Professional Documents
Culture Documents
CHAPTER ONE
1.1 The nature of a business: A business is an organization in which basic resources (inputs),
such as materials and labor, are assembled and processed to provide goods or services (outputs)
to customers. The objective of most businesses is to earn a profit. Profit is the difference
between the amounts received from customers for goods or services and the amounts paid for the
inputs used to provide the goods or services.
Types of businesses (Based on their operation): Three types of businesses operated for profit
include service, merchandising, and manufacturing businesses.
1. Service businesses provide services rather than products to customers. E.g: Delta Air Lines
(transportation services), The Walt Disney Company (entertainment services)
2. Merchandising businesses sell products they purchase from other businesses to customers.
E.g: Wal-Mart (general merchandise), Amazon.com (Internet books, music, videos)
3. Manufacturing businesses change basic inputs into products that are sold to customers. E.g:
General Motors Corporation (cars, trucks, vans), Dell Inc. (personal computers)
1.2 The role of accounting in business
Definition of Accounting: Accounting is the process of recording, classifying, summarizing,
analyzing &interpreting of financial information, and communicating financial information for
owners, managers, and other interested parties.
Evolution of accounting: People in all civilizations have maintained various types of records of
business activities. The oldest know as clay tablet records of the payment of wages in Babylonia
around 3600 B.C. However, early accounting dealt only with limited aspect of the financial
operations. These were no systematic accounting for all transactions of a particular unit, only for
specific types or portions of transactions. Now a day, as business and society become more
complex, accounting concept and techniques increased to meet financial information.
Double entry system:- This system was developed by venetian merchants in 1494. And Lucas
Pacioli, he is known as the father of Accounting, published about double entry system. -This
system says that each financial transaction affects at least two accounts.
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What is the role of accounting in business is that accounting provides information for managers
to use in operating the business. In addition, accounting provides information to other users in
assessing the economic performance and condition of the business. Thus, accounting can be
defined as an information system that provides reports to users about the economic activities and
condition of a business. Accounting is called as the “language of business.” This is because
accounting is the means by which businesses’ financial information is communicated to users.
1.3 Profession of Accountancy: Accountants are typically engaged in either private accounting
or public accounting.
Public Accounting – accountants who render accounting service on a fee basis and staff
accountants employed by them. They are called Independent Accountants. Accountants
employed individually or within a Accountant (CPA) public accounting firm in tax or audit
services.
Specialized accounting fields
Also, there are some other types of field in accounting such as: budgetary accounting, non- for-
profit accounting, social accounting, etc.
1.4 Types of business organizations: The three types of businesses (service, merchandising,
and Manufacturing) may be organized as proprietorships, partnerships, corporations, or limited
liability companies. Business organizations are classified as follows based on their forms:-
a. Sole proprietorship: These firms are owned by one person, usually the individual who has
day-to-day responsibility for running the business. Sole proprietors own all the assets of the
business and the profits generated by it. They also assume "complete personal" responsibility
for all of its liabilities or debts. In the eyes of the law, you are one in the same with the
business.
directors to oversee the major policies and decisions. The corporation has a life of its
own and does not dissolve when ownership changes.
d. Limited liability Company (LLC): combines the attributes of a partnership and a
corporation. Often used as an alternative to a partnership. It has tax and legal liability
advantages for owners.
e. Cooperatives: Firm owned, controlled, and operated by a group of users for their own
benefit. Each member contributes equity capital, and shares in the control of the firm on the
basis of one-member, one-vote principle (and not in proportion to his or her equity
contribution).
The resources (properties) owned by a business are its assets. Examples of assets include cash,
land, buildings, and equipment. The right or claim to the properties is referred as equities. If the
asset owned by a business is $100,000, the equity in the assets is also $ 100,000 i.e.
The rights or claims to the assets are divided into two types: (1) the rights of creditors and (2) the
rights of owners. The rights of creditors are the debts of the business and are called liabilities.
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The rights of the owners are called owner’s equity. Therefore we will get the accounting
equation i.e. the relationship among assets, liabilities, and owner’s equity:
Assets = Liabilities + Owner’s Equity
NB: We have to place liabilities before owner’s equity in the accounting equation because
creditors have preferential rights to the assets.
Business Transaction: The occurrence of an economic event that affects the financial position
of a business is called Business transaction. A particular business transaction may lead to an
event or condition that result in another transaction. For example, purchase of car on credit will
be followed by payment to the creditor, which is another transaction. The wearing- out of car is
not an exchange of goods or services between the business and an outsider, but it has to be
recorded. This type of transaction, as well as others that are not directly related to outsiders,
referred as internal transaction.
All business transactions from the simplest to the most complex can be stated in terms of the
resulting change in the three basic elements of the accounting equation. The following
illustration will demonstrate types of transaction and the accounting equation as follow:
Assume Mr. X establishes sole proprietorship business known as XYZ Taxi on August
1,2012.
Transaction –a-
Mr. X deposit $10,000 in a bank account in the name of XYZ Taxi. The effect of this transaction
is to increase the assets (cash), left side of equation and to increase the owner’s equity on the
right side by the same amount.
Transaction –b-
XYZ taxi co. purchased land, which is $ 7,500 in cash, is paid. This transaction changes the
composition of the assets but not change the total amount.
(b) - 7,500
Transaction –c-
XYZ taxi co. purchased $ 850 of gasoline, oil, and other supplies; agreed to pay in the near
future. This type of transaction is called purchased on account and liability is created known as
account payable. The transactions effect is increasing the assets amount and the liability
amount.
Transaction –d-
XYZ taxi co. paid for creditor $ 400, the effect is decreasing the assets and liabilities.
Transaction –e-
XYZ taxi co. earned fares of $ 4,500, receiving the amount in cash. In general the amount
charged to customers for goods or services sold is called Revenue. Instead of requiring the
payment of cash at the time goods or services are sold, a business may make sales on account,
allowing the customers to pay latter. In such cases the firm acquires an account receivable,
which is a claim against the customers. Account receivable is an asset and revenue is realized.
The effect of this transaction is increasing both the assets and owners equity.
Transaction –f-
The amount of assets consumed or services used in the process of earning revenue is called
expense. XYZ taxi co. incurred the following expenses and paid during the month were; wages
$1,125; rent $850; utilities $ 150; miscellaneous $ 75. The effect of this transaction is reducing
both asset and owner’s equity.
Transaction –g-
XYZ’s taxi co. supplies at the end of the month determined that $ 250 is on hand, the reminder
600 (850-250) have been used in the operation of the business. The effect of this situation is
decreasing both assets and owner’s equity.
Transaction –h-
At the end of the month Mr. X withdraws cash from the business $1,000 for personal use. This
transaction reduces the assets and owner’s equity.
(b) - 7,500
1. The effect of every transaction increased and / or decreased one or more of accounting
equations.
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.
The principal financial statements for sole proprietorship are the following:
1. Income Statement
It is a summary of revenues and expenses of a business entity for specific period of time,
such as a month or a year. The excess of revenues over expenses is called net income or
net profit. If the expenses exceed the revenues, the excess is net loss.
The determination of the periodic net income or net loss is a matching process involving
two steps. First, revenues are recognized during the period. Second, the assets consumed
in generating revenue must be matched against the revenue in order to determine the net
income or net loss.
It is a summary of the changes in the owner’s equity of a business entity that have
occurred during specific period of time.
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3. Balance Sheet
It is a list of assets, liabilities and owner’s equity of a business entity as of a specific date.
The asset section of a balance sheet begin with cash followed by receivables, supplies ,
prepaid insurance and other asset that can be converted in to cash or used up in the near
future. The asset of relatively permanent nature such as land, building and equipment
follow that order. In the liability and owner’s equity section of the balance sheet, the
liabilities presented first followed by owner’s equity.
It is a summary of cash receipts and cash payments of a business entity for a specific
period of time. This statement has three sections i.e. operating activities, investing
activities, and financing activities.
a. Operating Activities
This section includes cash transactions that enter in to the determination of net
income or net loss and also payment of cash to the creditor.
b. Investing Activities
This section includes the cash transaction for the acquisition and sale of relatively
long term or permanent type of assets.
c. Financing Activities
This section includes the cash transaction related to cash investment by the
owner’s and borrowing and withdrawals by the owner.
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.
The basic features of the four statements and their interrelationships are illustrated by taking
data from Mr. X taxi business as follow:
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Mr. X Taxi
Income Statement
For Month Ended August 31, 2012
Operating Expenses :
Mr. X Taxi
Statement of Owner’s Equity
For Month Ended August 31, 2012
Mr. X Taxi
Balance Sheet
August 31, 2012
Assets
Cash $3,400
Supplies 250
Land 7,500
Liabilities
Owner’s Equity
Mr. X Taxi
Statement of Cash Flow
For Month Ended August 31, 2012