CHAPTER ONE

INTRODUCTION TO ACCOUNTING
After studying this chapter, you should be able to:
Explain what accounting is.
Identify the users and uses of accounting.
Explain accounting standards and measurement principles.
Explain the monetary unit assumption and the economic entity assumption.
State the accounting equation, and define its components.
Analyse the effects of business transactions on the accounting equation.
Understand the four FS’s and how they are prepared.
1.1 EVOLUTION, DEFINITION AND IMPORTANCE OF ACCOUNTING
Accounting has evolved in response to the social and economic needs of society. As business and society
have become more complex over the year, accounting has developed new concepts, and techniques.
Accounting passes through two stages.
Primitive Accounting: a record keeping deals only one single financial operation.
Modern Accounting: record keeping deals both aspect of financial operation at equilibrium. Every
transaction should affect at least two things.
Definition of Accounting
Accounting is the process of identifying, recording and communicating the economic events of an
organization to interested users. 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 goods, the
providing of telephone services. Once a company 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, the company also classifies and
summarizes economic events. Finally, the company communicates the collected information to
interested users by means of accounting reports. The most common of these reports are called financial
statements. The following are Importance of Accounting:
 It determines the operation result of the organization.
 It facilitates rational decision making, for decision makers.
 It keeps systematic record of business transaction.
 It plays important roles in all economic social system.
1.2ACCOUNTING AS INFORMATION SYSTEM
Accounting called as the language of business. This language viewed as information system to make an
informed judgement and decision by the users of information. An Accounting System is designed to
accumulate data about firm financial affairs, classify the data in a meaningful way, and summarize it in
periodic report called financial statement.

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 Characteristics of accounting information and its users
Accounting information is composed principally of financial data about business transaction, expressed
in terms of money, and accounting reports the financial data by sorting and summarizing the recorded
data.
Users of Accounting Information
The results of accounting process are communicated to many individuals and organization. The users of
accounting information may be divided into broad groups: internal users and external users.
1. Internal users: are those individuals directly involved in the process of either planning or
controlling current operation or formulating long range plans and making major business decision. These
include marketing managers, production supervisors, finance directors, and company officers.
Managerial Accounting provides internal reports to help users make decisions about their companies.
Examples are financial comparisons of operating alternatives, projections of income from new sales
campaigns, & forecasts of cash needs for the next year.
2. External users: are individuals and organizations outside a company who want financial
information about the company. The two most common types of external users are investors and
creditors. Financial Accounting provides economic and financial information for investors, creditors,
and others.
 Investors (potential investors): use accounting information to make decisions to
buy, hold, or sell ownership shares of a company.
 Creditors (such as suppliers & bankers): use accounting information to evaluate
the risks of granting credit or lending money.
 Government Regulatory Agency: they are concerned with the financial activities of
business organizations for the purpose of regulation.
 Tax Authorities: government at every level is financed by through the collection of
taxes. For instance income tax, sales tax…
1.3 THE PROFESSION OF ACCOUNTING
Accountants are typically engaged in either private accounting or public accounting. Private Accounting:
Accountants employed in a particular business firm or non-for-profit organization, perhaps as chief
accountant, controller, and financial vice president. Public Accounting: Accountant who render
accounting service on fee basis and staff accountants employed by them.

1.4 ACCOUNTING STANDARDS, MEASUREMENT PRINCIPLES &

ASSUMPTIONS
Accounting Standards
In order to ensure high-quality financial reporting, accountants present FS’s in conformity with
accounting standards that are issued by standard setting bodies. Presently, there are two primary
accounting standard setting bodies—the IASB and FASB. More than 140 countries follow standards
referred to IFRS. IFRS’s (International Financial Reporting Standard) are determined by the
International Accounting Standards Board (IASB). The IASB is headquartered in London, with its 15
board members drawn from around the world.

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Most companies in the US follow standards issued by the Financial Accounting Standards Board
(FASB), referred to as GAAP. As markets become more global, it is often desirable to compare the
results of companies from different countries that report using different accounting standards. In order to
increase comparability, in recent years the two standard-setting bodies have made efforts to reduce the
differences between IFRS and U.S. GAAP. This process is referred to as convergence. As a result of
these convergence efforts, it is likely that someday there will be a single set of high-quality accounting
standards that are used by companies around the world.
Measurement Principles
IFRS generally uses one of two measurement principles, the historical cost principle or the fair value
principle. The selection of which principle to follow generally relates to trade-offs between relevance &
faithful representation. Relevance means that financial information is capable of making a difference in a
decision. Faithful representation means that the numbers and descriptions match what really existed or
happened they are factual.
1. Historical Cost principle (or Cost Principle): It dictates that companies record assets at their cost.
This is true not only at the time the asset is purchased, but also over the time the asset is held.
2. Fair Value principle: It states that assets and liabilities should be reported at fair value (the price
received to sell an asset or settle a liability). Fair value information may be more useful than HC for
certain types of assets and liabilities.
For example, certain investment securities are reported at FV because market value information is
usually readily available for these types of assets. In determining which measurement principle to use,
companies weigh the factual nature of cost figures versus the relevance of fair value. In general, even
though IFRS allows companies to revalue PPE and other long-lived assets to FV, most companies choose
to use cost. Only in situations where assets are actively traded, such as investment securities, do
companies apply the FV principle extensively.
Assumptions
Assumptions provide a foundation for the accounting process. Two main assumptions are the monetary
unit assumption and the economic entity assumption.
1. Monetary Unit Assumption
The monetary unit assumption requires that companies include in the accounting records only transaction
data that can be expressed in money terms. o This assumption enables accounting to quantify (measure)
economic events. The monetary unit assumption is vital to applying the historical cost principle. This
assumption prevents the inclusion of some relevant information in the accounting records. For example,
the health of a company’s owner, the quality of service, and the morale of employees are not included.
The reason: Companies cannot quantify this information in money terms.
2. Economic Entity Assumption
It requires that activities of the entity be kept separate and distinct from the activities of its owner and all
other economic entities.
Proprietorship

Partnership forms of business ownership

Corporation

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 Proprietorship Partnership

Owned by one person Owned by two or Corporation

Owner is often more persons
manager/operator Often retail and Ownership divided into
Owner receives any profits, service-type shares
suffers any losses, and is businesses Separate legal entity
personally liable for all Partnership organized under
debts. agreement corporation law
Generally Limited liability
unlimited personal
liability

1.5 THE DISTINCTION BETWEEN BOOKKEEPING AND ACCOUNTING

Even though book keeping and accounting have partly relationship, they have also a vast difference
which creates some confusion. Accounting is primarily concerned with the designation of the system of
records, the preparation of reports, based on the recorded data, and the interpretation of the report.
Accounting directs and reviews the work of book keepers. In any event, the accountant must have a
higher level of knowledge, conceptual understanding and analytical skill than requisite of the
bookkeeper. Bookkeeping is the art of recording financial transactions of a business enterprise to obtain
and communicate necessary information for decision-makers. Therefore, bookkeeping is the initial or the
recording phase of accounting.
1.6 BUSINESS TRANSACTION AND ACCOUNTING EQUATION
Business transaction is an occurrence of an event or a condition that must be recorded. A particular
business transaction may lead to an event or condition that result in other transaction. For example,
purchase of a machine on credit will be followed by payment to the creditor, which is another
transaction. The wearing out of a machine is not an exchange of goods or service between the business
and an outside, but it has to be recorded. This types of transaction, as well as others that are not directly
related to outsiders, referred as internal transaction.
Basic Accounting Equation
The properties owned by business enterprise referred as assets and the right or claim to the properties are
referred as equities. If the assets owned by a business are Br.50,000, the equity in the asset is also
Br.50,000.
Assets = Equities

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Equities may be subdivided in to two: the rights of creditors and the right of owners. The rights of
creditors represent debt of the business and are called liabilities. The right of owner are called owner’s
equity. Thus, we get the following accounting equation
Assets = Liabilities + Owner’s Equity
Remember that, liabilities should always be placed before owner’s equity in the accounting equation
since creditors have preferential right or claims against the assets.
All business transactions from the simplest to the most complex can be stated in terms of the resulting
changes in the three basic elements of the accounting equation. The following illustration demonstrates
types of transaction and the accounting equation.
Illustration to the accounting equation: assume Mr.X establishes sole proprietorship business that
operates taxi service in Dessie town as XYZ Taxi Compay.
Transaction A
In order to start up the business, Mr. X deposited Br. 10,000 in a bank account in the name of XYZ Taxi
Company. The effect of this transaction is to increase the assets (cash), left side of the equation and to
increase the owner’s equity on the right side of the accounting question by the same amount
Assets = Liability + Owner’s equity
Cash Mr. X Capital
(A) 10,000 10,000 investment
Transaction B
Mr. X purchased land, which costs Br.7, 500 by paying cash. This transaction changes the composition of
the assets but not the total amount
Assets = Liability + Owner’s equity
Cash + Land Mr. X Capital
(A) 10,000 10,000 investment
(B) -7,500 7,500 _
Bal. 2,500 7,500 10,000 ______

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Transaction C
Mr. X purchased Br.850 gasoline, oil, and other supplies and agreed to pay the money in the near future.
This types of transaction is called purchased on account and liability (account payable) is created. The
transaction effect is increasing both assets and liability amounts.
Assets = Liability + Owner’s equity
Cash + Supplies + Land Account payable Mr. X Capital
Bal. 2,500 7,500 10,000
(C) 850 850 ____
Bal. 2,500 850 7,500 850 10,000
Transaction D
Mr. X paid for creditors Br.400 for the supplies purchases in the above transaction, the effect is
decreasing the assets and liabilities.
Assets = Liability + Owner’s equity
Cash + Supplies + Land Account payable Mr. X Capital
Bal. 2,500 850 7,500 850 10,000
(D) -400 -400 _________________
Bal. 2,100 850 7,500 450 10,000
Transaction E
Mr. X taxi provided taxi services for the customers and earned fares (revenue) of Br.4,500, Mr. X
received the total amount of cash from the customers. In general the amount charged to customers for
goods or service 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. Accounts
receivable is as much as an asset as cash and revenue is realized. The effect of this transaction is
increasing both the assets and owner’s equity.
Assets = Liability + Owner’s equity
Cash + Supplies + Land Account payable Mr. X Capital
Bal. 2,100 850 7,500 450 10,000
(E) +4,500 ___ 4,500 Fares Earned
Bal. 6,600 850 7,500 450 14,500

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Transaction F
The amount of assets consumed or services used in the process of earning or generating revenue is called
expenses. Mr. X taxi incurred and paid the following expenses during the month: wage Br.1,125, rent
Br.850, utilities Br.150, miscellaneous Br.75. The effect of this transaction is reducing both assets and
owner’s equity.
Assets = Liability + Owner’s equity
Cash + Supplies + Land Account payable Mr. X Capital
Bal. 6,600 850 7,500 450 14,500
(F) -2,200 -1,250 Wage expense
-850 Rent expense
-150 Utilities expense
-75 Misc.expense
Bal. 4,400 850 7,500 450 12,300
Transaction G
Mr. X’s supplies on hand( not yet used) account for Br.250 at the end of the month, the 600(850-250)
have been used in the operation of the business. The effect of this internal transaction is decreasing both
assets and owner’s equity.

Assets = Liability + Owner’s equity

Cash + Supplies + Land Account payable Mr. X Capital
Bal. 4,400 850 7,500 450 12,300
(G) -600 -600 Supplies Expense
Bal. 4,400 250 7,500 450 11,700
Transaction H
At the end of the month, Mr. X withdraws Br.1,000 in cash from the business for his personal use. This
internal transaction reduces the assets and owner’s equity.
Assets = Liability + Owner’s equity
Cash + Supplies + Land Account payable Mr. X Capital
Bal. 4,400 250 7,500 450 11,700
(H) -1,000 -1,000 Withdrawal
Bal. 3,400 250 7,500 450 10,700____

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 Summary of the above “A” to “H” transactions presented as follow;
Assets = Liability + Owner’s equity
Cash + Supplies + Land Account payable Mr. X Capital
(A) 10,000 10,000 Investment
(B) -7,500 7,500_ _________________________
Bal. 2,500 7,500 10,000
(C) 850 850_____________________
Bal. 2,500 850 7,500 850 10,000
(D) -400 400_____________________
Bal. 2,100 850 7,500 450 10,000
(E) 4,500 +4,500_ Fares earned
Bal. 6,600 850 7,500 450 14,500
(F) -2,200 -1,125 Wages expense
-850 Rent expense
-150 tilities Expense
-75 Misc. Expense
Bal. 4,400 850 7,500 450 12,300
(G) -600 -600 Supplies Expenses
Bal. 4,400 250 7,500 450 11,700
(H) -1,000 -1,000 Withdrawal
Bal. 3,400 250 7,500 450 10,700_

As the above summary shows, at the end of transaction “H”, XYZ Taxi Company has a total of Br.
3,400, supplies of Br.250, land of Br.7,500, and the company also owed (liability) Br.450 to others and
the owner’s equity is Br.10,700. The following point applies for all types of business.
1. The effect of every transaction increases and/or decreases one or more of accounting
equations elements.
2. Equality of the two sides of the accounting equation should be satisfied always.
3. Owner’s equity is increased by the amount invested by owner and revenue earned. In
contrast it is decreased by the amount withdrawal made by the owner and expenses
incurred.
1.7 FINANCIAL STATEMENTS
After the effect of individual transaction has been determined, essential information is communicated to
the users. The accounting statements or reports that communicate this information are called financial
statements. Generally there are four types of financial statements.

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 1.7.1 Financial Statements for Sole Proprietorship and Partnership
The principal financial statements for sole proprietorship are the following:
1. Income Statement: it is a summary of revenue and expenses of a business entity for specific period of
time, such as a month or a year. The excess of revenue over expense 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 asset consumed in generating these revenues must be matched against revenue in order to
determine the net income or the net loss.
2. Statement of Owner’s Equity: it is a summary of changes in owner’s equity of a business entity that
have occurred during specific period of time. Increase in owner’s equity comes from: owner investments
and net income, and decreases in owner’s equity result from: owner’s withdrawals and net loss.
3. Statement of financial position: it is a list of assets, liabilities and owner’s equity of a business entity as
of a specific date. The assets section of a Statement of financial position (left hand side) begins assets of
relatively permanent nature such as land, equipment follow that order. Then followed by supplies
receivables, prepaid insurance, cash and other assets can be converted into cash or used up in the near
future. In the owner’s equity and liability section of the Statement of financial position (right hand side),
the owner’s equity are presented first and followed by liabilities.
4. Statement of cash flows: it reports the cash coming in (cash receipts) and the amount of cash going out
(cash payment) during a period. Business activities result in a net cash inflow (receipts greater than
payments) or a net cash outflow (payments greater than receipts). The statement of cash flow shows the
net increase or decrease in cash during the period and ending cash balance. This statement is reported in
three sections: operating activities, investing activities, and financing activities.
i. Operating activities: this section includes cash transaction that entered to the determination of net
income or net loss. The net cash flow from operating activities normally differs from the amount
of net income for the period.
ii. Investing activities: this section includes the cash transaction for the acquisition and sales of
relatively long term or permanent types of assets.
iii. 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 futures of the four statements and their interrelationship are illustrated by taking data from Mr.
X taxi business as follow:

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 XYZ Taxi Company
Statements of Owner’s Equity
For the Month Ended April 30, 2022

XYZ Taxi Company Investment during the month Br.10,000

Income Statement
Net Income for the month Br.1,700
For the Month Ended April 30, 2022
Fares Earned Br.4,500 Less: Withdrawal 1,000

Less: operating Expenses: Increase in Owner’s Equity 700

Wages expense Br.1,125 Mr. X Capital, April 30,2022 Br. 10,700

Rent expense 850

Supplies expense 600
Utilities expense 150
Miscellaneous expense 75
Total Expenses Br.2,800
Net Income Br. 1,700

XYZ Taxi Company

Statements of financial position
April 30, 2022
ASSETS
Land Br. 7,500
Supplies 250
Cash 3,400
Total Assets Br. 11,150
EQUITY AND LIABILITIES
Owner’s equity
Mr. X Capital Br. 10,700
Liabilities
Account payable Br.450
Total Equity and liabilities Br. 11,150

XYZ Taxi Company

Statement of cash flow
For the Month Ended April 30, 2022
Cash Flow from Operating Activities:
Cash received from customers Br. 4,500
Less: cash payments for expenses and payments to creditor 2,600
Net cash flows from operating activities Br. 1,900
Cash Flow from Investing Activities:
Cash payment for acquisition of land (7,500)
Cash Flow from Financing Activities:
Cash received as owner’s investment Br. 10,000
Less: cash withdrawn by owner 1,000
Net cash flow from financing activities 9,000
Net Cash Flow and April 30,2022 Cash Balance Br. 3,400

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In general, the information generated by the income statement, is entered in to the statement of owner’s
equity. And the information generated by statement of owner’s equity is entered in the Statement of
financial position in the list of owner’s equity. Moreover, the information generated by the statement of
cash flow is entered in the Statement of financial position in the list of Assets.
1.7.2 Financial Statement for Corporation
Business enterprises with large amount of assets are usually organized as corporation and have many
owners, called stockholders. The financial statements of corporations are similar to those of sole
proprietorship and partnership except that retained earnings statement is prepared instead of statement of
owner’s equity. The owner’s equity section of Statement of financial position is referred to as stockholder
equity rather than owner’s equity. In addition, the cash flows from financing activities for a corporation
arise from the sale of capital stock and payment of dividends, rather than from owner’s investment and
drawings.
1. Income Statement: Similar with the income statement prepared for sole proprietorship or/and
partnership.
2. Statements of Retained Earning: The emphasis in reporting the changes in the stockholders’
equity is on the changes in the retained earnings, or net income retained in the business. The
changes in retained earnings that have occurred during a period are reported in retained
earnings statement. Changes in the amount of earnings retained in the business would have
resulted from (1) net income and (2) distribution of earning, called dividends, to owners.
3. Statement of financial position: The only difference between the Statement of financial
position of sole proprietorship or/and partnership and corporation is that the stockholders’
equity section is presented rather than owner’s equity.
4. Statement of cash flow: The only difference between the Statement of financial position of sole
proprietorship or/and partnership and corporation is on the cash flow from financing activities
section, i.e., cash flow arise from the sales of capital stock and the cash payments to the
stockholders in the form of dividends.

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