UNIT TWO: INVENTORIES

Contents:

2.0 Aims and Objectives

2.1 Introduction
2.2 Internal control of Inventories
2.3 The effects of inventory errors on the financial statements
2.4 Inventory cost flow assumptions
2.5 Inventory costing methods under a perpetual and periodic inventory system
2.7 Valuation of inventory at other than cost
2.7 Estimating inventory costs
2.8 Presentation of merchandise inventory on the balance sheet
2.9 Summary
2.10 Answers to check your progress
2.11 Model examination questions

2.0 AIMS AND OBJECTIVES

The unit discusses the meaning, internal control over inventory, and effects of inventory errors on
financial statements. It also discusses the inventory costing methods and estimating inventory
costs. After studying this unit, you will be able to:
 Summarize and provide examples of internal control procedures that apply to inventories.
 Describe the effect of inventory errors on the financial statements.
 Describe three inventory cost flow assumptions and how they impact the income statement
and balance sheet.
 Compute the cost of inventory under the perpetual inventory system, using the following
costing methods: first-in, first-out; last-in, first-out; and average cost.
 Compute the cost of inventory under the periodic inventory system, using the following
costing methods: first-in, first out; last-in, first-out; and average cost.
 Compare and contrast the use of the three inventory costing methods.
  Compute the proper valuation of inventory at other than cost, using the lower-of-cost-or-
market and net realizable value concepts.
 Prepare a balance sheet presentation of merchandise inventory.
 Estimate the cost of inventory, using the retail method and the gross profit method

2.1 INTRODUCTION

Inventory is any form of asset item held for sale in the ordinary course of business or goods that
will be used in the production of goods to be sold. They are mainly divided into two major
categories:
 Inventories of manufacturing businesses.
 Inventories of merchandising businesses.
a) Inventories of manufacturing businesses:- manufacturing businesses are businesses that
produce physical output. They normally have three types of inventories. namely:
 Raw material inventory
 Work in process inventory
 Finished goods inventory
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.
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.
Finished goods inventory- is the cost identified with the completed but unsold units on hand at the
end of each period.
b) Inventories of merchandising businesses are merchandise purchased for resale in the
normal course of business. These types of inventories are called merchandise
inventories and the unit focuses on it.

2.2 INTERNAL CONTROL OF INVENTORIES

The cost of inventory is a significant item in many businesses’ financial statements. What do we
mean by the term inventory? Inventory is used to indicate (1) merchandise held for sale in the
normal course of business and (2) materials in the process of production or held for production. In
this chapter, we focus primarily on inventory of merchandise purchased for resale. What costs
should be included in inventory? the cost of merchandise is its purchase price, less any purchases
discounts. These costs are usually the largest portion of the inventory cost. Merchandise inventory
also includes other costs, such as transportation, import duties, and insurance against losses in
transit. Not only must the cost inventory be determined, but good internal control over inventory
must also be maintained. Two primary objectives of internal control over inventory are
safeguarding the inventory and properly reporting it in the financial statements. These internal
controls can be either preventive or detective in nature.
 A preventive control is designed to prevent errors or misstatements from occurring.
 A detective control is designed to detect an error or misstatement after it has occurred.
Control over inventory should begin as soon as the inventory is received. Pre-numbered
receiving reports should be completed by the company’s receiving department in order to
establish the initial accountability for the inventory. To make sure the inventory received is
what was ordered, each receiving report should agree with the company’s original purchase
order for the merchandise. Likewise, the price at which the inventory was ordered, as shown
on the purchase order, should be compared to the price at which the vendor billed the
company, as shown on the vendor’s invoice. After the receiving report, purchase order, and
vendor’s invoice have been reconciled, the company should record the inventory and related
account payable in the accounting records; as:-
Inventory ----------------------------xxx
A/payable----------------------xxx

Controls for safeguarding inventory include developing and using security measures to prevent
inventory damage or employee theft. For example, inventory should be stored in a warehouse or
other area to which access is restricted to authorized employees, only. The removal of merchandise
from the warehouse should be controlled by using requisition forms, which should be properly
authorized. The storage area should also be climate controlled to prevent damage from heat or cold.
Further, when the business is not operating or is not open, the storage area should be locked.
When shopping, you may have noticed how retail stores protect inventory from customer theft.
Retail stores often use such devices as two-way mirrors, cameras, and security guards. High priced
items are often displayed in locked cabinets. Retail clothing stores often place plastic alarm tags on
valuable items such as leather coats. Sensors at the exit doors set off alarms if the tags have not
been removed by the clerk. These controls are designed to prevent customers from shoplifting.

Using a perpetual inventory system for merchandise also provides an effective means of control
over inventory. The amount of each type of merchandise is always readily available in a subsidiary
inventory ledger.
ledger. In addition, the subsidiary ledger can be an aid in maintaining inventory
quantities at proper levels. Frequently comparing balances with predetermined minimum and
maximum levels allows for timely reordering and prevents ordering excess inventory.
To ensure the accuracy of the amount of inventory reported in the financial statements, a
merchandising business should take a physical inventory (i.e., count the merchandise). In a
perpetual inventory system, the physical inventory is compared to the recorded inventory in order
to determine the amount of shrinkage or shortage. If the inventory shrinkage is unusually large,
management can investigate further and take any necessary corrective action. Knowledge that a
physical inventory will be taken also helps prevent employee thefts or misuses of inventory. How
does a business “take” a physical inventory? The first step in this process is to determine the
quantity of each kind of merchandise owned by the business. A common practice is to use teams of
two persons. One person determines the quantity, and the other lists the quantity and description on
inventory count sheets. Quantities of high-cost items are usually verified by supervisors or a second
count team.

What merchandise should be included in inventory? All the merchandise owned by the business on
the inventory date should be included. For merchandise in transit, the party (the seller or the buyer)
who has title to the merchandise on the inventory date is the owner. To determine who has title, it
may be necessary to examine purchases and sales invoices of the last few days of the current period
and the first few days of the following period. As we discussed in an earlier chapter, shipping terms
determine when title passes. When goods are purchased or sold FOB shipping point, title passes to
the buyer when the goods are shipped. When the terms are FOB destination, title passes to the
buyer when the goods are delivered. To illustrate, assume that Keraj Co. orders birr 25,000 of
merchandise on December 28, 2010. The merchandise is shipped FOB shipping point by the seller
on December 30 and arrives at Keraj Co.’s warehouse on January 4, 2011. As a result,
the merchandise is not counted by the inventory crew on December 31, the end of Keraj Co.’s
fiscal year. However, the birr 25,000 of merchandise should be included in Keraj’s inventory
because title has passed. Keraj Co. should record the merchandise in transit on
December 31, debiting Merchandise Inventory and crediting Accounts Payable for birr 25,000.
Manufacturers sometimes ship merchandise to retailers who act as the manufacturer’s agent when
selling the merchandise. The manufacturer retains title until the goods are sold. Such merchandise
is said to be shipped on consignment to the retailers. The unsold merchandise is a part of the
manufacturer’s (consignor’s) inventory, even though the merchandise is in the hands of the
retailers. The consigned merchandise should not be included in the retailer’s (consignee’s)
inventory.

2.3 THE EFFECTS OF INVENTORY ERRORS ON THE FINANTIAL STATEMENTS

Any errors in the inventory count will affect both the balance sheet and the income statement. For
example, an error in the physical inventory will misstate the ending inventory, current assets, and
total assets on the balance sheet. This is because the physical inventory is the basis for recording
the adjusting entry for inventory shrinkage. Also, an error in taking the physical inventory misstates
the cost of goods sold, gross profit, and net income on the income statement. In addition, because
net income is closed to the owner’s equity at the end of the period, owner’s equity will also be
misstated on the balance sheet. This misstatement of owner’s equity will equal the misstatement of
the ending inventory, current assets, and total assets. To illustrate, assume that in taking the
physical inventory on December 31, 2010, Keraj Company incorrectly recorded its physical
inventory as birr 115,000 instead of the correct amount of birr 125,000. As a result, the
merchandise inventory, current assets, and total assets reported on the December 31, 2010 balance
sheet would be understated by birr 10,000 (birr 125,000 _ birr 115,000). Because the ending
physical inventory is understated, the inventory shrinkage and the cost of merchandise sold will be
overstated by birr 10,000. Thus, the gross profit and the net income for the year will be understated
by birr 10,000. Since the net income is closed to owner’s equity at the end of the period, the
owner’s equity on the December 31, 2010 balance sheet will also be understated by birr 10,000.
The effects on Keraj Company’s financial statements are summarized as follows:
Amount of
Misstatement
Balance Sheet:
Sheet:
Merchandise inventory understated br (10,000)
Current assets understated (10,000)
Total assets understated (10,000)
Owner’s equity understated (10,000)
Income Statement:
Cost of merchandise sold overstated br 10,000
Gross profit understated (10,000)
Net income understated (10,000)

Now assume that in the preceding example the physical inventory had been overstated on
December 31, 2010, by br 10,000. That is, Keraj Company erroneously recorded its inventory as br
135,000. In this case, the effects on the balance sheet and income statement would be just the
opposite of those indicated above. Errors in the physical inventory are normally detected in the
period after they occur. In such cases, the financial statements of the prior year must be corrected.

CHECK YOUR PROGRESS EXERCISE 2.1

If the inventory shrinkage at the end of the year is overstated by br 7,500, the error will cause an:
_______________________________________________________________________________
_______________________________________________________________________.
A. understatement of cost of merchandise sold for the year by br7,500.
B. overstatement of gross profit for the year by Br 7,500.
C. overstatement of merchandise inventory for the year by br 7,500.
D. understatement of net income for the year by 7,500.
2.4 INVENTORY COST FLOW ASSUMPTIONS

A major accounting issue arises when identical units of merchandise are acquired at different unit
costs during a period. In such cases, when an item is sold, it is necessary to determine its unit cost
so that the proper accounting entry can be recorded. To illustrate, assume that three identical units
of Item CC are purchased during May, as shown below:

Item CC Units Cost

May 10 Purchase 1 br 9
18 Purchase 1 13
24 Purchase 1 14
Total 3 br 36
Average cost per unit br 12

Assume that one unit is sold on May 30 for br 20. If this unit can be identified with a specific
purchase, the specific identification method can be used to determine the cost of the unit sold. For
example, if the unit sold was purchased on May 18, the cost assigned to the unit is br 13 and the
gross profit is br 7 (br 20 _ br 13). If, however, the unit sold was purchased on May 10, the cost
assigned to the unit is br 9 and the gross profit is br 11 (br20 _ br9).

The specific identification method is not practical unless each unit can be identified accurately. An
automobile dealer, for example, may be able to use this method, since each automobile has a
unique serial number. For many businesses, however, identical units cannot be separately
identified, and a cost flow must be assumed. That is, which units have been sold and which units
are still in inventory must be assumed. There are three common cost flow assumptions used in
business. Each of these assumptions is identified with an inventory costing method, as shown
below:-
 Cost Flow Assumption Inventory Costing Method

 Cost flow is in the order : First-in, first-out (FIFO)

in which the costs were incurred.
 Cost flow is in the reverse : Last-in, first-out (LIFO)
order in which the costs were incurred.
 Cost flow is an average of the costs. : Average cost

2.5 INVENTORY COSTING METHODS UNDER A PERPETUAL & 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. In this topic we
will give look at the perpetual and periodic inventory system one after the other.
2.5.1 A Perpetual Inventory System :- In a perpetual inventory system, as we discussed in a
previous chapter, all merchandise increases and decreases are recorded in a manner similar to
recording increases and decreases in cash. The merchandise inventory account at the beginning of
an accounting period indicates the merchandise in stock on that date. Purchases are recorded by
debiting Merchandise Inventory and crediting Cash or Accounts Payable. On the date of each sale,
the cost of the merchandise sold is recorded by debiting Cost of Merchandise Sold and crediting
Merchandise Inventory. As we illustrated in the preceding section, when identical units of an item
are purchased at different unit costs during a period, a cost flow must be assumed. In such cases,
the FIFO, LIFO, or average cost method is used. We illustrate each of these methods, using the data
for Item CB1, shown below.
 Item CB1 Units Cost
Jan. 1 Inventory 10 br 20
4 Sale 7
10 Purchase 8 21
22 Sale 4
28 Sale 2
30 Purchase 10 22

First-In, First-Out Method:-

Most businesses dispose of goods in the order in which the goods are purchased. This would be
especially true of perishables and goods whose styles or models often change. For example,
grocery stores shelve their milk products by expiration dates. Likewise, men’s and women’s
clothing stores display clothes by season. At the end of a season, they often have sales to clear
their stores of off-season or out-of-style clothing. Thus, the FIFO method is often consistent
with the physical flow or movement of merchandise. To the extent that this is the case, the
FIFO method provides results that are about the same as those obtained by identifying the
specific costs of each item sold and in inventory. When the FIFO method of costing inventory
is used, costs are included in the cost of merchandise sold in the order in which they were
incurred. To illustrate, the following table 2.1 shows the journal entries for purchases and sales
and the inventory subsidiary ledger account for Item CB1. The number of units in inventory
after each transaction, together with total costs and unit costs, are shown in the account. We
assume that the units are sold for Br 30 each on account.

Table 2.1: Perpetual Inventory Account (FIFO)

ITEM CB1
Purchase Cost of merchandise sold Inventory
Date Quantity Unit Total Quantity Unit Total Quantity Unit Total
cost cost cost cost cost cost
Jan. 1 10 20 200
4 7 20 140 3 20 60
10 8 21 168 3 20 60
8 21 168
22 3 20 60
1 21 21 7 21 147
28 2 21 42 5 21 105
30 10 22 220 5 21 105
10 22 220

The journal entries:

Jan. 4 Accounts Receivable 210
Sales 210

4 Cost of Merchandise Sold 140

Merchandise Inventory 140

10 Merchandise Inventory 168

Accounts Payable 168

22 Accounts Receivable 120

Sales 120

22 Cost of Merchandise Sold 81

Merchandise Inventory 81

28 Accounts Receivable 60
Sales 60

28 Cost of Merchandise Sold 42

Merchandise Inventory 42

30 Merchandise Inventory 220

Accounts Payable 220
You should note that after the 7 units were sold on January 4, there was an inventory of 3 units at
br 20 each. The 8 units purchased on January 10 were acquired at a unit cost of br 21, instead of br
20. Therefore, the inventory after the January 10 purchase is reported on two lines, 3 units at br 20
each and 8 units at br 21 each. Next, note that the br 81 cost of the 4 units sold on January 22 is
made up of the remaining 3 units at br 20 each and 1 unit at br 21. At this point, 7 units are in
inventory at a cost of br21 per unit.
Last-In, First-Out Method:-
When the lifo method is used in a perpetual inventory system, the cost of the units sold is the cost
of the most recent purchases. To illustrate, table 2.2 shows the journal entries for purchases and
sales and the subsidiary ledger account for Item 127B, prepared on a lifo basis.
Table 2.2 : Perpetual inventory accounting LIFO
ITEM CB1
Purchase Cost of merchandise sold Inventory
Date Quantity Unit Total Quantity Unit Total Quantity Unit Total
cost cost cost cost cost cost
Jan. 1 10 20 200
4 7 20 140 3 20 60
10 8 21 168 3 20 60
8 21 168
22 4 21 84 3 20 60
4 21 84
28 2 21 42 3 20 60
2 21 42
30 10 22 220 3 20 60
2 21 42
10 22 220

The journal entries-under LIFO

Jan. 4 Accounts Receivable 210

Sales 210
 4 Cost of Merchandise Sold 140
Merchandise Inventory 140

10 Merchandise Inventory 168

Accounts Payable 168

22 Accounts Receivable 120

Sales 120

22 Cost of Merchandise Sold 84

Merchandise Inventory 84

28 Accounts Receivable 60
Sales 60

28 Cost of Merchandise Sold 42

Merchandise Inventory 42

30 Merchandise Inventory 220

Accounts Payable 220
If you compare the ledger accounts for the FIFO perpetual system and the LIFO perpetual system,
you should discover that the accounts are the same through the January 10 purchase. Using LIFO,
however, the cost of the 4 units sold on January 22 is the cost of the units from the January 10
purchase (br21 per unit). The cost of the 7 units in inventory after the sale on January 22 is the cost
of the 3 units remaining from the beginning inventory and the cost of the 4 units remaining from
the January 10 purchase.

When the LIFO method is used, the inventory ledger is sometimes maintained in units only. The
units are converted to dollars when the financial statements are prepared at the end of the period.
Activity -2.2:-
The following units of a particular item were purchased and sold during the period:

Beginning inventory 40 units at br 20

First purchase 50 units at br 21
Second purchase 50 units at br 22
First sale 110 units
Third purchase 50 units at br 23
Second sale 45 units
What is the cost of the 35 units on hand at the end of the period as determined under the perpetual
inventory system by the LIFO costing method?
A.br 715 B. br 705 C. br 700 D. br 805

Average Cost Method: - When the average cost method is used in a perpetual inventory
system, an average unit cost for each type of item is computed each time a purchase is made. This
unit cost is then used to determine the cost of each sale until another purchase is made and a new
average is computed. This averaging technique is called a moving average. Since the average cost
method is rarely used in a perpetual inventory system, we do not illustrate it in this unit.

2.5.2 A Periodic inventory system: - When the periodic inventory system is used, only revenue is
recorded each time a sale is made. No entry is made at the time of the sale to record the cost of the
merchandise sold. At the end of the accounting period, a physical inventory is taken to determine
the cost of the inventory and the cost of the merchandise sold. Like the perpetual inventory system,
a cost flow assumption must be made when identical units are acquired at different unit costs
during a period. In such cases, the FIFO, LIFO, or average cost method is used.
First-In, First-Out Method: - To illustrate the use of the FIFO method in a periodic inventory
system, we assume the following data:

Jan. 1 Inventory: 200 units at br 9 br 1,800

Mar. 10 Purchase: 300 units 10 3,000
Sept. 21 Purchase: 400 units 11 4,400
Nov. 18 Purchase: 100 units 12 1,200
Available for sale during year 1,000 br10, 400

The physical count on December 31 shows that 300 units have not been sold. Using the FIFO
method, the cost of the 700 units sold is determined as follows:

Earliest costs, Jan. 1: 200 units at br 9 br1,800

Next earliest costs, Mar. 10: 300 units 10 3,000
Next earliest costs, Sept. 21: 200 units 11 2,200
Cost of merchandise sold: 700 br7,000
Activity-3.1:-

The following units of a particular item were available for sale during the period:
Beginning inventory 40 units at br 20
First purchase 50 units br 21
Second purchase 50 units br22
Third purchase 50 units br 23
What is the unit cost of the 35 units on hand at the end of the period as determined under the
periodic inventory system by the fifo costing method?
A. br 20 B. br 21 C. br 22 D. br 23

Last-In, First-Out Method:- When the LIFO method is used, the cost of merchandise sold is
made up of the most recent costs. Based on the data in the FIFO example, the cost of the 700 units
of inventory is determined as follows:
 Most recent costs, Nov. 18: 100 units at br12 br1,200
Next most recent costs, Sept. 21: 400 units 11 4,400
Next most recent costs, Mar. 10: 200 units 10 2,000
Cost of merchandise sold: 700 br7,600

Deducting the cost of merchandise sold of br7,600 from the br10,400 of merchandise available for
sale yields br2,800 as the cost of the inventory at December 31. The br2,800 inventory is made up
of the earliest costs incurred for this item.

Average Cost Method:- The average cost method is sometimes called the weighted average
method. When this method is used, costs are matched against revenue according to an average of
the unit costs of the goods sold. The same weighted average unit costs are used in determining the
cost of the merchandise inventory at the end of the period. For businesses in which merchandise
sales may be made up of various purchases of identical units, the average method approximates the
physical flow of goods.

The weighted average unit cost is determined by dividing the total cost of the units of each item
available for sale during the period by the related number of units of that item. Using the same cost
data as in the FIFO and LIFO examples, the average cost of the 1,000 units, $10.40, and the cost of
the 700 units, $7,280, are determined as follows:

Average unit cost: br10, 400/1,000 units = br10.40

Cost of merchandise sold: 700 units at $10.40 = br7,280
Deducting the cost of merchandise sold of br7,280 from the br10,400 of merchandise available for
sale yields br3,120 as the cost of the inventory at December 31.

2.6 VALUATION OF INVENTORY AT OTHER THAN COST

Cost is the primary basis for valuing inventories. In some cases, however, inventory is valued at
other than cost. Two such cases arise when (1) the cost of replacing items in inventory is below the
recorded cost and (2) the inventory is not salable at normal sales prices. This latter case may be due
to imperfections, shop wear, style changes, or other causes.
2.6.1 Valuation at Lower of Cost or Market: - If the cost of replacing an item in inventory is
lower than the original purchase cost, the lower-of-cost-or-market (LCM) method is used to value
the inventory. Market, as used in lower of cost or market, is the cost to replace the merchandise on
the inventory date. This market value is based on quantities normally purchased from the usual
source of supply. In businesses where inflation is the norm, market prices rarely decline. In
businesses where technology changes rapidly (e.g., microcomputers and televisions), market
declines are common. The primary advantage of the lower-of-cost-or-market method is that gross
profit (and net income) is reduced in the period in which the market decline occurred. In applying
the lower-of-cost-or-market method, the cost and replacement cost can be determined in one of
three ways. Cost and replacement cost can be determined for (1) each item in the inventory, (2)
major classes or categories of inventory, or (3) the inventory as a whole. In practice, the cost and
replacement cost of each item are usually determined.
To illustrate, assume that there are 400 identical units of Item A in inventory, acquired at a unit cost
of br10.25 each. If at the inventory date the item would cost br10.50 to replace, the cost price of
br10.25 would be multiplied by 400 to determine the inventory value. On the other hand, if the item
could be replaced at br9.50 a unit, the replacement cost of br9.50 would be used for valuation
purposes. The following table shows a method of organizing inventory data and applying the
lower-of-cost-or-market method to each inventory item. The amount of the market decline, br450
(br15,520 - br15,070), may be reported as a separate item on the income statement or included in
the cost of merchandise sold. Regardless, net income will be reduced by the amount of the market
decline.
Determining Inventory at Lower of Cost or Market
Commodity Inventory Unit cost Unit Total
quantity price market
Cost market Lower of C
price
or M
A 400 Br 10.25 Br 9.50 Br 4,100 Br 3,800 Br3,800
B 120 22.5 24.10 2,700 2,892 2,700
C 600 8 7.75 4,800 4,650 4,650
D 280 14 14.75 3,920 4,130 3,920
Total 15,520 15,472 15,070

2.6.2 Valuation at Net Realizable Value:- As you would expect, merchandise that is out of date,
spoiled, or damaged or that can be sold only at prices below cost should be written down. Such
merchandise should be valued at net realizable value. Net realizable value is the estimated selling
price less any direct cost of disposal, such as sales commissions. For example, assume that
damaged merchandise costing br 1,000 can be sold for only br 800, and direct selling expenses are
estimated to be br 150. This inventory should be valued at br650 (br800 - br150), which is its net
realizable value.

2.7 ESTIMATING INVENTORY COST

It may be necessary for a business to know the amount of inventory when perpetual inventory
records are not maintained and it is impractical to take a physical inventory. For example, a
business that uses a periodic inventory system may need monthly income statements, but taking a
physical inventory each month may be too
costly. Moreover, when a disaster such as a fire has destroyed the inventory, the amount of the loss
must be determined. In this case, taking a physical inventory is impossible, and even if perpetual
inventory records have been kept, the accounting records may also have been destroyed. In such
cases, the inventory cost can be estimated by using (1) the retail method or (2) the gross profit
method.

1) Retail Method of Inventory Costing:- The retail inventory method of estimating inventory
cost is based on the relationship of the cost of merchandise available for sale to the retail
price of the same merchandise. To use this method, the retail prices of all merchandise are
maintained and totaled. Next, the inventory at retail is determined by deducting sales for the
period from the retail price of the goods that were available for sale during the period. The
estimated inventory cost is then computed by multiplying the inventory at retail by the ratio
of cost to selling (retail) price for the merchandise available for sale. The illustrative
computation follows:
 Determining Inventory by the Retail Method

Cost Retail
Merchandise inventory, January 1 . . . . . . . . ……… ……19,400 br 36,000
Purchases in January (net) . . . . . . . . . . . . . . . ……………42,600
……………42,600 64,000
Merchandise available for sale . . . . . . . . . . . . 62,000 100,000
Ratio of cost to retail price: br 62,000/ br100,000 =62%

Sales for January (net) . . . . . . . . . . . . . . . . . . . . . . . . …………………………………70,000

Merchandise inventory, January 31, at retail . . . . . . . . …. …………………………br 30,000
Merchandise inventory, January 31, at estimated cost
(br 30,000 X 62%) . . . . . . . . . . . . . . . . . . . . . . . . ……. ………………………….br18,600

2) Gross Profit Method of Estimating Inventories: - The gross profit method uses the
estimated gross profit for the period to estimate the inventory at the end of the period. The gross
profit is usually estimated from the actual rate for the preceding year, adjusted for any changes
made in the cost and sales prices during the current period. By using the gross profit rate, the dollar
amount of sales for a period can be divided into its two components:
1/ gross profit and
2/ cost of merchandise sold.
The latter amount may then be deducted from the cost of merchandise available for sale to yield the
estimated cost of the inventory. The forth coming computation illustrates the gross profit method
for estimating a company’s inventory on January 31. In this example, the inventory on January 1 is
assumed to be br 57,000, the net purchases during the month are br 180,000, and the net sales
during the month are br 250,000. In addition, the historical gross profit was 30% of net sales.
Estimating Inventory by Gross Profit Method

Merchandise inventory, January 1 . . . . . . . . . . . . . . . ………..br 57,000

Purchases in January (net) . . . . . . . . . . . . . . . . . . . . …………. 180,000
Merchandise available for sale . . . . . . . . . . . . . . . . ................ br237,000
Sales in January (net) . . . . . . . . . . . . . . . . . . . . . ...br 250,000
Less estimated gross profit (br250,000 X 30%) . . . . ..75,000
Estimated cost of merchandise sold . . . . . . . . . . . . . ……………175,000
Estimated merchandise inventory, January 31 . . . . . . . ……..br 62,000

The gross profit method is useful for estimating inventories for monthly or quarterly financial
statements in a periodic inventory system. It is also useful in estimating the cost of merchandise
destroyed by fire or other disasters.

Check your progress-exercise-4:-

Keraj Co.’s beginning inventory and purchases during the year ended December 31, 2012, were as
follows:
Units Unit cost Total cost
January 1 Inventory 1,000 br 50.00 br 50,000
March 10 Purchase 1,200 52.50 63,000
June 25 Sold 800 units
August 30 Purchase 800 55.00 44,000
October 5 Sold 1,500 units
November 26 Purchase 2,000 56.00 112,000
December 31 Sold 1,000 units
Total 5,000 br 269,000
 F Instructions:
4.1. Determine the cost of inventory on December 31, 2012, using the perpetual inventory system
and each of the following inventory costing methods:
a. first-in, first-out
b. last-in, first-out
4.2. Determine the cost of inventory on December 31, 2012, using the periodic inventory system
and each of the following inventory costing methods:
a. first-in, first-out
b. last-in, first-out
c. average cost
4.3. Assume that during the fiscal year ended December 31, 2012, sales were br 290,000 and the
estimated gross profit rate was 40%. Estimate the ending inventory at December 31, 2012, using
the gross profit method.

2.7 PRESENTATION OF MERCHANDISE INVENTORY ON THE BALANCE SHEET

Merchandise inventory is usually presented in the Current Assets section of the balance sheet,
following receivables. Both the method of determining the cost of the inventory (fifo, lifo, or
average) and the method of valuing the inventory (cost or the lower of cost or market) should be
shown. It is not unusual for large businesses with varied activities to use different costing methods
for different segments of their inventories. The details may be disclosed in parentheses on the
balance sheet or in a footnote to the financial statements. The following prototype of balance sheet
attempts to brief the presentation:
3C Merchandizing PLC.
 Balance Sheet
Sene 30,2005
Assets:
2.8 Current Assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Account receivables . . . . . . . . 40,000 50,000 00
Less : allowance for doubtfull account 2,500
Merchandise inventory. . . . . . . . . . . . . . . . . . .. .
37,500 00

30,000 00

ANSWERS TO CHECK YOUR PROGRESS AND EXERCISES

F Solution to Check your progress:

1) D The overstatement of inventory shrinkage by Br7,500 at the end of the year will cause the
cost of merchandise sold for the year to be overstated by Br 7,500, the gross profit for the year
to be understated by br7,500, the merchandise inventory to be understated by br 7,500, and the
net income for the year to be understated by br 7,500 (answer D).

2) A The lifo method of costing is based on the assumption that costs should be charged against
revenue in the reverse order in which costs were incurred. Thus, the oldest costs are assigned
to inventory. Thirty of the 35 units would be assigned a unit cost of $20 (since 110 of the
beginning inventory units were sold on the first sale), and the remaining 5 units would be
assigned a cost of $23, for a total of $715 (answer A).

3) D The fifo method of costing is based on the assumption that costs should be charged against
revenue in the order in which they were incurred (first-in, first-out). Thus, the most recent
costs are assigned to inventory. The 35 units would be assigned a unit cost of br 23 (answer
D).
  Solution tocheck your progress- Exercise/s :
4.1.a
a) First-in, first-out method: br 95,200

Purchases Cost of Merchandise Inventory

Sold

Date Unit Unit Total Unit Total Cost

2012 Quantit Cost Total Quantit Cost Cost Quantit Cost
y Cost y y

Jan.1 1,000 50.00 50,000

Mar.10
1,200 52.50 63,000 1,000 50.00 50,000

1,200 52.50 63,000

June 25
800 50.00 40,000 200 50.00 10,000

1,200 52.50 63,000

Aug.30
800 55.00 44,000 200 50.00 10,000

1,200 52.50 63,000

800 55.00 44,000

Oct.5
200 50.00 10,000 700 55.00 38,500

1,200 52.50
63,000

100 55.00 5,500

Nov.26
2,000 56.00 112,000 700 55.00 38,500

2,000 56.00 112,000

Dec.31
700 55.00 38,500 1,700 56.00 95,200
 300 6.00 16,800

4.1.b.

b.) Last-in,
first-out
method: br
91,000
 (br35,000
+
br56,000)
Purchases Cost of Merchandise Inventory
Sold

Date Unit Total Unit Total Unit

Quantit Cost Cost Quantit Cost Cost Quantit Cost Total Cost
y y y
Jan.1
1,000 50.00 50,000
Mar.10
1,200 52.50 63,000 1,000 50.00 50,000

1,200 52.50 63,000

June 25
800 52.50 42,000 1,000 50.00 50,000
 400 52.50 21,000
Aug.30
800 55.00 44,000 1,000 50.00 50,000

400 52.50 21,000

800 55.00 44,000

Oct.5 800 55.00
44,000 700 50.00 35,000
400 52.50
21,000
300 50.00
15,000
Nov.26
2,000 56.00 112,000 700 50.00 35,000

2,000 56.00 112,000

Dec.31
1,000 56.00 56,000 700 50.0 35,000
0

1,000 56.0 56,000

0

4.2. a) First-in, first-out method: 1,700 units at br 56 =

br 95,200
b) Last-in, first-out method:
1,000 units at br 50.00 = br50,000
700 units at br52.50 = 36,750
1,700 units br 86,750
c) Average cost method:
Average cost per unit: br 269,000 ÷ 5,000 units = br 53.80
Inventory, December 31, 2012: 1,700 units at br 53.80 = br 91,460
4.3. Gross profit method: / Answer = br 95,000 /
Merchandise inventory, January 1, 2012 . . . . . . . . . . . . . . . . . . . ……… . . . . . . . br 50,000
Purchases (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ………… . . . . . . . 219,000
Merchandise available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . ………. . . . . . . . . 269,000
Sales (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .br290,000
Less estimated gross profit (br 290,000 _ 40%) . . . . . . . . . . . . . . 116,000
Estimated cost of merchandise sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174,000
Estimated merchandise inventory, December 31, 2012 . . . . . . . . . . . . . . . . . . . br 95,000

UNIT 4. CURRENT LIABILITIES

CONTENTS:
4.0 Aims and Objectives
4.1 Introduction
4.2 The nature of Liabilities
4.3 Short- term notes payable
4.4 Ethiopian Payroll system
4.5 Presentation of Liabilities on the Balance Sheet
4.0 AIMS AND OBJECTIVES

The unit discusses the meaning, nature of current Liabilities,, the Ethiopian payroll system and
Presentation of Liabilities on the Balance Sheet.. After studying this unit, you will be able to:
 Define and give examples of current liabilities.
 Prepare journal entries for short-term notes payable and the disclosure for the current
portion of long-term debt.
 Describe the accounting treatment for contingent liabilities
 Determine employer liabilities for payroll, including liabilities arising from employee
earnings and deductions from earnings.
 Describe payroll accounting systems of Ethiopia.
4.1 INTRODUCTION
Current liabilities are obligations that are to be paid out of current assets and are due within a short
time, usually within one year. This are caused either by receiving goods or services prior to making
payment ( Account payables) , receiving payment prior to delivering goods or services, deductions
and withholding from employee’s salary maturing portions of the long-term liabilities and Taxes
payable, Interest payable, Wages payable , so on .

4.2 THE NATURE OF CURRENT LIABILITIES

liabilities that are to be paid out of current assets and are due within a short time, usually within one
year, are called current liabilities. Most current liabilities arise from two basic transactions:
I. Receiving goods or services prior to making payment.
II. Receiving payment prior to delivering goods or services.
An example of the first type of transaction is accounts payable arising from purchases of
merchandise for resale. An example of the second type of transaction is unearned rent arising
from the receipt of rent in advance. In this chapter, we will introduce some other
common current liabilities. These include short-term notes payable,
contingencies, payroll liabilities, and employee fringe benefits.
4.3 SHORT-TERM NOTES PAYABLE

The current liability section of the balance sheet contain items that are used to finance business
operations, such as short-term notes payable and the portion of long-term debt that is due within
the coming period. Notes may be issued when merchandise or other assets are purchased. They
may also be issued to creditors to temporarily satisfy an account payable created earlier. For
example, assume that Keraj co. issues a 90-day, 12% note for br 1,000, dated August 1, 2012, to
WALMART Co. for the br1,000 overdue account. The entry to record the issuance of the note is as

follows:
 Aug.1 Accounts payable-WALMART.CO. . . . . . . . . . . . . . . . . . . . . . . . .1,000
Notes payable-WALMART
CO. . . . . . . . . . . . . . . . . . . . . . . . . . . .1,000
(A 90-day,12% notes on account of br 1,000)

When the note matures, the entry to record the payment of br 1,000 principal plus br 30 interest (br
1,000 _ 12% _ 90/360) is as follows:
Oct. 30. Notes payable-Walmart c. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1,000
Interest expense( 12% x 1,000 x 90/360). . . . . . . . . . . . .. . . . . 30
Cash. . . . . . . . . . .
… . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . ..1,030
(Payed principal plus notes against due notes)

Current Portion of Long-Term Debt:

Long-term liabilities are often paid back in periodic payments, called installments, such as
building, car and like long time loan . Long-term liability installments that are due within the
coming year must be classified as a current liability. The total amount of the installments due after
the coming year is classified as a long-term liability. To illustrate, Keraj Marchandizing Co.
reported the following scheduled debt payments in the notes to its Sene 30, 2005 annual report to
shareholders:
Fiscal year ending
2006 br 600,000
2007 100,000
2008 150,000
2009 300,000
2010 500,000
 After 5yrs 6,000,000
Total principal payments br 2,250,000
The debt of br 600,000 due in 2006 ( coming year) would be reported as a current
liability on the Sene30, 2005( end of year) balance sheet. The remaining debt of br
1,650,000 (br 2,250,000 - br 600,000) would be reported as a long-term liability on
the balance sheet.
Check your progress-1
A business issued a $5,000, 60-day, 12% note to the bank. What is the amount due at
maturity ? -
____________________________________________________________________
____________________________________________________.

Contingent Liabilities:-
Some past transactions will result in liabilities if certain events occur in the future. These potential
obligations are called contingent liabilities. For example, Bishoftu co. would have a contingent
liability for the estimated costs associated with warranty work on new car sales. The obligation is
contingent upon a future event, namely, a customer requiring warranty work on a vehicle. The
obligation is the result of a past transaction, which is the original sale of the vehicle. If a contingent
liability is probable and the amount of the liability can be reasonably estimated, it should be
recorded in the accounts. Bishoftu Car co.’s vehicle warranty costs are an example of a recordable
contingent liability. The warranty costs are probable because it is known that warranty repairs will
be required on some vehicles. In addition, the costs can be estimated from past warranty
experience. To illustrate, assume that during June of 2004, Bishoftu Car co. sells a double cabine
vehicle for br 600,000 on which there is a 24-month warranty for repairing defects. Past experience
indicates that the average cost to repair defects is 3.5% of the sales price over the warranty period.
The entry to record the estimated product warranty expense for June is as follows:

June,30 Product Warranty Expense . . . . . . . . . . . . . . . . . . . . . . . . . .21,000

Product Warranty Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
(Warranty expense for June, 3.5% x br 600,000)
This transaction matches revenues and expenses properly by recording warranty costs in the same
period in which the sale is recorded. When the defective product is repaired, the repair costs are
recorded by debiting Product Warranty Payable and crediting Cash, Supplies, or other appropriate
accounts. For example, if the customer required a br 6,000 part replacement on May 10,2005 ( 11
months later ) , the entry would be:

May 10,2005 Product Warranty Payable . . . . . . . . . . . . . . . . . . . . . . . .6,000

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6,0
00
(Replaced defective part under warranty)
Note:- If a contingent liability is probable but cannot be reasonably estimated or is only possible,
then the nature of the contingent liability should be disclosed in the foot-notes to the financial
statements. Professional judgment is required in distinguishing between contingent liabilities that
are probable versus those that are only possible.
4.4 ETHIOPIAN PAYROLL SYSTEM

The term payroll refers to the amount paid to employees for the services they provide during a
period. A business’s payroll is usually significant for several reasons. First, employees are sensitive
to payroll errors and irregularities. Maintaining good employee morale requires that the payroll be
paid on a timely, accurate basis. Second, the payroll is subject to various federal and state
regulations and the third is that the proceeds from payroll taxes are the largest source of revenue for
the government- so required a serious attention both from tax with-holding and tax administrative
sides. Various federal, state, and local laws require employers to keep accurate payroll records and
to prepare reports and submit to the appropriate units. The law also requires employers to remit the
amounts withheld from its employees and the payroll taxes imposed on itself. / For more detail
regarding the Ethiopian tax laws, regulations and proclamations please go through : the council of
ministers regulation No. 78 / 2002. And Article 33 or proclamation No. 64 / 1975 , Proclamation
No. 286 / 2002 and the other related issues on Negarit Gazeta/.

 Definition of payroll related terms:-

Salary and Wages:- Salaries and wages paid to employees are an employer’s labor expenses. The
term salary usually refers to payment for managerial, administrative, or similar services. The rate
of salary is normally expressed in terms of a month or a year. The term wages usually refers to
payment for manual labor, both skilled and unskilled. The rate of wages is normally stated on an
hourly or weekly basis. In practice, the terms salary and wages are often used interchangeably.

The Pay Day:- is the day on which wages or salaries are paid to employees. This is usually on the
last day of the pay period.
The Pay Period: A pay period refers to the length of time covered by each payroll payment.
A Payroll Register (sheet): is the list of employees of a business along with each employee’s gross
earnings; deductions and net pay (take home pay) for a particular pay period. The payroll register
(sheet) is prepared based on attendance sheets, punched (clock) cards or time cards.
Pay Check: A business can pay payroll by writing a check for the amount of the net pay. A check
is prepared in the name of each employee and handed to employees. Alternatively a check for the
total net pay can be prepared for employees to be paid by cash at the organization.

Gross Earnings:
Earnings: are taxes collected from the earnings of employees by t he employer organization
as per the regulations of the government. These have to be submitted (paid) to the government
because3d employer organization is only acting as an agent of the government in collecting these
taxes from employees.

Payroll Deductions: are deductions from the gross earnings of an employee such as employment
income taxes (with holding taxes), labor union dues, fines, credit association pays etc.

Net Pay: Net Pay is the earning of an employee after all deductions have been deducted. This is
the take home pay amount collected by an employee on the payday.

Pension Contribution:- currently, employees / working for more than 45 days,both in government
and Ngo’s/ in Ethiopia is expected to pay or contribute 7% of their basic salary to the governments’
pension trust fund.

This amount is withheld by the employer from each employee on every payroll and later be paid to
the respective government body.

The employer is also expected to contribute towards this same fund 8% of the basic salary of every
permanent government employee.

Therefore, the total contribution to the pension fund of the Ethiopian government is equal to 15%
of the basic salary of employees.

That is, 7% comes from the employees and 8% comes from the employer.

This enables the employee to be entitled to the pension pay when retiring provided the employee
satisfies the minimum requirements to enjoy the benefits.

 Exemptions
The tax proclamation also provides some exemptions. Exemption, in this context, refers to income,
which is not subject to tax. The following categories of income are exempted from employment
income tax:
 Casual employees (who do not work under the same employer for more than one month in a
year)
 Pension, provident fund and all other retirement benefit (up to 15% of the monthly salary of
employee)
 Income of diplomats or consular representatives
 Foreign personnel employed in Embassy, Legation, Consulate or mission who are bearers
of diplomatic passport
 Income specifically exempted by law or international treaty or an agreement approved by
Minister
 Consumption paid for personal injury
 Gratitude in relation to the death of another person

 Deductions
The following payments, made to an employee by an employer, are allowed to be deducted to
determine taxable income.
 Reimbursed medical expenses
 Transportation allowance
 Hardship allowance
 Reimbursed traveling expense (incurred on duty)
 Traveling expenses from the place of recruitment to the place of employment and on
completion of employment from the place of employment to the place of recruitment
 Allowances paid to the members and secretaries of the board of public enterprises and of
study groups set by federal or regional government.
 Income of persons employed for domestic duties

 Special Provision
The following category of employees shall declare and pay taxable income themselves.
 Those who are work for more than one employer
 Those who work in International Organization-Embassies, etc (who are not exempted)
  Penalties
For no filling or late filing:
 Birr 1,000 for the first 30 days
 Birr 2,000 for the next 30 days
 Birr 1,500 for each 30 days thereafter For non-payment:
 5% of tax unpaid on the first day after due date
 2%additional tax on the first day of each month thereafter For failure to withhold:
Withholding agent shall personally be liable to pay the amount due plus Br 1,000 and Br
1,000 will be imposed on the chief accountant or officer who is in charge of supervision.

A tax rate is applied to the taxable income to determine the tax that must be paid. Article 11 of the
Income Tax Proclamation sets out the tax rate schedule that lists the tax rates that must be applied
to determine the tax liability of an employee. This schedule called Schedule “A” is shown below.
The total tax payable on employment income can be determined using a simplest method.
Tax Liability = (Taxable Income X Tax Rate for the Bracket) -Deduction . If “I” is
taxable income, income tax on different brackets can be calculated as follows:

Income Bracket Rate Deduction

0 - 150 0 0
151 – 650 I X 10% 150
651 – 1,400 I X 15% 47.50
1,401 – 2,350 I X 20% 117.50
2,351 – 3,550 I X 25% 235.50
3,551 – 5,000 I X 30% 412.50
5001 & above I X 35% 662.50

Check your progress-2

Determine the total amount expected as income tax from an employee who earns a basic
monthly salary of Br. 3,200, a monthly allowance of Br. 600, and an overtime earning of Br.
 700?
____________________________________________________________________________
____________________________________________?
4.5 PRESENTATION OF CURRENT LIABILITIES ON THE BALANCE SHEET
Current liability is usually presented in the Capital and liability section of the balance sheet,
preceding the owners equity and capital items. On the balance sheet the current liabilities should be
kept separate from long and medium term notes that are to mature within a year, possibly in
chronology of maturity.

 POSSIBLE COMPONENTS OF A PAYROLL REGISTER

1 Employee Number:-Number
Number:-Number assigned to employees for identification purpose when a relatively
large number of employees are involved in a payroll register.

2 Name of Employees:- full name of the employees

3 Earnings

Money earned by an employee from various sources,. This may include.

a. Basic Salary-
Salary- a flat monthly salary of an employee for carrying out the normal work of
employment and subject to change when the employee is promoted.
b. Allowances- money paid monthly to an employee for special reasons, like:
- Position allowance-
allowance- a monthly paid to an employee of earning a particular
office responsibility.
- Housing allowance- a monthly allowance given to cover housing costs of the
individual employee when the employment contract requires the employer to provide
housing but the employer fails to do so.
- Hardship allowance-
allowance- a sum of money given to an employee to compensate
for an inconvenient circumstance caused by the employer. For instance, unexpected
transfer to aw different and distant work area or location.
 - Desert allowance- a monthly allowance given to an employee because of
assignment to a relatively hot region.
- Transportation (fuel) allowance- a monthly allowance to an employee to
cover cost of transportation up to her workplace if the employer has committed itself
to provide transportation service.

C. Overtime Earning: Overtime work is the work performed by an employee beyond the
regular working hours.

Overtime earnings are the amount paid to an employee for overtime work performed.

Article 33 of proclamation No. 64/1975 discussed the following about how overtime work should
be paid:

A worker shall be entitled to be paid at a rate of

i. one and one-quarter (1 ¼) times his ordinary hourly rate for overtime work
performed before 10:00 P.M in the evening.
ii. One and one half (1 ½) times his ordinary hourly rate for overtime work
performed between 10:00 P.M and six (6:00 A.M) in the morning.
iii. Two times the ordinary hourly rate for overtime work performed on weekly rest
days
iv. two and one half (2 ½ ) times the ordinary hourly rate for overtime work
performed on a public holiday.

All in all, the gross earnings of an employee may include the basic salary, allowance and overtime
earnings.

Illustration:
Ato Ahmed is an employee of Nile Travel co. and his monthly basic salary is Br 4,700. In addition
he is getting Br 100 monthly house allowance.
Required: Determine his taxable income and income tax liability.
Solution:
Taxable income = Br 4,700 + Br 100 = Br4,800
Tax liability = (Taxable income X Tax rate for the Bracket) – Deduction
= (4,800 X 30%) – 412.50
= Br 1,027.50
Recordings of both the with-held tax and payroll tax liabilities, as
follows:
F To record payment of salary to the employee:
Salary Expense ( basic + housing allo ) . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800
Payroll expense( 8%x4700) . . . . . . . . . . . . . . . …. . . . . . . . . . . . . . . . . . . . . . . . . .376
Employment Income Tax Payable…. . . . . ……………………………………1,027.50
Pension contribution payable ( 7% + 8% of the basic slry ) . . . . . . . . . . . . . . . . 705
Cash ( 4800 -329- 1,027.5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 3443.5

F To record the payment of withhold tax to Federal Inland Revenue Authority and the
pensions contribution to pension trust fund:
Employment Income Tax Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . 1,027.50
Pension contribution payable ( 7% + 8% of the basic slry ) . . . . . . . . . . . . . . . . . . . 705
Cash . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . . 1732.5
ANSWERS TO CHECK YOUR PROGRESS QUESTIONS:

Q1) The maturity value is br 5,100, determined as follows:

Face amount of note = br 5,000
Plus interest (br5,000 x 12% x 60/360) 100
Maturity value br 5,100

Q2) Gross Earnings of the employee = Basic Salary + Allowance + Overtime earning

Gross total Earnings = br. 3,200 + br. 600 + br. 700

Gross Total Earnings = br. 4,500

Taxable Income of the employee = br. 4,500

Total Employee Income Tax is therefore, br.4,500 x 30% - 412.5 = 937.5

MODEL EXAMINATION QUESTIONS

Problems :

1) Keraj merchandizing .CO, pays its employee’s salarie according to the Ethiopian
calendar Month. The following data relate to the month of Miazia, 2005 E.C.

S.No Employee Name Basic Salary

001 Tigist Regasa birr 3,500

002 Fatima Kemal birr 4500

003 Ojulu Narang birr 3,480

04 Abdalla Farah birr 2,500

Additional information
  All workers are expected to work 40 hours per week .
 Ojulu Narang has worked 15 hours of overtime during the month: out of which 5
hours on a public holy day and the remainingbetween 10 p.m to 6:00 a.m.
 Fatima Kemal has also worked 10 hours of overtime: 5 hours public holy days and 5
before10 p.m.
 Fatima Kemal reported to make a monthly deduction of br. 400 for Hidase Dam.
 All workers are permanent except Abdalla Farah.

Required:

 Compute the total deductions and net pay for each employee.
 Compute (calculate) the total:
a) Withholding Taxes
b) Payroll Tax
c) Record the payment of salary as of Miazia 30,2005.
 prepare the entry to pay the withholding taxes to the appropriate government unit.

2) FAMLY FURNITURE plc.. a family held business, pays the salary to its employees
according to the Ethiopian calendar month. The following data relates to the month of
Sene, 2005.

Name Basic Salary

Shumet Alamirew br. 5,350

Delelegn Bosoka 3,500

Ayana Baati 3,800

Raji Ahmed 4,650

Goitom Guish 3,670

Additional information

 The PLC. Wanted the worker to work 40 hours in a week .

 Ato Ayana Baati have worked 10 hours of overtime during 10:00pm to 6:00a.m.
  Ato, Delelegn Bosoka and Goitom Guish earn a monthly allowance of birr 900 and
br. 750 respectively.
Required: based on the information given above:

 Compute the income tax for each employee.

 Compute the total deductions for each employee.
 Determine the net pay (take-home-pay) for each employee.
 Compute the total withholding tax for the month.
 Compute the total payroll tax expense.
 Pass the journal entry to record the payment of salary as of Sene 30,2005.