UNIT 1.

INTRODUCTION TO ACCOUNTING

Contents
1.0 Aims & Objectives
1.1 Introduction
1.2 Definition, Importance and Users of Accounting Information
1.2.1 Accounting Defined
1.2.2 Importance and Users of Accounting Information.
1.3 Bookkeeping Versus Accounting
1.4 The accounting Profession
1.5 Accounting Principles and Concepts
1.6 Forms of Business Organizations
1.7 Business Transactions and the Accounting Equation
1.7.1 Assets, Liabilities, and Owner’s Equity
1.7.2. Transactions and the Accounting Equation.
1.8 Financial Statements of Sole Proprietorships
1.8.1 Income Statement
1.8.2 Owner’s Equity Statement
1.8.3 Balance Sheet
1.9 Summary
1.10 Answers to Check your Progress Exercises
1.11 Model Examination Questions.
1.12 Glossary of Terms

1.0 AIMS & OBJECTIVES

After studying this unit, you should be able to:

- explain the meaning of Accounting

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 - identify the users and uses of accounting
- explain the various branches in the profession of accounting
- explain the meaning of “generally accepted accounting principles”,
- explain the meaning of business entity assumption, cost principle and
monetary unit assumption
- state the basic accounting equation and explain the meaning of assets,
liabilities, and owner’s equity
- analyze the effects of business transactions on the basic accounting
equation, and
- prepare an income statement, owner’s equity statement, and balance sheet.

1.1 INTRODUCTION

We live in the information age-a time of communication, and a time when

information is a vital resource. In this information era, how we live, whom we
associate with, and the opportunities we have all depend on our access to and
understanding of information.

The same is true for businesses (businesses are one or more individuals selling
products or services for profit). Businesses that have better access to information
and that process information more quickly and accurately do the best.
Global computer networks and telecommunications equipment now allow us to
get access to all types of business information.

But to take advantage of these, we need knowledge of information systems.

An information system is the collecting, processing, and reporting of

information to decision makers. Understanding and processing information is
the core of accounting.

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The kind of information processed in accounting is financial i.e. of a monetary
nature.
Providing information about what businesses own, what they owe, and how they
perform is the aim of accounting. Accounting is, an information and
measurement system that identifies, records, and communicates relevant,
reliable, and comparable information about an organization’s (a business’s)
economic activities.

Therefore, a study of accounting helps people make better and informed

decisions about assessing opportunities, products, investments, and social and
community responsibilities.

But the use of accounting information is not limited to accountants or people in

business. You can use accounting information in your daily life. You can use
accounting information to get a loan for a house or to start a new business.
The study of accounting, therefore, opens you new and exciting possibilities
both in terms of becoming a professional accountant and using accounting
information in your daily life.

This course discusses the fundamental principles involved in processing

accounting information of business enterprises.

Understanding these fundamental principles is very important because

forthcoming courses that you are going to take in accounting will build on these
principles.

1.2. DEFINITION, IMPORTANCE, AND USERS OF ACCOUNTING

INFORMATION

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1.2.1. Accounting Defined
As a financial information system, accounting is defined as a process of
identifying measuring, recording and communicating economic events of an
organization (business or non- business) to interested users of the information.

Let’s take a closer look at the activities involved in the process:

1. The first part of the process – identifying – involves selecting those events
that are considered evidence of economic activity relevant to a particular
organization. The sale of goods by Hadiya Super Market, the rendering of
service by Ethiopian Telecommunications Corporation, the payment of
salary by the Commercial Bank of Ethiopia, and the purchase of Building
by Unity University College are examplesof economic events.

2. Once identified and measured in Birr and cents, economic events are
recorded to provide a permanent history of the financial activities of the
organization. Recording consists of keeping a chronological diary of
measured events in an orderly and systematic manner. In recording,
economic events are also classified and summarized. (This will be
discussed in detail in unit-2)
3. This identifying and recording activity is of little use unless the
information is communicated to interested users. The information is
communicated through the preparation and distribution of accounting
reports, the most common of which are called financial statements.

A Vital element in communicating economic events is the accountant’s ability

and responsibility to analyze and interpret the reported in formation. Analysis

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involves the use of ratios, percentages, graphs and charts to show the importance
of financial trends and relationships. Interpretation involves explaining to the
user the meaning, and limitation of reported data. The analysis and
interpretation part is left for advanced courses in accounting.

As accounting plays an important role in the decision making process of

business entities, it is often called the language of business. As a result, whether
you are an economist a marketer, investor, supplier or any other, to be
successful, you should be able to “speak” and be familiar with the basic terms
used in the business environment.

1.2.2 Importance of Accounting and Users of Accounting Information

Importance of accounting
The main purpose of accounting is to provide financial information to be used
for decision-making. For instance, Business executives and managers need the
financial information provided by the accounting system to help them plan and
control the activities of the business. Outsiders such as bankers, potential
investors, and labour unions and others also need accounting in formation.

In short the goal of the accounting system is to provide useful information to

decision makers. Thus, accounting is the connecting link between decision
makers and business operations.

1.3 BOOKKEEPING VERSUS ACCOUNTING

People often fail to understand the difference between accounting and

bookkeeping. Bookkeeping is the process of recording business activities, and
keeping the records. It is the record- making phase of accounting. The

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recording of transactions in Bookkeeping tends to be mechanical and repetitive;
it is only a small and probably the simplest but important part of accounting.

Accounting, on the other hand, includes the design of an information system that
meets users’ needs. The major goals of accounting are the analysis,
interpretation, and use of information. Accounting includes system design,
budgeting, cost analysis, auditing and tax planning and preparation.

A person might become a reasonably proficient bookkeeper in a few weeks or

months; however, to become a professional accountant requires several years of
study and experience.

Check Your Progress Exercise -1

1. Answer the following questions and compare your answer with the
answer key at the end of the unit.
a. Define accounting
b. Write in few words the importance of accounting.
c. Describe the basic distinction between accounting and
bookkeeping.

Users of Accounting Information

Today’s accountants focus on the ultimate needs of those who use accounting
information, whether the users are inside or out side the business. Accounting is
not an end by itself. The information that accounting provides allows users to
make “reasonable choices among alternative uses of scarce resources in the
conduct of business”

The people who use accounting information basically fall in to two categories:

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 1. External Users, and
2. Internal Users

1) External Users: External Users of accounting

information are parties, which are not directly involved in running the
business enterprise. These include lenders, shareholders (stock holders),
suppliers, employees and their Unions, government (regulatory bodies) and
others. External users rely (depend on) accounting information to help them
make better decisions in trying to achieve their goals.

- The area of accounting aimed at serving external users is called Financial

Accounting. Its main objective is to provide to external users information
through financial statements.

Each external user has its own specified information-need depending up on the
decisions to be made. That is to say, all external users do not have the same
intentions (objectives) when they use the information.

In the following paragraphs we well try to discuss how some external users use
accounting information.

a) Lenders / Creditors

Creditors lend money or other resources to an organization. Lenders include

banks, mortgage and finance companies. Lenders look for information to help
them assess the ability of borrowers to repay their debts.

b) Share- holders (Stockholders)

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Shareholders have legal control over part or all of a corporation. When it comes
to a corporation, shareholders are not directly involved in the management of the
corporation. However, as owners, they have claims over the properties of the
organization. Financial reports help to answer shareholders’ questions such as:

- what is the income of the organization for the current and past periods?
- are the properties adequate to meet business plan?
- will the business continue to be profitable in the future?

c) Employees and labour Unions

Employees and labor unions are interested in judging the fairness of their wages
and assessing future job prospects. They also use accounting reports as
evidence to ask for bonuses, when the organization is successful.

d) Government

The Inland Revenue Authority requires organizations to prepare financial

reports, in order to compute taxes.

2) Internal Users: These are persons that are directly

involved in managing and operating an organization. They include managers
and other important decision makers. The internal role of accounting is to
provide information to help improve the efficiency and effectiveness of an
organization.

The area of accounting aimed at serving the decision-making needs of internal

users is called Management Accounting. Internal users often have access to a

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lot of private and valuable information. Internal reports aim to answer questions
like:

 What are manufacturing costs per product?

 Which service activities are most profitable?
 What level of sales is necessary to break even?

1.4 THE ACCOUNTING PROFESSION

If you just joined the accounting profession, you may be wondering what job
you will be doing in the future. You probably would apply your expertise in one
of three major fields:

 Public Accounting
 Private Accounting or
 Not – for – profit Accounting

i) Public accounting
In Public Accounting you would offer expert service to the general public in
much the same way that a doctor serves patients and a lawyer serves clients. A
major portion of public accounting practice is involved with Auditing. In this
area, a certified Public Accountant (CPA) examines, the financial statements of
companies and expresses opinion as to the fairness of presentation. When
presentation is fair, users consider the statements to be reliable.
Management consulting is another area of public accounting. In this case, the
accountant consults the management generally about the growth and
development of the business enterprise.

ii) Private Accounting

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Instead of working in public accounting, an accountant may be an employee of a
business enterprise. In private accounting, you would be involved in one of the
following activities:
1. Cost Accounting: Determining the cost of producing specific
products.

2. Budgeting: Assisting management in quantifying goals concerning

revenues, costs of goods sold, and operating expenses.

3. General Accounting: recording daily transactions and preparing

financial statements and related information.

4. Accounting information systems: designing both manual and

computerized data processing systems.

5. Tax Accounting: preparing tax returns (-forms to be filled by a

company and returned to a taxing authority) and engaging in tax planning
for the company.

6. Internal Auditing: reviewing a company’s operations to determine

compliance with management policies and evaluating efficiency of
operations.

iii) Not for Profit Accounting

Like businesses that exist to make a profit, not - for-profit organizations also
need sound financial reporting and control. Donors to such organizations want
information about how well the organization has met its objectives and whether

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continued support is justified. In each of these cases, accounting expertise is
highly valued.

Check your Progress Exercise -2

1. What are the basic categories of the users of accounting information?

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2. _____________is the area of accounting aimed at serving external users

of accounting information.

3. _____________ is the area of accounting aimed at serving the decision-

making needs of internal users.

4. What are the three major fields of engagement for accountants?

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1.5. ACCOUNTING PRINCIPLES AND CONCEPTS

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. The principles and
concepts used in accounting are called Generally Accepted Accounting

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Principles (GAAP). These principles guide accountants how to record and
report business activities.

GAAP are developed over a long span of years by the accounting profession.
That is, their development is not revolutionary rather evolutionary. The main
purpose of these basic rules is to guide accountants in measuring and reporting
financial events of business enterprises.

GAAP are not like the unchangeable laws of nature found in biology and
chemistry. They can be changed as better methods are developed or as
circumstances change. Generally, it is from research, practice, and
pronouncements of professional bodies that GAAP evolve.

In this unit, we will discuss three of the generally accepted accounting

principles: Business Entity concept, Cost principle and Monetary Unit
Assumption.

i) Business Entity Concept

Accountants frequently refer to a business organization as an accounting or
business entity. A business entity is any business organization, such as a “super
market”, laundry, barberry, or a hotel, which exist as an economic unit. For
accounting purposes, each business enterprise has a separate existence from its
owners, creditors, employees, customers and other businesses.

This separate existence of the business enterprise is known as the business entity
concept. Thus, the business entity should have a completely separate set of
records and its financial records and reports should refer only about the business
enterprises.

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For example, W/o Muna Mamo has got her own two business enterprises one
called Munaye Super Market, and another hotel called Budena Hotel. Each
Business would be considered as an independent economic business unit. The
activities of each business are kept separately from each other and from the
owner’s personal records. Let say W/O Muna bought a house to live in. This
house would not be recorded and reported in the records of either the
supermarket or the hotel. The personal saving account she has will not as well
be included in the financial reports of either one of the businesses. She must
have to open separate bank accounts for the two businesses. The super market
should not record the payment of salary to employees of the hotel.

ii) The cost principle

The cost principle states “properties and services acquired by business
enterprises must be recorded at actual amounts paid or assumed in acquiring the
properties.”

For example, Modern Advertising Company is considering the purchase of a

building. The seller of the building offered a price of Birr 10,000 while the
buyer first offered a price of Birr 8000. However, after certain bargaining, the
seller agreed to sell the building for Birr 9000 and the buyer paid that amount.
According to the “cost principle” the buyer has to record the building in its
records at birr 9000- the actual amount paid to get the building.

The buyer may receive an offer of Birr 12,000 for the building a month after if
has been acquired. This has no effect on the accounting records because it
doesn’t originate from an actual exchange. It is simply a mere offer.

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If the buyer sells the building for Birr 20,000 after purchasing it, a gain of Birr.
11,000 would be realized. The new owner would use Birr 20,000 as the cost of
the building.

In an exchange between a buyer and a seller, both attempt to get the best price.
Only amounts agreed up on and paid are objective enough for accounting
purposes.

Monetary Unit Assumption

All business activities (events) are recorded in terms of money (-Birr, Dollar,
Pound or any other currency). Of course, information of a non -financial nature
can be recorded, but it is only through the recording of dollar (Birr) amounts that
the activities of a business can be measured. Money is the only factor common
to all business activities. Therefore, it is the only practical unit of measurement
that can produce financial data that can be compared.

The monetary unit used by a business depends on the country in which it exists.
For example, in Ethiopia the basic unit of measurement is the birr,as is the dollar
in the U.S.A, and Pound Sterling in the United Kingdom.

Check Your Progress Exercise -3

1. The abbreviation GAAP stands for ____________________________.

2. What do we mean by “GAAP are not like the unchangeable laws of

nature”?
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……………………………………………………………………………………
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3. Why do we need to record all business activities in terms of money?
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4. What is the principle that says properties acquired by business enterprises

must be recorded at actual amounts paid?
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………………………………………

1.6 FORMS OF BUSINESS ORGANIZATIONS

There are three basic forms of business organizations: sole proprietorships,

partnerships, and corporations. Accountants recognize each form as an
economic unit separate form its owners (Business Entity Concept).

In this course, we will begin by the accounting for sole proprietorships because
it is the simplest form of accounting.

1. Sole Proprietorships

A sole proprietorship is a business owned by one person and usually managed

by the owner. No special legal requirements must be met to start a sole

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proprietorship and usually only a limited investment is required to begin
operations.

A sole proprietorship is a separate entity for accounting purposes (Business

entity Concept) 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.

For instance, assume Flower Laundry is a sole proprietorship owned by Ato

Alemu. Assume also that the business has borrowed Birr 10,000 from the
Commercial Bank of Ethiopia and failed to pay its debts. In this case, if the
Commercial Bank of Ethiopia can’t recover the amount it lent from the
properties of the company it can go to the extent of selling the owner’s personal
properties.

2. Partnerships

A Partnership is like a sole proprietorship in most ways except that it has more
than one owner. A partnership is not a legal entity separate from the owners but
an association that brings together the talents and resources of two or more
people. The owners of a partnership are known as partners.

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.

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3. Corporations

A business organized as a separate legal entity with ownership divided into

transferable units of capital is called a corporation. The owners of a corporation
are called stockholders or shareholders. The corporation issues capital stock
certificates to each stockholder showing the number of shares (orstock) he or she
owns. The stockholders are free to sell all or part of these 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 owners (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.

Even though corporations are fewer in number than proprietorships and

partnerships, they contribute a lot to the economies of many countries in
monetary terms.

1.7 BUSINESS TRANSACTIONS AND THE ACCOUNTING EQUATION

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, as cotton is a raw
material for a textile factory.

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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. A transaction
can also be an event that has the same effect as an exchange transaction but
doesn’t involve an exchange transaction. Some examples of “non exchange”
transactions are losses from fire, flood; physical wear and tear on equipment;
donation of property and so forth.

For a given transaction to qualify to be recorded it has:

1. to be related to the business enterprise
2. to be measurable in terms of money
3. to be completed / happened/ action.

(i.e. it should not be a mere promise or intention; it must be at least partially

completed to be recorded)

1.7.1 Assets, Liabilities and Owner’s Equity

If you have noticed, in any organization you will find properties such as a
building, furniture, land, vehicles and the like. Such properties owned by
business enterprises are referred to as Assets. To buy these assets, businesses get
money from two sources: investments made by owners or amounts borrowed
from creditors. Therefore, both owners and creditors have a claim over the
assets of the business enterprise. The claims or rights of owners are referred to
as Equities. If the assets owned by a business amount to Birr 50,000 the
equities in the assets must also amount to Birr 50,000. The relationship between
the two may be stated in the form of an equation, as follows:

Economic Resources = claims over the resources

Assets =Equities.

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Equity may be subdivided in to two principal types: the rights of creditors and
the rights of owners. The rights of creditors represent debts of the business and
are called Liabilities. The rights of owners are called Owners’ Equity (capital).

Assets=equities
Equities = Liability + Owner’s equity
This equation can be written as:
Assets= liability + Owner’s Equity

It is customary to place “liabilities“ before “Owners equity” in the accounting

equation because creditors have priority (preferential) rights to the assets.
Because of this, the owners have a residual claim over the assets. To help you
understand this, assume X company has total assets of Br. 5000, liabilities of Br
2000 and owner’s equity of Br 3000. If the business is to be closed, the assets of
the company will be sold and distributed to the claimants. In accounting, the
Owner’s are given their share after the creditors are given their entire share. For
example, assume the assets are sold for Br 4,500. The creditors will be given
their share of Br. 2,000 and what ever remained (Br.2,500)is given to the
owners. If the assets were sold for Br. 7,000, the creditors would have been
given their share of Br. 2,000 and the remaining balance Br 5,000 would have
been given to the owners.

Liabilities
Assets &
Capital

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As you can notice, the owners are given whatever is left (it could be greater or
less than their share). That is why we said owners have residual claim over the
assets of the business whereas creditors are said to have priority clam over the
assets as they are paid first

Check Your Progress Exercise -4

1 Business organizations are classified in to three, based on what?

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2 What do we mean by the term ‘unlimited liability’?

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3 Which of the three forms of business originations is (are) separate legal

entity (entities) from their owners?
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4 ___________________ represents the claim of owner’s against assets of

the business enterprise.

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5 Assume total asset of Br 60,000, and owner’s equity of Br 45,000.
Determine the amount of liability .
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6 L=A-C Is this an acceptable way of writing the basic accounting

equation? Explain.
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7 What do we mean when we say “owners have a residual claim over the
assets of the business enterprise”?
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8 Define a business transaction, and give at least four examples.

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1.7.2 Transactions and the Accounting Equation

All business transactions from the simplest to the complex can be stated in terms
of the resulting effect on the three basic elements of the accounting equation.
How ever, it is important to remember that each transaction leaves the equation
in balance. Assets always equal the sum of liabilities and owner’s equity.

Let’s examine the effects of some of the most common business transactions on
the accounting equation. As a means of illustration, suppose Ato Dawit
Gemechu establishes a sole proprietorship to be known as Effective Garage, on
September1,200x . During September, the business engages in the following
transactions:

Transection (1)- Owner’s investment

Ato Dawit starts business by depositing Br. 100,000in a bank account opened in
the name of Effective Garage. The transfer of cash from the owner to the
business is on owner’s investment. The effect of the transaction is to increase
the assets (Cash) on the left side of the accounting equation by Birr 100,000 and
to increase owner’s equity by the same amount.

Assets = Liabilities + Owner’s Equity

Cash Dawit Gemechu, Capital

Tran.1 + Br. 100,000 +Br. 100,000
Balance Br. 100,000 Br. 100,000

At this point, the company has no liabilities; the only party having claim over
the assets of the company is the owner.

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N.B. the equation relates only to the business enterprise. Ato Dawit’s personal
assets, such as his home and personal bank account and personal liability are
excluded from consideration. The business must be treated as a separate entity.

Transaction (2)- Purchase of land for cash

Effective Garage bought land for Birr 20,000 in cash, to be used as a future site
for the business. This transaction changes the composition of the assets but it
doesn’t change the total amount of assets. It has no effect on the liability and
owner’s equity of the business.

Assets = Liabilities + Owner’s Equity

Cash + Land Dawit Gemechu, Capital.
Bal. Birr 100,000 Birr 100,000
Tran. 2 -20,000 +20,000 __-_____
Bal. Birr 80,000 + Br.20,000 = ________________ 100,000__

After the above transaction, the company will have less cash but a new asset
(land ). The total assets (cash + Land) amount to Birr 100,000, which is equal to
the owner’s equity.

Transaction (3) -Purchase of Supplies On credit

Ato Dawit bought office supplies for birr 2,500 on credit, to be used by the
business. Assets can be purchased on credit (on account) basis, where the buyer
promises to pay in the future. This type of transaction is called a purchase on
account and it results in a liability to the buyer; the liability created when
something is bought on credit is called Accounts Payable.

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 Assets______ = Liability + Owners
Equity
Cash + Supplies + Land Accounts payable Dawit
Gem, Captal
Bal. Birr 80,000 Br.20,000 Birr 100,000
Tran(3) -___ + 2,500 - + 2,500 ___ -
____
Bal. Br. 80,000 2,500 20,000 2,500
100,000
Birr 102,500 Birr 102,500

Goods that are physical consumed, such as a chalk to a school, gas oil for car,
and stationery materials for an office, are called supplies.

Transaction ( 4 ) – Payment of liability

Effective Garage paid Birr. 1,500 to creditors on account. As you might have
noticed, the business bought the supplies in transaction “C” by promising to pay
in the future, and as per the promise made it is now settling its liability. The
effect of this transaction on the accounting equation is as follows:

Assets______ = Liability + Owners

Equity
Cash + Supplies + Land Accounts payable Dawit
Gem, Captal
Bal Br 80,000 Br. 2,500 Br.20,000 Birr 2,000 Birr
100,000
Tran.4 -1,500 - - -1,500 -
___

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 Bal. Br. 78,500 Br.2,500 Br.20,000 Birr 1,000 Birr
100,000
Birr 101,000 Birr 101,000

As a result of the transaction, the total cash decreases by birr 1,500 because cash
is paid and the liability of the company also decreases by the same amount.
After the above transaction is completed, the total amount the company has to
pay in the future is only birr 1,000. Please note that the transaction has no effect
on the supplies that were bought on credit.

Transaction 5 – Selling of service

The amount charged to customers for goods or services sold to them is called
revenue. For instance, the amount of money that you pay to a shopkeeper after
buying a pair of shoes or something is revenue to the shopkeeper. Different
titles may be used for revenue depending up on the source of revenue. For
example, a service fee for a garage, interest revenue for interest earned by a
bank, rent income for revenues that result from renting rooms, fares earned for
revenues from a taxi service and others.

During the first month of operation, Effective Garage earned service Fees of
Birr 30,000 receiving the amount in cash for the garage services it rendered.

The effect of this transaction is to increase assets (because cash is collected) and
to increase owner’s equity by the same amount as revenue is earned.

Assets______ = Liability + Owners

Equity

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 Cash + Supplies + Land Accounts payable Dawit
Gem, Captal
Bal Br 78,500 Br. 2,500 Br.20,000 Birr 1,000 Birr
100,000
30,000 - - -
30,000
Bol. Br. 108,500 Br.2,500 Br.20,000 Birr 1,000 Birr
130,000
Birr 131,000 Birr 131,000

Service can be given for cash or on credit. In this example, the service is given
for cash (i.e., the company collects the cash on the spot service was given). But
instead of requiring customers to pay at the time of sale, a business may let the
customers to pay in the future. Such expected collections in the future result in
an Accounts Receivable to the company. An accounts receivable is as much an
asset as cash to the business enterprise. And the revenue from the sale of the
service or good on credit is realized and recorded on the date of sale with out
waiting for the collection of the cash.

Transaction (6 )- Recording Expenses

To generate revenue, Effective Garage has to hire employees and pay salary, it
has to consume electric power and water resource and pay the bill, and so forth.
The amounts of such cash payments and using up of supplies are expenses to the
business. That is, an expense is the amount of assets consumed or services used
in the process of generating revenue. Just as revenues are recorded when they
are earned, expenses are recorded when they are incurred (i.e. when the
obligation to pay them arises).

26
During the month of September, Effective Garage paid Birr 15,000 for different
types of expenses (birr 10,000 to salary of employees, birr 3000 Telephone, birr
1,500 for rent, and birr 500 for advertisement).

The effect of these transactions is to decrease assets (because cash is paid) and
decrease owner’s equity. This can be stated on the accounting equation as
follows:

Assets______ = Liability + Owners

Equity
Cash + Supplies + Land Accounts payable Dawit
Gem, Captal
Bal Br108, 500 Br. 2,500 Br.20,000 Birr 1,000 Birr
130,000
-15,000 - - __-___ -
15,000___
Bol. Br. 93,500 Br.2,500 Br.20,000 Birr 1,000 Birr
115,000
Birr 116,000 Birr 116,000

Transaction – 7 Owner’s Withdrawal

Ato Dawit Gemechu, the owner, withdrew Birr 3000 for his personal from the
business. Such assets taken out of the business for the owner’s personal use, by
the owner are called withdrawals. Owners can withdraw in cash or in kind. For
example, an owner of a super market can withdraw soap or something for his
personal benefit instead of cash.

27
The effect of the transaction in our case is to decrease assets as cash is taken out,
and decrease owner’s Equity by the same amount. This can be stated on the
accounting equation as follows:
Assets______ = Liability + Owners
Equity
Cash + Supplies + Land Accounts payable Dawit
Gem, Captal
Bal Br 93, 500 Br. 2,500 Br.20,000 Birr 1,000 Birr
115,000
-3,000 - - __-___ -
3,000___
Bol. Br. 90,500 Br.2,500 Br.20,000 Birr 1,000 Birr
112,000
Birr 113,000 Birr 113,000
Summary
The transactions of Effective Garage can be summarized in a tabular form as
shown below. Number identifies the transactions here and the balance of each
item is shown after each transaction.
Assets______ = Liability + Owners
Equity
Type of
Tra Accounts Dawit Gem. owner’s
. Cash + Supplies + Land Payable Capital Transactio
No n
1 +100,000 - - - + 100,000 Owners
Investmen

28
 t
Bal Birr - - - Birr
100,000 100,000
2 -20,000 - + 20,000 - -
Bal Birr - Birr - Birr
80,000 20,000 100,000
3 - +2500 +2500
Bal Birr Birr 2,500 Birr Birr2500 Birr
80,000 20,000 100,000
4 -1,500 - -1500
Bal Birr Birr 2,500 Birr Birr1,000 Birr
78,500 20,000 100,000
5 + 30,000 - - - + 30,000 Service
fee
Bal Birr Birr 2,500 Birr Birr1,000 Birr
108,500 20,000 100,000
6 -15,000 - - - -10,000 Salary
-3000 Exp.
Teleph.
Exp
- - - - -1500 Rent Exp.
-500 Adv. Exp.
Bal Birr Birr 2500 Birr Birr 1000 Birr
93,500 20,000 115,000
7 -3,000 - - - -3000 Owner’s
withdrowa

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 l
Bal Birr Birr 2500 Birr Birr 1,000 Birr
90,500 20,000 112,000
Total Assets =Birr 113,000 Total Liabilities and Owner’s Equity
= Birr 113,000

The following Observations, which apply to all types of Businesses, should be

noted:
1. The effect of every transaction can be stated in terms of increases and /or
decreases in one or more of the elements of the accounting equation.
2. The equality of the two sides of the accounting equation is always
maintained.
3. The owner’s investment and revenues increase the owner’s equity.
Withdrawals and expenses during the period decrease the owner’s equity.
The effect of these four types of transactions on owner’s equity can be
illustrated as follows:

Owner’s Equity

Decreased by: Increased by: Owner’s Investment and Revenues

Owner’s withdrawals and Expenses

The relationship of the above elements and their effect on the capital balance
can be shown as:
EC = BC + I – W + R - E
Where: EC – End Capital Balance

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 BC - Beginning Capital Balance.
I - Owner’s Investment
W - Owner’s Withdrawals
R - Revenue
E - Expense.

1.8 FINANCIAL STATEMENTS OF SOLE

PROPRIETORSHIPS

After the effect of the individual transactions has been determined, the essential
information is communicated to users at certain intervals. The accounting
reports, which communicate this information, are called financial statements.
Financial statements are said to be the central features of accounting because
they are the primary means of communicating important accounting information
to users.

Financial statements are the means of transferring the concise picture of

the profitability and financial position of the business to interested parties.

The major financial statements used to communicate accounting information

about a business are:
- income statement
- balance sheet
- statement of owner’s Equity
- statement of cash flows (will be discussed in senior courses)

Since these financial statements are in a sense the end products of the
accounting process, a student who acquires a clear under standing of the content
and meaning of financial statements will be in an excellent position to appreciate

31
the purpose of the earlier steps of recording and classifying business
transactions.

1.8.1 The Income Statement

The income statement is a financial statement that

summarizes the amount of revenues earned and
expenses incurred by a business over a period of
time. It reports the profitability of the business by
comparing revenues and expenses for a stated period
of time such as a month or a year. In accounting profitability is
measured for a period of time than on a daily basis. Though measuring daily
could be possible, it will not be practical and beneficial to the business
enterprise.

If the revenue of a period exceeds the expenses of that same period, net income
results. If expenses are greater than the revenues of a period, we say there is a
net loss, that is, the business has operated unprofitably.

N.B. The determination of periodic net income (net loss) is a matching process
involving two steps. First revenues earned are recognized during the period.
Second, the expenses incurred to generate revenues are matched (compared)
against revenues to determine net income or net loss.

All financial statements have a heading that you can find in any kind of a report.
The heading of these statements identifies the company, the type of statement,

32
and the time period covered by the statement. Note that the primary focus of the
income statement is reporting the success or profitability of the company’s
operations over a specified period of time. To indicate that it applies for a
period of time, the income statement is dated “For the month ended…”
The following is an income statement for Effective Garage for the month ended
September 30, 200x.

Effective Garage
Income statement
For the Month Ended September 30,200x

Revenues:
Service Fee Birr 30,000.00
Expenses:
Salary Expense Birr 10,000.00
Telephone Expense 3,000.00
Rent Expense 1,500.00
Advertising Expense 500.00
Total Expenses 15,000.00
Net Income Birr 15,000.00

1.8.2 Owner’s Equity Statement

This is a statement that summarizes the changes in owner’s equity for a specific
period of time. Data for the preparation of owner’s equity statement are
obtained from the owner’s equity column of the tabular summary (Illustration 1-
) and from the income statement. The heading of this statement identifies the
company, the type of statement, and the time period covered by the statement.

33
The time period is the same as that covered by the income statement and
therefore is dated “ For the Month Ended September 30, 200x.” The beginning
owner’s equity amount is shown on the first line of the statement. Then, the
owner’s investments, net income and the owner’s drawings are identified in the
statement.

The information provided by this statement indicates the reasons why owner’s
equity has increased or decreased during the period. The Owner’s equity
statement for effective Garage for the month of September is shown below:

Effective Garage
Statement of Owner’s Equity
For the Month ended September 30,200x

Dawit G. Capital, September 1……………………………………Birr -0-

Add: Investments…………………………………Birr 100,000.00
Net income……………………………………15,000.00
115,000.00
115,000.00
Less: Drawings………………………………………………………………
3,000.00
Dawit G. Capital, September 30………………………………… Birr
112,000.00

1.8.3 Balance Sheet

34
The balance sheet, sometimes called the statement of
financial Position, lists the company’s assets,
liabilities and owner’s equity as of a specific date-
usually at the end of a month or year.

Shown below is the balance sheet for Effective Garage as of September 30,
200x. The balance sheet heading contains the name of the company, the type of
statement, and the specific date on which assets; liabilities and owner’s equity
are identified and measured.

The total assets must equal the total liabilities and owner’s equity. There are tow
commonly used formats of the balance sheet:

The account format

Which lists assets on the left side and equities (i.e. liability and owner’s equity)
on the right side. It resembles a basic accounting format called an ‘account’ to
be introduced in unit 2.
_________
_________
_____
Assets Liability

Owner’s
Equity

The Report Format

-Lists assets, Liability and Owner’s equity vertically

35
__________
_________
_____

Assets

Liability

Owner’s Equity

You can choose either of the two formats for your balance sheet preparation.

The following is a balance sheet prepared for effective Garage based on the
sample transactions illustrated in the chapter.

Effective Garage
Balance Sheet
September 30,200x

Assets Liability
Cash…………Birr 90,500.00 Accounts payable…… Birr
Supplies……………2,500.00 1,000.00
Land………………20,000.00
Owner’s Equity
_________ Ato Dawit Gem., Capital
Total Assets……..113,000.00 Br12,000.00.

36
 Total Liabilities and
Owner’s equity……...Birr
113,000.00

The double line is drawn only when the total assets on the left side are equal to
total liabilities and Owner’s equity. In the Effective Garage illustration, only
one liability- accounts payable- is reported on the balance sheet. In most cases,
there will be more than one liability. When two or more liabilities are involved,
a customary way of listing is as follows:

Liabilities
Notes payable Birr 10,000.00
Accounts Payable 1,000.00
Salaries Payable 2,000.00
Total Liabilities Birr 13,000.00

Each statement provides management, owners, and other interested parties with
relevant financial data. The financial statements are interrelated: (1) Net income
of Birr. 15,000 shown on the income statement is added to the beginning
balance of owner’s capital in the owner’s equity statement. (2) Owner’s capital
of Birr 112,000 at the end of the reporting period shown in the Owner’s equity
statement is reported on the balance sheet as the Dawit G/M. capital balance.

Be sure to carefully examine the format and content of each statement.

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Check Your Progress Exercise -5

1. _____________ are assets used or consumed in the process of generating

revenue.

2. Drawings are assets taken out of the business for the owner’s personal
benefit. Do you advise owners to withdraw cash or in kind (i.e. furniture,
automobile..)? Why?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………
3. List the four factors that change owner’s equity. What is their effect on
owner’s equity?
……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………

4. What are the four financial statements?

……………………………………………………………………………………
……………………………………………………………………………………
……………………………………………………………………………………
………………………………………

5. Every financial statement has three lines as a heading,

1st line____________________________

38
 2nd line___________________________
3rd line __________________________

1.9 SUMMARY

Explain the meaning of accounting. Accounting is the process of identifying,

measuring recording and communicating the economic events of an organization
(business or non business) to interested users of the information. Accounting
helps us in the allocation of scarce resources in an efficient and effective
manner.

Identify the users and uses of accounting. (a) Management uses accounting
information in planning controlling and evaluating business operations. (b)
Investors (owners) judge the wisdom of buying, holding, or selling their
financial interests on the basis of accounting data, i.e. to see how their
investment is doing. (c) Creditors evaluate the risks of granting credit or lending
money. Other groups of users include taxing authorities, regulatory agencies,
customers, labor unions, and economic panniers. These users are grouped in to
two: 1- Internal users and ii- External users.

Explain the meaning of generally accepted accounting principles: Generally

accepted accounting principles are a common set of standards used by
accountants.

Explain the meaning of business entity assumption, cost principle and the
monetary unit assumption. The business entity concept states the economic
events of a particular business should be identified separate from other entities
and the owner’s personal records. The cost principle requires properties

39
acquired by business enterprises to be recorded at actual amounts paid and /or
assumed in acquiring the properties. The monetary unit assumption requires
only transactions capable of being expressed in terms of money be included in
the accounting records of the business enterprise.

State the basic accounting equation and explain the meaning of assets, liabilities,
and owner’s equity. The basic accounting equation is:

Assets = Liabilities + Owner’s Equity.

Assets are resources owned by a business, liabilities represent the claim of

creditors on the total assets, and owner’s equity is the ownership claim on
the total assets. It is often referred to as residual equity.

Analyze the effects of business transactions on the basic accounting equation.

Each business transaction must have a dual effect on the accounting equation.
For example, if an asset is decreased, there must be a corresponding (1)
Increase in another asset, or (2) decrease in a specific liability, or (3) decrease in
owner’s equity. After each transaction, the equality of assets to the sum of
liabilities and Owner’s equity must be maintained.

Prepare an income statement, owner’s equity statement, and balance sheet. An

income statement presents the revenues and expenses of a company for a
specific period of time. An owner’s equity statement summarizes the changes in
owner’s equity that have occurred for a specific period of time. A balance sheet
reports the assets, liabilities, and owner’s equity of a business at a specific date.

1.10 ANSWERS TO CHECK YOUR PROGRESS EXERCISES

40
Check Your Progress Exercise - 1

1) Accounting is the process of identifying, measuring, recording and

communicating economic events to permit informed decisions and decisions
by the users of the information.
2) Accounting as an information system helps others to make informed
decisions about the use of scarce resources.
3) Bookkeeping is the recording part of accounting. Accounting includes
analytical interpretation phases in addition to the recording phase.

Check Your Progress Exercise –2

1) i )internal users ii) external users.

2) Financial Accounting
3) Management Accounting
4) i) Public accounting
ii) Private accounting
iii) Not –for- profit accounting

Check Your Progress Exercise - 3

1. Generally Accepted Accounting Principles.
2. GAAP, are open for change whenever better methods are developed or as
circumstances change.
3. It is the only common unit of measurement to all business enterprises.
That is, why comparison of two unrelated business enterprises is possible.
4. The Cost Principle

Check Your Progress Exercise –4

41
1. Based on the number of people who own them and the style of ownership.
2. Unlimmitted Liability refers to the fact that the liability of the owners of a
sole proprietorship and a partnership is not limited to the extent of their
investment, but it extends to their personal properties.
3. Only corporations
4. Owner’s Equity
5. Liability=Asset –Owner’s Equity =>Liabilities=60,000-45,000=15,000
6. Though it is mathematically correct; it doesn’t reflect the practical fact
that capital is what is left after deducting liabilities from assets as creditor’s
claims take precedence over those of owners. Therefore, liability is not what
is left after owners take their shares.
7. When the assets of a business are not sufficient to satisfy all the claims of
both owners and creditors, first creditors are paid in full and owners take
whatever remains (i.e. the residue) even if this means they will not be fully
paid.
8. A transaction is an event that has to be recorded by accountants because it
affects the economic status of the business. The purchase of equipment, the
consumption of supplies, the collection of money from debtors, payment to
creditors, and the provision of service to customers are common examples of
transactions that accountants have to record daily.

Check Your Progress Exercise - 5

1. Supplies
2. It is not advisable for owners to withdraw in kind (such as a vehicle or
furniture) because this may interrupt the business's operation for sometime
until the withdrawn assets are replaced.

42
3. Factor Effect on owners equity
Revenues Increase
Expenses Decrease
Investment Increase
Drawings Decrease
4. The income statement, the balance sheet, statement of owner’s equity and
statement of cash flows.
- Name of company
- Name of report (statement)
- Period covered by financial statement

1.11 MODEL EXAMINATION QUESTIONS

1. Guji company had the following amounts of assets and liabilities at the
beginning and end of last year:
Assets Liabilities
Beginning of the year………………Br.75,000 Br. 30,000
End of the year….……………………120,000 46,000

Determine the net income or net loss of Guji for the year under each of the
following unrelated assumptions:
a) Owner made no additional investment and withdrew no amount during
the year
b)Owner made no additional investment but withdrew Br.17,500 to pay
for her personal expenses
c) Owner withdrew no amount during the year but made additional
investment of Br. 32,500 cash.

43
 d)Owner withdrew Br.17,500 and invested Br.25,000 cash during the
year.
2. For each of the following give an example of a transaction that creates the
described effects:
a) Decreases a liability and decreases an asset
b) Increases an asset and decreases another asset
c) Decreases an asset and decreases owners equity
d) Increases a liability and decreases owners equity
e) Increases an asset and increases a liability
f) Decreases an asset and decreases a liability

Mimi started a new business called Omo Company and completed the following
transactions during November:

Nov.1 Mimi transferred 56,000 out of a personal savings bank account to a

checking account she in the name of the business.
1. Rented office space and paid cash for the month’s rent of 800
3. Purchased electrical equipment for 14,000 by paying 3,200 and agreeing
to pay the remaining balance in six months
5. Purchased office supplies by paying 900 cash.
6. Completed electrical work and received 1,000 cash for doing the work.
3. Purchased 3,800 of office equipment on credit
15. Completed electrical work on credit in the amount of 4,000
20. Paid for the office equipment purchased on Nov.9
24. Billed a customer for electrical work completed 600
28. Received 4,000 for the work completed on Nov.15
30. Paid salary of employees 1,200

44
 30. Paid the monthly utilities bill 440
30. Withdrew 700 from the business for personal use

Required:
1. Arrange the following asset, liability and owner’s equity titles in a table
just like illustrated in this unit: Cash, Accounts Receivable, Office Supplies,
Office Equipment, Electrical Equipment, Accounts Payable and Mimi
Capital.

2. Use additions and subtractions to show the effect of each transaction on

the items in the equation. Show new totals after each transaction. Next to
each change in owners equity state whether the change was caused by an
investment, revenue, expense or withdrawal.

3. Prepare an income statement, a statement of owner’s equity, and a balance

sheet

1.12 GLOSSARY OF TERMS

Accounting - the process of identifying measuring, recording, and

communicating the economic events of an organization to interested users of the
information.

Assets – Resources owned by a business.

Auditing – the examination of financial statements by a certified public

accountant in order to express an opinion as to the fairness of presentation.

Balance Sheet – A financial statement that reports the assets, liabilities, and
owner’s equity on a specific date.

45
Basic Accounting Equation - Assets=Liabilities + owner’s equity

Bookkeeping – A part of accounting that involves only the recording of

economic events.

Corporation – a business organized as a separate legal entity under state

corporation law having ownership divided into transferable shares of stock.

Cost Principle – an accounting principle that states the assets should be

recorded at their actual cost .

Drawings – Withdrawals of cash or other assets from the business for the
owner’s personal use.

Economic (Business) Entity Assumption – An assumption that states a

business enterprise must be given separate and distinct existence from the
owners, creditors, customers and any other party.

Expenses - the cost of assets consumed or services used in the process of

earning revenue.

Income statement – A financial statement that presents the revenues and

expenses and resulting net income or net loss of a company for a specific period
of time.

Investment by owner – the assets put in to the business by the owner.

Liabilities – Represents the claim of creditors on the assets of the business.

46
Monetary unit assumption– An assumption stating that only transactions that
can be expressed in terms of money be included in the accounting records of the
business.

Net Income – the amount by which revenues exceed expenses.

Net loss – the amount by which expenses exceed revenues.

Owner’s Equity Statement – A financial statement that summarizes the

changes in owner’s equity for a specific period of time.

Partnership – An association of two or more persons to carry on a business as

co-owners for profit.

Private accounting – An area of accounting with in a company that involves

such activities as cost accounting, budgeting, and accounting information
systems.

Public Accounting – An area of accounting in which the accountant offers

expert service to the general public on a fee bases.

Revenues – the gross increase in Owner’s equity, resulting form business

activities entered in for the purpose of earning income. It is the amount charged
to customers for services sold or goods delivered to them.

Tax Accounting - an area of public accounting involving tax advice, tax

planning, and preparing tax returns.

Transactions – The economic events of the business recorded by the

accountant.

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48