FUNDAMENTAL OF ACCOUNTING I

CHAPTER ONE

INTRODUCTION TO ACCOUNTING AND BUSINESS

1.1. ACCOUNTING

Accounting: is the process of collecting, analyzing, recording, summarizing, and interpreting financial
activities of businesses to permit individuals and organization to make informed judgments and decisions.

Collecting: gathering relevant source documents

Analyzing: examining these reports by breaking them down in order to determine financial success or
failure.

Recording: making written records of events

Summarizing: the process of combining these written records

Interpreting: involves the use of financial data to make sound decision.

Things we record in accounting are expressed in terms of money (monetary term).

1.2. THE ROLE OF ACCOUNTING IN BUSINESS

Accounting is often called “the language of business” because it provides much of the information that
owners, managers, and investors need to evaluate a business’s financial performance. There are two types
of users of financial information’s. These are:

1. Internal Users

Internal users of accounting information are managers who plan organization & run a business. These
include marketing managers, production supervisors, finance sectors & company officers in order to
provide right decision users should get information on a right time.

2. External Users

There are several types of external users of accounting information. Investors (owners) use accounting
information to make decision to buy, hold or sell stock. Creditors such as supplies and bankers use
accounting information to evaluate the risks of granting credit or lending money. The tax authority also
wants to know whenever the financial information (financial statement) of a business organization is
prepared in accordance with the tax laws. A regulatory agency also wants to know whether the business
organization is operating with in prescribed rules. In addition to these customers, labor unions & economic
planners use information of a business organization for different purposes
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Field of Accounting

There are many specialized fields in accounting have evolved as a result of raped technological advanced
accelerated economic growth in the 20th century. These are.

Financial accounting- is concerned with the recording of transactions for various reports from such
records using generally accepted accounting principles (GAAP).

Auditing- is a field of activity involving independent review of the accounting records in converting an
audit & given an opinion regarding their fairness reliability.

Cost Accounting- emphasizes the determination & the control of costs. It is concerned primary with the
costs of management process & of management producers.

Managerial Accounting- use both historical and estimated data in assisting management in daily
operations and in planning future operations.

Tax Accounting- encompasses the preparation of tax returns and the consideration of the tax
consequences of proposed business transactions or alternative course of action.

Accounting Systems- is the special field concerned with the design and implementation of procedures for
the accumulation and reporting of financial data.

Budgetary Accounting- present the plan of financial operations for a period and through records and
summaries, provides comparisons of actual operation with the predetermined plan.

Not-for-profit Accounting- specializes in recording, reporting and planning the operations of various
governmental units and other not-for-profit organizations.

1.3. TYPES OF BUSINESS ORGANIZATIONS

It is important that the business owner seriously considers the different forms of business organization
types such as sole proprietorship, partnership, and corporation. Which organizational form is most
appropriate can be influenced by tax issues, legal issues, financial concerns, and personal concerns. For
the purpose of this overview, basic information is presented to establish a general impression of business
organization.

Sole proprietorship: A sole proprietorship, also known as the sole trader or simply a proprietorship, is a
type of business entity that is owned and run by one individual and in which there is no legal distinction
between the owner and the business. The owner receives all profits (subject to taxation specific to the

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business) and has unlimited responsibility for all losses and debts. Every asset of the business is owned by
the proprietor and all debts of the business are the proprietor's.

Partnership: A Partnership consists of two or more individuals in business together. Partnerships may be
as small as mom and pop type operations, or as large as some of the big legal or accounting firms that may
have dozens of partners. There are different types of partnerships and is an association of two or more
persons to carry on as co-owners of a business for a profit. This organization type have unlimited liability
and limited life.

Corporation: A legal entity that is separate and distinct from its owners. Corporations enjoy most of the
rights and responsibilities that an individual possesses; that is, a corporation has the right to enter into
contracts, loan and borrow money, sue and be sued, hire employees, own assets and pay taxes. The most
important aspect of a corporation is limited liability. That is, shareholders have the right to participate in
the profits, through dividends and/or the appreciation of stock, but are not held personally liable for the
company's debts.

On the other hand based up on type of operation activity or function businesses are classified into
service, merchandising and manufacturing.

Service: They are intangible activities ranging from the professional services of doctors, engineers,
accountants, teachers, mechanics, beauticians, barbers, taxi drivers, carpenters, consultants, etc. The
businesses that render these types of services are known as service enterprises.

Merchandising: A business that buy and resells good is called merchandising business. They acquire
merchandise for resale to customers. This makes them different from service rendering businesses.
Manufacturing: they refer to the actual process of making or creating tangible products out of materials
and parts. Manufacturers employ labor and use machinery to change raw materials to finished goods.

1.4. ACCOUNTING PRINCIPLES AND PRACTICES

Professional accounting associations periodically issue pronouncements on accounting principles.

Authoritative accounting pronouncements are issued by such bodies as the Financial Accounting
Standard Board (FASB). It is from research accepted accounting practices and pronouncements of
professional and authoritative bodies that generally accepted accounting principles evolve to form the
underlying basis for accounting practice. These are

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Business Entity Concept

In accounting, a business or an organization and its owners are treated as two separately identifiable
parties. This concept is called business entity concept. In accounting, the separate entity concept treats a
business as distinct and separate from its owners. The business stands apart from other organizations as a
separate economic unit. It is necessary to record the business's transactions separately, to distinguish them
from the owners' personal transactions. This helps to give correct determination of true financial condition
of the business. This concept can be extended to accounting separately for the various divisions of a
business in order to ascertain the financial results for each division. The idea here is that the financial
transactions of one individual or a group of individuals must be kept separate from any unrelated financial
transactions of those same individuals or group

The Cost Principle

In accounting, the cost principle is part of the generally accepted accounting principles. The record of
properties and services purchased by a business are maintained in accordance with the cost principle,
which requires that the monetary record be in terms of cost. Assets should always be recorded at their
cost, when the asset is new and also for the life of the asset. For instance, land purchased for $30,000 is
appraised at the much higher value because the housing market has risen, but the reported value of the
land will remain.

1.5. THE ACCOUNTING EQUATION AND ELEMENTS OF THE EQUATION

The accounting equation is composed of assets and equities. Assets can be categorized in to current assets
and long term assets as discussed here under.

Assets: Assets are items with money value that are owned by a business. It has dollar (birr) value to be
recorded in accounting records. Example cash, account receivable, supplies, inventories, equipment land,
buildings, etc.

Liabilities: Liabilities are debts and obligations owed by the business organizations. A liability that results
from purchasing goods and services on credit is called account payable. Other liabilities include notes
payable, interest payable, wages payable, etc.

Owner's equity: The difference between what is owned (assets) and what is owed (liability) is Owner's
equity. It is the excess of asset over liabilities. It is also called capital, net worth, net asset and
proprietorship.

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Revenues: Revenues are increases in capital due to inflow of resources from business operations such as,
provision of services or sales of goods.

Expenses: Expenses are decrease in capital due to outflow of resources for the purpose of business
operations.

Asset = Equities

Assts = Liabilities + Owner’s Equities

Liabilities usually come before equities, because creditors have preferential right to the assets.

Assets – Liabilities = Owner equities