Fundamentals of accounting I, chapter one

CHAPTER ONE

1. Introduction to Accounting and Business

1.1 The nature of a business: A business is an organization in which basic resources (inputs),
such as materials and labor, are assembled and processed to provide goods or services (outputs)
to customers. The objective of most businesses is to earn a profit. Profit is the difference
between the amounts received from customers for goods or services and the amounts paid for the
inputs used to provide the goods or services.
Types of businesses (Based on their operation): Three types of businesses operated for profit
include service, merchandising, and manufacturing businesses.
1. Service businesses provide services rather than products to customers. E.g: Delta Air Lines
(transportation services), The Walt Disney Company (entertainment services)
2. Merchandising businesses sell products they purchase from other businesses to customers.
E.g: Wal-Mart (general merchandise), Amazon.com (Internet books, music, videos)
3. Manufacturing businesses change basic inputs into products that are sold to customers. E.g:
General Motors Corporation (cars, trucks, vans), Dell Inc. (personal computers)
1.2 The role of accounting in business
Definition of Accounting: Accounting is the process of recording, classifying, summarizing,
analyzing &interpreting of financial information, and communicating financial information for
owners, managers, and other interested parties.

Evolution of accounting: People in all civilizations have maintained various types of records of
business activities. The oldest known as clay tablet records of the payment of wages in
Babylonia around 3600 B.C. However, early accounting dealt only with limited aspect of the
financial operations. These were no systematic accounting for all transactions of a particular unit,
only for specific types or portions of transactions. Now a day, as business and society become
more complex, accounting concept and techniques increased to meet financial information.

Double entry system:- This system was developed by venetian merchants in 1494. And Lucas
Pacioli, he is known as the father of Accounting, published about double entry system.-This
system says that each financial transaction affects at least two accounts.

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Accounting provides information for managers to use in operating the business. In addition,
accounting provides information to other users in assessing the economic performance and
condition of the business. Thus, accounting can be defined as an information system that
provides reports to users about the economic activities and condition of a business. Accounting is
called as the “language of business”. This is because accounting is the means by which
businesses’ financial information is communicated to users.

Users of Accounting Information: The process by which accounting provides information to

users is as follows:
Identification of Users -Internal users:
- Management (managers), Employees
External users:
User Information Needs - Investors, Suppliers, Creditors
-Owners, Customers, bankers
- Governmental Agencies

Economic Data Accounting System Reports User Decision

- Financial Statement - Investing

- Special Report - Approving Loan

- Tax Return Report -Assessing Taxes

- Regulatory Report - Negotiating labor

- Management Report - Union Contract

- Establishing Budget

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1.3 Profession of Accountancy: Accountants are typically engaged in either private accounting
or public accounting.

Private Accounting – accountants employed by a particular business firm, Government or non-

for- profit organization, perhaps as chief accountant, controller, and financial vice –president.

Public Accounting – accountants who render accounting service on a fee basis and staff
accountants employed by them. They are called Independent Accountants. Accountants
employed individually or within a Accountant (CPA) public accounting firm in tax or audit
services.
Specialized accounting fields

 Managerial Accounting (Management Accounting) - The area of accounting that

provides internal users with information. Its objective is to provide relevant and timely
information for managers’ and employees’ decision-making needs. It uses both historical
and estimated data in assisting management in daily operations and in planning future
operations. The managerial accountant is frequently concerned with identifying
alternative course of action and then helping to select the best one.
 Financial Accounting- The area of accounting that provides external users with
information. Its objective is to provide relevant and timely information for the decision-
making needs of users outside of the business. It is concerned with recording of
transactions for a business enterprise or other economic unit and the periodic preparation
of various reports from such business.
 Auditing – an independent review of the accounting records of the business.
 Cost Accounting – the determination and control of costs. It is concerned primarily with
the costs of manufacturing process and of manufactured products. The most duties of cost
accountant are to gather and explain cost data, both actual and prospective.
 Tax Accounting - preparation of tax returns and consideration of tax consequences of
proposed business transactions or alternative course of action.
 Accounting System – concerned with the designing and implementation of procedures
for the accumulation and reporting of financial data.

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Also, there are some other types of field in accounting such as: budgetary accounting, non- for-
profit accounting, social accounting, etc.

1.4 Types of business organizations: The three types of businesses (service, merchandising,
and Manufacturing) may be organized as proprietorships, partnerships, corporations, or limited
liability companies. Business organizations are classified as follows based on their forms:-
a. Sole proprietorship: These firms are owned by one person, usually the individual who has
day-to-day responsibility for running the business. Sole proprietors own all the assets of the
business and the profits generated by it. They also assume "complete personal" responsibility
for all of its liabilities or debts. In the eyes of the law, you are one in the same with the
business.

b. Partnership: In a Partnership, two or more people share ownership of a single

business. Like proprietorships, the law does not distinguish between the business and
its owners. The Partners should have a legal agreement that sets forth how decisions
will be made, profits will be shared, disputes will be resolved, how future partners
will be admitted to the partnership, how partners can be bought out, or what steps will
be taken to dissolve the partnership when needed. They also must decide up front
how much time and capital each will contribute, etc.
c. Corporation: A Corporation, chartered by the state in which it is headquartered, is
considered by law to be a unique entity, separate and apart from those who own it. A
Corporation can be taxed; it can be sued; it can enter into contractual agreements.
The owners of a corporation are its shareholders. The shareholders elect a board of
directors to oversee the major policies and decisions. The corporation has a life of its
own and does not dissolve when ownership changes.
d. Limited liability Company (LLC): combines the attributes of a partnership and a
corporation. Often used as an alternative to a partnership. It has tax and legal liability
advantages for owners.
e. Cooperatives: Firm owned, controlled, and operated by a group of users for their own
benefit. Each member contributes equity capital, and shares in the control of the firm on the
basis of one-member, one-vote principle (and not in proportion to his or her equity
contribution).

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1.5 Accounting Principles and Practices (IFRS): Professional accounting associations,

periodical issue pronouncements on accounting principles. Authoritative accounting
pronouncements are issued by such bodies as the Financial Accounting Standards Board
(FASB). It is from research, accepted accounting practices, and pronouncements of professional
and authoritative bodies that generally accepted accounting principles evolve to form the
underlying basis for accounting practice. The followings are some accounting principles and
concepts:

1. Business entity concept

It states that the property of the business should be recorded separately from its owner individual
property. Or the activities of a business are recorded separately from the activities of its owners,
creditors, or other businesses. A business entity may take the form of a proprietorship,
partnership, corporation, or limited liability company (LLC).
2. Cost principle

Under the cost concept, amounts are initially recorded in the accounting records at their cost or
purchase price. Or the records of properties and services purchased by a business are maintained
in accordance with the cost principle, which requires that the monetary record be in terms of
cost. To illustrate, assume that Awash bank purchased the following building on February 20,
2008:
Price listed by seller on January 1, 2008 $160,000
Awash banks’ 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
Assessed value for property taxes, December 31, 2010 $190,000
Under the cost concept, awash bank 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. The cost concept also involves the objectivity and unit of measure
concepts.
3. Objectivity Concept
It requires that the amounts recorded in the accounting records be based on objective evidence.

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4. Unit of Measure Concept

It requires that economic data be recorded in dollars.

5. Matching principle

It states that Revenue and related expenses should be reported in the same Accounting period.

6. Going concern concept

This concept states that an enterprise is expected to operate for an indefinite period of time.

1.6 The accounting equation and elements of the equation

The resources (properties) owned by a business are its assets. Examples of assets include cash,
land, buildings, and equipment. The right or claim to the properties is referred as equities. If the
asset owned by a business is $100,000, the equity in the assets is also $ 100,000 i.e.

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. Therefore we will get the accounting
equation i.e. the relationship among assets, liabilities, and owner’s equity:
Assets = Liabilities + Owner’s Equity

NB: We have to place liabilities before owner’s equity in the accounting equation because
creditors have preferential rights to the assets.

1.7 Business transactions and financial statements

Business Transaction: The occurrence of an economic event that affects the financial position
of a business is called Business transaction. A particular business transaction may lead to an
event or condition that result in another transaction. For example, purchase of car on credit will
be followed by payment to the creditor, which is another transaction. The wearing- out of car is
not an exchange of goods or services between the business and an outsider, but it has to be

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recorded. This type of transaction, as well as others that are not directly related to outsiders,
referred as internal transaction.

All business transactions from the simplest to the most complex can be stated in terms of the
resulting change in the three basic elements of the accounting equation. The following
illustration will demonstrate types of transaction and the accounting equation as follow:

 Assume Mr. X establishes sole proprietorship business known as XYZ Taxi on August
1, 2012.

Transaction –a-

Mr. X deposit $10,000 in a bank account in the name of XYZ Taxi. The effect of this transaction
is to increase the assets (cash), left side of equation and to increase the owner’s equity on the
right side by the same amount.

Assets = Liabilities + Owner’s Equity

Cash Mr. X Capital

(a) 10,000 10,000 Investment

Transaction –b-

XYZ taxi co. purchased land, which is $ 7,500 in cash, is paid. This transaction changes the
composition of the assets but not change the total amount.

Assets = Liabilities + Owner’s Equity

Cash + Land Mr. X Capital

(a) 10,000 10,000 Investment

(b) - 7,500 7500

Balance. 2,500 7,500 10,000

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Transaction –c-

XYZ taxi co. purchased $ 850 of gasoline, oil, and other supplies; agreed to pay in the near
future. This type of transaction is called purchased on account and liability is created known as
account payable. The transactions effect is increasing the assets amount and the liability
amount.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital

Bal. 2,500 7,500 10,000

(b) 850 850

Bal. 2,500 850 7,500 850 10,000

Transaction –d-

XYZ taxi co. paid for creditor $ 400, the effect is decreasing the assets and liabilities.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital

Bal. 2,500 850 7,500 850 10,000

(d) - 400 -400

Bal. 2,100 850 7,500 450 10,000

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Transaction –e-

XYZ taxi co. earned fares of $ 4,500, receiving the amount in cash. In general the amount
charged to customers for goods or services sold is called Revenue. Instead of requiring the
payment of cash at the time goods or services are sold, a business may make sales on account,
allowing the customers to pay latter. In such cases the firm acquires an account receivable,
which is a claim against the customers. Account receivable is an asset and revenue is realized.

The effect of this transaction is increasing both the assets and owners equity.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital

Bal. 2,100 850 7,500 450 10,000

(e) + 4,500 + 4,500 Fares earned

Bal. 6,600 850 7,500 450 14,500

Transaction –f-

The amount of assets consumed or services used in the process of earning revenue is called
expense. XYZ taxi co. incurred the following expenses and paid during the month were; wages
$1,125; rent $850; utilities $ 150; miscellaneous $ 75. The effect of this transaction is reducing
both asset and owner’s equity.

Assets = Liabilities + owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital

Bal. 6,600 850 7,500 450 14,500

(f) -2,200 - 1,125 wages expense

-850 Rent expense

-150 Utilities exp.

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-75 Miscel. exp.

Bal. 4,400 850 7500 450 12,300

Transaction –g-

XYZ’s taxi co. supplies at the end of the month determined that $ 250 is on hand, the reminder
600 (850-250) have been used in the operation of the business. The effect of this situation is
decreasing both assets and owner’s equity.

Assets = Liabilities + owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital

Bal. 4,400 850 7500 450 12,300

(g) - 600 - 600 supply expense

Bal. 4,400 250 7,500 450 11,700

Transaction –h-

At the end of the month Mr. X withdraws cash from the business $1,000 for personal use. This
transaction reduces the assets and owner’s equity.

Assets = Liabilities + owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital

Bal. 4,400 250 7,500 450 11,700

(h) -1,000 -1,000

Bal. 3,400 250 7,500 450 10,700

Summary of the above transactions presented as follows:

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Assets = Liabilities + Owner’s Equity

Cash + supplies + Land Account payable + Mr. X Capital

(a) 10,000 7,500 10,000 Investment

(b) - 7,500

2,500 7,500 10,000

(c) +850 +850

2,500 850 7,500 850 10,000

(d) -400 -400

2,100 850 7,500 450 10,000

(e) +4,500 +4,500 Fares earned

6,600 850 7,500 450 14,500

(f) -2,200 -1,125 Wages exp.

-850 Rent exp.

-150 Utility exp.

-75 miscel. exp.

4,400 850 7,500 450 12,300

(g) -600 -600 Supplies exp.

4,400 250 7,500 450 11,700

(h) -1,000 -1,000 Withdrawal

3,400 250 7,500 =450 10,700

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 The following points apply for all types of business:

1. The effect of every transaction increased and / or decreased one or more of accounting
equations.

2. Equality of the two sides of accounting equation should be maintained.

3. Owner’s equity increased by amounts invested by owner and decreased by amounts

withdrawal by the owner. In addition owner’s equity increased by revenues earned and
decreased by expenses; diagrammatically as follows:

Owner’s Equity

Decreased Increased

 Owners  Owners
withdrawals Investment
 Expenses  Revenues

Financial Statements

After the effect of the individual transactions has been determined, essential information is
communicated to users. The accounting statements that communicate this information are called
financial statement.

The principal financial statements for sole proprietorship are the following:

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1. Income Statement

It is a summary of revenues and expenses of a business entity for specific period of time,
such as a month or a year. The excess of revenues over expenses is called net income or
net profit. If the expenses exceed the revenues, the excess is net loss.

The determination of the periodic net income or net loss is a matching process involving
two steps. First, revenues are recognized during the period. Second, the assets consumed
in generating revenue must be matched against the revenue in order to determine the net
income or net loss.

2. Statement of Owner’s Equity

It is a summary of the changes in the owner’s equity of a business entity that have
occurred during specific period of time.

3. Balance Sheet

It is a list of assets, liabilities and owner’s equity of a business entity as of a specific date.
The asset section of a balance sheet begin with cash followed by receivables, supplies ,
prepaid insurance and other asset that can be converted in to cash or used up in the near
future. The asset of relatively permanent nature such as land, building and equipment
follow that order. In the liability and owner’s equity section of the balance sheet, the
liabilities presented first followed by owner’s equity.

4. Statement of Cash Flow

It is a summary of cash receipts and cash payments of a business entity for a specific
period of time. This statement has three sections i.e. operating activities, investing
activities, and financing activities.

a. Operating Activities

This section includes cash transactions that enter in to the determination of net
income or net loss and also payment of cash to the creditor.

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b. Investing Activities

This section includes the cash transaction for the acquisition and sale of relatively
long term or permanent type of assets.

c. Financing Activities

This section includes the cash transaction related to cash investment by the
owner’s and borrowing and withdrawals by the owner.

NB: the cash balance at the beginning of the period is added to the increase (or decrease) in
cash for the period to obtain the cash balance at the end of the period.

The basic features of the four statements and their interrelationships are illustrated by taking
data from Mr. X taxi business as follow:

Mr. X Taxi
Income Statement
For Month Ended August 31, 2012

Fares Earned $4,500

Operating Expenses :
Wages Expenses $1,125

Rent Expenses 850

Supplies Expenses 600

Utilities Expenses 150

Miscellaneous Expenses 75_

Total Expenses 2,800

Net Income $1,700

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Mr. X Taxi
Statement of Owner’s Equity
For Month Ended August 31, 2012

Investment During the Month $10,000

Net Income for the Month $1,700

Less: Withdrawal 1,000
Increase in Owner’s Equity 700__
Mr. X Capital, August 31, 2012 $10,700_

Mr. X Taxi
Balance Sheet
August 31, 2012

Assets

Cash $3,400
Supplies 250
Land 7,500
Total Assets $11,150

Liabilities
Account Payable $450
Owner’s Equity
Mr. X Capital $10,700
Total Liabilities and Owner’s Equity $11,150

Mr. X Taxi
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Statement of Cash Flow

For Month Ended August 31, 2012

Cash Flows from Operating Activities:

Cash Received from Customers $4,500

Deduct: Cash Payments for Expenses And Payment to 2,600
Creditor
Net Cash Flow from Operating Activities $1,900

Cash Flows from Investing Activities:

Cash Payments for Acquisition of Land (7,500)
Cash Flows from Financing Activities:
Cash Received as Owner’s Investment $10,000
Deduct: Cash Withdrawal by Owner 1,000
Net Cash Flow from Financing Activities $9,000
Net Cash Flow And August 31,2012 Cash Balance $3,400

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