FUNDAMENTALS OF ACCOUNTING I Chapter One: Introduction to Accounting and

Business

Chapter One
1. Introduction to Accounting and Business
1.1) Definition Of Accounting
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.
Accounting: The Language of Business
Accounting has rightly been termed as the language of the business. Accounting is used to
communicate financial information to various parties who have some stake (interest) in the
affairs of the business.

1.2) Evolution of Accounting

Similar to medicine, law, economics, and accounting has evolved in response to the social and
economic needs of society. As business and society have become more complex over the
years, many complex economic development and social programs cannot be undertaken due
to shortage of financial information. Therefore, accounting has evolved to develop new
concepts and techniques to meet the ever increasing needs for financial information.

❖ Primitive Accounting
In the civilization of human being, various types of records of business activities have been
maintained. Of these, the oldest known is Clay Tablet records of the payment of wages in
Babylonia around 3600 B.C. There are numerous evidences of record keeping and systems of
accounting control in Egypt and Greek City States. In English, under the direction of King
William the 12th records were compiled to ascertain the financial resources of the kingdom.

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FUNDAMENTALS OF ACCOUNTING I Chapter One: Introduction to Accounting and
Business

Drawbacks of the Primitive Accounting:

I. It dealt with limited aspects of the financial operations of private or government
enterprises.
II. There was no systematic accounting for all transaction of a particular unit i.e. only for
specific type or portion of transaction

❖ Double Entry System Accounting

Since the primitive accounting was incomplete, the evolution of the system of record keeping
which was said to be called “Double Entry System” was strongly influenced by Venetian
merchants. Double entry system is the recordings process of a transaction into two parts. The
first known description of the system was published in Italy in 1494 by a person called LUCA
PACIOLI

Double Entry System provides:

1. For all business transaction, recording in a systematic manner i.e. to establish in an
equilibrium. For example, if a business borrowed Br 500 from a bank, the amount of the
loan is recorded both as cash of Br 500 and an obligation to repay Br 500. Either of the Br
500 amount is balanced by the other Br 500 amount. In double entry system, every
transaction entered twice in the books of accounts as means of check and control.
2. For the set of integrated financial statements, reporting in money terms
In spite of the tremendous development of business operations since 1494, and the ever
increasing complexities of business and governmental organizations, the basic elements of
Double Entry System have continued virtually unchanged.

Reading Assignment: the contribution of industrial revolution to the development of

accounting

1.3) Profession of Accountancy

To say a field of study is a profession, there must be accumulated body of knowledge
(scientific knowledge) and an individual should engage in it to get earning unlike hobby.
Based on these two criteria accounting is definitely a profession. There are employment
opportunities in accounting and are expected to continue to grow and expand as businesses
are growing and expanding from time to time. There are two types of job opportunities in
accounting:
1. Private Accounting
2. Public Accounting
Private Accounting: accountants employed by a business firm or not for profit organization
are said to be engaged in private accounting. These accountants provide accounting services
to one organization a salary basis and do a variety of work including financial accounting,
management and cost accounting, budgeting, internal auditing, controller and others.
Public Accounting: accountants and their staff who provide services on a fee basis are said to
be engaged in public accounting. Public accountant are independent professional persons and
provide accounting service to many clients. They provide service such as:

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FUNDAMENTALS OF ACCOUNTING I Chapter One: Introduction to Accounting and
Business

1. Auditing-providing an opinion as to fairness and truth-ness financial reports

2. Management advisory services-to offer constructive suggestions for improving a
company’s method of operations
3. Accounting System Development- developing an AS a private or public enterprises
Reading Assignment: specialized accounting fields such as financial accounting, auditing,
cost accounting, managerial accounting, tax accounting, accounting systems, budgetary
accounting, international accounting, not-for-profit accounting, social accounting and
accounting instruction

1.4) Types and forms of business organization in Ethiopia

✓ Forms of business organizations

There are three different legal forms of business organization: those are
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 the owner is responsible to pay the debt of the business
even from his personal asset in case the business unable to meet its liability)
2. Partnership: - is business organization established by two or more persons.
Advantages:
Easier and less expensive to establish than corporation
Are not highly regulated by government
More capital and managerial skill than a single proprietor ship
Disadvantages:
Limited life
Unlimited liability (the partners are responsible to pay the debt of the
business even from their personal assets in case the business unable to meet
its liability)
Conflict between partners throughout operating the business.
3. Corporation: - is a business organized as a separate legal entity under state
corporation law with ownership divided into transferable shares of stock.
Advantages:
Long life
Limited liability
Can raise huge amount of capital to finance business operation
Disadvantages:
Double taxation

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FUNDAMENTALS OF ACCOUNTING I Chapter One: Introduction to Accounting and
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Highly regulated by government

Difficulty of controlling management, because ownership and management
is divorced in corporation.

✓ Types of Business Organizations

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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FUNDAMENTALS OF ACCOUNTING I Chapter One: Introduction to Accounting and
Business

Accounting Functions Performed by accountants

Observe events

Identify those events that

are economic events Observe, identify
and measure
events.
Measure economic events in
financial terms

Record measurements

Classify measurements Record, Classify and

summarize
measurements

Summarize measurements

Report economic events in

financial statements and
other reports Report economic
events and interpret
financial statements
Interpret the contents of
financial statements and
other reports.

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1.5) Accounting as Information Systems
In order to provide information an entity must establish its own accounting system. An
accounting system consists of methods and devices used by an entity to keep track its
financial activities and summarize in a manner useful to decision makers. The process of
forming an accounting system to provide information is performed as follows:
Identification of Users

Information need of users

Economic Data Accounting System Financial Decision by

Reports users

Step-1: Identification of Users of Accounting Information

Individuals or organizations who/which have stake (interest) in accounting information of a
business to make sound decisions are called users of accounting information. They will
receive different reports a business to make decision and are classified in to two: (1) Internal
users and (2) External users
1. Internal Users: are individuals within an organization or business entity that need
accounting information of the business for the affairs of the business. Internal users are
responsible for the administration of the business and include the following management,
BOD, department head, corporate officer like chief executive officers and chief operating
officers and chief financial officers. Management need an accounting information:
➢ To plan future operation
➢ To evaluate and control current operation
➢ To know the profitability of each department
➢ To know the company’s cash position
➢ To know the trend of earnings
➢ To assess whether spending kept within the budget limit or not(especially in NGO
and Governmental organization)
➢ To assure whether expenditure are authorized or not( governmental and not-for-
profit organization)
2. External Users: are those individual or institutions inside or outside an economic entity
who/which need accounting information about that entity for their own affair. They need
accounting information for their benefit. This group include: owners of the business,
potential investors, bankers, suppliers and other creditors, employees and labor union,
governmental agencies, etc.

Owners need accounting information:

➢ To know the operating results of the business
➢ To know its financial position

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Potential investors need accounting information a business to:
➢ Assess the risk ness of the investment
➢ Predict its future prosperities
Bankers need accounting information to
➢ Evaluate the financial soundness of a business organization
➢ Assess risks involved in giving loans
Suppliers need accounting information to:
➢ Decide whether to sell or not to sell goods and services on credit basis
Employees and labor union need accounting information before beginning negotiation of for
new labor contract to know:
➢ The financial position of a businesses
➢ The profitability of a business
➢ The stability of a business
Governmental Agencies need accounting information for purpose of determining income tax
payable and pension contribution of an employee

Step-2: Information Need of Users

This to determine the information needs of internal users i.e. the type of information needed
by internal or external stakeholders should be identified by information provider before
information is provided to users.

Step-3: Information Processing

The information need of users determine the economic data to be gathered and processed by
accounting system. Then the accounting system generate reports that communicate essential
information to users

1.6) Accounting Principles and Practices

Experienced professional accountants contribute their best thinking to the solution of problem
continually confronting their staff or employees. Professional association periodically issue
pronouncements on accounting principles and concepts. Accounting principles or standards
are conventional rules and regulations that govern actions in undertaking accounting
activities. Concepts are basic assumption up on which the science of accounting is based.
Practices are the application of accounting principles and concepts to specific accounting
situation. The most important concepts and principles are:
1.6.1. Overview of international financial reporting standards (IFRS)
International Financial Reporting Standards
Financial accounting standards issued by IASB are referred to as International Financial
Reporting Standards (IFRS).
Financial reporting
» General purpose financial reporting
» Aims to provide useful financial information about the reporting entity to
primary users who cannot require the reporting entity to provide information
directly to them.

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 » Special purpose financial reporting
» Responds to the requirements of users that have the authority to require the
reporting entity to provide the information that they need for their purposes
directly to them. Examples include:
» prudential regulation reporting requirements
» tax reporting requirements
International Financial Reporting Standards (IFRS)*
» Designed for general purpose financial reporting by profit-oriented entities
» might be found to be appropriate for not-for-profit activities too
» Focused on information needs of (primary users) existing and potential investors,
lenders and other creditors who cannot require information from the entity
» information to enable primary users to make their own assessments of the
reporting entity’s prospects for future net cash inflows
» as a basis for their decisions to buy, hold, sell equity and debt instruments or to
provide a loan or to require settlement of a loan

1.6.2. Basic Assumptions and accounting principles

The five basic assumptions in turn: (1) economic entity, (2) Going concern, (3) monetary
unit, (4) periodicity, and (5) accrual basis.

• Economic Entity Assumption

The economic entity assumption means that economic activity can be identified with a
particular unit of accountability. In other words, a company keeps its activity separate and
distinct from its owners and any other business unit. Thus, the entity concept does not
necessarily refer to a legal entity. A parent and its subsidiaries are separate legal entities, but
merging their activities for accounting and reporting purposes does not violate the economic
entity assumption

• Going Concern Assumption

Most accounting methods rely on the going concern assumption—that the company will
have a long life. Despite numerous business failures, most companies have a fairly high
continuance rate. As a rule, we expect companies to last long enough to fulfill their objectives
and commitments.

• Monetary Unit Assumption

The monetary unit assumption means that money is the common denominator of economic
activity and provides an appropriate basis for accounting measurement and analysis. That is,
the monetary unit is the most effective means of expressing to interested parties changes in
capital and exchanges of goods and services

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 • Periodicity Assumption
To measure the results of a company’s activity accurately, we would need to wait until it
liquidates. Decision-makers, however, cannot wait that long for such information. Users need
to know a company’s performance and economic status on a timely basis so that they can
evaluate and compare companies, and take appropriate actions. Therefore, companies must
report information periodically. The periodicity (or time period) assumption implies that a
company can divide its economic activities into artificial time periods. These time periods
vary, but the most common are monthly, quarterly, and yearly

• Accrual Basis of Accounting

Companies prepare financial statements using the accrual basis of accounting. Accrual basis
accounting means that transactions that change a company’s financial statements are
recorded in the periods in which the events occur

Basic Principles of Accounting

There are four basic principles of accounting to record and report transactions: (1)
measurement, (2) revenue recognition, (3) expense recognition, and (4) full disclosure.
We look at each in turn

• Measurement Principles
The most commonly used measurements are based on historical cost and fair value. Selection
of which principle to follow generally reflects a trade-off between relevance and faithful
representation.

Historical Cost, IFRS requires that companies account for and report many assets and
liabilities on the basis of acquisition price. This is often referred to as the historical cost
principle. Cost has an important advantage over other valuations: It is generally thought to
be a faithful representation of the amount paid for a given item.

Fair Value, Fair value is defined as “the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants at the measurement
date.” Fair value is therefore a market-based measure (exit price). Recently, IFRS has
increasingly called for use of fair value measurements in the financial statements. The IASB
believes that fair value information is more relevant to users than historical cost.

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 • Revenue Recognition Principle

Revenue refers to increases in economic benefits during the accounting period in the form of
enhancements of assets or decreases of liabilities that result in increases in equity, other
than those relating to contributions from equity participants. When the company satisfies the
performance obligation, it should recognize revenue.

• Expense Recognition Principle

Expenses refers to decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to equity participants. Expenses should be recognized
in the period in which they are incurred.

• Full Disclosure Principle

In deciding what information to report, companies follow the general practice of providing
information that is of sufficient importance to influence the judgment and decisions of an
informed user. Often referred to as the full disclosure principle, it recognizes that the nature
and amount of information included in financial reports reflects a series of judgmental trade-
offs.
1.7) Business Transaction and the Accounting Equation
1.7.1 Business Transaction
Business transactions are events or conditions that must be recorded in terms of money in
accounting records.
➢ Events-payments or a promise to make payment or receipts or acceptance of a promise to
receive cash within a specified period of time in exchange for goods and services
➢ Conditions- the tearing and wearing out of long lived properties of a business i.e.
decrease in usefulness of long lived property.
Example:
➢ Monthly electricity bill of Br 100
➢ The acquisition of a land and a building for Br 250,000

Nature of Business Transaction

❖ Business transaction could be Simple or complex
❖ Business transaction could be Internal or external
❖ Business transaction affects the financial position of a business and its operating results or
at least it affects two items
❖ Business transaction must be supported by source documents (business papers). Source
documents include sales invoice, receipts, checks, check stub, fright bill, and etc. Business
documents normally contain information as to the monetary amount to be recorded, the
parties involved, the term of transaction and other relevant information such as nature and
date of transactions.

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1.7.2 The Accounting Equation
The whole of financial accounting is based on a very simple idea. This is called the
accounting equation which sounds complicated but infact 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 by 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

1.7.3 Definition of Terms Used in Business Transactions and Accounting Equation

Definition of elements of financial statements
ASSET
A resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity.eg cash ,account receivable, supplies equipment
building etc.

LIABILITY
A present obligation of the entity arising from past events and the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
E.g account payable, wage payable bond payable etc.

EQUITY, is the residual interest in the assets of the entity after deducting liabilities. The
elements of income and expenses are defined as follows.

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INCOME/Revenue
Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than
those relating to contributions from equity participants.eg sales, service income
EXPENSES
Decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity, other than
those relating to distributions to equity participants.eg salary expense, rent expenses etc
Other related definition
➢ 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. Based on the source of revenue, it is classified into two:
Miscellaneous Revenue and Principal Revenue. Revenue can have different names such
as:
1. Royalties- revenue from sale of franchise
2. Fares revenue- a revenue generated by providing transportation service
3. Fees revenue- by providing professional service
4. Sales- revenue from sales of goods and services
5. Rent revenue- from renting real-estate and other equipment
6. Tuition fee- revenue from providing educational service
➢ 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
➢ Investment- represent the cash or other assets put into the business by the owner of a sole
proprietorship
➢ 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.

1.7.4 Accounting Equation and Business Transactions

The effect of business transaction on accounting equation can be demonstrated by taking
some typical transactions.
Illustration: Mr. Hara established a Sole Proprietorship Business known as Hara Taxi on
August 1, 1995 and decided the fiscal year of the business to be from September 1 to August
31. During the first month of operation the following transactions occurred:
August 1: Hara deposited Br 300,000 in a bank account in the name of the business.
August 2: The owner purchased two taxis at Br 100,000 each for the business
August 4: Purchased a land as a future building sites for Br 7,500 paid in cash
August 7: Purchased Br 850 of gasoline, oil, and other supplies on account promising to pay
in the future.

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 August 10: Paid creditors on account Br 400
August 15: Hara Taxi earned fares revenue of Br 4,500 receiving the amount in cash.
August 21: The business paid the following expenses in cash:
➢ Wages expense ........................................ Br 1,200
➢ Rent expense ........................................... 850
➢ Utilities expense ...................................... 150
➢ Miscellaneous expense ............................ 200
August 23: The business charged customers for the transportation service provided on account
Br 2,000
August 28: Received cash from customers on account Br 1,500
August 30: Mr. Hara withdrawn Br 1,000 from the business in cash for personal use
August 31: At the end of the month the cost of supplies left on hand is Br 50
Instructions:
1) Indicate (show) the effect of each of the above transactions on accounting equation
2) Prepare the accounting statements

Assets = Liabilities + Capital

Accounts Accounts Owner's
Date Cash Receivables Supplies Taxi Land = Payables Equity
August 1, +300,000 300,000
Balance 300,000 = 300,000
August 2, -200,00 +200,000
Balance 100,000 200,000 = 300,000
August 4, -75,000 +75,000
Balance 25,000 200,000 75,000 = 300,000
August 7, +850 +850
Balance 25,000 850 200,000 75,000 = 850 300,000
August 10, -400 -400
Balance 24,600 850 200,000 75,000 = 450 300,000
August 15, +4,500 +4,500 F.Revenue
Balance 29,100 850 200,000 75,000 = 450 304,500
August 21, -2,400 -1,200 W.Expense
-850 W.Expense
-200 W.Expense
-150 W.Expense
Balance 26,700 850 200,000 75,000 = 450 302,100
August 23, +2,000 +2,000 F.Revenue
Balance 26,700 2,000 850 200,000 75,000 = 450 304,100
August 28, +1,500 -1,500
Balance 28,200 500 850 200,000 75,000 = 450 304,100
August 30, -1,000 -1,000 Withdrawal
Balance 27,200 500 850 200,000 75,000 = 450 303,100
August 31, ______ _____ -800 _____ _____ ____ -800 S.Expense
Balance 27,200 500 50 200,000 75,000 = 450 302,300

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1.8) Accounting (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
➢ 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. For example, income statement for Hara Taxi

Hara Taxi
Income Statement
For the Year Ended August 31, 1995
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. For Hara Taxi
the capital statement is as follows:
Hara Taxi
Statement of Owner’s Equity
For the period ended August 31, 1995
Hara Capital, August 1, 1995 ........................ Br
200,000
Add: Additional Investment .......................... Br 100,000
Add: Net Income ........................................... 3,300
Less: Withdrawal ........................................... (1,000)
Net Increase In Capital .................................. 102,300
Hara Capital, August 31, 1995 ...................... Br
302,300

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3. BALANCE SHEET
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.
Hara Taxi
Balance Sheet
August 31, 1995
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 Hara, 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

Hara Taxi
Statement of Cash Flows
For the Year ended August 31, 1995
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, 1995 ........................................ Br 27,200

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