CHAPTER ONE

INTRODUCTION TO ACCOUNTING PRACTICE AND PRINCIPLES

Definition of Accounting
Accounting is a process of identifying, measuring, recording, and communicating
economic information to permit informed judgment and decisions by users of the
information.
Key terms:
 Identifying: involves selecting those events that are considered evidence of
economic activity relevant to a particular organization. E.g. the purchase of
computer by JU
 Measuring: means expressing those selected events in terms of monetary units
like dollar, pound sterling, birr/cents etc.
 Recording: consists keeping a chronological diary of measured events in an
orderly and systematic manner.
 Communication: occurs through the preparation & distribution of accounting
reports, the most common of which are called financial statements.
 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 labor unions and others also need accounting
information.
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.
 Users of Accounting Information
Today’s accountants focus on the ultimate needs of those who use accounting information,
whether the users are inside or outside 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:

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I. Internal users: - are individual who are responsible for day to day operation activities of
an enterprise.
1. Management: - needs accounting information to plans, organize, control and evaluate
the activities of a business. Includes board of directors, partners, officers, managers,
supervisors.
2. Owners– need accounting information to evaluate their invested capital that is
whether the money invested result in a profit or a loss.
II. External users: - need accounting information for a variety of decision. Example: - of
external users are owner’s, investors, creditors, gov’t agencies etc.
1. Potential investors – these are new investors who are interested to invest their money in
the business, which is investment selection.
2. Creditors – individuals or organizations who supplied are willing to supply their
money/resources to the business, which is credit selection
3. Governments’ agencies – need accounting information for the purpose of taxation,
regulation, statistical analysis etc
4. Employees union – are workers of the organization and need accounting information to
ask salary increases bonuses etc.
5. Financial analysts: they are experts who evaluate the financial strength and operating
results of business organizations. To accomplish these objectives, they need to gather
accounting data provided through the accounting information system.
6. Economists: they are also experts who forecast about the nature and performance of
group of businesses as well as the overall economic activity. To do so, they have to
obtain and use the data provided through the accounting information system. For instance
economists rely on accounting information to compute items like gross domestic product
(GDP).

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.

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 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.
 Characteristics of Accounting Information
Accounting information should
1. Reliable: - the information should represent fact/truth
2. Relevant: - the information should be related to the decision to be made
3. Understandable: - the accounting information provided to users should be
very easy to understand
4. Comparable and consistency: -When an entity applies the same accounting
treatment to similar events, from period to period, the entity is considered to
be consistent in its use of accounting standards. Information that has been
measured and reported in a similar manner for different enterprises is
considered comparable.
 Accounting Principle and Practices
They are standards or guidelines that the accountant should follow in identifying, measuring,
recording, and reporting the financial statements of an organization. They are collectively known
as Generally Accepted Accounting Principles (GAAP).
Some of the principles and concepts are the following:
1. Business entity concept/Economic entity assumption: - The business entity concept
views the business as an entity separate from its owners, creditors, or other stakeholders.
The business entity limits the economic data in the accounting system to that related
directly to the activities of the business. For accounting purpose, every business is
received and treated as if it is a separate entity that is distinct from its owners and from
every other business. Business entity is an economic unit which enters into business
transaction that must be recorded, summarized and reported.

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 2. Cost principle: - under the cost principle, all goods and service purchased are recorded at
cost. Costs are measured on cash or cash equivalent basis. Historical cost- means the
dollar amount originally paid to acquire the asset. This dollar amount neither indicated
the price at which the assets could be sold, nor the price at which they could be replaced.
3. Objective principle: - This is a principle which requires accounting records to be based
on verifiable events such as business transactions b/n independent parties. This principle
requires that the accounting records and reports be based upon objective evidence. To be
dependable accounting information must be based on objective data.
4. The unit of measure concept/stable dollar concept: - financial activities in business
enterprise should be expressed and recorded in terms of money. In accounting money is a
stable standard unit of measurement.
1. The Accounting Equation and Elements of the Equation
 The accounting equation
It is an algebraic equation that expresses the relationship between assets (resources), liabilities
(obligation), and owner’s equity (net residual interest after all liabilities have been meets)
 Elements of accounting equation:
1. Assets: are properties with money value that are owned by a business.
Examples:
 Cash
 Account receivables/Selling of goods or services on credit
 Supplies( office, store …)
 Building, Machinery, Land etc
2. Liabilities: are debts owed by a business. i.e. the claims/rights of creditors
Examples:
 Account payables/Purchasing of goods or services on credit
 Salary payable, Rent payable, Interest payable
 Notes payable /a formal written promise to pay a specific amount of money at a definite future
period.
3. Owner’s equity: it inset residual interest after all liabilities have been satisfied. It is also called
Capital, Proprietor ship, or Net worth.

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 Hence, if assets are properties that are owned by a business enterprise and the claims or
rights against the assets of a business enterprise are referred to as equities. It is always
true that every asset of a business might have someone to claim it. This implies that
assets equal equities. This can be stated in the form of equation as follows:
Assets= equities
Equities may be expanded into two principal types.
 The right of creditors which represent debt of the business and are called liabilities.
 The right of owners which are called owner’s equity.
Hence, the above equation can be reexpressed as follows and called the basic accounting
equation.
Assets= Liabilities + Owner’s Equity
It is customary to place liabilities before owner’s equity in accounting equation. Because,
Creditors have first claim against the asset of an enterprise. The residual claim of the owners is
sometimes given emphasis by transposing liabilities to the other side of the equation, yielding;
Assets - Liabilities = Owner’s Equity
2. Business transactions and financial statements
 Business transactions
 A business transaction is the occurrence of an event or a condition that must be recorded.
Example: Purchase of equipment, land, building, supplies, insurance etc; payment of
monthly salary, telephone, electricity.
 Business transaction means, business events which expressed in money and must be
record in the accounting record.
Simple transactions: Such transactions occur just only once. For example, the payment
of cash to settle the monthly telephone bill.
Complex transactions: in this case, one transaction will initiate another transaction &
may bring several such networks. For example, assume that a building is acquired partly
paying cash & promising to pay the remaining amount in the future. But for delaying the
pay, interest shall be paid for the seller monthly; when the building is used in business
operation of the Company, it decreases in value &such gradual decrease in value called
depreciation shall be taken into account. Hence, a single transaction also brings other
several transactions.

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 External transaction: is a transaction between an organization & an outside party. For
example, the payment of telephone bill, the acquisition of building, the payment of
interest etc.
Internal transaction: are transactions within the organization itself. For example, the
consideration of the decrease in the value of plant asset is an internal transaction,
recognition of uncollectible accounts, recognition of obsolescence of inventory are
considered as internal transaction.
Illustration:
Assume that Mr. John establishes a sole proprietorship to be known as John Taxi. The following
transactions occurred during the month of December 2011, the first month of operation for John
Taxi.
Transaction 1: John deposits Br. 10,000 in a bank account in the name of john taxi, which is
investment.
Effect of this transaction: - it increases the asset (cash) on the left side of the accounting
equation by Br. 10,000 and increases the owner’s equity (John, capital) on the right side of the
accounting equation by Br. 10,000.
Assets = Liabilities + Owner’s Equity
Cash = John, capital
(1)+10,000 + 10,000
Bal.10, 000 = 10,000
Transaction 2: John purchases land as a future building site, for which Br. 7,500 in cash is paid.
Effect of this transaction: - it does not change the total amount of the asset but changes only the
composite of the asset. I.e. Cash is decreased by Br. 7,500 and land (asset) is increased by the
same amount.
The right side of accounting equation is not affected by this transaction.
Assets = Liabilities + Owner’s Equity
Cash + Land = John, capital
Bal. 10,000 = 10,000
(2) - 7,500 + 7,500 -
Bal.2,500 + 7,500 = 10,000
Transaction 3: John purchases different supplies for Br. 850 from various suppliers agreeing to
pay on the near future.

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Effect of this transaction: - it increases both assets (supplies) and liabilities (account payable)
by Br. 850
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land = A/Payable + John, capital
Bal. 2,500 + 7,500 = 10,000
(3) - + 850 - +850
Bal. 2,500 + 850 + 7,500 = 850 + 10,000
Transaction 4: during the month john paid Birr 400 to creditors on account.
Effect of this transaction: - It reduces both asset (cash) and liabilities (A/Payable)
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land = A/Payable + John, capital
Bal. 2,500 + 850 + 7,500 = 850 + 10,000
(4) - 400 -400
Bal. 2,100 + 850 + 7,500 = 450 + 10,000
Transaction 5: John Taxi earned fares of Br.4, 500 from the service performed to the customers
and received in cash. The amount charged to the customers for goods and services sold to them
is called revenue.
Effect of this transaction: - it increase asset (cash) by Br. 4,500 and the owner’s equity (John,
capital) by the same amount.
Assets = Liabilities + Owner’s Equity
Cash + Supplies + Land = A/Payable + John, capital
Bal. 2,100 + 850 + 7,500 = 450 + 10,000
(5) +4,500 - - - + 4,500
Bal. 6,600 + 850 + 7,500 = 450 + 14,500
Transaction 6: John Taxi earned fares of Br. 1,000 from the service rendered to his customers
and agreed to collect in the near future. Such sales of service (goods) are termed as sales on
account. This creates a claim against the customers and termed as account receivable. This
becomes the assets of the business.

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Effect of this transaction: - it increases both assets (A/R) and owner’s equity, i.e. Mr. John,
capital components of accounting equation by Br. 1,000.
Assets = Liabilities + Owner’s Equity
Cash + A/R +Supplies + Land = A/Payable + John, capital
Bal. 6,600 + + 850 + 7,500 = 450 + 14,500
(6) - + 1,000 - - - + 1,000
Bal. 6,600 + 1,000 + 850 + 7,500 = 450 + 15,500
Transaction 7: For John Taxi various business expenses incurred and paid during the month
were as follows. Wages Br. 1,125, rent Br. 850, utilities Br. 150, miscellaneous expense Br. 75
Note: - the amount of asset consumed or service used in the process of earning revenue is called
expense.
Effect of this transaction: - it reduces both asset (cash) and owner’s equity (capital)
Assets = Liabilities + Owner’s Equity
Cash + A/R +Supplies + Land = A/Payable + John, capital
Bal. 6,600 + 1,000 + 850 + 7,500 = 450 + 15,500
- 1,125
-850
- 150
(7) - 2,200 - - - - -75
Bal. 4400 + 1,000 + 850 + 7,500 = 450 + 13,300
Transaction 8: at the end of the month it is determined that the cost of supplies on hand is Br.
250. The reminder I.e. 850-250=600 has been used in the operation of the business.
Effect of this transaction: - it reduces the assets (supplies) and owner’s equity (john, capital).
Assets = Liabilities + Owner’s Equity
Cash + A/R +Supplies + Land = A/Payable + John, capital
Bal. 4,400 + 1,000 + 850 + 7,500 = 450 + 13,300
(8) - - -600 - - - 600
Bal. 4,400 + 1,000 + 250 + 7,500 = 450 + 12,700
Transaction 9: at the end of the month, John withdraws from the business Br.1, 000 in cash for
personal use. This withdrawal is not the expense of the business. Because, it is not for the
earning of the revenue

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Effect of this transaction: - it reduces the asset (cash) and owner’s equity because; it is the
opposite of the investment in the business by the owner.
Assets = Liabilities + Owner’s Equity
Cash + A/R +Supplies + Land = A/Payable + John, capital
Bal. 4,400 + 1,000 + 250 + 7,500 = 450 + 12,700
(9) -1,000 - - - - - 1,000
Bal. 3,400 + 1,000 + 250 + 7,500 = 450 + 11,700
Summary in tabular form:
Assets = Liabilities + Owner’s Equity
Cash + A/R +Supplies + Land = A/Payable + Mr. John, capital
(1)+10,000 - - - +10,000
Bal. 10,000 = 10,000
(2) - 7,500 - - + 7,500 -
Bal. 2,500 - 7,500 = 10,000
(3) - - 850 +850 -
Bal. 2,500 - 850 + 7,500 = 850 + 10,000
(4) - 400 - - - - 400 -
Bal. 2,100 - 850 + 7,500 = 450 + 10,000
(5) +4,500 - - - - + 4,500
Bal. 6,600 - 850 + 7,500 = 450 + 14,500
(6) - + 1,000 - - - + 1,000
Bal 6,600 + 1,000 + 850 + 7,500 = 450 + 15,500
- - 1,125
- 850
- 150
(7) - 2,200 - - - - - 75
Bal. 4400 + 1,000 + 850 + 7,500 = 450 +13,300
(8) - - - 600 - - - 600
Bal. 4,400 + 1,000 + 250 + 7,500 = 450 +12,700
(9) -1,000 - - - - - 1,000
Bal. 3,400 + 1,000 + 250 + 7,500 = 450 + 11,700

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 The following observation should be noted from the above illustration.
1. The effect of every transaction can be stated in terms of increase and/or decreases in one or more
of the elements of accounting equation.
2. The equality of the two sides of the accounting equation is always maintained
3. The owner’s equity is increased by:
 Amounts invested by the owner, and
 Revenues
4. The owner’s equity is decreased by:
 Withdrawals by the owner, and
 Expenses
 Financial statements
F/S is reports prepared after transaction are recorded and summarized.
Financial statements are accounting statements that communicates or reports essential
information of a business enterprise to users of accounting information. By reading,
financial statements users of accounting information can make informed judgments
about:
 The financial position of a business,
 The financial progress of a business,
 The financial status of a business, and
 The cash flows (cash receipts and cash payments) of a business.
The most common financial statements are:
1. Income statement
2. Statement of owner’s equity
3. Balance sheet &
4. Statement of cash flow
1. Income Statement
A summary of the revenue and expenses for a specific period of time such as a month or a year,it
shows the results of business operations for specific period of time such as a month, a quarter, a
year. In other words, it shows the financial position of a business during any given time period. It

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 summarizes the revenues realized & expenses incurred by a business enterprise throughout its
operating activity.
 The excess of revenue over the expense incurred for the period results in net income or
profit. While, expense of the enterprise exceeds the revenue, the excess is termed as net
loss. In rare case when revenue and expenses are equal, the firm is said to be at Break
Even.
Income statement for John taxi is shown as follows:
John Taxi
Income statement
For the month ended December 31, 2011
Revenues:
Fares earned ……………………………………………………………… Br. 5,500
Less:Operating expenses:
 Wage expense ……………………………… Br. 1,125
 Rent expense………………………………… 850
 Supplies expense …………………………… 600
 Utilities expense …………………………… 150
 Miscellaneous expense ……………………… 75
Total operating expenses…………………………………………… (2,800)
Net Income ……………………………………………………………Br 2,700
2. Statement of owner’s Equity
It reports the changes in the owner’s financial interest (capital) of the business during the
period. It summarizes the effects of net income or loss for the period, owner’s drawing and
owner’s additional investments on the capital balance at the beginning. This statement is
prepared before balance sheet so that the amount of ending capital balance is available for
presentation on the balance sheet.

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 Statement of owner’s equity for John Taxi is as follows:
John Taxi
Statement of owner’s equity
For the month ended December 31, 2011
Beginning Capital …………………………………………………………. Br. -0-
Add: Investment during the month……………Br.10, 000
Net income for the month…………………… 2, 700
Less: withdrawal …………………………… (1,000)
Increase in owner’s equity………………………………………………………. 11, 700
John, capital, December 31, 2011………………………………………….Br 11, 700

Please note: For the business enterprise that had been in operation before the period for which
the statement of owner’s equity is to be prepared, there would be a beginning balance that would
be reported on the statements of owner’s equity.
Assume that john taxi reported net income of Br.2, 400 and withdraw Br.2, 000 during January
2012 (the second month of operation for john Taxi); the business capital at the end of January
2012 will be Br 12,100 which was calculated in the following manner.
John Taxi
Statement of owner’s equity
For the month ended January 31, 2012
John, capital, January 1, 2012………………………………………………….Br. 11, 700
Add: Net income for the month …………………………...Br.2, 400
Less: withdrawal……………………………………………. (2,000)
Increase in owner’s equity ……………………………………………………… 400
John, capital, January 31, 2011………………………………………………. Br 12,100
3. Balance Sheet
It is a financial statement that reports the financial status or financial condition of a business as
of a specific date. In other words, the statement shows what is owned, what owed, and what a
business is worth on a specific date. It summarizes the asset, liability and owner’s equity of a
business enterprise as of a specific date, usually at the close of last day of a month or a year.
Balance sheet can be presented in two forms:

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 Report form: - assets, liabilities and capital are presented in a vertical order. i.e. Liabilities and
owner’s equity section presented below the asset section.
 Account form: - assets are listed on the left and liabilities and capital are listed on the right hand
side.
Balance sheet (report form) for John taxi is shown as follows:
John Taxi
Balance Sheet
December 31, 2011
Assets:
Cash ………………………………………………...Br.3, 400
A/R ……………………………………………… 1,000
Supplies ………………………………………… 250
Land ……………………………………………. 7,500
Total assets …………………………………. Br 12,150
Liability:
A/P ……………………………………………...Br 450
Owner’s Equity:
John, capital December 31, 2011 ……………. Br. 11, 700
Total liabilities and owner’s equity …… Br 12,150
Asset section presentation is started with cash and followed respectively by assets that will be
converted into cash or used up in near future such as, receivables, supplies etc. relatively
permanent assets such as, equipments, buildings, land following in the same order. Liabilities are
presented first followed by owner’s equity in the equity section of the balance sheet which is
parallel to accounting equation.
4. Statement of Cash Flow
It is a summary of cash receipts and cash payments of a business enterprise for a specific period
of time, such as, a month or a year.
It is customarily to report cash flow in three sections.
Cash flows from operating activities: - related to cash transactions that inter into the
determination of net income or net loss.

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 Cash flows from investing activities: - cash transactions for the acquisition and sale of
relatively permanent assets.
Cash flows from financing activities: - cash transaction related to cash investment by owner’s,
borrowings, and cash withdrawals by owners.
Statement of Cash Flow for John taxi is shown as follows:
John Taxi
Statement of Cash Flow
For the month ended December 31, 2011
Cash flows from operating activities:
Cash received from customers ……………………Br 4, 500
Deduct: cash payment for expenses
& payments to creditors …………………. (2,600)
Net cash flow from operating activities …………………………………..Br. 1, 900
Cash flows from investing activities:
Cash payment for acquisition of land ……………… (7,500)
Net cash flow from investing activities ……………………………………… (7,500)
Cash flow from financing activities:
Cash received as owner’s investment ……………10, 000
Deduct: cash withdrawals by owner’s ……………. (1,000)
Net cash flow from financing activities……………………………………… 9,000
Net cash flow, & December 31, 2011 Cash balance …………………….. Br.3, 400
 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.
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:

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 Owner’s Equity

Decreased by: Increased by: Owner’s Investment

Owner’s withdrawals and Expenses and Revenues

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.
Please note: The following features are common for all the financial statements we have
discussed so far.
The name of the business
The title of the statement
The date or period of time

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