CHAPTER ONE

Introduction to Accounting
Meaning of Business
➢Businesses exist to provide goods or services to
customers in exchange for a financial reward.
➢The objective of most businesses is to earn a profit.
➢Shortly business mean any activity done for profit
purpose.
Every business asks three key questions:
1. How much money came in? The revenue.
2. Where did the money go? The costs and expenses
3. How much money is left? The profit
❑The answer to each question can come only from
the practice known as accounting.
 Cont’d
1.2. Meaning of Accounting?

❑Simply, accounting is the language of

business, because it is the method of
communicating business information.
❑Accounting involves the process of
identifying, analyzing, measuring ,
recording, classifying and summarizing
of past events and transactions of
financial nature to help the users of the
information to make rational decisions.
 Cont’d

❑Accounting can also be defined as an

information system that provides reports to
users about the economic activities and
condition of a business.
❑Accounting is an information and measurement
system that identifies, records, and communicates
relevant, reliable, and comparable information
about an organization’s business activities.
 Cont’d
❑Generally, the main purpose of accounting is to
provide financial information to be used for rational
decision-making.
❑The people who use accounting information basically
fall in to two categories:
1. External Users: External Users of accounting
information are parties, which are not directly
involved in running the business enterprise. These
include lenders, shareholders (stock holders),
suppliers and employees labor Unions, government
(regulatory bodies) and others.
❑ The area of accounting aimed at serving external
users is called Financial Accounting.
 Cont’d
2. Internal users: These are persons that are directly
involved in managing and operating an
organization.
➢ They include managers and other important
decision makers.
➢ The internal role of accounting is to provide
information to help improve the efficiency and
effectiveness of an organization.
❑The area of accounting aimed at serving the
decision-making needs of internal users is called
Management Accounting.
❑So that our course is directly related with
management Accounting
 1.3. Book keeping Vs Accounting
❑Book-keeping: Bookkeeping is the process
of recording business activities, and
keeping the records.
❑It is the recording phase of accounting. It
is that branch of knowledge which tells us
how to keep a record of business
transactions.
❑Responsible for record keeping.
Concerned about day to day financial
events and any one can be a bookkeeper
with short training
 Cont’d
❑Accounting: is a term which refers to a
systematic study of the principles and methods
of preparing financial statements to
communicate financial performance to others.
Accountants are:
A. Responsible for preparing financial statements
B. tax compliance
C. Analyzes and interprets financial data
D. Concerned about assets and liabilities, financial
healthiness of the organization
E. Accountants need to meet professional
standards and certification.
 1.4. Roles of Accounting in Business
and Limitations
❑Business organizations are setup with the principal
objective of creating wealth for the owners.
❑Modern business organizations can take any of the
following forms based on their ownership :
❑Sole Proprietorships,
❑Partnerships and
❑Corporations (share companies)
A. Sole Proprietorship or simply proprietorship.
it is a business owned by one person.
➢ No special legal requirement must be met to start a
proprietorship.
 Cont’d
B. Partnership : is a business owned by two or
more people, called partners.
➢ No special legal requirements must be met in
starting a partnership.
➢ The only requirement is an agreement between
partners to run a business together.
➢ The agreement can be either oral or written
and usually indicates how income and loss are
distributed.
 Cont’d
C. Corporation: is a business legally separate from its
owners, meaning it is responsible for its own acts and its
own debts.
➢ The owners are called share holders or stock holders
➢ A corporation is subject to double taxation. i.e. there is
business income(30%) and tax on dividend income(10%)

❑ There are three different types of businesses based on

their nature of operation:
A. Service,
B. Merchandize and
C. Manufacturing.
❑ The primary role of accounting in business is to provide
information for managers to use in operating the
business.
 Cont’d
Limitations of Accounting
1. Accounting recognizes that transactions are a financial
representation of the business events, measured in
monetary terms.
❑Transactions of non-monetary nature, such as
employee quality and moral, management goodwill, do
not have place in accounting.
2. Transactions are expressed in terms of their value at
the time a transaction is recorded in the accounts.
➢ Subsequent changes in the purchasing power of
money are not taken into account.
❑Using historical cost to measure assets fails to
account for changes in values over time. This causes
the relevance of accounting information to be
subjective, because the assets may be far less or more
valuable today.
 Cont’d
❑But currently there is new accounting standard
which is developed by “international Accounting
standard board” and the standard is known as
“International Financial Reporting standard
(IFRS)” which over come most of the above
limitations.
❑Currently this standard is acceptable and adopted
As of September, 2021 by more than 140 countries
including our country Ethiopia.
Example
1.Revluation model for fixed assets is acceptable in
this standard which not applicable in previous
standards.
2. Full disclosure of non financial information's as foot
note is also allowed on the new standard.
 Accounting Terms, Concepts, Assumptions
and Principles
❑Most often accounting terms may not hold
the same meaning as in the literal dictionary.
Some of the key terms include:
Basic Accounting equation
Asset = Equities; or Asset = Liabilities + equity
1. Assets: Things which has economic value and
owned by the business.
2. Liabilities: Debts owed by a business
3. Stockholders(owners) equity(capital): an equity
account showing the investment in a business
corporation by its stockholders (owners).
 Cont’d
Example : Assume X company has birr 100,000
total assets . To get this total asset the owner
contribute birr 70,000 and the remaining is
borrowed from the bank.
Required : Show X companies Accounting
equations and determine the amount of assets,
liabilities and owners equity?
Asset = Liabilities + owners equity
100,000= 30,000+70,000
Assets = 100,000
Liability = birr 30,000
Owners equity = birr 70,000
 Cont’d
Example 2: Assume X company paid monthly salary
expense for employees birr 20,000 in cash.
Required : Show the effect of this transaction on
Basic Accounting Equation?
Effect: Asset(cash) decreases by birr 20,000 and
owners equity decreases by birr 20,000 and no
effect on liability.
Asset = Liabilities + owners equity
Bal: 100,000 = 30,000 + 70,000
Effect (20,000) = - (20,000)
End Bal. 80,000 = 30,000 50,000
80,000 = 80,000
 Basic concepts in Accounting
❑Business Transaction
➢A business activity or event that causes a
measurable change in the items in the
accounting equation.
➢Businesses transactions are the raw materials of
accounting reports, as cotton is a raw material
for a textile factory
❑For a given transaction to qualify criteria to be
recorded as transaction:
A. To be related to the business enterprise
B. To be measurable in terms of money
C. To be completed / happened/ action.
 Cont’d
❑Financial statements: The accounting
reports that provide information to users
after transactions are recorded ,classified
and summarized.
❑The primary (basic) Financial statements of
a company are income statement, retained
earnings(statement of owners equity) ,
balance sheet, and statement of cash flows.
 Cont’d
❑Balance sheet: an element of financial
statement that lists a assets, liabilities, and
equity (including dollar amounts) as of a
specific date. Also called a statement of
financial position.
❑Income statement: A financial statement that
summarizes the amount of revenues earned and
expenses incurred by a business over a period
of time. Also called statement of Financial
performance
❑Owner’s Equity Statement :This is a statement
that summarizes the changes in owner’s equity
for a specific period of time.
 Cont’d
❑Statement of Cash Flows: Summarizes cash
inflows and out flow of the business
❑Revenues: Inflows of assets (such as cash)
resulting from the sale of products or the
rendering of services to customers.
❑ Expenses: Costs incurred to produce
revenues, measured by the assets consumed
in serving customers.
❑Net income: Amount by which the revenues of
a period exceed the expenses of the same
period.
 Cont’d
❑Net loss: Amount by which the expenses of a
period exceed the revenues of the same period.
❑Cost: Recourses Sacrifice or the resources
given up, measured in money terms, to acquire
some desired thing, such as a new equipment,
machine, merchandize or truck (asset).
❑Dividend: it is a distribution of income to
owners (investors) in a corporation; it is not an
expense of doing business.
❑Accounts payable: Amounts owed to suppliers
for goods or services purchased on credit.
 Cont’d
❑Accounts receivable: Amounts due from customers
for services or goods already provided.
❑Notes payable: Amounts owed to parties who loan the
company money after the owner signs a written
agreement (a note) for the company to repay each
loan.
❑Notes receivable: Amounts due from customers for
products or services already provided and the
customers signed a written agreement (note) to pay.
❑Entity: A business unit that is deemed to have an
separate existence and apart from its owners,
creditors, employees, customers, other interested
parties, and other businesses, and for which
accounting records are maintained.
 Accounting principle and Concepts
❑Accounting as any profession has its own
principles and concepts
❑Presently, there are two primary accounting
standard-setting bodies.
1. The International Accounting Standards Board
(IASB) and standard is called international
financial reporting standards(IFRS)
2. The Financial Accounting Standards Board
(FASB) and the standard is called Generally
Accepted Accounting principles(GAAP).
 Cont’d
❑In recent years the two standard setting
bodies have made efforts to reduce the
differences between IFRS and U.S. GAAP.
This process is referred to as convergence
and in the future we may have one
international accounting standard
 Cont’d
The major accounting principles and concepts
are:
1. Business entity concept/principle: Business
have separate economic activities from its
owners, creditors or others for accounting
purpose
2. Measurement Principles
❑IFRS generally uses one of two
measurement principles, the historical cost
principle or the fair value principle.
 Cont’d
❑Selection of which principle to follow
generally relates to trade-offs between
relevance and faithful representation.
➢Relevance: Means that financial information
is capable of making a difference in a
decision.
➢ Faithful representation: means that the
numbers and descriptions match what really
existed or happened they are factual.
 Cont’d
A. HISTORICAL COST PRINCIPLE
➢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.
 Cont’d
B. FAIR VALUE PRINCIPLE
❑The fair value principle states 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 value
information is usually readily available for these
types of assets.
 Cont’d
3. Accounting period (Fiscal period): business
activities take place over time. Financial
performance then can be reported and compared
for any period of time. Financial information is
produced for a fiscal year.
4. Matching (or accruals) principle: States Revenue
should be recognized when it is earned and
expenses when they are incurred, rather than on a
cash basis.
➢ Revenue and expenses of the period should
match.
 Cont’d
5. Monetary measurement: Despite the
importance of market, human, technological and
environmental factors, accounting records
transactions and reports information in financial
terms.
6. Going concern: states that a business entity will
continue to carry on its activities for an indefinite
period of time and the financial statements are
prepared on the basis that the business will
continue in operation.
 Cont’d
7. Full disclosure : States that financial information
should be complete for past transactions. That
is, there must be explanations (footnotes) of
external events (e.g., pending law suits),
changes in method/principle(s), internal events
such as union action, financial transactions with
managers and employees, to provide complete
and clear information for users.
 Cont’d
8. Consistency: The application of accounting
standards and principles should be consistent
from one year to the next. Where those
principles vary, the effect on profits is
separately reported under the disclosure
principle.
 Constraints in accounting

1. Materiality: States that, to make financial

statements meaningful, only material fact i.e.
important and relevant information that
influences the decision of users should be
provided in the financial statements.
➢The materiality of a fact depends on its nature
and the amount involved.
➢What is material for one company can be
immaterial for another company.
 Cont’d
2. Cost/benefit: Reporting an information
depends on the associated costs and
benefits.
3. Conservatism/Prudence: Means that when
two outcomes are equally probable, the less
optimistic should be reported. “Anticipate
no profit, but provide for all possible losses”.
Better to understate than to overstate´.
 Financial Reporting Environment and Qualitative
Characteristics of Accounting Information
❑Accounting principles are developed in response to
needs and Accounting principles are applied in
preparing financial statements
❑Accountant should prepare reports according to
GAAP or IFRS and Audits should performed their
auditing activity in accordance with Generally
Accepted Audit Standards (GAAS)
❑Both accounting and auditing help assure users of
financial statements gets relevant, reliable, and
comparable information.
❑But the above principles and standards are subject
to change.
 Qualitative Characteristics of Accounting
Information
❑The primary facts and ingredients that
accounting information should posses in order
to be most useful are referred to us basic
qualitative characteristics or qualities of
accounting information.
➢The two general qualities are:
1.Understandability:Accountinginformation
should be understandable to users who have a
reasonable knowledge of business and
economic activities and who are willing to study
the information with reasonable diligence.
 Cont’d
2. Decision usefulness: Decision usefulness is the
overall qualitative characteristics to be used in
judging the quality of accounting information.

❑ This Two overall quality can be separated into

the primary qualities of relevance and
reliability, and secondary qualities of
Comparability and consistency
 Cont’d
A. Primary Qualities
❑ Relevance: Mean makes difference in decision making.
Relevant accounting information helps users to evaluate
current conditions, make predictions about future
events.
❑ Relevance can be evaluated according to three
qualitative criteria.
1. Timelines: Accounting information should be timely
reported if it is to influence decisions.
2. Predictive value: Accounting information has predictive
value when it helps decision makers forecast more
present events.
3. Feedback value: Accounting information has feedback
value when it enables decision makers to conform or
correct prior expectations.
 Cont’d
❑Reliability: to ensure reliability, accounting
information should be free from error and bias and
faithfully represented what it claims to represent. It
must not mislead or deceive.
❑Reliability can be evaluated according to three
qualitative criteria.
1.Representational faithfulness: Exists when there is
agreement between a measure or a description and
the phenomenon it claims to represent.
2. Verifiability: Accounting information is verifiable when
a light degree of consensus can be secured among
independent measures using the same measurement
method that is the measurement result can be
duplicated.
 Cont’d
3. Neutrality: Accounting information is neutral when there
is an absence of bias intended to attain a predetermined
result or to influence behavior in a particular direction.
B. Secondary Qualities
1.Comparability: comparability of accounting information
enables users to identify and explain similarities and
differences between two or more sets of economic facts.
❑ Inter company comparison: comparing information of a
company with similar information from other companies.
❑ Intra company comparison: comparing information of a
company with similar information from past periods
within the company.
 Cont’d
B. Consistency: means conformity from period to
period, with accounting policies and procedures
remain unchanged. Consistency is an important
condition in enhancing comparability across
periods.
 Cont’d
Professional Ethics in Accounting
❑The goal of accounting is to provide useful
information for decisions. For information to
be useful, it must be trusted. This demands
ethics in accounting.
❑Ethics are beliefs that distinguish right from
wrong.
❑They are accepted standards of good and
bad behavior.
End of chapter one