CH 1 FAcc I @2015

Hawassa University College of Business &Economics Dep’t of Accounting &Finance
CHAPTER-ONE: INTRODUCTION TO ACCOUNTING AND BUSINESS

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
 Explain the meaning of Accounting
 Identify the users and uses of accounting information
 Explain the various branches in the profession of accounting
 Explain the meaning of “International financial reporting standard”,
 Explain the meaning of business entity assumption, cost principle and monetary unit assumption
 State the basic accounting equation and explain the meaning of assets, liabilities, and owner’s
equity
 Analyze the effects of business transactions on the basic accounting equation, and
 Prepare profit or loss statement, owner’s equity statement, and statement of financial position.
1.1Nature 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 into
generate income, business organizations may be divided into 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-workshops, etc.
Forms of business organizations
There are three basic forms of business organizations: sole proprietorships, partnerships, and
corporations. Accountants recognize each form as an economic unit separate from its owners (Business
Entity Concept). Let’s discuss each one by one
Proprietorship: A business owned by one person is generally a proprietorship. The owner is often
the manager/operator of the business. Small service-type businesses (plumbing companies, beauty
salons, and auto repair shops), farms, and small retail stores (antique shops, clothing stores, and used-
1 Fundamental of Accounting I
book stores) are often proprietorships. Usually only a relatively small amount of money (capital) is
necessary to start in business as a proprietorship. The owner (proprietor) receives any profits, suffers
any losses, and is personally liable for all debts of the business. There is no legal distinction between
the business as an economic unit and the owner, but the accounting records of the business activities are
kept separate from the personal records and activities of the owner.
A sole proprietorship is a separate entity for accounting purposes (Business entity Concept) but it is not
a separate legal entity from the owners. That is, from the legal point of view, the owner and the business
are treated as one and the same. The owner will be held personally responsible for the debts and actions
of the business. For instance, assume Flower Laundry is a sole proprietorship owned by Ato Alemu.
Assume also that the business has borrowed Birr 10,000 from the Commercial Bank of Ethiopia and
failed to pay its debts. In this case, if the Commercial Bank of Ethiopia can’t recover the amount it lent
from the properties of the company it can go to the extent of selling the owner’s personal properties.
Partnership: A business owned by two or more persons associated as partners is a partnership. In
most respects a partnership is like a proprietorship except that more than one owner is involved.
Typically a partnership agreement (written or oral) sets forth such terms as initial investment, duties of
each partner, division of net income (or net loss), and settlement to be made upon death or withdrawal of
a partner. Each partner generally has unlimited personal liability for the debts of the partnership. Like a
proprietorship, for accounting purposes the partnership transactions must be kept separate from the
personal activities of the partners. Partnerships are often used to organize retail and service-type
businesses, including professional practices (lawyers, doctors, architects, and certified public
accountants).
A partnership is not a legal entity separate from the owners but an association that brings together the
talents and resources of two or more people. The owners of a partnership are known as partners.
The partners share the profits and losses of the partnership according to an agreed –on formula. The
personal resources of each partner can be called on to pay the obligations of the partnership. That is,
each partner is personally responsible for the debts of the partnership. From an accounting standpoint,
however, a partnership is a business entity separate from the personal activities of the partners.
Corporation: Corporation is a business organized as a separate legal entity under state corporation
law and having ownership divided into transferable shares of capital. The corporation issues capital
share certificates to each shareholder showing the number of shares he or she owns. The holders of the
shares (shareholders) enjoy limited liability; that is, they are not personally liable for the debts of the
corporate entity. Their risk of loss is limited to the amount they paid (invested). Because of this limited
liability in a corporation shareholders are willing to invest in riskier, but potentially more profitable,
activities.
Shareholders may transfer all or part of their ownership shares to other investors at any tim e (i.e., sell
their shares). The ease with which ownership can change adds to the attractiveness of investing in a
corporation. Because ownership can be transferred without dissolving the corporation, the corporation
enjoys an unlimited life.
1.2 The Role of Accounting in Business Environment

1. Accounting Defined
As a financial information system, accounting is defined as a process of identifying, analysis, measuring,
recording and communicating economic events of an organization (business or non- business) to
interested users of the information. Accounting consists of three basic activities—it identifies, records,
and communicates the economic events of an organization to interested users.
To identify economic events, a company selects the economic events relevant to its business.
Examples of economic events are the sale of items, providing of telephone services, and payment of
wages.
Once a company identifies economic events, it records those events in order to provide a history of its
financial activities. Recording consists of keeping a systematic, chronological diary of events,
measured in dollars/birrs and cents. In recording, companies also classify and summarize economic
events (this
this will be discussed in detail in chapter 2).
2)
Finally, they communicate the collected information to interested users by means of accounting
reports. The most common of these reports are called financial statements. A vital element in
communicating economic events is the accountant’s ability to analyze and interpret the reported
information. Analysis involves use of ratios, percentages, graphs, and charts to highlight significant
financial trends and relationships. Interpretation involves explaining the uses, meaning, and
limitations of reported data. The analysis and interpretation part is left for advanced courses in
accounting.
As accounting plays an important role in the decision making process of business entities, it is often
called the language of business. As a result, whether you are an economist a marketer, investor, supplier
or any other, to be successful, you should be able to “speak” and be familiar with the basic terms used
in the business environment. So that it is also commonly known as the “language of business”.
2. Importance/purpose of Accounting - 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 range 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 execution. The area of accounting aimed
at serving the decision-making needs of internal users is called Management Accounting.
Internal users often have access to a lot of private and valuable information. 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. The area of accounting aimed at serving external users
is called Financial Accounting. Its main objective is to provide to external users information
through financial statements. 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.
 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. Characteristic of Accounting Information - accounting information is mainly quantitative
expressed in monetary terms. To be useful for decision making, accounting information must have;
Fundamental qualitative characteristic
 Relevant - highly related to and make a difference in decision
 Faithful representation- represent facts, neutral, free of material errors and bias.
Relevancy and faithful representation are commonly called the fundamental qualitative characteristic or
attribute that make accounting information useful for decision-making.
Relevant financial information is capable of making a difference in the decisions made by users.
Information may be capable of making a difference in a decision even if some users choose not to take
advantage of it or are already aware of it from other sources. Financial information is capable of making
a difference in decisions if it has predictive value, confirmatory value or both.
Financial information has predictive value if it can be used as an input to processes employed by users
to predict future outcomes. Financial information need not be a prediction or forecast to have
predictive value. Financial information with predictive value is employed by users in making their own
predictions.
Financial information has confirmatory value if it provides feedback about (confirms or changes)
previous evaluations.
Faithful representation
Financial reports represent economic phenomena in words and numbers. To be useful, financial
information must not only represent relevant phenomena, but it must also faithfully represent the
phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have
three characteristics. It would be complete, neutral and free from error.
A complete depiction (representation or depiction including numbers and words) includes all
information necessary for a user to understand the phenomenon being depicted, including all necessary
descriptions and explanations.
A neutral depiction is without bias (unfairness) in the selection or presentation of financial
information. Neutral information does not mean information with no purpose or no influence on
behaviour. On the contrary, relevant financial information is, by definition, capable of making a
difference in users’ decisions.
Free from error means there are no errors or omissions in the description of the phenomenon, and the
process used to produce the reported information has been selected and applied with no errors in the
process. In this context, free from error does not mean perfectly accurate in all respects. But, a
representation of any activities can be faithful if the amount is described clearly and accurately as it is,
the nature and limitations of the process are explained, and no errors have been made in selecting and
applying an appropriate process.
Enhancing qualitative characteristics

Comparability, verifiability, timeliness and understandability are qualitative characteristics that
enhance the usefulness of information that is relevant and faithfully represented.
A. Comparability Users’ decisions involve choosing between alternatives, for example, selling or
holding an investment, or investing in one reporting entity or another. Consequently, information about
a reporting entity is more useful if it can be compared with similar information about other entities
and with similar information about the same entity for another period or another date. A comparison
requires at least two items. Consistency, although related to comparability, is not the same. Consistency
refers to the use of the same methods for the same items, either from period to period within a reporting
entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that
goal.
B. Verifiability: Verifiability (that can be assured) helps assure users that information faithfully
represents the economic phenomena it purports to represent. Verifiability means that different
knowledgeable and independent observers could reach consensus, although not necessarily complete
agreement, that a particular depiction is a faithful representation.
C. Timeliness: Timeliness means having information available to decision-makers in time to be capable
of influencing their decisions. Generally, the older the information is the less useful it is. However, some
information may continue to be timely long after the end of a reporting period because, for example,
some users may need to identify and assess trends.
D. Understandability: Classifying, characterizing and presenting information clearly and concisely
makes it understandable. Financial reports are prepared for users who have a reasonable knowledge of
business and economic activities and who review and analyse the information diligently. At times, even
well-informed and diligent users may need to seek the aid of an adviser to understand information about
complex economic phenomena.
Constraint on useful financial reporting
Cost Constraint: Cost is a pervasive constraint on the information that can be provided by financial
reporting. Reporting financial information imposes costs, and it is important that those costs are justified
by the benefits of reporting that information. There are several types of costs and benefits to consider.
Providers of financial information expend most of the effort involved in collecting, processing, verifying
and disseminating financial information, but users ultimately bear those costs in the form of reduced
returns. Users of financial information also incur costs of analysing and interpreting the information
provided. If needed information is not provided, users incur additional costs to obtain that information
elsewhere.
In providing information with the qualitative characteristics that make it useful, companies must
consider an overriding factor that limits (constrains) the reporting. This is referred to as the cost
constraint (the cost-benefit relationship). That is, companies must weigh the costs of providing the
information against the benefits that can be derived from using it. In order to justify requiring a
particular measurement or disclosure, the benefits perceived to be derived from it must exceed the costs
perceived to be associated with it.
Materiality
The materiality constraint concerns an item’s impact on a company’s overall financial operations. An
item is material if its inclusion or omission would influence or change the judgment of a reasonable
person. It 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. The point involved here is of relative
size and importance.
Information is material if omitting it or misstating it could influence decisions that users make on the
basis of financial information about a specific reporting entity. In other words, materiality is an entity-
specific aspect of relevance based on the nature or magnitude, or both, of the items to which the
information relates in the context of an individual entity’s financial report. Consequently, the Board
cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in
a particular situation.
5. Bookkeeping versus Accounting - You should understand that the accounting process includes the
bookkeeping function. Bookkeeping usually involves only the recording of economic events. It is
therefore just one part of the accounting process. In total, accounting involves the entire process of
identifying, recording, Preparing, Interpreting, Reviewing records and reports for their accuracy
and communicating economic events. Accounting also designing accounting and reporting
systems.
Thus, it can be safely concluded that bookkeeping is one and the simplest part of accounting.
6. Profession of Accountancy – If you just joined the accounting profession, you may be wondering
what job you will be doing in the future. You probably would apply your expertise in one of three
major fields:
 Public Accounting
 Private Accounting or
 Not – for – profit Accounting

i) Public accounting
In Public Accounting you would offer expert service to the general public in much the same way that a
doctor serves patients and a lawyer serves clients. A major portion of public accounting practice is
involved with Auditing. In this area, a certified Public Accountant (CPA) examines, the financial
statements of companies and expresses opinion as to the fairness of presentation. When presentation is
fair, users consider the statements to be reliable.
Management consulting is another area of public accounting. In this case, the accountant consults the
management generally about the growth and development of the business enterprise.
ii) Private Accounting
Instead of working in public accounting, an accountant may be an employee of a business enterprise. In
private accounting, you would be involved in one of the following activities:
1. Cost Accounting:
Accounting: Determining the cost of producing specific products.
2. Budgeting: Assisting management in quantifying goals concerning revenues, costs of goods
sold, and operating expenses.
3. General Accounting:
Accounting: recording daily transactions and preparing financial statements and related
information.
4. Accounting information systems:
systems: designing both manual and computerized data processing
systems.
5. Tax Accounting:
Accounting: preparing tax returns (-forms to be filled by a company and returned to a
taxing authority) and engaging in tax planning for the company.
6. Internal Auditing:
Auditing: reviewing a company’s operations to determine compliance with
management policies and evaluating efficiency of operations.
iii) Not for Profit Accounting
Like businesses that exist to make a profit, not - for-profit organizations also need sound financial
reporting and control. Donors to such organizations want information about how well the organization
has met its objectives and whether continued support is justified. In each of these cases, accounting
expertise is highly valued.
7. Specialized Fields of Accounting - accountants may specialize in different accounting fields
including financial accounting, managerial accounting, cost accounting and tax accounting.
 Financial accounting - area of accounting aimed at serving information needs of external

users.
 Managerial accounting - field of accounting concerned with serving information needs of
internal users - managers.
 Cost accounting - a managerial accounting activity designed to help managers in identifying,
measuring and controlling operating costs.
 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.
1.3 International Financial Reporting Standard(IFRS)

IFRS is a globally recognized set of Standards for the preparation of financial statements by business
entities. Those Standards prescribe: the items that should be recognized as assets, liabilities, income and
expense; how to measure those items; how to present them in a set of financial statements; and related
disclosures about those items.
IFRS are referred to as being principles-based standards:
 Provide core principles (objectives) with minimum guidance.
o They are more loosely framed, allowing for professional judgment to be applied
o The judgments are expected to be consistent with clear conceptual framework
o Results in accounting that is more flexible to deal with unique economic and business
circumstances
o Some argue that allowing professional judgment introduces bias
o IFRS is developed by the International Accounting Standards Board (IASB), which operates
under the oversight of the IFRS Foundation.
o IASB was formerly called International Accounting Standards Committee (IASC)
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. Basic Assumptions
Four basic assumptions underlie the financial accounting structure: (1) economic entity,(2) going
concern, (3) monetary unit, and (4) periodicity. We’ll look at each in turn.
 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.. It states that the activities of the
entity must be kept separate and distinct from the activities of the owner. In order to assess a
company’s performance and financial position accurately, it is important that we not blur company
transactions with personal transactions (especially those of its managers) or transactions of other
companies. For accounting purposes, each business enterprise has a separate existence from its
owners, creditors, employees, customers and other businesses
 Going Concern Assumption: Most accounting methods rely on the going concern assumption—
that the company will have a long life. It states that the business will remain in operation for the
foreseeable future. Of course, many businesses do fail, but in general, it is reasonable to assume that
the business will continue operating.
 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. It requires that only those things that can be expressed in money are included in the
accounting records. This means that certain important information needed by investors, creditors,
and managers, such as customer satisfaction, is not reported in the financial statements. Money is the
only factor common to all business activities. Therefore, it is the only practical unit of measurement
that can produce financial data that can be compared.
 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 firms, 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. It states that the life of a business can be divided into
artificial time periods and that useful reports covering those periods can be prepared for the business.
 Accrual Basis of Accounting: transactions are recorded in the periods in which the events occur.
2. Basic Principles of Accounting
We generally use 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.
A. Measurement Principle: IFRS generally uses one of two measurement principles, the historical
cost principle or the fair value principle. Selection of which principle to follow generally relates to
trade-offs between relevance and faithful representation.
 Historical Cost: The historical cost principle (or cost principle) dictates that companies
record assets at their cost. This is true not only at the time the asset is purchased but also over
the time the asset is held. For example, if land that was purchased for $30,000 increases in
value to $40,000, it continues to be reported at $30,000.
 Fair Value: The fair value principle indicates that assets and liabilities should be reported at
fair value (the price received to sell an asset or settle a liability). Fair value information may be
more useful than historical cost for certain types of assets and liabilities. For example, certain
investment securities are reported at fair value because market price information is often
readily available for these types of assets. In choosing between cost and fair value, two
qualities that make accounting information useful for decision-making are used—relevance
and faithful representation. In determining which measurement principle to use, the factual
nature of cost figures is weighed versus the relevance of fair value. In general, most assets
follow the historical cost principle because market values are representationally faithful. Only
in situations where assets are actively traded, such as investment securities, is the fair value
principle applied.
B. Revenue Recognition Principle: When a company agrees to perform a service or sell a product to a
customer, it has a performance obligation. When the company satisfies this performance
obligation, it recognizes revenue. It requires that companies recognize revenue in the accounting
period in which the performance obligation is satisfied. In a service company, revenue is recognized
at the time the service is performed. In a merchandising company, the performance obligation is
generally satisfied when the goods transfer from the seller to the buyer.
C. Expense Recognition Principle: Expenses are defined as outflows or other “using up” of assets or
incurring of liabilities (or a combination of both) during a period as a result of delivering or
producing goods and/or performing services. In practice, the approach for recognizing expenses is,
“Let the expense follow the revenues.” This approach is the expense recognition principle. That is,
by matching efforts (expenses) with accomplishment (revenues). It dictates that efforts (expenses)
be matched with results (revenues). Thus, expenses follow revenues.
D. Full Disclosure Principle: Providing information that is of sufficient importance to influence the
judgment and decisions of an informed user. It requires that companies disclose all circumstances
and events that would make a difference to financial statement users. If an important item cannot
reasonably be reported directly in one of the four types of financial statements, then it should be
discussed in notes that accompany the statements.
1.4 Business Transactions and the Accounting Equation

1. Accounting Equation: is a mathematical expression that shows the relationship between assets,
liabilities and capital of a business:
Assets = Liabilities + Owner’s Equity

This relationship is the basic accounting equation. Assets must equal the sum of liabilities and owner’s
equity. Liabilities appear before owner’s equity in the basic accounting equation because they are paid
first if a business is liquidated. The equation provides the underlying framework for recording and
summarizing economic events.
2. 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, income and expenses.
 Assets: assets are resources a business owns. The business uses its assets in carrying out such
activities as production and sales. The common characteristic possessed by all assets is the capacity
to provide future services or benefits. In a business, that service potential or future economic
benefit eventually results in cash inflows (receipts). For example, Campus Pizza owns a delivery
truck that provides economic benefits from delivering pizzas. Other assets of Campus Pizza are
tables, chairs, jukebox, cash register, oven, tableware, and, of course, cash.
 Liabilities: Liabilities are claims against assets—that is, existing debts and obligations. Businesses
of all sizes usually borrow money and purchase merchandise on credit. These economic activities
result in payables of various sorts: Campus Pizza, for instance, purchases cheese, sausage, flour, and
beverages on credit from suppliers. These obligations are called accounts payable. Campus Pizza
also has a note payable to First National Bank for the money borrowed to purchase the delivery
truck. Campus Pizza may also have wages payable to employees and sales and real estate taxes
payable to the local government. All of these persons or entities to whom Campus Pizza owes
money are its creditors.
 Note: Creditors may legally force the liquidation of a business that does not pay its debts. In
that case, the law requires that creditor claims be paid before ownership claims.
 Owner’s Equity: The ownership claim on total assets is owner’s equity. It is equal to total assets
minus total liabilities. Here is why: The assets of a business are claimed by either creditors or
owners. To find out what belongs to owners, we subtract the creditors’ claims (the liabilities) from
assets. The remainder is the owner’s claim on the assets—the owner’s equity. Since the claims of
creditors must be paid before ownership claims, owner’s equity is often referred to as residual
equity.
Increases in owner’s equity
In a proprietorship, owner’s investments and revenues (income) increase owner’s equity.
 Investments by Owner: Investments by owner are the assets the owner puts into the business.
These investments increase owner’s equity. They are recorded in a category called owner’s capital.
 Revenues: Revenues are the gross increase in owner’s equity resulting from business activities
entered into for the purpose of earning income. Generally, revenues result from selling merchandise,
performing services, renting property, and lending money. Common sources of revenue are sales,
fees, services, commissions, interest, dividends, royalties, and rent. Revenues usually result in an
increase in an asset. They may arise from different sources and are called various names depending
on the nature of the business. Campus Pizza, for instance, has two categories of sales revenues—
pizza sales and beverage sales.
Decreases in owner’s equity
In a proprietorship, owner’s drawings and expenses decrease owner’s equity.
 Drawings: An owner may withdraw cash or other assets for personal use. We use a separate
classification called drawings to determine the total withdrawals for each accounting period.
Drawings decrease owner’s equity.
 Expenses: expenses are the cost of assets consumed or services used in the process of earning
revenue. They are decreases in owner’s equity that result from operating the business. For
example, Campus Pizza recognizes the following expenses: cost of ingredients (meat, flour, cheese,
tomato paste, mushrooms, etc.);cost of beverages; wages expense; utility expense (electric, gas, and
water expense);telephone expense; delivery expense (gasoline, repairs, licenses, etc.); supplies
expense(napkins, detergents, aprons, etc.); rent expense; interest expense; and property tax expense.
 In summary, owner’s equity is increased by an owner’s investments and by revenues from business
operations. Owner’s equity is decreased by an owner’s withdrawals of assets and by expenses. We
expand the basic accounting equation by showing the accounts that comprise owner’s equity. This
format is referred to as the expanded accounting equation.
Assets = Liabilities + Owner’s Capital-Owner’s Drawings+ Revenues-Expenses
3. Transactions (business transactions) are a business’s economic events recorded by

accountants. Transactions may be external or internal.
 External transactions involve economic events between the company and some outside
enterprise. For example, Campus Pizza’s purchases of cooking equipment from a supplier,
payment of monthly rent to the landlord, and sale of pizzas to customers are external
transactions.
 Internal transactions are economic events that occur entirely within one company. The uses of
cooking and cleaning supplies are internal transactions for Campus Pizza.
Companies carry on many activities that do not represent business transactions. Examples are hiring
employees, answering the telephone, talking with customers, and placing merchandise orders. Some of
these activities may lead to business transactions: Employees will earn wages, and suppliers will deliver
ordered merchandise. The company must analyze each event to find out if it affects the components of
the accounting equation. If it does, the company will record the transaction. Each transaction must have
a dual effect on the accounting equation. For example, if an asset is increased, there must be a
corresponding: (1) decrease in another asset, or (2) increase in a specific liability, or (3) increase in
owner’s equity. Two or more items could be affected.
Transaction Analysis
The following examples are business transactions for a computer programming business during its first
month of operations.
Transaction 1---Investment by Owner: Biruk Bekele decides to open a computer programming service
which he names Softbyte. On September 1, 2010, he invests birr 15,000 cash in the business. This
transaction results in an equal increase in assets and owner’s equity. On the asset side, cash increases by
birr 15,000, as does the owner’s equity, identified as Biruk, Capital.
Transaction 2---Purchase of Equipment for Cash: Softbyte purchases computer equipment for birr
7,000 cash. This transaction results in an equal increase and decrease in total assets, though the
composition of assets changes: Cash decreases by Birr 7,000 and the asset equipment increases by birr
7,000.
Transaction 3---Purchase of Supplies on Credit: Softbyte purchases for birr 1,600from XYZ Supply
Company computer paper and other supplies expected to last several months. XYZ agrees to allow
Softbyte to pay this bill in October. This transaction is a purchase on account (a credit purchase). Assets
increase because of the expected future benefits of using the paper and supplies, and liabilities increase
by the amount due to XYZ Company. The asset Supplies increases birr by 1,600, and the liability
accounts Payable increases by the same amount.
Transaction 4---Services Provided for Cash: Softbyte receives birr 1,200 cash from customers for
programming services it has provided. This transaction represents Softbyte’s principal revenue-
producing activity. Recall that revenue increases owner’s equity. In this transaction, Cash increases by
birr 1,200, and revenues (specifically, Service Revenue) increase by 1,200.
Transaction 5--Purchase of Advertising on Credit: Softbyte receives a bill for birr 250 from the Daily
News for advertising but postpones payment until a later date. This transaction results in an increase in
liabilities and a decrease in owner’s equity. The specific categories involved are Accounts Payable and
expenses (specifically, Advertising Expense).
Transaction 6---Services Provided for Cash and Credit: Softbyte provides birr 3,500 of
programming services for customers. The company receives cash of birr 1,500 from customers, and it
bills the balance of birr 2,000 on account. This transaction results in an equal increase in assets and
owner’s equity. Three specific items are affected: Cash increases by birr 1,500; Accounts Receivable
increases by birr 2,000; and Service Revenue increases by birr 3,500.
Transaction 7----Payment of Expenses: Softbyte pays the following Expenses in cash for September:
store rent birr 600, salaries of employees birr 900, and utilities birr 200.These payments result in an
equal decrease in assets and expenses. Cash decreases by birr 1,700 and the specific expense categories
(Rent Expense, Salaries Expense, and Utility Expense) decrease owner’s equity by the same amount.
The effect of these payments on the equation is:
Transaction 8-- Payment of Accounts Payable: Softbyte pays its birr 250 DailyNews bill in cash. The
company previously [in Transaction (5)] recorded the bill as an increase in Accounts Payable and a
decrease in owner’s equity. This payment“ on account” decreases the asset Cash by birr 250 and also
decreases the liability Accounts Payable by birr 250.
Transaction 9-- Receipt of Cash on Account. Softbyte receives birr 600 in cash from customers who
had been billed for services [in Transaction (6)].This does not change total assets, but it changes the
composition of those assets. Cash increases by birr 600 and Accounts Receivable decreases by birr 600.
Transaction 10---Withdrawal of Cash by Owner: Biruk bekele withdraws birr 1,300in cash from the
business for his personal use. This transaction results in an equal decrease in assets and owner’s equity.
Both Cash and Biruk, Capital decrease by birr 1,300.
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 September 30, 2010.
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 prepare four basic
financial statements: Profit or loss statement, statement of changes in owner’s equity. Statement of
financial position and statement of cash flows. Companies prepare four financial statements from the
summarized accounting data:
1. Profit or loss statement/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 - reports the assets, liabilities, and owner’s equity at
a specific date. It 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 - Summarizes information about the cash inflows (receipts) and outflows
(payments) for a specific period of time. The statement of cash flows reports (1) the cash effects of
a company’s operations during a period, (2) its investing transactions, (3) its financing transactions,
(4) the net increase or decrease in cash during the period, and (5) the cash amount at the end of the
period.
 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.
Reporting the sources, uses, and change in cash is useful because investors, creditors, and others want to
know what is happening to a company’s most liquid resource. The statement of cash flows provides
answers to the following simple but important questions.
1. Where did cash come from during the period?
2. What was cash used for during the period?
3. What was the change in the cash balance during the period?
Illustration 1.1: Below shows the first four financial statements of Softbyte
Soft byte co
Income Statement
For the month ended September 30, 2010
Revenues:
Service revenue ---------------------------------------------------------------------------------4,700
Expenses:
Salaries and wages expense-------------------------------------- 900
Rent expense------------------------------------------------------- 600
Advertising expense---------------------------------------------- 250
Utilities expense--------------------------------------------------- 200
Total expenses---------------------------------------------------------------------------------(1,950)
Net income ---------------------------------------------------------------------------------------2,750
Soft byte co
Statement of change in equity
Biruk, capital, September 1 --------------------------------------------------------------------- 0
Add: Investment by owner--------------------------------15,000
Net income ------------------------------------------2,750
Less: Biruk, Drawing--------------------------------------- (1,300)
Change in equity -----------------------------------------------------------------------------16,450
Biruk, capital, September 30---------------------------------------------------------------16,450
Soft byte co
Statement of Financial Position
As of September 30,2010
Asset:
Equipment ------------------------------------ 7,000
Supplies--------------------------------------- 1,600
Accounts receivable------------------------ 1,400
Cash--------------------------------------------8,050
Total assets ------------------------------------------------------------------------------18,050
Equity and Liabilities:
Equity:
Biruk, Capital--------------------------------16,450
Liabilities:
Accounts payable---------------------------- 1,600
Total equity and liabilities -------------------------------------------------------------18,050
Soft byte co
Statement of Cash Flow
Cash flows from operating activities:
Cash receipts from revenues -----------------------------------3,300
Cash payments for expenses--------------------------------- (1,950)
Net cash flow from operating activities-----------------------------------------------------1,350
Cash flows from investing activities:
Purchase of equipment------------------------------------------ (7,000)
Net cash flow from investing activities------------------------------------------------------- (7000)
Cash flows from financing activities:
Investment by owner-------------------------------------------15,000
Drawing---------------------------------------------------------- (1,300)
Net cash flow from financing activities----------------------------------------------------------13,700
Net increase in cash------------------------------------------------------------------------------- 8,050
Cash at the beginning of the period--------------------------------------------------------------- 0
Cash at the end of the period --------------------------------------------------------------------8,050
Exercise 1:
Guji Company had the following amounts of assets and liabilities at the beginning and end of last year:
Assets Liabilities
Opening balance………………..… Br.75,000 Br. 30,000
Closing balance….……………………120,000 46,000
Determine the net income or net loss of Guji for the year under each of the following unrelated
assumptions:
a) Owner made no additional investment and withdrew no amount during the year
b) Owner made no additional investment but withdrew Br.17,500 to pay for her personal
expenses
c) Owner withdrew no amount during the year but made additional investment of Br. 32,500
cash.
d) Owner withdrew Br.17,500 and invested Br.25,000 cash during the year.
Exercise 2: Mimi started a new business called Omo Company and completed the following
transactions during November:
Nov.1 Mimi transferred 56,000 out of a personal savings bank account to a checking
account she in the name of the business.
1. Rented office space and paid cash for the month’s rent of 800
3. Purchased electrical equipment for 14,000 by paying 3,200 and agreeing to pay the remaining
balance in six months
5. Purchased office supplies by paying 900 cash.
6. Completed electrical work and received 1,000 cash for doing the work.
9. Purchased 3,800 of office equipment on credit
15. Completed electrical work on credit in the amount of 4,000
20. Paid for the office equipment purchased on Nov.9
24. Billed a customer for electrical work completed 600
28. Received 4,000 for the work completed on Nov.15
30. Paid salary of employees 1,200
30. Paid the monthly utilities bill 440
30. Withdrew 700 from the business for personal use
Required:
1. Arrange the following asset, liability and owner’s equity titles in a table just like illustrated in this
unit: Cash, Accounts Receivable, Office Supplies, Office Equipment, Electrical Equipment,
Accounts Payable and Mimi Capital.
2. Use additions and subtractions to show the effect of each transaction on the items in the equation.
Show new totals after each transaction. Next to each change in owners equity state whether the
change was caused by an investment, revenue, expense or withdrawal.
3. Prepare an income statement, a statement of owner’s equity, and a balance sheet
Excersie 3:Presented below is selected information related to Inovation Group plc at December 31,
2017. Flanagan reports financial information monthly.
Equipment £10,000 Utilities Expense £ 4,000
Cash 8,000 Accounts Receivable 9,000
Service Revenue 36,000 Salaries and Wages Expense 7,000
Rent Expense 11,000 Notes Payable 16,500
Accounts Payable 2,000 Dividends 5,000
(a) Determine the total assets of Flanagan at December 31, 2017.
(b) Determine the net income that Flanagan reported for December 2017.
(c) Determine the equity of Flanagan at December 31, 2017.

CH 1 FAcc I @2015

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Hawassa University College of Business &Economics Dep’t of Accounting &Finance

CHAPTER-ONE: INTRODUCTION TO ACCOUNTING AND BUSINESS

1.1Nature and Classification of Business Organizations

1.2 The Role of Accounting in Business Environment

Enhancing qualitative characteristics

 Not – for – profit Accounting

 Financial accounting - area of accounting aimed at serving information needs of external

1.3 International Financial Reporting Standard(IFRS)

1.4 Business Transactions and the Accounting Equation

Assets = Liabilities + Owner’s Equity

Assets = Liabilities + Owner’s Capital-Owner’s Drawings+ Revenues-Expenses

3. Transactions (business transactions) are a business’s economic events recorded by

1.5 Financial statements

3. Prepare an income statement, a statement of owner’s equity, and a balance sheet

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