UNIT 1: INTRODUCTION TO BUSINESS AND ACCOUNTING

N ature of bus ine s s

A business is an organization (entity) in which basic resource (inputs) such as materials &
labor assembled and processed to provide goods and services to customers. The objective of
most business is to earn a profit. Business enterprises can be divided in different groups based
on certain classification basis.
Based on activities done or nature there are 3 types of business.
1. Service giving business- provides service (intangible product) rather than product to
customer. E.g. Ethiopian airlines (transportation service), Photo copy
2. Merchandising business- sell tangible products they purchase from other business
(manufacturing) to customers.
- is a type of business that purchases goods without changing the quality, form and
design of product only for reselling purpose. E.g. boutiques,
3. Manufacturing business- change (convert) basic inputs in to products that are sold to
customers. E.g. Dire-Dawa food complex, National cement Factory, etc
Form of business entity
Based on title of ownership or form businesses can be divided in to three:
i. Sole (Single) Proprietorship: is owned and operated by one single individual
Easy and cheap to organize
Resources are limited to those of the owner.
Used by small businesses
Limited life
Unlimited liability
Non tax (Single tax from profit)
ii. Partnership: is owned by two or more individuals
Combines the skills and resources of more than one person
Limited life
Unlimited liability
Non tax (Single tax from profit)
Mutual control over the asset of the business
Risk diversification on loss and operational costs
iii. Corporation: is organized under state or federal as separate legal taxable entity
Ownership is divided into shares called stock.
Can obtain large amounts of resources by issuing stock.
Double tax(from divided and profit)
Unlimited life
Limited liability
Used by large businesses

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 Definition: Accounting
Accounting is a system or tool of communicating accounting or business data
among users and business enterprises.
Accounting is the process (procedure) of identifying, measuring, recording and
communicating economic information to permit informed judgments and
decisions by users of the information.
Accounting is a service activity. Its function is to provide primarily quantitative
information, primarily financial in nature, about economic activities that is
intended to be useful in making economic decisions.

Accounting as language of business

 Thus, accounting is often called language of business. Why accounting as language of
business? Because it provides essential information’s about the financial activities of an
entity to various individuals and groups for their use in making informed judgment and
decision.
Users of accounting information
 All users of accounting data may not require the same information and for the purpose of
preparing accounting information, accountants need to identify their users. The content of
accounting information depends on users for whom it is equipped. The process of using
accounting to provide information to users is illustrated in the following diagram. The two
users of accounting:
 Internal users like employee, manager etc
 External users like Government, suppliers, investor, Bank etc.

No. Accounting users Purpose of requiring accounting data

1 Investors To assess the financial status(condition) & its future prospects
whether to invest or not
2 Bankers & Financial soundness of a business & risk involved in it before
suppliers granting loan or credit sale
3 Government Financial activities of a business for purpose of taxation & regulation
agencies
4 Employees & Stability and profitability of an organization to hires them.
union
representative
5 Management Evaluate current operation so as to plan properly in the future

 Profession of accountancy
Accounting is profession as others disciples like legal, medical. As a profession accountants
are typically engaged either as:
i) Private Accounting
Accountant employed by a business firm or not-for-profit assuming various positions such as
chief accountant, controller, and financial vice president. Private accounting is accounting
work that is done for your own company; frequently referred to as managerial
accountants/cost accountants. Not independent.

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 ii) Public Accounting
Are accountants and their staff who provide services on a fee basis. Public accounting
includes any accounting work that a company performs for another company. They are
independent of the enterprise in which they give services.

Accounting principles & practice

Accounting principles and concepts develop from research, accepted accounting practices and
pronouncement of regulations. In US, the financial accounting standard board (FASB) has the
primary responsibility for developing accounting principles. Many countries outside united
states use generally accepted accounting principles adopted by the international accounting
standards board (IASB), issues the international financial reporting standard (IFRS).
Significant differences currently exists b/n FASB and IASB accounting principles. IFRS are
considered to be more principle based than the US GAAP which is considered to be more
rules based.

The difference between GAAPs and IFRS

US Outside US

FASB(financial accounting standard IASB(international accounting standard board)-IFRS(International

board)-GAAPs(General accepted financial reporting standard)
accounting principles)
 “Rule based”
 Input to the IFRS
 Balance sheet
 Income statement
 Statement of owner’s equity
 “Payable”
 “net income/loss/”
 “Principle based”
 More judgment
 Mean reason was to reduce cross-country difference in
accounting standards.
 Accounting rules that can be used by a variety of countries
 It developed last 10 years
 Over 130 countries using this standard
 Statement of financial position
 Statement of comprehensive income
 Statement of changes in equity
 “Provision”
 “Profit or loss”

The basic principles that issued by FASB are as follows:

GAAP
1. Business/Economic/Accounting entity
2. Cost concept
3. Unit of measurement/Monitory principle
4. Accounting period/Periodicity principle
5. Going concern/Continuity
6. Matching revenue and expired costs
7. Adequate disclosure/Full disclosure
8. Materiality
9. Conservatism/prudence concept
10. Consistency
11. Objective evidence

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1. Business entity principle: The business entity concept assumes that a business enterprise is
separate and distinct from the persons who supply its partial or all assets and from every
other business. Under this assumption, all accounting records and reports are developed
from the viewpoint of a single entity, whether it is a proprietorship, a partnership, or a
corporation. Consequently, the records and reports of the business should not include either
the transactions of another business or the personal assets or transactions of its owner or
owners.
2. Cost Concept: Presently have a “mixed-attribute” system that permits the use of various
measurement bases. The most commonly used measurements are based on historical cost
and fair value. Historical Cost “GAAP” 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. Fair value “IFRS” 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. This
is often referred to as the fair value principle. Fair value information may be more useful
than historical cost for certain types of assets and liabilities and in certain industries. At
initial acquisition, historical cost equals fair value. In subsequent periods, as market and
economic conditions change, historical cost and fair value often diverge. Thus, fair value
measures or estimates often provide more relevant information about the expected future
cash flows related to the asset or liability.
3. Going–Concern (continuity) principle : under this principle the business entity in question
is expected not to liquidate, but to continue operations for the foreseeable future (indefinite
period of time.)
4. Periodicity Assumption: To measure the results of a company’s activity accurately, we
would need to wait until it liquidates. Decision makers, however, cannot wait that long for
such information. 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.
5. Monetary principle : Means that accountants assume money to be a useful standard
measuring unit for reporting the effects of business transactions. Money amounts are the
language of accounting – the common unit of measure (yardstick). Example, the unit of
measure in the United States is the dollar; in Japan it is the yen, in Ethiopia it is the birr.

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The revenue realization principle: This principle requires the recognition and reporting of
revenues in accordance with accrual basis accounting principles. States that revenue from
business transactions is recorded when goods or services are sold. Some business sell goods or
services on one date but receive payment on a later date. In such cases, the revenue is recorded
on the date of sale, not necessarily when the cash is received.
6. The matching Principle (expired cost): matching refers to the recognition of expenses.
The principle implies that all expenses incurred in earning the revenue recognized for a
period should be recognized during the same period. In practice, the approach for
recognizing an expense is, “Let the expense follow the revenues.”
7. Disclosure principle: Requires that financial statements be complete in the sense of
including all information (materiality information) necessary to users of the statements.
Disclosure of those accounting information is made by means of comments, footnotes,
supplementary schedules etc.
8. Consistent principle: This principle implies that accounting rules, practice and conventions
should be continuously observed and applied. In other words, these should not be changed
from year to year.
9. Objectivity Principle : This principle requires that entries in the accounting records and
data reported on financial statements be based on objectively determined evidence. If this
principle is not followed, the confidence of the many users of the financial statements could
not be maintained. For example, objective evidence such as invoices and vouchers for
purchase, bank statements for the amount of cash in bank, and physical counts for
merchandise on hand supports much of the accounting. Such evidence is completely
objective and can be verified.
10. Conservatism principle: Periodic statements are affected to a great degree by the selection
of accounting procedures and other value judgment. Historically, accountants have tended to
be conservative, and in selecting among alternatives they have often favored the method or
the procedure that yielded the lesser amount of net income or asset value. In other word,
follow accounting methods and techniques which amplifies expenses and lessening revenue.
This is done to protect the firm from uncertain risk of loss.

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Business Transactions and the Accounting Equation
What is business transaction?
Economic events or conditions that must be recorded are said to be transactions.
They are dealings or activities that must be recorded. The mere intent to buy goods or services in
the future does not represent a transaction. The term transaction refers to a completed action
rather than to an expected or possible future action. For an event to qualify as a transaction, it
must also be measurable in money terms.
Transactions are of two types:
(1) External transactions:
Exchange dealings between the business entity and parties outside the entity.
Involve direct relation with parties external to the entity.
They are also called business transactions.
Examples: purchase of merchandise from a supplier, purchase of insurance policy, etc.

(2) Internal transactions.

Economic events that occur within the organization
Do not involve dealings with outside parties.
They do not arise from exchange dealings.
Examples: depreciation of equipment, buildings and other fixed assets.
 Definition of Some Accounting Terms
Assets
The properties or economic resources owned and controlled by a business and that are
expected to benefit the future.
They may have definite physical form such as building, machinery, or merchandise.
Some exist not in physical or tangible form, but in the form of valuable legal claims or
rights; examples are accounts receivables, notes receivables, patent rights and the like.
Equities
Rights or claims against the assets of a business.
The obligations of the business to the right holders.
The claimants or right holders can be owners and/or creditors.
Thus, the value of the assets is equal to the value of the rights.
Assets = Equities
We may have two types of rights.
(3) Creditors' right which represent liabilities of the business
(4) Owners’ right which represent the owners’ equity (capital)
Liabilities:
The claims/rights of outsiders, or parties external to the entity.
Properties or assets that the business owed
Examples include accounts payable, salaries payable, taxes payable, notes payable, …etc.
Owners’ Equity:
The ownership rights of the owner(s)/the existing investors
Residual of asset after payment of liabilities; sometimes called net asset
Thus, the expansion of the above fundamental equation will be:
Assets = Liabilities + Capital
Referred to as Balance sheet Equation/the Accounting Equation.

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Revenues:
The amount charged to customers for goods sold or services rendered.
Revenues have an increasing effect on the firm’s capital.
Expenses:
The amount of assets consumed or services used in the process of earning revenue.
Expenses have a decreasing effect on the firm’s capital.
Withdrawals:
When the owner makes withdrawal from the business, it is generally referred to as
withdrawal.
The withdrawal reduces the owner’s investment or equity in the business,
It is not a business expense because the assets are not being used to produce revenue.
 Effects of Business Transactions on the Accounting Equation
Business transactions affect the elements of the Accounting Equation.
Regardless of what transactions a business completes, its accounting equation always
remains in balance.
The total assets of a business always equal the combined claims of its creditors and
the equity of its owner(s).

Illustration-1
On Nov. 1, of the current year, Net Solutions’ established a sole proprietorship under the name
of Net Solutions’
1. Chris Clark deposits $25,000 in a bank account in the name of Net Solutions.
2. Net Solutions paid $20,000 for the purchase of land as a future building site.
3. Net Solutions purchased supplies for $1,350 and agreed to pay the supplier in the near future.
4. Net Solutions received cash of $7,500 for providing services to customers.
5. Net Solutions paid the following expenses during the month: wages, $2,125; rent, $800; utilities,
$450; and miscellaneous, $275.
6. Net Solutions paid creditors on account, $950.
7. Chris Clark determined that the cost of supplies on hand at the end of the month was $550.
8. Chris Clark withdrew $2,000 from Net Solutions for personal use.

Q1. Indicate the effect of each transaction on the three accounting elements & balance each
transaction?

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 1.2 Financial Statements
After the effect of the individual transactions has been determined, essential information is
communicated to users. The accounting statements that communicate this information are called
financial statement.
 It is a statement or summary of a given entities financial and operating result. FS’s are the
formal reports of financial information about the entity. Most FS are identical for all forms of
business organizations. The heading a given financial statement includes:
- The name of the firm,
- Type of statement and
- The accounting period to which the statement relates.

There are four common types of financial statements

1. Income statement
A summary of the revenue and expense of a given entity for a specific period such as a month or
a year. It is also called statement of earnings, profit and loss account, or statement of operations.
The excess of revenues over the expenses incurred in earning the revenues is called net income
or net profit. If the expenses of the enterprise exceed the revenue, the excess is a net loss.

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2. Statement of owner’s Equity
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 a financial statement to report investments and withdrawals,
as well as net income. It is also called capital statement.
3. Balance Sheet
The balance sheet lists all the Assets, Liabilities, and Owner’s equity of an entity as of a specific
date, usually the end of a month or a year. This financial statement provides information about
the nature and amounts of investments in enterprise resources, obligations to creditors, and the
owners’ equity in net resources. It is also called the statement of financial position.

4. The Statement of Cash Flows

A summary of cash receipts and cash payments of a business for a specific period of time, such
as a month or a year. It shows where the cash came from during the period, how the cash was
used, and the resulting cash balance.
1. 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.
2. Cash Flows from Investing Activities: This section reports the cash transactions for the
acquisition and sale of relatively permanent assets.
3. Cash Flows from Financing Activities: This section reports the cash transactions related to
cash investments by the owner, borrowings, and withdrawals by the owner.

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Exercises
1. Colfax Dry Cleaners is owned and operated by Maria Acosta. A building and equipment are
currently being rented, pending expansion to new facilities. The actual work of dry cleaning
is done by another company at wholesale rates. The assets and the liabilities of the business
on November 1, 2010, are as follows: Cash, $34,200; Accounts Receivable, $40,000;
Supplies, $5,000; Land, $50,000; Accounts Payable, $16,400. Business transactions during
November are summarized as follows:
1. Maria Acosta invested additional cash in the business with a deposit of $35,000 in the
business bank account.
2. Purchased land for use as a parking lot, paying cash of $30,000.
3. Paid rent for the month, $4,500.
4. Charged customers for dry cleaning revenue on account, $18,250.
5. Paid creditors on account, $9,000.
6. Purchased supplies on account, $2,800.
7. Received cash from cash customers for dry cleaning revenue, $31,750.
8. Received cash from customers on account, $27,800.
9. Received monthly invoice for dry cleaning expense for November (to be paid on
December 10) $14,800.
10. Paid the following: wages expense, $8,200; truck expense, $1,875; utilities expense,
$1,575 and miscellaneous expense $850.
11. Determined that the cost of supplies on hand was $3,550; therefore, the cost of supplies
used during the month was $4,250.
12. Withdrew $10,000 for personal use.

Instructions:
1. Determine the amount of Maria Acosta’s capital as of November 1.
2. State the assets, liabilities, and owner’s equity as of November 1 in equation form similar
to that shown in this chapter. In tabular form below the equation, indicate increases and
decreases resulting from each transaction and the new balances after each transaction.
3. Prepare an income statement for November, a statement of owner’s equity for November,
and a balance sheet as of November 30.
4. Prepare a statement of cash flows for November.
NB: the cash balance at the beginning of the period is added to the increase (or decrease) in
cash for the period to obtain the cash balance at the end of the period.

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