Chapter seven

Basic Accounting Principles & Budgeting

Fundamentals
Corse outline

1.Classification of accounts
2.Accounting Concepts
3.Accounting statements
4.Budgets and budgetary control
 Introduction:
 Primary concept of accounting is:
o Design of system of records
o Preparation of reports based on recorded data
o Interpretation of reports
 Some fields of accounting:
o Financial accounting:
– concerned with recording of transactions
o Cost accounting:
– Determination and control off cost of Mnfg. Process
and manufactured products.
 …con’d
o Management Accounting:
– Use both historical & estimated data
– Deals with specific problems at various level and
– Identifying alternative course of action & select the
best
o Tax accounting:
– Preparation of tax returns and
– Consideration of tax consequences of business
transaction
o International accounting:
– Concerned with problems associated with
international trade of multinational trade organization
1. Classification of accounts
– Accounts classified as: Assets, Liabilities, Capital,
revenue and expenses.
Assets: a resource held by the business with the
following characteristics.
– Probable future benefit exist
• Through its use or sale items will have monetary value
– The business has an exclusive right to control the
benefit
– Benefit must arise from some past transaction or event
– Must be capable of measurement in monetary terms
• Any physical property (tangible) or legal rights
(intangible) that has monetary value & owned by
a business is an Asset.
• Assets can be classified into two:
– Current Asset: cash or other assets can be converted
into cash
• Cash
– Medium of exchange accepted by banks
• Notes receivable
– Claims against debtors
• Accounts receivable
– Like notes, but less formal
• Pre-paid expenses
– Supplies on hand & advance payments of expenses.
– Fixed Assets:
• Permanent or relatively fixed in nature
• E.g. equipment, machinery, buildings and land
• Except land other fixed assets will depreciate with time
Liabilities:
– Claims of individuals and organizations apart from the
owner arise from past transaction or event
• Classification
– Current liabilities: financial obligations for short
period of time. Includes:
• Notes payable
– Claim against creditors evidenced by written promise
• Accounts payable
– Like notes, but less formal
• Salary payable
• Interest and tax payable
– Long term (Fixed) liabilities
• Claims to be settled over several years
Capital:
– Claim of the owner against the business
– Sometimes referred to as owner’s equity
Capital (Equity) = Asset - Liabilities
Revenue:
– Increase in capital as a result of business activities.
– E.g sales, professional fee, commissions revenue, fare
earned and interest income.
Expense:
– Costs in process
– Include expired cost or expenses
2. Accounting Concepts
• There are several fundamental assumptions
during preparation of financial statements:
– Dual Aspect Concept:
• Total asset always equals to liability and equity
Asset = Liabilities + Equity
– Money measurement concept:
• Accounting records show only facts that can be expressed in
monetary terms
– Business entity Concept :
• Accounts kept business entities distinguished or separated
from the person associated with it.
– Going concern concept:
• A business will continue indefinitely and is not about to be
sold.
– Cost concept:
• Assets are valued at their cost and not by their market
value
– Accrual concept:
• Income measured as the difference b/n revenues and
expenses
• Rather than difference b/n cash receipt and disbursement
– Realization Concept:
• Revenue and expenses are recognized at time they
consumed.
 3. Accounting statements
• The statements are presented as a specific date
usually at close of the last day of a month or a
year.
• Includes:
– Income statements
• Summary of revenue and expense
– Capital statements
• Summarize the change in capital of business entity
– Balance sheet
• Gives list of the assets, liabilities and capital entity as of
specific date.
  Income statements
• Work sheet: source of all data reported on the
income statement.
• Arrangements commonly followed
– List expense in order of size, begin with large item
– Then miscellaneous expenses
E.g Addis Shoe Factory income statement for the
month end march 31,2008
 Sales: Birr 5125.00
 Operating expense:
– Supplies expense Birr 960.00
– Salary expense 825.00
– Rent expense 800.00
– Depreciation expense 175.00
 miscellaneous expenses Birr 369.00
– Total operating expense 3129.00

 Net Income Birr 1996.00

  Capital statements
• Serve as a link b/n income statement and balance
sheet
• The amount listed on work sheet as capital, does
not always, represent the account balance at the
beginning
• The variation is due to:
– Additional investment
– A withdrawal by the owner
• E.g. Addis Shoe factory capital statement for
Month Ended March 31, 2008
 Capital as of March 1, 2008 Birr 20,650.00
 Net income for the month 1996.00
 Less withdrawals 1500.00
 Increase in capital 496.00
 Capital as March 31, 2008 Birr 21,146.00
  Balance sheet
• Statement of financial position of the business at
a specific point of time.
– Is analogues to photograph—which ‘freezes’
particular moment in time
– Balance sheet represent ‘snapshot’ of business….
• The more current balance sheet better asses
financial position.
• Arrangements:
– Starts with asset section (cash, account receivable,
supplies, pre-paid insurance….)
– Then liabilities
– And finally capital section
• E.g. Addis Shoe Factory
Balance sheet for the month Ended March 31, 2008
Current Asset:
cash Birr 1632.00
Account receivable 1775.00
Supplies 890.00
pre-paid rent 1600.00
Total current asset 5897.00
Plant asset:
Equipment Birr 17499.00
Less accumulated depreciation . 175.00
17,324.00
Total Assets 23,221.00
• Liabilities
Current liabilities
Accounts payable Birr 2000.00
Salaries payable 75.00
Total Liabilities 2075.00
Capital
capital Birr 21,146.00
Total Liabilities and Capital(Asset) Birr 23,221.00
 Interpreting the balance sheet
• Balance sheet provide useful insight to the
financing and investing activities of a business.
• The following aspects of financial position
examined:
– The liquidity of the business:
• Ability of to meet short-term obligation
(current liabilities) from its liquid (cash and
near cash) assets.

• The highest liquidity; the current assets are

directly compared to the current liabilities.
• Liquidity is important b/c business failure
occurs when the business can not meet its
maturing obligations
– The ‘mix’ of assets held by the business:
• The relationship b/n fixed and current asset
is important
• Business with too much funds tied up in fixed
assets could be vulnerable to financial
failure.
–b/c fixed assets are not easy to turn into
cash to meet short term obligations.
– The financial structure of the business:
» Relative proportion of finance
contributed by owners and outsiders
should be calculated
• Shows whether the business heavily
dependent on outside financing
» Heavy borrowing led to pay large
interest charges and make large capital
repayments at regular time.
 Elements and classification of manufacturing costs
 Direct costs:
– Direct material cost
• Material charges closely related to output
• Factors to be considered
» The quantity (usage):
• Quantity variance: if actual quantity differ from standard
» The Price:
• Price variance: actual unit price differs from standard
– Direct labor cost
• Material cost closely related to output
» Time (usage or efficiency):
• Time variance
» The rates (price or wage):
• Rate variance
 Overhead costs:
– Have indirect nature and are not easily associated
with out put.
– It consists
• Factory expenses:
– salaries of foremen and factory office workers;
– Expense of maintenance staff
– Depreciation of equipment and building
– Payment for power, water, telephone, telex etc.
• Administrative Expenses:
– Salaries of administrative personnel
– Expense for office supplies
– Depreciation of office equipments and insurance fee
• Selling Expense
– Salary and commission of sales men,
– Advertising and traveling expenses
  Total cost
• Calculated using two different ways
1. Total cost is the sum of manufacturing cost and
selling expenses
total cost = manufacturing cost + selling expense(SE)
– Manufacturing cost in turn is factory cost and
expense
Manufacturing cost = factory cost + administrative
expense
MC = FC + AE
 – Factory cost is sum of prime cost and factory expense
Factory cost = Prime cost + Factory Expense
FC = PC + FE
– Prime cost is sum of direct labor and direct material
Prime cost = Direct labor + Direct Materia
PC = DL + DM
 Therefore, total cost is sum of direct labor, direct
material, factory expense, administrative expense
and selling expense
TC = DL + DM + FE + AE + SE
2. The total cost can also be calculated as the sum
of fixed cost and variable costs.
Total cost = Fixed cost + Variable Cost
TC = FC +VC = (FE +AE+ SE) + (DM + DL)
Fixed cost: expense independent of out put
volume.
– E.g factory building, lightning expense, property tax,
salary of administrative staff ….
Variable cost: varies proportionally with out put
– E.g. direct labor cost, expense of raw material, electric
power to operate production equipment …..
Overhead cost: other expenses
  Break-Even Analysis
• Business enterprises face problems of selecting
which profit maximization assumed to be the
governing factor.
• Business men concerned with revenues, costs
and the consequent profits or losses associated
with possible alternatives.
• Break-Even point:
– Revenue(sales) = Total cost
– Enterprise neither realize an operating income nor
incur an operating loss.
Birr

Break-Even point Q

Break-Even Chart
 Total cost = Fixed cost + variable cost
Income = Price*Quantity
At break-even sales,
Total cost = Income
Price * Quantity = Fixed cost + Variable cost
Let P = price
Q = break-even quantity
F = Fixed cost and V = Variable cost
PQ = F + VQ
Q(P-V) = F
Q = F/(P-V)
Break- Even quantity
• E.g. A firm is able to sale 10,000 units of its
products at a price of Birr 2 per unit. Its total
fixed cost is Birr 7000 and unit variable cost is
Birr 1.50.
– a. Does the firm make profit or loss?
– b. What are the possible alternative to break-even?
Solution:
a. Total cost = 7000+ 1.5*10000
= 22,000birr
Revenue = 2*10000
= 20,000birr
Revenue < Total cost ; the firm is at loss
b. To break-even
1. Increase sales price
Q = F/(P-V)  P = (F +VQ)/Q
P = (7000 + 1.5 * 10000)/ 10000
P = 2.20 Birr
2. Reduce the unit variable cost (through improved
process, methods, reducing waste, increasing
equipment efficiency, economize power
consumption etc..,)
V = (PQ-F)/Q
= (2*10000-7000)/10000
=birr 1.30 per unit
3. Increase volume of sales(through aggressive
promotion, more efficient distribution…)
Q = F/(P-V) =7000/(2-1.5) =1400units
4. Decrease fixed costs (through disposing idle
equipment ….)

F = (P-V)Q = (2-1.5)*10000
= Birr 5000