FOA I CH 1

Chapter-1 Introduction to Accounting and Business
1.1 Nature and Classification of Business Organizations

1. Definition - A business organization is an economic entity which is engaged in
converting basic inputs into products for sale at profit to customers. The basic inputs
include raw materials (wood, metal, etc), labor (employee’s physical and intellectual
efforts), capital (finance) and entrepreneur (owner/manager who combines raw
materials, labor and capital to produce products). The products may include goods
(tables and chairs) and services (banking, transportation, educational and health care
services).
2. Types of business organizations - based on the type of activities they perform or are
engaged in to generate income, business organizations may be divided in to three:
 Service - an enterprise that renders professional and technical services. E.g. banks,
telecommunication and transportation companies.
 Merchandising - an enterprise that buys and resells finished goods to customers.
E.g. Stationery shops, retail and wholesale stores, supermarkets, etc.
 Manufacturing - an enterprise that buys and converts raw materials into finished
products for sale to other businesses (merchandising) or direct to consumers. E.g.
textile and cement factories, wood- and metal-workshops, etc.
3. Forms of business organizations - Three different legal forms of businesses:

 Sole proprietorship - an enterprise owned by one person and usually operated and
managed by the same person. The sole proprietorship form of business is not a
separate legal entity from its owner. The life of a sole proprietorship usually
depends up on the life of the owner.
 Partnership - an enterprise owned by two/more persons called partners and the
partners are usually engaged in operations and management of the organization.
Like the sole proprietorship form of business. The life of a partnership usually
depends up on the admission of new partner/s or withdrawal of existing partner/s.
 Corporation - an enterprise owned by two/more persons called shareholders or
stockholders. The unique feature of a corporation is that it is a legal entity usually
referred to as an artificial person who is solely responsible for its act and debt. For
it has an independent existence, its life does not depend on the admission or
withdrawal of shareholder/s.
1.2 The Role of Accounting in Business Environment
1. Definition - Accounting is defined as an information system concerned with collection,
analysis and communication of financial information useful for decision making.
Financial information refers to quantitative information expressed in monetary terms.

For it is used as a means to exchange information among interested parties concerning
the financial performance, financial position and related issues of an organization, it is
also commonly known as the “language of business”.
As an information system, process of collecting, analyzing and communicating

information, it involves the following steps:
 Identifying - tracing and collecting recordable economic activities. Accounting
does not record and report all economic activities of an organization. Rather, it
records and reports only those economic activities of the organization which can be
expressed in terms of money.
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 Analyzing and Measuring - This involves determining whether the economic
activities bring changes (increase/decrease) assets, liabilities, capital, revenues,
and/or expenses (these terms will be defined in subsequent sections) of an
organization and expressing the changes in monetary terms.
 Recording - make, in a systematic way, a record of the effects of economic activities
on assets, liabilities, capital, revenues and expenses.
 Classifying - grouping recorded effects of economic activities into meaningful
classes.
 Summarizing - gathering and arranging data needed for preparation of reports and
statements.
 Reporting - preparing statements and reports in a manner that suits the need of users
so as to communicate information useful for decision making.
 Interpreting - provide explanation on reported information so that users can
understand and use the information as a basis for decision making.
2. Importance/purpose - Accounting can be seen as an important part of the total

information system of an organization. People, both inside and outside the business,
have to make decisions concerning the allocation of scarce resources. To ensure that
these resources are allocated in an efficient and effective manner, users require
economic information on which to base decisions. It is the role of the accounting system
to provide that information and the ultimate purpose of accounting is to give people
better information on which to base their decisions.
3. Users of Accounting Information - 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.
 Internal users are mainly management personnel of an organization who
have direct involvement and control over and who are responsible for the
day-to-day affairs of the organization. They need and use the financial
information to make decisions and plans for the business activities including
finance, human resource, production and marketing, and exercise control to
try to ensure that plans come to fruition.
 External users on the other hand, refer to users outside an organization who
are not directly involved in the day-to-day affairs of the organization but
have some interest in the financial and related affairs of the organization.
External users may include:

o 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.
o 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.
o Existing and potential employees (non-managers) and labor unions that need to
assess the ability of the business to continue providing them with employment
opportunities and better reward for services they rendered or may render to the
organization.
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o 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.
o 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.
o 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 should be
 Reliable - represent facts, neutral, free material errors and bias.
 Relevant - highly related to and make a difference in decision.
 Understandable - users with a reasonable knowledge of accounting and economic
activities should be able to easily understand and interpret the information.
Reliability, relevancy and understandability are commonly called the qualitative

characteristic or attributes that make accounting information useful for decision
making.
1.3 Assumptions and Principles
1. Business Entity Assumption - According to this assumption, each economic entity

exists separate from and independent of its owner/s and other economic entities under
the same or different owner/s. Thus, economic events can be identified with a particular
unit of accountability. And the economic activities of an accounting entity can be and
should be kept separate and distinct from its owner/s and all other entities. For instance,
records and reports of particular business should not reflect its owner’s personal
economic activities, assets and liabilities and that of another business other than its own
economic affairs
2. Going Concern/Continuity Assumption - This assumption states that, in the absence
of information to the contrary, the life of an economic entity is indeterminate and the
economic entity will continue in operation long enough to carry out its existing
objectives and commitments.
3. Accrual Concept - This concept requires that financial affairs of an economic entity
should be recognized (i.e. recorded and reported) as they occur regardless of the timing
of the in/out flows of cash associated with the economic events. According to this
principle, for instance, revenue should be recorded and reported when goods are
delivered or services are rendered to customers, and expenses should be recognized
when goods and services are consumed. The timing of the in/out flows of associated
cash, which may happen in advance, immediately or sometime in the futures, should
not determine the period in which the revenues and expenses should be recorded and
reported.
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4. Objectivity Principle - According to this principle, an economic entity’s financial
affairs to be recorded in its accounting records and reported on its financial statements
must be supported by objectively determinable evidences known as source documents.
This helps to enhance the reliability of information reported by the entity and the
confidence of users in relying on the reported accounting information for making
economic decisions. Objective evidences (source documents) include such things as
invoices, vouchers, checks, contracts and physical counts of resources.
5. Historical Cost Principle - This principle states that goods and services purchased or
sold should be recorded in the accounting records and then reported on the financial
statements at the initial amount of cash or cash equivalent given up to acquire them or
received in exchange for selling them rather than on an estimated or market value. Such
amount is known as the historical cost/exchange price and is retained in the accounting
records until such time that the goods and services are consumed
6. Unit of Measurement Assumption - According to this assumption, the national

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

1. Elements of Financial Statements - are items that are recorded in the accounting
records and then reported on commonly called financial statements of a business entity
reports. The elements of financial statements include assets, liabilities, capital, revenues
and expenses.
i. Assets - are resources owned/controlled by an economic entity and with the potential to
provide future benefits to the business. E.g. building, land, vehicle, money, office
machine such as computer, stationery materials, fuel, Inventory (merchandise held for
sale), Accounts Receivable (money claims against customers for goods and services
sold to them on credit), Rent Receivable (money claims against lessee/tenant/renter for
housing services rendered to them but not yet collected), Supplies (also called
consumable - refer to assets that are expected to be consumed within a very short period
of time and include such items as fuel, stationery materials, cleaning materials, etc)
ii. Liabilities - obligations/debts of a business that arise as a result of borrowing and/or
buying goods and services on credit. Liabilities may require use of business assets such
as cash and/or delivery of goods and services for their repayment or settlement. E.g.
Accounts Payable (liability arising from purchase of goods on credit), Salary Payable
(obligation for professional or technical services received from employees), Utility
Payable (obligation to utility companies for utility services such as telephone,
electricity and water services received but not yet paid), Bank Loan Payable (money
borrowed from banks), Interest Payable (interest accrued on loans not yet repaid),
iii. Capital - also called owner’s equity/net worth/net assets refer to resources contributed
by or that belong to the owner/s of a business entity. Capital represents claims/rights of
owner/s against assets of a business. Capital may include direct investment of resources
by owner/s and profit generated from business operations that are accumulated over
time or not withdrawn by the owner/s for personal use.
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iv. Revenues - refer to money or other assets received in exchange for goods and services
sold to customers. Business organizations may sell goods and services on cash and/or
credit basis.
Cash sale - refers to a situation where customers buying goods and services are
required to immediately pay and accordingly paid cash for goods and services sold
to them.
Credit sale - refers to a situation where customers are allowed to pay money
sometime in the future for goods and services currently sold to them
Revenues may be generated from different activities and different terms may be used
to refer them accordingly. Below are some examples.
 Selling finished goods such as food/clothing items, drugs - Sales
 Providing services such as transportation, auditing, legal, medical - Fees Earned
 Lending money - Interest Income
 Leasing/renting properties - Rent/Royalty Income
 Providing brokerage service - Commission Income
v. Expenses - refer to goods and services consumed/used in operating or carrying on day-

to-day activities of a business. Like sales of goods and services, expenses or purchases
of goods and services may be on cash or credit basis.
 Cash expense/purchase - refers to a situation where a business
immediately pays cash for expenses it incurred or goods and
services it purchased.
 Credit expense/purchase - refers to a situation where a business
is allowed to pay money sometime in the future for expenses it
currently incurred or goods and services it currently purchased.
 Different terms are used to refer to expenses based on the type of goods and
services consumed. Below are some examples.
o Cost of Goods Sold - expired costs finished goods resulting from sale of
the goods to customers
o Supplies Expense - representing cost of supplies consumed
o Utility Expenses - value of utility services consumed
o Wages/Salary Expenses - values of services received from employees
o Interest Expense - interest accrued/paid on loans
o Rent/Royalty Expense - value of services received from property
owners
o Miscellaneous Expenses - values of goods and services consumed but
minor enough in amount to be classified in either of the above types of
expenses
2. Business Transactions - are economic activities of a business that bring monetary

changes in its assets, liabilities, capital, revenues and expenses and should be recorded
in the accounting records of the business. They include buying and selling goods and
services and collecting and paying money. Business transactions are raw materials or
inputs to the accounting process.
3. The Accounting Equation - is a mathematical expression that shows the

relationship between assets, liabilities and capital of a business.
The basic accounting equation is:
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Assets = Liabilities + Owner's Equity
This indicates that a business may get its assets from its owner/s in the form of
investment and/or from its creditor/s in the form loan or credit.
 Assets - Liabilities = Owner's Equity

The accounting equation may further be rearranged, as shown above, to indicate that
owner’s equity represents the residual interest in business assets. This implies that
creditors have priority or preferential right over the assets of a business upon the event
of liquidation.
4. Business Transactions and the Accounting Equation - Business transactions affect

one or more elements of the accounting equation. Each business transaction brings
equal dollar amount of net changes into both the left and right sides of the accounting
equation. As a result, the equation remains in balance (equal).
Below are sample transactions and their effects on the elements of the financial
statements.
i. Collections of resources from
 owner/s in the form of investment, increase both assets and capital
 creditor/s in the form of credit/loan, increase both assets and liabilities
 customer/s in exchange for goods and services sold to them, increase both assets and
revenues
ii. Consumptions of goods and services such as
 previously purchased supplies, stationery materials and fuel, increase expenses and
decrease assets
 utility, housing and employee services for which money is not yet paid, increase both
expenses and liabilities
 money taken out of business by the owner for personal use called withdrawals, decrease
both assets and capital
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: income statement, statement of
changes in owner’s equity (capital), balance sheet and statement of cash flows.
Financial statements have two major parts: the header where the name of business
organization, the type of the statement and the time period the statement covers are
written; and the main part (body) where the elements of the financial statements are
reported.
1. 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
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as a month or a year. The statement includes beginning and ending capital balances,
additional investment, withdrawal and net income/loss.
3. Balance Sheet - is used to provide information about amounts and types of assets a
business owns and amounts and types of resources contributed by its owner/s and
creditor/s. Elements of the balance sheet include assets, liabilities and capital. The
balance sheet lists assets, liabilities and capital of a business on a specific date, usually
at the end of a month or a year. There are two forms of a balance sheet: report and
account.
Report form - lists assets first followed by liabilities and capital in report writing form
Account form - lists assets on the left side and liabilities and capital on the right side of
the balance sheet
4. Statement of Cash Flows - is used to provide information about sources and uses of
cash over a specific period of time such as a month or a year. Cash flows are classified
based on the activities of an organization: operating, investing and financing.
 Operating activities - refer to cash activities of a business that are entered into
determination of net income/loss. Examples include cash collections from
customers for goods and services sold to them and cash paid for goods and services
(such as utilities, supplies and rent) consumed in operating a business.
 Investing activities - refer to cash activities of a business that involve acquisition
and sale of relatively long-term assets such as furniture, fixtures, vehicles, buildings
and machines.
 Financing activities - refer to cash activities of a business that affect equities of
owner/s and long-term creditors of the business. Examples include money invested
and withdrew by owner/s.
Illustrative example:
On January 1, 2020, Daniel Getachew, an ex-manager of Commercial Bank of Ethiopia,
Arat Kilo Branch, established his own consultancy business. He named his business
"DG Consultancy Services". The objective of the business is to render financial
consultancy services to clients on a fee basis. The following transactions are occurred
during the first month of operation of the firm (from January 1 to 31 of January, 2020).
Transaction 1:
January 1: Daniel deposited birr 20,000 cash in a bank account in the name of his
business- DG Consultancy Services.
The establishment of bank account on January 1 is the first transaction of DG
Consultancy Service. There are two financial facts that should be recorded on this date
such as;
a. The DG Consultancy Service has asset of birr 20,000 in terms of cash
b. Daniel has ownership right of birr 20,000 from the business asset
The company position at this time can be expressed by the following equation
DG Consultancy Service
Asset = Ownership right
Cash (a) Daniel, capital (b)
Jan 1: Birr 20,000 Birr 20,000
The equation, asset is equals to ownership right, represent the company has a total asset
of birr 20,000 and it comes from the owner of the company Mr. Daniel Getachew.
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Transaction 2:
January 3: Daniel transferred furniture worth birr 30,000 from his home for office uses
by DG Consultancy Services. He also has extra home furniture and other personal assets
worth birr 860,000.
It represents additional investment made by Daniel for his company use and it is made
in kind (furniture) instead of cash. Therefore, the effect of the transaction should be
reported in the equation as follows.
Asset = Ownership Right
Cash + Furniture Daniel, capital
Jan 1: Birr 20,000 Birr 20,000
Jan 3: Birr 30,000 Birr 30,000
Balance br 20,000 br 30,000 Birr 50,000
The above equation shows the company has total asset of Birr 50,000 comprising birr
20,000 cash and birr 30,000 furniture which comes from Daniel investment. Personal
asset of Mr. Daniel birr 860,000 is not recorded in the equation because, according to
business entity principle, the asset of the company should be separately treated from
personal asset of the owner.
Transaction 3:
January 6: the company purchased office supplies worth birr 5,000 from various
suppliers agreeing to pay the sum within two weeks.
The transaction represents purchase of supplies on account from outside suppliers and
it affects the following accounts.
a. Purchase of supplies increase the asset of a company.
b. Since the purchase is made on credit it creates a new liability account called
accounts payable.
The next table shows the effect of the above transaction.
Asset = Liability + Ownership right
Cash + Furniture + Supplies Accounts payable Daniel, capital
Jan 1: Birr 20,000 Birr 5,000 Birr 20,000
Jan 2: Birr 30,000 Birr 30,000
Jan 4: Birr 5,000
Balance br 20,000 br 30,000 br 5,000 Birr 5,000 Birr 50,000
Transaction 4:
January 7: DG paid Birr 3,000 cash for advertising its services through ETV.
This transaction required payment of birr 3,000 for advertisement expense and it
reduced the owner’s investment.
Jan 5: (br 3000) (Birr 3,000)
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As you see from the above table transaction 4 reduced the cash balance of the company
for birr 3,000 and again reduced the capital of Daniel for birr 3,000.
Transaction 5:
January 10: DG received Birr 20,000 cash for consultancy services it rendered to cash
clients.
It is the first transaction of the company for realization of revenue and cash collection.
Jan 8: br 20,000 Birr 20,000
Transaction 6:
January 11: DG purchased a used car for business purposes. The business paid birr
28,000 cash for the car. Brokers estimated that the car currently worth birr 30,000 and
the Inland Revenue assessed the car at birr 25,000 for property tax purposes.
This transaction changes the composition of the company asset items.
Cash + Furniture + Supplies + Vehicle Accounts payable Daniel, capital
Bal. br 37,000 br 30,000 br 5,000 Birr 5,000 Birr 67,000
Jan 10: (br 28,000) br 28,000
Bal. br 9,000 br 30,000 br 5,000 br 28,000 Birr 5,000 birr 67,000
Transaction 7:
January 14: DG received birr 10,000 additional cash investment from its owner.
Dear distance learners, as you seen from the previous transactions, the cash balance of
DG Company become deteriorated to birr 9,000. So, in order to strengthen the company
cash balance the owner invests additional cash of birr 10,000 in January. The effect of
this transaction is shown below.
Cash + Furniture + Supplies + Vehicle Accounts payable Daniel, capital
Jan 11: br 10,000 Birr 10,000
Transaction 8:
January 16: DG rendered consultancy services worth Birr 15,000 to clients who
promised to pay the sum within two weeks.
Hear the company provides consultancy service for customers without payment.
Therefore the transaction creates the new accounts receivable account and since the
company earned revenue the owner’s equity account also increased for the same
amount.
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Asset = Liability Ownership
right
Cash + Furniture + Supplies + Vehicle + Account Accounts Daniel,
Receivable Payable Capital
Bal. br 19,000 br 30,000 br 5,000 br 28,000 Birr 5,000 Birr 77,000
Jan 14: br 15,000 Birr 15,000
Bal. br 19,000 br 30,000 br 5,000 br 28,000 br 15,000 Birr 5,000 Birr 92,000
Transaction 9:
January 18: DG paid birr 4,000 cash to suppliers for its credit purchase of supplies on
January 4.
right
Cash + Furniture + Supplies + Vehicle + Account Accounts Daniel,
Receivable Payable Capital
Jan 14: (br 4,000) (Birr 4,000)
Transaction 10:
January 20: DG employed an accountant and a secretary for monthly salary of birr 1,200
and birr 700, respectively.
This business event has no cash payment for and receipt of services from the employed
individuals. Therefore, there is no need of recording the stated amount of salary as a
payment, liability and reduction of the owner investment.
Transaction 11:
January 21: DG borrowed birr 14,000 cash from Dashen Bank. The loan is repayable
over six months.
right
Cash + Furniture + Supplies + Vehicle + Account A/P bank Loan DC
Receivable
Bal. br 15,000 br 30,000 br 5,000 br 28,000 br 15,000 Br1,000 Br92,000
Jan 14: br 14,000 Br 14,000
Bal. br 29,000 br 30,000 br 5,000 br 28,000 br 15,000 Br1,000 Br14,000 Br92,000
Transaction 12:
January 29: AH incurred and paid for the following expenses. Wages birr 6,000, Rent
birr 4,500, Utilities birr 1,200, and others birr 800.
10 | P a g e
right
Receivable
Jan 14: (br 12,500) (Br12,500)
Transaction 13:
January 27: DG collected birr 12,000 from its credit customers
right
Receivable
Jan 14: br 12,000 (br 12,000)
Transaction 14:
January 30: DG paid birr 450 cash to Dashen Bank consisting of birr 400 principal and
birr 50 one month interest on part of the loan due in January.
right
Receivable
Jan 14: (br 450) (Br 400) (Br 50)
Transaction 15:
January 31: AH paid its owner birr 5,000 cash to pay house utility expenses
right
Receivable
Jan 14: (br 5,000) (Br 5,000)
Transaction 16:
January 31: DG determined that cost of supplies remained on hand at the end of the
current month total birr 1,300.
11 | P a g e
right
Receivable
Jan 14: (br 3,700) (br 3,700)
12 | P a g e

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FOA I CH 1

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Chapter-1 Introduction to Accounting and Business

1.1 Nature and Classification of Business Organizations

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

Financial information refers to quantitative information expressed in monetary terms.

As an information system, process of collecting, analyzing and communicating

2. Importance/purpose - Accounting can be seen as an important part of the total

External users may include:

4. Characteristic of Accounting Information - accounting information is mainly

Reliability, relevancy and understandability are commonly called the qualitative

1.3 Assumptions and Principles

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

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

1.4 Business Transactions and the Accounting Equation

v. Expenses - refer to goods and services consumed/used in operating or carrying on day-

2. Business Transactions - are economic activities of a business that bring monetary

3. The Accounting Equation - is a mathematical expression that shows the

The basic accounting equation is:

 Assets - Liabilities = Owner's Equity

4. Business Transactions and the Accounting Equation - Business transactions affect

1.5 Financial Statements

1. Income Statement - is used to provide information about financial performance of a

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

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