UNIT 1.

INTRODUCTION TO ACCOUNTING AND BUSINESS

Contents
1.1 Introduction
1.2 Definition, Importance and Users of Accounting Information
1.2.1 Accounting Defined
1.2.2 Importance and Users of Accounting Information.
1.3 Bookkeeping Versus Accounting
1.4 The accounting Profession
1.5 Accounting Principles and Concepts
1.6 Forms of Business Organizations
1.7 Types of Business organizations
1.8 Business Transactions and the Accounting Equation
1.9 Financial Statements of Sole Proprietorships

COURSE OBJECTIVES

After studying this unit, you should be able to:

- explain the meaning of Accounting
- identify the users and uses of accounting
- explain the various branches in the profession of accounting
- explain the meaning of “generally accepted accounting principles”,
- state the basic accounting equation and explain the meaning of assets, liabilities, and
owner’s equity
- analyze the effects of business transactions on the basic accounting equation, and
prepare an income statement, owner’s equity statement, and balance sheet.
INTRODUCTION

. Nature of Business and Accounting

A business is an organization in which basic resources (inputs), such as
materials and labor, are assembled and processed to provide goods or services
(outputs) to customer.
The objective of most businesses is to earn a profit

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An information system is the collecting, processing, and reporting of information to decision
makers. Understanding and processing information is the core of accounting.
accounting.

The kind of information processed in accounting is financial i.e. of a monetary nature.

Providing information about what businesses own,
own, what they owe, and how they perform is
the aim of accounting. Accounting is, an information and measurement system that
identifies, records, and communicates relevant, reliable, and comparable information
about an organization’s (a business’s) economic activities.

Therefore, a study of accounting helps people make better and informed decisions about
assessing opportunities, products, investments, and social and community responsibilities.

The study of accounting, therefore, opens you new and exciting possibilities both in terms of
becoming a professional accountant and using accounting information in your daily life.

This course discusses the fundamental principles involved in processing accounting

information of business enterprises.
enterprises.
DEFINITION OF ACCOUNTING
As a financial information system, accounting is defined as a process of identifying,
measuring, recording and communicating economic events of an organization (business or
non- business) to interested users of the information.

– identifying – involves selecting those events that are considered evidence of economic
activity relevant to a particular organization. Ex- sale of goods and rendering of service
- Once identified it shoud be measured in Birr and cents, then economic events are
recorded to provide a permanent history of the financial activities of the organization.
- Recording consists of keeping a chronological diary of measured events in an orderly
and systematic manner. In recording, economic events are also classified and
summarized.
- This identifying and recording activity is of little use unless the information is
communicated to interested users. The information is communicated through the preparation
and distribution of accounting reports, the most common of which are called financial
statements.

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.As accounting plays an important role in the decision making process of business entities, it
is often called the language of business.
business.
Importance of accounting
The main purpose of accounting is to provide financial information to be used for decision-
making.
making. For instance, Business executives and managers need the financial information
provided by the accounting system to help them plan and control the activities of the
business. Outsiders such as bankers, potential investors, and labour unions and others also
need accounting in formation for their own decision making.
-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

The people who use accounting information basically fall in to two categories:
1. External Users, and
2. Internal Users

1. External Users: External Users of accounting information are parties, which are not
directly involved in running the business enterprise. These include lenders, shareholders
(stock holders), suppliers, employees and their Unions, government (regulatory bodies) and
others. External users rely (depend on) accounting information to help them make better
decisions in trying to achieve their goals.
- The area of accounting aimed at serving external users is called Financial Accounting. Its
main objective is to provide to external users information through financial statements.
2. Internal Users: These are persons that are directly involved in managing and operating an
organization. They include managers and other important decision makers. The internal role
of accounting is to provide information to help improve the efficiency and effectiveness of an
organization.
-The area of accounting aimed at serving the decision-making needs of internal users is called
Management Accounting.
ACCOUNTING PROFESSION\ BRANCH OF ACCOUNTING

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You probably would apply your expertise in one of three major fields:
fields:
i) Public accounting
In Public Accounting you would offer expert service to the general public in much the same
way that a doctor serves patients and a lawyer serves clients. A major portion of public
accounting practice is involved with Auditing.
Auditing. In this area, a certified Public Accountant
(CPA) or ACCA examines, the financial statements of companies and expresses opinion as to
the fairness of presentation. When presentation is fair, users consider the statements to be
reliable. Management consulting is another area of public accounting.
ii) Private Accounting
an accountant may be an employee of a business enterprise. In private accounting, you
would be involved in one of the following activities:
ex- CostAccounting,Budgeting,Generalaccounting,Accounting information system,Tax
Accounting,internal Auditing etc..
iii) Not for Profit Accounting
Not - for-profit organizations also need sound financial reporting and control. Donors to
such organizations want information about how well the organization has met its objectives
and whether continued support is justified.
justified.

ACCOUNTING PRINCIPLES AND CONCEPTS

Accounting, as it is true for other disciplines, has got its own principles and practices. One
must be able to understand these principles and practices to understand and prepare financial
statements and reports. The principles and concepts used in accounting are called Generally
Accepted Accounting Principles (GAAP
(GAAP).
). These principles guide accountants how to record
and report business activities.
Generally Accepted Accounting Principles
Financial accountants follow generally accepted accounting principles
(GAAP) in preparing reports.
Within the U.S. , the Financial Accounting Standards Board (FASB) has the
primary responsibility for developing accounting principles .
Many countries ( including Saudi Arabia ) adopted the International Financial
Reporting Standards (IFRS) that are issued by the International Accounting
Standards Boards (IASB) .

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Within Saudi Arabia ,the Saudi Organization for certified public accountant
(SOCPA) has the primary responsibility for developing accounting principles.
These reports allow investors and other users to compare one company to

another .

Business entity concept; The activities of a business are recorded separately

from the activities of its owners, creditors, or other.

Cost concept; Amounts are initially recorded in the accounting records at their
cost or purchase price.
Objectivity concept: Requires that the amounts recorded in the accounting
records be based on objective evidence.
Unit of measure concept: Requires that economic data be recorded in dollars

or birr.

Accounting period concept: Requires that revenues and expenses be reported in

the proper period.

Revenue recognition concept: Supporting the reporting of revenues when they

are earned regardless of when cash is received.

Matching concept: Supporting reporting revenues and related expenses in the

same period.

FORMS OF BUSINESS ORGANIZATIONS

There are three basic forms of business organizations: sole proprietorships, partnerships, and
corporations.
1. Sole Proprietorships
A sole proprietorship is a business owned by one(single) person and usually managed by the
owner. No special legal requirements must be met to start a sole proprietorship and usually
only a limited investment is required to begin operations.

A sole proprietorship is a separate entity for accounting purposes (Business entity Concept)
but it is not a separate legal entity from the owners. That is, from the legal point of view,

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the owner and the business are treated as one and the same. The owner will be held
personally responsible for the debts and actions of the business.

2. Partnerships
A Partnership is an association of two or more persons to carry on business as co-owner for
profit. A partnership is not a legal entity separate from the owners but an association that
brings together the talents and resources of two or more people. The owners of a
partnership are known as partners.
partners.

The partners share the profits and losses of the partnership according to an agreed ratio. The
personal resources of each partner can be called on to pay the obligations of the partnership.
That is, each partner is personally responsible for the debts of the partnership.
partnership.

3. Corporations
-A business organized as a separate legal entity with ownership divided into transferable
units of capital is called a corporation. The owners of a corporation are called
stockholders or shareholders.
shareholders. The corporation issues capital stock certificates to each
stockholder showing the number of shares (stock) he or she owns.
-The stockholders are free to sell all or part of these shares to other investors at any
time. This ease of transfer of ownership adds to the attractiveness of investing in a
corporation.
-A corporation is a separate legal entity,
entity, the owners (stockholders) are not personally
liable for the debts of the corporation.
corporation. Their risk of loss is limited to the amount they
paid (invested). Because of this limited liability in a corporation shareholders are willing
to invest in riskier, but potentially more profitable, activities.

TYPES OF BUSINESS ORGANIZATIONS

There are three types of businesses organizations; service business, merchandizing business
and manufacturing business
1. Service businesses: are businesses that provide service to customers
EX- Hospital, schools, transportation, garage, barber, lawyer, etc.
Note: Do not have inventory or cost of goods sold account, because they don’t have anything
to sell.
2. Merchandising businesses: are businesses that are engaged in purchase of goods or
commodities for resale without changing phisically. It has cost og goods sold account.
i.e SALES= CGS+ GP
EX- Supermarkets, drugstores, groceries etc.
3. Manufacturing businesses: are businesses that produce physical output(change basic
input in to products that are to be sold to customers).
EX- Cement, sugar, textile, flour, chemical factories etc.

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BUSINESS TRANSACTIONS AND THE ACCOUNTING EQUATION

Business transactions
-Are economic events that should be recorded because they affect the financial position of the
business enterprise.
- Are economic events or conditions that directly changes on entity’s financial conditions or
its results of operations.
-These businesses transactions are the raw materials of accounting reports, as cotton is a raw
material for a textile factory.

* A transaction can be an exchange (such as the purchase or sale of property, payment or

collection of a loan etc.) between two or more parties.
* A transaction can also be non exchange an event that has the same effect as an exchange
transaction Some examples of “non exchange” transactions are losses from fire, flood;
physical wear and tear on equipment; donation of property and so forth.

** For a given transaction to qualify to be recorded it has:

a. to be related to the business enterprise
b. to be measurable
measurable in terms of money
c. to be completed / happened/ action.

ACCOUNTING EQUATION

Economic Resources = claims over the resources

Assets =Equities.
Assets=equities
Equities = Liability + Owner’s equity
This equation can be written as:

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 Assets= liability + Owner’s Equity(capital)
A= L+ C
ASSETS:
ASSETS: are the wealth that has been accumulated and owned by the businesses.( Resources
owned and controlled by the business)
EQUITY: are the right or claims owners over the asset of the business
LIABILITY:
LIABILITY: are the right of creditors(debts or obligation of the business).
OWNER’S EQUTY(CAPITAL):
EQUTY(CAPITAL): are the right or claim of owners over the asset of the
business(the amount left over after paying the liability). It is also called networth, net asset(A-
L=C), residual amount.
**It is customary to place “liabilities“ before “Owners equity” in the accounting
equation because creditors have priority (preferential) rights to the assets. Because of
this, the owners have a residual claim over the assets.

Liabilities
Assets &
Capital

***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
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.
equity. Withdrawals
and expenses during the period decrease the owner’s equity.
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 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.

FINANCIAL STATEMENTS OF SOLE PROPRIETORSHIPS

At the end of accounting period, after the effect of the individual transactions has been
determined or recorded, the essential information is communicated to users at certain peroid
through the accounting reports, which communicate this information, are called financial
statements.
-Financial statements are said to be the central features of accounting because they are the
primary means of communicating important accounting information to users.

-Financial statements are the means of transferring the concise picture of the profitability
and financial position of the business to interested parties.

**The major financial statements used to communicate accounting information about a

business are:
- income statement
- statement of owner’s Equity

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 - balance sheet
- statement of cash flows

1. Income Statement
-The income statement is a financial statement that summarizes the amount of revenues
earned and expenses incurred by a business over a period of time. -It reports the
profitability(operational performance) of the business by comparing revenues and expenses
for a stated period of time such as a month or a year. In accounting profitability is measured
for a period of time than on a daily basis.

-If the revenue of a period exceeds the expenses of that same period, net income results.
results. If
expenses are greater than the revenues of a period, we say there is a net loss.
loss.
N.B. The determination of periodic net income (net loss) is a matching process involving two
steps. First revenues earned are recognized during the period. Second, the expenses incurred
to generate revenues are matched (compared) against revenues to determine net income or net
loss.

2. Owner’s Equity Statement

-This is a statement that summarizes the changes in owner’s equity for a specific period of
time.
-The information provided by this statement indicates the reasons why owner’s equity has
increased or decreased during the period.
3. Balance Sheet
The balance sheet, sometimes called the statement of financial Position,
Position, lists the company’s
assets, liabilities and owner’s equity as of a specific date-
date- usually at the end of a month or
year.
4. Cash flow statement

Is a summary of cash receipts and cash payments for a specific period of time, such as a
month or a year.It shows net cash flows( inflow and outflow) of the business. Cash outflow or
inflow may be arisied from three activities:
a. Operating activities : from normal or ordinary course of the business
b. Investement activities:
activities: from purchase of asset( real or financial asset)
c. Financing activities : from borrowing or equity capital.

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GLOSSARY OF TERMS

Accounting - the process of identifying measuring, recording, and communicating the

economic events of an organization to interested users of the information.

Assets – Resources owned by a business.

Auditing – the examination of financial statements by a certified public accountant in order to

express an opinion as to the fairness of presentation.

Balance Sheet – A financial statement that reports the assets, liabilities, and owner’s equity
on a specific date.

Basic Accounting Equation - Assets=Liabilities + owner’s equity

Bookkeeping – A part of accounting that involves only the recording of economic events.

Corporation – a business organized as a separate legal entity under state corporation law
having ownership divided into transferable shares of stock.

Cost Principle – an accounting principle that states the assets should be recorded at their
actual cost .

Drawings – Withdrawals of cash or other assets from the business for the owner’s personal
use.

Economic (Business) Entity Assumption – An assumption that states a business enterprise

must be given separate and distinct existence from the owners, creditors, customers and any
other party.

Expenses - the cost of assets consumed or services used in the process of earning revenue.

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Income statement – A financial statement that presents the revenues and expenses and
resulting net income or net loss of a company for a specific period of time.

Investment by owner – the assets put in to the business by the owner.

Liabilities – Represents the claim of creditors on the assets of the business.

Monetary unit assumption–

assumption– An assumption stating that only transactions that can be
expressed in terms of money be included in the accounting records of the business.

Net Income – the amount by which revenues exceed expenses.

Net loss – the amount by which expenses exceed revenues.

Owner’s Equity Statement – A financial statement that summarizes the changes in owner’s
equity for a specific period of time.

Partnership – An association of two or more persons to carry on a business as co-owners for

profit.

Private accounting – An area of accounting with in a company that involves such activities
as cost accounting, budgeting, and accounting information systems.

Public Accounting – An area of accounting in which the accountant offers expert service to
the general public on a fee bases.

Revenues – the gross increase in Owner’s equity, resulting form business activities entered in
for the purpose of earning income. It is the amount charged to customers for services sold or
goods delivered to them.

Tax Accounting - an area of public accounting involving tax advice, tax planning, and
preparing tax returns.

Transactions – The economic events of the business recorded by the accountant.

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