CHAPTER ONE

INTRODUCTION TO ACCOUNTING AND BUSINESS

Introduction

We live in the information age-a time of communication, and a time when information is a vital
resource. In this information era, how we live, whom we associate with, and the opportunities we
have all depend on our access to and understanding of information. The same is true for businesses
(businesses are one or more individuals selling products or services for profit). Businesses that have
better access to information and that process information more quickly and accurately do the best.

Global computer networks and telecommunications equipment now allow us to get access to all types
of business information. But to take advantage of these, we need knowledge of information systems.

An information system is the collecting, processing, and reporting of information to decision makers.
Understanding and processing information is the core of accounting. The kind of information
processed in accounting is financial i.e. of a monetary nature. Providing information about what
businesses own, what they owe, and how they perform is the aim of accounting. Accounting is an
information system and measurement system that identifies, records, and communicates relevant,
reliable, and comparable information about an organization’s (a business’s) economic activities.

Therefore, a study of accounting helps people make better and informed decisions about assessing
opportunities, products, investments, and social and community responsibilities. But the use of
accounting information is not limited to accountants or people in business. You can use accounting
information in your daily life. You can use accounting information to get a loan for a house or to start
a new business. The study of accounting, therefore, opens you new and exciting possibilities both in
terms of becoming a professional accountant and using accounting information in your daily life. This
course discusses the fundamental principles involved in processing accounting information of
business enterprises.

The purpose of this chapter is to show you that accounting is the system used to provide useful
financial information.

Learning Objectives:
After completing this chapter the students should be able to:
- Explain the nature and classification of business
- Understand the meaning of accounting
- Explain the main difference between bookkeeping and accounting
- Identify the users and uses of accounting.
- Identify fields of accounting
- Understand the accounting profession
- Explain accounting standards and the measurement principles.
- Explain the monetary unit assumption and the economic entity assumption
- Analyze the effects of business transactions on the accounting equation.
- Understand about the four financial statements and how they are prepared.
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1.1 The Nature of Business

A business is an organization which is engaged in converting basic resources (inputs), such as raw
materials; labor (physical and mental effort of employees) into goods (cloths, tables, computers and
Automobiles) and services (transportation, banking, Education and health care services) for sale on
profit to customers. Businesses come in all sizes, which range from a small local commodity shop
like DD Shop to big multinational businesses like Pepsi cola which sales its products throughout the
world.

Business is an economic activity undertaken with the motive of maximize earning profits and to
maximize the wealth for the owners. A business is an institution established with the objective of
making profit. Other organizations may generate profit in their way giving services; however, if their
objective of establishment is not to generate profit, they are not businesses.

The objective of businesses is to earn profit. Profit is the difference between the amounts received
from customers for goods or services and the amounts paid for the in-puts used to provide the goods
or services. In this module, we focus on businesses operating to earn a profit. However there are also
not-for- profit organizations such as hospitals, churches, and government agencies which, convert
inputs into goods and service for free delivery or at cost recovery to the society without profit
intention.

For accounting purposes, each business organization or entity has an existence separate from its
owner(s), creditors, employees, customers, and other businesses. This separate existence of the
business organization is known as the business entity concept. Thus, in the accounting records of the
business entity, the activities of each business should be kept separate from the activities of other
businesses and from the personal financial activities of the owner(s).

1.1.1 Types of Businesses

According to their type of activities or nature of operations, business organizations are also
classified in to three main types:
1. Service Rendering / giving Businesses: Examples: provide services rather than products to
customers. Example: Hotels, restaurants, transport and communication services, professional
firms like consultations by accountants, lawyers, engineers etc.

2. Merchandising businesses: sell products they purchase from other businesses to customers
Examples: Super-markets, garment and shoe shops, drug stores, stationary shops, auto spare
parts, importers, exporters etc.

3. Manufacturing businesses: change basic inputs into products that are sold to customers.
Sometimes, they sale goods to other manufacturing firms, which utilize the goods as raw
materials for production activities. Examples: Cement factories, sugar factories, soap factories,
textile factories, paper factories, etc.

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1.1.2. Form of Business Organization

The three main forms of business organization are the proprietorship, the partnership, and the
corporation.

Starting Up as a Proprietorship
Many companies begin as a proprietorship, which is an unincorporated business controlled by one
individual. Starting a business as a proprietor is easy one merely begins business operations after
obtaining any required city or state business licenses.

The proprietorship has three important advantages: (1) it is easily and inexpensively formed, (2) it is
subject to few government regulations, and (3) its income is not subject to corporate taxation but is
taxed as part of the proprietor’s personal income. However, the proprietorship also has three
important limitations: (1) it may be difficult for a proprietorship to obtain the capital needed for
growth; (2) the proprietor has unlimited personal liability for the business’s debts, and (3) the life of a
proprietorship is limited to the life of its founder.

Partnership:
A Partnership exists whenever two or more persons or entities associate to conduct a non-corporate
business for profit. Partnership agreements define the ways any profits and losses are shared between
partners. A partnership’s advantages and disadvantages are generally similar to those of a
proprietorship.
Regarding liability, the partners can potentially lose all of their personal assets, even assets not
invested in the business, because under partnership law, each partner is liable for the business’s debts.
Therefore, in the event the partnership goes bankrupt, if any partner is unable to meet his or her
liability.

To avoid this, it is possible to limit the liabilities of some of the partners by establishing a limited
partnership. In a limited partnership, the limited partners can lose only the amount of their
investment in the partnership, while the general partners have unlimited liability.
1. Ordinary Partnership: is an association of two or more persons who intend to join together
make contributions for the purpose of carrying out activities of an economic nature and of
participating in the profits and losses arising out thereof, if any. According to the Commercial
Code of Ethiopia, contributions in partnership are possible in the following conditions.
 Each person shall make a contribution, which may be in money, debts, other property or skill;
 Property or the use of property may form a contribution;
 Unless otherwise agreed, contributions shall be equal and of the nature and extent required for
carrying out the purposes of the partnership.
2. Joint venture: is an agreement between partners on terms mutually agreed and is subject to the
general principles of law relating to partnerships stated above.
3. General partnership: consists of partners who are personally, jointly, severally and fully liable
between themselves and to the partnership ram’s undertakings. This means that each partner is
responsible for and must assume the consequences of the actions of the other partner(s). All
members share the management of the business. The death or withdrawal of a general partner, or
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 the expiration of the term of the general partnership, will dissolve the partnership. Continuation of
the partnership following such events may be dealt with, however, in the partnership agreement.
Since a partnership is generally a “voluntary” association, any general partner who no longer
desires to be associated with the partnership may withdraw and force dissolution. Dissolution of a
partnership, as a general rule, requires the winding up of its airs and a liquidation of the
partnership’s assets.
4. Limited partnership: Some members are general partners who control and manage the business
and may be entitled to a greater share of the profits, while other partners are limited and
contribute only capital. Limited partners take no part in control or management and are liable for
debts to a specified extent only. A Legal document, outlining specific requirements, must be
drawn up for a limited partnership.

Corporation: Many Owners

A corporation is a legal entity created under state laws, and it is separate and distinct from its owners
and managers. Corporation is a form of business established by selling shares of stock in the market.
Therefore, it is owned by shareholders or stockholders. Corporations can be private or public. A
private company has a limited number of owners and there is no organized market for its shares

 The value of shares issued by a private company can be difficult to determine

 A public company has many owners and its shares trade on an organized market, called a stock
market (stock exchange)
 Stock markets provide liquidity for a company’s shares and determine the market price for those
shares. The markets in which various financial assets or securities are traded
This separation gives the corporation three major advantages: (1) unlimited life—a corporation can
continue after its original owners and managers are deceased; (2) easy transferability of ownership
interest—ownership interests are divided into shares of stock, which can be transferred far more
easily than can proprietorship or partnership interests; to raise money in the financial markets and
grow into large companies and (3) limited liability losses are limited to the actual funds invested.

1.2. Definition of Accounting and Accounting Information

Accounting is the process of identifying, measuring, recording, classifying, summarizing, reporting/

communicating, and interpreting economic and financial events of an entity for use by interested
parties for the purpose of informed judgment and decisions.

Accounting is a process of identifying, measuring and communicating economic information to

permit informed judgments and decisions by the users of accounting AAA (Year 1966)

Accounting is the “science and art” of identifying, recording, classifying and summarizing in a
significant manner and in terms of money, transactions and events of a financial character, and
communicating the economic transaction of the business entities.

Accounting is an information system provides that analyzing, identifying, recording, measuring

transaction in terms of monetary value (birr / dollar) and communicates the economic activities and
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condition of a business to stakeholders. Accounting is an a “language of business,” through it
businesses communicated with information users.

As a financial information system, accounting is defined as a process of identifying measuring,

recording and communicating economic events of an organization (business or non- business) to
interested users of the information. Once a company identifies economic events, it records those
events in order to provide a history of its financial activities.

Accounting consists of three basic activities; it identifies, records, and communicates the economic
events of an organization to interested users.

1) The first activity in the accounting process is identification of the economic events relevant to a
particular business. A company identifies the economic events relevant to an organization
Example: Sale, receipt of money, payment etc. The sale of goods by Jupiter super market, the
rendering of service by Ethiopian Telecommunications Corporation, the payment of salary by the
Commercial Bank of Ethiopia, and the purchase of Building by company are examples of
economic events.
2) Once a company identifies economic events, it records those events in order to provide its
financial activities. Recordkeeping / Bookkeeping is recording of transactions and events, either
manually or electronically of an organization’s day-to-day activities. Recordkeeping is only
ONE part of Accounting. Recording consists of keeping a systematic, chronological diary of
events, measured in dollars and cents. In recording, company also classifies and summarizes
economic events. (This will be discussed in detail in Chapter-2)
Example: Bookkeeper of a shoe store keeps the day-to-day records as to how many shoes are
sold and what bills need to be paid;

Accountant is a professional man who analyzes this data to evaluate the profitability and health
of the business. These statements provide relevant financial data for internal and external users.
3) Finally, communicates 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. Communicates relevant, reliable, Timeless and comparable information about an
organization’s business activities.

1.3. The Role of Accounting for Business

Accounting provides information for managers to use in operating the business. In addition,
accounting provides information to other stakeholders to use in assessing the economic
performance and position or condition of the business. In a general sense, accounting can be defined
as an information system that provides reports to stakeholders about the economic activities and
condition of a business.

Accounting is often called “the language of business.” Because it communicates so much of the
information that owners, managers, and investors need to evaluate a company’s financial
performance. These people are all stakeholders in the business they’re interested in its activities
because they are affected by the business. In fact, the purpose of accounting is to help stakeholders
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make better business decisions by providing them with financial information. Obviously, no one tries
to run an organization or make investment decisions without having accurate and timely financial
information. It is the accountant who prepares this information.

The main purpose of accounting is to provide financial information to be used for decision-making.
In addition, accounting provides information to other users in assessing the economic performance
and condition of the business

1. Providing Information to the Users for Rational Decision-making

The primary objective of accounting is to provide useful information for decision-making to
stakeholders.
2. Systematic Recording of Transactions
To ensure reliability and precision for the accounting measurements, it is necessary to keep a
systematic record of all financial transactions of a business enterprise.

3. Determine the Financial Performance and Position of Business

‘Financial position’ is another core accounting measurement. Financial position is identified by
preparing a statement of ownership i.e., Assets and Owings i.e., liabilities of the business as on a
certain date.

Book Keeping Vs Accounting

Accounting and Book keeping is to closely related activities. Both involves in recording business
transactions. Record keeping is the only task to bookkeepers, but one of the tasks to accountants.
Unlike bookkeeping the accounting process involves in a more detailed and advanced professional
activities, of designing the information system, analyzing and interpreting the information of
accounting. More over few days recording experience is enough for being book keeper but being an
accountant requires several years in-depth study and working experience.

In general, 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
- Preparing reports and statements
- Interpreting reported information and
- Reviewing records and reports for their accuracy.
1.4. Fields of Accounting

Accounting can be characterized as a profession that has experienced rapid development during the
current century. As professionals, Accountants are typically work in one of the two major fields,
namely Management accountants and financial accountants. These basic categories farther
decomposed in to various fields which are maintained under the title “the Accounting
Profession” below.

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Managerial Accounting
Managerial accounting plays a key role in helping managers carry out their responsibilities.
Because the information that it provides is intended for use by people who perform a wide variety of
jobs, the format for reporting information is flexible. Since the reports are intended to internal users
they are not obliged to follow a uniform set of accounting standards and are tailored to the needs of
individual managers. The purpose of such reports is to supply relevant, accurate, timely
information in a format that will aid managers in making decisions. In preparing, analyzing, and
communicating such information, accountants work with individuals from all the functional areas of
the organization—human resources, operations, marketing, and finance.

Financial Accounting
Financial accounting is responsible for preparing the organization’s financial statements. Namely
income statement, the statement of owner’s equity, the statements of financial position, and the
statement of cash flow. The statement summarizes a company’s past performance and evaluates its
current financial condition. The purpose of the report is to give reliable, relevant and up-to-date
information which serves to all external users. In preparing financial statements, adherence to
uniform set of accounting standards is mandatory. The statements are general purpose in nature and
are not address the specific requirements of individual users. I.e. one type of income statement is
prepared to serve different users like investors, banks, government etc.

1.4.1 The Profession of Accounting

Why is accounting such a popular major and career choice?

First, there are a lot of jobs. In recent years, in our country Ethiopia, the demand for accountants
highly increased because of the increase in number of various businesses, the introduction of different
tax laws like VAT, the change in accounting standard- IFRS, the emergence of different multinational
organization and the related reporting requirements, etc.

Accounting is also hot because it is obvious that accounting matters. Interest in accounting has
increased, ironically, because of the attention caused by the turmoil over toxic (misstated) assets at
many financial institutions. These widely publicized scandals revealed the important role that
accounting plays in society. Most people want to make a difference, and an accounting career
provides many opportunities to contribute to society. Finally, recent internal control requirements
dramatically increased demand for professionals with accounting training.

Accountants are in such demand that it is not uncommon for accounting students to have accepted a
job offer a year before graduation. As the following discussion reveals, the job options of people with
accounting degrees are virtually unlimited.

Public Accounting

Individuals in public accounting offer expert service to the general public, in much the same way
that doctors serve patients and lawyers serve clients.

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A major portion of public accounting involves auditing. In auditing, an independent accountant, such
as a chartered accountant (CA) or a certified public accountant (CPA), examines company financial
statements and provides an opinion as to how accurately the financial statements present the
company’s results and financial position. Analysts, investors, and creditors rely heavily on these
“audit opinions,” which CAs and CPAs have the exclusive authority to issue.

Taxation is another major area of public accounting. The work that tax specialists perform includes
tax advice and planning, preparing tax returns, and representing clients before governmental agencies.

A third area in public accounting is management consulting. It ranges from installing basic
accounting software or highly complex enterprise resource planning systems, to providing support
services for major marketing projects and merger and acquisition activities.

Many accountants are entrepreneurs. They form small- or medium-sized practices that frequently
specialize in tax or consulting services.

Private Accounting
Instead of working in public accounting, In private (or managerial) accounting, you would be
involved in activities such as cost accounting (finding the cost of producing specific products),
budgeting, accounting information system design and support, and tax planning and preparation. You
might also be a member of your company’s internal audit team. In response to corporate failures, the
internal auditors’ job of reviewing the company’s operations to ensure compliance with company
policies and to increase efficiency has taken on increased importance.

Alternatively, many accountants work for not-for-profit organizations, such as the International Red
Cross or performing arts organizations.

Forensic Accounting
Forensic accounting uses accounting, auditing, and investigative skills to conduct investigations into
theft and fraud. It is listed among the top 20 career paths of the future. The job of forensic
accountants is to catch the perpetrators of theft and fraud occurring at companies. This includes
tracing money-laundering and identity-theft activities as well as tax evasion. Insurance companies
hire forensic accountants to detect insurance frauds such as arson, and law offices employ forensic
accountants to identify marital assets in divorces.

1.5. Users of Accounting Information

Users of financial information are categorized in to two, i.e., internal users and external users.

Internal Users
Internal users of accounting information are managers who plan, organize, and run the business.
These include marketing managers, production supervisors, finance directors, and company officers.
Financial information show, for example, whether the company did or didn’t make a profit, whether
cash is adequate to make pay dividend, whether the company affords pay raise to employee, etc. They
also furnish other information that managers and owners can use in order to take corrective action.

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External Users

External users are individuals and organizations outside a company who are not directly involved
in running and organizing the business want financial information about the company for their own
purpose. External users include investors, creditors, government agencies and others

Investors and Creditor

Investors and creditor are the two most common types of external users. Investors (owners) use
accounting information to make decisions to buy, hold, or sell ownership shares of a
company. Creditors such as bankers and suppliers use accounting information to evaluate the risks of
granting credit or lending money. 

If you lend money to a friend to start a business, wouldn’t you want to know how the business was
doing? Investors and creditors furnish the money that a company needs to operate, and not
surprisingly, they feel the same way. Because they know that it’s impossible to make smart
investment and loan decisions without accurate reports on an organization’s financial health, they
study financial statements to assess a company’s performance and to make decisions about continued
investment.

Government Agencies
Government agencies like taxing authorities and regulatory agencies.
Taxing authorities, such as the Internal Revenue Service, want to know whether the company
complies with tax laws. To determine the exact amount of income tax to be charged on
individuals and business organizations the Internal Revenue Service (IRS) requires
businesses and individuals to file annual income tax returns designed to measure taxable
income.

Regulatory Authority: Regulatory laws for the protection of the public for excessive price charges
by monopolies. Laws requiring regulated banks and savings and loan associations to meet
record-keeping and reporting requirements and permit periodic examination of their records by
governmental agencies.

Financial analysts and consultants need financial information of business organizations to search
for promising investment opportunities. For instance, they can compare the financial reports of
different companies to determine the company that is more profitable, financially stronger, and
offers the best chance of future success.
Labor unions such as the Association want to know whether the owners have the ability to pay
increased wages and benefits.
Customers need accounting information to assess the stability of the enterprise with which
they make frequent transactions, know their outstanding balances etc.
In general the information needs of internal users are supplied by both Financial and Managerial
accounting. Whereas the information needs of external users are satisfied only by financial
accounting.

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 1.6. Overview of International Financial Reporting Standards (IFRS)

International Financial reporting standards (IFRS) are the practice and procedure guidelines used
to prepare and maintain financial records and reports; authorized by the International Accounting
Standards Board (IASB). International Financial Reporting Standards (IFRS) are established by the
International Accounting Standards Board (IASB). More than 130 countries now require listed firms
to comply with IFRS, and dozens more permit or require firms to follow IFRS to some degree.

International Financial Reporting Standards (IFRSs) the main objective of IFRSs is to converge the
diverse business language being used by the business communities all over the world. However, its
adoption and implementation bring opportunities and pose challenges to the adopter(s). Accordingly,
as Ethiopia is moving toward implementing IFRS within the next five years, this paper, therefore,
aims, to assess the IFRS adoption progress in Ethiopia and investigate factors that motivate Ethiopia
to adopt IFRS, and advantages and challenges ahead of IFRS adoption in Ethiopia to provide an input
for stakeholders and serve as stepping stone for future. The process of international convergence
towards a global set of standards started in 1973 when 16 professional accountancy bodies from
Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the United Kingdom and the
United States of America agreed to form the International Accounting Standards Committee (IASC).

The International Accounting Standards Board (IASB) was established in 2001 as part of IASC
Foundation which renamed IFRS Foundation in 2010 (IFRS Foundation, 2015). “The newly
established Board embarked on a review processes aimed at refining the standards that results in a
reduction in the number of standards from 41 in the year 2000 to 28 by the year 2008”. The first IFRS
was issued in 2003, by which time at least 19 countries required compliance with the international
standards. IFRS are sets of Standards for the preparation of financial statements by business entities
and IFRS are accounting rules that are principle based, market oriented and globally recognized and
accepted, and published to require more extensive disclosure in comparison with prior standards, i.e.
IFRS.
International Financial Reporting Standards (IFRS) are designed for general purpose financial
reporting by profit-oriented entities that might be found to be appropriate for not-for-profit activities
too focused on information needs of (primary users) existing and potential investors, lenders and
other creditors who have no authority to require information from the entity information to
enable primary users to make their own assessments of the reporting entity’s prospects for future
net cash inflows as a basis for their decisions to buy, hold, sell equity and debt instruments or to
provide a loan or to require settlement of a loan.
Financial reporting can generally classified into two:
 General purpose financial reporting is a type of reporting which, aims to provide useful
financial information about the reporting entity to primary users who cannot enforce the
reporting entity to provide information directly to them.
 Special purpose financial reporting is a type of reporting that responds to the requirements of
users that have the authority to require the reporting entity to provide the information that they
need for their purposes directly to them. Examples include:
o Prudential regulation reporting requirements
o Tax reporting requirements.
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1.6.1 Overview of Financial Reporting requirements in Ethiopia and AABE

A federal board overseeing audit practice is to begin a review of financial reports filed in compliance
with the International Financial Reporting Standards (IFRS), from institutions including banks,
insurance firms and state-owned enterprises such as Ethio telecom, and Ethiopian Energy & Power
(EEP).

The Accounting & Auditing Board of Ethiopia (AABE) began compelling companies to convert their
financial reporting requirement from a general standard to the IFRS, following a law parliament
passed in 2015. About 8,000 companies, including share companies, state-owned enterprises, private
limited companies, and small and micro enterprises, are expected to comply with one of the three
reporting standards.

Standard IFRS Requirements

IFRS covers a wide range of accounting activities. There are certain aspects of business practice for
which IFRS set mandatory rules.
1. Statement of Financial Position: This is the balance sheet. IFRS affects the ways in which the
components of a balance sheet are reported.
2. Statement of Comprehensive Income: This can take the form of one statement or be separated
into a profit and loss statement and a statement of other income, including property and
equipment.
3. Statement of Changes in Equity: Also known as a statement of retained earnings, this
documents the company's change in earnings or profit for the given financial period.
4. Statement of Cash Flows: This report summarizes the company's financial transactions in the
given period, separating cash flow into operations, investing, and financing.

Accounting Principles and IFRS

Accounting principles have been defined as “the body of doctrines commonly associated with the
theory and procedure of accounting, serving as an explanation of current practices and as a guide for
the selection of conventions or procedures where alternatives exist”.

In short, accounting principles are guidelines to establish standards for sound accounting practices
and procedures in reporting the financial status and periodic performance of a business. These
principles can be classified into two categories (i) Accounting conventions; and (ii) Accounting
concepts (assumptions).

Accounting Conventions: The term ‘convention’ denotes custom or tradition or practice based on
general agreement between the accounting bodies which guide the accountant while preparing the
financial statements. It is a guide to the selection or application of a procedure.

Accounting concepts are defined as basic assumptions on the basis of which financial statements of a
business entity are prepared. They are used as a foundation for formulating various methods and
procedures for recording and presenting the business transactions. In this unit, we will discuss some
of these universally accepted principles: business entity concept, monetary unit assumption,
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periodicity assumption, and the going concern assumption are covered under the headings of
basic assumptions and measurement principles, revenue recognition principle, expense recognition
and full disclosures are discussed under the heading of basic principles.

Basic Assumptions/ Concepts

These concepts explain how companies should recognize, measure, and report financial elements and
events.

1. Economic Entity Assumption (Separate Entity Concept): 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.

According to this concept, business is treated as an entity separate from its owners. It is treated to
have a distinct accounting entity which controls the resources of the concern and is accountable
thereof. Accounts are kept for a business entity as distinguished from the person(s) owning it. All
transactions of the business are recorded in the books of the business from the point of view of the
business.
The failure to recognize the business as a separate accounting entity would make it extremely
difficult to evaluate the performance of the business since the private transactions would get
mixed with business transaction. The overall effect of adopting this concept is:
 Only the business transactions are recorded and reported and not the personal transactions of the
owners.
 Income or profit is the property of the business unless distributed among the owners.
 The personal assets of the owners or shareholders are not considered while recording and
reporting the assets of the business entity.

2. Going Concern Assumption: that the company will have a long life. Despite numerous business
failures, most companies have a fairly high continuance rate. As a rule, we expect companies to
last long enough to fulfill their objectives and commitments.
3. Monetary unit assumption:
It states that all business activities (events) are recorded in terms of money (Birr, Dollar, Pound or
any other currency). Means that money is the common denominator of economic activity and
provides an appropriate basis for accounting measurement and analysis. That is, the monetary unit
is the most effective means of expressing to interested parties changes in capital and exchanges of
goods and services.
4. Periodicity Assumption: Users need to know a company’s performance and economic status on
a timely basis so that they can evaluate and compare companies, and take appropriate actions.
Therefore, companies must report information periodically.
The periodicity (or time period) assumption implies that a company can divide its economic
activities into artificial time periods. These time periods vary, but the most common are monthly,
quarterly, and yearly

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 Basic Principles of Accounting

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

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

Historical Cost

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

For example, assume that Business Center purchased land for Br. 500,000, on January 2016 and
initially reports it in its accounting records at 500,000. But what does the company do if, by the end
of the year, the fair value of the land has increased to 650,000. Under the historical cost principle, it
continues to report the land at 500,000. It is a reliable report since it is supported by business
document, but it is not relevant for decision making since it does not represent the fact on the land i.e
Br. 650,000.

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

The IASB believes that fair value information is more relevant to users than historical cost.

Revenue Recognition Principle

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

Expense Recognition Principle

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

Full Disclosure Principle

In deciding what information to report, companies follow the general practice of providing
information that is of sufficient importance to influence the judgment and decisions of an informed

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user. Often referred to as the full disclosure principle, it recognizes that the nature and amount of
information included in financial reports reflects a series of judgmental trade-offs.

1.7. The Basic Accounting Equations and Its Element

Assets
Asset is a resource controlled by the entity as a result of past events and from which future economic benefits
are expected to flow to the entity. As noted above, assets are resources that a business controls and uses
its assets in carrying out its activities of production and sales. The common characteristic possessed
by all assets is the capacity to provide future services or benefits. Assets include cash, building,
equipment, cash register machine, etc. the further classification of assets will be discussed in chapter
two.

Liabilities
Liabilities are claims against assets, those resulted from borrow money and purchase merchandise on
credit. Liabilities are present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources representing economic benefits.
Liabilities result in payables of various sorts. For instance a company may purchase supplies on credit
results Accounts Payable, Borrowing money from bank results notes payable, having unsettled salary
of employees results Salary Payable etc. the supplier, the bank and the employees who owes money
are a company are its creditor and have the first claim against the assets before owners.

Equity
The residual interest in the assets of the entity after deducting all its liabilities. The ownership claim
on a company’s total assets is equity. It is equal to total assets minus total liabilities. Since the assets
of a business are claimed by either creditors or shareholders and the creditors have prior claim over
the owners, equity is “left over” after creditors’ claims are satisfied. Thus owner’s equity is often
referred to as residual equity.

Equity of a sole propitiator and a partners business comes primarily from the investment made by
owners. Then this equity subsequently increased whenever there are revenues generated from sales
of merchandise, performing services, renting property, and lending money etc. Withdrawals made
owners and payments for business expenses like salary, rent, electricity etc. decreases equity owners.
Equity = Owners’ investment + Liability

Equity of a corporation business generally consists of share capital—ordinary and retained earnings.
Share capital is funds obtained by selling ordinary shares to investors. Whereas retained earnings is
obtained from the composition of three items i.e. revenue, expanse and dividends.
Equity = Share capital ordinary + Retained Earnings
Retained Earnings = Revenue - (Expense + Dividend)

Therefore the equity of corporate business presents the equity obtained from owners investment
separately from the equity obtained from operating activity.

Revenue is the gross inflow of economic benefits during a period arising in the course of ordinary
activities when those inflows result in increases in equity, other than increases relating to
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contributions from equity participants. For instance University generates revenues by selling
educational service whereas Supermarket generates revenue by selling goods. In general revenue
is an income generated from sales of a product or a service.

Expenses are the cost of assets consumed or services used in the process of earning revenue. For
example University incurred expenses while using office and classroom equipment’s and paying
salary to employees in the process render educational service. Expenses results a gross decrease in
equity that result from operating the business. 

Dividend/ Drawing are the distribution of cash or other assets to shareholders. It is similar to
owners’ withdrawal cash in the case of a proprietor and a partnership business. Dividend reduces
retained earnings.
In summary, the principal sources (increases) of equity are investments by shareholders and revenues
from business operations. In contrast, reductions (decreases) in equity result from expenses and
withdrawals or dividend.
 The basic accounting equation:
Asset = Equity + Liability

Economic resources = Claims over the resources

Asset = Equities

The expanded accounting equation

Asset= Owners’ investment + Liability

Equity = Share capital ordinary + Retained Earnings
Retained Earnings = Revenue - (Expense + Dividend)

This relationship is the basic accounting equation. Assets must equal the sum of liabilities and
equity. The accounting equation applies to all economic entities regardless of size, nature of
business, or form of business organization. The equation provides the underlying framework for
recording and summarizing economic events.

If the amounts of two of the three elements of the accounting equation are known, we can solve
amount of three third one using the equation.

To illustrate, assume that a business has a total asset of Birr 50, 000 and a total liability of Birr
20,000, the owners’ equity as follows.

Asset = Owners Equity + Liability

Equity = Asset – Liability
= Birr 50,000- 20,000
Equity = Birr 30,000

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1.8. Business Transaction and Financial Statements

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

All financial transactions have an effect on the components of an accounting equation. Transactions
may be external or internal. 

External transactions involve economic events between the company and some outside enterprise.
For example, payment of monthly electric bill, purchase of computers, and purchase building and sale
educational service to students are external transactions. 

For example, purchase operating equipment from a supplier, payment of monthly rent to the

landlord, payment of monthly electric Bill, purchase of computers, purchase operating equipment
from a supplier, payment of monthly rent to the landlord, sale educational service to students is
external transactions etc.

Internal transactions are economic events that occur entirely within one company. Companies carry
on many activities that do not represent business transactions. Examples are hiring employees,
responding to e-mails, talking with customers, and placing merchandise orders. Although most of
these activities lead to business transactions: like employees will earn wages (payment transaction),
and suppliers will deliver ordered merchandise (purchase transaction), they are not transactions by
themselves.

As a result companies must analyze each activities and event to find out whether it affects the
accounting equation or not. If it does, the company will record the transaction. Each transaction must
have a dual effect on the accounting equation.

Analysis of Business Transaction

The term transaction analysis refers to an activity of specifying the effects of a particular
transaction on the components of the accounting equation. All transactions regardless of their type
and nature require to be analyzed. To demonstrate the way to analyze business transaction, we will
review the business activities of Solution and the impact of transactions on the basic accounting
equation.

Illustration, Suppose George establishes a sole proprietorship to be known as Solution, on

September1, 200X. During January, the business engages in the following transactions:
Transaction (1) - Owner’s investment
George deposits Birr 250,000 in a bank account in the name of Solutions. The effect of this
transaction is to increase the asset cash (on the left side of the equation) by Birr 250,000. To balance
the equation, the owner’s equity (on the right side of the equation) is increased by the same amount.
The equity of the owner is referred to by using the owner’s name and “Capital,” such as “George,
Capital.”
Assets = Owner’s Equity + Liabilities

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 Cash George, Capital
Tran.1 + Br. 250,000 + Br. 250,000
Transaction (2) - Purchase of land for cash
Solutions exchanged Birr 200,000 cash for land. The purchase of the land changes the makeup of the
assets but does not change the total assets.
Assets = Liabilities + Owner’s Equity
Cash + Land George, Capital
Bal. + Br. 250,000 + Br. 250,000
(2) (200,000) + 200,000 ______________________
Bal. Br 50,000 + Br.200, 000 = Br. 250,000

Transaction (3) -Purchase of Supplies on credit

During the month, Solutions bought supplies for 13,500 and agreeing to pay the supplier in the near
future. This type of transaction is called a purchase on account. The liability created is called an
account payable. Items such as supplies that will be used in the business in the future are called
prepaid expenses, which are assets. The effect of this transaction is to increase assets and liabilities by
Birr 13,500. This type of transaction is called a purchase on account and it results in a liability to the buyer;
the liability created when something is bought on credit is called Accounts Payable.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Accounts Payable George, Capital
Bal. Br 50,000 + Br. 200, 000 = Br. 250,000
(3) 13,500 13,500
Bal. Br 50,000 13,500 200, 000 = 13,500 Br. 250,000

Transaction 4– Selling of service

The amount charged to customers for goods or services sold to them is called revenue. During its
first month of operations, Solutions provided services to customers, earning fees of 75,000 and
receiving the amount in cash. The receipt of cash increases Solutions’ assets and also increases
George equity in the business. Thus, this transaction increased cash and the owner’s equity by Birr
75,000. Service can be given for cash or on credit. In this example, the service is given for cash (i.e.,
the company collects the cash on the spot service was given). But instead of requiring customers to
pay at the time of sale, a business may let the customers to pay in the future. Such expected
collections in the future result in an Accounts Receivable to the company. An accounts receivable is
as much an asset as cash to the business enterprise. And the revenue from the sale of the service or
good on credit is realized and recorded on the date of sale without waiting for the collection of the
cash.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Accounts Payable George, Capital
Bal. Br 50,000 13,500 200, 000 = 13,500 Br. 250,000
(4) 75,000 - - = - 75,000 - service revenue
Bal. 125,000 13,500 200,000 = 13,500 325,000

Transaction (5) - Recording Expenses

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The expenses paid during the month were as follows: wages, Birr 21,250; rent, 8,000; utilities, 4,500;
and miscellaneous, 2,750. Miscellaneous expenses include small amounts paid for such items as
postage, coffee, and magazine subscriptions. The effect of this group of transactions is the opposite of
the effect of revenues.
These transactions reduce cash and owner’s equity.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Accounts Payable George, Capital
Bal. 125,000 13,500 200,000 13,500 325,000
(5) (36,500) - - - (36,500) - Expenses
Bal. 88,500 13,500 200,000 = 13,500 288,500

Transaction (6) – Payment of liability

Solutions pay Br 9,500 to creditors during the month; it reduces both assets and liabilities.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Accounts Payable George, Capital
Bal. 88,500 13,500 200,000 13,500 288,500
(6) (9,500) - - (9,500)
Bal. 79,000 13,500 200,000 = 4,000 288,500

Transaction (7) Supplies on hand

At the end of the month, the cost of the supplies on hand (not yet used) is Br. 5,500. The remainder of
the supplies (13,500 – 5,500) was used in the operations of the business and is treated as an expense.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land Accounts Payable George, Capital
Bal. 79,000 13,500 200,000 4,000 288,500
(7) - (8,000) - (8,000)–supplies expenses
Bal. 79,000 5,500 200,000 = 4,000 280,500

Transaction – (8) Owner’s Withdrawal

At the end of the month, George withdraws 20,000 in cash from the business for personal use. This
transaction is the exact opposite of an investment in the business by the owner. Cash and owner’s
equity are decreased. The cash payment is not a business expense but a withdrawal of a part of the
owner’s equity.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Accounts Payable George, Capital
Bal. 79,000 5,500 200,000 = 4,000 280,500
(8) (20,000) - - - (20,000) –Drawing
Bal. 59,000 5,500 200,000 = 4,000 260,500

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Summary: The transactions of Solutions are summarized as follows. They are identified by letter,
and the balance of each item is shown after each transaction.
Accounting Equation
Assets = Liabilities + Owner’s Equity
Accounts George, Capital
Cash + Supplies + Land = Payable + ________________
1. +250,000 + 250,000 - Investment by George
2. (200,000) +200,000
Bal. 50,000 200,000 250,000
3. +13,500 +13,500
Bal. 50,000 13,500 200,000 13,500 250,000
4. + 75,000 + 75,000 Fees earned
Bal. 125,000 13,500 200,000 13,500 325,000
5. – 36,500 - 21,250 Wages expense
- 8,000 Rent expense
- 4,500 Utilities expense
- 2,750 Misc. expense
Bal. 88,500 13,500 200,000 13,500 288,500
6. – 9,500 - 9,500
Bal. 79,000 13,500 200,000 4,000 288,500
7. – 8,000 - 8,000 Supplies expense
Bal. 79,000 5,500 200,000 4,000 280,500
8. -20,000 -20,000 Withdrawal
Bal. Br. 59,000 5,500 200,000 = 4,000 260,500

The following Observations, which apply to all types of Businesses, should be noted:
1. The effect of every transaction can be stated in terms of increases and /or decreases in one or
more of the elements of the accounting equation.
2. The equality of the two sides of the accounting equation is always maintained.
3. The owner’s investment and revenues increase the owner’s equity. Withdrawals and expenses
during the period decrease the owner’s equity. The effect of these four types of transactions on
owner’s equity can be illustrated as follows:
Effects of transactions owner’s Equity

Owner’s Equity

Decreased Increased by
by

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  Owner’s withdrawals/  Owner’s Investments
Dividend  Revenues
 Expenses  Gains and other income
 Loss
Financial Statements
After transactions have been recorded and summarized, reports are prepared for users. The
accounting reports providing this information are called financial statements. These statements
provide a company’s information quantified in terms of money. The financial statements most
frequently provided are the following.

1. Statement of profit or Loss and Other comprehensive income presents the summery of
revenues and expenses to determine the resulting net income or net loss for a specific period of
time. Such as a month or a year.
2. A statement of owner’s equity summarizes the changes in owner’s equity for a specific period of
time. Such as a month or a year.
3. A statement of financial position (sometimes referred to as a balance sheet) reports the assets,
liabilities, and equity of a company at a specific date. Usually at the close of the last day of a
month or a year.
4. A statement of cash flows summarizes information about the cash inflows (receipts) and
outflows (payments) for a specific period of time. Such as a month or a year.
NB: The income statement, statements of owner’s equity, statement of cash flows, and
comprehensive income statement holds financial information of a particular period, whereas the
statement of financial position is for a point in time.

1. Statement of Profit or Loss and Other Comprehensive Income

The income statement reports the success or profitability of the company’s operations over a
specific period of time. Investors and creditors use this statement to determine and predict the
profitability and future cash inflows of a particular business. It is prepared from the data appearing in
the revenue and expense.

The income statement lists revenues followed by expenses and then, shows net income (or net loss).
Net income results when revenues exceed expenses, whereas net loss results when expenses exceed
revenues. IFRS does allow an alternative statement format in which the information in the income
statement can be combined and presented as a single statement with the comprehensive income
statement referred to as a statement of comprehensive income.

2. Statement of owner’s: A summary of the changes in the owner’s equity that have occurred
during a specific period of time, such as a month or a year. It is prepared after the income
statement because the net income or net loss for the period must be reported in this statement.
Similarly, it is prepared before the balance sheet, since the amount of owner’s equity at the end of
the period must be reported on the balance sheet. Because of this, the statement of owner’s equity
is often viewed as the connecting link between the income statement and balance sheet.

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 The owner’s equity statement reports the changes in owner’s equity for a specific period of time.
It is prepared after the income statement because the amount of net income or net loss of the
period is necessary for the preparation of the statement.

Owner’s equity statement is prepared before the balance sheet, since the amount of owner’s equity at
the end of the period is necessary for the preparing balance sheet. Because of this, the statement of
owner’s equity is often viewed as the connecting link between the income statement and balance
sheet.

3. Balance sheet: A list of the assets, liabilities, and owner’s equity as of a specific date, usually at
the close of the last day of a month or a year.

4. Statement of cash flows: A summary of the cash receipts and cash payments for a specific period
of time, such as a month or a year. The statement of cash flows consists of three sections
 Cash Flows from Operating Activities This section reports a summary of cash receipts and cash
payments from operations. The net cash flow from operating activities normally differs from the
amount of net income for the period.
 Cash Flows from Investing Activities This section reports the cash transactions for the
acquisition and sale of relatively permanent assets.
 Cash Flows from Financing Activities This section reports the cash transactions related to cash
investments by the owner, borrowings, and withdrawals by the owner.
All financial statements have a heading that you can find in any kind of a report. The heading of these
statements identifies the company, the type of statement, and the time period covered by the
statement.

Solution Business
Income statement
For the Month Ended September 30,200X
Revenues:
Service Fee Birr 75,000.00
Expenses:
Salary Expense Birr 21,250.00
Utilities Expense 4,500.00
Rent Expense 8,000.00
Supplies Expense 8000.00
Misc. Expense 2,750.00
Total Expenses 44,500.00
Net Income Birr 30,500.00

Solution Business
Statement of Owner’s Equity
For the Month ended September 30,200X
George. Capital, Jan 1……………………………………. Birr -0-
Add: Investments…………………………………Birr 250,000.00
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 Net income…………………………………… 30,500.00 280,500.00
Less: Drawings………………………………………………… 20,000.00
George. Capital, January 30………………………………… Birr 260,500.00
Solution Business
Balance Sheet
September 30,200x

Assets Owner’s Equity

Land………………200,000.00 George Capital Birr 260,500.00
Supplies……………5,500.00 Liability
Cash…………..Birr 59,000.00 Accounts payable…… Birr 4,000.00
_________ Total Liabilities ______________
Total Assets……..264,500.00 Owner’s equity……... Birr 264,500.00
Solution Business
Statements of Cash Flow
For the Month ended August 30,2016
Cash Flows from operating activity
Cash receipts from revenue Birr. 75,000
Cash payment for Expenses (46,000)
Net cash provided by operating activity 29,000
Cash flows from investing activity
Purchase of Land (200,000)
Cash flows from Financing activity (200,000)
Investment by owner Birr. 250,000
Drawing by owner (20,000) 230,000
 Net increase in Cash
Cash at the beginning of the month 0
Cash at the end of the month Birr. 59,000

Financial Statements and their Interrelationships

The preparation of the financial statements for Solution has been finalized. Now it is the time to
show you the interrelationship between the statements.
 Net income determined by the income statement, Birr 30,500 is used in the statements of owner’s
equity to determinate ending balance of owner’s equity.
 The figure for ending equity Birr 260,500 in the statements of owner’s equity is used by
statements of financial position for the determination of the balance for total liability and equity.
 The cash balance Birr 59,000 shown in the statements of financial position to reconcile the ending
cash balance determined in the statements of cash flow.
Problem: Use an accounting equation and show the effects of the following transaction on the
components of the equation.
1. Purchase of supplies for cash Birr. 2,000
2. Sales of service on credit Birr. 30,000
3. Purchase of equipment on credit Birr. 50,000
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 4. Payment of cash as a full settlement Birr. 5,000

Financial Statement for Company (Corporation)

Business enterprises with a large amount of asset are usually organized as corporation and owners is
called stockholders. The financial statements of corporation are statement of cash flow balance sheet
and retained earnings statement.

If Solution had been owned by corporation; the only change on the financial statement will be the
retained earnings statement of owner equity and the balance sheet account of owner equity should be
stockholder equity.

a. Retained earnings are reporting a change in the stockholder equity on the changes in retained
earnings, or the net income retained in the business. Changes in the amount of earning retained in the
business would have resulted from
1. Net Income
2. Distribution of earnings called Dividend to the owners.
3. Retained Earnings is a cumulative Net Income
b. Balance sheet is the only difference of Balance sheet of sole proprietorship and corporation is the
stock holder equity section.
c. Statement cash flow the only difference b/n cash flow statement of corporation and sole
proprietorship is on the financing activity section, the cash received as investment of stockholder
arises from the sale of capital stock and cash payment to stock holder are in the form of dividend.
Activity
1. Prepare the income statement, statement of retained earnings, and balance sheet, for Solution
Company using the following condensed data from its fiscal year ended September 26, 20X2.
Accounts payable Birr 35,490
Other liabilities 135,634
Cost of sales (expense) 140,089
Cash 21,120
Retained earnings, September 29, 20X1 87,152
Dividends in fiscal year 20X2 48,262
Revenues 233,715
Investments and other assets 230,039
Land and equipment 22,471
Selling and other expense 40,232
Accounts receivable 16,849
Net income 53,394
Retained earnings, September 26, 20X2 92,284
Common stock 27,071

Exercise: John car repair shop started the year with total assets of Birr 60,000 and total liabilities of
Birr 40,000. During the year the business recorded Birr 100,000 in car repair revenues, Birr 55,000 in
expenses, and dividends of Birr 10,000.
Required: The net income reported by John’s Car Repair Shop for the year was?

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==============================End of Chapter One ===========================

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