CHAPTER ONE: INTRODUCTION TO ACCOUNTING

1.1. Evolution, Definition of Accounting

People in all civilizations have maintained various types of records of business activities. The
oldest know as clay tablet records of the payment of wages in Babylonia around 3600 B.

However, early accounting dealt only with limited aspect of the financial operations of private or
government enterprises. These were no systematic accounting for all transactions of a particular
unit, only for specific types or portions of transactions. Now a day, as business and society
become more complex, accounting concept and techniques increased to meet financial
information.

Accounting is the process of recording, classifying, summarizing, interpreting, and

communicating financial information for owners, mangers, and other interested parties.

1.2. Characteristics of Accounting Information and its User

Accounting called as the language of business. This language viewed as information system to
make an informed judgment and decision by the users’ of the information.

An Accounting System is designed to accumulate data about a firm’s financial affairs, classify
the data in a meaningful way, and summarize it in periodic reports called financial statements.

Users of Accounting Information

Today’s accountants focus on the ultimate needs of those who use accounting information,
whether the users are inside or out side the business. 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:

1. External Users, and

2. Internal Users
1) External Users: External Users of accounting information are parties, which are not directly
involved in running the business enterprise. These include lenders, shareholders (stock
holders), suppliers, employees and their Unions, government (regulatory bodies) and others.
External users rely (depend on) accounting information to help them make better decisions in
trying to achieve their goals.
- The area of accounting aimed at serving external users is called Financial Accounting.
Its main objective is to provide to external users information through financial
statements.
Each external user has its own specified information-need depending up on the decisions to be
made. That is to say, all external users do not have the same intentions (objectives) when they
use the information.

In the following paragraphs we will try to discuss how some external users use accounting
information.

a) Lenders / Creditors

Creditors lend money or other resources to an organization. Lenders include banks, mortgage
and finance companies. Lenders look for information to help them assess the ability of
borrowers to repay their debts.

b) Share- holders (Stockholders)

Shareholders have legal control over part or all of a corporation. When it comes to a
corporation, shareholders are not directly involved in the management of the corporation.
However, as owners, they have claims over the properties of the organization. Financial reports
help to answer shareholders’ questions such as:

- What is the income of the organization for the current and past periods?

- are the properties adequate to meet business plan?

- will the business continue to be profitable in the future?

c) Employees and labor Unions

Employees and labor unions are interested in judging the fairness of their wages and assessing
future job prospects. They also use accounting reports as evidence to ask for bonuses, when the
organization is successful.

d) Government

The Inland Revenue Authority requires organizations to prepare financial reports, in order to
compute taxes.

2) Internal Users: These are persons that are directly involved in managing and operating an
organization. They include managers and other important decision makers. The internal role
of accounting is to provide information to help improve the efficiency and effectiveness of an
organization.
The area of accounting aimed at serving the decision-making needs of internal users is called
Management Accounting. Internal users often have access to a lot of private and valuable
information. Internal reports aim to answer questions like:

 What are manufacturing costs per product?

 Which service activities are most profitable?
 What level of sales is necessary to break even?
1.3. The Accounting Profession

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.

1.4. Principles and Practice of Accounting

Accounting, as it is true for other disciplines, has got its own principles and practices. One must
be able to understand these principles and practices to understand and prepare financial
statements and reports. The principles and concepts used in accounting are called Generally
Accepted Accounting Principles (GAAP). These principles guide accountants how to record and
report business activities.

GAAP are developed over a long span of years by the accounting profession. That is, their
development is not revolutionary rather evolutionary. The main purpose of these basic rules is to
guide accountants in measuring and reporting financial events of business enterprises.

GAAP are not like the unchangeable laws of nature found in biology and chemistry. They can
be changed as better methods are developed or as circumstances change. Generally, it is from
research, practice, and pronouncements of professional bodies that GAAP evolve.

In this unit, we will discuss three of the generally accepted accounting principles: Business
Entity concept, Cost principle and Monetary Unit Assumption.

1. Business entity concept

It is based on the applicability of accounting to individual economic units in society.
These individual economic unit include all business enterprises organized for profit;
governmental unit; non for profit units; and individual persons and family units. The
basic economic data for a unit must first be recorded, followed by analysis and
summarization, and finally by periodic reporting. Thus accounting applies to each
separate unity. It is possible of course, to combine the data for similar economic units to
obtain an overall view. The three major legal form of business entity are the sole
proprietorship, partnership, and corporation.
Sole proprietorship is a business entity owned by one person, example, small businesses
are operated as sole proprietorships.
Partnership is small a business entity owned by two or more people in accordance with
contractual agreement.
Corporation is a separate legal entity in which ownership is divided into shares of stock
and it is organized in accordance with the state statutes.

2. Cost principle
 The records of properties and services purchased by a business are maintained in
accordance with the cost principle, which requires that the monetary record be in terms of
cost.

The other accounting principles and concepts will be discussed in latter chapter.

1.5. Business Transaction and Accounting Equation

A business transaction is the occurrence of an event or of a condition that must be recorded. A

particular business transaction may lead to an event or condition that result in another
transaction. For example, purchase of car on credit will be followed by payment to the creditor,
which is another transaction. The wearing- out of car is not an exchange of goods or services
between the business and an outsider, but it has to be recorded. This type of transaction, as well
as others that are not directly related to outsiders, referred as internal transaction.

The accounting equation

The properties owned by business enterprise referred as assets and the right or claim to the
properties are referred as equities. If the asset owned by a business is $50,000, the equity in the
assets is also $ 50,000 i.e.

Assets= Equities

Equities may be subdivided in to two: the rights of creditors and the right of owners. The rights
of creditors represent debt of the business and are called as liabilities. The rights of owner are
called owner’s equity. Therefore we will get the accounting equation i.e.:-

Assets= Liabilities + Owner’s Equity

NB: We have to place liabilities before owner’s equity in the accounting equation because
creditors have preferential rights to the assets.

Transactions and the Accounting Equation

All business transactions from the simplest to the most complex can be stated in terms of the
resulting change in the three basic elements of the accounting equation. The following
illustration will demonstrate types of transaction and the accounting equation as follow:

Assume Mr. X establishes sole proprietorship business known as XYZ Taxi.

Transaction –a-

Mr. X deposit $10,000 in a bank account in the name of XYZ Taxi. The effect of this transaction
is to increase the assets (cash), left side of equation and to increase the owner’s equity on the
right side by the same amount.

Assets = Liabilities + Owner’s Equity

Cash Mr. X Capital

(a) 10,000 10,000 Investment

Transaction –b-

Mr. x purchased land, which is $ 7,500 in cash, is paid. This transaction changes the
composition of the assets but not change the total amount.

Assets = Liabilities + Owner’s Equity

Cash + Land Mr. X Capital

(a) 10,000 7,500 10,000 Investment

(b) - 7,500

BAL. 2,500 7,500 10,000

Transaction –c-

Mr. X purchased $ 850 of gasoline, oil, and other supplies; agreed to pay in the near future. This
type of transaction is called purchased on account and liability is created known as account
payable. The transactions effect is increasing the assets amount and the liability amount.
 Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital

Bal. 2,500 7,500 10,000

(c) 850 850

Bal. 2,500 850 7,500 850 10,000

Transaction –d-

Mr. X paid for creditor $ 400, the effect is decreasing the assets and liabilities.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital

Bal. 2,500 850 7,500 850 10,000

(d) - 400 -400

Bal. 2,100 850 7,500 450 10,000

Transaction –e-

Mr. X taxi earned fares of $ 4,500, receiving the amount in cash. In general the amount charged
to customers for goods or services sold is called revenue. Instead of requiring the payment of
cash at the time goods or services are sold, a business may make sales on account, allowing the
customers to pay latter. In such cases the firm acquires an account receivable, which is a claim
against the customers. Account receivable is as much as an asset as cash and revenue is realized.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital

Bal. 2,100 850 7,500 450 10,000

(e) + 4,500 + 4,500 Fares earned

Bal. 6,600 850 7,500 450 14,500

The effect of this transaction is increasing both the assets and owners equity.

Transaction –f-

The amount of assets consumed or services used in the process of earning revenue is called
expense. Mr. X taxi incurred the following expense and paid during the month were; wages
$1,125; rent $850; utilities $ 150; miscellaneous $ 75. The effect of this transaction is reducing
both asset and owner’s equity.

Assets = Liabilities + owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital

Bal. 6,600 850 7,500 450 14,500

(f) -2,200 - 1,125 wage exp.

-850 Rent exp.

-150 Utilities exp.

-75 Miscel. exp.

Bal. 4,400 850 7500 450 12,300

Transaction –g-

Mr. X’s supplies at the end of the month determined that $ 250 is on hand, the reminder (850-
250) have been used in the operation of the business. The effect of this situation is decreasing
both assets and owner’s equity.

Assets = Liabilities + owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital

Bal. 4,400 850 7500 450 12,300

(g) - 600 - 600

Bal. 4,400 250 7,500 450 11,700

Transaction –h-

At the end of the month Mr. x withdraws from the business $1,000 in cash for personal use. This
transaction reduces the assets and owner’s equity.

Assets = Liabilities + owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital

Bal. 4,400 250 7,500 450 11,700

-1,000 -1,000

Bal. 3,400 250 7,500 450 10,700

Summary of the above transaction presented as follows:

Assets = Liabilities + Owner’s Equity

Cash +supplies + Land Account payable + Mr. X Capital

(a) 10,000 7,500 10,000 Investment

(b) - 7,500

2,500 7,500 10,000

(c) +850 +850

2,500 850 7,500 850 10,000

(d) -400 -400

2,100 850 7,500 450 10,000

(e) +4,500 +4,500 Fares earned

6,600 850 7,500 450 14,500

(f) -2,200 -1,125 Wages exp.

-850 Rent exp.

-150 Utility exp.

-75 miscel. exp.

4,400 850 7,500 450 12,300

(g) -600 -600 Supplies exp.

4,400 250 7,500 450 11,700

(h) -1,000 -1,000 Withdrawal

3,400 250 7,500 450 10,700

The following points apply for all types of business:

1. The effect of every transaction increased and / or decreased one or more of accounting
equations.

2. Equality of the two sides of accounting equation should be maintained.

3. Owner’s equity increased by amounts invested by owner and decreased by amounts

withdrawal by the owner. In addition owner’s equity increased by revenues earned and
decreased by expenses; diagrammatically as follows:

Owner’s Equity
Decreased Increased

 Owners  Owners
1.6. FINANCIAL STATEMENTS

After the effect of the individual transactions has been determined, essential information is
communicated to users. The accounting statements that communicate this information are called
financial statement.

FINANCIAL STATEMENTS FOR SOLE PROPRIETORSHIP

The principal financial statements for sole proprietorship are the following:

1. Income Statement

It is a summary of revenues and expenses of a business entity for specific period of time,
such as a month or a year. The excess of revenues over expenses is called net income or
net profit. If the expenses exceed the revenues, the excess is net loss.

The determination of the periodic net income or net loss is a matching process involving
two steps. First, revenues are recognized during the period. Second, the assets consumed
in generating revenue must be matched against the revenue in order to determine the net
income or net loss.

2. Statement of Owner’s Equity

It is a summary of the changes in the owner’s equity of a business entity that have
occurred during specific period of time.

3. Balance Sheet
 It is a list of assets, liabilities and owner’s equity of a business entity as of a specific date.
The asset section of a balance sheet begin with cash followed by receivables, supplies ,
prepaid insurance and other asset that can be converted in to cash or used up in the near
future. The asset of relatively permanent nature such as land, building and equipment
follow that order. In the liability and owner’s equity section of the balance sheet, the
liabilities presented first followed by owner’s equity.

4. Statement of Cash Flow

It is a summary of cash receipts and cash payments of a business entity for a specific
period of time. This statement has three sections i.e. operating activities, investing
activities, and financing activities.

a. Operating Activities

This section includes cash transactions that enter in to the determination of net
income or net loss.

b. Investing Activities

This section includes the cash transaction for the acquisition and sale of relatively
long term or permanent type of assets.

c. Financing Activities

This section includes the cash transaction related to cash investment by the
owner’s and borrowing and withdrawals by the owner.

NB: the cash balance at the beginning of the period is added to the increase
(or decrease) in cash for the period to obtain the cash balance at the end of
the period.

The basic features of the four statements and their interrelationships are
illustrated by taking data from Mr. X taxi business as follows:
 Mr. X Taxi

Income Statement

For Month Ended August 31, 2007

Fares Earned $4,500

Operating Expenses :

Wages Expenses $1,125

Rent Expenses 850

Supplies Expenses 600

Utilities Expenses 150

Miscellaneous Expenses 75

Total Expenses 2,800

Net Income $1,700

Mr. X Taxi

Statement of Owner’s Equity

For Month Ended August 31, 2007

Investment During the Month $10,000

Net Income for the Month $1,700

Less: Withdrawal 1,000

Increase in Owner’s Equity 700

Mr. X Capital, August 31, 2007 $10,700

Mr. X Taxi

Balance Sheet

August 31, 2007

Assets

Cash $3,400

Supplies 250

Land 7,500

Total Assets $11,150

Liabilities

Account Payable $450

Owner’s Equity

Mr. X Capital $10,700

Total Liabilities and Owner’s Equity $11,150

Mr. X Taxi

Statement of Cash Flow

For Month Ended August 31, 2007

Cash Flows from Operating Activities:

Cash Received from Customers $4,500

 Deduct: Cash Payments for Expenses And Payment 2,600
to Creditor

Net Cash Flow from Operating Activities $1,900

Cash Flows from Investing Activities:

Cash Payments for Acquisition of Land (7,500)

Cash Flows from Financing Activities:

Cash Received as Owner’s Investment $10,000

Deduct: Cash Withdrawal by Owner 1,000

Net Cash Flow from Financing Activities 9,000

Net Cash Flow And August 31,2007 Cash Balance $3,400

FINANCIAL STATEMENT FOR CORPORATION

Business enterprises with large amount of assets are usually organized as corporations and have
many owners, called stockholders. The financial statements of corporations are statement of
cash flow, income statement, balance sheet, and retained earnings statement.

a. Retained Earning

The emphasis is reporting the changes in the stockholders’ equity are on the changes
in retained earnings, or net income retained in the business. The changes in retained
earning that have occurred during a period are reported in retained earnings
statement. Change in the amount of earnings retained in the business would have
resulted from (1) net income and (2) distribution of earnings, called dividends, to
owners.

b. Balance Sheet
 The only difference between the balance sheet of sole proprietorship and corporation
is the stockholders’ equity section presented rather than owner’s equity.

c. Statement of Cash Flow

The only difference between cash flow statement of corporation and sole
proprietorship is on the financing activities section, the cash received as investments
of stockholders arises from the sale of capital stock and the cash payments to
stockholders are in the form of dividends.

d. Income Statement

It is a summary of revenues and expenses of a business entity for specific period of

time, such as a month or a year. The excess of revenues over expenses is called net
income or net profit. If the expenses exceed the revenues, the excess is net loss.

If Mr. X Taxi had been organized as corporation; the only change on the financial statements
will be the retained earnings statement instead of statement of owner’s equity and the balance
sheet account of owner’s equity should be changed by stockholders’ equity. For example

Mr. X Taxi

Retained Earnings Statement

For Month Ended August 31, 2007

Net Income for the Month 1,700

Less: Dividends 1,000

Retained Earnings, August 31, 2007 700

Mr. X Taxi

Balance Sheet

August 31, 2007

 Assets

Cash $3,400

Supplies 250

Land 7,500

Total Assets $11,150

Liabilities

Account Payable $450

Stockholders’ Equity

Capital Stock $10,000

Retained Earnings 700

Total Stockholders’ Equity 10,700

Total Liabilities and Owner’s Equity $11,150

1. What are the basic categories of the users of accounting information?

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2. _____________is the area of accounting aimed at serving external users of accounting
information.
3. _____________ is the area of accounting aimed at serving the decision-making needs of
internal users.
4. What are the three major fields of engagement for accountants?
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 5. The abbreviation GAAP stands for ____________________________.

6. What do we mean by “GAAP are not like the unchangeable laws of nature”?
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7. Why do we need to record all business activities in terms of money?
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8. What is the principle that says properties acquired by business enterprises must be recorded at
actual amounts paid?
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9. ___________________ represents the claim of owner’s against assets of the business
enterprise.
10. Assume total asset of Br 60,000, and owner’s equity of Br 45,000. Determine the amount of
liability.
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11. L=A-C is this an acceptable way of writing the basic accounting equation? Explain.
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12. What do we mean when we say “owners have a residual claim over the assets of the business
enterprise”?
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13. Define a business transaction, and give at least four examples.

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