INVENTORIES

INTRODUCTION
In the last section of Principles of Accounting I, you have learned about the principles
and practices of accounting for receivables – one of the current asset items in the balance
sheet of a retail business. In this unit you will learn and discuss the concepts in
accounting for inventories.

Inventories are asset items held for sale in the ordinary course of business or goods that
will be used or consumed in the production of goods to be sold. They are mainly divided
into two major:
 Inventories of merchandising businesses
 Inventories of manufacturing businesses

i. Inventories of merchandising businesses are merchandise purchased for resale

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

 Raw material inventory

 Work in process inventory
 Finished goods inventory

1. Raw material inventory -is the cost assigned to goods and materials on hand but not
yet placed into production. Raw materials include the wood to make a chair or other
office furniture’s, the steel to make a car etc.
2. Work in process inventory-
inventory- is the cost of raw material on which production has been
started but not completed, plus the direct labor cost applied specifically to this material
and allocated manufacturing overhead costs.
3. Finished goods inventory- is the cost identified with the completed but unsold units on
hand at the end of each period.

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In this unit only the determination of the inventory of merchandise purchased for resale
commonly called merchandise inventory will be discussed.

1.2 IMPORTANCE OF INVENTORIES

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

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

2. The cost of merchandise sold is the largest deductions from sales.
3. Inventories (ending inventories) are the largest of the current assets or those
firms.

Because of the above reasons inventories, have effects on the current and the following
period’s financial statements. If inventories are misstated (understated of overstated), the
financial statements will be distorted.

1.3 THE EFFECTS OF INVENTORIES ON CURRENT AND FOLLOWING

PERIOD’S FINANCIAL STATEMENTS.
STATEMENTS.

1.3.1 Effect of ending inventory on current period’s financial statements

Ending inventory is the cost of merchandise on hand at the end of accounting period. Let
us see its effect on current period’s financial statements.
Income statement

a. Cost of goods (merchandise) sold =Beginning inventory +

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

b. Gross Profit = Net sales – Cost of merchandise sold

Here, the cost of merchandise sold had indirect relationship to gross profit. So, the effect
of ending inventory on gross profit is the opposite of the effect on cost of merchandise

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sold. That is, if ending inventory is understated, the gross profit will be understated and if
ending inventory is overstated, the gross profit will be overstated. This is a direct
(positive) relationship.

c. Operating income = Gross Profit – Operating Expenses

Gross profit and operating income have direct relationships. Thus, the effect of ending
inventory on net income is the same as its effect on gross profit, i.e. direct (positive)
effect (relationship).

Balance Sheet
1. Current assets - Ending inventory is part of current assets, even the largest. So, it
has a direct (positive) relationship to current assets. If ending inventory balance is
understated (overstated), the total current assets will be understated (overstated).
Since current assets are part of total assets, ending inventory has direct
relationship to total assets.

2. Liabilities-
Liabilities- No effect on liabilities. Inventory misstatement has no effect on
liabilities.

3. Owners’ equity – The net income will be transferred to the owners’ equity at the
end of accounting period. Closing income summary account does this. So, net
income has direct relationship with owners’ equity at the end of accounting
period. The effect-ending inventory on owners’ equity is the same as its effect on
net income, i.e. if ending inventory is understated (Overstated), the owners’ equity
will be understated (Overstated).
1.3.2 Effects of beginning inventory on current period’s financial statements
Beginning inventory is inventory balance that was left on hand in the previous period and
transferred to the current period. Its effect is summarized below:

Income Statement
1. Cost of merchandise sold= Beginning inventory + Net Purchases – Ending
inventory
As you see, beginning inventory is an addition in determining cost of goods sold.
It has direct effect on cost of merchandise sold. That is, if the beginning inventory

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 is understated (Overstated), the cost of merchandise sold will be understated
(Overstated)

2. Gross Profit= Net Sales – Cost of merchandise sold

The effect of beginning inventory on gross profit is the opposite of the effect on
cost of merchandise sold, i.e. indirect (negative) relationship. If the beginning
inventory is understated, the gross profit will be overstated and if it is overstated,
the gross profit will be understated.

3. Net income = Gross Profit – Operating expenses

The effect of beginning inventory on net income is the same as its effect on gross
profit.

Balance sheet
1. Current assets – The inventory included in current assets is the ending inventory.
So, beginning inventory has no effect on current assets.

2. Owners’ equity-
equity- If the effect comes from the previous year, the beginning
inventory will not have an effect on ending owners’ equity since the positive or
negative effect of the previous year will be netted off by the negative or positive
effect of the current year. But if the error is made in the current period, it will have
indirect effect on ending owners’ equity.

1.3.3 Effect of ending inventory on the following period’s financial statements

The ending inventory of the current period will become the beginning inventory for the
following period. So, it will have the same effect as beginning inventory of the current
period. Let us summarize it.
Income statement of the following period
Cost of merchandise sold direct relationship
Gross profit indirect relationship
Net income indirect relationship

Balance sheet of the following period

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The ending inventory of the current period will not have an effect on the following
period’s balance sheet items.

Illustration - 1
The following amounts were reported in Belay Company’s financial statements for three
consecutive fiscal year ended December 31.

2000 2001
2002
a) Cost of merchandise sold Br. 130,000 Br. 154,000 Br.
140,000
b) Net income 40,000 50,000
42,000
c) Total Current assets 210,000 230,000 200,000
d) Owner’s equity 234,000 260,000
224,000

In making the physical counts of inventory, the following errors were made:
 Inventory on December 31,2000, under stated by Br. 12,000
 Inventory on December 31, 2001, overstated by Br. 6000

Required:
Determine the correct amount of the items listed above.

Solution
2000 2001 2002
a) Cost of merchandise sold:
sold:
Reported Br. 130,000 Br. 154,000 Br.
140,000
Adjustment of
2000 error (12,000) 12,000
_

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 2001 error _ 6,000
(6,000)
Corrected Br. 118,000 Br. 172,000 Br.
136,000
b) Net income:
Reported Br. 40,000 Br. 50,000 Br.
42,000
Adjustment of
2000 error 12,000 (12,000)
_
2001 error _ (6,000)
(6,000)
6,000
Corrected Br. 52,000 Br. 32,000 Br.
48,000

c) Total current assets:

Reported Br. 210,000 Br. 230,000 Br.
200,000
Adjustment of
2000 error 12,000 _
_
2001 error _ (6,000)
(6,000)
_
Corrected Br. 222,000 Br. 224,000 Br.
200,000

d) Owner’s equity:
Reported Br. 234,000 Br. 260,000 Br.
224,000
Adjustment of
2000 error 12,000 _
_

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 2001 error _ (6,000)
_
Corrected Br. 246,000 Br. 254,000 Br.
224,000

1.4 INVENTORY SYSTEMS: PERIODIC VS PERPETUAL

There are two principal systems of inventory accounting periodic and perpetual.

1.4.1 Periodic inventory system

Under this system there is no continuous record of merchandise inventory account. The
inventory balance remains the same through out the accounting period, i.e. the beginning
inventory balance. This is because when goods are purchased, they are debited to the
purchases account rather than merchandise inventory account.

The revenue from sales is recorded each time a sale is made. No entry is made for the
cost of goods sold. So, physical inventory must be taken periodically to determine the
cost of inventory on hand and goods sold.

The periodic inventory system is less costly to maintain than the perpetual inventory
system, but it gives management less information about the current status of merchandise.

This system is often used by retail enterprises that sell many kinds of low unit cost
merchandise such as groceries, drugstores, hardware etc.

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

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 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

1.4.2 Perpetual inventory system

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

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

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 Merchandise inventory XX at cost
Accounts payable/cash XX
To record cost of goods sold

2. At the time of sale of merchandise

Accounts receivable or cash XX at retail
price
Sales XX
To record cost of goods sold

To record the sales

Cost of goods sold XX
Merchandise inventory XX at cost
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
In its beginning inventory on Jan 1, 2002, NINI Company had 120 units of merchandise
that cost Br. 8 Per unit. The following transactions were completed during 2002.
February 5 Purchased on credit 150 units of merchandise at Br. 10 per unit.
9 Returned 20 detective units from February 5 purchases to the supplier.

June 15 Purchased for cash 230 units of merchandise at Br 9 per unit.

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

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

Required: Prepare general journal entries for NINI Company to record the above
transactions and adjusting or closing entry for merchandise inventory on December 31,
a) Periodic inventory system
b) Perpetual inventory system
Solution
a) February 5 Purchases (150 x Br.10)
1,500
Account payable

1,500
9 Accounts payable (20 x Br. 10)
200
Purchase returns and allowances

200
June 15 Purchases (230 x Br. 9)
2,070
Cash

2,070
September 6 Cash (220 x Br. 15)

3,300
Sales

3,300
December 31 To record or close the merchandise inventory account
Income summary (120 x Br. 8)
960
Merchandise inventory (beginning)

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 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

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)

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 = Br. 960 + Br. 1,000 = Br. 1,960
Cost of merchandise sold 1,960
Merchandise inventory 1,960

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

1.5 DETERMINING ACTUAL QUANTITIES IN THE INVENTORY

The physical count of inventory is needed under both inventory systems. Under periodic
inventory system, it is needed to determine the cost of inventory and goods sold.
The inventory account under a perpetual inventory systems is always up to date. Yet
events can occur where the inventory account balance is different from inventory on
hand. such events include theft,, loss, damage, and errors. The physical count (some times
called “taking an inventory”) is used to adjust the inventory ac count balance to the actual
inventory on hand.

We determine a birr (dollar) amount for physical count of inventory on hand at the end of
a period by:
(1) Counting the units of each product on hand
(2) Multiplying the count for each product by its cost per unit
(3) Adding the cost for all products

At the time of taking an inventory, all the merchandise owned by the business on the
inventory date, and only such merchandise, should be included in the inventory. The
merchandise owned by the business may not necessarily be in the warehouse. They may
be in transit.

The legal title to the merchandise in transit on the inventory date is known by examining
purchase and sales invoices of the last few days of the current accounting period and the
first few days of the following accounting period. This legal title depends on shipping
terms (agreements).

There are two main types of shipping terms. FOB shipping point and FOB destination

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 (1) FOB shipping point
point- the ownership title passes too the buyer when the goods are
shipped (when the goods are loaded on the means of transportation, i.e. at the
seller’s point). The purchaser is responsible for freight charges.
(2) FOB destination – the title passes to the buyer when the goods arrive at their
destination, i.e. at the buyer’s point.

So, in general, goods in transit purchased on FOB shipping point terms are included in
the inventories of the buyer and excluded from the inventories of the buyer and excluded
from the inventories of the seller. And goods in transit purchased on FOB destination
terms are included in the inventories of the seller and excluded from the inventories of
the buyer.

There are also a problem with goods on consignment at the time of taking and inventory.
Goods on consignment to another party (agent) called the consignee. A Consignee is to
sell the goods for the owner usually on commission are included in the consignor’s
inventories and excluded from the consignee’s inventories.

1.6 SUMMARY

Inventories are goods held for sale in the ordinary course of business or goods that will be
used or consumed in the production of goods to be sold. They are included in the current
asset section of the balance sheet.

Goods purchased and sold are the most active elements in the merchandising businesses
due to many reasons. Because of this reason, they have significant effects on the current
and the following period’s financial statements.

There are two principal systems of inventory accounting periodic and perpetual. In the
periodic system, only the revenue from sales is recorded at the time the sale is made no
entry is made until the end of the period to record the merchandise inventory and the cost
of goods sold. In the perpetual inventory system, sales and cost of merchandise sold are
recorded at the time each sale is made. In this way, the accounting records continuously
disclose the amount of inventory on hand.

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The first step in “taking an inventory” is to count the merchandise on hand. To this count
is added merchandise in transit that is owned. Therefore, it is normally necessary to
examine purchases and sales invoices of the last few days of the accounting period and
the first few days of the following period to determine who has legal title to merchandise
in transit on the inventory date.

DETERMINING THE COST OF INVENTORY

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2.1 INTRODUCTION

This chapter is the continuation of the previous chapter, in which we have discussed the
meaning and concepts of inventory. In this chapter, we will discuss the determination of
the cost of inventory.
Costs included in merchandise inventory are those expenditures necessary, directly or
indirectly, to bring an item to a salable condition and location. In other words, cost of an
inventory item includes its invoice price minus any discount, plus any added or incidental
costs necessary to put it in a place and condition for sale. Added or incidental costs can
include import duties, transportation-in, storage, insurance against losses while the goods
are in transit, and costs incurred in an aging process(for example, aging of wine and
cheese).

Minor costs that are difficult to allocate to specific inventory items may be excluded from
inventory cost and treated as operating expenses of the period. This is based on
materiality principle or the cost-to –benefit constraint.

2.2 INVENTORY COSTING METHODS UNDER PERIODIC INVENTORY

SYSTEM

One of the most important decisions in accounting for inventory is determining the per
unit costs assigned to inventory items. When all units are purchased at the same unit cost,
this process is simple since the same unit cost is applied to determine the cost of goods
sold and ending inventory. But when identical items are purchased at different costs, a
question arises as to what amounts are included in the cost of merchandise sold and what
amounts remain in inventory. A periodic inventory system determines cost of
merchandise sold and inventory at the end of the period. We must record cost of
merchandise sold and reductions in inventory as sales occur using a perpetual inventory
system. How we assign these costs to inventory and cost of merchandise sold affects the
reported amounts for both systems.

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There are four methods commonly used in assigning costs to inventory and cost of
merchandise sold. These are:

 Specific identification
 First-in first-out(FIFO)
 Last-in first-out (LIFO)
 Weighted average

Let us see these costing methods under periodic inventory system based on the following
illustration

Illustration:
Beza Company began the year and purchased merchandise as follows:
Jan-1 Beginning inventory
80 units@ Br. 60 = Br. 4,800
Feb. 16 Purchase 400 units@ 56 = 22,400
Sep.2 Purchase 160 units @ 50 = 8,000
Nov. 26 Purchase 320 units@ 46 = 14,720
Dec. 4 Purchase 240 units@ 40 = 9,600
Total
1200 units Br.59,
Br.59, 520

The ending inventory consists of 300 units, 100 from each of the last three purchases.

2.2.1 Specific Identification Method

When each item in inventory can be directly identified with a specific purchase and its
invoice, we can use specific identification (also called specific invoice pricing) to assign
costs. This method is appropriate when the variety of merchandise carried in stock is
small and the volume of sales is relatively small. We can specifically identify the items
sold and the items on hand.

Example

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From the above illustration, the ending inventory consists of 300 units, 100 from each of
the last purchases. So, the items on hand are specifically known from which purchases
they are:

Cost of ending inventories under specific identification method

Br. 40 x 100
= Br. 4,000
Br. 46 x 100
= 4,600
Br. 50 x 100
= 5,000

300units Br. 13,600

 Cost of Ending inventory cost = Br. 13,600

 The cost of merchandise sold = Cost of goods available for sale - Ending inventory
= Br. 59,520 – Br. 13,600
= Br. 45,920

2.2.2 First-in, First-out (FIFO)

This method of assigning cost to inventory and the goods sold assumes inventory items
are sold in the order acquired. This means the cost flow is in the order in which the
expenditures were made. So, to determine the cost of ending inventory, we have to start
from the most recent purchase and continue to the next recent. Because the first
purchased items (old purchases) are the first to be sold they are used (included) in the
computation of cost of goods sold.

For example, easily spoiled goods such as fruits, vegetables etc., must be sold near the
time of their acquisition. So, the inventory on hand will be from the recent purchases. As
an example, consider the previous illustration on page 21.

The cost of ending inventory under FIFO method

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 = Br. 40 x 240
Br. 9,600
= Br. 46 x 60
2,760

300 units Br. 12,360

‡ Cost of Ending inventory Br. 12,360

‡ Cost of merchandise sold = Br. 59,520 – Br. 12,360

Br. 47,160

2.2.3 Last-in first-out (LIFO)

This method of assigning cost assumes that the most recent purchases are sold first. Their
costs are charged to cost of goods sold, and the costs of the earliest purchases are
assigned to inventory. The cost flow is in the reverse order in which expenditures were
made.

In calculating the cost of goods sold, we will start from the earliest purchases.

As an example, take the previous illustration

The cost-ending inventory under FIFO method
=Br.60 x 80 = Br. 4,800
=Br. 56 x 220 = 12,320
300 units
Ending inventory cost = Br. 17,120
Cost of merchandise sold = Br. 59,520 – Br. 17,120
= Br. 42,400

2.2.4 Weighted Average Method

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This method of assigning cost requires computing the average cost per unit of
merchandise available for sale. That means the cost flow is an average of the
expenditures.

To calculate the cost of ending inventory, we will calculate first the cost per unit of goods
available for sale

Average cost per unit = Cost of goods available for sale

Total units available for sale

Then the weighted average unit cost is multiplied by units on hand at the end of the
period to calculate the cost of ending inventory. Also, the same average unit cost is
applied in the computation of cost of goods sold.

As an example, take the previous illustration

Weighted average unit cost = Br. 59,520 = Br. 49.60
1,200

‰ Ending inventory cost = Br. 49.60x 300

= Br. 14,880

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

= Br. 44,640

2.3 COMPARISON OF INVENTORY COSTING METHODS

If the cost of units and prices at which they are sold remains stable, all the four methods
yield the same results. But if prices change, the three methods usually yield different
amounts for:

- Ending inventory
- Cost of merchandise sold
- Gross profit or net income
In periods of rising (increasing) prices: (or if there is inflationary trend):

FIFO yields – higher ending inventory

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 _ Lower cost of merchandise sold
_ Higher gross profit (net income)

LIFO yields _ Lower ending inventory

_ Higher cost of merchandise sold
_ Lower gross profit (net income)

‰ Weighted average yields the results between the two.

In periods of declining (decreasing) prices:

FIFO yields _ Lower ending inventory

_ Higher cost of merchandise sold
_ Lower gross profit or net income

LIFO yields_
yields_ higher ending inventory
_ Lower cost of merchandise sold
_ Higher gross profit or net income
‰ Weighted average- between the two

2.4 INVENTORY COSTING METHODS UNDER PERPETUAL INVENTORY SYSTEM

Under perpetual inventory systems we will apply the inventory costing methods each
time sale of merchandise is made. We calculate the cost of goods (merchandise) sold and
inventory on hand at the time of each sale. This means the merchandise inventory account
is continually updated to reflect purchase and sales.

Illustration:
The beginning inventory, purchases and sales of Nesru Company for the month of
January fare as follows:

Units Cost
Jan. 1 Inventory

20
 12 Br. 10.00
6 Sale

5
10 purchase

10 Br. 12.00
20 Sale

8
25 purchase

8 Br. 12.50
27 Sale

10
30 purchase

15 Br. 14.00

2.4.1 First-in first-out Method

The assignment of costs to goods sold and inventory using FIFO is the same for both the
perpetual and periodic inventory systems. Because each withdrawal of goods is from the
oldest stock on hand. The oldest is the same whether we use periodic inventory system or
perpetual inventory system.

Let us calculate the cost of goods sold and ending inventory under perpetual inventory
system from the above illustration.

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 Perpetual - FIFO
Date Purchase Cost of merchandise sold Inventory
Qty. Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Jan. 1 15 Br. 10.00 Br. 150.00
6 5 Br. 10.00 Br. 50.00 10 10.00 100.00
10 10.00 100.00
10 10 Br. 12.00 Br.120.00 10 12.00 120.00

20 8 10.00 80.00 2 10.00 20.00

10 12.00 120.00
2 10.00 20.00
25 8 12.50 100.00 10 12.00 120.00
8 12.50 100.00
27 2 10.00 20.00 2 12.00 24.00
8 12.00 96.00 8 12.50 100.00
2 12.00 24.00
30 15 14.00 210.00 8 12.50 100.00
5 14.00 210.00
23 Br. 246.00 25 Br. 334.00

So, the cost of merchandise sold and ending inventory under perpetual- FIFO method are
Br. 246 and Br. 334 respectively.
Let us see them under periodic - FIFO method:
Units on hand = units available for sale – units sold
= (15 + 10 + 8 + 15 ) – ( 5+ 8 + 10 )
= 48 - 23 = 25

Cost of ending inventory = Br. 14 x 15 = Br. 210

Br. 12.50 x 8 = 100
Br. 12 x 2 = 24

Br. 334

Cost of goods available for sale = Br. 120 + Br. 100 + Br. 210 = Br. 580
Cost of goods sold = Br. 580 – Br. 334

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 Br 246

So, the same results of cost of gods sold and ending inventory under both periodic
inventory systems.

2.4.2 Lasting, First-Out method

Unlike FIFO method, different results may occur under periodic and perpetual inventory
system. The most recent purchases change when new purchase occurs.

Let us calculate first the cost of goods sold and ending inventory for the above illustration
under perpetual inventory system. Then, we will see the results under periodic inventory
system.
Perpetual - LIFO
Date Purchase Cost of merch. Sold Inventory
Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Jan. 1 15 Br. 10.00 Br. 150.00
6 5 Br. 10.00 Br. 50.00 10 10.00 100.00
10 10 Br. 12.00 Br. 120.00 10 10.00 100.00
10 12.00 120.00
20 8 Br. 12.00 Br. 96.00 10 10.00 100.00
2 12.00 24.00
25 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
8 12.50 100.00
27 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
30 15 14.00 210.00 10 10.00 100.00
15 24.00 210.00
23 Br. 270.00 25 Br. 310.00
So, the cost of merchandise sold and ending inventory under perpetual inventory system
are Br. 270 and Br. 310 respectively.
The results under periodic inventory system are:
Cost of ending inventory = Br. 10 x 15 = Br. 150
Br. 12 x 10 = 120
25 Br. 270

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 Cost of merchandise sold = Br. 580 - 270
= Br. 310
As you see, the results are different under periodic & perpetual inventory systems.
2.4.3 Weighted average cost method.
Under this method, the average unit cost is calculated each time purchased is made to be
applied on the sales made after the purchases. The results may be different under periodic
and perpetual inventory system.
Let us calculate the cost of merchandise sold and ending inventory comes out from the
previous illustration under perpetual inventory system.
Average Cost Method (Moving Average)
Purchase Cost of merchandise sold Inventory
Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Date

Jan. 15 Br. 10.00 Br. 150.00

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

27 10 11.60 116.00 10 11.60 116.00

30 15 14.00 210.00 15 13.04 326.00
116+210
10+15
23 Br. 254.00 25 Br. 13.04 Br 326.00

So, the cost of goods sold and ending inventory under perpetual inventory system are Br.
254.00 and Br. 326.00, respectively.

The results under periodic inventory system are:

Weighted average unit cost = Br. 580 = Br. 12.08

24
 48
Ending inventory cost = Br. 12.08 x 25
= Br. 302
Cost of merchandise sold = Br. 580 – Br. 302
= Br. 278
So, the result is different under periodic and perpetual inventory systems.

2.5 SUMMARY

The cost of merchandise inventory is made up of the purchase price and all expenditure
incurred in acquiring such merchandising including transportation, customs duties, and
insurance against losses in transit.

Under periodic inventory system, in determining the cost of merchandise sold and the
inventory at the end of the period, it is customary to use an assumption as to the flow of
costs of merchandise through an enterprise. The four methods of costing an inventory are
specific identification, FIFO, LIFO and weighted average of which the last three are the
cost flow assumptions. The FIFO method of costing inventory is based on the assumption
that costs should be charged against revenue in the order in which they were incurred.
The LIFO method is based on the assumption that the most recent costs incurred should
be charged against revenues. The weighted average method is based on the assumption
that costs should be charged against revenue according to the weighted average unit costs
of the goods sold.

If the cost of units and the prices at which they are sold remain stable, all three inventory
costing methods will yield the same results. However, during a period of rising prices, the
use of FIFO method will result in a higher amount of gross profit than the other two
methods. In a period of declining prices, the use of LIFO method will result in a higher
amount of gross profit than the other two methods. The average cost method is often
viewed as a compromise between the FIFO and LIFO methods.

25
Under a perpetual inventory system, costs are assigned to the cost of merchandise sold
account each time a sale occurs. Specific identification assigns a cost to each item sold by
referring to its actual cost. Weighted average assigned a cost to items sold by taking the
current balance in the merchandise inventory account and dividing it by the total items to
determine the weighted average cost per unit.

ADDITIONAL VALUATION PROBLEMS FOR INVENTORIES

3.1 INTRODUCTION

26
An attempt has been made in this unit to explain valuation of inventory valuation and the
problems such as valuation at lower of cost or market, retail method and gross profit
method of estimating an inventory cost.

3.2 VALUATION AT LOWER OF COST OR MARKET (LCM)

It was explained how costs are assigned to ending inventory and cost of goods sold using
one of four costing methods (FIFO, LIFO, Weighted average, or specific identification).
Yet, the cost of inventory is not necessarily the amount always reported on a balance
sheet. Accounting principles require that inventory be reported at the market value of
replacing inventory when market is lower than cost. Merchandise inventory is then said
to be reported on the balance sheet at the lower of cost or market (LCM).

In applying LCM, cost is the acquisition price of inventory computed using one of the
historical cost methods - specific identification, FIFO, LIFO, and Weighted average;
market is defined as the current market value (cost) of replacing inventory. It is the
current cost of purchasing the same inventory items in the usual manner. It is important to
know that market is not defined as the sales prices. A decline in market cost reflects a loss
of value in inventory. This is because the recorded cost of inventory is higher than the
current market cost. When this occurs, a loss is recognized. This is done by recognizing
the decline in merchandise inventory from recorded cost to market cost at the end of the
period.

LCM is applied in one of three ways:

(1) Separately to individual item
(2) To major categories of items
(3) To the whole of inventory

The less similar the items are that make up inventory, the more likely it is that companies
apply LCM to individual items. Advances in technology further encourage the individual
item application.

Illustration

27
The following are the inventory of ABC motor sports, retailer.
Inventory
units
per unit
Items on hand
cost market
Cycles:
Roadster 50
Br. 15,000 Br. 14,000
Sprint
20 9,000
9,500

Off Road:
Trax-4
10 10,000
11,200
Blaz’m
6 16,000
14,500

Let us see LCM computation under the three ways:

(1) Separately to each individual item

Inventory items Total cost

Total market LCM

Roadster Br. 750,000

Br. 700,000
Br. 700,000

28
 Sprint 180,000
190,000
180,000
Categories sub total Br. 930,000
Br. 890,000
Trax-4 100,000
112,000
100,000
Blaz’m 96,000
87,000
87,000
Categories sub total Br. 196,000
Br. 199,000
Totals Br.1,126,000
Br.1,126,000
Br. 1,089,000
Br. 1,1,067,000

(2) Major categories of items

Inventory Categories
Categories
LCM
categories total cost
total market
Cycles Br. 930,000
Br. 890,000
Br. 890,000
Off. Road 196,000
199,000
199,000
Totals Br. 1,126,000
Br. 1089,000
Br. 1,086,000

29
When LCM is applied to the whole of inventory, the market cost is Br. 1,089,000. Since
this market cost is Br. 37,000 lower than Br. 1,126,000 recorded cost, it is the amount
reported for inventory on the balance sheet. When LCM is applied to individual items of
inventory, the marked cost is Br. 1,067,000. Since market is again less than Br. 1,126,000
cost, it is the amount reported for inventory. When LCM is applied to the major
categories of inventories, the market is Br. 1,086,000 which is also lower than cost.

3.3 ESTIMATING INVENTORY COST

In practice, an inventory amount is estimated for some purposes. When it is impossible to

take a physical inventory or to maintain perpetual inventory records.

Example
1) Monthly income statements are needed. It may b e too costly, to take physical
inventory. This is especially the case when periodic inventory system is used.
2) When a catastrophe such as a five has destroyed the inventory. In such case, to ask
claims from insurance companies, the is a need of estimated inventory.

To estimate the cost of inventory, two methods are used. These are retail method and
gross profit method.

3.3.1 Retail method of inventory costing

This method is mostly used by retail business. The estimate is made based on the relation
ship between the cost and the retail price of merchandise available for sale.

The steps to be followed are:

(1) Calculate the cost to retail ratio = Cost of merchandise available for sale
Retail Price of merchandise available for sale

(2) Calculate the ending inventory at retail price

Ending inventory at retail price = retail price of merchandise available for sale –
Sales

(3) Calculate the estimated cost of ending inventory

30
 Estimated cost of ending inventory = Cost to retail ration X Ending inventory at
retail

Example

Cost
Retail
Sep. 1, beginning inventory Br. 25,000
Br. 40,000
Purchases in September (net) 125,000
160,000
Sales in September (net)
140,000

(1) Cost retail ration = Br. 25,000 + Br. 125,000 = 0.75

Br. 40,000 + Br. 160,000

(2) Ending inventory at retail = (Br. 40,000 + Br. 160,000) – Br. 140,000 = Br. 60,000
(3) Estimated ending inventory at cost = 0.75 X Br. 60,000

= Br. 45,000

3.3.2 Gross profit method

This method uses an estimate of the gross profit realized during the period to estimate the
cost of inventory. The gross profit rate may be estimated based on the average of previous
period’s gross profit rates.

The steps are as follows:

(1) The gross profit rate is estimated and then estimated gross profit is calculated.
Estimated gross profit = Gross profit rate X Sales

(2) Cost of merchandise sold is estimated

Estimated cost of merchandise sold = Sales - Estimated gross profit

31
(3) Calculate the estimated cost of ending inventory
Estimated cost of ending inventory =
Cost of merchandise available for sale – Estimated cost of merchandise sold.

Example

Oct. 1, beginning inventory (cost) – Br. 36,000

Net purchases during October (cost) 204,000
Net sales during October 220,000
Estimated gross profit rate is 40%

The ending inventory is estimated as follows:

(1) Estimated gross profit = 0.4 X 220,000
= Br. 88,000
(2) Estimated cost of merchandise sold
= Br. 220,000 – Br. 88,000
= Br. 132,000
(3) Estimated cost of ending inventory
= (Br. 36,000 + 204,000) – Br. 132,000
= Br. 240,000 – Br. 132,000
= Br. 108,000

3.4 SUMMARY

If the market price of an item of inventory is lower than its cost, the lower of cost or
market method is used to value inventory. Market, as used in the phrase lower of cost or
market; is interpreted to mean the cost to replace merchandise on the inventory date. It is
possible to apply the lower of cost or market basis to each item in the inventory, to major
classes or categories, or to the inventory as a whole.
When it is impractical or impossible to take a physical inventory or to maintain perpetual
inventory records, two commonly used methods of estimating inventory would be
applied:
1) the retail method and

32
 2) the gross profit method
The retail method of inventory estimation is based on the relation ship of the cost of
merchandise available for sale to the retail prices of the same merchandise. The inventory
at retail is determined by deducting net sales for the period from the retail price of the
goods that were available for sale during the period. The inventory at retail is then
converted to cost on the basis of the ratio of cost to selling price of the merchandise
available for sale.
The gross profit method of estimating inventory is based upon the historical relationship
of the gross profit to the sales. The rate of gross profit is multiplied by the sales to
determine the gross profit. To determine the cost of merchandise sold, the gross profit is
then subtracted from sales. The estimated cost of ending inventory is computed by
subtracting the cost of merchandise sold from cost of merchandise available for sale
ACCOUNTING FOR PLANT ASSETS AND DEPRECIATION

4.0 AIMS AND OBJECTIVES

This unit aims at discussing the meaning and nature of plant assets, acquisition costs, and
the related cost allocation (depreciation) of plant assets. The units also discuss the
different methods of computing depreciation and the accounting procedures involved in
recording the transactions relating to disposal of plant assets.

After having studied and worked through this unit, you will able to be:
 determine the acquisition c cost of tangible assets
 compute depreciation for plant assets using various depreciation methods
 record depreciation expense in the accounting records
 distinguish expenses from expenditures that should be capitalized
 differentiate depreciation for financial reporting from depreciation for income tax

4.1 INTRODUCTION

In the previous chapter you have learnt about the accounting for current assets (i.e.
accounting for cash, receivables and inventories). In this chapter you will learn about the
issues of plant assets and its related depreciation.

33
Most business enterprise holds such major assets as land, buildings, equipments,
furnitures, tools, and etc. These assets help produce revenue over many periods by
facilitating the production and sale of goods or services to customers. Because these
assets are necessary in a company’s day-to-day operations, companies do not sell them in
the ordinary course of business. Keep in mind, though; one company’s long-term asset
might be another company’s short-term asset. For example, a delivery truck is a long-
term asset for most companies, but a truck dealer would regard a delivery truck as a
current asset merchandise inventory.

4.2 NATURE AND MEANING OF LONG-TERM ASSETS

Assets that can be used by a business enterprise for relatively long period (usually more
than one year) are called Long-Term Assets.
Assets.

Long-term assets are divided into tangible and intangible categories.

Tangible assets (also called plant assets or fixed assets) are assets with physical substance
that can be charged in the operations of business for a relatively longer period of time,
usually more than one year or one operating cycle whichever is longer. Examples are
land, buildings, equipments and machineries, trucks, etc.

In contrast, intangible assets are assets without a physical feature that can be charged in
the operations of business for long period of time. They generally consist of rights or
advantages held such as goodwill, patents, copyrights, franchise, trade marks,
organization costs, etc.

4.3 DETERMINATION OF THE ACQUISITION COST OF PLANT ASSETS

The acquisition cost of plant (fixed) assets is the cash or cash-equivalent purchase price,
including incidental costs required to complete the purchase, to transport the asset, and to
prepare it for use.

For example, expenditures related to the acquisition of a plant asset such as freight,
insurance while in transit, and installation are included in the cost of the asset because
they are necessary if the asset is to function. According to the matching principle,

34
therefore, such costs are allocated to the economic life of the asset rather than charged as
expenses in the current period.

Land
The acquisition cost of land includes the negotiated cash price plus other costs such as the
cost of land surveys, legal fees, title fees, broker’s commissions, co9st of preparing the
land to build on, and even the demolition costs of old structures that might be torn down
to get the land ready for its intended use.

Under the historical cost assumption, land is reported in the balance sheet at its original
cost. Land is not subjected to depreciation because land does not have a limited useful
life.

The following illustration will help us how to determine the cost of land.

Illustration-1
A business enterprise acquires a piece of land for future site. It pays a cash price of Br.
210,000, pays brokerage fees of Br. 7500 and title fees of Br. 3000, pays Br. 5000 to have
unwanted building removed, and pays, Br. 1500 to have the site graded. The business
receives

Br. 2000 salvage from the old building. The cost of the land is determined as follows:
Cash prices (negotiated price)…………………………………………Br.
210,000.00
Title
Fees……………………………………………………………………..3,000.00
Brokerage
Fees………………………………………………………………...7,500.00
Cost of Grading……………………………………………………………..…
1,500.00
Cost of removing (demolition) unwanted building Br. 5000
Less: Salvage received……………………………….(2000)…………………
3,000.00

35
 Total cost of land…………………………………………………… .….Br.
.….Br.
225,000.00

Generally, land is part of property, plant and equipment. If the major purpose of acquiring
and holding land is speculative, it is more appropriately classified as an investment. If the
land is held on a real estate concern for resale, it should be classified as inventory. When
the land has been purchased for the purpose of constructing a building, all costs incurred
up to the excavation for the new building are considered land costs. Removal of old
buildings clearing, grading and filling are considered land costs because these costs are
necessary to get the land in condition for its intended purpose. Any proceeds obtained in
the process of getting the land ready for its intended use, such as salvage receipts on the
demolition of an old building are treated as reductions in the price of the land.

Cost of buildings
When an existing building is purchased its cost includes, the purchase price plus all
repairs and other expenses required to put it in a usable conditions. On the other hand,
when a business constructs a new building, the cost includes all reasonable and necessary
expenditures, such as those for materials, labor, part of the overhead and other indirect
costs, engineers and architects’ fees, insurance during construction, interest incurred on
construction loans during the period of construction, lawyers' fees, and building permits.
If outside contractors are used in the construction, the net contract price plus other
expenditures necessary to put the building in usable condition are included.

Cost of equipment
The term “ equipment” in accounting includes office equipment, store equipment, factory
equipment, delivery equipment, machinery, furnitures and fixtures, and similar fixed
assets. The cost of such assets includes the invoice (purchase) price, transportation and
handling charges, insurance on the equipment while in transit, assembling and installation
costs, and costs of conducting trail runs. As indicated earlier, all costs of getting an asset
ready for its intended use are costs of that asset.

4.4 NATURE AND MEANING OF DEPRECIATION

36
As plant assets are used in the operations of a business, their value to provide service
decreases through usage and the passage of time.

This cost allocation of plant asset, called depreciation,

depreciation, is recorded in the accounting
books periodically.

Depreciation is frequently misunderstood. The term depreciation, as used in accounting,

does not refer to the physical deterioration of an asset or the decrease in market value of
an asset overtime.

Depreciation means the allocation of the cost of a plant asset to the periods that benefit
from the services of the asset.
The term depreciation is used to describe the gradual conversion of the cost of the asset
into an expense.

Depreciation is not a process of valuation.

valuation. Ac counting records are kept in accordance
with the cost principle; they are not indicators of changing price levels. It is possible that,
through an advantageous buy and specific market conditions the market value of a
building may rise. Nevertheless, depreciation must continue too be recorded because it is
the result of an allocation, not a valuation process.

4.5 FACTORS THAT AFFECT THE COMPUTATION OF DEPRECIATION

Four factors affect the computation of depreciation. They are:

(1) Cost
(2) Residual value
(3) Depreciable cost, and
(4) Estimated economic (useful) life.

Cost- is the net purchase price plus all reasonable and necessary expenditures to get the
asset in place and ready for use.

37
Residual value- also known as salvage value,
value, disposal value, scrape value, or trade-in
value represents the estimated market value of the asset at the time of its retirement.

Depreciable cost - represents the difference between the asset cost and its estimated
residual value. For example, an item of equipment that costs Br. 5000 and has a residual
value of Br. 500 would have a depreciable cost of Br. 4500, (Br. 5000 - Br. 500). The
depreciable costs must be allocated over the estimated economic life of the asset.

Estimated economic (useful) life- the estimated economic life of an asset is the total
number of service units expected from the asset. Service units may be measured in terms
of years the asset is expected to be used, units expected to be produced, miles or
kilometers expected to be driven, or similar measures. In determining the estimated
useful life of an asset, the accountant should consider all relevant information, including
(1) past experience with similar repair assets, (2) the asset’s present condition, (3) the
company’s repairs and maintenance policy, (4) current technological and industry trends,
and (5) local conditions such as whether.

4.6 METHODS OF COMPUTING DEPRECIATION

Depreciation methods differ primarily in the amount of cost allocated to each period. A
list of depreciation amounts for each year of an asset’s useful life is called depreciation
schedule.
schedule.
The most common methods of computing depreciation for plant assets are:
(1) The straight line method
(2) The units of production method
(3) The double-declining balance method, and
(4) The sum-of- the years-digits method.

4.6.1 Straight-Line Depreciation

When this method is used to allocate depreciation, the depreciable cost of the asset is
spread evenly (uniformly) over the useful life of an asset. The straight-line method is
based on the assumption that depreciation depends only on the passage of time. The
depreciation expense for each period is computed by dividing the depreciable cost by the

38
 number of accounting periods in the asset’s estimated useful life. The depreciation
expense to be reported is the same in each year. The following illustration will help us to
understand the Straight-Line method of computing depreciation.

Illustration - 2
Suppose, for example a business enterprise acquires a new computer (office equipment)
at a cost of Birr 6000. It is estimated that the computer has an estimated residual value of
Birr 1000 at the end of its estimated useful life of 4 years. The yearly (annual)
depreciation would be Birr 1250m computed as follows:

Annual depreciation = Cost - Salvage value

Estimated useful life

= Birr 6000 – Birr 1000 = Birr 1250

4 years
The depreciation to be reported for each of the four years would be as follows:

Depreciation Method- Straight-Line Method

Year Cost Yearly Accumulated Carrying value
Depreciation Depreciation (Book Value)
Beginning of first year Br. 6000 - - Br. 6000.00
End of first year 6000 Br. 1250.00 Br. 1250.00 4750.00
End of second year 6000 1250.00 1250.00 3500.00
End of third year 6000 1250.00 3750.00 2250.00
End of fourth year 6000 1250.00 5000.00 1000.00

NB.
NB. There are three important points to note from the depreciation schedule for the straight-line
depreciation method. First, the depreciation is the same each year. Second, the accumulated
depreciation increases uniformly. Third, the carrying (Book) value decreases uniformly until it
reaches the estimated residual value.

4.6.2 Units of Production Method

The production method of depreciation is based on the assumption that depreciation is
mainly the result of use and that the passage of time plays no role in the depreciation

39
 process. If we assume that the office equipment from the previous illustration has an
estimated useful life of 10,000 hours, the depreciation cost per hour would be determined
as follows:

Hourly depreciation = Cost – Salvage value = Br. 6000.00 – 1000 = Br.

0.50
Rate Estimated units of useful life
10,000 operating hrs.
If we assume that the use of the equipment was 2800 hours for the first year, 3600 hours
for the second, 2400 hours for the third, and 1200 hours for the fourth, the depreciation
schedule for the office equipment would appear as follows:

Depreciation Schedule – Production Method

Year Cost Hours Depreciation Yearly Accum. Carrying value

Per Hour Depr. Depr. (Book value)
Beginning of the Br. 6,000 - Br. 0.50 - - Br. 6,000.00
First year
End of first year 6,000 2,800 0.50 Br. 1,400.00 Br. 1,400.00 4,600.00
End of second year 6,000 3,600 0.50 1,800.00 3,200.00 2,800.00
End of third year 6,000 2,400 0.50 1,200.00 4,400.00 1,600.00
End of fourth year 6,000 1,200 0.50 600.00 5,000.00 1,000.00

Under the production method, there is a direct relation between the amounts of
depreciation each year and the units of output or use. Also, the accumulated depreciation
increases each year indirect relation to units of output or use. Finally, the carrying amount
decreases each year in direct relation to units of output or use until it reaches the
estimated residual value.

Under the production method, the units of output or use that is used to measure estimated
useful fife for each asset should be appropriate for that asset. For example, for one
machine number of units produced may be an appropriate measure, for another number of
hours may be a better measure. The production method should be used only when the
output of an asset over its useful life can be estimated with reasonable accuracy.

4.6.3 Declining Balance Method

40
 This method of depreciation results in relatively large amount of depreciation in the early
years of an assets life and smaller amounts in later years. This method is based on the
assumption of the passage of time. Since most kinds of plant assets are most efficient
when new, and so they provide more and better service in the early years of useful life. It
is consistent with the matching rule to allocate more depreciation to the early years than
to later years if the benefits or services received in the early years are greater.

The declining-balance method is the most common accelerated method of depreciation.

Under this method depreciation is computed by applying a fixed rate to the book value of
the asset, resulting in higher depreciation charges during the early years of the asset’s life.
Though any fixed rate might be used under the method, the most common rate is a
percentage equal to twice the straight-line percentage. When twice the straight-line rate is
used, the method is usually called the double-declining balance method.
method.

Referring to the previous example, the equipment had an estimated useful life of four
years. Consequently, under the straight-line method, the depreciation rate for each year
was 25 percent, (100/ estimated useful life of the asset for 100/ 4 years).

Therefore, under the double-declining balance method, the fixed rate is 50 percent (2X 25
percent). This fixed rate of 50 percent is applied to the remaining carrying value at the
end of each year. Estimated residual value is not taken into account in computing
depreciation except in the last year of an asset’s useful life, when depreciation is limited
to the amount necessary to bring the carrying value down to the estimated residual value.
The depreciation schedule for this method is as follows:

Depreciation Schedule, Double-Declining Balance Method

Year Cost Fixed Depr. Yearly Accumulated Carrying Value

Rate Depreciation Depreciation (BV)
Date of purchase Br. 6000 50% - - Br. 6000

41
End of first year 6000 50% Br. 3000 Br. 3000 3000
End of Second year 6000 50% 1500 4500 1500
End of third year 6000 50% 750 5250 750
End of fourth year 6000 50% 250 550 500
NB. The fixed rate of 50% is always applied to the Book value at the end of the previous
year. The depreciation is greatest in the first year and declines each year after that.
Finally, the depreciation in the last year is limited to the amount necessary to reduce book
value to residual value, Br. 250 = Br. 750 – Br. 500 (i.e. Previous book value minus
residual value).

4.6.4 The Sum of The Years Digits Method

Like the declining balance method, the sum of the years digits method provides a higher
amount of periodic depreciation expense in the earlier use of the asset's life and a decline
depreciation expense thereafter because a successively smaller fraction is applied each
year to the depreciable cost of the asset. Under this method, first we must determine the
denominator of the fraction, which is the sum of the digits representing the years of life.
While computing depreciation, the denominator of the fraction is unchanged and would
remain the same. On the other hand the numerator of the fraction, decreases year by year
(4/10,3/10/2/10/1/10). At the end of the asset’s useful life, the balance remaining should
be equal to the salvage value. For example, for a plant asset with an estimated life of 4
years, the denominator of the fraction is 4+3+2+1 = 10. The depreciation schedule for
this method is as follows:

Depreciation Schedule- Sum - of - the - Years - Digits Method

Year Depreciable Rate Yearly Accumulated Book Value
Cost Depreciation Depreciation
Date of purchase Br6000 - - - Br. 6000
End of first year 6000 4/10 Br. 2200 Br. 2200 3800
End of second year 6000 3/10 1650 3850 2150
End of third year 6000 2/10 1100 4950 1050
End of fourth year 6000 1/10 550 5500 500

42
NB.
NB. The above illustration for the sum of year’s digit method is based on the assumption
that the first use of the asset concide with the beginning of the fiscal period. When the
first use of the asset does not concide with the beginning of a fiscal year, it is necessary to
allocate each full year’s depreciation b/n the two fiscal years benefited. Assuming that the
asset in the example was placed in service after four months of the fiscal year had been
elapsed, the depreciation for that fiscal year would be Br. 1466.67 computed as follows:

First year depreciation = 4/10 X (6000 – 500) X 8/12…………………. Br. 1466.67

Therefore, the depreciation for the second year would be ….Br. 1833.33
Computed as follows:

= 4/10 X (6000 – 500) X 4/12……………….. Br. 733.33

= 3/10 X (6000 – 500) X 8/12……………………. 1100.00

Total, second fiscal year depreciation…………………………… Br. 1833.33

4.7 COMPARISON OF DEPRECIATION METHODS

The straight-line depreciation provides a uniform or equal depreciation charges to

expense throughout the service life of the asset.

The production method of depreciation provides for periodic charges to depreciation

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

The major limitation of the production method is that it is not appropriate in situation in
which depreciation is a function of time instead of activity. Another problem in using the
production method is that an estimate of units of output or service hours received is often
difficult to determine.

Both the declining balance and the sum of the years digits methods are referred to as
accelerated depreciation methods, because they provides (report) relatively higher
depreciation expense in the earlier uses of the life of the asset and a gradually declining
periodic expense thereafter.

43
The main justification for this approach is that more depreciation should be charged in
earlier years because the asset suffers its greatest loss of services in those years.
Accelerated depreciation method also recognizes that changing technologies make some
equipment lose their capacity to yield services rapidly. Thus, it is appropriate to allocate
more to depreciation in the early years, than in later years.

Another argument in favor of an accelerated method is that repair (maintenance) expense

is likely to be greater in later years than in early years. Thus, the reduced amounts of
depreciation reported in later years of the asset’s life are offset to some extent by
increased repair (maintenance) expense.

A visual comparison may provide a better understanding of the three-depreciation

methods disc ribe above. Figure 4-1 compares the yearly depreciation under the four
methods.

300
Graphical Comparison of three methods
of
Yearly 2500 determining depreciation
Depreciation
2000

1500 SLD

1000
SYD
500
DDBD

1
2 3 4

44
In the above graph that shows yearly depreciation, straight-line depreciation is uniform at
Birr 1375 per year over the four years period. However, the declining balance method
begins at an amount greater than straight line (Br.3000) and decreases each year to
amounts that are less than straight line (ultimately, Br. 250). The production method does
not generate a regular pattern because of the random fluctuation of the depreciation from
year to year. In general companies use different methods of deprecation for goods reason.
The straight-line method can be advantageous for financial reporting because it can
produce the highest net income, and the accelerated depreciation method can be
beneficial for tax purposes because it can result in lower income taxes.

4.8 RECORDING DEPRECIATION

The amount by which a fixed asset decreases is an expense of the business. The amount
of depreciation expense should be recorded each fiscal period. If depreciation expense is
not recorded, the income statement will not contain all the expenses of the business. This
will cause the net income to be reported higher than it should be. Income tax laws allow a
business to deduct depreciation as an expense in determining net income. If depreciation
expenses are not included on the income tax reports, the business will pay more income
taxes than it should be.

Depreciation may be recorded by an entry a t the end of each month, or the adjustment
may be delayed until the end of the year.

To record the periodic cost expiration (allocation) of plant asset, the expense account,
depreciation expense is debited and the part of the entry that records the decrease in the
plant asset is credited to a contra asset account entitled Accumulated Depreciation or
Allowance for Depreciation. The use of this contra asset account permits the original cost
to remain unchanged in the plant asset account. This facilitates the computation of
periodic depreciation, the listing of both cost and accumulated depreciation on the
balance sheet, and reporting required for property and income tax purposes.
NB. An exception to the general procedure of recording depreciation monthly or annually is often
made when a plant asset is sold, traded-in, or discarded.

45
Illustrative Problem
TORA-BORA Construction Company acquired a new crane for Birr 360,500 at the
beginning of year 1. The crane has an estimated residual value of Birr 35,000 and an
estimated useful life of five years. The crane is expected to last 10,000 operating hours. It
was used 1800 hours in year 1, 2000 hours in year 2. and 2500 hours in year 3. Based on
the information given above:

1) Compute the annual depreciation and the carrying value for the crane for each of
the first three years under each of the following methods:
a) Straight line method,
b) Units of production method,
c) Double-declining-balance method, and
d) Sum-of-the-years-digits method.

2) Prepare the adjusting entry that would be made each year to record the
depreciation calculated under the straight line method.

Solution:
1) a) Straight Line Method:
Annual depreciation = original cost – estimated salvage value
Estimated Economic life

= Br. 36,500 – Br. 35,000

5 years

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

5
Therefore, deprecation for the first year, second year, and for the third year, is uniformly
Br. 65,100.

46
 b) Units of Production Method:
Hourly Depreciation Rate = Original Cost – Salvage value
Estimated Operating Hours

= Br. 360,500 – 35,000

10,000 operating hours

= Br. 32.55

During the first year the crane has been in operation for 1800 hours. Therefore, the
depreciation for the first year is Br. 58,590, computed as follows:

Br. 32,55 X 1800 hours = Br. 58,590

Second year deprecation = Br. 32.55 X 2000 hours = Br. 65,100

Third year depreciation = Br. 32.55 X 2500 hours = Br. 81,375

c) Double-declining- balance Method:

To proceed with the double-declining-balance method, first we have to determine the
rate. The double-declining rate for the asset can be obtained by the following formula:

Rate = 100 X2
Estimated
Life

Rate = 100 2 = 40%

5 years

Unlike the other methods, in the declining-balance method the salvage value is not
deducted in computing the depreciation base. The declining balance rate is multiplied b y
the book value of the asset at the beginning of each period. Therefore,

First year depreciation = 40/100 X 36,500 = Br. 144,200

47
 Second year deprecation = 40/100 X (360,500 – 144,200)
= 40/100 X 216,300 = Br.
Br. 86,520

Third year depreciation = 40/100 (360,500 – 230,720)

= 0.4 X 129,780 = Br. 51,912

d) Sum-of-the-years-digits Method
To work with this method, we must determine the denominator of the fraction,
The denominator or the fraction for an asset with an estimated economic life of 5 years is
5+4+3+2+1 = 15

 Depreciation for year 1 is therefore, 5/15 x (OC – Salvage value)

 Which is 5/15x (325,500) = Br. 108,500
 Second year depreciation = 4/15 x (325,500) = Br. 86,800
 Third year depreciation= 3/15 x 325,500 = Br. 65,100

4.9 SPECIAL DEPRECIATION METHODS

Some times each of the four depreciation methods discussed so far may not b e suitable
because the assets involved have unique characteristics, or the nature of the industry
requires that a special depreciation method be use of these methods, the group and
composite methods are discussed below:
4.9.1 Group and Composite Methods
Depreciation methods are usually applied to a single asset. Under some circumstances,
however, a number (group) of asset accounts are depreciated using one rate. For example,
an enterprise such as Ethiopian Telecommunication Corp. might depreciate telephone
poles, microwave systems, or switchboards by groups.

Group depreciation - the term “group” refers to a collection of assets that are similar in
nature. The group method is frequently used when the assets are fairly homogeneous and
have approximately the same useful lives. The group method more closely approximates
a single-unit cost procedure because the dispersion from the average is not as great.

48
Composite-rate depreciation - the term “composite” refers to collection of assets that are
not similar (or dissimilar) in nature.

The composite method is used when the assets are heterogeneous and have different
lives.
When depreciation is computed on the basis of a composite group of assets of differing
life spans, a rate based on averages must be developed. This is done by (1) computing the
annual depreciation for each asset, (2) determining the annual depreciation, and (3)
dividing the sum thus determined by the total cost of the assets.

Illustration - 3
TANA Transport share Co. depreciates its group of cars, buses, and trucks on the basis of
composite-depreciation method. The composite-rate depreciation is computed in the
following manner:
Original Residual Depreciable
Estimated Annual Dep.
Asset Cost Value Cost Life (straight line method)
method)

Cars Br.400,000 Br. 80,000 Br. 320,000

8 years Br. 40,000
Buses 2,400,000 240,000 2,160,000 10 years
216,000
Trucks 1,500,000 150,000 1,350,000 9 years
150,000
Br. 4,300,000 Br. 470,000 Br. 3,830,000
Br. 406,000

Composite depreciation rate = Br. 406,000 = 9.44%

Br. 4,300,000

If no change exists in the asset account, the group of assets will be depreciated to the
residual or salvage value at the rate of Br. 406,000 (Br. 4,300,000 x 9.44%) a year.

The composite depreciation rate may be applied against total asset cost on a monthly
basis, or some reasonable assumption may be made regarding the timing of increases and

49
decreases in the group. A common practice is to assume that all additions and retirements
have occurred uniformly throughout the year. The composite rate is then applied to the
average of the beginning and ending balances of the account. Another acceptable
averaging technique is to assume that all additions and retirements during the first-half of
the year occurred as of the first day of the year, and that all additional and retirements
during the second half of the year occurred on the first day of the following year.

NB. If an asset within the composite group is retired before, or after, the average service
life of the group is reached, the resulting gain or loss should not be recognized. This
practice is justified because some assets will be retired (disposed) before the average
service life of the group and others after the average life. For this reason, the debit to
Accumulated Depreciation is the difference between original costs and cash received.

Illustration - 4
Suppose that TANA Transport share Co. in the previous example, sold one of the trucks
with the cost of Br. 75,000, at a selling price of Br. 40,000, at the end of the fourth year.
Therefore, the entry to record the disposal would be:

Solution:
Original cost of the asset………………………………………..Birr 75,000
Less:
Less: cash receipts from sale of asset………………………………..40,000
Accumulated Depreciation of the asset…………………………Birr 35,000

Accumulated Depreciation……………35,000
Cash…………………………………...40,000
Cars, Buses, and Trucks……………….75,000

4.10
4.10 REVISION OF DEPRECIATION RATES

When a plant asset is acquired, depreciation rates are carefully determined based on past
experience with similar assets and other relevant information. The provisions for
depreciation are only estimates, however, and it may be necessary to revise the estimated

50
economic life and that of salvage value during the life of the asset. Unexpected physical
deterioration or unforeseen obsolescence may make the useful life of the asset less than
originally estimated. Good maintenance procedures, revision of operating procedures, or
similar improvements may prolong the life of the asset beyond the original estimate.

Illustration - 5
Assume that a delivery truck originally acquired for Br. 75,000 is estimated to have a 16-
year life with a residual value of Br. 3000. However, after 10 years of intensive use, it is
determined that the delivery truck will last only 4 more years, (instead of 6 years) but its
estimated residual value at the end of the four years will be Br. 6000, (instead of Br.
3000).

Solution:
Before the revision of the estimated life and the residual value of the asset at the
beginning of the 11th year, the asset ac count and its related accumulated depreciation
account would appear as shown below:
Delivery Trucks
Accumulated Depr- Delivery Truck

Cost 75,000
45,000 Balance at the
end of the 10th Year

After the revision, at the beginning of the 11 th year, the remaining depreciable cost and
the revised annual depreciation by the straight-line method are computed as follows.

Original Cost of the truck…………………………………………….Birr 75,000

Less:
Less: Accumulated depreciation already taken………………………………… 45,000

51
 Remaining cost of the delivery truck…………………………………Birr 30,000
Less:
Less: Revised estimated salvage value…………………………………………...6,000
value…………………………………………...6,000
Revised annual depreciation 30,000 - 6000
4 years …………………….Birr
…………………….Birr 6,000

The new annual periodic depreciation expense is computed by dividing the revised
depreciable cost of Br. 24,000 by the remaining revised useful life of 4 years. Therefore,
the new periodic depreciation charge is Br. 6000. The annual adjusting entry for
depreciation for the next two years would be as follows:

Year 11
Dec. 31, Depreciation Expense - Delivery Truck………………..6000
Accumulated Depreciation - Delivery Truck………………6000
Year12
Dec. 31 Depr. Expense-Truck…………………………….6000
Accum. Depreciation-Truck……………………………60000

Depreciation of partial years

So far, the illustrations of the depreciation methods have assumed that the plant assets
were purchased at the beginning or end of the accounting period. However, business does
not often buy assets exactly at the beginning or end of the accounting period. In most
cases, they acquire the assets when they are needed and sell or discard them when they
are no longer useful or needed. The time of year is normally not a factor in the decision.
Thus, it is often necessary to calculate depreciation for partial years.

Illustration - 6
Assume that a piece of equipment is purchased for Br. 5000 and that it has an estimated
useful life of five years, and an estimated residual value of Br. 500. Assume further that
the equipment is purchased on October 2 and that the yearly accounting period ends on
December 31. Depreciation must be recorded for three months, October through
December, or 3/12 of a year. This factor is applied to the calculated depreciation for the

52
entire year. The three months’ depreciation under the straight-line method is calculated as
follows:

Solution:
Annual depreciation = Original cost – Estimated Salvage value
Estimated useful life

= Br. 5000 – Br. 500 = Birr 900

5 years

Depreciation for partial year (Oct – Dec. 31) is therefore, Br. 900 x 3/12 = Br. 225

If the company used the double declining balance method on the above equipment, the
depreciation on the asset would be: Br. 5000 x 40/100 x 3/12, = Br. 500, depr. For three
months,

If the company used the sum-of-years-digits method, the depreciation on the asset would
be:

Birr (5000 – 500) x 5/15 x 3/12 = Birr 375,

375, and the depreciation for the second year
would be:

(5000 – 500) x 5/15 x 9/12 =

Br. 1125
(5000 – 500) x 4/15 x 3/12 =
300
Therefore, total 2nd year depreciation Br. 1425

NB.
NB. In this specific example depreciation was recorded from the beginning of October. If
the equipment had been purchased on October 16, or thereafter, depreciation would be
calculated beginning November 1, as if the equipment were purchased on that date.

4.11 CAPITAL AND REVENUE EXPENDITURES

Capital Expenditures-
Expenditures- are expenditures that improve the operating efficiency (or
capacity) or costs incurred to achieve greater future benefits.

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In addition to the acquisition of plant assets, capital expenditures included additions and
betterments.

An addition is an enlargement to the physical layout of a plant asset. Suppose for

example, if a new wing is added to a building, the benefits from the expenditure will be
received over several years, and the amount paid for it should be debited to the asset
account.

A betterment, on the other hand, is an improvement that does not add to the physical
layout of the asset. Installation of an air conditioning system is an example of betterment,
Replacement of a concrete floor for a wooden floor is also betterment that will provide
benefits over a number of years, so its cost should be charged (debited) to an asset
account.

Another types of capital expenditures include extraordinary repairs.

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

Extraordinary repairs are recorded by debiting the accumulated depreciation account,

under the assumption that some of the depreciation previously recorded has now been
eliminated. The effect of this reduction in the accumulated depreciation account is to
increase the book value of the asset by the cost of the extraordinary repair. As a result, the
new book value of the asset should be depreciated over the new estimated useful life.

Illustration - 7
Suppose for example, a machine costing Br. 35,000 had no estimated residual value and
an original estimated useful life of ten years, has been depreciated for 7 years. At the very
beginning of the 8th year, the machine was given a major overhaul costing Br. 3000. This
expenditure extended the useful life of the machine 3 years beyond the original estimate.

54
The computation of the new book value and the entry for the extraordinary repair would
be as follows:

Solution
To record extraordinary repair
Jan. 4. Accumulated Depreciation – Machinery……………3000.00
Cash …………………………………………………………3000.00
Extraordinary repair to machinery

The revised annual depreciation for each of the six years remaining in the machine’s
useful life would be calculated as follows:
Cost of Machine……………………………………… Birr 35,000
Accum. Depreciation before extraordinary repair Br. 24,500
Less: extraordinary repair (Debited to Accum. Depr.)….3000
Depr.)….3000 21,500
Book value (carrying value) after extraordinary repair… Br.13,500
Revised Annual periodic depreciation= 13500……………………….
13500……………………….2,250
2,250
6 years

Revenue expenditures
Revenue expenditures are expenditures incurred in order to maintain the normal
operating efficiency of the asset.

Among the more usual kinds of revenue expenditures for plant asset are the repairs,
maintenance, lubrication, Cleaning and inspection necessary to keep an asset in good
working condition.

Ordinary repairs are expenditures that are necessary to keep an asset in good operating
conditions. Trucks must have tune-ups, their tires and batteries must be replaced
regularly, and other routine repairs must be made. Offices and halls must be painted
regularly, and broken tiles or woodwork must be replaced. Such repairs benefits only the
current period and therefore must be charged against the revenue in the current fiscal
period.

55
4.12 SUMMARY

Almost all business enterprises of any size or activity use assets of a durable nature. Such
assets, commonly refereed to as property, plant, and equipment, plant assets, or fixed
assets, support the operating activities in every business organization, instead of being a
part of the operating activities. Such assets include land, building, and equipments
(machinery, furniture, tools).

The major characteristics of plant (or fixed) assets are:

1) they are acquired for use in the operations of a business, they are not intended for
resale purpose. If the business holds them for resale they are categorized under the
caption 'Inventories', in the balance sheet.
2) they are long-term in nature and usually subject to depreciation long-term assets
are capable of repeated usage in the operating activities of the business, and
3) they posse’s physical features.

One of the big issues in accounting for plant assets is the determination of cost. The
acquisition cost of a plant asset includes the cash or cash equivalent purchase price of
obtaining the asset and bringing it to the location and condition necessary for its intended
use.

Cost of Land: Includes the negotiated cash price plus other costs such as the cost of land
surveys, legal fees, broker’s commissions, title fees, cost of preparing the land to build
on, and the cost of tearing-down (or razing) old building, and any expenditures associated
with the acquisition of land that are necessary to get the land ready for its intended use.

Cost of buildings:
buildings: Includes the purchase price plus all repairs and other expenses
requited to put it in a usable condition. When a business constructs a new building, the
cost includes all reasonable and necessary expenditures, such as materials, labor, part of
the overhead and other indirect costs, engineers and architects’ fees, insurance during
construction period, lawyers fees, and building permits.

Cost of Equipments:
Equipments: Includes the invoice price, transportation and handling costs,
insurance on the equipment while in transit, assembling and installation costs, and costs
of conducting test (trail) runs.

56
As plant assets are used in the operation of a business, their value to provide services
decreases through usage and the passage of time. This cost allocation of plant asset
through usage and the passage of time are called depreciation.
depreciation.

Depreciation is frequently misunderstood. The term doesn’t refer to the decrease in

market value of an asset overtime; no it is a process of valuation. Instead, the term is used
to describe the gradual conversion of the cost of the asset into an expense account. Four
factors affect the computation of depreciation. They are:

(1) cost, (2) residual value, (3) depreciable cost, and (4) estimated
useful life of the asset. Business may be different methods to compute
depreciation
The most common methods of computing depreciation for plant assets are (1) straight
line method, (2) production method, (3) double-declining balance method, and (4) sum-
of-years-digits method.

After the determination of periodic depreciation, the amount of depreciation expense

should be recorded each fiscal period by debiting the depreciation expense and crediting
a contra asset account called Accumulated Depreciation. The use of this contra asset
account permits the original cost to remain unchanged in the plant asset account.

Sometimes each of the four depreciation methods may not be appropriated because the
assets involved have unique characteristics or the nature of the industry requires that a
special depreciation method be used. Of these methods, the group and composite methods
are often used by business enterprises.

When a plant asset is acquired, deprecation rates area carefully determined based on past
experience with similar assets and other relevant information, however, it may be
necessary to revise the estimated economic life and that of salvage value during the life
of the asset. Unexpected physical deterioration or unforeseen obsolescence may make the
useful life of the asset less than originally estimated. Good maintenance procedures,
revision of operating procedures, or similar improvements may prolong the life of the
asset beyond the originals estimate.

57
After plant assets are acquired and ready for use, additional costs are incurred that range
from ordinary repairs to significant additions. The major problem is allocating these costs
to the proper time periods. These costs are divided into two major categories: capital, and
revenue expenditures.

Capital expenditures are expenditures that improves the operating capacity (or efficiency)
or expenditure that increases the useful life of the asset beyond the original estimate. The
most common capital expenditures are (1) additions, (2) betterments, and (3)
extraordinary repairs.

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

58
 DISPOSAL OF PLANT ASSETS

5.0 AIMS AND OBJECTIVES

This unit aims at discussing the meaning of disposing of plant assets, the different ways
of disposing plant assets, and the accounting procedures involved in recording
transactions relating to the discarding sale and exchange of plant or (fixed) assets.

After going through this unit, you will be able to;

- understand the concept of disposing of plant assets.
- examine the different ways of disposing of plant assets.
- analyze and record the transactions involving the discarding, sale,
and exchange of plant assets.
- Differentiate accounting for financial reporting from accounting
for income tax with respect of exchange of plant assets.

5.1 INTRODUCTION

So far we have seen how to account for property, plant, and equipment assets, from
calculating acquisitions cost to depreciating this cost up to the end of the asset’s useful
life. Plant assets, such as equipment, delivery trucks, or machineries cannot be used
forever. The assets may wear out or the business may replace them with newer model.
When a plant asset is no longer useful to a business the asset may be disposed of either
through discarding, sale, or traded-in with similar) or dissimilar) assets. This chapter
therefore, is presented this concept in detail.

5.2 DISPOSALS OF PLANT ASSETS

A plant asset rarely lasts exactly as long as its estimated life. If it lasts longer than its
estimated life, it is not depreciated past the point at which its carrying value equals its
residual value. The purpose of depreciation is to spread the depreciable cost of the asset
over the economic life of the asset. Thus, the total accumulated depreciation should never
exceed the total depreciable cost. If the asset is still used in the business beyond the end
of its estimated life, its cost and accumulated depreciation remain in the ledger accounts.
Proper records will thus be available for maintaining control over plant assets. If the

59
residual value is zero, the book value of a fully depreciated asset is zero until the asset is
disposed off. If such an asset is discarded, no gain or loss results. A plant asset may be
disposed by:
(1) Discarding it as worthless; (2) Selling it; or (3) Trading it in on a new asset

5.2.1 Recording Discarding of a Plant Asset

If a plant asset is of no further use to the business and cannot be sold or traded, then the
plant asset is discarded. If the asset has no book value. (i.e., if it is fully depreciated), the
plant asset account is credited for the amount of the original cost of the item being
discarded. At the same time, the accumulated depreciation account is debited for the
amount of the total accumulated depreciation of the item being discarded. In this case
neither gain nor loss is realized. On the other hand, if a plant asset has a book value (if
not fully depreciated) at the time it is discarded, the business incurs a loss.

Illustration - 1
Suppose for example, on July 5, year 5, equipment that was acquired On Jan 10, year 1,
at a cost of Br. 11,000, is discarded as worthless. The discarded equipment has a carrying
value of Br. 2000 at the time of disposal. The carrying value is computed as the
difference between the cost of asset Br. 11,000 and accumulated deprecation, Br. 9000. A
loss equal to the carrying value should be recorded when the equipment is discarded.

Solution:
The journal entry required to discard the plant asset as of July 5, year 5, is:
Year 5
July 5. Accumulated Deprecation, Equipment …………9000.00
Loss on disposal of plant Asset…………………2000.00
Equipment ……………………………….11000.00
Discarding Equipment no longer used in
the business.

5.2.2 Recording the Sale of Plant Asset

The entry to record the sale of an asset for cash is similar to the one illustrated above
except that the receipt of cash should also be recorded. The following entries show how

60
to record the sale of equipment under three assumptions about the selling price. In the
first case, the Br. 2000 cash received is exactly equal to the book value of the equipment
(which is equal to Br. 2000).

Case 1.
1. Sold at an amount equal to Book value, Br. 2000, no gain or loss results.
Year 5
July 5. Cash ……………………………………2000.00
Accumulated Depreciation, Equip……...9000.00
Equipment ………………………………..11000.00
Sale of equipment at an amount equal to book value

Case 2. Sold at Br. 1500 cash; Loss of Br. 500, (BV = Br. 2000)
Year 5
July 5. Loss on sale of equipment………………….500.00
Accumulated Depreciation……………………… 9000.00
Cash ……………………………………………….1500.00
Equipment…………………………………11000.00
Sale of equipment at less than the book value. Loss of Br. 500

Case 3. Sold at Br. 3000 cash; gain of Br. 1000, cash received through
Sale less book value of the asset (Br. 3000 – Br. 2000)
Year 5
July 5.
Cash ……………………………………….3000.00
Accumulated Depr, Equipment……………9000.00
Equipment……………………………………………..11000.00
Gain on sale of plant asset……………………………...1000.00
Sale of equipment at more than the book value; gain of Br. 1000,
(Br. 3000 – Br.2000) recorded

5.2.3 Recording Exchange of Plant Assets

Businesses also dispose of plant assets by trading them in on the purchase of other plant
assets. Exchanges may involve similar assets, such as an old machine traded-in on a

61
newer model, or dissimilar assets, such as a machine traded-in on a truck. In either case,
the purchase price is reduced by the amount of the trade-in allowance.

The basic accounting for exchanges of plant assets is similar to accounting for sales of
plant assets for cash. If the trade-in allowance received is greater than the carrying value
of the assets surrendered, there has been a gain. If the trade-in allowance is less than the
carrying value, there has been a loss.

There are special rules for recognizing these gains and losses, depending on the nature of
the assets exchanged.
Exchange Losses Gains

Recognized
Recognized
For Financial Reporting Purposes:

 Of similar assets………………………… Yes……………………………….No

 Of Dissimilar assets……………………….. Yes…………………………….. Yes

For Income Tax purposes:

 Of similar assets…………………………… No………………………….. No

 Of dissimilar assets………………………… Yes……………………… Yes

Both Gains and Losses are recognized when a company exchanges dissimilar assets.
Assets are dissimilar when they perform different functions; assets are similar when they
perform the same function.

For financials reporting purposes, gains on exchanges of similar assets are not recognized
because the earning lives of the asset surrendered are not considered to be completed.

When a company trades-in an older machine on a newer machine of the same type, the
economic substance of the transaction is the same as that of a major renovation and
upgrading of the older machine.

62
Accounting for exchange of similar assets is complicated by the fact that neither gains
nor losses are recognized for income tax purposes.

Loss Recognized on the Exchange

A loss is recognized for financial reporting purposes on all exchange in which a material
loss occurs.

Illustration-2

To illustrate the recognition of a loss, assume that the business exchange a machine with
a cost of Br. 11,000, and accumulated depreciation of Br. 9000 for a newer more modern
machine on the following terms:

Cost of new machine ………………………Birr 12000.

Trade-in Allowance for old machine……………(1500)
machine……………(1500)
Cash payment required (Boot)……………..Birr 10500.

Solution
In the illustration above, the trade-in allowance (1500) is less than the carrying value (Br.
2000) of the old machine. The loss on the exchange is Br. 500, (Br. 2000 – Br. 1500).
Therefore, the journal entry required to record the exchange of assets would be as
follows:

Year 5.
5.
July 5. Equipment (New)……………………..120,00.00
Accum. Depreciation-Equip…………………...9,000.00
Loss on Exchange of plant assets………………. 500.00
Equipment (old)……………………………………11,000.00
Cash…………………………….…………………. 10,500.00

Loss Not Recognized on the Exchange

In the previous illustration, in which a loss was recognized, the new asset was recorded at
the purchase price of Br. 12000 and a loss of Br. 500 was recognized. If the transaction is
for similar assets and is to be recorded for income tax purpose, the loss should not be

63
recognized. In this case, the cost basis of the new asset will reflect the effect of the
unrecorded loss. The cost basis for the new asset, therefore, is computed by adding the
cash payment to the carrying value of the old asset:

Carrying (Book) value of old Equipment……………………..Birr 2,000.00

Cash paid (Boot given)………………………………………… 10,500.00
Cost-basis of new Equipment ……………………………… Birr 12,500.00

Note that no loss is recognized in the entry to record this transaction.

Year 5.
July 5. Equipment (New)……………………………….12,500.00
Accumulated Depreciation……………………… 9,000.00

Equipment (old)……………………………11,000.00
Cash……………………………………….. 10,500.00
To record exchange of Equipments - cost of old Equipments
and its related Accumulated Depreciation removed from the
accounts; new equipment recorded at amount equal to book
value of old equipment plus boot given.

NB.
NB. The new equipment is recorded (reported) at a purchase price of Br. 12000 plus the
unrecognized loss of Br. 500. the post postponement of the loss. Since depreciation of the
new equipment will be computed based on a cost of Br. 12500 instead of Br. 12000, the
“unrecognized” loss results in more depreciation each year on a new equipment than the
loss had been recognized.

Gain Recognized on the Exchange

Gains on exchanges are recognized for financial reporting purposes when dissimilar
assets are exchanged. To illustrate the recognition of a gain, assume the following terms
in which the machines being exchanged serve different functions:

Price of new machine………………………………Birr 12,000.00

Trade-in Allowance for old machine………………….(3000)
machine………………….(3000)
Cash payment required (Boot given)……………….Birr 9,000.00

64
Here the trade-in allowance (Br. 3000) exceeds the carrying value (Br. 2000) of the old
machine by Br. 1000. thus, there is a gain on the exchange, if the trade-in allowance
represents the fair mark value of the old machine. Assuming that this condition is true,
the entry to record the transaction is as follows:
Years 5
July 5. Equipment (New)……………………………12,000
Accumulated Depreciation…………………….9,000
Equipment (old)………………………….11,000
Cash ……………………………………… 9,000
Gain on exchange of Equip………………..1,000
To record the exchange of Equipments to remove
cost of old equipment and the related accumulated
depreciation, new equipment recorded at cost price;
gain recognized.

Gain Not Recognized on the Exchange:

A gain on an exchange should not be recognized in the accounting records if the assets
perform similar functions. The cost basis for the new equipment must indicate the effect
of the unrecorded gain. This cost basis is computed by adding the cash payment to the
carrying value of the old asset:
Carrying value of old equipment …………………………..Birr 2,000.00
Cash paid (Boot Given)………………………………………… 9,000.00
Cost basis of new Equipment……………………………. Birr 11,000.00

The entry to record the transaction is as follows:

Year 5
July 5. Equipment (New)……………………………..11,000.00
Accumulated Depreciation…………………… 9,000.00
Equipment (old)…………………………………..11,000.00
Cash…………………………………………………9,000.00

To record exchange of Equipment to remove the cost of old

equipment and the related accum. depr. of old assets; new

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 equipment recorded at a cost equal to BV of old asset plus cash paid.

As with the no recognition of losses, the no recognition of the gain on exchanges is, in
effect, a postponement of the gain. Since depreciation will be computed on the cost basis
of Br. 11,000, the “unrecognized” gain is reflected in less deprecation each year on new
equipment than if the gain had been recognized.

Illustrative Problem:
Problem:
ABC Corporation acquired machine X for Br. 84,000 on January 10.1999. Machine X
had an estimated useful life of six years with no salvaged value. The machine was
depreciated on the basis of Sum-of-the-years-digits’ method. On May 5, 2002, machine X
was exchanged for another similar machine Y. The new machine had a cash price of Br.
95,000. In addition to Machine X, cash of Br. 25,000 and three notes for Br. 45,000 was
given up in the exchange. Machine Y has an estimated useful life of seven years and
salvage value of Br. 1000. Machine Y is to be depreciated using the straight-line method.
The corporation had the experience of recording the exchange for financial reporting
purposes.

Required: With reference to the above information:

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

Solution to Illustrative Problem:

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

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  Depreciation for 2000, 5/2 X 84,000………………………………. 20,000.00
 Depreciation for 2001, 4/21 X 84,000……………………………. 16,000.00
 Depreciation for 2002 (for four months only) 3/12 X 84,000 X 4/12 . 4,000.00

 Total Accumulated Depreciation as of May 5, 2002, Br. 64,000.00

Old Equipment Traded-In (Machine X)

Cost…………………………………………………………Birr 84,000
Accumulated Depreciation, May 5, 2002………………………..64,000
2002………………………..64,000
Book Value………………………………………………… Birr 20,000

New Equipment Traded-In (Machine Y)

Purchase (List) price…………………………………….Birr 95,000
 Trade-in Allowance on old Machine…………………………25,000
Machine…………………………25,000
Boot Given (cash + Notes)……………………………… Br 70,000

Therefore, the cost-basis of Machine Y can be obtained by adding the Book Value and the
amount of Boot given which is ; Br. 20,000 + 70,000 = Br. 90,000.
90,000. There is unrecognized
gain on the exchange.

(2) 2002
May 5. Machine Y…………………………………..90,000.00
Accumulated Depreciation ………………….64,000.00
Machine X……………………………………………...84,000.00
Cash…………………………………………………….25,000.00
Notes payable…………………………………………..45,000.00

3. Depreciation Expense on Machine Y for year ending Dec. 31,2002 by the straight line
method is:

Ann. Depr. = Br. 90,000.00 – Br. 1000.00 = Br. 12714.29, since the Machine is
employed in
7 Years

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service after four months had been elapsed, the depreciation for 8 months, (May through
Dec. 31) would be:
Br. 12714.29 X 8/12 = Br. 8476.20

4. The cost-basis for Machine Y for income tax regulation is:

Since gains and losses resulting from the exchange of similar assets are not recognized
for income tax purposes, the cost basis of the Machine is the same that is Br. 90,000.

5. Journal entry to record the exchange of machine Y for purposes of income tax
regulation would be:
2002
May 5. Machine Y………………………………………………90,000
Accumulated Depreciation, Machine X…………………64,000
Machine X…………………………………………. 84,000
Cash …………………………………………………25,000
Notes Payable……………………………. …………45,000

5.3 ACCOUNTING FOR INTANGIBLE ASSETS AND NATURAL RESOURCES

Intangible Assets:
Assets: are long-term assets that do not have physical substance and in most
cases relate to legal rights or advantages held.
Intangible assets include patents, copyrights, trademarks, franchises, organization costs,
leaseholds, leasehold improvements, and goodwill. The allocation of intangible assets to
the periods they benefits is called amortization.

Intangible assets are accounted for at acquisition cost, that is, the amount paid for them.
Some intangible assets such as goodwill and trademarks may be acquired at little or no
cost. Even though they may have great value and be needed for profitable operations they

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should not appear on the balance sheet unless they have been purchased from another
party at a price established in the market place.

The, Accounting Principles Board (APB) has decided that a company should record as
assets the costs of Intangible assets acquired from others. However, the company should
record as expenses the cost of developing intangible assets. Also, intangible assets that
have a determinable useful life such as patents, copyrights, and leaseholds, should be
written off through periodic amortization over that useful life in much the same way that
plant assets are depreciated.

Even though some intangible assets, such as goodwill and trademarks, have no
measurable limit on their lives, they should also be amortized over a reasonable length of
time (not to exceed forty years).

Illustration - 3
Assume that on Jan 2,2002 MOHA Soft Drink Bottling company purchased a patent on a
unique bottle cap for Br. 54,000.
The entry to record the patent would be as follows:

2002
Jan 2. Patent……………………………..54,000
Cash……………………………………..54,000
To record the purchase of Bottle cap patent

Assume that MOHA’s management determines that, although the patent for the bottle cap
will last for seventeen years, the product using the cap will be sold only for the next six
years. The entry to record the annual amortization would be as follows:

Amortization Expense………………………..9,000.00
Patent……………………………………………9,000.00
To record annual amortization of patent (Br. 54000/ 6 years)

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Note that the patent account is reduced directly by the amount of the amortization
expense. This is in contrast to other long-term asset accounts in which depreciation or
depletion is accumulated in a separate contra account.

If the patent becomes worthless before it is fully amortized, the remaining carrying value
is written off as a loss. For instance, assume that after the first two years MOHA soft
Drink Bottling Company’s chief competitor’s offers a bottle with a new type of cap that
makes MOHA’s cap obsolete. The entry to record the loss is:

Loss on patent……………………………36,000.00
Patent……………………………………36,000.00
To record the loss resulting from patents becoming
worthless.

Depletion of Natural Resources

We now turn our attention to another group of long-lived assets natural resources, such as
minerals, oil, and timber or lumber. These natural resources are extracted from the earth.

Depletion is the accounting measure used to allocate the acquisition cost of natural
resources. Depletion differs from depreciation because depletion focuses specifically on
the physical use and exhaustion of the natural resources, while depreciation focuses more
broadly on any reduction of the economic value of a plant or fixed asset. The costs of
natural resources are usually classified as long-terms assets.

Depletion expense is the measure of that portion of long-term assets that is used up in a
particular period.

Illustration - 4
Suppose for example, MIDROC Construction has acquired the right to use 10,000 acres
of land in Kibre-Mengist territory to mine for gold at a total cost of, Br. 10,000.000. The
Company estimated that the mine will; provide approximately 500,000 grams of gold.
The depletion rate established is computed in the following manner.
Total cost – Salvage value = Depletion cost per unit.
Total estimated units available

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 Br. 10,000,000 = Br. 20 per gram
500,000 units

If 100,000 grams are extracted in the first year, then the depletion for the year is 2000.000
(1000,000 x Br. 20.00). The entry to record the depletion is therefore:

Depletion Expense…………………..2,000,000
Accumulated Depletion……………………….2,000,000

5.4. SUMMARY

Plant assets, such aw equipments, trucks, or machineries, cannot be used forever. The
assets may wear out or the business may replace them with newer models. When a fixed
asset is no longer useful to a business, the asset may be disposed of by: (1) discarding it
as worthless; (2) selling it: or (3) trading it in on a new asset.

If a plant asset is of no further use to the business and cannot be sold or traded, then the
plant asset is discarded. If the asset is fully depreciated, no loss or gain is recognized.
Otherwise, if the asset is not fully depreciated at the time of disposal, the business incurs
a loss.

Another means of disposing of a plant asset is sale of plant asset. While selling plant
assets, if the selling price exceeds the book (carrying) value of the asset, there is a gain,
and the gain should be reported in the income statement for the period under other
income section because it results from no operating activities. On the other hand, if the
cash received through sales of plant asset is less than the book (carrying) value of the
asset sold, there is a loss, and this loss is reported among the other expense section on the
income statement. If the amount of cash received through sale of a plant assert is exactly
equal to the book value of the asset, neither gain nor loss is realized.

Business also dispose of plant assets by trading them in on the purchase of other plant
assets- Exchanges may involve similar assets that serves the same function, or it may
involve dissimilar assets that serve different functions.

The basic accounting for exchanges of plant assets is similar to accounting for sales of
plant assets for cash. If the trade-in allowance received on old asset is greater than the

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carrying (book) value of the asset surrendered, there has been a gain. In contrast, if the
trade-in allowance is less than the carrying (book) value, there has been a loss.

There are special rules for recognizing these gains and losses, depending on the nature of
the assets exchanged.

If the assets exchanged are dissimilar (perform different functions), both gains and loses
are recognized. If the assets exchanged are similar (perform the same function), loss on
exchanges is recognized, but if the exchange results in a gain, the gain should not be
recognized for financial reporting purposes.

For income tax purposes, neither gain nor loss is recognized from the exchange of similar
assets. However, income tax law allows the recognition of both gains and losses from the
exchange of dissimilar assets.

The chapter also discussed accounting for intangible assets and natural resources.
Intangible assets are long-term assets without a physical substance, and inmost cases
related to legal rights or advantages held. Intangible assets include patents, copyrights,
trademarks, franchising, organization costs, leaseholds, leasehold improvements, and
goodwill. The cost allocation of intangible assets to the periods they benefit is called
amortization.

Natural resources are another group of long-term assets that are extracted from the earth
such as minerals, oils, (or petroleum), and timber (or lumber). The periodic cost
allocation of these natural resources is referred to as depletion.
depletion.

Unlike plant assets, natural resources are consumed physically over the period of use and
do not maintain their physical characteristics.

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