2. Nature of Business and Accounting
• A business is defined as an organization established to earn
profit. Profit is the difference between the amounts received
from customers for goods or services and the amounts paid for
the inputs used to provide the goods or services. Businesses
range in scale from a sole proprietorship to an international
corporation.
3. Types of Businesses
• Service giving businesses:-
Provide services rather than goods
to customers. E.g Ethiopian Air
Lines (transportation services) etc.
• Merchandising businesses:- Sell
products they purchase from other
businesses to customers. E.g Wal-
Mart (general merchandise) etc.
• Manufacturing businesses:-
Change basic inputs into products
that are sold to customers. E.g
General Motors Corporation (cars,
trucks, vans), Dell Inc. (personal
computers) etc.
Three types of
businesses
operated for
profit include
service,
merchandising,
and
manufacturing
businesses.
5. B. Partnership
Owned by two or more
individuals called
Partners.
Limited life: The life a
business is limited to
the withdrawal of old
partner, admission of
new partner or death
of a partner.
Unlimited personal
liability: there isn't any
protection for the
partners' personal
assets if the business
fails to meet its debt.
Moderate to form
because it requires at
least partners
agreement.
Single taxation:- It is
taxed once
6. C. Corporation
A Corporation is the
most common type
of organization and
can have an
unlimited number of
owners called
shareholders.
Ownership divided
into shares
Separate legal entity
organized under state
corporation law
Limited liability:- It is a form of legal
protection for shareholders that prevents
individuals from being held personally
responsible for their company’s debts. In
other words, investors' and owners' private
assets are not at risk if the company fails to
meet its debt.
There are also
federal and local
regulations they
must follow.
Unlimited life:- The life
of a corporation is not
depend on the life of its
owners/shareholders.
Double Taxation:- It is
when income or profits
are taxed twice. This
may happen when
profit is taxed on the
corporate level and then
again as income on the
personal level.
7. What is Accounting?
Accounting is an information system that identifies, records
and communicates the economic events of an organization to
interested user.
It is a process of identifying, analysing, measuring, recording,
classifying, summarizing, reporting and interpreting the
financial information or economic events of an entity to the
decision-makers/interested users.
Accounting is “the language of business.” This is because
accounting is the means by which businesses’ financial
information is communicated to users.
8. Cont.
It is the language that Companies use to communicate the
firm's financial information to interested parties such as
Investors, Creditors etc. It is used as a means to exchange
information among interested parties concerning the financial
performance, financial position and related issues of an
organization.
Financial information refers to quantitative information
expressed in monetary terms.
9. Generally, accounting involves the following steps:
Identifying - tracing and collecting recordable economic
activities. Accounting does not record and report all economic
activities of an organization. Rather, it records and reports only
those economic activities of the organization which can be
expressed in terms of money.
Analyzing and Measuring - This involves determining
whether the economic activities bring changes
(increase/decrease) assets, liabilities, capital, revenues, and/or
expenses of an organization and expressing the changes in
monetary terms.
Recording - make, in a systematic way, a record of the effects
of economic activities on assets, liabilities, capital, revenues
and expenses.
10. Cont.
Classifying - grouping recorded effects of economic activities
into meaningful classes.
Summarizing - gathering and arranging data needed for
preparation of reports and statements.
Reporting - preparing statements and reports in a manner that
suits the need of users so as to communicate information
useful for decision making.
Interpreting - provide explanation on reported information so
that users can understand and use the information as a basis for
decision making.
11. Cont.
The process by which accounting provides information to
users is as follows:
1. Identify users. Internal and External
2. Assess users’ information needs. What type of accounting
information they need? E.g some may need profit information
others may need assets, liability information and so forth.
3. Design the accounting information system to meet users’
needs.
4. Record economic data about business activities and events.
Record business transactions in the accounting book of the entity
called Journal (will be discussed in Ch-2).
5. Prepare accounting reports for users. Income statement,
Owner’s equity statement or Retained earning statement,
Statement of financial position and Cash flow statement.
12. Users of Accounting Information
1. Internal users of accounting information include managers
and employees.
These users are directly involved in managing and operating
the business.
The area of accounting that provides internal users with
information is called managerial accounting or management
accounting.
The objective of managerial accounting is to provide relevant
and timely information for managers’ and employees’
decision-making needs. Often times, such information is
sensitive and is not distributed outside the business. Examples
of sensitive information might include information about
customers, prices, and plans to expand the business.
Managerial accountants employed by a business are employed
in private accounting (it will be discussed later)
13. Users of Accounting Information
2. External users of accounting information include customers,
creditors, investors, suppliers, government etc.
These users are not directly involved in managing and operating the
business.
The area of accounting that provides external users with information
is called Financial Accounting.
The objective of financial accounting is to provide relevant and
timely information for the decision-making needs of users outside of
the business. For example, financial reports on the operations and
condition of the business are useful for banks and other creditors in
deciding whether to lend money to the business.
14. Cont.
General-purpose financial statements is the most common type
of financial accounting report that is distributed to external
users.
The term general-purpose refers to the wide range of decision-
making needs that these reports are designed to serve.
Companies prepare a single set of general-purpose financial
statements aims to provide useful financial information about
the reporting entity to interested users.
Users expect these statements to present the company’s
financial operations fairly, completely, and clearly.
15. Characteristics of Accounting Information
Accounting information is mainly quantitative expressed in
monetary terms. To be useful for decision making, accounting
information should be:
Reliable - represent facts, neutral, free material errors and bias.
Relevant - highly related to and make a difference in decision.
Understandable - users with a reasonable knowledge of
accounting and economic activities should be able to easily
understand and interpret the information.
16. The Role of Accounting in Business
To identifying, recording and communicating the economic events
of an organization to interested users.
To prepare financial statements such as income statement, statement
of financial position, owner’s equity statement and cash flow
statement.
To prepare necessary notes and disclosures to the users about the
financial performances and positions of the organization.
To perform the managerial functions for the organization i.e;
business and non-business activities maintaining, budgeting,
standard-setting, controlling and decision making.
To analyse and interprets financial activities for next rectifying and
improvements.
17. Bookkeeping versus Accounting
Bookkeeping refers to the art of recording, in a prescribed and
systematic way, the economic activities of an organization. It
is routine and clerical in nature. Accounting, on the other hand,
goes beyond bookkeeping and is concerned with:
Designing accounting and reporting systems.
Recording economic activities.
Preparing reports and statements.
Interpreting reported information and
Reviewing records and reports for their accuracy.
Thus, it can be safely concluded that bookkeeping is one and
the simplest part of accounting.
18. Opportunities for Accountants
• Numerous career opportunities are available for students
majoring in accounting. Currently, the demand for accountants
exceeds the number of new graduates entering the job market.
This is partly due to the increased regulation of business
caused by the accounting and business frauds.
• Also, more and more businesses have come to recognize the
importance and value of accounting information.
1. Accountants employed by an entity are said to be employed in
private accounting.
19. Opportunities for Accountants
Private accountants have a variety of possible career options
within a company.
Under private accounting, accountants can be employed by
companies, government, and not-for-profit entities on the basis
of salary. They may be employed as Bookkeeper, Payroll
clerk, Certified Payroll Professional (CPP), General
accountant, Budget analyst or officer, Cost accountant,
Financial Manager, Certified Management Accountant (CMA),
Internal auditor, Certified Internal Auditor (CIA), Information
technology auditor etc.
20. Cont.
2. Public Accounting:- Accountants employed individually or
within a public accounting firm in tax, general consultant service
, audit services etc.
Accountants who provide audit services, called auditors, verify
the accuracy of financial records, accounts, and systems.
Several private accounting careers have certification options.
• Accountants and their staff who provide services on a fee
basis are said to be employed in public accounting.
• In public accounting, an accountant may practice as an
individual or as a member of a public accounting firm. Public
accountants who have met a state’s education, experience, and
examination requirements may become Certified Public
Accountants (CPAs). CPAs generally perform general
accounting, audit, or tax services.
• The required certification at the international level is having
Certified Public Accountant (CPA)
21. Role of Ethics in Accounting and Business
The objective of accounting is to provide relevant, timely
information for user decision making.
Accountants must behave in an ethical manner so that the
information they provide will be trustworthy and, thus, useful
for decision making.
Managers and employees must also behave in an ethical
manner in managing and operating a business.
Otherwise, no one will be willing to invest in or loan money to
the business.
22. Role of Ethics in Accounting and Business
Ethics are moral principles that guide the conduct of individuals.
Unfortunately, business managers and accountants sometimes
behave in an unethical manner.
A number of managers of the companies engaged in accounting or
business fraud.
These ethical violations led to fines, firings, and lawsuits. In some
cases, managers were criminally prosecuted, convicted, and sent to
prison. E.g American International Group, Inc. (AIG) inflate its
performance used sham accounting transactions. This led to CEO
resigned. Executives criminally convicted. AIG paid $126 million in
fines.
23. International Financial Reporting Standards
(IFRS)
IFRS:- a common set of standards that indicates how to report
economic events.
Financial accountants follow International Financial Reporting
Standards (IFRS) in preparing reports. These reports allow
investors and other users to compare one company to another.
International Accounting Standard bord (IASB) has the
primary responsibility for developing accounting principles.
The objective of IASB is to develop and improve accounting
standards (IFRS).
The objective of IFRS is to provide financial information
about the reporting entity that is useful to interested users.
IFRS are considered to be more “principles-based” than U.S.
GAAP, which is considered to be more “rules-based.”
24. Cont.
1. Business Entity Concept:-The business is viewed as an entity
separate from its owners, creditors, or other businesses. For example,
the accountant for a business with one owner would record the
activities of the business only and would not record the personal
activities, property, or debts of the owner.
• Under this principle, the activities of a business are recorded
separately from the activities of its owners, creditors, or other
businesses.
2. The Monetary unit concept:- Requires that economic data be
recorded in birr, dollars etc. Money is a common unit of measurement
for reporting financial data and reports.
25. 3. Measurement Principles
Fair value measurement: indicates that assets and liabilities
should be reported at market value.
– IFRS and the IFRS for SMEs require (or permit) fair value
measurement for a number of assets and liabilities.
– Existing Ethiopian Reporting does not permit use of fair
value measurement except in financial institutions.
• This measurement principle provides more relevant or useful
and reliable information for decision making than historical
cost principle.
26. Cont.
3.1. Cost Principle (Historical) – states that companies record
assets at their cost.
Assets are reported at cost when purchased and also over the
time the asset is held.
• To illustrate, assume that Aaron Publishers purchased the
following building on February 20, 2008: Price listed by seller
on January 1, 2008 $160,000, Aaron Publishers’ initial offer to
buy on January 31, 2008 140,000, Purchase price on February
20, 2008 150,000, Estimated selling price on December 31,
2010 220,000 and Assessed value for property taxes,
December 31, 2010 190,000. Under the cost concept, Aaron
Publishers records the purchase of the building on February
20, 2008, at the purchase price of $150,000. The other
amounts listed above have no effect on the accounting records.
27. Cont.
4. The objectivity concept:- Indicates that the amounts recorded
in the accounting records be based on objective evidence. Only
the final agreed-upon amount is objective enough to be recorded
in the accounting records.
5. Periodicity principle: It states that an organization can report
its financial results within certain designated periods of time.
This typically means that an entity consistently reports its
results and cash flows on a monthly, quarterly, or annual basis.
The economic life of business can be divided into artificial
time periods usually on annual basis.
28. Cont.
6. Going Concern/Continuity Assumption - the life of an economic
entity is indeterminate and the economic entity will continue in operation
long enough to carry out its existing objectives and commitments.
7. Revenue and expense recognition principle (Accrual Basis
principle): It states that revenues are recognized when earned
and expenses are recognized when consumed or incurred (accrual basis
of accounting).
8. Matching principle: It states that expenses incurred during a period
be recorded in the same period in which the related revenues are earned.
This principle recognizes that businesses must incur expenses to earn
revenues. (The remaining IFRS standards will be discussed in
Intermediate Accounting I Course)
29. Exercise
1. Combining the activities of Kellogg and General Mills would violate the
A. Cost principle. C. Economic entity assumption.
B. Monetary unit assumption. D. Ethics principle.
2. A business organized as a separate legal entity under state law having
ownership divided into shares is a
A. Proprietorship. C. Partnership.
B. Corporation. D. Sole proprietorship.
30. The Basic Accounting Equation
• Accounting Equation shows the mathematical relationship
among the assets, liabilities and equity of a business.
• Assets are resources controlled by a business and provide
future benefits. Examples of assets include cash, land,
buildings, and equipment etc. The rights or claims to the assets
are divided into two types: (1) the rights of creditors and (2)
the rights of owners. The rights of creditors are the debts of the
business and are called liabilities. The rights of the owners are
called owner’s equity. The following equation shows the
relationship among assets, liabilities, and owner’s equity:
• Assets = Liabilities + Equity
31. Cont.
• Liabilities usually are shown before owner’s equity in the
accounting equation because creditors have first rights to the
assets. However, owners have residual right over the assets of
an entity.
• Provides the underlying framework for recording and
summarizing economic events.
• Applies to all economic entities regardless of size.
32. Cont.
The expanded Accounting Equation is as follows:
Assets =Liabilities +Share Capital + Retained Earning ( For
Corporate business)
OR
Assets =Liabilities +Share Capital + Revenue-Expense –
Dividend ( For Corporate business)
OR
Assets =Liabilities +Owner’s investment+ Revenue - Expense
– Owner’s withdrawal (For non corporate business)
The equation must be in balance after every transaction.
33. Cont.
According to IFRS, assets are defined as resource
controlled by an entity as a result of past events and from
which future economic benefits are expected to flow to
the entity.”
• Liability is a present obligation of an entity arising from
past events, the settlement of which is expected to result
in an outflow from the entity of resources embodying
economic benefits” Some examples of liability are Bank loan
payable, Bond payable, Accounts payable, Salary payable, Tax
payable etc.
• Equity = assets – liabilities (‘net financial position’)
34. Cont.
Revenue:- are total incomes generated from performing
operative activities. Generally results from selling
merchandise, performing services, renting property, and
lending money.
It is the increases in economic benefits or returns during the
accounting period in the form of enhancements of assets or
decreases of liabilities that result in increases in equity. E.g.
Sales, Service revenue, Rent revenue, Dividend revenue,
Interest revenue etc.
35. Cont.
Expense:- are the cost of assets consumed or services used in
the process of earning revenue.
It is the decreases in economic benefits during the accounting
period in the form of outflows or reductions of assets or
incurrences of liabilities that result in decreases in equity or it
is the decreases in assets.
Common examples of expenses are salaries expense, rent
expense, utilities expense, tax expense, etc. Utilities
expense is the cost incurred by using utilities such as
electricity, water etc.
36. Cont.
Dividends are the distribution of cash or other assets to
shareholders or the portion of net income distributed to
shareholders.
Reduce retained earnings
Not an expense
37. Exercise:- Classify the following items as issuance of
shares, dividends, revenues, or expenses. Then indicate
whether each item increases or decreases equity.
.
Classification
1. Rent expense
2. Service revenue
3. Dividends
4. Salaries expense
Expense Decrease
Revenue Increase
Dividends Decrease
Expense Decrease
Effect on Equity
38. Business Transactions and the Accounting Equation
Transactions are a business’s economic events or activities
recorded by accountants. Economic events that affect the
financial performance or position of an entity. E.g. Paying a
monthly telephone bill of $168, affects a business’s financial
condition because it now has less cash on hand, purchasing
land for $50,000, Paying $10,000 salary to employees,
borrowing $ 100,000 cash from bank, selling of goods at $
2,000 etc.
Transactions may be external or internal.
Not all activities represent business transactions.
Each transaction has a dual effect on the accounting
equation and the effect may be only in the left/right or both
side of the accounting equation.
39. Exercise:- Are the following events recorded in the accounting
records? And analyze the effects of business transactions on the
accounting equation.
• .
Event
Purchase
computer.
Criterion Is the financial position (assets, liabilities, or
equity) or financial performance (income) of the
company changed?
Discuss
product
design with
customer.
Pay rent.
Record/
Don’t Record
40. Illustration: Transactions Analysis
Consider the following business transactions, and identify
which component of the accounting equation is affected and
analyze the effect (increase or decrease) of the following
transactions on the basic accounting equation.
• Transaction (1). Investment by Shareholders. Alex decides
to open a computer programming service entity which he
names Softbyte. On September 1, 2011, He invest $15,000
cash in exchange for capital shares.
• Transaction (2). Purchase of Equipment for Cash. Soft
byte purchases computer equipment for $7,000 cash.
• Transaction (3). Purchase of Supplies on Credit. Soft byte
purchases for $1,600 from Acme Supply Company computer
paper and other supplies expected to last several months.
41. Cont.
• Transaction (4). Services Provided for Cash. Softbyte
receives $1,200 cash from customers for programming
services it has provided.
• Transaction (5). Purchase of Advertising on Credit.
Softbyte receives a bill for $250 from the Daily News for
advertising but postpones payment until a later date.
• Transaction (6). Services Provided for Cash and Credit.
Softbyte provides $3,500 of programming services for
customers. The company receives cash of $1,500 from
customers, and it bills the balance of $2,000 on account.
• Transaction (7). Payment of Expenses. Softbyte pays the
following Expenses in cash for September: store rent $600,
salaries of employees $900, and utilities $200.
42. Cont.
• Transaction (8). Payment of Accounts Payable. Softbyte
pays its $250 Daily News bill in cash.
• Transaction (9). Receipt of Cash on Account. Softbyte
receives $600 in cash from customers who had been billed for
services [in Transaction (6)].
• Transaction (10). Dividends. The corporation pays a
dividend of $1,300 in cash.
44. Cont.
You should note the following in the above business
transaction summary:
1. The effect of every transaction is an increase or a decrease in
one or more of the accounting equation elements.
2. The two sides of the accounting equation are always equal.
3. The owner’s equity is increased by amounts invested by the
owner and is decreased by withdrawals by the owner. In addition,
the owner’s equity is increased by revenues and is decreased by
expenses.
45. Financial Statements
• After transactions have been recorded and summarized, reports
are prepared for users.
• The accounting reports providing this information are called
financial statements. The primary 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 that the financial statements are prepared and
the nature of each statement is described as follows.
46. Financial Statements are prepared in the following order:
A. Income statement:- A summary of the revenue and expenses
for a specific period of time, such as a month or a year. This
statement reports the revenues and expenses for a period of time,
based on the matching concept. This concept is applied by
matching the expenses with the revenue generated during a
period by those expenses. The excess of the revenue over the
expenses is called net income or net profit. If the expenses
exceed the revenue, the excess is a net loss. Net income for a
period increases the owner’s equity (capital) for the period. A net
loss decreases the owner’s equity (capital) for the period.
47. Cont.
• Reports the revenues and expenses for a specific period of time.
• Net income – revenues exceed expenses.
• Net loss – expenses exceed revenues.
48. Cont.
B. Statement of owner’s equity:- A summary of the changes in the
owner’s equity that have occurred during a specific period of time,
such as a month or a year. It is prepared after the income statement
because the net income or net loss for the period must be reported in
this statement. Similarly, it is prepared before the balance sheet, since
the amount of owner’s equity at the end of the period must be reported
on the balance sheet. Because of this, the statement of owner’s equity is
often viewed as the connecting link between the income statement and
balance sheet. It applies to proprietorship and partnership (it is
called capital statement for partnership business) form of business.
49. • Retained Earning Statement:- indicates the reasons why
retained earnings has increased or decreased during the period.
Retained earnings statement applies to corporations. It
presents changes in equity during the reporting period. The
report format varies, but can include the sale or repurchase of
shares, dividend payments, and changes caused by reported
profits or losses.
50. Cont.
C. Statement of Financial Position:- A list of the assets,
liabilities, and owner’s equity as of a specific date, usually at the
close of the last day of a month or a year. It reports the amounts
of the company's’ assets, liabilities, and owner’s equity as of the
specific date (the date at the end of the accounting period). The
asset and liability amounts are taken from the last line of the
summary of transactions. Capital as of the end of the accounting
period, is taken from the statement of owner’s equity.
• There are two forms of Balance Sheet (1) Account form (2)
Report form
51. Cont.
(1) Account form:- it resembles the basic format of the accounting
equation, with assets on the left side and the liabilities and owner’s
equity sections on the right side.
(2) Report form:- All components of the accounting equation (Assets,
Liabilities and Capital) are reported consecutively.
• The assets section of the balance sheet presents assets in the order
that they will be converted into cash or used in operations. Cash is
presented first, followed by receivables, supplies, prepaid insurance,
and other assets. The assets of a more permanent nature are shown
next, such as land, buildings, and equipment ( Under GAAP), but
under IFRS the inverse is used.
53. Cont.
D. Statement of cash flows:- A summary of the cash receipts
and cash payments for a specific period of time, such as a month
or a year.
• The statement of cash flows consists of three sections, as (1)
operating activities, (2) investing activities, and (3) financing
activities. Each of these sections is briefly described below.
1. Cash Flows from Operating Activities This section reports a
summary of cash receipts and cash payments from operations.
The net cash flow from operating activities normally differs
from the amount of net income for the period.
54. Cont.
2. Cash Flows from Investing Activities:- This section reports the cash
transactions for the acquisition and sale of relatively permanent assets.
3. Cash Flows from Financing Activities:- This section reports the cash
transactions related to cash investments by the owner, borrowings, and
withdrawals by the owner.
Preparing the statement of cash flows requires that each of the September
cash transactions for Softbite be classified as operating, investing, or
financing activities.
Answers the following:
1. Where did the cash come from?
2. What was cash used for?
3. What was the change in the cash balance?
56. Cont.
• All financial statements are identified by the name of the
business, the title of the statement, and the date or period of
time. The data presented in the income statement, the
statement of owner’s equity, and the statement of cash flows
are for a period of time. The data presented in the statement of
financial position (balance sheet) are for a specific date.
• Generally, Financial statements are prepared in the order of the
income statement, statement of owner’s equity, statement of
financial position (balance sheet), and statement of cash flows.
This order is important because the financial statements are
interrelated.
57. Exercise
Net income will result during a time period when:
a. assets exceed liabilities.
b. assets exceed revenues.
c. expenses exceed revenues.
d. revenues exceed expenses.
58. Review Question
• Cecil Jameson, Attorney-at-Law, is a proprietorship owned and
operated by Cecil Jameson. On July 1, 2009, Cecil Jameson,
Attorney-at-Law, has the following assets and liabilities: cash,
$1,000; accounts receivable, $3,200; supplies, $850; land,
$10,000; 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:
59. Review Question
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 supplies on account, $245.
g. Received cash from clients on account, $3,000.
h. Received invoice for paralegal 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 supplies on hand was $980; therefore, the cost of
supplies used during the month was $115.
k. Jameson withdrew $1,000 in cash from the business for personal use.
