AFM Chapter 01

Chapter One
Accounting: Information for Decision Making
1.1. Introduction
• The history of accounting or accountancy is thousands of years old and
can be traced to ancient civilizations.
• Evidences indicated that accounting began as a simple system of clay
tokens to keep truck of goods and animals before developing complex
transactions and other financial information.
• These were practiced at ancient civilizations of Mesopotamia (present Iraq),

1 Compiled By Addisu Gemeda (PhD Candidate) 11/24/2020
China, Greece and Egypt.
• Evidences also indicated that accounting is as old as money itself.
People of that time used to record the growth of crops and herds.
• Accounting has evolved, as have medicine, law and most other
fields of human activity in response to the social and economic
needs of society.
• People in all civilizations have maintained various types of
records of business activities.
• The oldest known are clay tablet records of the payment of
wages in Babylonia around 600 B.C.

Accounting was also being used to keep records
regarding the cost of labour and materials used in

building great structures like the Pyramids.
Early accounting dealt only with limited aspects of
the financial operations of private or governmental

enterprises.
Complete accounting system for an enterprise
which came to be called as “double entry system”.

The first known description of double entry book keeping
was first published in 1494 by Lucas Pacioli.
The onset of the industrial revolution necessitated the
development of more sophisticated accounting system.

The increase in competition and mass production of goods
led to the rise of accounting as a formal branch of study.

With the passage of time, the corporate world
grew.
In the nineteenth century, companies came up in
many areas of infrastructure like the railways, steel,

communication, etc. led to a rapid growth in
accounting.
As the complexities of business grew, ownership
and management of business was divorced.

 As corporations became larger, an increasing number of
individuals and institutions looked to accountants to

provide economic information about these enterprises.
 Because owners wants to know how to make their
businesses as cost efficient as possible.

As such, managers had to come up with well-defined,
structured systems of accounting to report the

performance of the business to its owners.

Government also has had a lot to do with more accounting
developments. The Income Tax brought about the

concept of ‘income’ and the attention of government
with accounting.
Government takes a host of other decisions,
relating to education, health, economic planning,

for which it needs accurate and reliable
information, to be communicated through financial
7
reporting.
Compiled By Addisu Gemeda (PhD Candidate) 11/24/2020
1.1.1.What is Accounting?
In 1941, the American Institute of Certified Public Accountants (AICPA)
defined Accounting as “The art of recording, classifying, summarizing,
analyzing and interpreting the business transactions systematically and
communicating business results to interested users.”

The American Accounting Association (AAA, 1966) defines Accounting as
the process of:

 Identifying,
Measuring and
Communicating of economic information to permit informed judgments and sound
decision.
 In a comprehensive way, Accounting is the process of
 Identifying,
 Measuring,
 Recording,
 Classifying,
 Summarizing,
 Analyzing,
 Interpreting, and
 Communicating
 the financial transactions and events in monetary terms for
9 informed judgment
Compiled By Addisu and
Gemeda (PhD sound decision.
Candidate) 11/24/2020
Usually, accounting is understood as the Language of
Business. However, a business may have a lot of aspects
which may not be of financial nature.
As such, a better way to understand accounting could be
to call it The Language of Financial Decisions.

We have different roles to perform in life-the role of a
student, of a family head, of a manager, of an investor,

etc.
The better the understanding of the language, the better is
the management of financial aspects of living.

Many aspects of our lives as; personal financial planning,
investments, income-tax, loans, etc. are based on

accounting.
The knowledge of accounting is an added
advantage in performing different roles.

1.2. Accounting as an Information System
 Accounting plays an important role in our economic and
social system.
 Sound decisions made by individuals, businesses,
governments, and other entities are essential for the
efficient distribution and use of the nation’s

scarce resources.
 To make such decisions, these groups must have reliable
information provided by the accounting system.

 Accounting “is not an end in itself”, but it is an
information system that measures, processes, and

communicates financial information about an
identifiable economic unit.
 Accounting provides a vital service by supplying the
information decision makers need to make reasoned

choices among alternative uses of scarce resources in
the conduct of business and economic activities.

 Accounting is a link between decision makers and business
Activities
o First, accounting measures business activities by recording data
about them for future use.

o Then the data are sorted until needed and then processed to
become useful information.

o Finally, the information is communicated through reports to
decision makers.
Therefore, we can say that data about business activities are the
input to the accounting system and the useful information for

decision
14 makers is the output.
October 12, 2016
The Accounting
Process: Accomplished
by storage & preparation of
data
Accounting “links”
decision makers with
economic activities Communication:
Economic Accomplished by
Activities: and with the results Reporting
of their decisions.
Actions
(decisions)
Decision makers
1.3. Basic Functions of Accounting
Accounting is often called the language of business.
The following are the advantages of a properly maintained accounting system.

1. Keep systematic record of financial transactions
2. Communicating the result to interested parties
3. Assist to meet basic legal requirements
4. Provides control over assets
5.Facilitates a comparison of costs, expenses, sales and profits
6. Assists the management for basic decisions
7. Reveal fraud or thefts
8. Assist the government in tax matters
9. Ascertaining value of business

Figure Below summarizes the basic Function of Accounting

1.4. Decision-Makers: The Users of Accounting Information
The Users of Accounting Information
Decision Makers
Management Those With Direct Those With Indirect

Finance Financial Interest Financial Interest
Operations &
Investors Tax Authorities
Production
Creditors Regulators
Marketing
Labor Unions
Human Resources
Information Customers
Systems Economic Planners

The following paragraphs throw light on the various users
of accounting information and what do they do with that

information.
1. Individuals
Individuals may use accounting information to manage
their routine affairs like operating and managing their

bank accounts, to evaluate the worthwhileness of a job in
an organization, to invest money, to rent a house, etc.

2. Business Managers
Business Managers have to set goals, evaluate progress and initiate corrective
action in case of unfavorable deviation from the planned course of action.

Accounting information is required for many such decisions as;
• Purchasing equipment,
• Maintenance of inventory,
• Hire additional staff
• Make or Buy
• Go for cost leadership or differentiate
• Introduce new advertisement campaign
20
Borrow
•Compiled By Addisuor issue
Gemeda additional
(PhD Candidate) shares etc. 11/24/2020
3. Investors and creditors
Investors and creditors are keen to evaluate the
profitability and solvency of a company before

they decide to provide money to the organization.
Therefore, they are interested to obtain financial
information about the company in which they are

contemplating an investment.

4. Government and Regulatory agencies
Are charged with the responsibility of guiding the socio-
economic system of a country in such a way that it

promotes common good.
The government’s task of managing the industrial
economy becomes simplify if the accounting

information such as profits, costs, taxes, etc. is
presented in a uniform manner without any
manipulation or ‘window-dressing.”

5. Employees and Trade Unions
Employees and trade unions use the accounting
information to settle various issues related to

wages, bonus, profit sharing, etc.
6. General Public
The general public are also interested in knowing
the amount of income earned by various business

houses.
23
7. Others
Customers:
To Know goods and service delivery capacity of businesses .
Suppliers:
to know whether customers will be capable of paying for goods
and services supplied.

Donors/Sponsors:
• To know whether the organization is utilizing funds in an efficient
and effective manner,

Analysts and Advisors:
 to make analysis and advising all the concerned parties such as
Compiled By Addisu Gemeda (PhD Candidate)
24 investors, lenders, public and others. 11/24/2020
1.5.Financial Vs. Management Accounting
The financial literature classifies accounting into two broad

categories, viz, Financial Accounting and Management Accounting.
Financial accounting is charged with the primary responsibility of
external reporting.
The users of information generated by financial accounting, like
o Bankers,
o Other financial institutions,
o Regulatory authorities,
o Government,
o Investors, etc. want the accounting information to be consistent so as
25 to facilitate
Compiled comparison.
By Addisu Gemeda (PhD Candidate) 11/24/2020
The significance of financial accounting lies in the fact
that it aids the management in directing and
controlling the activities of the firm and to

frame relevant managerial policies related to
areas like production, human resource ,
marketing, financing, etc.

Management Accounting
Management accounting is ‘tailor-made’ accounting.
It facilitates the management by providing accounting
information in such a way so that it is conducive for

policy making and running the day-to-day operations
of the business.
Its basic purpose is to communicate the facts according to
the specific needs of decision-makers by presenting the

information in a systematic and meaningful manner.
Management accounting, therefore, specifically helps in
planning and controlling.

 It helps in setting standards and in case of variances
between planned and actual performances, it helps in

deciding the corrective action.
Since management accounting caters to the specific
decision needs, it does not rest upon any well-defined

and set principles.

One important variant of management accounting is the cost
analysis. Cost accounting makes elaborate cost records regarding

various products, operations and functions.
 It is the process of determining and accumulating the cost of a
particular product or activity.

 Any product, function, job or process for which costs are
determined and accumulated, are called cost centers.

The basic purpose of cost accounting is to provide a detailed
breakup of cost of different departments, processes, jobs, products,

sales territories, etc., so that effective cost control can be exercised.
1.6. Comparison of Financial and Management Accounting

1.7. Ethics in Accounting
Ethics is a term that refers to a code or moral system that
provides criteria for evaluating right and wrong. An ethical
dilemma is a situation in which an individual or group is faced
with a decision that tests this code. Many of these dilemmas
are simple to recognize and resolve.
Accountants, like others operating in the business world, are
faced with many ethical dilemmas, some of which are
complex and difficult to resolve.
For instance, the capital markets’ focus on periodic profits
may tempt a company’s management to bend or even break
accounting rules to inflate reported net income. In these
situations, technical competence is not enough to resolve the
dilemma.
In carrying out their responsibilities as professionals, members should exercise
sensitive professional and moral judgments in all their activities
Members should accept the obligation to act in a way that will serve the public interest, honor
the public trust, and demonstrate commitment to professionalism
To maintain and broaden public confidence, members should perform all professional
responsibilities with the highest sense of integrity
A member should maintain objectivity and be free of conflicts of interest in discharging

professional responsibilities. A member in public practice should be independent in fact and
appearance when providing auditing and other attestation services.

A member should observe the profession's technical and ethical standards, strive
continually to improve competence and the quality of services, and discharge professional
responsibility to the best of the member's ability
A member in public practice should observe the Principles of the Code of Professional
Conduct in determining the scope and nature of services to be provided
These principles reinforce the profession's recognition of its responsibilities to the audit
client, outsiders that might use the financial statements and to colleagues in the workplace.
These general principles are designed to serve as a guide for professional behavior and
express the basic understanding of ethical and professional conduct. They require
professional behavior even at the cost of personal disadvantage

1.8. The Accounting Cycle
The accounting cycle is the name given to the collective

process of recording and processing the accounting events of a
company.
The series of steps begin when a transaction occurs and end

with its inclusion in the financial statements, to closing the
accounts.
The cycle repeats itself every Accounting period as long as the

company remains in business.

1. Analyze Business Transaction
What is business Transaction?

 A business transaction is an event that can be measured in
monetary value that affects the financial condition of a business.
Business transactions are generally evidenced by source
documents.
Let as elaborate these concept by using one transaction.
Jan 01,2018 Dream business paid $24,000 for 12 months of office
rent.
 Identify who paid the cash? The business
 What the benefit received?12 months office space
 What is the amount involved?$24,000
 Which accounts is affected by this transaction? Asset

Diagrammatic presentation of Accounting Cycle
1. Analyze business transactions
9. Prepare a post-closing 2. Journalize the

trial balance transactions
8. Journalize and post

3. Post to ledger accounts
closing entries
7. Prepare financial
4. Prepare a trial balance
statements
6. Prepare an adjusted trial 5. Journalize and post

balance adjusting entries

1.1. Chart of Accounts
A chart of accounts (COA) is a financial organizational tool

that provides a complete listing of every account in
an accounting system.
An account is a unique record for each type of asset, liability,
equity, revenue and expense.
The chart is used by the accounting software to aggregate
information into an entity's financial statements.
The chart is usually sorted in order by account number, to
ease the task of locating specific accounts.
1st digit represent nature of account.
2nd digit represent Classification of an account.

Dream Business Chart Accounts

1.2.Rules of Debit and Credit

2. Journal Entries
 Jan 01,2018 The Owner of Dream business invest Br.100,000 as initial
investment.
 Jan 01,2018 Dream business paid Br.24,000 for 6 months of office

rent.
Jan,06,2018 Dream business purchased office furniture and

equipment on account from 3F for Br.10,000.

3.Posting transaction to Ledger
After journal entries are made, the next step in

the accounting cycle is to post the journal entries into the ledger.
A general ledger contains accounts that are broad in nature such as
Cash, Accounts Receivable, Supplies, and so on.
There is another type of ledger which we call subsidiary ledger. It
consists of accounts within accounts (i.e., specific accounts that
make up a broad account).
After journal entries are made, the next step in
the accounting cycle is to post the journal entries into the ledger.
Posting refers to the process of transferring entries in the journal
into the accounts in the ledger.
Posting to the ledger is the classifying phase of accounting.
Posting to Ledger

Posting to Ledger Cont’d..



Po s tin g to Led g er Co n t’d. .


4.Unadjusted Trial Balance
What is a trial balance ?
A trial balance is a list of all the company's accounts and their
balance at the time the trial balance is prepared.
An unadjusted trial balance is a trial balance that is prepared
before adjusting entries are made into accounts.
The information comes directly from the ledger.
The total debit balance and total credit balance must be equal.
Purpose of the trial balance

A trial balance checks that double entry system works .
Used as basis for preparation of financial Statement

Unadjusted Trial Balance Cont’d
Should the TB always balance?
 Yes
If not, need to check accounts/balances for errors
Trial balance will not be balance due to
Arithmetic errors
Posting errors
One sided entry
Entered twice on same side
Transposition error
Slide error

Unadjusted Trial Balance Cont’d
Trial Balance will not show
Errors of omission – transaction left out completely
Errors of commission – correct amounts, wrong account(s)
Errors of principle – e.g. posted a capital expense as revenue

expense
Compensating errors – errors which cancel each other out
Reversal of entries – wrong sides of each account used.

5.Accounts need adjusting Entries
Adjustments are necessary to bring the balances of certain accounts up to

date prior to preparing the financial statements at the end of the fiscal
period.
Assets must be adjusted to show amounts used or allocated to periods and
are recorded as expenses.
Supplies used need to be adjusted.
Prepaid rent expired over time.
Equipment depreciated.
Expenses incurred must be recorded in the correct period before the
period closes. e.g. accrued salaries which have not been previously
recorded.
What is Accrual?
The accrual concept in accounting means that expenses and revenues are
recorded in the period they occur, whether or not cash is involved. The
benefit of the accrual approach is that financial statements reflect all the
55 expenses associated
Compiled with(PhD
By Addisu Gemeda theCandidate)
reported revenues for an accounting11/24/2020
period.
Unadjusted Trial Balance

What is Deferral?
In accounting this means to defer or to delay recognizing certain revenues
or expenses on the income statement until a later, more appropriate time.
Revenues are deferred to a balance sheet liability account until they are
earned in a later period.
What is a contra asset account?
The most common contra asset account is Accumulated Depreciation.
Accumulated Depreciation is associated with property, plant and
equipment.
It is credited when Depreciation Expense is recorded.
Recording the credits in the Accumulated Depreciation means that the cost
of the property, plant and equipment will continue to be reported.
Reporting the accumulated depreciation separately allows the readers of
the balance sheet to see how much of the cost has been depreciated and
how much has not yet been depreciated.

 Another contra asset account is Allowance for Doubtful Accounts. This
account appears next to the current asset Accounts Receivable.
 The account Allowance for Doubtful Account is credited when a company
enters estimated amounts as debits to Bad Debts Expense under the
allowance method.
 The use of Allowance for Doubtful Accounts permits a reader to see the
documented amounts in Accounts Receivable that the company has a right
to collect from its credit customers.
 The separate credit balance in the account Allowance for Doubtful
Accounts tells the reader how much of the debit balance in Accounts
Receivable is unlikely to be collected.
For the case of Dream business the following accounts needs adjustment.
1. Pre paid rent
2. Supplies
3. Merchandize inventory
4. Furniture and equipment

Information's available for preparation of month end adjustments.
1)According to physical inventory count made in January 31,2018 the

merchandize inventory on hand shows Br.3,500 and supplies on hand is
Br.500.
2) Straight line method of deprecation is used to calculate deprecation

expense.
- Estimated useful life is 5 Years.
- Estimated salvage value is Zero.
3) Prepaid rent also needs adjustment since the payment all advance payment
is record as an asset at end of one month one month expense should be
recorded against Asset.
4) Periodic inventory system is used.
The periodic inventory system only updates the ending inventory balance in

the Compiled
59
generalByledger when(PhD
Addisu Gemeda you conduct a
Candidate) physical inventory count. 11/24/2020
DREAM BUSINESS INVEST
INVENTORY COUNT AT END OF JANUARY

Unit Of unit of Total
S.N ITEMS NAME Measurment Quanty Unit Cost Amount shortage overage remark
1 GLASS MIRROR M3 175.00 20.00 3,500.00 NO NO

2
3
8
PREPARED BY Approved by

DREAM BUSINESS INVEST

SUMMARY REPORT OF INVENTORY OF JANUARY
TOTAL
EXPLANATION QTY Unit Cost AMOUNT
Beginning Balance - - -
Add: Purchase of inventory 1,000.00 20.00 20,000.00
Less: Ending Inventory 175.00 20.00 (3,500.00)
Cost of Goods Sold 825.00 16,500.00

PREPARED BY Approved by
6. Adjusting Entries

7. Worksheet

8. Financial Statement
What is financial statement?
A financial statement is a quantitative way of showing how a

company is doing.
Propose of financial statement
The general purpose of the financial statements is to provide
information about the results of operations, financial position,
and cash flows of an organization.
This information is used by the readers of financial statements

to make decisions.

Cont’d
Types of Financial Statement

1) Income statement - Reports the company's financial
performance in terms of net profit or loss over a specified period.
Composed of Revenue & Expense
2) Balance sheet -Presents the financial position of an entity at a

given date. It is comprised of the following three elements:
 Assets: Something a business owns or controls (e.g. cash,
machinery, etc.)
Liabilities: Something a business owes to someone (e.g.
creditors, bank loans
Equity: What the business owes to its owners. This represents
the amount of capital that remains in the business after its assets
64 are used
Compiledto pay off
By Addisu its(PhD
Gemeda outstanding
Candidate) liabilities. 11/24/2020
Cont’d
3) Cash Flow Statement - Presents the movement in cash over a

period. It classified into the following segments:
Operating Activities: Represents the cash flow from primary
activities of a business.
Investing Activities: Represents cash flow from the purchase and
sale of assets other than inventories (e.g. purchase of a factory plant).
Financing Activities: Represents cash flow generated or spent on
raising and repaying share capital and debt together with the
payments of interest and dividends.
4) Statement of Changes in Equity: It is a summary of changes in
the owner’s equity of a business entity that have occurred over a
specified period of time
Income Statement

Balance Sheet

Statement of Owner’s Equity

Statement of Cash Flow

9. Closing entries
It is journal entries made in a manual accounting system at
the end of an accounting period to shift the balances in
temporary accounts to permanent accounts. Examples of
temporary accounts are the revenue, expense, and
dividends paid accounts.

10. Post closing Trial Balance

End of Chapter One!!!

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Chapter One

Accounting: Information for Decision Making

• The history of accounting or accountancy is thousands of years old and

can be traced to ancient civilizations.

• Evidences indicated that accounting began as a simple system of clay

tokens to keep truck of goods and animals before developing complex

transactions and other financial information.

• These were practiced at ancient civilizations of Mesopotamia (present Iraq),

• Accounting has evolved, as have medicine, law and most other

fields of human activity in response to the social and economic

• People in all civilizations have maintained various types of

records of business activities.

• The oldest known are clay tablet records of the payment of

wages in Babylonia around 600 B.C.

regarding the cost of labour and materials used in

Early accounting dealt only with limited aspects of

the financial operations of private or governmental

which came to be called as “double entry system”.

was first published in 1494 by Lucas Pacioli.

The onset of the industrial revolution necessitated the

development of more sophisticated accounting system.

led to the rise of accounting as a formal branch of study.

many areas of infrastructure like the railways, steel,

and management of business was divorced.

individuals and institutions looked to accountants to

businesses as cost efficient as possible.

structured systems of accounting to report the

6 Compiled By Addisu Gemeda (PhD Candidate) 11/24/2020

developments. The Income Tax brought about the

Government takes a host of other decisions,

relating to education, health, economic planning,

defined Accounting as “The art of recording, classifying, summarizing,

analyzing and interpreting the business transactions systematically and

communicating business results to interested users.”

the process of:

Communicating of economic information to permit informed judgments and sound

Business. However, a business may have a lot of aspects

which may not be of financial nature.

As such, a better way to understand accounting could be

to call it The Language of Financial Decisions.

student, of a family head, of a manager, of an investor,

the management of financial aspects of living.

investments, income-tax, loans, etc. are based on

The knowledge of accounting is an added

advantage in performing different roles.

11 Compiled By Addisu Gemeda (PhD Candidate) 11/24/2020

 Accounting plays an important role in our economic and

governments, and other entities are essential for the

efficient distribution and use of the nation’s

information provided by the accounting system.

information system that measures, processes, and

information decision makers need to make reasoned

13 Compiled By Addisu Gemeda (PhD Candidate) 11/24/2020

about them for future use.

become useful information.

input to the accounting system and the useful information for

Accounting is often called the language of business.

The following are the advantages of a properly maintained accounting system.

16 Compiled By Addisu Gemeda (PhD Candidate) 11/24/2020

17 Compiled By Addisu Gemeda (PhD Candidate) 11/24/2020

The Users of Accounting Information

Management Those With Direct Those With Indirect

18 Compiled By Addisu Gemeda (PhD Candidate) 11/24/2020