Fundamentals of Accounting II CHATER 2

Chapter Two
2. Plant, property, equipment, Intangible Assets and natural resources
2.1. Plant, property, equipment (IAS 16)
According to IAS 16 standards Plant, property, equipment are held for use in the production or
supply of goods or services, or rental to others, or for administrative purposes and bearer plants that are expected
to be used during more than one period. This Standard does not apply to Property, plant and equipment classified
as held for sale, Biological assets Mineral Resources and Mineral rights Applies to PPE used to develop or
maintain the assets described above.
Long term assets are divided into:
 Tangible assets also called plant assets or fixed assets that 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, equipment’s and machineries,
trucks, etc.
 Intangible assets are assets that have no 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, trademarks, organization costs, etc.
Measurement::
The process of determining monetary amounts at which elements are recognized and Financial reports are based
on estimates, judgments and models rather than exact depictions.
These measurements include:
Historical Cost
An item of Plant Property and Equipment that qualifies for recognition as an asset shall be measured at its cost.
The HC of an asset is the consideration given to acquire or to develop it and it includes: The amount of cash or
cash equivalents paid; or the fair value of the consideration given to acquire it
Cost Model
Plant Property and Equipment shall be carried at its cost less any accumulated depreciation and any
accumulated impairment losses.
Revaluation Model
Plant Property Equipment who’s FV can be measured reliably shall be carried at a revalued amount. It’s FV at
the date of the revaluation less any subsequent acc. Dep. & subsequent accumulated impairment losses.
2. 1.2. Measurement of PPE at inicial recognition
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.
1. Initial cost of Equipment
The term “equipment” in accounting includes office equipment, store equipment, factory equipment, delivery
equipment, machinery, furniture and fixtures, and similar fixed assets. The cost of such assets includes the

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 Fundamentals of Accounting II CHATER 2

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.
Purchase price and its factors factors:
 Purchase price ………………………………………… Br 10,000
 Sales tax ………………….………………………………….400
 Freight charges ……………………………………....……… 200
 Installation costs……………………………….………….… 500
 Testing of installed machine …………………………………300
Initiasl Cost of equipment ………………………………….………. 11,400
The journal entry would be:
Equipment 11,400
Cash (A/P) 11,400
2. Initial cost of Land
A purchase of land often raises some interesting questions about related expenditures. Suppose a firm retains a
local real estate broker at a fee of Br.2, 000 to locate and appropriate site for its new office building. The property
eventually chosen has an old residence on it, which will be razed. The terms of the sale include a payment of Br
40,000 to the seller, with the buyer paying off an existing mortgage of Br 10,000 and Br 300 of accrued interest.
In addition, the buyer agrees to pay accrued real estate taxes of Br 800. Other related expenditures include legal
fees of Br 400 and a title insurance premium of Br 500. A local salvage company will raze the old residence;
level the lot, keeps all the materials, and pays the firm Br 200.
If we apply the general plant asset measurement rule, we compute the initial cost of the land as follows:
 Purchase pricese (Payment to the seller) ……………………….… Br 40,000
 Commission for finding property …………………………………..….. 2,000
 Payment of mortgage and interest due at time of sale ………..…….…. 10,300
 Payment of property taxes owed by seller …………………………….… 800
 Legal fees ……………………………………………………….………. 400
 Title insurance premium ……………………………………….…….…. 500
 Gross Initial land cost ………………………………….………………. 54,000
 Less: Net recovery from razing cost of land ……………….…………….(200)
 Initial Cost of Land …………...…………………………………………. 53,800
The journal entry would be:
Land prise………………….…………………. 53,800
Cash (A/P.)………….……………………..…. 53,800
3. Initial 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

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 Fundamentals of Accounting II CHATER 2

are used in the construction, the net contract price plus other expenditures necessary to put the building in usable
condition are included.
2.1
1.3. Subsquent measurment of PPE
2.1
1.3.1. Depreciation of PPE
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, is recorded in the accounting
books periodically. Depreciation is frequently misunderstood as the term depreciation, as used in accounting,
does not refer to the physical deterioration of an asset or the decrease in market value of asset overtime.
Depreciation means the allocation of the cost of a plant asset to the periods that benefit from the services of the
asset.
The term depreciation is used to describe the gradual conversion of the cost of the asset into an expense.
Depreciation is not a process of valuation. Accounting 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 to be
recorded because it is the result of an allocation, not a valuation process.
NB: IAS 16 states that, although land normally has an unlimited useful life and is not to be depreciated, where
the cost of the land includes estimated dismantlement or restoration costs, these are to be depreciated over the
period of benefits obtained by incurring those costs. In some cases, the land itself may have a limited useful life,
in which case it is to be depreciated in a manner that reflects the benefits to be derived from it.
I. Factors That Affect the Computation of Depreciation
Four factors affect the computation of depreciation. They are:
 Cost
 Residual value
 Depreciable cost, and
 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.
 Residual value- also known as salvage 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,

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 Fundamentals of Accounting II CHATER 2

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.
II. Case one Full Year Depreciations
IAS 16 states that the depreciation method should reflect the pattern in which the asset’s future economic
benefits are expected to be consumed by the entity, and that appropriateness of the method should be reviewed at
least annually in case there has been a change in the expected pattern. 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. The most common methods of computing depreciation for plant assets are:
1. The straight line method 3. The double-declining balance method, and
2. The units of production method 4. The sum-of- the years-digits method.
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 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.
Example: Suppose, for example a business enmterprise 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 500 at the end of its estimated
useful life of 4 years. The yearly (annual) depreciation would be Birr 1375 computed as follows:
Annual depreciation = Cost - Salvage value
Estimated useful life
= Birr 6000 – Birr 500
4 years
= Birr 1375 Depreciable base
Or
Annual depreciation= (1\n) (DB)
= (1\4) (5500) Number of years
= (0.25) (5500)
= Br. 1375.00
The depreciation to be reported for each of the four years would be as follows:
Straight-Line Depreciation Method schedule

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 Fundamentals of Accounting II CHATER 2

Year Cost Depreciable Yearly Accumulated Carrying value

base Depreciation Depreciation (Book Value)
Beginning of first year Br. 6000 5500 - - Br. 6000.00
End of first year 6000 5500 Br. 1375.00 Br. 1375.00 4625.00
End of second year 6000 5500 1375.00 2750.00 3250.00
End of third year 6000 5500 1375.00 4125.00 1875.00
End of fourth year 6000 5500 1375.00 5500.00 500.00

NB. There are three important points to note from the depreciation schedule for the straight-line depreciation
method. These are
 First, the depreciation is the same each year.
 Second, the accumulated depreciation increases uniformly.
 Third, the carrying (Book) value decrease uniformly until it reaches the estimated residual value.
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 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 Rate = Cost – Salvage value
Estimated units of useful life
= Br. 6000.00 – 500
10,000 operating hrs.
= Br. 0.55
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:

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 Fundamentals of Accounting II CHATER 2

Production Method Depreciation Schedule

Year Cost Depreciable Hours Depreciation Yearly Accum. Carrying

Base Per Hour Depr. Depr. value (Book
value)
Beginning of the Br. 5500.00 - Br. 0.55 - - Br. 6,000.00
First year 6,000
End of first year 6,000 5500.00 2,800 0.55 Br.1540.00 Br.1540.00 4,460.00
End of second year 6,000 5500.00 3,600 0.55 1980.00 3520.00 2480.00
End of third year 6,000 5500.00 2,400 0.55 1320.00 4840.00 1160.00
End of fourth year 6,000 5500.00 1,200 0.55 660.00 5500.00 500.00

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.
3. Declining Balance Method
This method of depreciation results in relatively large amount of depreciation in the early years of an assets life
and smaller amounts in later years. This method is based on the assumption of the passage of time. Since most
kinds of plant assets are most efficient when new, and so they provide more and better service in the early years
of useful life. It is consistent with the matching rule to allocate more depreciation to the early years than to later
years if the benefits or services received in the early years are greater.
The declining-balance method is the most common accelerated method of depreciation. Under this method
depreciation is computed by applying a fixed rate to the book value of the asset, resulting in higher depreciation
charges during the early years of the 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.
Referring to the previous example, the equipment had an estimated useful life of four years. Consequently, under
the straight-line method.

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The depreciation rate = 2(1\n)

= 2(1\4)
= 2(0.25)
= 0.50 or 50%
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:
Double-Declining Balance Method Depreciation Schedule
Year Cost Depreciable Fixed Depr. Yearly Accumulated Carrying
Base Rate Depreciation Depreciation Value (BV)

Date of purchase Br. 6000 5500 50% - - Br. 6000

End of first year 6000 5500 50% Br. 3000 Br. 3000 3000
End of Second year 6000 5500 50% 1500 4500 1500
End of third year 6000 5500 50% 750 5250 750
End of fourth year 6000 5500 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. last year Previous
book value minus residual value).
4. The Sum of the Years Digits Method
Like the declining balance method, the sum of the year’s digits method provides a higher amount of periodic
depreciation expense in the earlier use of the asset's life and 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,
Denominator of the fraction =Y/ ((n (n+1)) /2)
= Y/ ((4 (4+1)) /2)
= Y/ (4 (5) /2)
= Y/ (20 /2) = Y/10
So the depreciation rate = (4/10, 3/10/2/10/1/10).
This indicates as the numerator of the fraction, decreases year by year. At the end of the asset’s useful life, the
balance remaining should be equal to the salvage value.

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

Year Cost Depreciable Rate Yearly Accumulated Book
Cost Depreciation Depreciation Value
Date of purchase 6000 5,500 - - - Br. 6000
End of first year 6000 5,500 4/10 Br. 2200 Br. 2200 3800
End of second year 6000 5,500 3/10 1650 3850 2150
End of third year 6000 5,500 2/10 1100 4950 1050
End of fourth year 6000 5,500 1/10 550 5500 500

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
2.1.3.4. 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 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.
Exampe: 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). Assume the it apply striate line method.
Solution: Before the revision of the estimated life and the residual value of the asset at the beginning of the 11th
year, the asset account and its related accumulated depreciation account would appear as shown below:

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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 11th 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: Accumulated depreciation already taken………………………………… 45,000
Remaining cost of the delivery truck…………………………………Birr 30,000
Less: Revised estimated salvage value…………………………………………...6,000
Revised annual depreciation 30,000 - 6000
4 years …………………….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
2.1.4. Capital expenditures and revenue expenditures

I. Capital Expenditures
Capital Expenditures are expenditures that improve the operating efficiency or capacity or to achieve greater
future benefits. The Common types of Capital expenditures are additions, extraordinary repairs 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.
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.
Extraordinary repairs are repairs of a more 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

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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.
Example: 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. 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 21,500
Book value (carrying value) after extraordinary repair… Br.13,500
Revised Annual periodic depreciation= 13500……………………….2,250
6 years
II. Revenue expenditures
Revenue expenditures are expenditures that 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 Ordinary repairs.
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.
2. 1.4. Disposal 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 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.

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A plant asset may be disposed by:

1. Discarding the plant asset as worthless
2. Selling the plant asset
3. Trading the plant asset in on a new asset
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.

Example –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
depreciation, 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 Depreciation, Equipment …………9000.00
Loss on disposal of plant Asset…………………2000.00
Equipment ……………………………….11000.00
Discarding Equipment no longer used in the business.
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 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. 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

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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
3. Recording Exchange of Plant Assets
Businesses also dispose of plant assets by trading them in on the purchase of other plant assets. Exchanges may
involve similar assets, such as an old machine traded-in on a newer model, or dissimilar assets, such as a machine
traded-in on a truck. In either case, the purchase price is reduced by the amount of the trade-in allowance. 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 financial reporting
purposes, gains on exchanges of similar assets are not recognized because the earning lives of the asset
surrendered are not considered to be completed. When a company trades-in an older machine on a newer
machine of the same type, the economic substance of the transaction is the same as that of a major renovation and
upgrading of the older machine. Accounting for exchange of similar assets is complicated by the fact that neither
gains nor losses are recognized for income tax purposes.
3.1. Loss Recognized on the Exchange
A loss is recognized for financial reporting purposes on all exchange in which a material loss occurs.
Example2: 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.

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Trade-in Allowance for old 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.
July 5. Equipment (New)……………………..12,000.00
Accum. Depreciation-Equip…………………...9,000.00
Loss on Exchange of plant assets………………. 500.00
Equipment (old)……………………………………11,000.00
Cash…………………………….…………………. 10,500.00
3.2. 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 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 Equipment’s 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. 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.

3.3. 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)
Cash payment required (Boot given)……………..……… 9,000.00

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 Fundamentals of Accounting II CHATER 2

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 Equipment’s to remove cost of old equipment and the related accumulated
depreciation, new equipment recorded at cost price; gain recognized.)

3.4. 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 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.

2.1.5. Internal controls of plant assets versos Presentation of PPE on the balance sheet
I. Internal Control over plant assets
In many companies the following elements of Internal Control over plant assets are considered and performed
according to standard guidelines:
 Approval process for Capital Expenditures (Capex)
 Determination whether planned expenditure is capitalized or expensed
 Purchasing and Accounts Payable systems are correctly applied
 If capitalized, appropriate useful life and salvage value determined

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 Fundamentals of Accounting II CHATER 2

 Correct depreciation expense is calculated and applied each period

 Property tax reports filed with tax jurisdictions
 Insurance coverage relates directly to asset exposure
However, there is one critical element of Internal Control that often is missed. This involves periodically
checking that the information shown in the property record system corresponds to the actual assets reported to be
there. To put this into perspective, a company may have a very good system of invoicing and accounts
receivable, but it is still necessary to confirm that outstanding balances as part of the required annual audit. One
well known aspect of this is the verification of ageing debts in the A/R ledger to confirm their collectability.
Similarly, with inventory (raw material, work in process and finished goods), for the past 70 years companies
have been required to perform a physical count and valuation at least once a year. Further, auditors are required
to monitor closely the inventory taking and pricing. In the case of perpetual inventory systems, periodic sample
testing is required, again with external auditor input.
After the reconciliation of receivables and inventory, adjusting entries must be made to bring the accounting
records into agreement with the underlying assets. It is equally necessary that the same kind of reconciliation of
reported balances to actual physical assets is in place because for many companies, PP&E may represent 35% or
more of total assets. Without a periodic reconciliation, the property record system will lose accuracy as items are
scrapped or enhanced. If reconciliation is performed and adjusting entries made, however, the resultant asset
category totals have been verified. Management can then sign with confidence the Section 404 certification – its
assertion that there is a system of Internal Controls and that the system is working properly.

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 Fundamentals of Accounting II CHATER 2

II. Presentation of PPE on the balance sheet

Addis Manufacturing Company
Statement of Balance Sheet
Sene 30, 2013
Items

Non-Current Assets:
Land and Buildings ……………………………………………………………………Br.1,300,000
Equipment and property………….……………….………………………………………200,000
Trade mark and Copy right………………………………………………………..………1,000,000
Investment in association………………………………………………………………….100,000
Differed income tax assets ……………………………………………………….……....40,000
Total Non-Current Assets:………………………………………………………… Br.2,640,000
Current Assets:
Inventories ………………………………………………………………. …………Br. 70,000
Trade and Other receivable…………………………………………………….……… 250,000
Current income tax assets ……………………………………………..………….……60,000
Cash and Cash equivalent assets……………………………………….………………540,000
Total Current Assets…………………………………………………………………920,000
Total Assets………………………………………………………………………………….Br. 3,560,000
Equity and Liabilities
Equity
Ordinary Shares…………………………………………………….……………..…Br.1, 000,000
Retained earnings…………………………………………………...……….…………900,000
Other equity components………………………….……………...………………..… 560,000
Total Equity……………………………………………………………………… Br.2, 460,000
Non-Current liabilities
Borrowing ………………………………………………………………………… Br.160,000
Differed income tax liabilities …………………………………………………………200,000
Total Non-Current liabilities…………………………………………………………360,000
Current liabilities
Trade payable …………………………………………………………………………190,000

Other payable…………………………………………………………………….……350,000
Current income tax liabilities …………………………………………………………200,000
Total Current liabilities……………………………………………………………… 740,000
Total equity and liabilities……………………………………………………………...… Br. 3,560,000
Figure 2.1

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 Fundamentals of Accounting II CHATER 2

2.2. Intangible Assets

2.2.1. Nature and classification of Intangible assets
Intangible Assets: are long-term assets that do not have physical substance and in most cases relate to legal
rights or advantages held. Intangible assets include patents, copyrights, trademarks, franchises, organization
costs, leaseholds, leasehold improvements, and goodwill. The allocation of intangible assets to the periods they
benefits is called amortization. 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 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).
2.2.2. Recognition and measurement at the time of acquisition.
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 (A\P)……………………………………..54,000
To record the purchase of Bottle cap patent
2.2.3. Measurement after acquisition.
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)
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.

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 Fundamentals of Accounting II CHATER 2

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.
2.2.4. Presentation of intangible assets on the balance sheet (Refer Figure 2.1)
2.3. Natural resources
2.3.1. Nature of natural recourses
Natural resource is to another group of long-lived assets, 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.
2.3.2. Recognition and measurement
Depletion expense is the after recognition measurement of long-term assets (natural resource) that is used up in a
particular period. 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.
Depletion cost per unit = Total cost – Salvage value
Total estimated units available
= Br. 10,000,000
500,000 units
=Br. 20 per gram
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

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