Financial and Managerial

Accounting

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Chapter one: Introduction to Accounting

Meaning of Accounting

Accounting is famously known as the "language of business". Through the

financial statements, the end-product reports in accounting, it delivers
information to different users.

Accounting is a means through which information about a business entity is

communicated.

Technical definitions of accounting have been published by different accounting

bodies. The American Institute of Certified Public Accountants (AICPA) defines
accounting as:

the art of recording, classifying, and summarizing in a significant manner and in

terms of money, transactions and events which are, in part at least of financial
character, and interpreting the results thereof.
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 Cont…
Accounting consists of three basic activities—it identifies, records, and
communicates the economic events of an organization to interested users.

Three Activities
As a starting point to the accounting process, a company identifies
the economic events relevant to its business.
Examples of economic events are the sale of food and snacks by
Unilever.
Once a company like Unilever identifies economic events, it records
those events in order to provide a history of its financial activities.
Recording consists of keeping a systematic, chronological diary of
events, measured in monetary units. In recording, Unilever also
classifies and summarizes economic events.

Finally, Unilever communicates the collected information to

interested users by means of accounting reports. The most
common of these reports are called financial statements.
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 Cont.…

The accounting process includes the

bookkeeping function.
Bookkeeping usually involves only the
recording of economic events. It is therefore
just one part of the accounting process.
In total, accounting involves the entire
process of identifying, recording, and
communicating economic events.

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Accounting Concerned with transactions and events having financial character

For example, hiring an additional employee is qualitative information

with no financial character. Hence, it is not recorded. However, the
payment of salaries, acquisition of an office building, sale of goods, etc.
are recorded because they involve financial value.

Business transactions are expressed in terms of money

They are assigned amounts when processed in an accounting system.

Using one of the examples above, it is not enough to record that the
company paid salaries for April. It must include monetary figures – say
for example, $20,000 salaries expense.

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Interpreting the results

Interpreting results is part of the phases of accounting. Information is useless if

they cannot be interpreted and understood. The amounts, figures, and other data
in the financial reports have meanings that are useful to the users.

By studying the definition alone, we learned some important concepts in

accounting. It also gave us an idea of what accountants do.

You may not notice but the simple things you do and encounter everyday can
actually be related to some level of accounting. You make budgets, count change
and check the receipts from the supermarket. You may also have listed things you
spent your money with at one point in your life.

We are surrounded by business – from managing our own money to seeing profit
statements of big corporations. And where there is business, there sure is
accounting.
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Branches of Accounting

As a result of economic, industrial, and

technological developments, different
specialized fields in accounting have
emerged.

• financial accounting,
The famous • managerial accounting,
branches or • cost accounting,
types of • auditing, taxation,
• AIS,
accounting • fiduciary, and
include: • forensic accounting. 7
 Cont…

1. Financial Accounting

Financial accounting involves recording and classifying business transactions, and

preparing and presenting financial statements to be used by external users.
In the preparation of financial statements, strict compliance with generally
accepted accounting principles or GAAP is observed. Financial accounting is
primarily concerned in processing historical data.

2. Managerial Accounting
Managerial or management accounting focuses on providing information for use
by internal users, the management. This branch deals with the needs of the
management rather than strict compliance with generally accepted accounting
principles.
Managerial accounting involves financial analysis, budgeting and forecasting, cost
analysis, evaluation of business decisions, and similar areas.

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How Managerial Accounting Adds Value to the Organization

 Providing information for decision making and

planning.
 Assisting managers in directing and controlling
activities.
 Motivating managers and other employees
towards organization’s goals.
 Measuring performance of activities, managers,
and other employees.
 Assessing the organization’s competitive position.
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 Managerial versus Financial Accounting

•• Accounting
Accounting System
System
•• (accumulates
(accumulates financial
financial and
and
managerial
managerial accounting
accounting data)
data)

Managerial
Managerial Accounting
Accounting Financial
Financial Accounting
Accounting
Information
Information for
for decision
decision Published
Published financial
financial
making,
making, and
and control
control statements
statements and
and other
other
of
of an
an organization’s
organization’s financial
financial reports.
reports.
operations.
operations.

Internal External
Users Users
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Managerial versus Financial Accounting

Managerial Accounting Financial Accounting

Users of information Managers within company Interested outside parties

Regulation Required. Must comform to

Not required because for internal
GAAP which is regulated by
use only
FASB and SEC.
Basic accounting system plus Almost exclusively from the
Source of Data
various other sources basic accounting system
Reports often focus on subunits. Reports focus on the enterprise
Nature of Reports Based on a combination of in its entirety. Based on
and Procedures historical data, estimates, and historical transactions.
projections of future events.
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 Cont…
3. Cost Accounting

Sometimes considered as a subset of management accounting, cost accounting refers to the

recording, presentation, and analysis of manufacturing costs. Cost accounting is very useful
in manufacturing businesses since they have the most complicated costing process.
Cost accountants also analyze actual and standard costs to help managers determine future
courses of action regarding the company's operations.

4. Auditing

External auditing refers to the examination of financial statements by an independent party

with the purpose of expressing an opinion as to fairness of presentation and compliance with
GAAP. 
Internal auditing focuses on evaluating the adequacy of a company's internal control
structure by testing segregation of duties, policies and procedures, degrees of authorization,
and other controls implemented by management. 12
 5. Tax Accounting
Tax accounting helps clients follow rules set byCont…
tax authorities.
It includes tax planning and preparation of tax returns.
It also involves determination of income tax and other taxes, tax advisory services such as ways to
minimize taxes legally, evaluation of the consequences of tax decisions, and other tax-related matters.

6. Accounting Information Systems

Involves the development, installation, implementation, and monitoring of accounting procedures and
systems used in the accounting process.
It includes the employment of business forms, accounting personnel direction, and software
management.

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 Cont…

7. Fiduciary Accounting

involves handling of accounts managed by a person entrusted with the

custody and management of property of or for the benefit of another person.

Examples of fiduciary accounting include trust accounting, receivership, and

estate accounting.

8. Forensic Accounting

Involves court and litigation cases, fraud investigation, claims and dispute
resolution, and other areas that involve legal matters.

This is one of the popular trends in accounting today.

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 Objectives of Accounting
Here is the list of objectives that accounting helps the
company to obtain.
1. Permanent Record
 Any business firm needs a permanent record of the
transactions that it indulges in.
 required for internal purpose,
 for taxation purpose or
 for any other purpose.
 Accounting serves this function. Whenever the organization
commits any resource of monetary value either within the
firm or outside the firm, a record is made.
 This permanent record is held on for years and can be
retrieved as and when need be. 15
 Cont…
2. Measurement of Outcome
 A business firm may indulge in numerous transactions
every day.
 It may make profit in some of these transactions while
it may make losses in some other transactions.
 However, the effect of all these transactions needs to
be aggregated over a period of time.
 There must be daily, weekly and monthly reports
which provides information to the organization about
how well it is performing its activities.
 Accounting serves this purpose by providing periodic
financial statements which help the firm adjust their
operations accordingly.
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 Cont…

3. Creditworthiness
 Firms need resources for their functioning.
 Firms do not have any capital stock at hand and
need to obtain them from investors.
 Investors will give money to the firm only if they
have reasonable assurance that the firm will be
able to generate enough profit.
 Past accounting records help a great deal in proving this.
 All kinds of investors from banks to shareholders ask for
past accounting details before they trust the
management with their money.

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 Cont…
4. Efficient Use of Resources
 Firms can also conduct useful internal analysis with the help of accounting
data.
 Accounting records tell the firm what resources were committed to
what activity and what time.
 These records also summarize the return that was obtained from
these activities.
 Management can then analyze past behavior and draw lessons about
how they could have performed better and used resources more
efficiently.
5. Projections
 Accounting helps management and investors look forward. Costs and
revenue growths can be projected after substantial data has been
accumulated.
 The assumption made is that the company is likely to behave exactly as it
has done in the past.
 Thus, analysts can make reasonable assumptions about the future based on
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the past record.
 Fundamental Concepts or Elements of Accounting
 The elements of accounting pertain to assets, liabilities, and capital.
  Assets resource controlled by the entity result of past event expected inflow of
economic benefits
 liabilities are obligations to creditors and lenders; and
  capital refers to the interest of the owners in the business after deducting all
liabilities from all assets (or, what is left for the owners after all company
obligations are paid).
A. Assets
 Assets can be classified as current or non-current.
 An asset is considered current if it is for sale, if it can be realized within 12
month from the end of the accounting period or within the company's normal
operating cycle if it exceeds 12 months. In addition, cash is generally considered
current asset.
• Current assets include: Cash and Cash Equivalents, Marketable Securities,
Accounts Receivable, Inventories, and Prepaid Expenses. Assets that do not meet
the criteria to be classified as current are, by default, non-current assets.
• Examples of non-current assets are: Long-term Investments; Property, Plant and
Equipment; and Intangibles. 19
 Cont…
B. Liabilities
 Liabilities can also be classified as current or non-current.
 A liability is considered current of they are payable within
12 months from the end of the accounting period, or within
the company's normal operating cycle if the cycle exceeds
12 months.
• Current liabilities include: Accounts Payable, Short-term
Notes Payable, Tax Payable, Accrued Expenses, and other
short-term obligations. 
• Non-current liabilities include those that do not meet the
above criteria. Examples of non-current liabilities are: Loans
Payable and Bonds Payable which are long-term in nature,
and Deferred Tax Liabilities.
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 Cont..
C. Capital
 Capital refers to the interest of the owner/s of the business. The owner's
interest is the value of total assets left after all liabilities to creditors and
lenders are settled.
 Capital is increased by contributions by the owner/s and income. It
is decreased by withdrawals by owners (dividends in
corporations) and expenses.
D. Income
 Income refers to an increase in assets or decrease in liability, and an increase
in capital other than that arising from contributions made by owner/s.
 Examples of income accounts include: Sales, Service Revenue,
Professional Fees, Interest Income, Rent Income, and others.
E. Expense
 Expenses result in decrease in assets or increase in liabilities, and decrease in
capital other than those arising from withdrawals of the owner/s.
 Some examples are: Cost of Sales, Salaries Expense, Rent Expense, Utilities
Expense, Delivery Expense, and others.
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 Principles and Rules of Accounting
 Accounting Principles:
 Accounting assumptions and principles provide the bases in
preparing, presenting and interpreting general-purpose
financial statements.
1. Accrual
 Income is recognized when earned regardless of when
collected, and expenses are recognized when incurred
regardless of when paid.
2. Going Concern
 Also known as continuing concern concept or continuity
assumption, it means that a business entity will continue
to operate indefinitely.
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 Cont…
3. Accounting Entity Concept
 A specific business enterprise is treated as one
accounting entity, separate and distinct from its owners.
4. Time Period Assumption
The indefinite life of an enterprise is subdivided into
time periods or accounting periods
 which are usually of equal length for the purpose
of preparing financial reports.
5. Monetary Unit Assumption
Transactions are recorded in terms of
money (quantifiability).

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 What is IFRS?
IFRS is a globally recognized set of Standards for the preparation of financial statements by
business entities.

• single-set of high quality

• globally accepted and enforced set of standards that require high quality, transparent and
Comparable information in financial statements

Those Standards prescribe:

the items that should be recognized as assets, liabilities, income and expense

how to measure those items;

how to present them in a set of financial statements; and

related disclosures about those items. 24

 Cont…

Ethiopia passed a financial reporting law in 2014 which requires

the use of IFRS by commercial businesses operating in Ethiopia.

Proclamation No. 847/2014

Regulation No. 332/2014

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 Rules of Accounting
 Golden Rules of Accounting
1. Debit The Receiver, Credit The Giver
 This principle is used in the case of personal accounts.
When a person gives something to the
organization, it becomes an inflow and therefore
the person must be credit in the books of accounts.
The converse of this is also true, which is why the
receiver needs to be debited.

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 Cont…
2. Debit What Comes In, Credit What Goes Out
 This principle is applied in case of real accounts.
 Real accounts involve machinery, land and building
etc.
 They have a debit balance by default.
 Thus when you debit what comes in, you are adding
to the existing account balance. This is exactly what
needs to be done.
 Similarly when you credit what goes out, you are
reducing the account balance when a tangible asset
goes out of the organization.

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 Cont…
3. Debit All Expenses And Losses, Credit All Incomes And Gains
 This rule is applied when the account in question is a
nominal account.
 The capital of the company is a liability. Therefore it has a
default credit balance.
 When you credit all incomes and gains, you increase the
capital and by debiting expenses and losses, you decrease
the capital. This is exactly what needs to be done for the
system to stay in balance.
 The golden rules of accounting allow anyone to be a
bookkeeper. They only need to understand the types of
accounts and then diligently apply the rules.

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 The General Rules of Debit And Credit
Accounting Element To Increase To Decrease

1.Assets Debit Credit

2. Liability Credit Debit
3. Capital Investment Credit Debit
4. Capital - Withdrawal Debit Credit
5. Income Credit Debit
6. Expense Debit Credit

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 Double Entry Bookkeeping System in Accounts

 The double entry system of bookkeeping is said to have

revolutionized growth in modern business.
 It is only because businesses are able to keep track of their
growing scale of transactions efficiently that they grow
further.
 This has been facilitated by a well designed, error
preventing accounting system called the double entry
system.
 What Is Double Entry System ?
 In a double entry bookkeeping system there are two sides
to every transaction.
 The sides are equal in magnitude i.e. the debits
must always equal the credits.
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 Cont..
 Large Firms
 When a firm grows beyond a certain size it has to use double
entry system of accounting. This is both because it is mandated
by law as well as because it is the most efficient system.
 Complete Records
 Double entry accounting system keeps a record of all major
accounting transactions.
 These could be transactions outside the firm with third
parties.
 Or they could be intra firm transactions where raw
material has now been converted to Work In Progress
(WIP).
 By making sure every record about credit as well as intra firm
transactions is being accounted for, double entry system
provides the most accurate record. 31
 Cont…
 Automatic Reconciliation
• As the scale of a business grows, it becomes more prone to
clerical errors.
• A clerk accounting for a large number of transactions all day
is bound to make some mistakes.
• However, the double entry system does not allow these
mistakes to have a cascading effect.
• This is because the system is constantly checking whether
total debits equal total credits.
• When they are not, accountants know they are dealing with
an error.
• They can then find out the error, correct it and then move
forward. This saves a lot of time and builds incredible
accuracy in the system. 32
 Cont…
 However the double entry accounting system is not 100%
error proof. There is a possibility that an entry may have
been completely omitted or that there may have been
compensating errors done while passing the entry.
 Fraud is Difficult
 Just like reconciliation, when a business grows, more and
more responsibilities need to be entrusted to workers.
 Many times this leads to frauds by the workers as they
embezzle cash and make use of resources for personal
benefits.
 However, the double entry accounting system, when used
correctly prevents such situations from arising.
 The system has strong inbuilt controls to avoid misuse of
any resources. 33
Classification of Accounts
 What is an Account?
 In accounting, an account is a descriptive storage unit
used to collect and store information of similar nature.
 For example, "Cash". Cash is an account that stores all
transactions that involve cash receipts and cash payments.
All cash receipts are recorded as increases in "Cash" and all
payments are recorded as deductions in the same account.
 Types of Accounts
 All accounts within the organization can be split into
three types.
 An account can be of one and only one of the following
type and not more. Here are the various types of
accounts.
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 Cont…
1. Personal: Personal accounts make most intuitive sense.
 We keep a track of all the transactions that we have undertaken
with a particular person in them.
 We all maintain personal accounts like the money we owe our
friends, the grocer and so on.
2. Real: Real accounts are accounts which have been created to
account for tangible things.
 Accounts such as land and building, machinery a/c etc are called real
accounts.
3. Nominal: Nominal accounts are a special category of accounts.
 While the other accounts can hold balance and carry it forward,
nominal account are automatically reset to zero as soon as the time
period is over.
 Their balance is carried forward to other accounts and the books for
that period are closed.
 Examples of such accounts are Profit a/c, depreciation a/c etc. 35
End of Chapter one

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