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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
- 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.

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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.
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

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,
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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 are examples of
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 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 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.
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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:
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)
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

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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 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
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
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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 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 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.

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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.
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.
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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3. Why do we need to record all business activities in terms of money?
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………………………………………………………………………………………………………………………
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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 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.
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
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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.
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.

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).
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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

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.
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.

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

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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 2,500 Birr 100,000
Tran.4 -1,500 - - -1,500 -___
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
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
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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).
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.

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

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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
No Cash + Supplies + Land Payable Capital Transaction
1 +100,000 - - - + 100,000 Owners
Investment
Bal Birr 100,000 - - - Birr 100,000
2 -20,000 - + 20,000 - -
Bal Birr 80,000 - Birr 20,000 - Birr 100,000
3 - +2500 +2500
Bal Birr 80,000 Birr 2,500 Birr 20,000 Birr2500 Birr 100,000
4 -1,500 - -1500
Bal Birr 78,500 Birr 2,500 Birr 20,000 Birr1,000 Birr 100,000
5 + 30,000 - - - + 30,000 Service fee
Bal Birr 108,500 Birr 2,500 Birr 20,000 Birr1,000 Birr 100,000
6 -15,000 - - - -10,000 Salary Exp.
-3000 Teleph. Exp
- - - - -1500 Rent Exp.
-500 Adv. Exp.
Bal Birr 93,500 Birr 2500 Birr 20,000 Birr 1000 Birr 115,000
7 -3,000 - - - -3000 Owner’s
withdrowal
Bal Birr 90,500 Birr 2500 Birr 20,000 Birr 1,000 Birr 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.

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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
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
- statement of owner’s Equity
- balance sheet
- 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 the purpose of the earlier steps of recording and classifying business transactions.
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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, 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

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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. 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

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1.8.3 Balance Sheet

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

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The Report Format

-Lists assets, Liability and Owner’s equity vertically

__________
_________
_____
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 1,000.00
Supplies……………2,500.00
Land………………20,000.00 Owner’s Equity
Ato Dawit Gem., Capital Br12,000.00.
_________ Total Liabilities and
Total Assets……..113,000.00 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
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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.

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____________________________
2nd line___________________________
3rd line __________________________

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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 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.

1.11 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

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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.
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
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

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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.
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.
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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