an individual-item basis barring practical difficulties. In
addition, the individual-item approach gives the lowest valuation for statement of financial position
purposes. In some cases, a company prices inventory on a total-inventory basis when it offers only
one end product (comprised of many different raw materials). If it produces several end products, a
company might use a similar-or-related approach instead. Whichever method a company selects, it
should apply the method consistently from one period to another.

N:B The rationale for use of the individual-item approach whenever practicable is to avoid
realization of unrealized gains, which can arise when applying LCNRV on a similar-or related- item
approach (e.g., unrealized gains on some items offset unrealized losses on other items). In general,
IFRS prohibits recognition of unrealized gains in income.

Materials and other supplies held for use in the production of inventories are not written down
below cost if the finished products in which they will be incorporated are expected to be sold at or
above cost. However, a decline in the price of materials may indicate that the cost of the finished
products exceeds net realizable value. In this situation, the materials are written down to net
realizable value.

1.6.1. Recording Net Realizable Value Instead of Cost

One of two methods may be used to record the income effect of valuing inventory at net
realizable value. One method, referred to as the cost-of-goods-sold method, debits cost of
goods sold for the write-down of the inventory to net realizable value. As a result, the company
does not report a loss in the income statement because the cost of goods sold already includes
the amount of the loss. The second method, referred to as the loss method, debits a loss
account for the write-down of the inventory to net realizable value. We use the following
inventory data for Ricardo Company to illustrate entries under both methods.

Cost of goods sold (before adjustment to net realizable value) …………… $108,000

Ending inventory (cost) ………………………………………………………82,000

Ending inventory (at net realizable value) ……………………………………..70,000

To reduce inventory from cost to net Realizable value

Cost-of-Goods-Sold Method

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Cost of Goods Sold ………………………..12,000

Inventory…………………………………12,000

Loss Method

Loss Due to Decline of Inventory to Net Realizable Value ……12,000

Inventory ……………………………………12,000

The cost-of-goods-sold method buries the loss in the Cost of Goods Sold account. The loss
method, by identifying the loss due to the write-down, shows the loss separate from Cost of
Goods Sold in the income statement.

Illustration 6 contrasts the differing amounts reported in the income statement under the two
approaches, using data from the Ricardo example

IFRS does not specify a particular account to debit for the write-down. But the loss method
presentation is preferable because it clearly discloses the loss resulting from a decline in inventory
net realizable values.

1.6.1. Use of an Allowance

Instead of crediting the Inventory account for net realizable value adjustments, companies
generally use an allowance account, often referred to as the “Allowance to Reduce Inventory to Net
Realizable Value.” For example, using an allowance account under the loss method, Ricardo
Company makes the following entry to record the inventory write-down to net realizable value.

Loss Due to Decline of Inventory to Net Realizable Value…………… 12,000

Allowance to Reduce Inventory to Net Realizable Value………….. 12,000

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Use of the allowance account results in reporting both the cost and the net realizable value of the
inventory. Ricardo reports inventory in the statement of financial position as follows.

Inventory (at cost)……………………………………………….… $ 82,000

Allowance to reduce inventory to net realizable value……………… (12,000)

Inventory at net realizable value…………………………………….. $ 70,000

The use of the allowance under the cost-of-goods-sold or loss method permits both the income
statement and the statement of financial position to reflect inventory measured at $82,000,
although the statement of financial position shows a net amount of $70,000. It also keeps subsidiary
inventory ledgers and records in correspondence with the control account without changing prices.

2.6.2. Recovery of Inventory Loss

In periods following the write-down, economic conditions may change such that the net realizable
value of inventories previously written down may be greater than cost or there is clear evidence of
an increase in the net realizable value. In this situation, the amount of the write-down is reversed,
with the reversal limited to the amount of the original write-down.

Continuing the Ricardo example, assume that in the subsequent period, market conditions change,
such that the net realizable value increases to $74,000 (an increase of $4,000). As a result, only
$8,000 is needed in the allowance. Ricardo makes the following entry, using the loss method.

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Allowance to Reduce Inventory to Net Realizable Value ……….4, 000

Recovery of Inventory Loss ………………..($74,000 _ $70,000) 4,000

The allowance account is then adjusted in subsequent periods, such that inventory is
reported at the LCNRV.

3.7. Estimating Inventory Cost

For companies using a periodic inventory system taking physical inventory to prepare interim
financial reports is both expensive and time consuming. Therefore, such companies may use
estimated amount inventory balance in preparing monthly or quarterly financial statements. There
are two methods of inventory estimation: the retail method and the gross profit method.

1. Retail Method
It is used by retailers to estimate the cost of inventory on hand. Under this method:

 Records are kept for goods available for sale at both selling price (Retail Price) and at Cost
 Sales are recorded and total sales for accounting period are deducted from the total value
of goods available for sale to determine the ending inventory at selling price.
 The EI valued at selling price is changed to estimated cost by multiplying by the cost to
retail ratio
Illustration 8: the following data was extracted from MM Corporation for the month of March.

Items @ Cost @ Selling Price

Beginning Inventory Br 60,000 Br 100,000

Net Purchases 96,000 160,000

CMAS 156,000 260,000

Sales 180,000

Instruction: Estimate the cost of Ending Inventory by the Retail Method

 Cost to Retail Ratio = 156,000 / 260,000= 60%

 Beginning Inventory..................................................... 100,000
 Net Purchases..................................................................160,000
 CMAS................................................................................... 260,000
 Less: Sales.........................................................................(180,000)
 Ending Inventory@ Selling Price............................ 80,000
 Ending Inventory@ Cost = 60% * 80,000 =Br 48,000
2. The Gross Profit Method

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When the GP rate or percentage is known, the ending inventory can be estimated by the following
procedures:

 Determine the CMAS from the accounting records.

 Estimate the gross profit by multiplying the net sales by the GP rate.

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 Determine CMS by deducting the gross profit from the net sales
 Determine the estimated ending inventory by deducting CMS from the CMAS
Illustration 10: the following data is taken from MM Corporation as to one of its inventory

 Beginning Inventory............................................................. Br 20,000

 Net Purchases.......................................................................... 80,000
 Sales............................................................................................. 90,000
 Estimated Gross Profit Rate.............................................. 25%
Instruction: determine the estimated ending inventory

 Beginning Inventory............................................................. Br 20,000

 Net Purchases..........................................................................80,000
 Cost of Merchandise Available for Sales......................Br 100,000
 Less: COGS = Sales – Est. GP Rate
(Br 90,000 – 25% * 90,000)............................................... (67,500)

 Estimated Cost of Ending Inventory.............................. Br 32,500

2.7. The Effect of an Error in the Determination Inventory on the Financial Statements
Inventory determination plays an important role in matching expired costs with revenues of the
period. An error in the determination of the inventory amount at the end of the period will cause
the following errors:

 Misstatement of gross profit and net income

 The incorrect amount of inventory i.e. the inventory to be reported in the balance sheet is
incorrect amount.
Illustration 11: the effect of an error in the determination of ending inventory on the current
period for BB Company. You are given the following data for year I.

Net Sales for year I............................................................ Br 450,000

Beginning Inventory (January 1, Year I)................. 75,000

Net Purchases..................................................................... 420,000

Other Assets (December 31, Year I).......................... 310,000

Liabilities (December 31, Year I)................................ 225,000

Operating Expenses......................................................... 135,000

Instruction: Prepare Income Statement and Balance Sheet under the following assumption:

1. Ending Inventory is correctly stated at Br 220,000

2. Ending Inventory is incorrectly stated at Br 210,000
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Assumption 1: Ending Inventory is correctly stated at Br 220,000

Income Statement

BB Company

Income Statement

For the year ended December 31, Year I

Net Sales............................................................................ Br 450,000

Less: Cost Goods Sold..................................................

Beginning Inventory............................... 75,000

Net Purchases............................................ 420,000

CMAS.............................................................. 495,000

Less: Ending Inventory.......................... (220,000)

Cost of Goods Sold.................................... (275,000)

Gross Profit....................................................................... 175,000

Less: Operating Expenses.......................................... (135,000)

Net Income........................................................................ Br 40,000

BB Company

Balance Sheet

December 31, Year I

Merchandise Inventory...................... 220,000 Liabilities..................... 225,000

Other Assets............................................ 310,000 Capital........................... 305,000

Total Assets............................................. 530,000 Liabilities and OE..... 530,000

Assumption 2: COEI is incorrectly stated as Br 210,000 (Understated by Br 10,000)

Income Statement

BB Company

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Income Statement

For the year ended December 31, Year I

Net Sales Br 450,000

Less: Cost Goods Sold

Beginning Inventory 75,000

Net Purchases 420,000

CMAS 495,000

Less: Ending Inventory (210,000)

Cost of Goods Sold (285,000)

Gross Profit 165,000

Less: Operating Expenses (135,000)

Net Income Br 30,000

Balance Sheet

BB Company

Balance Sheet

December 31, Year I

Merchandise Inventory...................... 210,000 Liabilities..................... 225,000

Other Assets............................................ 310,000 Capital........................... 295,000

Total Assets............................................. 520,000 Liabilities and OE..... 520,000

The effects of understating Ending Inventory by Br 10,000 were as follows:

1. In the income statement

 It increases Cost of Goods Sold by Br 10,000
 It decreases Gross Profit by Br 10,000
 It decreases Net Income by Br 10,000 or increases Net Loss by Br 10,000
2. In the balance sheet
 It understates total assets by Br 10,000
 It understates Capital by Br 10,000
Ending Inventory Understated Overstated

Cost of Goods Sold Overstated Understated

Gross Profit Understated Overstated

Net Income Understated Overstated

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Total Assets Understated Overstated

Capital Understated Overstated

The understatement or overstatement of ending inventory does not only affect the financial
statement of one accounting period but also the financial statement of the subsequent period.

Illustration 12: The effect of an error in the determination of Ending Inventory in year I will have
the following impact on the financial statements of the subsequent accounting period. You are given
the following data for Year II:

Net Sales for Year II.......................................................... Br 600,000

Net Purchases..................................................................... 375,000

Ending Inventory............................................................... 150,000

Operating Expenses......................................................... 105,000

Other Assets (December 31, Year II)........................ 300,000

Total Liabilities (December 31, Year II).................. 110,000

Instruction: Prepare Income statement and balance sheet assuming that ending inventory of year I
are reported under the two assumptions above for BB Company

1. Beginning Inventory is Correctly Stated at Br 220,000

2. Beginning Inventory is incorrectly stated Br 210,000
Assumption 1: Beginning Inventory is correctly stated as Br 220,000

Income Statement

BB Company

Income Statement

For the year ended December 31, Year II

Net Sales............................................................................ Br 600,000

Less: Cost Goods Sold..................................................

Beginning Inventory............................... 220,000

Net Purchases............................................ 375,000

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CMAS.............................................................. 595,000

Less: Ending Inventory.......................... (150,000)

Cost of Goods Sold.................................... (445,000)

Gross Profit....................................................................... 155,000

Less: Operating Expenses.......................................... (105,000)

Net Income........................................................................ Br 50,000

Balance Sheet

BB Company

Balance Sheet

December 31, Year II

Merchandise Inventory...................... 150,000 Liabilities..................... 110,000

Other Assets............................................ 300,000 Capital........................... 340,000

Total Assets............................................. 450,000 Liabilities and OE..... 450,000

Assumption 2: Beginning Inventory is incorrectly stated at Br 210,000

Income Statement

BB Company

Income Statement

For the year ended December 31, Year II

Net Sales............................................................................ Br 600,000

Less: Cost Goods Sold..................................................

Beginning Inventory............................... 210,000

Net Purchases............................................ 375,000

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CMAS.............................................................. 585,000

Less: Ending Inventory.......................... (150,000)

Cost of Goods Sold.................................... (435,000)

Gross Profit....................................................................... 165,000

Less: Operating Expenses.......................................... (105,000)

Net Income........................................................................ Br 60,000

Balance Sheet

BB Company

Balance Sheet

December 31, Year II

Merchandise Inventory...................... 150,000 Liabilities..................... 110,000

Other Assets............................................ 300,000 Capital........................... 340,000

Total Assets............................................. 450,000 Liabilities and OE..... 450,000

The effects of understating Beginning Inventory by Br 10,000, on the income statement, were as
follows:

 It understates CMAS by Br 10,000

 It understates Cost of Goods Sold by Br 10,000
 It overstates Gross Profit by the Same amount Br 10,000
 It overstates Net Income by Br 10,000 or understates net loss by the same amount
Summary of errors in Beginning Inventory (Ending Inventory of the previous accounting period) on
the financial statement of the current of period are as follows:

Beginning Inventory Understated Overstated

CMAS Understated Overstated

Cost of Goods Sold Understated Overstated

Gross Profit Overstated Understated

Net Income Overstated Understated

 If inventory amount is stated incorrectly in one period, the effect is limited to the period of the
error and the following period only.

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 If there is no additional error, both total assets and owner’s equity will be correct during the
following period.
 The balance sheet will not be affected by the error of the previous period
 The error of one accounting period set-off against the error of the subsequent period. The
overstatement of items in the income statement of one accounting period will result in
understatement of items in the subsequent in the subsequent period-set off.
2.8. Disclosure Requirements
IAS 2 sets forth certain disclosure requirements relative to inventory accounting methods
employed by the reporting entity. According to this standard, the following must be disclosed:

Balance sheet related disclosures:

• Carrying amount in each category of inventory (materials, WIP, finished goods, production
supplies, merchandise) and in total
• Carrying amount of any inventory measured at fair value less costs to sell
• Carrying amount of inventory pledged as collateral for liabilities
Income statement related disclosures:

• Amount of inventory recognized as an expense (usually cost of sales/cost of goods sold)

• Amount of write-downs to NRV or other losses
• Amount of any write-down reversals

DEPARTMENT OF ACCOUNTING AND FINANCE-OSU Page 95