Chapter one: Introduction to Accounting and Business

1.1. The nature of a business

A business is the activity of making one’s living or making money by producing or buying and
selling products (goods and services). The objective of most businesses is to maximize profits.
Profit is the difference between the amounts received from customers for goods or services
provided and the amounts paid for the inputs used to provide the goods or services.

Some businesses operate with an objective other than to maximize profits. The objective of such
nonprofit businesses is to provide some benefit to society. In other cases, governmental units
such as cities operate water works sewage treatment plants on a nonprofit basis. However, the
focus of this course is businesses operating to earn a profit.

There are three types of businesses:

 Manufacturing businesses: change basic inputs into products that are sold to individual
customers. E.g. Coca-cola, Sony, Nike, General Motors
 Merchandising businesses: also sell products to customers. However, rather than making the
products, they purchase them from other businesses (such as manufacturers). E.g. Wal-Mart,
Amazon.com
 Service businesses: provide services rather than products to customers. E.g. Air Lines,
Hospitals
1.2. Form and Type of Business Organizations
Proprietorship: it is owned by one individual and usually managed by the owner. The
popularity of this form is due to the ease and the low cost of organizing. The primary
disadvantage of proprietorships is that the financial resources available to the business are
limited to the individual owner’s resources and has unlimited liability. A proprietorship is a
separate entity for accounting purposes but it is not a separate legal entity from the owners. That
is, from the legal point of view, the owner and the business are treated as one and the same. The
owner will be held personally responsible for the debts and actions of the business.

Advantages:

Easy to establish the business

It is least regulated by government

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 No profit sharing

Disadvantages:

Limited life

Limited capital to finance business operation

Unlimited liability the owner is responsible to pay the debt of the business even from
his personal asset in case the business unable to meet its liability)

Partnership: is owned by two or more individuals. It has more financial resources than a
proprietorship and has additional management skills. Its disadvantage is unlimited liability. The
partners share the profits and losses of the partnership according to an agreed –on formula. The
personal resources of each partner can be called on to pay the obligations of the partnership. That
is, each partner is personally responsible for the debts of the partnership. From an accounting
standpoint, however, a partnership is a business entity separate from the personal activities of the
partners.

Advantages:

Easier and less expensive to establish than corporation

Are not highly regulated by government

More capital and managerial skill than a single proprietor ship

Disadvantages:

Limited life

Unlimited liability (the partners are responsible to pay the debt of the business even
from their personal assets in case the business unable to meet its liability)

Conflict between partners throughout operating the business.

Corporation: is organized under state or federal statutes as a separate legal taxable entity. The
ownership of a corporation is divided into shares of stock. A corporation issues the stock to
individuals or other businesses, who then become owners or stockholders of the corporation. Its
advantage is the ability to obtain large amounts of resources by issuing stocks. The stockholders

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are free to sell all or part of their shares to other investors at any time. This ease of transfer of
ownership adds to the attractiveness of investing in a corporation.

Since a corporation is a separate legal entity, the stockholders are not personally liable for the
debts of the corporation. Their risk of loss is limited to the amount they paid (invested). Because
of this limited liability in a corporation shareholders are willing to invest in riskier, but
potentially more profitable, activities. Its disadvantage is double taxation.

Advantages:

Long life

Limited liability

Can raise huge amount of capital to finance business operation

Disadvantages:

Double taxation

Highly regulated by government

Difficulty of controlling management, because ownership and management is divorced

in corporation.

 Types of Business Organizations

According to their type of activities or nature of operations, business organizations are also
classified in to three main types:

1. Service rendering businesses: - are business organizations that are predominantly

engaged in rendering of services to customers for the purpose of maximizing profit.

Examples: Hotels, restaurants, cafeterias, bars, transport and communication services,

professional firms like consultations by accountants, lawyers, engineers etc.

2. Merchandising businesses: - is profit seeking businesses, which are engaged in

purchasing and reselling of merchandises.

Examples: Supermarkets, boutiques, garment and shoe shops, drug stores, stationary shops, auto
spare parts, importers, exporters etc.

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 3. Manufacturing businesses: - are business organizations that are primarily involved in
the conversion of raw materials and parts in to finished goods; and sale their finished
goods to merchandising enterprises and consumers. Sometimes, they sale goods to other
manufacturing firms, which utilize the goods as raw materials for production activities.

Examples: Cement factories, sugar factories, soap factories, textile factories, paper factories,
etc.

1.3. The role of accounting in business

Accounting is defined as the process of identifying, measuring, recording, classifying,
summarizing, analyzing and interpreting economic events (financial transactions) and
communicating the results thereof to the entities interested in such information to enable them
make informed judgments. The analysis the definition is as follows:
 Identifying- to distinguish an event or a transaction that must be recorded.
 Measuring- quantifying an event or a transaction i.e. accounting deals with only those
transactions and events that can be expressed in terms of money.
 Recording- this is the basic function of accounting. It is essentially concerned with not only
ensuring that all business transactions of financial character are in fact recorded but also that
they are recorded in an orderly manner.
 Classifying- it is concerned with the systematic analysis of the recorded data with a view to
group transactions or entries of one nature at one place.
 Summarizing-this involves presenting the classified data in a manner which is
understandable and useful to the internal as well as external end users of accounting
statements or other accounting information
 Analyzing-means methodical classification of the data given in the financial statements. For
example, all items relating to “current assets” are put at one place.
 Interpreting- explaining the meaning and significance of the data so simplified and analyzed
 Communicating- the accounting information after being meaningfully analyzed and
interpreted has to be communicated in a proper form and manner to the proper person.
Accounting: The Language of Business
Accounting has rightly been termed as the language of the business. Accounting is used to
communicate financial information to various parties who have some stake (interest) in the
affairs of the business.
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Accounting provides information for managers to use in operating the business. In addition,
accounting provides information to other stakeholders to use in assessing the economic
performance and condition of the business. In a general sense, accounting can be defined as an
information system that provides reports to stakeholders about the economic activities and
condition of a business.
Accounting is defined as a process of identifying measuring, recording and communicating economic events
of an organization to interested users of the information.

You may think of accounting as the “language of business.” This is because accounting is the
means by which business information is communicated to the stakeholders. Stakeholders use
accounting reports as a primary source of information on which they base their decisions.
Stakeholders can be internal and external.
 Internal: These are persons that are directly involved in managing and operating an
organization. The area of accounting aimed at serving the decision-making needs of internal
users is called Management Accounting. E.g. Owners, managers and human resource
Internal users are responsible for the administration of the business and include the following
management, BOD, department head, corporate officer like chief executive officers and chief
operating officers and chief financial officers. Management need an accounting information:
 To plan future operation
 To evaluate and control current operation
 To know the profitability of each department
 To know the company’s cash position
 To know the trend of earnings
 To assess whether spending kept within the budget limit or not (especially in NGO
and Governmental organization)
 To assure whether expenditure are authorized or not (governmental and not-for-profit
organization)
 External: they are parties, which are not directly involved in running the business enterprise.
The area of accounting aimed at serving external users is called Financial Accounting. They
need accounting information for their benefit. This group include: owners of the business,

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 potential investors, bankers, suppliers and other creditors, employees and labor union,
governmental agencies, etc.
Owners need accounting information:
 To know the operating results of the business
 To know its financial position
Potential investors need accounting information a business to:
 Assess the risk ness of the investment
 Predict its future prosperities
Bankers need accounting information to
 Evaluate the financial soundness of a business organization
 Assess risks involved in giving loans
Suppliers need accounting information to:
 Decide whether to sell or not to sell goods and services on credit basis
Employees and labor union need accounting information before beginning negotiation of for
new labor contract to know:
 The financial position of a businesses
 The profitability of a business
 The stability of a business
Governmental Agencies need accounting information for purpose of determining income tax
payable and pension contribution of an employee
1.4 Evolution of Accounting
Similar to medicine, law, economics, and accounting has evolved in response to the social and
economic needs of society. As business and society have become more complex over the years,
many complex economic development and social programs cannot be undertaken due to shortage
of financial information. Therefore, accounting has evolved to develop new concepts and
techniques to meet the ever increasing needs for financial information.
 Primitive Accounting
In the civilization of human being, various types of records of business activities have been
maintained. Of these, the oldest known is Clay Tablet records of the payment of wages in
Babylonia around 3600 B.C. There are numerous evidences of record keeping and systems of

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accounting control in Egypt and Greek City States. In English, under the direction of King
William the 12th records were compiled to ascertain the financial resources of the kingdom.
Drawbacks of the Primitive Accounting:
I. It dealt with limited aspects of the financial operations of private or government
enterprises.
II. There was no systematic accounting for all transaction of a particular unit i.e. only for
specific type or portion of transaction
 Double Entry System Accounting
Since the primitive accounting was incomplete, the evolution of the system of record keeping
which was said to be called “Double Entry System” was strongly influenced by Venetian
merchants. Double entry system is the recordings process of a transaction into two parts. The
first known description of the system was published in Italy in 1494 by a person called LUCA
PACIOLI
Double Entry System provides:
1. For all business transaction, recording in a systematic manner i.e. to establish in an
equilibrium. For example, if a business borrowed Br 500 from a bank, the amount of the loan
is recorded both as cash of Br 500 and an obligation to repay Br 500. Either of the Br 500
amount is balanced by the other Br 500 amount. In double entry system, every transaction
entered twice in the books of accounts as means of check and control.
2. For the set of integrated financial statements, reporting in money terms
In spite of the tremendous development of business operations since 1494, and the ever
increasing complexities of business and governmental organizations, the basic elements of
Double Entry System have continued virtually unchanged.

1.4. The Profession of Accounting

Accountants engage in either private accounting or public accounting.

Private Accounting: Accountants employed by a business firm or a not-for-profit organization.

The scope of activities and duties of private accountants varies widely. Private accountants are
frequently called management accountants. If they are employed by a manufacturer, they may be
referred to as industrial or cost accountants.

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Public accounting: Accountants and their staff who provide services on a fee basis. In public
accounting, an accountant may practice as an individual or as a member of a public accounting
firm. A major portion of public accounting practice is involved with Auditing. Public
accountants who have met a state’s education, experience, and examination requirements may
become Certified Public Accountants (CPAs).

1.5. Accounting principles and practices

Accounting, as it is true for other disciplines, has got its own principles and practices. One must
be able to understand these principles and practices to understand and prepare financial
statements and reports. In order to ensure high-quality financial reporting, accountants present
financial statements in conformity with accounting standards that are issued by standard setting
bodies. Presently, there are two primary accounting standard setting bodies: the International
Accounting Standards Board (IASB) & the Financial Accounting Standards Board (FASB).
More than 130 countries, including Ethiopia, follow standards referred to as International
Financial Reporting Standards (IFRS). IFRSs are determined by the IASB. The IASB is
headquartered in London, with its 15 board members drawn from around the world. Most
companies in the United States follow standards issued by the FASB, referred to as generally
accepted accounting principles (GAAP).

1.5.1. International financial reporting standard

Financial accounting standards issued by the IASB are referred to as International Financial
Reporting Standards (IFRS).

Financial reporting

» General purpose financial reporting

» aims to provide useful financial information about the reporting entity to primary
users who cannot require the reporting entity to provide information directly to
them.

» Special purpose financial reporting

» responds to the requirements of users that have the authority to require the
reporting entity to provide the information that they need for their purposes
directly to them. Examples include:

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 » prudential regulation reporting requirements

» tax reporting requirements

International Financial Reporting Standards (IFRS)*

» Designed for general purpose financial reporting by profit-oriented entities

» might be found to be appropriate for not-for-profit activities too

» Focused on information needs of (primary users) existing and potential investors,

lenders and other creditors who cannot require information from the entity

» information to enable primary users to make their own assessments of the

reporting entity’s prospects for future net cash inflows

» as a basis for their decisions to buy, hold, sell equity and debt instruments or to
provide a loan or to require settlement of a loan

IFRS has the best potential to provide a common platform on which companies can report and
investors can compare financial information. It is simpler and less stringent in its accounting and
disclosure requirements. It is more principles-based.

Qualities of Useful Information

Recently, the IASB and FASB completed the first phase of a joint project in which they
developed a conceptual framework to serve as the basis for future accounting standards. The
framework begins by stating that the primary objective of financial reporting is to provide
financial information that is useful to investors and creditors for making decisions about
providing capital. According to the IASB, useful information should possess two fundamental
qualities, relevance and faithful representation.

Relevance: Accounting information has relevance if it would make a difference in a business

decision. Information is considered relevant if it provides information that has predictive value,
that is, helps provide accurate expectations about the future, and has confirmatory value, that is,
confirms or corrects prior expectations. In addition, materiality is a company-specific aspect of
relevance. An item is material when its size makes it likely to influence the decision of an
investor or creditor.

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Faithful Representation: It means that information accurately depicts what really happened. To
provide a faithful representation, information must be complete (nothing important has been
omitted), neutral (is not biased toward one position or another), and free from error. So sentence
should read: To provide faithful representation, information must be complete (nothing important
has been omitted), neutral (is not biased toward one position or another), and free from error.
Enhancing Qualities
In addition to the two fundamental qualities, the IASB and FASB also describe a number of
enhancing qualities of useful information. These include comparability, consistency,
verifiability, timeliness, and understandability. In accounting, comparability results when
different companies use the same accounting principles. Another characteristic that enhances
comparability is consistency. Consistency means that a company uses the same accounting
principles and methods from year to year. Information is verifiable if independent measures,
using the same methods, obtain similar results. For accounting information to have relevance, it
must be timely. That is, it must be available to decision-makers before it loses its capacity to
influence decisions. Information has the quality of understandability if it is presented in a clear
way.

Assumptions
Monetary Unit Assumption: The monetary unit assumption requires that only those things that
can be expressed in money are included in the accounting records. This means that certain
important information needed by investors, creditors, and managers, such as customer
satisfaction, is not reported in the financial statements.

Economic Entity Assumption: The economic entity assumption states that the activities of the
entity must be kept separate and distinct from the activities of the owner. In order to assess a
company’s performance and financial position accurately, it is important that we not blur
company transactions with personal transactions (especially those of its managers) or
transactions of other companies.

Time Period (Periodicity) Assumption: Notice that the income statement, retained earnings
statement, and statement of cash flows all cover periods of one year, and the statement of
financial position is prepared at the end of each year. The time period assumption states that the

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life of a business can be divided into artificial time periods and that useful reports covering those
periods can be prepared for the business.

Going Concern Assumption: The going concern assumption states that the business will remain
in operation for the foreseeable future. Of course, many businesses do fail, but in general, it is
reasonable to assume that the business will continue operating.

Principles in financial reporting

Measurement Principles
IFRS generally uses one of two measurement principles, the historical cost principle or the fair
value principle. Selection of which principle to follow generally relates to trade-offs between
relevance and 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.

Historical cost principle: The historical cost principle (or cost principle) 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. For example, if Gazprom purchases land for $300,000, the
company initially reports it in its accounting records at $300,000. But what does Gazprom do if,
by the end of the next year, the fair value of the land has increased to $400,000? Under the
historical cost principle, it continues to report the land at $300,000.

Fair value principle: The fair value principle 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 historical cost for certain types of assets and liabilities. For example, certain
investment securities are reported at fair value 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 property, plant, and equipment and other long-
lived assets to fair value, most companies choose to use cost. Only in situations where assets are
actively traded, such as investment securities, do companies apply the fair value principle
extensively.

Revenue recognition principle

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The revenue recognition principle requires that companies recognize revenue in the accounting
period in which the performance obligation is satisfied. In a service company, revenue is
recognized at the time the service is performed. In a merchandising company, the performance
obligation is generally satisfied when the goods transfer from the seller to the buyer. At this
point, the sales transaction is complete and the sales price established.

Expense recognition principle

The expense recognition principle (often referred to as the matching principle) dictates that
efforts (expenses) be matched with results (revenues). Thus, expenses follow revenues.
Full disclosure principle
The full disclosure principle requires that companies disclose all circumstances and events that
would make a difference to financial statement users. If an important item cannot reasonably be
reported directly in one of the four types of financial statements, then it should be discussed in
notes that accompany the statements.

Cost Constraint
The cost constraint relates to the fact that providing information is costly. In deciding whether
companies should be required to provide a certain type of information, accounting standard-
setters weigh the cost that companies will incur to provide the information against the benefit
that financial statement users will gain from having the information available.

1.6 Overview of financial reporting requirements in Ethiopia and AABE

The Ethiopian government has been undertaking various activities to prepare and present
credible, transparent and easy-to-read financial reports based on the financial sector. The
government set up the Accounting and Auditing Board of Ethiopia (AABE) to lead the sector.
The board requires companies entire accounting system to be in accordance with international
financial reporting standard (IFRS). In addition to that, companies in Ethiopia are also
regulated to perform their activities by adhering the commercial code.

According to the Ethiopian Commercial Code, any person or business organization carrying on
trade shall keep books and accounts considering the business practice and regulations. Petty

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traders may be exempted from keeping accounts. Business organizations are required to take
inventory at the beginning of business practice and at the end of each business period to facilitate
the preparation of balance sheet and profit or loss account.

The books and accounts should be kept in chronological order without any blanks or alterations.
They should also be given a serial number and initiated by the prescribed authority which will
specify the total number of pages for the document. All books and accounting documents shall
be preserved for ten years from the date of the last entry in such books or from the date of such
documents.

The assets shall appear in the following order, (Establishment expenses; Fixed assets; Stocks;
Short term or liquid assets and the results (Debit balance of the Profit and Loss Account)).
Liabilities in the Balance Sheet shall appear in the following order, (The proper capital account
and reserves; Profits brought forward and renewal funds; Provisions and long-term debts;
personnel pension funds, if any; Short term debts and the results (Credit balance of the Profit and
Loss Account)).

Amortizations and provisions for depreciation shall appear under the respective headings of the
assets in the balance sheet. The adjustment accounts shall appear in the assets or liabilities side
of the balance sheet following the accounts to which they relate.

1.6. The accounting equation and elements of the equation

The resources owned by a business are its assets. Examples of assets include cash, land,
buildings, and equipment. The rights or claims to the properties are normally divided into two
principal types: (1) the rights of creditors and (2) the rights of owners. The rights of creditors
represent debts of the business and are called liabilities. The rights of the owners are called
owner’s equity. The relationship between the two may be stated in the form of an equation called
accounting equation, as follows:
Assets = Liabilities + Owner’s Equity

It is usual to place liabilities before owner’s equity in the accounting equation because creditors
have first rights to the assets.

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Exercise 1.1: If a company’s assets increase by $20,000 and its liabilities decrease by $5,000,
how much did the owner’s equity increase or decrease?

Assets: are resources a business owns. The business uses its assets in carrying out such activities
as production and sales. The common characteristic possessed by all assets is the capacity to
provide future services or benefits. To qualify as assets, there are three characteristics to be
fulfilled
 Have future economic benefits (be capable of producing profits).
 Be under managements control (can be freely deployed or disposed of)
 Result from past transaction (the transaction or event giving rise to the entity’s right to, or
control of, the benefit has already occurred)
Liabilities: are claims against assets—that is, existing debts and obligations. Businesses of all
sizes usually borrow money and purchase merchandise on credit. Creditors may legally force the
liquidation of a business that does not pay its debts. In that case, the law requires that creditor
claims be paid before ownership claims. To qualify as liabilities, obligations must:
 Require transfer of assets having future economic benefit.
 Specify to whom the asset must be transferred (the terms, parties, and
conditions under which asset transfers will take place must be
specified).
 Result from past transactions.

Owner’s/Shareholders equity: The ownership claim on total assets is owner’s equity. Since
the claims of creditors must be paid before ownership claims, owner’s equity is often referred to
as residual equity that remains after deducting its liabilities. It generally consists of (1) share
capital – ordinary and (2) retained earnings.

Share Capital – Ordinary: A corporation may obtain funds by selling ordinary shares to
investors. Share capital - ordinary is the term used to describe the amounts paid in by
shareholders for the ordinary shares they purchase.

Retained earnings: it is determined by three items: revenues, expenses, and dividends.

 Revenues: They are the gross increases in equity resulting from business activities entered
into for the purpose of earning income. Generally, revenues result from selling merchandise,

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 performing services, renting property, and lending money. Revenues usually result in an
increase in an asset.
 Expenses: They are the cost of assets consumed or services used in the process of earning
revenue. They are decreases in equity that result from operating the business. Like revenues,
expenses take many forms and are called various names depending on the type of asset
consumed or service used.

1.7. Business transactions and financial statements

Business transactions are economic events that should be recorded because they affect the
financial position of the business enterprise. These businesses transactions are the raw materials
of accounting reports. A transaction can be an exchange (such as the purchase or sale of
property, payment or collection of a loan etc.) between two or more parties.

For a given transaction to qualify to be recorded it has: to be related to the business enterprise, to
be measurable in terms of money and to be completed / happened/ action. Transactions may be
external or internal. External transactions involve economic events between the company and
some outside enterprise. Internal transactions are economic events that occur entirely within
one company.

1.7.1. Transaction Analysis

All business transactions can be stated in terms of changes in the elements of the accounting
equation.

Illustration 1.1 Assume that on November 1, 2010 several shareholders formed a corporation
that will be known as Net Solutions. The first phase of the business plan is to operate Net-
Solutions as a service business that provides assistance to individuals and small businesses in
developing Web pages and in configuring and installing application software. The corporation
expects this initial phase of the business to last one to two years. During this period, the company
will gather information on the software and hardware needs of customers. During the second

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phase of the business plan, the company plans to expand its business into a personalized retailer
of software and hardware for individuals and small businesses.

Each transaction or group of similar transactions during Net Solutions’ first month of operations
is described in the following paragraphs. The effect of each transaction on the accounting
equation is then shown.

Transaction a- The shareholders contributed $25,000 in exchange for ordinary shares of Net
Solutions. The effect of this transaction is to increase the asset cash (on the left side of the
equation) by $25,000. To balance the equation, the shareholders equity (on the right side of the
equation) is increased by the same amount.

Assets = Shareholders’ equity

Cash = Share Capital-Ordinary
a. 25,000 25,000

NB: Net solutions is a corporate form of business, formed by shareholders. Note, too, that the
accounting equation shown above relates only to the business, Net Solutions. Under the business
entity concept, shareholders personal assets, such as a home or personal bank account, and
personal liabilities are excluded from the equation.

Transaction b Net Solutions exchanged $20,000 cash for land. The land is located in a new
business park with convenient access to transportation facilities. The company plans to rent
office space and equipment during the first phase of the business plan. During the second phase,
a company plans to build an office and warehouse on the land.

Assets = Shareholders Equity

Cash + Land Share Capital-Ordinary
Bal. 25,000 = 25,000
b. -20,000 + 20,000
Bal. 5,000 20,000 25,000

Transaction c During the month, Net Solutions buying supplies for $1,350 and agreeing to pay
the supplier in the near future. This type of transaction is called a purchase on account. The
liability created is called an account payable. The effect of this transaction is to increase assets
and liabilities:
Assets = Liability + Shareholders’ Equity
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 Cash + Supplies + Land Accounts payable ShareCapital-Ordinary
Bal. 5,000 20,00 = 25,000
0
c. + 1,350 + + 1,350
20,000
Bal. 5,000 1,350 20,0 25,000
00

Transaction d A business earns money by selling goods or services to its customers. This
amount is called revenue. During its first month of operations, Net Solutions provided services
to customers, earning fees of $7,500 and receiving the amount in cash. The receipt of cash
increases Net Solutions’ assets and also increases equity in the business.

Assets = Liability Shareholders’ Equity

+
Cash Supplie + Land Accounts Share + Retained earnings
+ s payable capital Rev. - Exp. Div.
, -
Bal. 1,35 20,000 = 1,35 25,000
5,000 0 0
d. + + Fees earned
7,500 7,500
Bal. 12, 1,35 20,000 1,35 25,00 7,500
500 0 0 0

Instead of requiring the payment of cash at the time services are provided or goods are sold, a
business may accept payment at a later date. Such revenues are called fees on account or sales
on account. In such cases, the firm has an account receivable, which is a claim against the
customer.
Transaction e Net Solutions spent cash or used up other assets. The amounts used in this
process of earning revenue are called expenses. Expenses include supplies used, wages of
employees, and other assets and services used in operating the business. For Net Solutions, the
expenses paid during the month were as follows: wages, $2,125; rent, $800; utilities, $450; and
miscellaneous, $275. Miscellaneous expenses include small amounts paid for such items as
postage, coffee, and magazine subscriptions. The effect of this group of transactions is the
opposite of the effect of revenues. These transactions reduce cash and owner’s equity, as shown
here.

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 Assets = Liability + Shareholders Equity
Cash Supplies + Land Accounts Share, + Retained earnings
+ payable Capital Rev. - Exp. - Div.
Bal. 12, 1,350 20,000 = 1,35 25,00 7,500
500 0 0
e. - 2,125 Wages
3,650 expense
800 Rent
expense
450 Utilities
expense
275 Misc.
expense
Bal. 1,350 20,0 1,35 25,00 7,500 3,650
8,850 00 0 0

Transaction f Net Solutions pays $950 to creditors during the month, it reduces both assets and
liabilities, as shown below.
Assets = Liability + Shareholders Equity
Cash Supplies + Land Accounts Share, + Retained earnings
+ payable Capital Rev. - Exp. - Div.
Bal. 1,350 20,00 = 1,35 25,000 7,500 3,650
8,850 0 0
f. - - 950
950
Bal. 1,350 20,000 400 25,00 7,500 3,650
7,900 0

NB: paying an amount on account is different from paying an amount for an expense. The
payment of an expense reduces equity, as illustrated in transaction (e). Paying an amount on
account reduces the amount owed on a liability.

Transaction g At the end of the month, the cost of the supplies on hand (not yet used) is $550.
The remainder of the supplies ($1,350 - $550) was used in the operations of the business and is
treated as an expense. This decrease of $800 in supplies and owner’s equity is shown as follows:
Assets = Liability + Shareholders Equity
Cash Supplies + Land Account Share + Retained earnings
+ s Capital Rev. - Exp. - Div.
payable
Bal. 7,900 1,350 20,000 = 400 25,000 7,500 3,650
g. - 800 800 supplies expense

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Bal. 550 20,000 400 28,05 7,500 4,450
7,900 0

Transaction h- At the end of the month, the company paid a cash dividend of $2,000 to its
shareholders. This transaction is the exact opposite of an investment in the business by the
shareholders. Cash and shareholders’ equity are decreased. The cash payment is not a business
expense but a distribution of a part of the owners’ equity. The effect of the $2,000 dividend is
shown as follows:

Assets = Liability + Shareholders Equity

Cash Supplie + Account Share + Retained earnings
+ s Land s Capital Rev. - Exp. - Div.
payable
Bal. 55 20,00 = 400
25,000 7,50 4,450
7,900 0 0 0
h. - 2000 Dividend
2,000
Bal. 55 20,00 400 25,00 7,50 4,450 2000
5,900 0 0 0 0
Summary: The transactions of Net Solutions are summarized as follows. They are identified by
letter, and the balance of each item is shown after each transaction.
Assets = Liabilities + Shareholders’ Equity
Cash + Supplies + Land = Accounts Share Retained earnings
Payable + Capital Rev. - Exp. - Div.
A 25,000 25,000 Investment by owners
B -20,000 20,000
C + 1,350 +1,350
d. + 7,500 7,500 Fees earned
e. - 3,650 2,125 Wages expense
800 Rent expense
450 Utilities expense
275 Misc. expense
F - 950 -950
G -800 800 Supplies expense
H -2,000 2,000 Dividend
Bal. 5,900 550 20,000 400 25,000 7,500 4,450 2,000

1.7.2. Financial statements

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After transactions have been recorded and summarized, reports are prepared for users. The
accounting reports that provide this information are called financial statements. The principal
financial statements of a proprietorship are the income statement, the statement of owner’s
equity, the balance sheet, and the statement of cash flows. The order in which the statements are
normally prepared and the nature of the data presented in each statement are as follows:
1. An income statement presents the revenues and expenses and resulting net income or net
loss for a specific period of time.
2. A retained earnings statement summarizes the changes in retained earnings for a specific
period of time.
3. A statement of financial position (sometimes referred to as a balance sheet) reports the
assets, liabilities, and equity of a company at a specific date.
4. A statement of cash flows summarizes information about the cash inflows (receipts) and
outflows (payments) for a specific period of time.
 Cash Flows from Operating Activities: reports a summary of cash receipts and cash
payments from operations.
 Cash Flows from Investing Activities: This section reports the cash transactions for the
acquisition and sale of relatively permanent assets.
 Cash Flows from Financing Activities: This section reports the cash transactions related to
cash investments by the owner, borrowings, and cash withdrawals by the owner.
All financial statements should be identified by the name of the business, the title of the
statement, and the date or period of time.

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 Net Solutions
Income Statement
For the Month Ended November 30, 2010
Fees earned $7,500.00
Operating expenses:
Wages expense $2,125.00
Rent expense 800.00
Supplies expense 800.00
Utilities expense 450.00
Miscellaneous expense 275.00
Total operating expenses $4,450.00
Net income $3,050.00

Net Solutions
Statement of Shareholders Equity
For the Month Ended November 30, 2010
Retained Earnings, November 1, 2010 $0
Net Income for November $3,050.00
Sub total $3,050.00
Less Dividend $2000
Retained Earnings, November 30, 2010 $1,050

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 Net Solutions
Statement of Retained Earnings
For the Month Ended November 30, 2010
Share Capital, November 1, 2010 $0
Share Capital-Ordinary 1, 2010 $25,000.00
Retained Earnings, November 30, 2010 $1050.00
Increase in shareholders’ equity $26,050.00
Shareholders Equity, November 30, 2010 $ 26,050.00

Net Solutions
Statement of Financial Position
November 30, 2010
Assets Liabilities
Cash $5,900.00 Accounts payable $400.00
Supplies $550.00 Shareholders’ Equity, November 30, 2010 26,050.00
Land $20,000.00

Total assets $26,450.00 Total liabilities and Shareholders' equity 26,450.00

Net Solutions
Statement of Cash Flows
For the Month Ended November 30, 2010
Cash flows from operating activities:
Cash received from customers $7,500.00
Deduct cash payments for expenses and
payments to creditors 4,600.00
Net cash flow from operating activities $2,900.00
Cash flows from investing activities:
Cash payments for acquisition of land (20,000.00)
Cash flows from financing activities:
Cash received from issuance of ordinary shares $25,000.00
Deduct cash dividend paid 2,000.00
Net cash flow from financing activities 23,000.00
Net cash flow and November 30, 2010 cash
balance $5,900.00

Worksheet for Chapter 1

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1. Cecil Jameson, Attorney-at-Law, is a corporation formed by shareholders. On July 1, 2005,
Cecil Jameson, Attorney-at-Law, has the following assets and liabilities: cash, $1,000;
accounts receivable, $3,200; supplies, $850; land, $10,000 and accounts payable, $1,530.
Office space and office equipment are currently being rented, pending the construction of an
office complex on land purchased last year.
Business transactions during July are summarized as follows:
a. Received cash from clients for services, $3,928.
b. Paid creditors on account, $1,055.
c. Received cash from Cecil Jameson as an additional investment, $3,700.
d. Paid office rent for the month, $1,200.
e. Charged clients for legal services on account, $2,025.
f. Purchased office supplies on account, $245.
g. Received cash from clients on account, $3,000.
h. Received invoice for paralegal (supporting) services from Legal Aid Inc. for July (to be
paid on August 10), $1,635.
i. Paid the following: wages expense, $850; answering service expense, $250; utilities
expense, $325; and miscellaneous expense, $75.
j. Determined that the cost of office supplies on hand was $980; therefore, the cost of
supplies used during the month was $115.
k. Jameson paid cash dividend $1,000.
Instructions
i. Determine the amount of shareholders equity as of July 1, 2005.
ii. State the assets, liabilities, and shareholders’ equity as of July 1 in equation form similar
to that shown in this chapter. In tabular form below the equation, indicate the increases
and decreases resulting from each transaction and the new balances after each
transaction. Explain the nature of each increase and decrease in owner’s equity by an
appropriate notation at the right of the amount.
iii. Prepare an income statement for July, a statement of shareholders’ equity for July, and
statement of financial position as of July 31, 2005.
2. Eureka Dry Cleaners is a corporate form of business. A building and equipment are currently
being rented, pending expansion to new facilities. The actual work of dry cleaning is done by

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 another company at wholesale rates. The assets and the liabilities of the business on June 1,
2006, are as follows: Cash, $8,600; Accounts Receivable, $9,500; Supplies, $1,875; Land,
$15,000; Accounts Payable, $4,100. Business transactions during June are summarized as
follows:
a. Paid rent for the month, $4,000.
b. Charged customers for dry cleaning sales on account, $8,150.
c. Paid creditors on account, $2,680.
d. Purchased supplies on account, $1,500.
e. Received cash from cash customers for dry cleaning sales, $17,600.
f. Received cash from customers on account, $8,450.
g. Received monthly invoice for dry cleaning expense (drying, ironing) for June (to be paid
on July 10), $7,400.
h. Paid the following: wages expense, $2,800; truck expense, $825; utilities expense, $710;
miscellaneous expense, $390.
i. Determined that the cost of supplies on hand was $1,600; therefore, the cost of supplies
used during the month was $1,775.
j. Paid a cash dividend of $3,500.
Instructions
i. Determine the amount of shareholders equity as of June 1.
ii. State the assets, liabilities, and shareholders’ equity as of June 1 in equation form similar to
that shown in this chapter. In tabular form below the equation, indicate increases and
decreases resulting from each transaction and the new balances after each transaction.
Explain the nature of each increase and decrease in owner’s equity by an appropriate notation
at the right of the amount.
iii. Prepare an income statement for June, a statement of shareholders’ equity for June, and
Statement of Financial Positions as of June 30.

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