Accounting and Finance for Managers

Chapter One
Introduction to Accounting and Business

1.1. Nature of business, Types and forms of Business organizations

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. 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. Business organizations can be established differently in terms of
operation and legal formation.
There are three different legal forms of business organization:
1. Sole proprietorship: - is a business owned and managed by single individual.
Advantages:
 Easy to establish the business
 It is least regulated by government
 No profit sharing
Disadvantages:
 Limited life
 Limited capital to finance business operation
 Unlimited liability
2. Partnership: - is business organization established by two or more persons.
Advantages:
o Easier and less expensive to establish than corporation
o Are not highly regulated by government
o More capital and managerial skill than a single proprietor ship
Disadvantages:
o Limited life
o Unlimited liability

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3. Corporation: - is a business organized as a separate legal entity under state

corporation law with ownership divided into transferable shares of stock.
Advantages:
o Long life
o Limited liability
o Can raise huge amount of capital to finance business
operation
Disadvantages:
 Double taxation
 Highly regulated by government
According to their type of activities or nature of operations, business organizations are also
classified in to three main types:

1. Service rendering businesses: - are business organizations that are predominantly

engaged in rendering of services to customers for the purpose of maximizing profit.
Examples: Hotels, restaurants, cafeterias, bars, transport and communication
services, professional firms like consultations by accountants, lawyers, engineers
etc.
2. Merchandising businesses: - is profit seeking businesses, which are engaged in
purchasing and reselling of merchandises.
Examples: Supermarkets, boutiques, garment and shoe shops, drug stores,
stationary shops, auto spare parts, importers, exporters etc.
3. Manufacturing businesses: - are business organizations that are primarily involved in
the conversion of raw materials and parts in to finished goods; and sale their finished
goods to merchandising enterprises and consumers. Sometimes, they sale goods to other
manufacturing firms, which utilize the goods as raw materials for production activities.
Examples: Cement factories, sugar factories, soap factories, textile
factories, paper factories, etc.

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1.2. Accounting, Objectives and Role of Accounting in Business

Accounting has rightly been termed as the language of business. The basic function of a
language is to serve as a means of communication Accounting also serves this function. It
communicates the results of business operations to various parties who have some stake in the
business viz., the proprietor, creditors, investors, Government and other agencies. Though
accounting is generally associated with business but it is not only business which makes use of
accounting. Persons like housewives, Government and other individuals also make use of
accounting. For example, a housewife has to keep a record of the money received and spent by
her during a particular period. She can record her receipts of money on one page of her
"household diary" while payments for different items such as milk, food, clothing, house,
education etc. on some other page or pages of her diary in a chronological order. Such a record
will help her in knowing about:
o The sources from which she received cash and the purposes for which it was utilized.
o Whether her receipts are more than her payments or vice-versa?
o The balance of cash in hand or deficit, if any at the end of a period.
In case the housewife records her transactions regularly, she can collect valuable information
about the nature of her receipts and payments. For example, she can find out the total amount
spent by her during a period (say a year) on different items say milk, food, education,
entertainment, etc. Similarly she can find the sources of her receipts such as salary of her
husband, rent from property, cash gifts from her relatives, etc. Thus, at the end of a period (say a
year) she can see for herself about her financial position i.e., what she owns and what she owes.
This will help her in planning her future income and expenses (or making out a budget) to a great
extent.

With regard to its history, accounting is as old as money itself. However, the act of accounting
was not as developed as it is today because in the early stages of civilization, the number of
transactions to be recorded were so small that each businessman was able to record and check for
himself all his transactions. However, the modern system of accounting based on the principles
of double entry system owes it origin to Luco Pacioli who first published the principles of
Double Entry System in 1494 at Venice in Italy. Thus, the art of accounting has been practiced

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for centuries but it is only in the late thirties that the study of the subject 'accounting' has been
taken up seriously.

Generally, accounting can be 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.

The various definitions and explanations of accounting has been propounded by different
accounting experts from time to time and the following aspects comprise the nature of
accounting:
 Accounting as a service activity: Accounting is a service activity. Its function is to
provide quantitative information, primarily financial in nature, about economic entities
that is intended to be useful in making economic decisions, in making reasoned choices

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among alternative courses of action. It means that accounting collects financial

information for the various users for taking decisions and tackling business issues.
Accounting in itself cannot create wealth though, if it produces information which is
useful to others, it may assist in wealth creation and maintenance.
 Accounting as a profession: Accounting is very much a profession. A profession is a
career that involve the acquiring of a specialized formal education before rendering any
service. Accounting is a systematized body of knowledge developed with the
development of trade and business over the past century. The accounting education is
being imparted to the examinees by national and international recognized the bodies like
American Institute of Certified Public Accountants (AICPA). The candidate must pass a
vigorous examination in Accounting Theory, Accounting Practice, Auditing and Business
Law. The members of the professional bodies usually have their own associations or
organizations, where in they are required to be enrolled compulsorily as Associate
member of the Institute of Chartered Accountants (A.C.A.) and fellow of the Institute of
Chartered Accountants (F.C.A.). In a way, accountancy as a profession has attained the
stature comparable with that of lawyer, medicine or architecture.
 Accounting as a social force: In early days, accounting was only to serve the interest of
the owners. Under the changing business environment the discipline of accounting and
the accountant both have to watch and protect the interests of other people who are
directly or indirectly linked with the operation of modern business. The society is
composed of people as customer, shareholders, creditors and investors. The accounting
information/data is to be used to solve the problems of the public at large such as
determination and controlling of prices. Therefore, safeguarding of public interest can
better be facilitated with the help of proper, adequate and reliable accounting information
and as a result of it the society at large is benefited.
 Accounting as a language: Accounting is rightly referred the "language of business". It
is one means of reporting and communicating information about a business. As one has
to learn a new language to converse and communicate, so also accounting is to be learned
and practiced to communicate business events. A language and accounting have common
features as regards rules and symbols. Both are based and propounded on fundamental
rules and symbols. In language these are known as grammatical rules and in accounting,

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these are termed as accounting rules. The expression, exhibition and presentation of
accounting data such as a numerals and words and debits and credit are accepted as
symbols which are unique to the discipline of accounting.
 Accounting as science or art: Science is a systematized body of knowledge. It
establishes a relationship of cause and effect in the various related phenomenon. It is also
based on some fundamental principles. Accounting has its own principles e.g. the double
entry system, which explains that every transaction has two fold aspect i.e. debit and
credit. It also lays down rules of journalizing. So we can say that accounting is a science.
Art requires a perfect knowledge, interest and experience to do a work efficiently. Art
also teaches us how to do a work in the best possible way by making the best use of the
available resources. Accounting is an art as it also requires knowledge, interest and
experience to maintain the books of accounts in a systematic manner. Everybody cannot
become a good accountant. It can be concluded from the above discussion that
accounting is an art as well as a science.

Objectives of Accounting

The following are the main objectives of accounting:

 To keep systematic records: Accounting is done to keep a systematic record of financial
transactions. In the absence of accounting there would have been terrific burden on human
memory which in most cases would have been impossible to bear.
 To protect business properties: Accounting provides protection to business properties from
unjustified and unwarranted use. This is possible on account of accounting supplying the
following information to the manager or the proprietor:
o The amount of the proprietor's funds invested in the business.
o How much the business have to pay to others?
o How much the business has to recover from others?
o How much the business has in the form of (a) fixed assets, (b) cash in
hand, (c) cash at bank, (d) stock of raw materials, work-in-progress and
finished goods? Information about the above matters helps the proprietor

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in assuring that the funds of the business are not necessarily kept idle or
underutilized.
 To ascertain the operational profit or loss: Accounting helps in ascertaining the net profit
earned or loss suffered on account of carrying the business. This is done by keeping a proper
record of revenues and expense of a particular period. The Profit and Loss Account is
prepared at the end of a period and if the amount of revenue for the period is more than the
expenditure incurred in earning that revenue, there is said to be a profit. In case the
expenditure exceeds the revenue, there is said to be a loss. Profit and Loss Account will help
the management, investors, creditors, etc. in knowing whether the business has proved to be
remunerative or not. In case it has not proved to be remunerative or profitable, the cause of
such a state of affairs will be investigated and necessary remedial steps will be taken.
 To ascertain the financial position of the business: The Profit and Loss Account gives the
amount of profit or loss made by the business during a particular period. However, it is not
enough. The businessman must know about his financial position i.e. where he stands? What
he owes and what he owns? This objective is served by the Balance Sheet or Position
Statement. The Balance Sheet is a statement of assets and liabilities of the business on a
particular date. It serves as barometer for ascertaining the financial health of the business.
 To facilitate rational decision making: Accounting these days has taken upon itself the
task of collection, analysis and reporting of information at the required points of time to the
required levels of authority in order to facilitate rational decision-making. The American
Accounting Association has also stressed this point while defining the term accounting
when it says that accounting is the process of identifying, measuring and communicating
economic information to permit informed judgements and decisions by users of the
information. Of course, this is by no means an easy task. However, the accounting bodies all
over the world and particularly the International Accounting Standards Committee, have
been trying to grapple with this problem and have achieved success in laying down some
basic postulates on the basis of which the accounting statements have to be prepared.

The Role of Accounting in Business

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What is the role of accounting in business? The simplest answer to this question is that
accounting provides information for managers to use in operating the business. In addition,
accounting provides information to other stakeholders to use in assessing the economic
performance and condition of the business.

1.3. Branches of Accounting

 Financial Accounting: Financial accounting involves recording and categorizing

transactions for business. This data is generally historical, meaning it’s from the past. It
also involves generating financial statements based on these transactions. All financial
statements, such a balance sheet and income statement, must be prepared according to the
international financial reporting standards.
 Managerial Accounting: Also known as management accounting, this type of
accounting provides data about a company’s operations to managers. The focus of
managerial accounting is to provide data that managers need to make decisions about a
business’s operations, not comply strictly with reporting standards. Managerial
accounting includes budgeting and forecasting, cost analysis, financial analysis,
reviewing past business decisions and more.
 Cost Accounting: Cost accounting is considered a type of managerial accounting. Cost
accounting is most commonly used in the manufacturing industry, an industry that has a
lot of resources and costs to manage. It is a type of accounting used internally to assess a
company’s operations. Cost accounting concerns itself with recording and analyzing
manufacturing costs. It looks at a company’s fixed (unchanging and constant costs, like
rent) and variable costs (changing costs, like shipping charges) and how they affect a
business and how these costs can be better managed, according to accounting tools.
 Accounting Information Systems: Known as AIS for short, accounting information
systems concerns itself with everything to do with accounting systems and processes and
their construction, installment, application and observation. This can include accounting
software management and the management of bookkeeping and accounting employees.

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 Tax Accounting: Tax accounting involves planning for tax time and the preparation of
tax returns. This branch of accounting aides businesses be compliant with regulations set.
Tax accounting also helps businesses figure out their income tax and other taxes and how
to legally reduce their amount of tax owing. Tax accounting also analyzes tax-related
business decisions and any other issues related to taxes.
 Forensic Accounting: This specialized accounting service is trending in accounting and
is becoming increasingly popular. Forensic accounting focuses on legal affairs such as
inquiry into fraud, legal cases and dispute and claims resolution. Forensic accountants
need to reconstruct financial data when the records aren’t complete. This could be to
decode fraudulent data or convert a cash accounting system to accrual accounting.
Forensic accountants are usually consultants who work on a project basis, according to
accounting tools.

1.4. Users of accounting information

[

The basic objective of accounting is to provide information which is useful for persons inside the
organization and for persons or groups outside the organization. Accounting is the discipline that
provides information on which external and internal users of the information may base decisions
that result in the allocation of economic resources in society.
1. External Users of Accounting Information: External users are those groups or persons who
are outside the organization for whom accounting function is performed. Following can be
the various external users of accounting information:
 Investors, Those who are interested in investing money in an organization are interested
in knowing the financial health of the organization of know how safe the investment
already made is and how safe their proposed investment will be. To know the financial
health, they need accounting information which will help them in evaluating the past
performance and future prospects of the organization. Thus, investors for their
investment decisions are dependent upon accounting information included in the
financial statements. They can know the profitability and the financial position of the
organization in which they are interested to make that investment by making a study of
the accounting information given in the financial statements of the organization.

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 Creditors. Creditors (i.e. supplier of goods and services on credit, bankers and other
lenders of money) want to know the financial position of a concern before giving loans
or granting credit. They want to be sure that the concern will not experience difficulty in
making their payment in time i.e. liquid position of the concern is satisfactory. To know
the liquid position, they need accounting information relating to current assets, quick
assets and current liabilities which is available in the financial statements.
 Members of Non-profit Organizations. Members of non-profit organizations such as
schools, colleges, hospitals, clubs, charitable institutions etc. need accounting
information to know how their contributed funds are being utilized and to ascertain if the
organization deserves continued support or support should be withdrawn keeping in view
the bad performance depicted by the accounting information and diverted to another
organization. In knowing the performance of such organizations, criterion will not be the
profit made but the main criterion will be the service provided to the society.
 Government. Central and State Governments are interested in the accounting
information because they want to know earnings or sales for a particular period for
purposes of taxation. Income tax returns are examples of financial reports which are
prepared with information taken directly from accounting records. Governments also
needs accounting information for compiling statistics concerning business which, in turn
helps in compiling national accounts.
 Research Scholars. Accounting information, being a mirror of the financial
performance of a business organization, is of immense value to the research scholars
who wants to make a study to the financial operations of a particular firm. To make a
study into the financial operations of a particular firm, the research scholar needs
detailed accounting information relating to purchases, sales, expenses, cost of materials
used, current assets, current liabilities, fixed assets, long term liabilities and shareholders'
funds which is available in the accounting records maintained by the firm.
2. Internal Users of Accounting Information. Internal users of accounting information are
those persons or groups which are within the organization. Following are such internal users :
o Owners. The owners provide funds for the operations of a business and they want to
know whether their funds are being properly used or not. They need accounting
information to know the profitability and the financial position of the concern in which

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they have invested their funds. The financial statements prepared from time to time from
accounting records depicts them the profitability and the financial position.
o Management. Management is the art of getting work done through others, the
management should ensure that the subordinates are doing work properly. Accounting
information is an aid in this respect because it helps a manager in appraising the
performance of the subordinates. Actual performance of the employees can be compared
with the budgeted performance they were expected to achieve and remedial action can be
taken if the actual performance is not up to the mark. Thus, accounting information
provides "the eyes and ears to management". The most important functions of
management are planning and controlling. Preparation of various budgets, such as sales
budget, production budget, cash budget, capital expenditure budget etc., is an important
part of planning function and the starting point for the preparation of the budgets is the
accounting information for the previous year. Controlling is the function of seeing that
programmes laid down in various budgets are being actually achieved i.e. actual
performance ascertained from accounting is compared with the budgeted performance,
enabling the manager to exercise controlling case of weak performance. Accounting
information is also helpful to the management in fixing reasonable selling prices. In a
competitive economy, a price should be based on cost plus a reasonable rate of return. If
a firm quotes a price which exceeds cost plus a reasonable rate of return, it probably will
not get the order. On the other hand, if the firm quotes a price which is less than its cost,
it will be given the order but will incur a loss on account of price being lower than the
cost. So, selling prices should always be fixed on the basis of accounting data to get the
reasonable margin of profit on sales.
o Employees. Employees are interested in the financial position of a concern they serve
particularly when payment of bonus depends upon the size of the profits earned. They
seek accounting information to know that the bonus being paid to them is correct.
1.5. Financial statement and relationships among financial statements
Accounting statements are different summaries that communicate accounting information of a
business to users. And include:
 Income statement
 Statement of owner’s equity

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 Balance sheet
 Cash flow statement
Financial statements are identified by three headings:
 The name of the business
 The title of the statement
 The specific date or period

1. Income Statement
This statement is a summary of revenues and expenses for the specific period of time. The
procedure is the total expenses are deducted from the total of revenues to determine net loss or
net income.

ABC Company
Income Statement
For the Year Ended August 31, 2020
Fares Revenue Br 6,500
Less: Expenses
Wages Expense 1,200
Rent Expense 850
Utilities Expense 200
Supplies Expense 800
Miscellaneous Expense 150
Total Expense (3,200)
Net Income Br 3,300

2. Capital Statement (Statement Of Owner’s Equity)

This statement is a summary which shows change in owner’s equity or capital.
ABC Company
Statement of Owner’s Equity
For the period ended August 31, 2020
ABC Capital, August 1, 2020 Br 200,000
Add: Additional Investment Br 100,000
Add: Net Income 3,300
Less: Withdrawal (1,000)
Net Increase In Capital 102,300
ABC Capital, August 31, 2020 Br 302,300

3. BALANCE SHEET

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Balance Sheet is a statement that shows the financial position of a business on a specific date. It lists
Assets, Liabilities and Capital on any specific date, which is the last date of the accounting period.
ABC Company
Balance Sheet
August 31, 2020
Assets: In Birr Liabilities and Capital In Birr
Cash 27,200 Liabilities:
A/Receivables 500 A/Payables 450
Supplies 50
Land 75,000 Capital:
Taxi 200,000 ABC, Capital 302,300
Total Assets 302,750 Total liabilities + OE 302,750

4. Cash Flows Statement

Cash flows statement is a summary of cash inflows (Cash receipts) and Cash outflows (Cash payments)
for a specific period of time. It is reported in three sections:
 Cash flows from operating activities
 Cash flows from investing activities
 Cash flows from financing activities
ABC Company
Statement of Cash Flows
For the Year ended August 31, 2020
Cash Flows From Operating Activities:
Cash inflow from revenue 6,000
Cash outflow for expense (2,800)
Net cash flows from operating activities 3,200
Cash Flows From Investing Activities:
Cash inflow from investing 0.00
Cash outflow for investing (75,000)
Net cash flows from investing activities (75,000)
Cash Flows From Financing Activities:
Cash inflow from financing 100,000
Cash outflow from financing (1,000)
Net cash flows from financing activities 99,000
Cash Balance on August 31, 2020 Br 27,200

.6. Accounting Equation and Definition of Terms Used in Business Transactions

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The whole of financial accounting is based on a very simple idea. This is called the accounting
equation which sounds complicated but in fact easy to understand. If a firm is to be set up or
established definitely it need resources. In the first place let us assume that it is the owner of the
business has supplied all of the resources. This can be shown:
Resources in the Business = Resources Supplied by the Owner
In accounting the term used to describe the resources supplied the owner is called Owner’s
Equity. The term used to describe the actual resource in a business is called Asset. Thus, the
accounting equation is:
Assets = Owner’s Equity
In the second place let us assume that people other than the owner have supplied some of the
resources (material or financial resources). Thus,

Resources in a Business = Resources Supplied + Resources Supplied

by the Owner by Others
Liabilities are the term given to the amounts of resource supplied people other than the owners.
This is amount of asset owed to others by the business. Thus the accounting equation is now
changed to

Assets = Owner’s Equity + Liabilities

However, liabilities are placed before Owner’s Equity, in the accounting equation, because
creditors have preferential right to the assets of the business. Thus, the accounting equation can
be stated as:
Assets = Liabilities + Owner’s Equity

The following are some definitions of accounting transaction related terms:

 Assets- are properties of all kinds such as buildings, machineries, motor vehicles, benefits
(debt by customers or account receivables), and amount of money on hand or in a bank
account.
 Liabilities-consists of money owing for goods and services supplied to the firm and expenses
for which the payment was not made. It also included loans made to the firm by other
business and financial institution.

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 Capital- is often called the owners’ equity or net worth. It is the difference between assets
and liabilities
 Accounts receivable-is money to be collected in the future. It is an asset that arises from the
sale of goods and services on credit basis or on account.
 Account payable-is money to be paid in the future. It is a liability that arises from
purchasing goods or services on account basis.
 Prepaid expenses- are assets which represent consumable goods purchased such as supplies,
prepaid rent, prepaid insurance, prepaid interest
 Revenue-is a general term that stands for the amount of charge against customer for goods or
services sold to them.
 Expenses- represent the cost of assets consumed or services used up in the process of earning
or generating revenue. For example, salary expense, supplies expenses, insurance expense,
etc
 Net income/ net profit-is the excess of revenue earned over the expenses in the process of
generating revenue.
 Net loss- is the excess of expenses over the revenue earned during the period
 Withdrawal (drawing)-is the cash or any asset withdrawn (taken away) from the business
by the owner for personal use. Withdrawal is recorded in accounting record of the business.

.7. Flow of Accounting Data While Producing Financial Reports

The flow of accounting data from the time a transaction occurs to its recording in the ledger is as
follows:

 Transaction Occurs – there must be business transaction, be it internal or external, to

initiate the flow of Accounting Data.
 Analyzing Transaction: Analysis of a transaction is a three steps procedure:
o Determining the accounts affected by the transaction
o Determining the effect of a transaction as increases and decreases
o Analyzing the increases and decreases as Debit and Credit

 Recording Transaction in a Journal: After analyzing transactions, they are recorded in a

book called journal in an orderly manner. Journal provides for transactions:
 Permanency-it is permanent record of transactions for reference
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 Orderliness or chronology-transactions are recorded sequentially

 Accuracy or Approval- before transactions are recorded in their account
approval will be made
 Posting a transaction
 Preparation of trial balance
 Adjusting deferrals and accruals and making journal entries for the adjustment
 Preparation of worksheet
 Preparation of financial statement
 Closing temporary accounts
 Preparing post-closing trial balance

1.8. Accounting Principles and Practices

In dealing with the framework of accounting theory, we are confronted with a serious problem
arising from differences in terminology. A number of words and terms have been used by
different authors to express and explain the same idea or notion. The various terms used for
describing the basic ideas are: concepts, postulates, propositions, assumptions, underlying
principles, fundamentals, conventions, doctrines, rules, axioms, etc. Each of these terms is
capable of precise definition. But, the accounting profession has served to give them lose and
overlapping meanings. One author may describe the same idea or notion as a concept and
another as a convention and still another as postulate. For example, the separate business entity
idea has been described by one author as a concept and by another as conventions. It is better for
us not to waste our time to discuss the precise meaning of generic terms as the wide diversity in
these terms can only serve to confuse the learner. We do feel, however, that some of these
terms/ideas have a better claim to be called ‘concepts ‘while the rest should be called
‘conventions’. The term ‘Concept’ is used to connote the accounting postulates, i.e., necessary
assumptions and ideas which are fundamental to accounting practice. In other words,
fundamental accounting concepts are broad general assumptions which underline the periodic
financial statements of business enterprises. The reason why some of the terms should be called
concepts is that they are basic assumptions and have a direct bearing on the quality of financial
accounting information. The term ‘convention’ is used to signify customs or tradition as a guide

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to the preparation of accounting statements. The following are the important accounting concepts
and conventions:
 Separate Business Entity Concept. In accounting we make a distinction between business
and the owner. All the books of accounts records day to day financial transactions from the
view point of the business rather than from that of the owner. The proprietor is considered
as a creditor to the extent of the capital brought in business by him. For instance, when a
person invests birr 1,000 into a business, it will be treated that the business has borrowed
that much money from the owner and it will be shown as a ‘liability’ in the books of
accounts of business. Similarly, if the owner of a shop were to take cash from the cash box
for meeting certain personal expenditure, the accounts would show that cash had been
reduced even though it does not make any difference to the owner himself. Thus, in
recording a transaction the important question is how does it affects the business? For
example, if the owner puts cash into the business, he has a claim against the business for
capital brought in. In so far as a limited company is concerned, this distinction can be
easily maintained because a company has a legal entity of its own. Like a natural person it
can engage itself in economic activities of buying, selling, producing, lending, borrowing
and consuming of goods and services. However, it is difficult to show this distinction in the
case of sole proprietorship and partnership. Nevertheless, accounting still maintains
separation of business and owner. It may be noted that it is only for accounting purpose that
partnerships and sole proprietorship are treated as separate from the owner (s), though law
does not make such distinction. In fact, the business entity concept is applied to make it
possible for the owners to assess the performance of their business and performance of
those whose manage the enterprise. The managers are responsible for the proper use of
funds supplied by owners, banks and others.
 Money Measurement Concept. In accounting, only those business transactions are
recorded which can be expressed in terms of money. In other words, a fact or transaction or
happening which cannot be expressed in terms of money is not recorded in the accounting
books. As money is accepted not only as a medium of exchange but also as a store of value,
it has a very important advantage since a number of assets and equities, which are
otherwise different, can be measured and expressed in terms of a common denominator.

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 Dual Aspect Concept. Financial accounting records all the transactions and events
involving financial element. Each of such transactions requires two aspects to be recorded.
The recognition of these two aspects of every transaction is known as a dual aspect
analysis. According to this concept every business transactions has dual effect. For
example, if a firm sells goods of birr. 10,000 this transaction involves two aspects. One
aspect is the delivery of goods and the other aspect is immediate receipt of cash (in the case
of cash sales). In fact, the term ‘double entry’ book keeping has come into vogue because
for every transaction two entries are made. According to this system the total amount
debited always equals the total amount credited. It follows from ‘dual aspect concept’ that
at any point in time owners’ equity and liabilities for any accounting entity will be equal to
assets owned by that entity. This idea is fundamental to accounting and could be expressed
as the following equalities:
Assets = Liabilities + Owners Equity............... (1)
Owners’ Equity = Assets - Liabilities............... (2)
The above relationship is known as the ‘Accounting Equation’. The term ‘Owners Equity’
denotes the resources supplied by the owners of the entity while the term ‘liabilities’ denotes
the claim of outside parties such as creditors, debenture-holders, bank against the assets of
the business. Assets are the resources owned by a business. The total of assets will be equal
to total of liabilities plus owners capital because all assets of the business are claimed by
either owners or outsiders.
 Going Concern Concept. Accounting assumes that the business entity will continue to
operate for a long time in the future unless there is good evidence to the contrary. The
enterprise is viewed as a going concern, that is, as continuing in operations, at least in the
foreseeable future. In other words, there is neither the intention nor the necessity to liquidate
the particular business venture in the predictable future. Because of this assumption, the
accountant while valuing the assets do not take into account forced sale value of them. In
fact, the assumption that the business is not expected to be liquidated in the foreseeable
future establishes the basis for many of the valuations and allocations in accounting.
 Accounting Period Concept. This concept requires that the life of the business should be
divided into appropriate segments for studying the financial results shown by the enterprise
after each segment. Although the results of operations of a specific enterprise can be known

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precisely only after the business has ceased to operate, its assets have been sold off and
liabilities paid off, the knowledge of the results periodically is also necessary. Those who are
interested in the operating results of business obviously cannot wait till the end. The
requirements of these parties force the businessman ‘to stop’ and ‘see back’ how things are
going on. Thus, the accountant must report for the changes in the wealth of a firm for short
time periods. A year is the most common interval on account of prevailing practice, tradition
and government requirements. Some firms adopt financial year of the government, some
other calendar year. Although a twelve month period is adopted for external reporting, a
shorter span of interval, say one month or three month is applied for internal reporting
purposes. This concept poses difficulty for the process of allocation of long term costs. All
the revenues and all the cost relating to the year in operation have to be taken into account
while matching the earnings and the cost of those earnings for the any accounting period.
This holds good irrespective of whether or not they have been received in cash or paid in
cash. Despite the difficulties which stem from this concept, short term reports are of vital
importance to owners, management, creditors and other interested parties. Hence, the
accountants have no option but to resolve such difficulties.
 Cost Concept. The term ‘assets’ denotes the resources land building, machinery etc. owned
by a business. The money values that are assigned to assets are derived from the cost
concept. According to this concept an asset is ordinarily entered on the accounting records at
the price paid to acquire it. For example, if a business buys a plant for birr. 5 the asset would
be recorded in the books at birr. 5, even if its market value at that time happens to be birr. 6.
Thus, assets are recorded at their original purchase price and this cost is the basis for all
subsequent accounting for the business. The assets shown in the financial statements do not
necessarily indicate their present market values. The term ‘book value’ is used for amount
shown in the accounting records. The cost concept does not mean that all assets remain on
the accounting records at their original cost for all times to come. The asset may
systematically be reduced in its value by charging ‘depreciation’, which have the effect of
reducing profit of each period. The prime purpose of depreciation is to allocate the cost of an
asset over its useful life and not to adjust its cost. However, a balance sheet based on this
concept can be very misleading as it shows assets at cost even when there are wide difference
between their costs and market values.

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 The Matching concept. This concept is based on the accounting period concept. In reality
we match revenues and expenses during the accounting periods. Matching is the entire
process of periodic earnings measurement, often described as a process of matching expenses
with revenues. In other words, income made by the enterprise during a period can be
measured only when the revenue earned during a period is compared with the expenditure
incurred for earning that revenue. Broadly speaking revenue is the total amount realized from
the sale of goods or provision of services together with earnings from interest, dividend, and
other items of income. Expenses are cost incurred in connection with the earnings of
revenues. Costs incurred do not become expenses until the goods or services in question are
exchanged. Cost is not synonymous with expense since expense is sacrifice made, resource
consumed in relation to revenues earned during an accounting period. Only costs that have
expired during an accounting period are considered as expenses.
 Realization Concept. Realization is technically understood as the process of converting
non-cash resources and rights into money. As accounting principle, it is used to identify
precisely the amount of revenue to be recognized and the amount of expense to be matched
to such revenue for the purpose of income measurement. According to realization concept
revenue is recognized when sale is made. Sale is considered to be made at the point when the
property in goods passes to the buyer and he becomes legally liable to pay. This implies that
revenue is generally realized when goods are delivered or services are rendered. The
rationale is that delivery validates a claim against the customer. However, in case of long run
construction contracts revenue is often recognized on the basis of a proportionate or partial
completion method. Similarly, in case of long run instalment sales contracts, revenue is
regarded as realized only in proportion to the actual cash collection. In fact, both these cases
are the exceptions to the notion that an exchange is needed to justify the realization of
revenue.
 Convention of Materiality. Materiality concept states that items of small significance need
not be given strict theoretically correct treatment. In fact, there are many events in business
which are insignificant in nature. The cost of recording and showing in financial statement
such events may not be well justified by the utility derived from that information.
 Convention of Consistency. The convention of consistency requires that once a firm
decided on certain accounting policies and methods and has used these for some time, it

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should continue to follow the same methods or procedures for all subsequent similar events
and transactions unless it has a sound reason to do otherwise. In other worlds, accounting
practices should remain unchanged from one period to another. For example, if depreciation
is charged on fixed assets according to straight line method, this method should be followed
year after year. Analogously, if stock is valued at ‘cost or market price whichever is less’,
this principle should be applied in each subsequent year. However, this principle does not
forbid introduction of improved accounting techniques. If for valid reasons the company
makes any departure from the method so far in use, then the effect of the change must be
clearly stated in the financial statements in the year of change. The application of the
principle of consistency is necessary for the purpose of comparison. One could draw valid
conclusions from the comparison of data drawn from financial statements of one year with
that of the other year. But the inconsistency in the application of accounting methods might
significantly affect the reported data.
 Convention of full disclosure: The disclosure principle implies that accounts must be
modestly prepared and all material information must be disclosed there in usually, the
contents of balance sheet and income statement are prescribed by law. These are designed to
make disclosure of all material facts compulsory. The term disclosure does not imply that all
information that anyone could conceivably desire is to be included in accounting statements
the term only implies that there is to be a sufficient disclosure of information of information
which is of material interest to proprietors, present and potential creditors and investors. The
practice of appending notes relative to various facts or items which do not find place in
accounting statements in pursuance to the concept of full disclosure of material facts.
Changes which have a significant impact upon accounts which are produced must be
disclosed. Public and private companies have a legal obligation to disclose certain
information in their published financial statements, for example their accounting policies and
significant changes. The concept tends to conflict with the consistency concept. The position
could thus read you must prepare your accounts using a consistent basis, but if you do change
that basis, you are to declare it and disclose it!

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