CHAPTER ONE

INTRODUCTION TO ACCOUNTING AND BUSINESS

Learning Objectives
After thoroughly learning this chapter, you should be able to:
 Describe the nature of Businesses and the role of Accounting in Business

 Summarize the development of accounting principles and relate them to practice

 State the accounting equation and describe each element of Accounting equation

 Describe and illustrate how business transactions can be recorded in terms of the resulting change in
the elements of accounting equation

 Describe financial statements and their relation ships

1.1. Introduction
Welcome to the world of Accounting and Finance! And to the world of Economic activities of Businesses! This
course introduces you to Accounting, the language of business.

Why is accounting so popular? What consistently ranks as one of the top career opportunities in business? What
frequently rates among the most popular majors on campus? What is the undergraduate degree chosen by most
Business owners and professionals? Why did these people choose accounting?
They wanted to understand what was happening financially to their organizations. Accounting is the financial
information system that provides these insights. In short, to understand your organization, you have to know the
numbers. Accounting consists of three basic activities—it identifies records, and communicates the economic
events of an organization to interested users.

You should understand that 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, measuring and communicating economic
events.

1.2. The nature of business and accounting

Activity
Accounting exists because Businesses and their economic activities exist. What is Business in this context?
A Business is an organization in which basic resources (inputs) such as material and labor, are assembled and
processed to provide goods or services (outputs) to customers. It can be small sized (like Local Coffee Houses)
or very Large(like MIDROC which has many million turnover per year).

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. In
this text, we focus on businesses operating to earn a profit. However many of the same concepts and principles
also apply to not-for profit organizations such as hospitals, churches, and government agencies.

1
TYPES OF BUSINESSES
Businesses operating in the economy about which financial information is summarized and reported can be
classified in different ways. One way of classifying is based on the activities in which they could be engaged.
Based on the activities in which they are engaged businesses can be classified in to four:
1. Service giving businesses
2. Merchandising businesses
3. Manufacturing businesses
4. Construction firms

Service givingfirms are those businesses which provide services rather than products. Examples of service
giving businesses include; Ethiopian Airlines, Selam Bus, Sky Bus, Oromiya International Bank, Ethiopian
Insurance Company, Hilton Hotel, Abebech Hotel, etc…
Merchandising businesses are those entities which sell the products they purchase from others to customers.
Examples of such firms include; ETBC, Alsam Plc, OMEDAD, DIRE Electronics, Amazon.com, etc…
Manufacturing businesses are those organizations which changes/transforms inputs in to products or finished
goods that are sold to customers. Examples of such firms are: General Motor Corporation, Lifan Motors,
Abesha Cement factory, Mugar cement factory, Fincha sugar factory, Bedel Brewery, Fafa food complex, etc…
Construction businesses are firms whose activities are somehow similar to the manufacturing firms because the
process of conversion of raw materials to finished goods is available here too. Construction firms however have
peculiar nature in that they are mostly engaged in long term construction contracts such as construction of
buildings, roads, bridges, dams, etc… Examples of such firms include: MIDROC Construction, Sunshine
Construction, Satcon Construction, etc…

Looking at the form of ownership, any of the above organizations can fall under any of the following three
categories:
1. Sole proprietorship
2. Partnership
3. Corporations/Share Companies
Proprietorship. A business owned by one person is generally a proprietorship. The owner is often the
manager/operator of the business. Small service-type businesses (plumbing companies, beauty salons, and auto
repair shops), farms, and small retail stores (antique shops, clothing stores, and used-book stores) are often
proprietorships. Usually only a relatively small amount of money (capital) is necessary to start in business as a
proprietorship. The owner (proprietor) receives any profits, suffers any losses, and is personally liable for all
debts of the business.
There is no legal distinction between the business as an economic unit and the owner, but the accounting
records of the business activities are kept separate from the personal records and activities of the owner.
Partnership. A business owned by two or more persons associated as partners is a partnership. In most respects,
a partnership is like a proprietorship except that more than one owner is involved. Typically a partnership
agreement (written or oral) sets forth such terms as initial investment, duties of each partner, division of net
income (or net loss), and settlement to be made upon death or withdrawal of a partner. Each partner generally
has unlimited personal liability for the debts of the partnership. Like a proprietorship, for accounting purposes
the partnership transactions must be kept separate from the personal activities of the partners. Partnerships are
often used to organize retail and service-type businesses, including professional practices (lawyers, doctors,
architects, and certified public accountants).
Corporation. A business organized as a separate legal entity under state corporation law and having ownership
divided into transferable shares of stock is corporation. The holders of the shares (stockholders) enjoy limited
liability; that is, they are not personally liable for the debts of the corporate entity. Stockholders may transfer all
or part of their ownership shares to other investors at any time(i.e., sell their shares). The ease with which
ownership can change adds to the attractiveness of investing in a corporation. Because ownership can be
transferred without dissolving the corporation, the corporation enjoys an unlimited life.

2
1.3. The role of accounting in business
Activity
What do you think are the role of Accounting in Business?

Accounting provides information to the managers to use in operating the business and also provides information
to other users in assessing the economic activities and condition of the business.
Hence Accounting can be defined as: an information system that provides information to users about the
economic activities and conditions of the business so that the users can make informed decisions.

As an information system it consists of:

Inputs Processing Output
Economic events Analyzing Information
Documents/vouchers Recording
Data Summarizing
Reporting
Interpreting
Accounting can be thought of as the language of business because it is the means by which business financial
information is communicated to users.
The process by which Accounting Information System can provide information:
i. Identify the users of an information
ii. Assess users’ information needs
iii. Design the appropriate AIS to meet information needs
iv. Record economic data about activities and events/admit events in to AIS
v. Prepare accounting reports to users

In total Accounting can be described as the art/process of identifying, recording, and summarizing,
communicating and interpreting financial information to the users.
Who are the users of accounting information/data?
The users of accounting information of any business can be classified as:
1. Internal users
2. External users

Internal users of accounting information are those individuals inside a company who plan, organize, and run
the business. These include marketing managers, production supervisors, finance directors, and company
officers. In running a business, internal users must answer many important questions relating to the business,
prices, costs, cash flows, dividend payments, etc…
To answer these and other questions, internal users need detailed information on a timely basis. 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, and forecasts of cash
needs for the next year.

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. Investors (owners) use
accounting information to make decisions to buy, hold, or sell ownership shares of a company. Creditors (such
as suppliers and bankers) use accounting information to evaluate the risks of granting credit or lending money.
Taxing authorities (such as Revenue Bureaus and Ethiopian Revenue and Customer Authority) want to know
whether the company complies with tax laws. Regulatory agencies, want to know whether the company is
operating within prescribed rules. Customers are interested in whether a company will continue to honor

3
product warranties and support its product lines. Labor unions want to know whether the owners can pay
increased wages and benefits.

The information needs of external users vary considerably. Financial accounting answers these questions. It
provides economic and financial information for investors, creditors, and other external users.

1.4. The profession of accountancy

Activity
Can you describe the development of accounting and career opportunities in accounting? Please try it before
moving to the following.

1.3.1Evolution of Accounting
Accounting is the result of changes in socio economic, political and technological environment. Historically
there was an evidence of record keeping in Babylonia around 3600 BC to provide information for wage
payments. There are also evidences of the existence of record keeping and primitive accounting control in
ancient Egypt and Greece City states.
The ground breaking achievement in the history of Accounting was, however, the innovation of Double entry
system in the late 15th century by Luca Pacioli, an Italian Renaissance mathematician.
In addition, the industrial revolution of mid-nineteenth Century in England, expansion of business operation and
formation of large corporation in USA in 20th Century and the increased interest of the governments in
organizations’ operating results, advancements in technology has necessitated accounting. Improvements in
business activities and increased complexities of running today’s business and the globalization have
contributed to the development of accounting profession.

1.3.2 The current status of accounting profession

Accounting is the profession that has experienced rapid development in this century which is accompanied by
increased career opportunities in accounting and finance areas.
As Professional Accountants/finance experts, accountants can fall under either of the following categories: 1)
Private accountants 2) Public accountants
Accountants employed by a business are said to be employed in private accounting. Private accountants have
a variety of possible career options within company. Some of these career options are Payroll clerk, General
accountant, Budget analyst, Cost accountant, internal auditor
Information technology auditor, Financial Manger, etc…

1.3.3. Specializations in Accounting

The following are among the specified field in Accounting and Finance:
Managerial Accounting: It is an Accounting information system which focuses on providing information for
internal users, especially for the management of the organization about the costs, forecasts, product prices, plans
to expand and possible investment plans.
Financial Accounting: It is an Accounting Information System which focuses to provide information mainly
for external users about performance, financial positions, claims and cash flows. It also focuses on providing
relevant and reliable information for decision making needs of investors, creditors, government agencies and
others. It usually provides General Purpose financial information.
Auditing: It focuses on an independent review of records and assurance services.
Tax Accounting: It mainly focuses on determining tax returns.
Budgetary Accounting: It is concerned with financial plans and comparisons.
Accounting Systems: Designing procedures and systems for accounting and recording data.

4
Corporate finance: It is mainly concerned with Financial Management and analysis, capital budgeting for
investment decisions
There are also other fields of specialization in finance and investments.

1.4. Accounting principles and practices: International Financial Reporting standards (IFRS) and
Conceptual Framework
1.4.1. International Financial Reporting standards (IFRS)
In accounting there are certain standards to follow in order to produce useful information. Can you gauge these
principles to be followed?

Accountants follow certain standards in undertaking accounting activities and reporting financial information.
These standards are generally accepted and universally practiced. The common set of standards applied across
the globe and in Ethiopia is International Financial reporting Standards (IFRS).
These standards emanate from, researches, and accepted accounting practices, pronouncements of regulators,
bulletins/opinions issued by professional bodies, and standards issued by recognized Professional organizations.
In IASB-International Accounting Standard Board has primary responsibility to develop accounting principles.
Many countries relies on IFRS(International Financial Reporting Standards). Globally, the influential standard
setting body in accounting is International Accounting Standard Board (IASB) which develops IFRS/IAS
(International Financial Reporting Standard/International Accounting Standard. However, these rules and
sets of concepts are further influenced by the accounting environment of countries such as: social and cultural
values, political and legal systems, etc

In Ethiopia, Accounting and Auditing Board of Ethiopia (AABE) is responsible to Issue standards and
directives relating to financial reporting and auditing. Ethiopia passed a financial reporting law in 2014,
Proclamation No. 847/2014 and Regulation No. 332/2014, which requires the use of IFRS by commercial
businesses operating in Ethiopia.

The proclamation requires that Commercial organizations to follow International Financial Reporting Standards
(IFRS), or International Financial Reporting Standards for Small and Medium Enterprises (IFRS for SME) ;
Charities and societies to follow International Public Sector Accounting Standards (IPSAS) and Public auditors
to follow International Standards for Auditing.

As per AABE, Public interest entity (PIE) should use the full IFRS. A PIE is a reporting entity that is of
significant public relevance because of the:
 nature of its business,
 its size,
 its number of employees.
PIE also includes banks, insurance companies, and any other financial institutions and public enterprises.
Nevertheless, Small or medium enterprises (SME) are not considered as public interest entity

What is IFRS?
IFRS (International Financial Reporting Standards) is single-set of high quality,globally accepted and enforced
set of standards that require high quality, transparent and comparable information in financial statements and is
issued by IASB [International Accounting Standards Board]
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

5
 5
m
C
6
1
p
R
F
4
2
-
)
I
(
s
d
S
g
u
c
A
l
o
i
a
r
e
t
n
3
 Related disclosures about those items.

IAS 1: Presentation of Financial Statements

IAS 2: Inventories
IAS 7: Statement of Cash Flows
IAS 8: Accounting Policies, Changes in Accounting Estimates and Errors
IAS 10: Events after the Reporting Period
IAS 11: Construction Contracts (will be superseded by IFRS 15 as of 1 January 2018)
IAS 12: Income Taxes
IAS 16: Property, Plant and Equipment
IAS 17: Leases (superseded by IFRS 16 as of 1 January 2019)
IAS 18: Revenue (will be superseded by IFRS 15 as of 1 January 2018)
IAS 19: Employee Benefits
IAS 20: Accounting for Government Grants and Disclosure of Government Assistance
IAS 21: The Effects of Changes in Foreign Exchange Rates
IAS 23: Borrowing Costs
IAS 24: Related Party Disclosures
IAS 26: Accounting and Reporting by Retirement Benefit Plans
IAS 27: Separate Financial Statements
IAS 28: Investments in Associates and Joint Ventures
IAS 29: Financial Reporting in Hyperinflationary Economies
IAS 32: Financial Instruments: Presentation
IAS 33: Earnings per Share
IAS 34: Interim Financial Reporting
IAS 36: Impairment of Assets
IAS 37: Provisions, Contingent Liabilities and Contingent Assets
IAS 38: Intangible Assets
IAS 39: Financial Instruments: Recognition and Measurement (will be superseded by IFRS 9 as of 1 January
2018)
IAS 40: Investment Property
IAS 41: Agriculture

IFRS 1: First-time Adoption of International Financial Reporting Standards

IFRS 2: Share-based Payment
IFRS 3: Business Combinations
IFRS 4: Insurance Contracts (will be superseded by IFRS 17 as of 1 January 2021)
IFRS 5: Non-current Assets Held for Sale and Discontinued Operations
IFRS 6: Exploration for and Evaluation of Mineral Resources
IFRS 7: Financial Instruments: Disclosures
IFRS 8: Operating Segments

6
IFRS 9: Financial Instruments (will replace IAS 39 as of 1 January 2018)
IFRS 10: Consolidated Financial Statements
IFRS 11: Joint Arrangements
IFRS 12: Disclosure of Interests in Other Entities
IFRS 13: Fair Value Measurement
IFRS 14: Regulatory Deferral Accounts
IFRS 15: Revenue from Contracts with Customers (will replace IAS 11 and IAS 18 as of 1 January 2018)
IFRS 16: Leases (replaces IAS 17 as of January 1, 2019)
IFRS 17: Insurance Contracts (replaces IFRS 4 as of January 1, 2021)

1.4.2. Conceptual Framework-base of accounting principles & Standards

Conceptual Framework sets out the concepts that underlie IFRS financial statements
The conceptual framework comprises of:
 The objectives of financial reporting,
 The qualitative characteristics of accounting information,
 Accounting assumptions and principles: recognition, measurement, presentation and disclosure
 Basic elements of financial reports, and
 Other concepts all flow from the objective
1. Objectives of Financial reporting

2. Qualitative Characteristics of Accounting Information

7
 3. Accounting assumptions and principles
Accounting and reporting generally follows the specific IFRS standards for recognition, measurement,
presentation and disclosure of financial information. However there is general underlying assumptions or
usually called general principles in accounting and reporting.

The fundamental concepts are discussed as follows;

1. Business Entity/Economic entity concept

This principle requires that the activity of the business entity should be kept separate and distinct from the
activities of its owners and other economic entity. i.e. for any business one need to report the result of economic
activities of the organization only.

2. Monetary Unit Assumption

It requires that the accounting records of the company should include the data which can be expressed in terms
of monetary value. That means the unit of measurement in accounting is money expressed in certain
denominations.

3. Going Concern concept

This concept assumes that the organization once established has indefinite life or the existence of business for
indefinite period of time to the future. Hence Accounting measurements, recognition of the elements of financial
report assumes this as an underlying assumption. For example, expenditures for the resources from which the
company generates future economic benefits are recognized as assets not expense.

4. Periodicity Assumption
Even though the entity is assumed to be going concern, periodic classification continue; i.e., Monthly, quarterly,
yearly for reporting purpose so that the information would be useful for decision making.

8
 5. The measurements/ basis of Valuation

Specific standards required that elements of financial reports are initially admitted in to the accounting records
at their initial cost or purchase price. Subsequently changes may be made to initial costs to fair value, NRV or
Replacement cost, etc… measurement. For example: Suppose Mega Publishing So the basis of measurement
may be Historical cost, current cost, Cost, Fair value, NRV, Present value, as the case may be . Hence, the
measurement basis in IFRS could be:
 Historical cost: cash paid or fair value of consideration given
 Current cost: Cash that would be paid if acquired now
 Realizable (settlement) value: cash that could be obtained by selling the asset now
 Present value: present discounted value of future net cash inflows that the item is expected to generate
6. Accrual basis model.
There are two accounting models to recognize and report Revenues and Expenditures and other elements of
financial report. These are Accrual basis and Cash basis. The concepts, standards and principles of International
Financial reporting Standards and other pronouncements issued by IASB takes Accrual basis of Accounting as
underlying concept. Accrual basis is an accounting approach where revenues and expenses are recognized on an
economic basis regardless of when cash is paid or received.

1.5. Elements of the Financial Statements and Accounting equation

The Basic Elements or building blocks of the financial statements that is the basic and general financial
information reported for external users by business organizations are:
1) Assets,
2) Liabilities,
3) Net Assets/owners’ equity,
4) Revenues/Income,
5) Expenses,

Well, in any organization the total resource owned by the organization is the same as the value of the total
investment on that organization. All the resources that an organization owns are usually named in accounting,
Assets. Therefore, Assets are resource that an organization control by the entity as a result of past event from
which there is expected inflow of economic benefits.

In the assets of the business there are claims; which might be the claims of the creditors (an amount owed) or
the claims of the owners (residual equity).

The Assets are therefore, the total investments and the rights to these assets are either the rights (claims) of the
creditors or the rights (claims) of the owners. The claims of the creditors are described in accounting as
Liabilities and the claims of the owners are described as Owners’ equity/residual equity.
Liabilities are present obligation arising from past event that leads to expected outflow of economic benefits
The logical deduction from the above discussion results in the following equation which reveals the relationship
among assets, liabilities and owners’ equity.

ASSETS = LIABILITIES + OWNERS’ EQUITY

Notes About the above equation

 It is usually described as the basic accounting equation which provides the underlying framework for
recording and summarizing economic events. The three (Assets, Liabilities and Owners’ Equity) are
called elements of the accounting equation.

9
  The equation applies to all organizations regardless of their form, nature and regardless of the
activities in which they are engaged.
 Assets must be equal to the of liabilities (amount owed or total debt) and the amount of residual
equity (owners’ equity or capital or stockholders’ equity).
 Liability is written before owners’ equity to reflect that the creditors have prior claims/rights over the
assets of the business than the owners. I.e. creditors are paid first up on liquidation.

Let’s have close look in to the above elements of the accounting equation.
Assets:
As it is described above, assets constitute what an organization owns. Which include; cash, supplies,
Receivables, inventories, furniture and fixtures, equipment and facilities, Building and land
Liabilities:
Liabilities are the amount owed to an organization. They constitute obligations involving future sacrifices of
assets/economic benefits. Liabilities are identified in accounting records by the suffix “… payables”. Examples
can be Accounts Payable, Note payable, Interest payables, Bonds payable, etc…
Owners’ Equity:
Owners’ equity represents the residual claim of the owner and is the referred as the rights of the owners over the
assets of the enterprises. Owner’s equity changes due to the following:
- Investment by owners: This constitutes assets that the owners put in to the business.
- Incomes/Revenues: This constitutes an increase in owners’ equity resulting from activities to generate
income. Hence, Income is recognised increase in asset/decrease in liability in current reporting period
that result in increased equity except contributions from owners
- Expenses: this constitutes cost of assets or services used in generating revenue. Expenses are recognised
decrease in asset/increase in liability in current reporting period that result in decreased equity except
distributions to owners
- For example: payment of salary expense, payment of water/electric bill, consumption of supplies.
- Withdrawal: this is an amount which is taken out from the business by the owners for their personal use.
The first two make the owners equity to increase and the later two make the owners equity to decrease.

1.6. Business Transactions and financial statements

Activity
Can you describe business transactions? Please try to an example.
1.6.1.Business transactions
Well! Business transaction is condition or event or economic activity which directly changes an entity’s
financial condition or its results of operation. The following can well describe the nature of a business
transaction:
- Any transaction affects the financial condition means it affects at least one of the three elements of the
accounting equation. For example a payment of cash to purchase equipment for $20, 000 affects an
asset. i.e. it results in an increase to equipment and a decrease to cash.
- Therefore, any business transaction can be stated in terms of the changes in the elements of the
accounting equation.
- Nevertheless, the equilibrium (the equation) is maintained at any time since there is Double entry
system which systematically reflects the economic duality of all transactions.
- All business transactions are expressed in terms of money.
- A particular business transaction may lead to an event or a condition that result in another transaction.
For example, the purchase of merchandise on credit will be followed by payment to the creditor, which
is another transaction. Each time a portion of a merchandise sold, another transaction occurs.

10
Business transaction could be internal transaction or External transaction. External transactions are an
exchange of goods or services between the business and an outsider. Internal transactions are not an exchange
of goods and services between the business and an outsider, but these are conditions that must be recorded. For
example: the wearing-out of building, consumption of office supplies, etc.

 Activity

Do the following activities constitute a transaction?

Yes No
1. Talking with customers
2. Answering the telephone
3. Hiring and firing employees
4. Placing merchandise orders
5. Offering a certain amount to buy an item

Note: To be a transaction an event/activity must affect the financial position of the company and must be able to
be recorded in the financial records.
₤ Transaction and the accouning equation

As pointed out earlier All business transactions, from the simplest to the most complex, can be stated in terms
the resulting change in the three basic elements of the accounting equation.
Illustration: -Assume that Mr X establishes a sole proprietorship to be known as x- taxi.

Transaction a
Mr. X’s first transaction is to deposit 10,000bir in a bank account in the name of x-taxi price. The effect
of this transaction is to increase the asset (cash) , on the left side of the equation by 10,000birr and to increase
the owners equity, on the other side of the equation by the same amount.

Assets = Liabilities + owner’s equity

A Cash 10,000 Mr. X-capital

10,000

It should be noted the equation relates only to the business enterprise Mr. X’s personal assets, such as his home
and his personal bank account, and his personal liabilities are excluded from consideration.
The business is treated as a separate entity, with cash of 10,000 (asset) and owners’ Equity of 10,000. Recall the
Business Entity concept.

Transaction B

 Mr. X next transaction is to purchase land as a future building site for which 7500 in cash is paid. This
transaction changes the composition of the assets but does not change the total amount.

Assets Liabilities + Owner’s E

Cash + Land
Beg. Bal 10,000

11
 b -7,500 + 7500 10,000
End. Bal 2500 7500

10,000 = 10,000

Transaction c

During the month, X- Co. – purchases 850 birr of gasoline, oil and other supplies from various
suppliers, agreeing to pay in the near future.
 This type of transaction is called a purchase on Account and the liability created is termed accounts
payable.
 The effect of this transaction is to increase assets and liabilities by 850birr a follow:
Assets Liabilities + Owner’s Equity
Cash + Supplies + Land Accounts + x- capital
25000 850 7500 850 10,000

10,850 10,850

Transaction d

 During the month, 400birr is paid to creditors on account, thereby reducing both assets and Liabilities.
The effect of this equation is as follow:

Assets Liabilities + Owner’s Equity

Cash + Supplies + land
Beg. Bal 2500 Account payable + X- capital
(d) - 400 850 7500 850 10,000
Bal. 2100 -400
Bal. 450 10,000
10,450 10,450

Transaction E

During the first month of operation Mr. X’s- business earned fee of 4500birr receiving the amount in cash. The
total effect of these transaction is to increase cash by birr 4500 and to increase owners’ equity by the same
amount. In terms of the accounting equation, the effect of the receipt of cash for the services performed is as
follow:
Assets
Liabilities + Owner’s Equity
Cash + Supplies + Land Accounts pay. X- capital
Bal. 2100 850 7500 85010,000
e + 4500 -400 + 4500
Bal. 6,600 850 7500 450 14,500

14,95014,950

12
 In general, the amount charged to customers for goods or services sold to them is called revenue. Other terms
may be used for certain kinds of revenue, such as sales for the sale of merchandise or business services, fees
earned for charges by physician to patients, rent earned for the use of real estate or other property, and fares
earned by Taxi service providers.
Instead of requiring the payment of each at the time goods or services are sold, a business may make sales on
account, allowing the customer to pay later. In such cases, the firm acquires an account receivable, which is a
claim against the customer. An account receivable is as much an asset as cash , and the revenue is realized in
exactly the same manner as if cash had been immediately received. At a later date, when money is collected,
there is only an exchange of one asset for another, with cash increasing and accounts receivable decreasing.

Transaction F
In broad sense, the amount of assets consumed or services used in the process of earning revenue is called
expense. Expenses would include supplies used wages of employees and other assets and services used in
operating the business.
 For X- taxi various business expenses incurred and paid during the month were as follows: Wages , 1,
125birr, Rent, 850birr; Utilities 150birr; miscellaneous 75birr. The effect of this group of transactions is
to reduce cash and to reduces owner’s equity, as follow:

Assets Liabilities + Owner’s Equity

Cash + Supplies + Land Acct. pay. + x-capital
Bal. 6600 850 750 450
(f) - 2,200 14,500
-1,125 Wages Exp.
- 850 Rent Exp.
- 150 Uti. Exp.
-75 Mis. Exp
4400 850 750 = 450 12, 300

12,750 12,750
Transaction g
At the end of the month it is determined that the cost of the supplies on hand is 250, the remainder (850-250)
having been used in the operations of the business. This reduction 600birr in supplies and owner’s equity is
shown as follows:
Assets

Cash + Supplies + Land Liabilities + Owner’s Equity

Acct. Pay. X- capital

Bal. 4400 850 7500 450 12,300

(g) -600 -600supp.exp.
Bal. 4400 250 7500 450 117000

12,150 === 12,150

13
Transaction h

At the end of the month, Mr. X- withdraws, from the business 1000birr in cash for his personal use. This
transaction, which reduces cash and reduces owner’s equity, is the exact, opposite of an investment in the
business by the owner. It is not a business expense, but a withdrawal of a portion of the owner’s equity. The
effect of the 1000 withdrawal is as follow:-

Assets
Cash + Supplies + Land liabilities + Owner’s Eq.
Acc. Pay.
Bal. 4,400 250 7500 450 11,700
h -1000 -- -- -- -1,000 withdrawal
Bal. 3400 250 7500 450 10,700

11,150 == 11,150

Summary:-

The business transaction of x- taxi is summarized in tabular form, as follows.

The transactions are identified by letter, the balance of each item is shown after each transaction.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Accounts. Pay + x- Capital
a + 10,000 + 10,000
b -7500 +7500 ------
2500 7500 10,000
c 2500 + 850 7500 +850 10,000
2500 850 7500 850 10,000
d -400 _____ _____ -400 ______
2100 850 7500 450 10,000
e + 4500 _ _--___ __--___ __--___ 14500
6600 850 7500 450 14500
f -2200 -1125W.Exp
-850 R.Exp.
-150.U.Exp.
______ _________ _______ _________ - 75 Mis. Exp.
4400 850 7500 450 12300
g _____ -600 _____ ______ -600
4400 250 7500 450 11700
h -1000 _____ _____ ______ -1000
3400 250 7500 450 10,700

Note the following observations, which apply to all types of business.

1. The effect of every transaction can be stated in terms of increases and /or decreases in one or more of
the accounting equation element.
2. The equality of the two sides of the accounting equation is always maintained.

14
 3. The owner’s equity is increased by amounts invested by owner and decreased by withdrawals by the
owner. In addition , owner’s equity is increased by revenues and is decreased by expenses.

Owner’s Equity

Decreased by Increased by

Owner’s withdrawals Owner’s Investments

Expenses Revenues
Effects of transactions owner’s Equity

Portrait- painting business of Joan Smith

Exercise
Transaction
1. On January 1, 1994, Joan Smith began her business by investing $35000 in cash in a checking account
that she opened in the name of business.
2. On January 2 smith rented a small room in the basement of a house for a studio. She paid $ 900 for a
year’s rent in advance.
3. On January 3, smith purchased art supplies for $ 1000 on credit.
4. On January 4, smith purchased furniture and fixtures costing $ 2000 for cash.
5. On January 10, smith delivered her first painting to a customer, with the painting, smith delivered a bill
for services rendered of $3000 on credit.
6. On January 11, the customer in transaction 5 paid half of his bill.
7. On January 12, the account payable that result from transaction 3 was paid in full.
8. On January 15, smith withdrew $1000 from the business for her personal use.
9. On January 15, smith paid $100 to sure-clean Inc-to clean the studio.
10. On January 31, smith determined that she had $900 of art supplies left on hand.
11. On January 31, smith determined that unused prepaid rent was $825.
12. On January 31, smith estimated depreciation on Furniture and fixtures for the month was $ 25.

Required show the effect of each of the above transactions on the accounting equation elements; show the
balance after each transaction.

1.6.2.Financial Statements
After the effect of individual transaction has been determined, the essential information is communicated to
users. The accounting statements that communicate this information are called financial statements. Financial
statements are the result of financial accounting process.

There are four principal financial statements for proprietorships and partnerships:

1. Income statement - Presents the results of operations of an entity for a particular period of time. It is a
summary of the revenue and the expenses of a business entity for a specific period of time, such as a
year or month.

15
 2. Balance sheet - Presents information about the financial position of an entity at a particular date. It is a
list of assets, liabilities and owner’s equity of a business entity as of a specific date, usually at the close
of the last day of a month or a year.
3. Statement of Cash flow - A summary of cash receipts and cash payments of a business entity for a
specific period of time such as a month or a year.
4. Statement of Owner’s Equity- Presents information about how owner’s equity has changed over a
particular period of time. It is the summary of the changes in the owner’s equity of a business entity that
have occurred during a specific period time.

1. Income Statement

The excess of revenue over the expenses incurred in the earning the revenue is called net income. If the
expenses of the enterprise exceed the revenue, the excess is a net loss.

 It is ordinarily impossible to determine the exact amount of expense incurred in connection

with each revenue transaction.
 Therefore it is satisfactory to determine the net income or net loss for stated period of time.
 The determination of 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 the revues must be
matched against the revenues in order to determine the net come or the loss.

Example of Income Statement

Joan Smith Portraits

Income Statement
For the month ended January 31, 1994
Revenue (sales)-----------------------------------------------------------3,000
Expenses:
Cleaning expenses-----------------------100
Supplies expense------------------------100
Rent Expense ---------------------------75
Depreciation------------------------------25 300
Net income2700

* Note that, income statement shows financial performance of the business during a period; it shows by haw
much the business was better off or worse off during the period.

2. Balance sheet
The purpose of balance sheet is to show financial position an entity on a particular date.
Balance sheet format could vary from business to business. The most common and acceptable formats are:
Report format, Account format and financial position format. The difference between these formats lies on the
manner in which the information’s are arranged in the statement; therefore it is a matter of the appearance of the
report not the content.
 Report format – Under the report format liabilities and owner’s equity are listed below the asset
section.
 Account format – Under this formats assets are listed on the left and liabilities and owner’s
equity are listed on the right. It resembles the accounting equation.

16
  Financial position format- It is a vertical format in which current liabilities are deducted from
current assets to derive working capital. Other assets then are added and other liabilities are
deducted leaving a residual amount as a owner’s equity.

Example

Joan Smith Portraits

Balance sheet
January 31, 1994

Assets Liabilities
Cash-------------------------31500 AlP-----------------------0
Accounts Receivable------1500 Owner’s Equity
Art Supplies---------------- 900 Joan-Smith Capital------36700
Prepaid Rent--------------- 825
Furniture and Fixture------1975
Total Assets 36700 Total L and OE 36700

3.Statement of Owner’s Equity

Generally we have said that three types of transactions affect owner’s Equity during a period:-
1. Investment by owner
2. Revenues and Expenses as a result of operation of a business: and
3. Withdrawal by owner.

The purpose of preparing statement of owners’ Equity is to summarize these transactions effect in summary
form. It is considered as a link between the balance sheet and the income statement.
Example

Joan Smith Portraits

Statement of Owner’s Equity
For the month ended, January 31, 1994
Balance Before January 1 ------------------------0
Add: Investments in January-----------35000
Net income for January--------- 2700
Sub-total---------------------------------------------37700
Less Withdrawals in January------------(1000)
Balance , January 31-------------36,700

4. Statement of Cash flows (SCF)

In the statement of cash flow, it is customary to report cash flows (cash receipts and cash payments) in three
sections

1. Operating activities
2. Investing activities
3. Financing activities

17
1. Operating activities - Cash flows that result from the day-to-day income producing activities of
business.Cash flows in this section includes cash transactions that enter in to the determination of net income.
Examples include
Cash inflows: - Collection of Receivable, sale of merchandise on cash,
Collection of interest Revenue collection of dividend from investment in other
co.
Cash out flows:- Payments for creditors for purchase of inventory or supplies; and other payment for business
operating costs, payment for interest on debt.

2. Investing activities - Cash flows from investing activities section reports the cash transactions for the
acquisition and sale of relatively long-term or permanent type assets. It includes purchase or sale of productive
assets like: Building, Land, Machinery, furniture and Fixtures, etc and Purchase or sale of other companies
debt or equity longterm securities.
3.Financing activities - the cash flows from financing activities section reports the cash transactions related to
cash investments by the owner, borrowings and cash withdrawals of owner. For corporation form of business
this includes payment of dividend to stockholders; issuance of equity or debt securities; repayment of the loan
principal.
Example
Joan Smith Portraits
Statement of Cash Flows
For the month ended, January 31,1994
Cash flows from operating activities:
Cash Received from customers-----------------------1500
Cash payments for expenses and
To creditors---------------------------------------------(2000)
Net cash flow from operating activity (500)
Cash flow from investing activity
Cash payments for purchase
of Furniture and Fixture--------------------------------(2000)
Cash flow from financing activity
Cash withdrawal by owner-----------------------------(1000)
Net cash flow during the period ( 3500)
Cash balance Jan1, 1994--------------------------------------------35000
Cash balance Jan31, 1994-------------------------------------------31,500

Exercise
1) Assume that a company has the following balances on December 31,1995:
Total assets-------------------------------20,000
Total liabilities---------------------------15,000
Required: a. What is the amount of owner’s equity?
b. What is the amount of net asset?

2) Indicate the net effect each of the following transaction has on the amount of assets, liabilities, and owner’s
equity. ( + for an increase, - for a decrease and – 0 – for no change).
Assets Liabilities Owner’s Equity
a. Purchase of Supplies for cash
b. Purchase of supplies on credit
c. Payment of Monthly water bill
d. Payment of Employee salaries
e. Payment of Rent for one month in advance

18
f. Payment of fee of independent accountant
g. Payment of telephone bill
h. Payment of the next three years’ property insurance premiums in advance

3) The following are group of accounts as of January 31, 1995

Cash----------------------------------15,000
Acc. Receivable.--------------------------- 6,000
Inventory---------------------------- 7,000
Furniture Fixture------------------- 10,000
Accounts payable----------------- ?
J. Jones, capital------------------- ?
The J. Jones, capital account balance on January 1, 1995, was 4000, J. Jones invested 4,000 of his personal
funds in the business during January. She withdrew no funds during the month, the net income for the month of
January was 2,000.
Required:

a. Determine the balance of Accounts payable and J. Jones, capital as of January 31, 1995.
b. Prepare a balance sheet as of January 31, 1995.

4) The following are the year-end balance sheet amounts for company for three years

Dece. 31 Dece. 31 Dece. 31

Assets 1984 19851986
Cash-------------------------------------- 10,000 15,000 16,000
Accounts Receivable------------------- 12,000 14,000 16,000
Supplies------------------------------------ 1,000 1,000 2,000
Equipment--------------------------------- 10,000 12,000 14,000
Total Assets 33,000 42,000 48,000

Liabilities and Owner’s Equity

Accounts payable-------------1000 2000 3000
Bank Loan payable 10,000 15,000 17,000
X- Capital 22,000 25,000 28,000
Total Liabilities and owner’s Equity33,000 42,000 48,000

Additional information
1984 1985 1986
- Personal withdrawals by-Mr . x 1000 2000 3000
- Investments in business by Mr. X 9000 7000 9000
- The balance in Mr X-S’ Capital on January 1, 1984 was 8,000.

Required:-
a. What was the net income or net loss for the business for 1984, 1985, and for 1986?
b. On the basis of business’s earning trend, do you think that a bank should lend the business more money?
Explain.
5. Joan Bowan established Joan Boan services on July 1 of the current year. The effect of each transaction and
the balances after each transaction for the month of July are as follows:

19
 Assets = Liabilities + Owner’s Equity
Cash + Accounts Supplies Accounts. Pay + Joan Bowan
Receivable + Capital
a + 3000 + 3000investm.
b -2000 -2000
Bal. 1000 1000
c -------- + 550 + 550 --------
Bal. 1000 550 550 1000
d -4500 _____ ________ _+4500Fee
Bal. 5500 550 550 5500
e -250 ____ _-250_ _____
Bal. 5250 550 300 5500
f ----- + 12500 ------- -------- +1250Fees Ea.
Bal 5250 1250 550 300 6750

g -380-Auto.Ex.
-655 --------- --------- ---------- -275 Mis.Ex.
Bal. 4595 1250 550 300 6,095

h -1000 ________ ________ __________ -1000saler. Ex.

Bal. 3595 1250 550 300 5095

i _______ ________ -125 ________ -125 supp.Ex.

Bal. 3595 1250 425 300 4970
j -1200 __________ _______ ___________ -1200withd.
Bal. 2,395 1,250 425 300 3770
Required:

1. Prepare income statement for the month ended July 31.

2. Prepare balance sheet as of July 31.
3. Prepare a statement of owner’s Equity for the month ended July 31.
4. Prepare a statement of cash flows for the month ended July31.

20