FUNDAMENTALS OF ACCOUNTING-I

CHAPTER-ONE- Introduction to Accounting and Business

1.1 Nature and Classification of Business Organizations
Definition -A business organization is an economic entity which is engaged in converting basic
inputs into products (provision of service) for sale at profit to customers.

Types of business organizations - based on the type of activities they perform or are engaged in to
generate income, business organizations can be divided in to three:
 Service - an enterprise that renders professional and technical services. E.g. banks,
telecommunication and transportation companies.
 Merchandising - an enterprise that buys and resells finished goods to customers. E.g.
Stationery shops, retail and wholesale stores, supermarkets, etc.
 Manufacturing - an enterprise that buys and converts raw materials into finished
products for sale to other businesses (merchandising) or direct to consumers. E.g. textile
and cement factories, wood- and metal-work shops, etc.
Forms of business organizations - Three different legal forms of businesses:
 Sole proprietorship - an enterprise owned by one person and usually operated and
managed by the same person. The sole proprietorship form of business is not a separate
legal entity from its owner. The life of a sole-proprietorship usually depends up on the
life of the owner.
 Partnership - an enterprise owned by two/more persons called partners and the partners
are usually engaged in operations and management of the organization. Like the sole
proprietorship form of business, partnership is not legally separate from its owners. The
life of a partnership usually depends up on the admission of new partner/s or withdrawal
of existing partner/s.
 Corporation - an enterprise owned usually by three/more persons called shareholders or
stockholders. The unique feature of a corporation is that it is a legal entity usually
referred to as an artificial person which is solely responsible for its act and debt. For it
has an independent existence, its life does not depend on the admission or withdrawal of
shareholder/s.
1.2 The Role of Accounting in Business Environment
1. Definition - Accounting is defined as an information system concerned with collection, analysis
and communication of financial information useful for decision-making. It is used as a means to
exchange information among interested parties concerning the financial performance, financial
position and related issues of an organization, it is also commonly known as the ―language of
business‖.
As an information system, process of collecting, analyzing and communicating information, it
involves the following steps:
 Identifying - tracing and collecting recordable economic activities. Accounting does not
record and report all economic activities of an organization. Rather, it records and reports
only those economic activities of the organization which can be expressed in terms of money.
 Analyzing and Measuring - This involves determining whether the economic activities bring
changes (increase/decrease) assets, liabilities, capital, revenues, and/or expenses (these terms
will be defined in subsequent sections) of an organization and expressing the changes in
monetary terms.
 Recording - make, in a systematic way, a record of the effects of economic activities on
assets, liabilities, capital, revenues and expenses.

 Classifying - grouping recorded effects of economic activities into meaningful classes.

 Summarizing - gathering and arranging data needed for preparation of reports and
statements.

1
  Reporting - preparing statements and reports in a manner that suits the need of users so as to
communicate information useful for decision making.
 Interpreting - provide explanation on reported information so that users can understand and
use the information as a basis for decision making.

2. Importance/purpose - Accounting can be seen as an important part of the total information

system of an organization. People, both inside and outside the business, have to make decisions
concerning the allocation of scarce resources. To ensure that these resources are allocated in
an efficient and effective manner, users require economic information on which to base
decisions. It is the role of the accounting system to provide that information. And the ultimate
purpose of accounting is to give people better information on which to base their decisions.
Some of the uses of accounting information in relation to the users of the information are
discussed below.

3. Users of Accounting Information - Accounting seeks to satisfy the needs of a wide rage of
users. In relation to a particular business, there may be various groups of users which are likely
to have an interest in financial aspects of it. The major users of financial information are
commonly grouped as internal and external users.

i. Internal users are mainly management personnel of an organization who have direct
involvement and control over and who are responsible for the day-to-day affairs of the
organization. They need and use the financial information to make decisions and plans for
the business activities including finance, human resource, production and marketing, and
exercise control to try to ensure that plans come to fruition. Management people use
accounting information to:
o Formulate long-, medium- and short-term plans
o Control and evaluate operation and performance, and
o Make other major decisions related to financing and investment, product costing and
pricing, selecting product mix and allocating scarce resources.

ii. External users on the other hand, refer to users outside an organization who are not directly
involved in the day-to-day affairs of the organization but have some interest in the financial
and related affairs of the organization.
External users include:
 Existing and potential owners/investors who want to assess how effectively managers are
running the business and to make judgments about the likely levels of risk and return
associated with investment in the business and decide to invest or de-invest.
 Existing and potential suppliers and creditors who need to assess the ability of the business
to pay for goods and services supplied or to be supplied to it and to meet its obligations when
due.
 Potential employees (non-managers) and labor unions that need to assess the ability of the
business to continue providing them with employment opportunities and better reward for
services they rendered or may render to the organization.
 Government agencies who need to assess how much tax the business should pay, whether it
complies with approved pricing policies, protect the public from excessive price charges by
monopolies, and so on.
 Existing and potential customers who want to assess the ability of the entity to continue in
business to supply them with the necessary goods and services and to know their outstanding
balances.
 Investment analysts and consultants who want to assess the likely risks and returns
associated with investment in an organization in order to determine investment potentials and
advise their clients accordingly.
2
  Community representatives who need to assess the ability of the entity to continue providing
employment opportunities for the community, use community resources, to support
environmental improvements and so on.
 Competitors who need to assess the threat posed by the business to their market share and
profitability, and need for a benchmark by which to compare efficiency and performance.
 To make their respective decisions, external users need among other things accounting
information about a business of their concern.

4. Characteristic of Accounting Information - accounting information is mainly quantitative

expressed in monetary terms. To be useful for decision making, accounting information should
be
 Reliable - represent facts, neutral, free of material errors and bias.
 Relevant - highly related to and make a difference in decision.
 Faithful representation means that the numbers and descriptions match what really existed
or happened—they are factual.
 Understandable - users with a reasonable knowledge of accounting and economic activities
should be able to easily understand and interpret the information.
 Relevancy and Faithful Representation are commonly called the qualitative characteristic or
attribute that make accounting information useful for decision-making.

5. Bookkeeping versus Accounting –

 Bookkeeping refers to the art of recording, in a prescribed and systematic way, the
economic activities of an organization. It is routine and clerical in nature.
 Accounting, on the other hand, goes beyond bookkeeping and is concerned with
 Designing accounting and reporting systems
 Recording economic activities
 Preparing reports and statements
 Interpreting reported information and
 Reviewing records and reports for their accuracy.
 Thus, it can be safely concluded that bookkeeping is one and the simplest part of accounting.

6. Profession of Accountancy - Accounting is an occupation, which requires advanced education

and special training. After completing the required education and training accounting
professionals may work as private or public accountants.
 Private accountants refer to those accountants who work for a single employer on salary
basis. Private accountants may assume different positions with in an organization including
chief accountant, financial manager, controller, budget officer and cost accountant.
 Public accountants refer to those accountants who provide professional services to the public
in general on a fee basis. They include certified public accountants and authorized
independent accountants.
7. Specialized Fields of Accounting - accountants may specialize in different accounting fields
including financial accounting, managerial accounting, cost accounting and tax accounting.
 Financial accounting - area of accounting aimed at serving information needs of external
users.
 Managerial accounting - field of accounting concerned with serving information needs of
internal users - managers.
 Cost accounting - a managerial accounting activity designed to help managers in identifying,
measuring and controlling operating costs.
 Tax accounting - field of accounting that includes preparing tax returns and planning future
transactions to minimize (not of course to evade which is an illegal act) amount of profit tax
3
 payable.
8. Evolution of Accounting - Accounting is highly affected by the economic, social, cultural,
legal, technological and political developments of a society.
Higher-level economic, social, cultural, legal, technological, and political developments of a
society need more elaborated and sophisticated accounting systems. In line with the changes in
the aforementioned environmental factors, accounting has evolved through several phases. These
phases may be grouped into two major classes: primitive and modern.

 Primitive - primitive accounting is believed to have begun about 4000 BC. At this stage,
accounting was identified to be unsystematic and incomplete dealing with certain aspects
and types of economic affairs (like receipts or payments of money), which does not provide
information sufficient enough to evaluate the financial performance and position of an
economic entity.
 Modern - modern accounting emerges with the invention of the ―Double-entry accounting
system‖ in 1494 by an Italian monk named Luca Pacioli. Double-entry accounting system
provides for recording the dual, commonly called debit and credit, aspects of financial affairs
of an entity which enhances the accuracy of records and facilitates preparation of reports.

1.3 Accounting Principles and Concepts

1.3.1 Convergence from GAAP to IFRS

In order to ensure high-quality financial reporting, accountants should present financial
statements in conformity with accounting standards that are issued by standard setting bodies.
Presently, there are two primary accounting standard-setting bodies—the International
Accounting Standards Board (IASB) and the Financial Accounting Standards Board
(FASB).
 More than 130 countries follow standards referred to as International Financial
Reporting Standards (IFRS). IFRSs are determined by the IASB. The IASB is
headquartered in London, with its 15 board members drawn from around the world.
 Most companies in the United States follow standards issued by the FASB, referred to as
generally accepted accounting principles (GAAP).

As markets become more global, it is often desirable to compare the results of companies
from different countries that report using different accounting standards. In order to increase
comparability, in recent years the two standard-setting bodies have made efforts to reduce the
differences between IFRS and U.S. GAAP. This process is referred to as convergence.
As a result of these convergence efforts, it is likely that someday there will be a single set of
high-quality accounting standards that are used by companies around the world.

 GAAP and IFRS include general concepts, assumptions, principles as well as specific
accounting and reporting procedures, policies and methods such as inventory valuation, revenue
recognition, depreciation computation, etc.

 IFRS is a guideline and mechanism for presenting a company's financial statements, only using
international standards.
 IFRS which stands for International Financial Accounting Standard is an international accounting
standard published by the International Accounting Standard Board (IASB).
 In its preparation, International Accounting Standards (IAS) involved four primary global
organizations, namely: the International Accounting Standards Agency (IASB), the European
Community Commission (EC), the International Organization for Capital Markets (IOSOC), and
the International Accounting Federation (IFAC).
 Advantages of Using IFRS
4
 1. Implementing IFRS financial standards can increase the comparability of financial
reports and put quality financial reports news on the international capital market.
2. Another benefit that can be felt by applying IFRS to your company is that it can
eliminate international capital flow constraints by reducing disparities in financial
reporting requirements.
3. In addition, IFRS can also reduce the use of multinational corporations' financial
reporting portfolios and costs for financial analysis for corporate financial analysts.
4. IFRS can improve the quality of your company's financial reporting towards best
practice.
Accounting standards are influenced by the economic, political, legal and social environment in
which they are established and applied, thus, subject to revision or change in line with the changes in the
previously mentioned environmental factors.
 The following sections discuss some of the basic accounting assumptions, principles, and
concepts that guide the accounting and reporting practices for the financial affairs of
commercial economic entities.

1.3.2. Assumptions
 Assumptions provide a foundation for the accounting process. Main assumptions are
the monetary unit assumption and the economic entity assumption.
I. Economic Entity Assumption - According to this assumption, each economic entity exists
separate from and independent of its owner/s and other economic entities under the same or
different owner/s. Thus, economic events can be identified with a particular unit of
accountability.
And the economic activities of an accounting entity can be and should be kept separate and
distinct from its owner/s and all other entities.

 For instance, records and reports of particular business should not reflect its owner’s
personal economic activities, assets and liabilities and that of another business other than
its own economic affairs.
An economic entity can be any organization or unit in society. It may be a company [Apple
Company, Salale Drug Store, Rift Valey University, Abdi Boru Primary School, Hana Super
Market, Awash Bank…Etc], a governmental unit, a municipality, a school district, or a church or
Mosques.
 The economic entity assumption requires that the activities of the entity be kept separate
and distinct from the activities of its owner and all other economic entities.

This assumption establishes limit/boundary as to what information to include in the accounting

records and reports of an economic entity and thus makes the financial accounting and reporting
practices manageable. The accounting entity concept, however, does not necessarily refer to a
legal entity. For instance, accounting assumes all types of business organizations (i.e. sole
proprietorship, partnership and corporation) as separate and independent economic entities.
However, it is only corporation that is legally treated as separate and independent entity.
II. Going Concern/Continuity Assumption - This assumption states that, in the absence of
information to the contrary, the life of an economic entity is indeterminate and the economic
entity will continue in operation long enough to carry out its existing objectives and
commitments.
 This assumption serves as a basis for other principles such as the historical cost principle
and affects classification of assets and liabilities as current and non-current for reporting
purposes. Because of this assumption, liquidation values of assets and liabilities are not
relevant for recording and reporting the financial affairs of an economic entity.
III. Unit of Measurement Assumption
5
 According to this assumption, the national currency (money) should be used as a unit of
measure or common denominator for recording and reporting the economic affairs of an
economic entity operating in a given country.
Besides, the unit of measure is assumed to remain constant over time despite the fact that the purchasing
power of money changes over time. According to this assumption, only those economic activities
capable of being expressed in terms of money should be recorded in the accounting records and
ultimately reported on the financial reports of an economic entity.

 However, many factors affecting economic activities and future prospects of an economic entity
cannot be expressed in monetary terms. For instance, such factors as the capabilities, dedication and
trust of employees including management, environmental impact (costs and benefits) of the
existence of the economic entity, and the relative strengths and weaknesses of competitors cannot
be expressed in monetary terms. Although such matters are important to and highly affect the
operations and performances of an economic entity, at the present time, accountancy does not
assume responsibility for recording and reporting information of such kind. Besides, accountancy
does not assume responsibility for recording and reporting the effects of changes in purchasing
power of money on previously recorded values of goods and services.
1.3.3. Concepts
I. Accrual Concept - This concept requires that financial affairs of an economic entity should be
recognized (i.e. recorded and reported) as they occur regardless of the timing of the in/out flows
of cash associated with the economic events. According to this principle, for instance, revenue
should be recorded and reported when goods are delivered or services are rendered to customers,
and expenses should be recognized when goods and services are consumed. The timing of the
in/out flows of associated cash, which may happen in advance, immediately or sometime in the
future, should not determine the period in which the revenues and expenses should be recorded
and reported.
 This concept avoids distortion of information on financial performance and position of an
economic entity that arises as a result of mismatch of costs/expenses and revenues when
the timing of cash flows is treated as a basis for recording and reporting the financial
affairs of an economic entity.

1.3.4. Principles

I. Objectivity Principle - According to this principle, an economic entity’s financial affairs to be

recorded in its accounting records and reported on its financial statements must be supported by
objectively determinable evidences known as source documents. This helps to enhance the
reliability of information reported by the entity and the confidence of users in relying on the
reported accounting information for making economic decisions. Objective evidences (source
documents) include such things as invoices, vouchers, checks, contracts and physical counts of
resources.
Evidences supporting the financial affairs of an entity are not always conclusive. Keeping
accounting records and preparing reports may rely on judgments, estimates and other subjective
factors. In such cases, the records and reports should be based on the most objective evidence
available and be kept in such a way that an independent individual (e.g. an auditor) could verify
their accuracy or reliability. This means that the independent individual should be able to arrive
at the same information using the bases the information is recorded in the accounting records and
reported on the financial statements.

II. Measurement Principles

 IFRS generally uses one of two measurement principles, the historical cost principle or the fair
value principle. Selection of which principle to follow generally relates to trade-offs between
6
 relevance and faithful representation. Relevance means that financial information is capable of
making a difference in a decision. Faithful representation means that the numbers and
descriptions match what really existed or happened—they are factual.
A. Fair value Principle
 The fair value principle states that assets and liabilities should be reported at fair value (the
price received to sell an asset or settle a liability). Fair value information may be more useful
than historical cost for certain types of assets and liabilities. For example, certain investment
securities are reported at fair value because market value information is usually readily
available for these types of assets.

In determining which measurement principle to use, companies weigh the factual nature of cost
figures versus the relevance of fair value. In general, even though IFRS allows companies to
revalue property, plant, and equipment and other long-lived assets to fair value, most
companies choose to use cost. Only in situations where assets are actively traded, such as
investment securities, do companies apply the fair value principle extensively.

B. Historical Cost Principle

 The historical cost principle (or cost principle) dictates that companies record assets at their
cost. This is true not only at the time the asset is purchased, but also over the time the asset is
held. This principle states that goods and services purchased or sold should be recorded in the
accounting records and then reported on the financial statements at the initial amount of cash or
cash equivalent given up to acquire them or received in exchange for selling them rather than on
an estimated/appraised/assessed or market value. Such amount is retained in the accounting
records until such time that the goods and services are consumed, sold or liquidated and
removed. The justification for using the historical cost as a basis for recording and reporting
financial affairs is the fact that it is the most reliable figure usually supported by objectively
determinable evidences.

1.4 Business Transactions and the Accounting Equation

1. Elements of Financial Statements - are items that are recorded in the accounting records and
then reported on commonly called financial statements of a business entity reports. The
elements of financial statements include assets, liabilities, capital, revenues and expenses.
i. Assets - are resources owned/controlled by an economic entity and with the potential to
provide future benefits to the business.

 E.g. building, land, vehicle, money, office machine such as computer

 Inventory (merchandise held for sale),
 Accounts Receivable (money claims against customers for goods and services sold to
them on credit),
 Rent Receivable (money claims against lessee/tenant/renter for housing services
rendered to them but not yet collected),
 Supplies (also called consumable - refer to assets that are expected to be consumed
within a very short period of time and include such items as fuel, stationery
materials, cleaning materials, postage and postage stamps, etc), etc.
Note: As seen in the above cases, money claims against customer for goods and services rendered to
them on credit basis are identified by names including a suffix Receivable.

ii. Liabilities - obligations/debts of a business that arise as a result of borrowing and/or buying
goods and services on credit. Liabilities may require use of business assets such as cash
and/or delivery of goods and services for their repayment or settlement.
 E.g. Accounts Payable (liability arising from purchase of goods on credit),
 Salary Payable (obligation for professional or technical services received from employees),
7
  Utility Payable (obligation to utility companies for utility services such as telephone,
electricity and water services received but not yet paid),
 Bank Loan Payable (money borrowed from banks),
 Interest Payable (interest accrued on loans not yet repaid),
 Sales Tax (VAT) Payable (amount collected from customers on behalf of and due to
government/tax authority) and
 Unearned Rent (money collected from tenants promising to provide them housing services
in the future).
Note: Most liabilities are identified by names including a suffix Payable or a prefix Unearned.

 Liabilities represent claims/rights of creditors against the resources/assets of a business or value

of assets supplied by creditors.
iii. Capital - also called owner’s equity/net worth/net assets refer to resources contributed by or
that belong to the owner/s of a business entity. Capital represents claims/rights of owner/s
against assets of a business. Capital may include direct investment of resources by owner/s
and profit generated from business operations that are accumulated over time or not
withdrawn by the owner/s for personal use.
iv. Revenues - refer to money or other assets received in exchange for goods and services sold to
customers. Business organizations may sell goods and services on cash and/or credit basis.
 Cash sale - refers to a situation where customers buying goods and services are required
to immediately pay and accordingly paid cash for goods and services sold to them.
 Credit sale - refers to a situation where customers are allowed to pay money sometime in
the future for goods and services currently sold to them. Credit sale gives rise to an asset
known as Accounts/Rent/Commission Receivable representing the right of the business
to claim money or other assets from customers buying its goods and services on credit.
Revenues may be generated from different activities and different terms may be used to refer
them accordingly. Below are some examples.
o Selling finished goods such as food/clothing items, stationery materials - Sales
o Providing services such as transportation, auditing, legal, medical - Fees Earned
o Lending money - Interest Income
o Leasing/renting properties - Rent/Royalty Income
o Providing brokerage service - Commission Income

v. Expenses - refer to goods and services consumed/used in operating or carrying on day-to-day

activities of a business. Like sales of goods and services, expenses or purchases of goods and
services may be on cash or credit basis.
 Cash expense/purchase - refers to a situation where a business immediately pays cash
for expenses it incurred or goods and services it purchased.
 Credit expense/purchase - refers to a situation where a business is allowed to pay money
sometime in the future for expenses it currently incurred or goods and services it
currently purchased. Credit expense/purchase gives rise to an obligation/a liability
known as Accounts/Rent/Interest/Salary/Utility Payable representing the rights/claims of
creditors/suppliers against the assets of the business.
Different terms are used to refer to expenses based on the type of goods and services
consumed. Below are some examples.
o Cost of Goods Sold - expired costs finished goods resulting from sale of the goods to
customers
o Supplies Expense - representing cost of supplies consumed
o Utility Expenses - value of utility services consumed
o Wages/Salary Expenses - values of services received from employees
o Interest Expense - interest accrued/paid on loans
8
 o Rent/Royalty Expense – resource sacrificed for value of services received from
property owners
o Miscellaneous Expenses - values of goods and services consumed but minor enough
in amount to be classified in either of the above types of expenses.
2. Business Transactions - are economic activities of a business that bring monetary changes in its
assets, liabilities, capital, revenues and expenses and should be recorded in the accounting
records of the business. They include buying and selling goods and services and collecting and
paying money. Business transactions are raw materials or inputs to the accounting process.
Business transactions may be categorized as external and internal transactions:
 External transactions - refer to exchanges of goods and services between a business
organization and an outside party such as individuals and/or other organizations. E.g. buying
telephone services from ETC, selling goods to a customer, purchasing vehicle from Nyala
Motors, etc.
 Internal transactions - refer to consumptions of goods and services within a business entity,
which do not affect external party. E.g. use of previously purchased stationery materials, fuel,
office machine, etc.
3. The Accounting Equation - is a mathematical expression that shows the relationship between
assets, liabilities and capital of a business. Below are three but fundamentally the same ways of
expressing the relationship between elements of the financial statements.
i. Resources = Equities/Claims to Resources
This equation indicates that resources of a business organization come from two major sources
collectively known as equities or claims to the resources. Accordingly, resources are equal to
their sources/equities. Resources contributed or invested by owner/s are called owner’s equity or
capital and those resources supplied by creditors are identified as liabilities. Expansion of the
previous equation to give recognition to the two basic type’s equities leads to another equation
given below.
ii. Assets = Liabilities + Owner's Equity
This indicates that a business may get its assets from its owner/s in the form of investment and/or
from its creditor/s in the form loan or credit.
Assets - Liabilities = Owner's Equity
The accounting equation may further be rearranged, as shown above, to indicate that owner’s
equity represents the residual interest in business assets. This implies that creditors have priority
or preferential right over the assets of a business upon the event of liquidation.
 Business Transactions and the Accounting Equation - Business transactions affect one or
more elements of the accounting equation. Each business transaction brings equal dollar/Birr
amount of net changes into both the left and right sides of the accounting equation. As a result,
the equation remains in balance (equal) regardless of the nature and complexity of the
transaction. Each and every business transaction is recorded in terms of the changes (increases
and decreases) it brings into the elements of the accounting equation. Thus, the accounting
equation is used to keep track of changes in the elements of the financial statement.
 Below are sample transactions and their effects on the elements of the financial statements.
i. Collections of resources from
 Owner/s in the form of investment, increase both assets and capital
 Creditor/s in the form of credit/loan, increase both assets and liabilities
 Customer/s in exchange for goods and services sold to them, increase both assets and
revenues
ii. Consumptions of goods and services such as
 Previously purchased supplies, stationery materials and fuel, increase expenses and
decrease assets
 Utility, housing and employee services for which money is not yet paid, increase both
expenses and liabilities
9
  Money taken out of business by the owner for personal use called withdrawals, decrease
both assets and capital
 Note that revenues and expenses represent increases and decreases in capital, respectively.

1.5 Financial Statements

Definition - Financial Statements are reports prepared by a business to provide financial
information about its economic affairs to users for decision making. Business organizations
prepare four basic financial statements: Income Statement, Statement of Changes in Owner’s
Equity (Capital), Statement of Financial position (Balance Sheet) and Statement of Cash Flows.
1. Income Statement - is used to provide information about financial performance of a business
over time. The statement summarizes the revenues earned and expenses incurred in a specific
period of time such as a month or a year. Expenses are deducted from revenues on the income
statement to determine whether the business earned a net income or incurred a net loss. Excess of
revenues over expenses is called net income, while excess of expenses over revenues is called
net loss.
2. Statement of Changes in Owner’s Equity - is a summary of changes (increases and decreases)
in owner’s equity that have occurred during a specific period of time such as a month or a year.
The statement includes beginning and ending capital balances, additional investment, withdrawal
and net income/loss.
3. Balance Sheet - is used to provide information about amounts and types of assets a business
owns and amounts and types of resources contributed by its owner/s and creditor/s.

Elements of the balance sheet include assets, liabilities and capital. The balance sheet lists assets,
liabilities and capital of a business on a specific date, usually at the end of a month or a year. There
are two forms of a balance sheet: report form and account form.
 Report form - lists assets first followed by liabilities and capital in report writing form
 Account form - lists assets on the left side and liabilities and capital on the right side of the
balance sheet
4. Statement of Cash Flows - is used to provide information about sources and uses of cash over a
specific period of time such as a month or a year. Cash flows are classified based on the
activities of an organization: operating, investing and financing.

i. Operating activities - refer to cash activities of a business that are entered into determination
of net income/loss. Examples include cash collections from customers for goods and services
sold to them and cash paid for goods and services (such as utilities, supplies and rent)
consumed in operating a business.

ii. Investing activities - refer to cash activities of a business that involve acquisition and sale of
relatively long-term assets such as furniture, fixtures, vehicles, buildings and machines.

iii. Financing activities - refer to cash activities of a business that affect equities of owner/s and
long-term creditors of the business. Examples include money invested and withdrew by
owner/s, proceeds from bank loans and repayment of principal part of bank loan.

Example (Analyzing business transactions)

Let’s examine the effects of some of the most common business transactions on the accounting equation.
As a means of illustration, suppose Ato Elias 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 Elias 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

10
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 Elias, 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.

N.B. the equation relates only to the business enterprise. Ato Elias’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 Elias, 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 Elias 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 + Owner’s Equity

Cash + Supplies + Land Accounts payable Elias, Capital
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 ―3‖ by promising to pay in the future, and as per the promise made it
is now settling its liability. The effect of this transaction on the accounting equation is as follows:

Assets = Liability + Owners Equity

Cash + Supplies + Land Accounts payable Elias, Capital
11
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 Elias, Capital
Bal Br 78,500 Br. 2,500 Br.20,000 Birr 1,000 Birr 100,000
30,000 - - - 30,000
Bal. 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 without 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 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 Elias, Capital
Bal Br108, 500 Br. 2,500 Br.20,000 Birr 1,000 Birr 130,000
-15,000 - - __-___ -15,000
12
Bal. 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 Elias, 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 Elias, Capital
Bal Br 93, 500 Br. 2,500 Br.20,000 Birr 1,000 Birr 115,000
-3,000 - - __-___ -3,000
Bal. 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 the transactions here and the balance of each item is shown after each transaction.
Assets______ = Liability + Owners Equity
Type of owner’s
Tra. Accounts Elias, Capital Transaction
No Cash + Supplies + Land Payable
1 +100,000 - - - + 100,000 Owners initial
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 Telephone 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 withdrawal
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.
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:

13
 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.

Preparations of Financial Statements

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.

As discussed above the major financial statements used to communicate accounting information about a
business are:
- income statement
- balance sheet
- statement of owner’s Equity
- statement of cash flows (will be discussed in senior courses)
1. Income statements
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

2. Statement of Financial Position/ Balance sheet

14
 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
Elias, Capital Br12, 000.00.
_________ Total Liabilities and
Total Assets……..113,000.00 Owner’s equity……...Birr 113,000.00

3. Statement of Owner’s Equity

Effective Garage
Statement of Owner’s Equity
For the Month ended September 30,200x

Elias, Capital, September 1…………………..…Birr 100,000.00

Net income…………………………..………15,000.00 115,000.00
Less: Drawings…………………………………………….……………3,000.00
Elias Capital, September 30…………….……………………… Birr 112,000.00

15