CHAPTER ONE

INTRODUCTION

1. BASIC STRUCTURE OF ACCOUNTING

1.1 Evolution, definition, and importance of accounting

Evolution of accounting

People in all civilizations have maintained various types of records of business activities. The oldest know as
clay tablet records of the payment of wages in Babylonia around 3600 B.C.

However, early accounting dealt only with limited aspect of the financial operations of private or government
enterprises. These were no systematic accounting for all transactions of a particular unit, only for specific types
or portions of transactions. Now a day, as business and society become more complex, accounting concept and
techniques increased to meet financial information.

Definition of accounting

Accounting is the process of recording, classifying, summarizing, interpreting, and communicating financial
information for owners, mangers, and other interested parties
.
Accounting as an information system

Accounting called as the language of business. This language viewed as information system to make an
informed judgment and decision by the users’ of the information.

An Accounting System is designed to accumulate data about a firm’s financial affairs, classify the data in a
meaningful way, and summarize it in periodic reports called financial statements.

Importance of accounting

Determine the operation results of the organization.

Facilitates rational decision making, for decision makers.

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 Keep systematic record of business transaction.

It plays important role in all economic social system.

1.2 characteristics of accounting information and its users

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

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

Users of accounting information

The results of accounting process are communicated to many individuals and organization. The users of
accounting information may be divided into two broad groups.

1. Internal users; are those individuals directly involved in the process of either planning or controlling
current operations or for formulating long- range plans and making major business decision.

Example; Managers and employees

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

2. External users; those are parties that are not directly involves in the running the operation of the business.

Example; investors, creditors, Bankers, suppliers, governments, employees union, and tax authorities.

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

making loans or granting credit. Government agencies are concerned with financial activities of business
organization for purpose of taxation and regulation. Labors unions are also interested in the stability and
profitability of the enterprise.

1.3 The profession of accounting

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

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 - Private Accounting – accountants employed by a particular business firm or non- for- profit
organization, perhaps as chief accountant, controller, and financial vice –president.
- Public Accounting – accountants who render accounting service on a fee basis and staff accountants
employed by them.

1.4 Accounting principles and concepts

Professional accounting associations periodical issue pronouncements on accounting principles. Authoritative

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

1. Business entity concept

It is based on the applicability of accounting to individual economic units in society. These individual economic
unit include all business enterprises organized for profit; governmental unit; non for profit units; and individual
persons and family units. The basic economic data for a unit must first be recorded, followed by analysis and
summarization, and finally by periodic reporting. Thus accounting applies to each separate unity. It is possible
of course, to combine the data for similar economic units to obtain an overall view. The three major legal form
of business entity are the sole proprietorship, partnership, and corporation.
Sole proprietorship is a business entity owned by one person, example, small businesses are operated
as sole proprietorships.
Partnership is small a business entity owned by two or more people in accordance with contractual
agreement.
Corporation is a separate legal entity in which ownership is divided into shares of stock and it is
organized in accordance with the state statutes.

2. Cost principle

The records of properties and services purchased by a business are maintained in accordance with the
cost principle, which requires that the monetary record be in terms of cost.

The other accounting principles and concepts will be discussed in latter chapter.

1.5 The distinction between bookkeeping and accounting

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Even though book keeping and accounting have partly relationship they have, also a vast deferens which create
some confusion.

Bookkeeping–is recording of business data in a prescribed manner. Book Keeping is commonly known as clerk
may be responsible, for keeping, all the records of a business.

Accounting –is primarily concerned with the designation of the system of Records, the presentation of reports,
based on the recorded data, and the interpretation of the report. Accounting directs and reviews the work of
book keepers.

In any event, the accountant must have a higher level of knowledge, conceptual understanding and analytical
skill than requisite of the book keeper.

Business transaction

A business transaction is the occurrence of an event or of a condition that must be recorded. A particular
business transaction may lead to an event or condition that result in another transaction. For example, purchase
of car on credit will be followed by payment to the creditor, which is another transaction. The wearing- out of
car is not an exchange of goods or services between the business and an outsider, but it has to be recorded. This
type of transaction, as well as others that are not directly related to outsiders, referred as internal transaction.

The accounting equation

The properties owned by business enterprise referred as assets and the right or claim to the properties are
referred as equities. If the asset owned by a business is $50,000, the equity in the assets is also $ 50,000 i.e.

Assets= Equities

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

Assets= Liabilities + Owner’s Equity

NB: We have to place liabilities before owner’s equity in the accounting equation because creditors have
preferential rights to the assets.

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16. Transactions and the accounting equation

All business transactions from the simplest to the most complex can be stated in terms of the resulting change in
the three basic elements of the accounting equation. The following illustration will demonstrate types of
transaction and the accounting equation as follow:

Assume Mr. X establishes sole proprietorship business known as XYZ Taxi.

Transaction –a-Mr. X deposit $10,000 in a bank account in the name of XYZ Taxi. The effect of this
transaction is to increase the assets (cash), left side of equation and to increase the owner’s equity on the right
side by the same amount.

Assets = Liabilities + Owner’s Equity

Cash Mr. X Capital
(a) 10,000 10,000 Investment

Transaction –b-

Mr. x purchased land, which is $ 7,500 in cash, is paid. This transaction changes the composition of the assets
but not change the total amount.

Assets = Liabilities + Owner’s Equity

Cash + Land Mr. X Capital
(a) 10,000 7,500 10,000 Investment

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

Transaction –c-

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Mr. X purchased $ 850 of gasoline, oil, and other supplies; agreed to pay in the near future. This type of
transaction is called purchased on account and liability is created known as account payable. The transactions
effect is increasing the assets amount and the liability amount.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital
Bal 2,500 7,500 10,000
(c) 850 850

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

Transaction –d-

Mr. X paid for creditor $ 400, the effect is decreasing the assets and liabilities.

Assets = Liabilities + Owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital
Bal. 2,500 850 7,500 850 10,000
(d) - 400 -400

Bal. 2,100 850 7,500 450 10,000

Transaction –e-

Mr. X taxi earned fares of $ 4,500, receiving the amount in cash. In general the amount charged to customers
for goods or services sold is called revenue. Instead of requiring the payment of cash at the time goods or
services are sold, a business may make sales on account, allowing the customers to pay latter. In such cases the
firm acquires an account receivable, which is a claim against the customers. Account receivable is as much as
an asset as cash and revenue is realized.

Assets = Liabilities + Owner’s Equity

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 Cash + Supplies + Land Account Payable Mr. X Capital
Bal. 2,100 850 7,500 450 10,000
(e) + 4,500 4,500 Fares earned
Bal. 6,600 850 7,500 450 14,500
The effect of this transaction is increasing both the assets and owners equity.

Transaction –f- The amount of assets consumed or services used in the process of earning revenue is called
expense. Mr. X taxi incurred the following expense and paid during the month were; wages $1,125; rent $850;
utilities $ 150; miscellaneous $ 75. The effect of this transaction is reducing both asset and owner’s equity.

Assets = Liabilities + owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital
Bal. 6,600 850 7,500 450 14,500
(f) -2,200 - 1,125 wage exp.
-850 Rent exp.
-150 Utilities exp.
-75 Miscel. exp.
Bal. 4,400 850 7500 450 12,300
Transaction –g-

Mr. X’s supplies at the end of the month determined that $ 250 is on hand, the reminder (850-250) have been
used in the operation of the business. The effect of this situation is decreasing both assets and owner’s equity.

Assets = Liabilities + owner’s Equity

Cash + Supplies + Land Account Payable Mr. X Capital
Bal. 4,400 850 7500 450 12,300
(g) - 600 - 600
Bal. 4,400 250 7,500 450 11,700
Transaction –h- At the end of the month Mr. x withdraws from the business $1,000 in cash for personal use.
This transaction reduces the assets and owner’s equity.

Assets = Liabilities + owner’s Equity

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 Cash + Supplies + Land Account Payable Mr. X Capital
Bal. 4,400 250 7,500 450 11,700
-1,000 -1,000
Bal. 3,400 250 7,500 450 10,700
Summary of the above transaction presented as follows.
Assets = Liabilities + Owner’s Equity
Cash +supplies + Land Account payable + Mr. X Capital
(a) 10,000 7,500 10,000 Investment
(b) - 7,500
2,500 7,500 10,000
(c) +850 +850
2,500 850 7,500 850 10,000
(d) -400 -400
2,100 850 7,500 450 10,000
(e) +4,500 +4,500 Fares earned
6,600 850 7,500 450 14,500
(f) -2,200 -1,125 Wages exp.
-850 Rent exp.
-150 Utility exp.
-75 miscel.exp.
4,400 850 7,500 450 12,300
(g) -600 -600 Supplies exp.
4,400 250 7,500 450 11,700
(h) -1,000 -1,000 Withdrawal
3,400 250 7,500 450 10,700

The following points apply for all types of business:

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 1. The effect of every transaction increased and / or decreased one or more of accounting equations.

2. Equality of the two sides of accounting equation should be maintained.

3. Owner’s equity increased by amounts invested by owner and decreased by amounts withdrawal by the
owner. In addition owner’s equity increased by revenues earned and decreased by expenses;
diagrammatically as follows:

Owner’s Equity
Decreased Increased

Owners withdrawals Owners Investment

Expenses Revenues

1.7 FINANCIAL STATEMENTS

After the effect of the individual transactions has been determined, essential information is communicated to
users. The accounting statements that communicate this information are called financial statement.

FINANCIAL STATEMENTS FOR SOLE PROPRIETORSHIP

The principal financial statements for sole proprietorship are the following:

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Income Statement

It is a summary of revenues and expenses of a business entity for specific period of time, such as a
month or a year. The excess of revenues over expenses is called net income or net profit. If the
expenses exceed the revenues, the excess is net loss.

The determination of the periodic net income or net loss is a matching process involving two steps.
First, revenues are recognized during the period. Second, the assets consumed in generating revenue
must be matched against the revenue in order to determine the net income or net loss.

2. Statement of Owner’s Equity

It is a summary of the changes in the owner’s equity of a business entity that have occurred during
specific period of time.

3. Balance Sheet

It is a list of assets, liabilities and owner’s equity of a business entity as of a specific date. The asset
section of a balance sheet begin with cash followed by receivables, supplies , prepaid insurance and
other asset that can be converted in to cash or used up in the near future. The asset of relatively
permanent nature such as land, building and equipment follow that order. In the liability and owner’s
equity section of the balance sheet, the liabilities presented first followed by owner’s equity.

4. Statement of Cash Flow

It is a summary of cash receipts and cash payments of a business entity for a specific period of time.
This statement has three sections i.e. operating activities, investing activities, and financing
activities.

Operating Activities

This section includes cash transactions that enter in to the determination of net income or net
loss.

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 a. Investing Activities

This section includes the cash transaction for the acquisition and sale of relatively long term or
permanent type of assets.

b. Financing Activities

This section includes the cash transaction related to cash investment by the owner’s and
borrowing and withdrawals by the owner.

NB: the cash balance at the beginning of the period is added to the increase (or decrease)
in cash for the period to obtain the cash balance at the end of the period.

The basic features of the four statements and their interrelationships are illustrated by taking data from Mr. X
taxi business as follow

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

Fares Earned $4,500

Operating Expenses :
Wages Expenses $1,125

Rent Expenses 850

Supplies Expenses 600

Utilities Expenses 150

Miscellaneous Expenses 75

Total Expenses 2,800

Net Income $1,700

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

Investment During the Month $10,000

Net Income for the Month $1,700

Less: Withdrawal 1,000
Increase in Owner’s Equity 700
Mr. X Capital, August 31, 2007 $10,700

Mr. X Taxi
Balance Sheet
August 31, 2007

Assets

Cash $3,400
Supplies 250
Land 7,500
Total Assets $11,150
Liabilities
Account Payable $450
Owner’s Equity
Mr. X Capital $10,700
Total Liabilities and Owner’s Equity $11,150

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

Cash Flows from Operating Activities:

Cash Received from Customers $4,500

Deduct: Cash Payments for Expenses And Payment 2,600
to Creditor
Net Cash Flow from Operating Activities $1,900
Cash Flows from Investing Activities:
Cash Payments for Acquisition of Land (7,500)
Cash Flows from Financing Activities:
Cash Received as Owner’s Investment $10,000
Deduct: Cash Withdrawal by Owner 1,000
Net Cash Flow from Financing Activities 9,000
Net Cash Flow And August 31,2007 Cash Balance $3,400

FINANCIAL STATEMENT FOR CORPORATION

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

A. Retained Earning

The emphasis is reporting the changes in the stockholders’ equity are on the changes in retained
earnings, or net income retained in the business. The changes in retained earning that have occurred
during a period are reported in retained earnings statement. Change in the amount of earnings
retained in the business would have resulted from (1) net income and (2) distribution of earnings,
called dividends, to owners.

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 B. Balance Sheet

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

C. Statement of Cash Flow

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

D. Income Statement

It is a summary of revenues and expenses of a business entity for specific period of time, such as a
month or a year. The excess of revenues over expenses is called net income or net profit. If the
expenses exceed the revenues, the excess is net loss.

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

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

Net Income for the Month 1,700

Less: Dividends 1,000

Retained Earnings, August 31, 2007 700

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 Mr. X Taxi
Balance Sheet
August 31, 2007

Assets

Cash $3,400
Supplies 250
Land 7,500
Total Assets $11,150
Liabilities
Account Payable $450
Stockholders’ Equity
Capital Stock $10,000
Retained Earnings 700
Total Stockholders’ Equity 10,700
Total Liabilities and Stockholders $11,150
Equity

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