Chapter one

1. Introduction to Accounting and Business

1.1 The nature of a business
A business is an organization in which basic resources (inputs), such as materials and labor, are
assembled and processed to provide goods or services (outputs) to customers. A business’s
customers are individuals or other businesses that purchase goods or services in exchange for
money or other items of value. The objective of most businesses is to maximize profits. Profit is
the difference between the amounts received from customers for goods or services provided and
the amounts paid for the inputs used to provide the goods or services. Some businesses operate
with an objective other than to maximize profits. The objective of such nonprofit businesses is to
provide some benefit to society, such as medical research or conservation of natural resources. In
other cases, governmental units such as cities operate water works or sewage treatment plants on
a nonprofit basis. We will focus in this course on businesses operating to earn a profit.
1.2 Types of business organizations
There are three basic forms of business organizations: sole proprietorships, partnerships, and
corporations. Accountants recognize each form as an economic unit separate from its owners
(Business Entity Concept).
1. Sole Proprietorships
A sole proprietorship is a business owned by one person and usually managed by the owner. No
special legal requirements must be met to start a sole proprietorship and usually only a limited
investment is required to begin operations.
A sole proprietorship is a separate entity for accounting purposes (Business entity Concept) but it
is not a separate legal entity from the owners. That is, from the legal point of view, the owner
and the business are treated as one and the same. The owner will be held personally responsible
for the debts and actions of the business.
2. Partnerships
A Partnership is like a sole proprietorship in most ways except that it has more than one owner.
A partnership is not a legal entity separate from the owners but an association that brings
together the talents and resources of two or more people. The owners of a partnership are known
as partners.
The partners share the profits and losses of the partnership according to an agreed –on formula.
The personal resources of each partner can be called on to pay the obligations of the partnership.
That is, each partner is personally responsible for the debts of the partnership. From an
accounting standpoint, however, a partnership is a business entity separate from the personal
activities of the partners.
3. Corporations
A business organized as a separate legal entity with ownership divided into transferable units of
capital is called a corporation. The owners of a corporation are called stockholders or
shareholders. The corporation issues capital stock certificates to each stockholder showing the
number of shares (or stock) he or she owns. The stockholders are free to sell all or part of these

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shares to other investors at any time. This ease of transfer of ownership adds to the attractiveness
of investing in a corporation. Since a corporation is a separate legal entity, the owners
(stockholders) are not personally liable for the debts of the corporation. Their risk of loss is
limited to the amount they paid (invested). Because of this limited liability in corporation
shareholders are willing to invest.
Even though corporations are fewer in number than proprietorships and partnerships, they
contribute a lot to the economies of many countries in monetary terms.
We can also group business entities by the type of business activity they perform
1. Service companies
Service companies perform services for a fee. This group includes companies such as accounting
firms, law firms, repair shops and many others.
2. Merchandising companies
Merchandising companies purchase goods that are ready for sale and sell them to customers.
Merchandising companies include such companies as out dealership, clothing stores, and
supermarkets.
3. Manufacturing companies
Manufacturing companies buy materials, convert them into products, and then sell the products
to other companies or final consumers. Example of manufacturing companies is cloth
manufactures, auto manufacturers and flour factories.
1.3 The roles of accounting
Definition: -
Accounting is defined as the process of identifying, measuring, recording, classifying,
summarizing, analyzing and interpreting economic events (financial transactions) and
communicating the results thereof to the entities interested in such information to enable them
make informed judgments. The analysis the definition is as follows:
 Identifying- to distinguish an event or a transaction that must be recorded.
 Measuring- quantifying an event or a transaction i.e., accounting deals with only those
transactions and events that can be expressed in terms of money.
 Recording- this is the basic function of accounting. It is essentially concerned with not only
ensuring that all business transactions of financial character are in fact recorded but also that
they are recorded in an orderly manner.
 Classifying- it is concerned with the systematic analysis of the recorded data with a view to
group transactions or entries of one nature at one place.
 Summarizing-this involves presenting the classified data in a manner which is
understandable and useful to the internal as well as external end users of accounting
statements or other accounting information
 Analyzing-means methodical classification of the data given in the financial statements. For
example, all items relating to “current assets” are put at one place.
 Interpreting- explaining the meaning and significance of the data so simplified and
analyzed
 Communicating- the accounting information after being meaningfully analyzed and
interpreted has to be communicated in a proper form and manner to the proper person.

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Roles of accounting: -
As accounting plays an important role in the decision-making process of business entities, it is
often called the language of business. As a result, whether you are an economist, manager,
investor, supplier or any other, to be successful, you should be able to “speak” and be familiar
with the basic terms used in the business environment.
So far Accounting defined as an information system. Therefore, a study of accounting helps
people make better and informed decisions about assessing opportunities, products, investments,
and social and community responsibilities.
But the use of accounting information is not limited to accountants or people in business. You
can use accounting information in your daily life. You can use accounting information to get a
loan for a house or to start a new business. The study of accounting, therefore, opens you new
and exciting possibilities both in terms of becoming a professional accountant and using
accounting information in your daily life.
Accounting is not an end by itself. The information that accounting provides allows users to
make “reasonable choices among alternative uses of scarce resources in the conduct of business”
The people who use accounting information basically fall in to two categories:
Internal users:
 Internal users are parties inside the reporting entity (company) who are interested in the
accounting information.
 Internal users are those individuals directly involved in managing and operating an
organization.

Example: managers-for controlling, monitoring and planning, officers, internal auditors,

sales managers, budget officer, other internal decision maker.
External users
 External users are parties outside the reporting entity (company) who are interested in the
accounting information.
 They are not directly involved in running the organization.
Examples:
 lenders (banks and financial companies)-whether an organization is likely to repay its
loan with interest and to grant loan
 shareholders(investors)-what is income for current and past periods-to assess the return
and risk in acquiring shares
 External auditors-to examine and provide an opinion on whether financial statements are
prepared according to GAAP.
 Employees-to judge the fairness of their wages, to assess future jobs prospective.
 Regulators (internal revenue service, tax authorities)-to compute taxes
 Others such as:
 Voters, Legislators, elected officials to monitor and evaluate a government
receipts and expenses.
 Contributors to not for profit organization-to evaluate the use and impact of their
donations.
 Suppliers – to judge the soundness of the business before making sales on credit.

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  Customers –to assess the staying power of suppliers.
In short, the goal of the accounting system is to provide useful information to decision makers.
Thus, accounting is the connecting link between decision makers and business operations.
1.4 The profession of accounting
If you just joined the accounting profession, you may be wondering what job you will be doing
in the future. You probably would apply your expertise in one of three major fields:
 Public Accounting
 Private Accounting or
 Not – for – profit Accounting
i) Public accounting
In Public Accounting you would offer expert service to the general public in much the same way
that a doctor serves patients and a lawyer serves clients. A major portion of public accounting
practice is involved with Auditing. In this area, a certified Public Accountant (CPA) examines
the financial statements of companies and expresses opinion as to the fairness of presentation.
When presentation is fair, users consider the statements to be reliable.
Management consulting is another area of public accounting. In this case, the accountant
consults the management generally about the growth and development of the business enterprise.

ii) Private Accounting

Instead of working in public accounting, an accountant may be an employee of a business

enterprise. In private accounting, you would be involved in one of the following activities:
1. Cost Accounting: Determining the cost of producing specific products.
2. Budgeting: Assisting management in quantifying goals concerning revenues,
costs of goods sold, and operating expenses.
3. General Accounting: recording daily transactions and preparing financial
statements and related information.
4. Accounting information systems: designing both manual and computerized data
processing systems.
5. Tax Accounting: preparing tax returns (-forms to be filled by a company and
returned to a taxing authority) and engaging in tax planning for the company.
6. Internal Auditing: reviewing a company’s operations to determine compliance
with management policies and evaluating efficiency of operations.
iii) Not for Profit Accounting
Like businesses that exist to make a profit, not - for-profit organizations also need sound
financial reporting and control. Donors to such organizations want information about how well
the organization has met its objectives and whether continued support is justified. In each of
these cases, accounting expertise is highly valued.
1.5 Accounting principles and practices (GAAP&IFRS)

i) Business Entity Concept

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 Accountants frequently refer to a business organization as an accounting or business entity. A
business entity is any business organization, such as a “super market”, laundry, barberry, or a
hotel, which exist as an economic unit. For accounting purposes, each business enterprise has a
separate existence from its owners, creditors, employees, customers and other businesses.
This separate existence of the business enterprise is known as the business entity concept. Thus,
the business entity should have a completely separate set of records and its financial records and
reports should refer only about the business enterprises.
For example, W/o Muna Mamo has got her own two business enterprises one called Munaye
Super Market, and another hotel called Budena Hotel. Each Business would be considered as
an independent economic business unit. The activities of each business are kept separately
from each other and from the owner’s personal records. Let say W/O Muna bought a house
to live in. This house would not be recorded and reported in the records of either the
supermarket or the hotel. The personal saving account she has will not as well be included in
the financial reports of either one of the businesses. She must have to open separate bank
accounts for the two businesses. The super market should not record the payment of salary
to employees of the hotel.

ii) The cost principle

The cost principle states “properties and services acquired by business enterprises must be
recorded at actual amounts paid or assumed in acquiring the properties.”
For example, Modern Advertising Company is considering the purchase of a building. The
seller of the building offered a price of Birr 10,000 while the buyer first offered a price of
Birr 8000. However, after certain bargaining, the seller agreed to sell the building for Birr
9000 and the buyer paid that amount. According to the “cost principle” the buyer has to
record the building in its records at birr 9000- the actual amount paid to get the building.
The buyer may receive an offer of Birr 12,000 for the building a month after if has been
acquired. This has no effect on the accounting records because it doesn’t originate from an
actual exchange. It is simply a mere offer.
If the buyer sells the building for Birr 20,000 after purchasing it, a gain of Birr. 11,000 would be
realized. The new owner would use Birr 20,000 as the cost of the building.
In an exchange between a buyer and a seller, both attempt to get the best price. Only amounts
agreed up on and paid are objective enough for accounting purposes.

iii) Monetary Unit Assumption

All business activities (events) are recorded in terms of money (-Birr, Dollar, Pound or any other
currency). Of course, information of a non -financial nature can be recorded, but it is only
through the recording of dollar (Birr) amounts that the activities of a business can be measured.
Money is the only factor common to all business activities. Therefore, it is the only practical unit
of measurement that can produce financial data that can be compared.
The monetary unit used by a business depends on the country in which it exists. For
example, in Ethiopia the basic unit of measurement is the birr, as is the dollar in the U.S.A,
and Pound Sterling in the United Kingdom.
iv) Objectivity Concept
It requires that the amounts recorded in the accounting records be based on objective evidence.
v) Matching principle
It states that Revenue and related expenses should be reported in the same accounting period.
vi) Going concern concept

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This concept states that an enterprise is expected to operate for an indefinite period of time.
vii) Time Period (Periodicity) concept:
The economic life of a business should be divided in to artificial period of time. Analysis of
Financial condition and preparation of financial statements is done at regular intervals.
 The length of time for which an analysis of business operations is done is called a Fiscal
Period or Accounting period.
 Fiscal period/accounting period may consist either of: a month usually minimum, a
quarter, semiannual, a year –usually maximum length.
 The accounting time period of one year in length is usually known as a fiscal
year.
1.6 The Elements of Accounting
1. Assets
 Are items with money value that are owned by a business.
 An item has a dollar (birr) value to be recorded in accounting records. Example:
cash, accounts receivable, supplies, inventories, equipment, land buildings etc
2. Liabilities:
 Debts owed by the business-obligation of a business.
 A liability that results from purchasing goods and services on credit is called
accounts payable. Other liabilities include notes payable, interest payable, wages
payable etc
3. Owner’s Equity:
 the difference between what is owned and what is owed is owner’s equity.
 It is the excess of assets over liabilities.
 Also called capital, proprietorship, net worth, and net asset.
4. Revenues:
 Revenues are increases in capital due to inflow of resources from business
operations such as, provision of services or sales of goods.
5. Expenses:
 Expenses are decrease in capital due to outflow of resources for the purpose of
business operations.
6. Drawings: An owner may withdraw cash or other assets during the accounting period for
personal use. These withdrawals could be recorded as a direct decrease of owner’s equity
and recorded in drawings account.
 Drawings decrease total owner’s equity.

Basic Accounting Equation

The relationship among the accounting elements can be expressed in a single mathematical form
known as the accounting equation or the basic accounting equation (balance sheet equation)
Equities: are claims against the asset of a business.
Assets = Equities
Claims are divided into two categories:
 Creditors' claims that are called liabilities

 Owners' claims that are called equity

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 Assets = Liabilities + Owner’s Equity
A= L + OE
It is customary to place “liabilities “before “Owners equity” in the accounting equation because
creditors have priority (preferential) rights to the assets. Because of this, the owners have a
residual claim over the assets. To help you understand this, assume X Company has total assets
of Br. 5000, liabilities of Br 2000 and owner’s equity of Br 3000. If the business is to be closed,
the assets of the company will be sold and distributed to the claimants. In accounting, the
Owner’s are given their share after the creditors are given their entire share. For example,
assume the assets are sold for Br 4,500. The creditors will be given their share of Br. 2,000 and
whatever remained (Br.2, 500) is given to the owners. If the assets were sold for Br. 7,000, the
creditors would have been given their share of Br. 2,000 and the remaining balance Br 5,000
would have been given to the owners.
If a company goes bankrupt, liabilities are paid off first to creditors, while owner’s equity is the
last to be distributed. Therefore, owners' equity is also called residual equity.

1.7 Business Transactions and Accounting Equation

 Any activity that changes the value of assets, liabilities, owner’s equity, revenue or
expenses is called transaction.
 Business transaction is an exchange of economic consideration between two
parties/event of occurrence or condition that must be recorded.
E.g., hiring an employee does not change the value of any assets, liabilities and owner’s equity,
so it is not a transaction.
Business transactions are economic events that should be recorded because they affect the
financial position of the business enterprise. These businesses transactions are the raw materials
of accounting reports, as cotton is a raw material for a textile factory.
A transaction can be an exchange (such as the purchase or sale of property, payment or
collection of a loan etc.) between two or more parties. A transaction can also be an event that
has the same effect as an exchange transaction but doesn’t involve an exchange transaction.
Some examples of “non exchange” transactions are losses from fire, flood; physical wear and
tear on equipment; donation of property and so forth.
For a given transaction to qualify to be recorded it has:
1. to be related to the business enterprise
2. to be measurable in terms of money
3. to be completed / happened/ action.
Transaction can be created internally or external.
Internal transaction: internally created
E.g., Salary payment, Depreciation, Supplies, Allowance for uncollectible
External transaction: transaction related to outsiders
Example: purchase of asset on account, cash payment to a creditor, receipt of cash for service
rendered, payment of rent and collection of accounts receivable

ILLUSTRATION
Recording the effect of transactions on the accounting Equation for the Month ended
December 31, 2010
a) Alex the owner of Alex PLC invested Br. 10,000 cash in the business
b) Invested supplies valued at Birr 2000 in the business.

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 c) Paid rent for the month Birr 600.
d) Performed service and received cash Br 800.
e) Purchased supplies on credit Br 200.
f) Preformed service on credit, Br 625
g) Withdrew cash for personal use Br 500.
h) Received Br 250 cash as partial payment for service performed on account.

Dr. Br 12,525 Cr. Br 12,525

Assets Liabilities + Owners’ Equity Description
Cash + A/R + Supplies = A/Payable + Alex, Capital
a. Br.10,000 Br10,000 Investment
b. 2,000 2,000 Investment
c. (600) (600) Rent expense
d. 800 800 Revenue
e. 200 200
f. 625 625 Revenue
g. (500) (500) Withdrawal
h. 250 (250)
Total 9,950 + 375 + 2,200 = 200 + 12,325

1.8 Financial Statements

 Financial statements are summaries of financial activities of an enterprise.
 Financial statements are prepared at the end of an accounting period
 Financial statements are prepared from business transitions.
 Financial statements are output of accounting system
The four major financial statements are:
1. Income statement:
 Describes a company’s revenues and expenses along with the resulting net
income or net loss over a period of time.
 An income statement is also called Statement of Operations, Earnings
Statement, or Profit and Loss Statement (P/L).
 When revenue exceeds expenses, there is a net income.
 When expenses exceed revenue, there is a net loss.
2. Statement of Owner’s equity:
 Explains changes in equity due to items such as net income, net loss, owner’s
investment, and owner’s withdrawal over a period of time.
 Expenses & owner’s withdrawal decreases the Owners equity of a business.
 Revenues & owner’s investment increases the Owners equity of a business.
 Preparation of owners’ equity statement is optional.
3. Balance sheet:
 A listing of a firm’s assets, liabilities and owner’s equity at a specific date.
 A balance sheet is also called Statement of Financial Position.
There are two forms of balance sheet:

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  An account form balance sheet.
 a report form balance sheet
The body of account form balance sheet has two sides: a left-hand side and a right-hand side.
The assets of a business are listed on the left-hand side of the balance sheet. The liabilities and
capital are listed on the right-hand side of the balance sheet.

Account form Balance Sheet (Two sides of balance sheet)

Left-hand side Right-hand-side

A) ASSETS B) LIABILITIES
(What is owned?) (What is owed?)
C) CAPITAL
(What the businesses worth)

TOTAL ASSETS Total LIABILITIES + CAPITAL

In report form of balance sheet, all items—assets, liabilities, and capital—are listed down in the
order shown below:

Report form balance sheet

Account Titles
Amounts
Assets
xx
Total Assets
xx
Liabilities
xx
Capital
xx
Total Liabilities & Capital
xx
4. Statement of cash flows: identifies cash inflows and outflows over a period of time.
There are 3 types of cash flows (CF):
 Cash flow from operating activities – cash flow generated by normal business operations
 Cash flow from investing activities – cash flow from buying and selling assets: buildings,
real estate, investment portfolios, equipment.
 Cash flow from financing activities – cash flow from investors or long-term creditors

Financial statements have these elements:

 A proper heading, consisting of
o Company Name
o Title of Statement
o Time Period or Date of Statement
 The body of the statement presenting financial information, in correct format.
 Totals and subtotals, specific to each financial statement.
 Articulation of balances and totals between statements.
 Notes disclosing additional information according to GAAP

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See the following financial statements prepared for Alex Barber, service business from the above
transactions.

Alax PLC
Income statement
For the month ended December 31,2010
Revenue (service fee) …………………… Br1,425
Operating expense:
Rent expense …………………. … Br. 600
Net income ………………………………. Br825
Alax PLC
A statement of Owner’s Equity
For the month ended December 31,2010

Alex Beginning capital……………………………0

Add: Investment during the year ………. Br12,000
Net income (net loss)………………………. 825
Less: Withdrawal ……………………………..(500)
Alex, Ending capital -------------------------Br12,325
Alax PLC
Balance sheet
December 31,2010
Assets
Cash.……………………………………….Br9,950
Accounts receivable…………………………… 375
Supplies……………………………………… 2,200
Total assets……………………………... Br12,525
Liabilities
Accounts payable……………………………….. 200
Owner’s equity
Alex, capital…………………………………..12,325
Total liabilities and owner’s equity…………Br12,525
Alax PLC
Cash Flow Statement
For the month ended December 31,2010
Cash inflows:
Collection from customers Br1,050
Investment by the owner 10,000
Total cash inflows Br11,050
Cash outflows:
Expenses 600
Withdrawal 500
Total cash outflows 1,100
Net cash flow Br9,950

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