1 Fundamentals of Accounting – I Ch01: Introduction to Business & Accounting

CHAPTER 1

INTRODUCTION TO BUSINESS & ACCOUNTING

After studying this chapter, you should be able to:

• Explain what accounting is.

• Identify the users and uses of accounting.
• Understand why ethics is a fundamental business concept.
• Explain accounting standards and the measurement principles.
• Explain the monetary unit assumption and the economic entity assumption.
• State the accounting equation, and define its components.
• Analyze the effects of business transactions on the accounting equation.
• Understand the four financial statements and how they are prepared.

• Introduction
Many students who take this course do not plan to be accountants. If you are in that group, you might be
thinking, “If I’m not going to be an accountant, why do I need to know accounting?” In response, consider
the quote from Harold Geneen, the former chairman of a major international company: “To be good at your
business, you have to know the numbers.”

Success in any business comes back to the numbers. You will rely on them to make decisions, and managers
will use them to evaluate your performance. That is true whether your job involve marketing, production,
management, or information systems.

In business, accounting is the means for communicating the numbers. If you don’t know how to read financial
statements, you can’t really know your business. Many companies spend significant resources teaching their
employees basic accounting so that they can read financial statements and understand how their actions affect
the company’s financial results. Employers need managers in all areas of the company to be “financially
literate.” Taking this course will go a long way to making you financially literate. The purpose of this chapter
is to show you that accounting is the system used to provide useful financial information.

• What is Accounting
What consistently ranks as one of the top career opportunities in business? Why do people choose
accounting? They want to acquire the skills needed to understand what is happening financially inside a
company. Accounting is the financial information system that provides these insights. In short, to
understand an organization of any type, you have to know the numbers.

• Accounting –consists of three basic activities—it identifies, records, and communicates the economic
events of an organization to interested users.

• Let’s take a closer look at these three activities.

Three Activities

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As a starting point to the accounting process, a company identifies the economic events relevant to its
business. Examples of economic events are the sale of food and snacks by time cafe, the providing of
telephone services by ethio-telecom, and the manufacture of motor vehicles by Tata Motors.

Once a company like Tata motors identifies economic events, it records those events in order to provide a
history of its financial activities. Recording consists of keeping a systematic, chronological diary of events,
measured in monetary units. In recording, Tata also classifies and summarizes economic events.

Finally, acompany communicates the collected information to interested users by means of accounting reports.
The most common of these reports are called financial statements. To make the reported financial
information meaningful, company reports the recorded data in a standardized way. It accumulates information
resulting from similar transactions. For example, Tata accumulates all sales transactions over a certain period
of time and reports the data as one amount in the company’s financial statements. Such data are said to be
reported in the aggregate. By presenting the recorded data in the aggregate, the accounting process simplifies
a multitude of transactions and makes a series of activities understandable and meaningful.

A vital element in communicating economic events is the accountant’s ability to analyze and interpret the
reported information. Analysis involves use of ratios, percentages, graphs, and charts to highlight significant
financial trends and relationships. Interpretation involves explaining the uses, meaning, and limitations of
reported data.

“At this point, these financial statements probably strike you as complex and confusing. By the end of this
course, you’ll be surprised at your ability to understand, analyze, and interpret them.”

You should understand that the accounting process includes the bookkeeping function. Bookkeeping usually
involves only the recording of economic events. It is therefore just one part of the accounting process. In total,
accounting involves the entire process of identifying, recording, and communicating economic events.

• Who Uses Accounting Data

The specific financial information that a user needs depends upon the kinds of decisions the user makes. There
are two broad groups of users of financial information: Internal users and External users.

• Internal Users
Internal users of accounting information are managers who plan, organize, and run the business. These
include marketing managers, production supervisors, finance directors, and company officers. In running a
business, internal users must answer many important questions like:

• Is cash sufficient to pay dividends to our shareholders? Finance

• What price for our product will maximize the company's net income? Marketing
• Can we afford to give our employees pay raises this year? Human Resources
• Which product line is the most profitable? Should any product lines be eliminated? Management
To answer these and other questions, internal users need detailed information on a timely basis. Managerial
Accounting provides internal reports to help users make decisions about their companies. Examples are

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financial comparisons of operating alternatives, projections of income from new sales campaigns, and
forecasts of cash needs for the next year.

• External Users
External users are individuals and organizations outside a company who want financial information about
the company. The two most common types of external users are investors and creditors. Investors (owners)
use accounting information to make decisions to buy, hold, or sell ownership shares of a company. Creditors
(such as suppliers and bankers) use accounting information to evaluate the risks of granting credit or lending
money. Financial Accounting – It provides economic and financial information for investors, creditors, and
other external users. The information needs of external users vary considerably.

• Measurement Principles

IFRS generally uses one of two measurement principles, the historical cost principle or the fair value principle.
Selection of which principle to follow generally relates to trade-offs between relevance and faithful
representation.
Relevance means that financial information is capable of making a difference in a decision.
Faithful representation means that the numbers and descriptions match what really existed or happened—
they are factual.

NB. “Relevance and faithful representation are two primary qualities that make accounting information useful
for decision-making”

• HISTORICAL COST PRINCIPLE

The historical cost principle (or cost principle) dictates that companies record assets at their cost. This is true
not only at the time the asset is purchased, but also over the time the asset is held. For example, if JJ purchases
land for $300,000, the company initially reports it in its accounting records at $ 300,000. But what does JJ do
if, by the end of the next year, the fair value of the land has increased to $400,000? Under the historical cost
principle, it continues to report the land at $ 300,000.

• FAIR VALUE PRINCIPLE

The fair value principle states that assets and liabilities should be reported at fair value (the price received to
sell an asset or settle a liability). Fair value information may be more useful than historical cost for certain
types of assets and liabilities. For example, certain investment securities are reported at fair value because
market value information is usually readily available for these types of assets. In determining which
measurement principle to use, companies weigh the factual nature of cost figures versus the relevance of fair
value. In general, even though IFRS allows companies to revalue property, plant, and equipment and other
long-lived assets to fair value, most companies choose to use cost.

Only in situations where assets are actively traded, such as investment securities, do companies apply the fair
value principle extensively.

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• Assumptions
Assumptions provide a foundation for the accounting process. Two main assumptions are the monetary unit
assumption and the economic entity assumption.

• MONETARY UNIT ASSUMPTION

The monetary unit assumption requires that companies include in the accounting records only transaction
data that can be expressed in money terms. This assumption enables accounting to quantify (measure)
economic events. The monetary unit assumption is vital to applying the historical cost principle.
This assumption prevents the inclusion of some relevant information in the accounting records. For example,
the health of a company’s owner, the quality of service, and the morale of employees are not included. The
reason: Companies cannot quantify this information in money terms. Though this information is important,
companies record only events that can be measured in money.

• ECONOMIC ENTITY ASSUMPTION

An economic entity can be any organization or unit in society. It may be a company [such as Awash Bank,
a governmental unit (the city-government of Hawassa). The economic entity assumption requires that the
activities of the entity be kept separate and distinct from the activities of its owner and all other economic
entities. To illustrate, JJ, owner of JJ’s Boutique, must keep her personal living costs separate from the expenses
of the boutique. Similarly, Birhan insurance and Birhan Bank are segregated into separate economic entities
for accounting purposes.

• TYPES OF ECONOMIC ENTITIES

Proprietorship – A business owned by one person is generally a proprietorship. The owner is often the
manager/operator of the business. Small service-type businesses (plumbing companies, beauty salons, and
auto repair shops), farms, and small retail stores (antique shops, clothing stores, and used-book stores) are often
proprietorships. Usually only a relatively small amount of money (capital) is necessary to start in business as
a proprietorship. The owner (proprietor) receives any profits, suffers any losses, and is personally liable for
all debts of the business. There is no legal distinction between the business as an economic unit and the owner,
but the accounting records of the business activities are kept separate from the personal records and activities of
the owner.

Partnership – A business owned by two or more persons associated as partners is a partnership. In most
respects a partnership is like a proprietorship except that more than one owner is involved. Typically a
partnership agreement (written or oral) sets forth such terms as initial investment, duties of each partner,
division of net income (or net loss), and settlement to be made upon death or withdrawal of a partner. Each
partner generally has unlimited personal liability for the debts of the partnership. Like a proprietorship, for
accounting purposes the partnership transactions must be kept separate from the personal activities of the
partners. Partnerships are often used to organize retail and service-type businesses, including professional
practices (lawyers, doctors, architects, and chartered public accountants).

Corporation – A business organized as a separate legal entity under corporation law and having ownership
divided into transferable shares is a corporation. The holders of the shares (shareholders) enjoy limited
liability; that is, they are not personally liable for the debts of the corporate entity. Shareholders may transfer

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all or part of their ownership shares to other investors at any time (i.e., sell their shares). The ease with
which ownership can change adds to the attractiveness of investing in a corporation. Because ownership can
be transferred without dissolving the corporation, the corporation enjoys an unlimited life.

Although the combined number of proprietorships and partnerships in the world significantly exceeds the
number of corporations, the revenue produced by corporations is much greater. Most of the largest companies
in the world—for example, Royal Dutch Shell, Wal-Mart Stores Inc. (USA), and Toyota (JPN)—are
corporations.

• The Basic Accounting Equation

The two basic elements of a business are what it owns and what it owes. Assets are the resources a business
owns. For example, adidas has total assets of approximately €10.6 billion. Liabilities and owner’s equity are
the rights or claims against these resources. Thus, adidas has €10.6 billion of claims against its €10.6 billion
of assets. Claims of those to whom the company owes money (creditors) are called liabilities. Claims of
owners are called equity. adidas has liabilities of €6.0 billion and equity of €4.6 billion.

We can express the relationship of assets, liabilities, and equity as an equation:

This relationship is the basic accounting equation. Assets must equal the sum of liabilities and equity.

The accounting equation applies to all economic entities regardless of size, nature of business, or form of
business organization. It applies to a small proprietorship as well as to a giant corporation. The equation
provides the underlying framework for recording and summarizing economic events.

Let’s look in more detail at the categories in the basic accounting equation.

• Assets
As noted above, assets are resources a business owns and controls. The business uses its assets in carrying out such
activities as production and sales. The common characteristic possessed by all assets is the capacity to provide
future services or benefits. Asset can be current and non-current.

• Liabilities
Liabilities are claims against assets—that is, existing debts and obligations. Businesses of all sizes usually
borrow money and purchase merchandise on credit. These economic activities result in payables of various
sorts. Liabilities can be current and non-current.

All of these persons or entities to whom a business owes money are its creditors. Creditors may legally force the
liquidation of a business that does not pay its debts. In that case, the law requires that creditor claims be paid before
ownership claims.

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• Equity
The ownership claim on total assets is equity. It is equal to total assets minus total liabilities. Here is why:
The assets of a business are claimed by either creditors or shareholders. To find out what belongs to
shareholders, we subtract creditors’ claims (the liabilities) from the assets. The remainder is the shareholders’
claim on the assets—equity. It is often referred to as residual equity—that is, the equity “left over” after
creditors’ claims are satisfied.

Equity generally consists of (1) share capital—ordinary and (2) retained earnings.

• SHARE CAPITAL—ORDINARY
A corporation may obtain funds by selling ordinary shares to investors. Share capital—ordinary is the term
used to describe the amounts paid in by share- holders for the ordinary shares they purchase.

• RETAINED EARNINGS
Retained earnings – is determined by three items: revenues, expenses, and dividends.

• Revenues
Revenues are the gross increases in equity resulting from business activities entered into for the purpose
of earning income. Generally, revenues result from selling merchandise, performing services, renting
property, and lending money.

Revenues usually result in an increase in an asset. They may arise from different sources and are called various
names depending on the nature of the business. Other titles for and sources of revenue common to many
businesses are sales, fees, services, commissions, interest, dividends, royalties, and rent.

The effect of revenues is positive—an increase in equity coupled with an increase in assets or a decrease in liabilities.

• Expenses
Expenses are the cost of assets consumed or services used in the process of earning revenue. They are
decreases in equity that result from operating the business. Like revenues, expenses take many forms and
are called various names depending on the type of asset consumed or service used: wages expense; utilities
expense (electric, gas, and water expense); telephone expense; delivery expense (gasoline, repairs, licenses,
etc.); supplies expense; rent expense; interest expense; and property tax expense.

The effect of expenses is negative—a decrease in equity coupled with a decrease in assets or an increase in
liabilities.

• Dividends
Net income represents an increase in net assets which is then available to distribute to shareholders. The
distribution of cash or other assets to shareholders is called a dividend. Dividends reduce retained earnings.
However, dividends are not an expense. A corporation first determines its revenues and expenses and then
computes net income or net loss. If it has net income, and decides it has no better use for that income, a
corporation may decide to distribute a dividend to its owners (the shareholders).

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In summary, the principal sources (increases) of equity are investments by shareholders and revenues from
business operations. In contrast, reductions (decreases) in equity result from expenses and dividends. These
relationships are shown as follows:

• Transactions (Business transactions)

Business transactions are a business’s economic events recorded by accountants. Transactions may be external
or internal. External transactions involve economic events between the company and some outside
enterprise. Internal transactions are economic events that occur entirely within one company.
Companies carry on many activities that do not represent business transactions. Examples are hiring
employees, answering the telephone, talking with customers, and placing merchandise orders. Some of these
activities may lead to business transactions: Employees will earn wages, and suppliers will deliver ordered
merchandise. The company must analyze each event to find out if it affects the components of the
accounting equation. If it does, the company will record the transaction.

Each transaction must have a dual effect on the accounting equation. For example, if an asset is increased, there
must be a corresponding (1) decrease in another asset, or (2) increase in a specific liability, or (3) increase in
equity.

• Transaction Analysis
In order to analyze transactions, we will examine a computer programming business (Softbyte Inc.) during its
first month of operations. As part of this analysis, we will expand the basic accounting equation. This will
allow us to better illustrate the impact of transactions on equity. Recall that equity is comprised of two parts:
share capital—ordinary and retained earnings. Share capital— ordinary is affected when the company issues
new ordinary shares in exchange for cash. Retained earnings are affected when the company earns revenue,
incurs expenses, or pays dividends.

“You will want to study these transactions until you are sure you understand them. They are not difficult, but
understanding them is important to your success in this course. The ability to analyze transactions in terms of
the basic accounting equation is essential in accounting.”

Transaction 1: Investment by shareholder

Hailu and Neja decide to open a computer programming company that they incorporate as Softbyte Inc. On
September 1, 2014, they invest €15,000 cash in the business in exchange for €15,000 of ordinary shares. This
transaction results in an equal increase in both assets and equity.

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Observe that the equality of the basic equation has been maintained. Note also that the source of the increase in
equity (in this case, issued shares) is indicated.

Transaction 2: Purchase of equipment for cash

Softbyte Inc. purchases computer equipment for €7,000 cash. This transaction results in an equal increase and
decrease in total assets, though the composition of assets changes.

Observe that total assets are still €15,000. Share Capital—Ordinary also remains at €15,000, the amount of
the original investment.

Transaction 3: Purchase of supplies on credit

Softbyte Inc. purchases for €1,600 from Acme Supply Company computer paper and other supplies expected
to last several months. Acme agrees to allow Softbyte to pay this bill in the coming October. This transaction
is a purchase on account (a credit purchase). Assets increase because of the expected future benefits of using
the paper and supplies, and liabilities increase by the amount due Acme Company.

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Total assets are now €16,600. This total is matched by a €1,600 creditor’s claim and a €15,000 ownership
claim.

Transaction 4: Services provided for cash

Softbyte Inc. receives €1,200 cash from customers for programming services it has provided. This transaction
represents Softbyte’s principal revenue-producing activity. Recall that revenue increases equity.

The two sides of the equation balance at €17,800. Service Revenue is included in determining Softbyte’s net
income.

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.
This transaction results in an increase in liabilities and a decrease in equity.

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The two sides of the equation still balance at €17,800. Retained Earnings (OE) decreases when Softbyte incurs
the expense. Expenses do not have to be paid in cash at the time they are incurred. When Softbyte pays at a
later date, the liability Accounts Payable will decrease and the asset Cash will decrease (see Transaction 8).
The cost of advertising is an expense (rather than an asset) because Softbyte has used the benefits. Advertising
Expense is included in determining net income.

Transaction 6: Services provided for cash and credit

Softbyte Inc. 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. This transaction results in an equal increase in assets and equity.

Softbyte earns revenues when it provides the service, and therefore it recognizes €3,500 in revenue. In exchange for
this service, it received €1,500 in Cash and Accounts Receivable of €2,000. This Accounts Receivable represents
customers’ promise to pay €2,000 to Softbyte in the future. When it later receives collections on account, Softbyte will
increase Cash and will decrease Accounts Receivable (see Transaction 9).

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Transaction 7: Payment of expenses

Softbyte pays the following expenses in cash for September: store rent €600, salaries and wages of employees
€900 and utilities €200. These payments result in an equal decrease in assets and expenses.

The two sides of the equation now balance at €19,600. Three lines are required in the analysis to indicate the
different types of expenses that have been incurred.

Transaction 8: Payment of accounts payable

Softbyte pays its €250 Daily News bill in cash. The company previously (in Transaction 5) recorded the bill
as an increase in Accounts Payable and a decrease in equity.

Observe that the payment of a liability related to an expense that has previously been recorded does not affect
equity. Softbyte recorded the expense (in Transaction 5) and should not record it again.

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Transaction 9: Receipt of cash on account

Softbyte receives €600 in cash from customers who had been billed for services (in Transaction 6). This
transaction does not change total assets, but it changes the composition of those assets.

Note that the collection of an account receivable for services previously billed and recorded does not affect
equity. Softbyte already recorded this revenue (in Transaction 6) and should not record it again.

Transaction 10: dividends

The corporation pays a dividend of €1,300 in cash to Hailu and Naja, the shareholders of Softbyte Inc. This
transaction results in an equal decrease in assets and equity

Note that the dividend reduces retained earnings, which is part of equity. Dividends are not expenses. Like
shareholders’ investments, dividends are excluded in determining net income.

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Summary of Transactions
The following illustration summarizes the September transactions of Softbyte Inc. to show their cumulative
effect on the basic accounting equation. It also indicates the transaction number and the specific effects of
each transaction.
Finally, the illustration demonstrates a number of significant facts:
• Each transaction must be analyzed in terms of its effect on:
(a) The three components of the basic accounting equation.
(b) Specific types (kinds) of items within each component.
• The two sides of the equation must always be equal.
• The Share Capital—Ordinary and Retained Earnings columns indicate the
causes of each change in the shareholders’ claim on assets.

Evolution of Accounting
Accounting is highly affected by the economic, social, cultural, legal, technological and political
developments of a society. Higher-level economic, social, cultural, legal, technological, and political
developments of a society need more elaborated and sophisticated accounting systems. In line with the
changes in the aforementioned environmental factors, accounting has evolved through several phases.

These phases may be grouped into two major classes: primitive and modern.

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1. Primitive - primitive accounting is believed to have begun about 4000 BC. At this stage, accounting
was identified to be unsystematic and incomplete dealing with certain aspects and types of economic
affairs (like receipts or payments of money), which does not provide information sufficient enough to
evaluate the financial performance and position of an economic entity.

2. Modern - modern accounting emerges with the invention of the “Double-entry accounting system” in
1494 by an Italian monk named Luca Pacioli. Double-entry accounting system provides for recording
the dual, commonly called debit and credit, aspects of financial affairs of an entity which enhances the
accuracy of records and facilitates preparation of reports.

• Financial statements
Companies prepare four financial statements from the summarized accounting data:

• An income statement presents the revenues and expenses and resulting net income or net loss for a
specific period of time.
• A retained earnings statement summarizes the changes in retained earnings for a specific period of time.
• A statement of financial position (sometimes referred to as a balance sheet) reports the assets, liabilities,
and equity of a company at a specific date.
• A statement of cash flows summarizes information about the cash inflows (receipts) and outflows
(payments) for a specific period of time.

NB: in IFRS--Explanatory notes and supporting schedules are an integral part of every set of financial
statements. We illustrate these notes and schedules in later

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

• Income Statement
The income statement reports the success or profitability of the company’s operations over a specific period
of time. For example, Softbyte Inc.’s income statement is dated “For the Month Ended September 30, 2014.”
The heading of the statement identifies the company, the type of statement, and the time period covered by
the statement

The income statement lists revenues first, followed by expenses. Finally, the statement shows net income (or
net loss). When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss
results.

• Retained Earnings Statement

Softbyte Inc.’s retained earnings statement reports the changes in retained earnings for a specific period of time. The
time period is the same as that covered by the income statement (“For the Month Ended September 30, 2014”).

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• Net income of €2,750 on the income statement is added to the beginning balance of retained earnings in
the retained earnings statement.
• Retained earnings of €1,450 at the end of the reporting period shown in the retained earnings statement
is reported on the statement of financial position.
• Cash of €8,050 on the statement of financial position is reported on the statement of cash flows.

Statement of Financial Position

Softbyte Inc.’s statement of financial position reports the assets, liabilities, and equity at a specific date
(September 30, 2014). Observe that the statement of financial position lists assets at the top, followed by
equity and then liabilities. Total assets must equal total equity and liabilities. Softbyte Inc. reports only one
liability, Accounts Payable, on its statement of financial position.

Statement of Cash Flows

The statement of cash flows provides information on the cash receipts and payments for a specific period of
time. The statement of cash flows reports (1) the cash effects of a company’s operations during a period, (2)
its investing transactions, (3) its financing transactions, (4) the net increase or decrease in cash during the
period, and (5) the cash amount at the end of the period. Reporting the sources, uses, and change in cash is
useful because investors, creditors, and others want to know what is happening to a company’s most liquid
resource.

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The statement of cash flows provides answers to the following simple but important questions.

• Where did cash come from during the period?

• What was cash used for during the period?
• What was the change in the cash balance during the period?

As shown in Softbyte Inc.’s statement of cash flows in Illustration 1, cash increased €8,050 during the
period. Net cash flow provided from operating activities increased cash €1,350. Cash flow from investing
transactions decreased cash €7,000. And cash flow from financing transactions increased cash €13,700. At
this time, you need not be concerned with how these amounts are determined.

THE END OF CHAPTER ONE!

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