Chapter-1

Introduction to Accounting and Business

1.1 Nature and Classification of Business Organizations
Definition - A business organization is an economic entity which is engaged in converting
basic inputs into products (provision of service) for sale at profit to customers.

Types of business organizations - based on the type of activities they perform or are
engaged in to generate income, business organizations may be divided in to three:
 Service - an enterprise that renders professional and technical services. E.g.
banks, telecommunication and transportation companies.
 Merchandising - an enterprise that buys and resells finished goods to
customers. E.g. Stationery shops, retail and wholesale stores, supermarkets,
etc.
 Manufacturing - an enterprise that buys and converts raw materials into
finished products for sale to other businesses (merchandising) or direct to
consumers. E.g. textile and cement factories, wood- and metal-work shops,
etc.

Forms of business organizations - Three different legal forms of businesses:

 Sole proprietorship - an enterprise owned by one person and usually operated
and managed by the same person. The sole proprietorship form of business is
not a separate legal entity from its owner. The life of a sole-proprietorship
usually depends up on the life of the owner.
 Partnership - an enterprise owned by two/more persons called partners and
the partners are usually engaged in operations and management of the
organization. Like the sole proprietorship form of business, partnership is not
legally separate from its owners. The life of a partnership usually depends up
on the admission of new partner/s or withdrawal of existing partner/s.
 Corporation - an enterprise owned usually by three/more persons called
shareholders or stockholders. The unique feature of a corporation is that it is a
legal entity usually referred to as an artificial person which is solely
responsible for its act and debt. For it has an independent existence, its life
does not depend on the admission or withdrawal of shareholder/s.

1.2 The Role of Accounting in Business Environment

1. Definition - Accounting is defined as an information system concerned with
collection, analysis and communication of financial information useful for decision-
making. For it is used as a means to exchange information among interested parties
concerning the financial performance, financial position and related issues of an
organization, it is also commonly known as the “language of business”.
As an information system, process of collecting, analyzing and communicating
information, it involves the following steps:
 Identifying - tracing and collecting recordable economic activities. Accounting
does not record and report all economic activities of an organization. Rather, it
records and reports only those economic activities of the organization which can
be expressed in terms of money.

 Analyzing and Measuring - This involves determining whether the economic

activities bring changes (increase/decrease) assets, liabilities, capital, revenues,

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 and/or expenses (these terms will be defined in subsequent sections) of an
organization and expressing the changes in monetary terms.
 Recording - make, in a systematic way, a record of the effects of economic
activities on assets, liabilities, capital, revenues and expenses.
 Classifying - grouping recorded effects of economic activities into meaningful
classes.
 Summarizing - gathering and arranging data needed for preparation of reports and
statements.
 Reporting - preparing statements and reports in a manner that suits the need of
users so as to communicate information useful for decision making.
 Interpreting - provide explanation on reported information so that users can
understand and use the information as a basis for decision making.
2. Importance/purpose - Accounting can be seen as an important part of the total
information system of an organization. People, both inside and outside the business,
have to make decisions concerning the allocation of scarce resources. To ensure that
these resources are allocated in an efficient and effective manner, users require
economic information on which to base decisions. It is the role of the accounting
system to provide that information and the ultimate purpose of accounting is to give
people better information on which to base their decisions. Some of the uses of
accounting information in relation to the users of the information are discussed below.

3. Users of Accounting Information - Accounting seeks to satisfy the needs of a wide

rage of users. In relation to a particular business, there may be various groups of users
which are likely to have an interest in financial aspects of it. The major users of
financial information are commonly grouped as internal and external users.
i. Internal users are mainly management personnel of an organization who have
direct involvement and control over and who are responsible for the day-to-day
affairs of the organization. They need and use the financial information to make
decisions and plans for the business activities including finance, human resource,
production and marketing, and exercise control to try to ensure that plans come to
fruition. Management people use accounting information to
o Formulate long-, medium- and short-term plans
o Control and evaluate operation and performance, and
o Make other major decisions related to financing and investment, product
costing and pricing, selecting product mix and allocating scarce resources.
ii. External users on the other hand, refer to users outside an organization who are
not directly involved in the day-to-day affairs of the organization but have some
interest in the financial and related affairs of the organization.
External users include:
 Existing and potential owners/investors who want to assess how effectively
managers are running the business and to make judgments about the likely levels
of risk and return associated with investment in the business and decide to invest
or de-invest.
 Existing and potential suppliers and creditors who need to assess the ability of the
business to pay for goods and services supplied or to be supplied to it and to meet
its obligations when due.
 Potential employees (non-managers) and labor unions that need to assess the
ability of the business to continue providing them with employment opportunities
and better reward for services they rendered or may render to the organization.

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  Government agencies who need to assess how much tax the business should pay,
whether it complies with approved pricing policies, protect the public from
excessive price charges by monopolies, and so on.
 Existing and potential customers who want to assess the ability of the entity to
continue in business to supply them with the necessary goods and services and to
know their outstanding balances.
 Investment analysts and consultants who want to assess the likely risks and
returns associated with investment in an organization in order to determine
investment potentials and advise their clients accordingly.
 Community representatives who need to assess the ability of the entity to continue
providing employment opportunities for the community, use community
resources, to support environmental improvements and so on.
 Competitors who need to assess the threat posed by the business to their market
share and profitability, and need for a benchmark by which to compare efficiency
and performance.
To make their respective decisions, external users need among other things accounting
information about a business of their concern.

4. Qualitative Characteristics of Accounting Information

Qualitative characteristics are either fundamental or enhancing characteristics, depending on

how they affect the decision-usefulness of information. Regardless of classification, each
qualitative characteristic contributes to the decision-usefulness of financial reporting
information. However, providing useful financial information is limited by a pervasive
constraint on financial reporting-cost should not exceed the benefits of a reporting practice.

1. Fundamental Quality-Relevance
Relevance is one of the two fundamental qualities that make accounting information useful
for decision-making. Relevance and related ingredients of this fundamental quality are shown
below.
To have relevance, accounting information must be capable of making a difference in a
decision. Information with no bearing on a decision is irrelevant. Financial information is
capable of making a difference when it has predictive value, confirmatory value, or both.

Financial information has predictive value if it has value as an input to predictive processes
used by investors to form their own expectations about the future. For example, if potential
investors are interested in purchasing common shares in UPS (United Parcel Service), they
may analyze its current resources and claims to those resources, its dividend payments, and
its past income performance to predict the amount, timing, and uncertainty of UPS’s future
cash flows.

Relevant information also helps users confirm or correct prior expectations; it has
confirmatory value. For example, when UPS issues its year-end financial statements, it
confirms or changes past (or present) expectations based on previous evaluations. It follows
that predictive value and confirmatory value are interrelated. For example, information about
the current level and structure of UPS’s assets and liabilities helps users predict its ability to
take advantage of opportunities and to react to adverse situations. The same information helps
to confirm or correct users’ past predictions about that ability.

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Materiality is a company-specific aspect of relevance. Information is material if omitting it
or misstating it could influence decisions that users make on the basis of the reported
financial information. An individual company determines whether information is material
because both the nature and/or magnitude of the item(s) to which the information relates must
be considered in the context of an individual company’s financial report. Information is
immaterial, and therefore irrelevant, if it would have no impact on a decision-maker. In short,
it must make a difference or a company need not disclose it.

Fundamental Quality—Faithful Representation

Faithful representation is the second fundamental quality that makes accounting information
useful for decision-making.

Faithful representation means that the numbers and descriptions match what really existed
or happened. Faithful representation is a necessity because most users have neither the time
nor the expertise to evaluate the factual content of the information. For example, if General
Motors’ income statement reports sales of $60,510 million when it had sales of $40,510
million, then the statement fails to faithfully represent the proper sales amount. To be a
faithful representation, information must be complete, neutral, and free of material error.

Completeness. Completeness means that all the information that is necessary for faith- ful
representation is provided. An omission can cause information to be false or mis- leading and
thus not be helpful to the users of financial reports. For example, when Citigroup fails to
provide information needed to assess the value of its subprime loan receivables (toxic assets),
the information is not complete and therefore not a faithful representation of their values.

Neutrality. Neutrality means that a company cannot select information to favor one set of
interested parties over another. Unbiased information must be the overriding consid- eration.
For example, in the notes to financial statements, tobacco companies such as R.J. Reynolds
should not suppress information about the numerous lawsuits that have been filed because of
tobacco-related health concerns—even though such disclosure is damaging to the company.
Neutrality in rule-making has come under increasing attack. Some argue that the FASB
should not issue pronouncements that cause undesirable economic effects on an industry or
company. We disagree. Accounting rules (and the standard-setting process) must be free from
bias, or we will no longer have credible financial statements. Without credible financial
statements, individuals will no longer use this information. An anal- ogy demonstrates the
point: Many individuals bet on boxing matches because such con- tests are assumed not to be
fixed. But nobody bets on wrestling matches. Why? Because the public assumes that
wrestling matches are rigged. If financial information is biased (rigged), the public will lose
confidence and no longer use it.

Free from Error An information item that is free from error will be a more accurate
(faithful) representation of a financial item

2. Enhancing Qualities
Enhancing qualitative characteristics are complementary to the fundamental qualitative
characteristics. These characteristics distinguish more-useful information from less- useful
information. Enhancing characteristics, shown below, are comparability, verifiability,
timeliness, and understandability.

Comparability. Information that is measured and reported in a similar manner for different
companies is considered comparable. Comparability enables users to identify the real

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similarities and differences in economic events between companies. For example, historically
the accounting for pensions in Japan differed from that in the United States. In Japan,
companies generally recorded little or no charge to income for these costs. U.S. companies
recorded pension cost as incurred. As a result, it is difficult to compare and evaluate the
financial results of Toyota or Honda to General Motors or Ford. Investors can only make
valid evaluations if comparable information is available.

Another type of comparability, consistency, is present when a company applies the same
accounting treatment to similar events, from period to period. Through such application, the
company shows consistent use of accounting standards. The idea of consistency does not
mean, however, that companies cannot switch from one accounting method to another. A
company can change methods, but it must first demonstrate that the newly adopted method is
preferable to the old. If approved, the company must then disclose the nature and effect of the
accounting change, as well as the justification for it, in the financial statements for the period
in which it made the change.9 When a change in accounting principles occurs, the auditor
generally refers to it in an explanatory para- graph of the audit report. This paragraph
identifies the nature of the change and refers the reader to the note in the financial statements
that discusses the change in detail.10

Verifiability. Verifiability occurs when independent measurers, using the same methods,
obtain similar results. Verifiability occurs in the following situations.
1. Two independent auditors count PepsiCo’s inventory and arrive at the same physical
quantity amount for inventory. Verification of an amount for an asset therefore can occur by
simply counting the inventory (referred to as direct verification). 2. Two independent auditors
compute PepsiCo’s inventory value at the end of the year using the FIFO method of
inventory valuation. Verification may occur by checking the inputs (quantity and costs) and
recalculating the outputs (ending inventory value) using the same accounting convention or
methodology (referred to as indirect verification).

Timeliness. Timeliness means having information available to decision-makers before it

loses its capacity to influence decisions. Having relevant information available sooner can
enhance its capacity to influence decisions. A lack of timeliness, on the other hand, can rob
information of its usefulness. For example, if Dell waited to report its interim results until
nine months after the period, the information would be much less useful for decision-making
purposes.

Understandability. Decision-makers vary widely in the types of decisions they make, how
they make decisions, the information they already possess or can obtain from other sources,
and their ability to process the information. For information to be useful, there must be a
connection (linkage) between these users and the decisions they make. This link,
understandability, is the quality of information that lets reasonably informed users see its
significance. Understandability is enhanced when information is classified, characterized, and
presented clearly and concisely.

5. Bookkeeping versus Accounting - Bookkeeping refers to the art of recording, in a

prescribed and systematic way, the economic activities of an organization. It is routine
and clerical in nature. Accounting, on the other hand, goes beyond bookkeeping and is
concerned with
 Designing accounting and reporting systems
 Recording economic activities

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  Preparing reports and statements
 Interpreting reported information and
 Reviewing records and reports for their accuracy.
Thus, it can be safely concluded that bookkeeping is one and the simplest part of
accounting.
6. Profession of Accountancy - Accounting is an occupation, which requires advanced
education and special training. After completing the required education and training
accounting professionals may work as private or public accountants.
a. Private accountants refer to those accountants who work for a single employer on
salary basis. Private accountants may assume different positions with in an
organization including chief accountant, financial manager, controller, budget
officer and cost accountant.
b. Public accountants refer to those accountants who provide professional services to
the public in general on a fee basis. They include certified public accountants and
authorized independent accountants.
7. Specialized Fields of Accounting - accountants may specialize in different
accounting fields including financial accounting, managerial accounting, cost
accounting and tax accounting.
a. Financial accounting - area of accounting aimed at serving information needs of
external users.
b. Managerial accounting - field of accounting concerned with serving information
needs of internal users - managers.
c. Cost accounting - a managerial accounting activity designed to help managers in
identifying, measuring and controlling operating costs.
d. Tax accounting - field of accounting that includes preparing tax returns and
planning future transactions to minimize (not of course to evade which is an
illegal act) amount of profit tax payable.
8. Evolution of Accounting - Accounting is highly affected by the economic, social,
cultural, legal, technological and political developments of a society. Higher-level
economic, social, cultural, legal, technological, and political developments of a
society need more elaborated and sophisticated accounting systems. In line with the
changes in the aforementioned environmental factors, accounting has evolved through
several phases. These phases may be grouped into two major classes: primitive and
modern.
a. Primitive - primitive accounting is believed to have begun about 4000 BC. At this
stage, accounting was identified to be unsystematic and incomplete dealing with
certain aspects and types of economic affairs (like receipts or payments of
money), which does not provide information sufficient enough to evaluate the
financial performance and position of an economic entity.
b. Modern - modern accounting emerges with the invention of the “Double-entry
accounting system” in 1494 by an Italian monk named Luca Pacioli. Double-entry
accounting system provides for recording the dual, commonly called debit and
credit, aspects of financial affairs of an entity which enhances the accuracy of
records and facilitates preparation of reports.

1.3 INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS)

Historically, countries around the world have had their own national accounting standards
(some countries have treasured these for whatever reason, most likely due to the pride of

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national sovereignty). However, with such a compulsion to be part of the globalization
movement, wherein businesses across national boundaries are realizing that it is an astute
business strategy to embrace the world as their workplace and marketplace, having
different rules (standards) of accounting for the purposes of reporting financial results
would not help them at all; rather, it would serve as an impediment to the smooth flow of
information. Businesses, therefore, have realized that they need to talk to each other in a
common language. The adoption of accounting standards that require high-quality,
transparent, and comparable information is welcomed by investors, creditors, financial
analysts, and other users of financial statements. It is difficult to compare worldwide
financial information without a common set of accounting and financial reporting
standards. The use of a single set of high- quality accounting standards would facilitate
investment and other economic decisions across borders, increase market efficiency, and
reduce the cost of raising capital. International Financial Reporting Standards (IFRS) are
increasingly becoming the set of globally accepted accounting standards that meet the
needs of the world’s increasingly integrated global capital markets.

WHAT ARE IFRS?

IFRS are a set of standards promulgated by the International Accounting Standards Board
(IASB), an international standard-setting body based in London. The IASB places
emphasis on developing standards based on sound, clearly stated principles, from which
interpretation is necessary (sometimes referred to as principles-based standards). This
contrasts with sets of standards, like U.S. generally accepted accounting principles
(GAAP), the national accounting standards of the United States, which contain
significantly more application guidance. These standards are sometimes referred to as
rules-based standards, but that is really a misnomer as U.S. standards also are based on
principles—they just contain more application guidance (or rules). IFRS generally do not
provide bright lines when distinguishing among circumstances in which different
accounting requirements are specified. This reduces the chances of structuring
transactions to achieve particular accounting effects.

The following sections discuss some of the basic accounting assumptions, principles, and
concepts that guide the accounting and reporting practices for the financial affairs of
commercial economic entities.

1. Economic Entity Assumption - According to this assumption, each economic entity

exists separate from and independent of its owner/s and other economic entities under
the same or different owner/s. Thus, economic events can be identified with a
particular unit of accountability. And the economic activities of an accounting entity
can be and should be kept separate and distinct from its owner/s and all other entities.
For instance, records and reports of particular business should not reflect its owner’s
personal economic activities, assets and liabilities and that of another business other
than its own economic affairs. This assumption establishes limit/boundary as to what
information to include in the accounting records and reports of an economic entity
and thus makes the financial accounting and reporting practices manageable. The
accounting entity concept, however, does not necessarily refer to a legal entity. For
instance, accounting assumes all types of business organizations (i.e. sole
proprietorship, partnership and corporation) as separate and independent economic
entities. However, it is only corporation that is legally treated as separate and
independent entity.

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 2. Going Concern/Continuity Assumption - This assumption states that, in the absence
of information to the contrary, the life of an economic entity is indeterminate and the
economic entity will continue in operation long enough to carry out its existing
objectives and commitments. This assumption serves as a basis for other principles
such as the historical cost principle and affects classification of assets and liabilities
as current and non-current for reporting purposes. Because of this assumption,
liquidation values of assets and liabilities are not relevant for recording and reporting
the financial affairs of an economic entity.

3. Accrual Concept - This concept requires that financial affairs of an economic entity
should be recognized (i.e. recorded and reported) as they occur regardless of the
timing of the in/out flows of cash associated with the economic events. According to
this principle, for instance, revenue should be recorded and reported when goods are
delivered or services are rendered to customers, and expenses should be recognized
when goods and services are consumed. The timing of the in/out flows of associated
cash, which may happen in advance, immediately or sometime in the future, should
not determine the period in which the revenues and expenses should be recorded and
reported. This concept avoids distortion of information on financial performance and
position of an economic entity that arises as a result of mismatch of costs/expenses
and revenues when the timing of cash flows is treated as a basis for recording and
reporting the financial affairs of an economic entity.

4. Objectivity Principle - According to this principle, an economic entity’s financial

affairs to be recorded in its accounting records and reported on its financial statements
must be supported by objectively determinable evidences known as source
documents.
This helps to enhance the reliability of information reported by the entity and the
confidence of users in relying on the reported accounting information for making
economic decisions. Objective evidences (source documents) include such things as
invoices, vouchers, checks, contracts and physical counts of resources.
Evidences supporting the financial affairs of an entity are not always conclusive. Keeping
accounting records and preparing reports may rely on judgments, estimates and other
subjective factors. In such cases, the records and reports should be based on the most
objective evidence available and be kept in such a way that an independent individual (e.g. an
auditor) could verify their accuracy or reliability. This means that the independent individual
should be able to arrive at the same information using the bases the information is recorded in
the accounting records and reported on the financial statements.

5. VALUATION PRINCIPLE

Realization, which is a key principle in income measurement, forms the basis for
distinguishing methods of valuation used in the reporting of assets and liabilities in the
balance sheet.

A general class of assets called monetary assets usually is carried in the balance sheet at
amounts closely approximating current value. Examples of monetary assets are cash,
certificates of deposit, short-term investments, and receivables. All these assets represent
current purchasing power. Promissory notes receivables and notes payables that are non-
interest bearing, or that have an unrealistically low rate of interest, are not to be valued at face
amount, but at their present value. Present value is determined by discounting all future

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payments on a promissory note at the current fair rate of interest. This requirement for
discounting receivables and payables to their present value applies principally to notes; it is
not applicable to receivables and payables arising from transactions with customers or
suppliers that are due within one year or less.

Another broad category of assets, termed non-monetary assets or productive resources, are
reported in the balance sheet at costs. Inventories and prepayments are examples of short-
term productive resources that will be realized (used) at an early date. Building, equipments,
patents, and investments in affiliated companies are examples of long term productive
resources that will be realized over a number of accounting periods. Until realization occurs,
productive resources are measured and reported in the balance sheet at historical costs; after
realization, valuations of the monetary assets received in exchange for productive assets
generally approximate current fair value. These valuation principles govern the accounting
for assets.

How should costs be measured when non-monetary assets or services are acquired in non-
cash transactions? For example, a land may be acquired in exchange for corporations’
common stock .Cost then is defined as the cash equivalent or the current fair value of the land
acquired or the cash equivalent of the common stock issued whichever is more clearly
evident.

Because a liability is an obligation to convey assets or perform services the appropriate

valuation of liabilities in a balance sheet is in terms of the cash or cash equivalent value
necessary to discharge the obligation on the balance sheet date. If payment is to be made
later, liabilities are measured at the present discounted value of the future payments necessary
to discharge the obligation.
Alternative valuation models include;
 cost model
 revaluation model
 fair value model

6. Unit of Measurement Assumption - According to this assumption, the national currency

(money) should be used as a unit of measure or common denominator for recording and
reporting the economic affairs of an economic entity operating in a given country. Besides,
the unit of measure is assumed to remain constant over time despite the fact that the
purchasing power of money changes over time.

According to this assumption, only those economic activities capable of being expressed in
terms of money should be recorded in the accounting records and ultimately reported on the
financial reports of an economic entity. However, many factors affecting economic activities
and future prospects of an economic entity cannot be expressed in monetary terms. For
instance, such factors as the capabilities, dedication and trust of employees including
management, environmental impact (costs and benefits) of the existence of the economic
entity, and the relative strengths and weaknesses of competitors cannot be expressed in
monetary terms. Although such matters are important to and highly affect the operations and
performances of an economic entity, at the present time, accountancy does not assume
responsibility for recording and reporting information of such kind. Besides, accountancy
does not assume responsibility for recording and reporting the effects of changes in
purchasing power of money on previously recorded values of goods and services.

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1.4 Business Transactions and the Accounting Equation
1. Elements of Financial Statements - are items that are recorded in the accounting
records and then reported on commonly called financial statements of a business
entity reports. The elements of financial statements include assets, liabilities, capital,
revenues and expenses.
i. Assets - are resources owned/controlled by an economic entity and with the
potential to provide future benefits to the business. E.g. building, land, vehicle,
money, office machine such as computer, stationery materials, fuel, Inventory
(merchandise held for sale), Accounts Receivable (money claims against
customers for goods and services sold to them on credit), Rent Receivable (money
claims against lessee/tenant/renter for housing services rendered to them but not
yet collected), Supplies (also called consumable - refer to assets that are expected
to be consumed within a very short period of time and include such items as fuel,
stationery materials, cleaning materials, postage and postage stamps, etc), etc. As
seen in the above cases, money claims against customer for goods and services
rendered to them on credit basis are identified by names including a suffix
Receivable.
ii. Liabilities - obligations/debts of a business that arise as a result of borrowing
and/or buying goods and services on credit. Liabilities may require use of business
assets such as cash and/or delivery of goods and services for their repayment or
settlement. E.g. Accounts Payable (liability arising from purchase of goods on
credit), Salary Payable (obligation for professional or technical services received
from employees), Utility Payable (obligation to utility companies for utility
services such as telephone, electricity and water services received but not yet
paid), Bank Loan Payable (money borrowed from banks), Interest Payable
(interest accrued on loans not yet repaid), Sales Tax (VAT) Payable (amount
collected from customers on behalf of and due to government/tax authority) and
Unearned Rent (money collected from tenants promising to provide them housing
services in the future). Most liabilities are identified by names including a suffix
Payable or a prefix Unearned. Liabilities represent claims/rights of creditors
against the resources/assets of a business or value of assets supplied by creditors.
iii. Equity/Capital - also called owner’s equity/net worth/net assets refer to resources
contributed by or that belong to the owner/s of a business entity. Capital
represents claims/rights of owner/s against assets of a business. Capital may
include direct investment of resources by owner/s and profit generated from
business operations that are accumulated over time or not withdrawn by the
owner/s for personal use.
iv. Income: 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.
i. Cash sale - refers to a situation where customers buying goods and
services are required to immediately pay and accordingly paid cash for
goods and services sold to them.
ii. Credit sale - refers to a situation where customers are allowed to pay
money sometime in the future for goods and services currently sold to
them. Credit sale gives rise to an asset known as
Accounts/Rent/Commission Receivable representing the right of the
business to claim money or other assets from customers buying its
goods and services on credit.

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 Revenues may be generated from different activities and different terms may be
used to refer them accordingly. Below are some examples.
o Selling finished goods such as food/clothing items, stationery materials -
Sales
o Providing services such as transportation, auditing, legal, medical - Fees
Earned
o Lending money - Interest Income
o Leasing/renting properties - Rent/Royalty Income
o Providing brokerage service - Commission Income
v. Expense: decreases in economic benefits during the accounting period in the form
of outflows or depletions of assets or incurrence of liabilities that result in
decreases in equity, other than those relating to distributions to equity participants.
iii. Cash expense/purchase - refers to a situation where a business
immediately pays cash for expenses it incurred or goods and services it
purchased.
iv. Credit expense/purchase - refers to a situation where a business is
allowed to pay money sometime in the future for expenses it currently
incurred or goods and services it currently purchased. Credit
expense/purchase gives rise to an obligation/a liability known as
Accounts/Rent/Interest/Salary/Utility Payable representing the
rights/claims of creditors/suppliers against the assets of the business.
Different terms are used to refer to expenses based on the type of goods and
services consumed. Below are some examples.
o Cost of Goods Sold - expired costs finished goods resulting from sale of
the goods to customers
o Supplies Expense - representing cost of supplies consumed
o Utility Expenses - value of utility services consumed
o Wages/Salary Expenses - values of services received from employees
o Interest Expense - interest accrued/paid on loans
o Rent/Royalty Expense – resource sacrificed for value of services received
from property owners
o Miscellaneous Expenses - values of goods and services consumed but
minor enough in amount to be classified in either of the above types of
expenses
2. Business Transactions - are economic activities of a business that bring monetary
changes in its assets, liabilities, capital, revenues and expenses and should be recorded
in the accounting records of the business. They include buying and selling goods and
services and collecting and paying money. Business transactions are raw materials or
inputs to the accounting process.
Business transactions may be categorized as external and internal transactions.
 External transactions - refer to exchanges of goods and services between a
business organization and an outside party such as individuals and/or other
organizations. E.g. buying telephone services from ETC, selling goods to a
customer, purchasing vehicle from Nyala Motors, etc.
 Internal transactions - refer to consumptions of goods and services within a
business entity, which do not affect external party. E.g. use of previously
purchased stationery materials, fuel, office machine, etc.

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 3. The Accounting Equation - is a mathematical expression that shows the relationship
between assets, liabilities and capital of a business. Below are three but fundamentally
the same ways of expressing the relationship between elements of the financial
statements.
i. Resources = Equities/Claims to Resources
This equation indicates that resources of a business organization come from two
major sources collectively known as equities or claims to the resources. Accordingly,
resources are equal to their sources/equities. Resources contributed or invested by
owner/s are called owner’s equity or capital and those resources supplied by creditors
are identified as liabilities. Expansion of the previous equation to give recognition to
the two basic type’s equities leads to another equation given below.
ii. Assets = Liabilities + Owner's Equity
This indicates that a business may get its assets from its owner/s in the form of
investment and/or from its creditor/s in the form loan or credit.

Assets - Liabilities = Owner's Equity

The accounting equation may further be rearranged, as shown above, to indicate that
owner’s equity represents the residual interest in business assets. This implies that
creditors have priority or preferential right over the assets of a business upon the event
of liquidation.
4. Business Transactions and the Accounting Equation - Business transactions affect
one or more elements of the accounting equation. Each business transaction brings
equal dollar amount of net changes into both the left and right sides of the accounting
equation. As a result, the equation remains in balance (equal) regardless of the nature
and complexity of the transaction. Each and every business transaction is recorded in
terms of the changes (increases and decreases) it brings into the elements of the
accounting equation. Thus, the accounting equation is used to keep track of changes
in the elements of the financial statement.
Below are sample transactions and their effects on the elements of the financial
statements.
i. Collections of resources from
 Owner/s in the form of investment, increase both assets and capital
 Creditor/s in the form of credit/loan, increase both assets and liabilities
 Customer/s in exchange for goods and services sold to them, increase both
assets and revenues
ii. Consumptions of goods and services such as
 Previously purchased supplies, stationery materials and fuel, increase expenses
and decrease assets
 Utility, housing and employee services for which money is not yet paid,
increase both expenses and liabilities
 Money taken out of business by the owner for personal use called
withdrawals, decrease both assets and capital
Note that revenues and expenses represent increases and decreases in capital,
respectively.

1.5 Financial Statements

Definition - financial statements are reports prepared by a business to provide financial
information about its economic affairs to users for decision making. Business organizations

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 prepare four basic financial statements: income statement, statement of changes in owner’s
equity (capital), balance sheet and statement of cash flows.

1. Statement of profit or loss/Income Statement - is used to provide information about

financial performance of a business over time. The statement summarizes the
revenues earned and expenses incurred in a specific period of time such as a month or
a year. Expenses are deducted from revenues on the income statement to determine
whether the business earned a net income or incurred a net loss. Excess of revenues
over expenses is called net income, while excess of expenses over revenues is called
net loss.

2. Statement of Changes in Owner’s Equity - is a summary of changes (increases and

decreases) in owner’s equity that have occurred during a specific period of time such
as a month or a year. The statement includes beginning and ending capital balances,
additional investment, withdrawal and net income/loss.
3. Statement of financial position/Balance Sheet - is used to provide information
about amounts and types of assets a business owns and amounts and types of
resources contributed by its owner/s and creditor/s.

Elements of the balance sheet include assets, liabilities and capital. The balance sheet lists
assets, liabilities and capital of a business on a specific date, usually at the end of a month
or a year. There are two forms of a balance sheet: report and account.
 Report form - lists assets first followed by liabilities and capital in report writing
form
 Account form - lists assets on the left side and liabilities and capital on the right
side of the balance sheet
4. Statement of Cash Flows - is used to provide information about sources and uses of
cash over a specific period of time such as a month or a year. Cash flows are
classified based on the activities of an organization: operating, investing and
financing.
 Operating activities - refer to cash activities of a business that are entered into
determination of net income/loss. Examples include cash collections from
customers for goods and services sold to them and cash paid for goods and
services (such as utilities, supplies and rent) consumed in operating a business.
 Investing activities - refer to cash activities of a business that involve acquisition
and sale of relatively long-term assets such as furniture, fixtures, vehicles,
buildings and machines.
 Financing activities - refer to cash activities of a business that affect equities of
owner/s and long-term creditors of the business. Examples include money
invested and withdrew by owner/s, proceeds from bank loans and repayment of
principal part of bank loan.

Example 1: Mr. X started a delivery service, ABC Deliveries, on November 1, 2009. The
following transactions occurred during the month of November.
a. Nov. 1, 2009 Mr. X deposits $25,000 in a bank account in the name of ABC Deliveries.
b. Nov. 5, 2009 ABC Deliveries paid $20,000 for the purchase of land as a future building
site.

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c. Nov. 10, 2009 ABC Deliveries purchased supplies for $1,350 and agreed to pay the
supplier in the near future.
d. Nov. 18, 2009 ABC Deliveries received cash of $7,500 for providing services to
customers.
e. Nov. 30, 2009 ABC Deliveries paid the following expenses during the month: wages,
$2,125; rent, $800; utilities, $450; and miscellaneous, $275.
f. Nov. 30, 2009 ABC Deliveries paid creditors on account, $950.
g. Nov. 30, 2009 Mr. X determined that the cost of supplies on hand at the end of the
month was $550.
h. Nov. 30, 2009 Mr. X withdrew $2,000 from ABC Deliveries for personal use.

Required:
a) Analyze the above transactions in terms of their effect on the elements of financial
statement
b) Prepare financial statements for the business for the month of January 2003.

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