WOLAITA SODDO UNIVERSITY

FACULITY OF BUSINESS AND ECONOMICS

ACCOUNTING AND FINANCE DEPARTMENT

CHAPTER ONE: ACCOUNTING PRINCIPLE AND CONCEPTS

1.1 Introduction: Evolution of accounting and its definition

Unlike most other modern professions, accounting has a history that is usually discussed in terms
of one seminal event – the invention and dissemination of the double entry bookkeeping
processes which is developed in the 14th century. But there is a view of accounting history even
in ancient and medieval times. With respect to its origination, there is no clear consensus among
scholars. Some argue that accounting developed purely in response to the needs of the time
brought about by changes in the environment and societal demands. Others claim that the
development of the science of accounting has itself driven the evolution of commerce since it
was only through the use of more precise accounting methods that modern business was able to
grow, flourish and respond to the needs of its owners and the public. Either way, the history of
accounting throws a light on economic and business history generally, and may help us better
predict what is on the horizon as the pace of global business evolution escalates. As long as
civilization has been started to engage in trade, methods of record keeping, accounting, and
accounting tools have been invented. Marla Matzer Rose, author of Accounting & Auditing
History writes that the earliest known writing discovered by archaeologists has, when translated,
been found to be records of tax accounting. Such writings have been found on clay tablets from
Egypt and Mesopotamia as early as 2000 to 3300 B.C., as humans formed governments,
accounting became a necessity. Clay tablet records of the payment of wages were also used in
Babylonia around 3600 B.C.

However, early accounting dealt only with limited aspect of the financial operations of private
or government enterprises. There were no systematic accounting for all transactions of a
particular unit; it is only for specific types or portions of transactions. Now a day, as business

WSU, Principle of accounting: Compiled by; Ganfure T. Page 1

and society become more complex, accounting concept and techniques increased to meet
financial information users’ demand.

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. Financial statement is the end product of an accountant in order to
communicate effectively with all users of the information. Effective communication is the key
success of every business.

Financial statements are prepared as per agreed upon guidelines. In order to understand these
guidelines, it is feasible to understand the objectives of financial reporting. The objectives of
financial reporting, as discussed in the Financial Accounting standards Board (FASB) Statement
of Financial Accounting Concepts No. 1, are to provide information that is:

 Useful to existing and potential investors and creditors and other users in making rational
investment, credit, and similar decisions.

 Helps existing and potential investors and creditors and other user to assess the amounts,
timing, and uncertainty of prospective net cash inflows to the enterprise.

 Identifies the economic resources of an enterprise, the claims to those resources and the
effects that transactions, events, and circumstances have on those resources. .

1.2 Accounting as an information system

Sometimes, accounting is defined as the language of business. This language viewed as

information system to make an informed judgment and decision by the users’ of the information.
An Accounting System is designed to accumulate data about a firm’s financial affairs, classify
the data in a meaningful way, and summarize it in periodic reports called financial statements.
The sources as well as the outputs of this statement are recorded either manually or electronically

WSU, Principle of accounting: Compiled by; Ganfure T. Page 2

which further help us to retrieve the information after some years later. Therefore accounting can
serve us as an information system.

Importance of accounting

 Determine the operation results of the organization.

 Facilitates rational decision making, for decision makers.

 Keep systematic record of business transaction.

 It plays important role in all economic and social system.

1.3 Users of accounting information

Accounting information is composed of principally of financial data about business transaction,

expressed in terms of money, and accounting reports the financial data, by sorting and
summarizing the recorded data.

The results of accounting process are communicated to many individuals, government agencies
and organizations. The users of accounting information may be divided into two broad
categories.

1. Internal users; are those individuals directly involved in the process of either planning or
controlling current operations or for formulating long- range plans and making major business
decisions. This category includes all levels (top level, middle level and bottom level) of
managers and employees.

Managers need information that will help them to evaluate the results of their operation and plan
and make decision for the future. And employees are interested in the financial information of
the business that employees them.

2. External users; those parties that are not directly involves in running the business. It includes
investors, creditors or Bankers, suppliers, governments, labour union, and tax authorities.

Investors in a business enterprise need information about the financial status and its future
prospect. Bankers and creditors appraise the financial soundness of a business organization and

WSU, Principle of accounting: Compiled by; Ganfure T. Page 3

assess the risk involved before granting credit. Government agencies are concerned with
financial activities of business organization for purpose of taxation and regulation. Labor unions
are also interested in the stability of the enterprise and often they need bonuses or options tied to
their performance.

1.4 The profession of accounting

Accountants are typically engaged in either private accounting or public accounting.

Private Accounting: accountants employed by a particular business firm 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. Most of them are those who have met the state education
or the certified by the certified public accountant that is prepared and given by Financial
Accounting Standard Board (FASB).

1.5 Accounting principles and concepts

Professional accounting associations periodical issue pronouncements on accounting principles

and these 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 the first two accounting
principles:

1. Business entity concept

It is based on the applicability of accounting to individual economic units in society. These
individual economic unit include all business enterprises organized for profit; governmental unit;
non for profit units; and individual persons and family units. The basic economic data for a unit
must first be recorded, followed by analysis and summarization, and finally by periodic
reporting. Thus accounting applies to each separate unity. It is possible of course, to combine the
data for similar economic units to obtain an overall view. The three major legal form of business
entity are the sole proprietorship, partnership, and corporation.

WSU, Principle of accounting: Compiled by; Ganfure T. Page 4

Sole proprietorship: is a business entity owned and managed by a single person.
Partnership is small a business entity owned by two or more people in accordance with
contractual agreement-called article of partnership.
Corporation is a separate legal entity in which ownership is divided into shares holders or
holders of stock and it is organized in accordance with the state statutes.

2. cost principle

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.

N.B. The other accounting principles and concepts will be discussed in coming and different
chapters.

1.6 Business transaction and basic accounting equation

1.6.1 Business transaction

A business transaction is the occurrence of an event or of a condition that must be recorded. 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 recorded. This type of transaction, as well
as others that are not directly related to outsiders, referred as internal transaction.

1.6.2 Basic accounting equation

The properties owned by business enterprise referred as assets and the right or claim to the
properties are referred as equities. If the asset owned by a business is $90,000, the equity in the
assets is also $ 90,000 i.e.

Assets= Equities

WSU, Principle of accounting: Compiled by; Ganfure T. Page 5

Equities may be subdivided in to two: the rights of creditors and the right of owners. The rights
of creditors represent debt of the business and are called as liabilities. The rights of owner are
called owner’s equity. Therefore we will get the accounting equation;

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.

Illustration of transactions and the accounting equation

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.

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-

Mr. x 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 7,500 10,000 Investment

WSU, Principle of accounting: Compiled by; Ganfure T. Page 6

(b) - 7,500
Bal. 2,500 7,500 10,000

Transaction –c-

Mr. X 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
(c) 850 850

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

Transaction –d-

Mr. X 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

WSU, Principle of accounting: Compiled by; Ganfure T. Page 7

Transaction –e-

Mr. X taxi 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 as much as an asset as cash and revenue is realized.

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

The effect of this transaction is increasing both the assets and owner’s equity or capital.

Transaction –f-

The amount of assets consumed or services used in the process of earning revenue is called
expense. Mr. X taxi incurred the following expense 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 wage exp.
-850 Rent exp.
-150 Utilities exp.
-75 Miscel. exp.
Bal. 4,400 850 7500 450 12,300
WSU, Principle of accounting: Compiled by; Ganfure T. Page 8
Transaction –g-
Mr. X’s supplies at the end of the month determined that $ 250 is on hand, the reminder (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
Bal. 4,400 250 7,500 450 11,700

Transaction –h-
At the end of the month Mr. x withdraws from the business $1,000 in cash 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
-1,000 -1,000
Bal. 3,400 250 7,500 450 10,700

WSU, Principle of accounting: Compiled by; Ganfure T. Page 9

Summary of the above transaction presented as follows.

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

WSU, Principle of accounting: Compiled by; Ganfure T. Page 10

In order to summarize the effects of every transaction, the following points were applied 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 is:

Decreased by; Increased by;

 Expenses and withdrawal  Revenue (sales or earnings) and

Withdrawal has different names based on  Owner’s investment (deposits or

the type of business enterprise; savings)

 Withdrawal- for sole proprietorship

 Drawing- for partnership and

 Dividend- for corporation type

1.8 Financial Statements for Sole Proprietorship

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. Financial statement may have different styles as per the requirement. Some
of them are: management report form- for managers, special report form- for special occasions,
returns report form and tax return report form for tax authorities and so on.
WSU, Principle of accounting: Compiled by; Ganfure T. Page 11
The principal financial statements for sole proprietorship are the following;

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.

WSU, Principle of accounting: Compiled by; Ganfure T. Page 12

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, 2007

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

WSU, Principle of accounting: Compiled by; Ganfure T. Page 13

 Mr. X Taxi
Statement of Owner’s Equity
For Month Ended August 31, 2007

Investment During the Month $10,000

Net Income for the Month $1,700

Less: Withdrawal 1,000
Add: Increase in Owner’s Equity 700

Mr. X Capital, August 31, 2007 $10,700

Mr. X Taxi
Balance Sheet
August 31, 2007

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

WSU, Principle of accounting: Compiled by; Ganfure T. Page 14

 Mr. X Taxi
Statement of Cash Flow
For Month Ended August 31, 2007

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 31,2007 Cash Balance $3,400

Financial Statement for Corporation

Business enterprises with large amount of assets are usually organized as corporations and have
many owners, called stockholders. The financial statements of corporations are statement of
cash flow, income statement, balance sheet, and retained earnings statement.

A. Retained Earning

The emphasis is reporting the changes in the stockholders’ equity are on the changes in
retained earnings, or net income retained in the business. The changes in retained earning that
have occurred during a period are reported in retained earnings statement. Change in the
amount of earnings retained in the business would have resulted from (1) net income and (2)
distribution of earnings, called dividends, to owners.
WSU, Principle of accounting: Compiled by; Ganfure T. Page 15
B. Balance Sheet

The only difference between the balance sheet of sole proprietorship and corporation is the
stockholders’ equity section presented rather than owner’s equity.

C. Statement of Cash Flow

The only difference between cash flow statement of corporation and sole proprietorship is on the
financing activities section, the cash received as investments of stockholders arises from the sale
of capital stock and the cash payments to stockholders are in the form of dividends.

D. 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.

If Mr. X Taxi had been organized as corporation; the only change on the financial statements
will be the retained earnings statement instead of statement of owner’s equity and the balance
sheet account of owner’s equity should be changed by stockholders’ equity. Accordingly, the
financial statement looks like the following

Mr. X Taxi
Retained Earnings Statement
For Month Ended August 31, 2007

Net Income for the Month 1,700

Less: Dividends 1,000

Retained Earnings, August 31, 2007 700

WSU, Principle of accounting: Compiled by; Ganfure T. Page 16

 Mr. X Taxi
Balance Sheet
August 31, 2007

Assets

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

Liabilities
Account Payable $450

Stockholders’ Equity
Capital Stock $10,000
Retained Earnings 700

Total Stockholders’ Equity 10,700

Total Liabilities and Stockholders $11,150
Equity

WSU, Principle of accounting: Compiled by; Ganfure T. Page 17