Chapter 1 – Part One

GENERAL INTRODUCTION
1. Introduction
- Accounting is one of the fastest-growing professions and one of the most popular fields of study in
colleges and universities. The need for accountants is increasing because of the increase in number, size
and complexity of business enterprises. The reason for this growth is quite simple accounting is the
financial information system that provides relevant financial information to every person who owns or
uses economic resources or otherwise engages in economic activity.
- Regardless of one's pursuits or occupation, the need for financial information is inescapable. Such
common endeavors as earning a living, spending money, buying on credit, making investments, paying
taxes not to mention managing a business involve receiving, using, or dispensing financial
information. Accounting is vital to our economic system.
What is Accounting?
- Def . Accounting is the process of identifying (recordable events), measuring, recording, communicating
n

(reporting) and interpreting economic events of an organization (business or nonbusiness) for use by
different individuals or groups in making informed judgments and decisions.
 Identifying It is the bringing together (gathering) of all financial information that has an effect on
a specific business.
 Measuring Once identified, the economic events (called transaction by accountants) must be
measured in financial terms.
 Recording the systematic recording of these pieces of financial information through proper
accounting process. In recording, the accountant also classifies and summarizes these events.
 Reporting the information is communicated through the preparation and distribution of
accounting reports, the most common of which are called financial statements.
 Interpreting interpretation involves analyzing and explaining the uses, meaning, and limitations
of reported data. Through ratios, percentages, graphs, and charts, significant financial trends and
relationships are reported to the users of financial reports.
- Accounting is often called the language of business because it provides financial information to various
individuals or groups for their use in making sound decisions.
2. Accounting and Bookkeeping Distinguished
- Accounting is often confused with bookkeeping. They are usually considered to be one and the same.
This confusion is understandable because the accounting process includes the bookkeeping function, but
it also includes much more.
Bookkeeping:
o Is the record -making phase of accounting which tends to be mechanical and repetitive. It is only a
small part of the field of accounting and probably the simplest part. The individuals are called
bookkeepers or accounting clerks

Accounting:
o Includes bookkeeping but goes will beyond it in scope. It includes: the design of accounting
systems, preparation of financial statements, audits, cost studies, development of forecasts and
budgets, analysis and interpretation of accounting information as an aid to making business
decisions, provides tax services
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 3. Users and Uses of Accounting Information
- Users of accounting information are individuals and organizations who are interested to know the
financial activities of a business through reports, summaries, analysis etc.
- They are broadly categorized into two:
i) Internal Users:
o Internal users are individuals and units who are collectively called management of the business
organization.
o Management at all levels uses accounting information in planning, controlling, and evaluating business
operations. For example, some questions asked by the managers of a company might be: Is cash
sufficient to pay our debts? Are customers paying their bills promptly? What is the cost of
manufacturing each unit of product? What costs exceed budget? Which product line is the most
profitable? How much money must be borrowed to expand the factory?
o To assist management in these and other questions, accounting provides internal reports such as:
financial comparisons of operating alternatives, projections of income from new sales campaigns, and
forecasts of cash needs for the next year. In addition, financial statements on the financial condition and
results of operations of the entire business are prepared
ii) External Users:
External users lack direct access to the business records and include large number of parties as briefly
discussed below:
o Owners (shareholders)/Investors put their money in a business to make money. They use accounting
information to assess amounts, timing and uncertainty of future cash returns on their investments. They
may decide then either to increase or reduce their present investment
o Banks or Creditors/SuppliersAssessing probability of collection and the risk of late (non-) payment
o Customers are interested in a company's financial strength as an indication of its ability to continue to
honor product warranties. They also ask if the company is expected to be a reliable and economical
source of supply.
o Employees and their union does the company have the ability to pay increased wage and other
benefits? Is the company financially able to provide long-term employment for its work force?
o Government for taxation and other regulation (control the activities of organizations).
o Donors need information about how well the organization has met its objectives and whether
continued support is justified.
o Financial analysts and advisers use accounting data to form their opinions on which they base their
investment recommendations.
o The Public enterprises affect members of the public in a variety of ways. For example, enterprises
often employ a number of people in a locality and patronize local suppliers; so the prosperity of the
local community depends on the success of the enterprises. The public may ask the following questions:
Do companies exploit local suppliers? Are the products of companies safe and wholesome? Do
companies hinder competition in the industry?
- The many and varied uses of accounting information clearly attest to its importance. Without accounting,
our existing systems of production, investment, credit, and taxation would be seriously impaired. But note
that accounting is only one source of information.

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- Note that accounting information is user oriented. The type of information that a specific user will
require and the frequency at which it is to be provided depends upon the kind of decisions that person
must make.

4. Profession of Accounting
- Accountants engage in either private accounting or public accounting.
i) Private Accounting
o Accountant employed by a business firm or not-for-profit organization (such as hospitals, universities,
and charitable groups) assuming various positions such as chief accountant, controller, financial vice
president. Private accounting is accounting work that is done for your own company.
o Frequently referred to as managerial accountants/cost accountants.
o They give services like general (financial) accounting, cost accounting, budgeting, internal auditing
(which involves looking at controls and procedures in use by their employers), management accounting.
o Not independent
ii) Public Accounting
o Accountants and their staff who provide services on a fee basis. Public accounting includes any
accounting work that a company performs for another company. They are independent of the enterprise
in which they give services. A public accountant may practice as an individual or as a member of a
public accounting firm.
o Their services include:
External auditing (attestation service) In this area, the CPA examines the financial statements of
companies and expresses an opinion as to the fairness of presentation.
Tax services relate to the providing of help in the preparation and filing of tax returns and the
rendering of advice on the tax consequences of alternative actions.
Advisory/consultancy services can vary dramatically, and include such diverse activities as
information systems engineering to evaluating production methods, on desirability of merger with
another company, the creation of a pension plan for employees, etc.
o To engage in the practice of public accounting usually requires one to be licensed as a CPA (Certified
Public Accountant). The CPA must fulfill certain education and experience requirements and pass a
rigorous examination.

Specialized Accounting Fields

- The diversity of interested parties in accounting information leads to a logical division in the discipline of
accounting:
a) Financial Accounting
o Devoted to the preparation of financial statement and the provision of information to external users of
accounting information.
o Governed by what are called GAAP to facilitate comparability of financial statements of different
periods and different organizations.
o Financial accounting reports are intended to be general purpose in orientation. This means they are not
prepared especially for owners, or creditors, or any other particular user group. Instead, they are
intended to be equally useful for all user groups. As such, attempts are made to keep them free from
bias (neutral).
b) Cost Accounting
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o Cost accounting relates to the determination and accumulation of product, process, or service costs.

c) Management Accounting
o In sharp contrast to financial accounting, managerial accounting information is intended to serve the
specific needs of management.
o Business managers are charged with business planning, controlling, and decision making. As such,
they may desire specialized reports, budgets, product costing data, and other details that are generally
not in line with GAAP.
d) Auditing
o An area of accounting that is concerned about providing attestation and verification services that reports
prepared by business enterprises are authentic and dependable in material respects. This is evaluated in
their adherence to generally accepted accounting principles.
o In addition to retaining external auditors (who are called public accountants) most companies will
employ internal auditors who will determine whether the various units are following management's
policies and procedures.
e) Tax Accounting
o It is an area of accounting that encompasses the preparation of tax returns (reports) for the different
governmental units about taxable amounts and the consideration of the tax consequences of proposed
business transactions and/or alternative courses of action.
o Hence, it guides companies of legal ways of minimizing taxes and other areas of taking tax advantages.
Accountants in this specializing area shall be familiar with the tax statutes affecting their employers and
clients and shall keep up to date on court decision on tax related cases.
f) Accounting Information Systems
o Is an area of accounting that is concerned with the analysis, design, implementation and revision of
procedures for the accumulation, processing and reporting of financial data to various users.
o The system accountant must devise appropriate “check and balances” to safeguard business properties
and provide for information flow that will be efficient and helpful to management. Familiarity with the
uses and relative merits of various data processing method, including computer hardware and software
is also essential
g) Fund Accounting
o Also called not-for-profit accounting, an area of accounting that specialized in recording, reporting and
planning the operations of non-profit, governmental and most non-governmental entities such as
hospitals, schools, etc.
o It will help management to adhere to restrictions and other requirements imposed by law, other
institutions or individual donor groups.
h) International Accounting
o It is concerned with the special problems associated with the international trade of multinational
business organization.
o This area of accounting has increased in importance because of increase in the number of international
companies in response to globalization and expansion of international trade.
o Accountants specializing in this area must be familiar with the influences that custom, law, and taxation
of various countries will place on international operations and accounting principles.
i) Accounting Instruction

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 o This is an area of accounting that involves the teaching of accounting at various levels. It involves
research publication and related activities that are intended to integrate accounting theory with
accounting practice.
 There is a considerable degree of specialization within a particular field. For example, in auditing one
may become expert in a single type of business enterprise such as department stores or public utilities. In
tax accounting one may become a specialist in oil and gas producing companies. In systems one may
become an expert in electronic data processing equipment.

5. Forms of Business Organizations

- Accounting is discussed with reference to a certain organization. Generally, organization may be
classified into two categories:
 Business (Profit making) organizations are those firms established with the ultimate objective
of making maximum profit as their primary objectives.
 Nonbusiness (Not-for-profit –making) organization are those firms established with a primary
objective of giving service to the society.
E.g. Government owned schools and hospitals, Libraries, Museums, Army,
NGOs (charitable organizations, churches)
Accounting for nonbusiness organizations is usually a fund-based system, but the basic principles
are similar to accounting for business organizations.
Note that not-for-profit firms may earn profit in the process of giving services to the society as their
secondary objectives.
- This course deals only with business organizations. Such organizations may also be referred to as
business enterprises, business firms or for the sake of convenience as organizations, firms, enterprises,
companies etc.
- Business organizations may be classified further in various ways:
1. On the basis of activities:
i) Service Giving Businesses
o Are business organizations that produce and sell benefits of intangible nature to customers. Examples
are: banks, insurance companies, colleges and universities, hotel, hospital etc
ii) Merchandising Businesses
o Are business organizations that purchase and resale tangible goods called merchandise to customers.
They purchase their goods for resale either from manufacturers or from wholesalers. Examples are:
importers, exporters, boutiques, stationery shops, auto spare parts, etc
iii) Manufacturing Businesses
o Are business organizations that acquire raw martial, convert into finished goods, and sell to customers.
Examples include: Cement factories, sugar factories, soup factories, textile factories, paper factories, etc
2. On the basis of ownership:
i) Sole-proprietorship (single proprietorship)
o A business owned by one person (often the owner acts as the manager).
o Is the most common form and is widely used for small businesses. Examples include: barber shops, law
offices, plumbing companies, and auto repair shops, farms, and small retail stores (antique shops,
clothing stores, and jewelry stores) etc
Characteristics:
 Usually only a limited amount of money (capital) is necessary to start business.
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  From the legal point of view, it is not a separate legal entity. So there is unlimited liability. The
owner is liable for all obligations of the business.
 From accounting point of view, a sole-proprietor is a separate entity from its owners.
 Limited life life of the business ends (is terminated) when the owner decides to stop operating
the business, dies, or is incapacitated.
ii) Partnership
o A form of business owned by two or more persons voluntarily with an agreement to carry on as co-
owners of a business for profit. Partnerships are often used to organize small retail and service-type
businesses, including professional practices (lawyers, doctors, and certified public accountants).
o In most respects a partnership is similar to a sole proprietorship except that more than one owner is
involved. The owners are called partners.
o When a partnership is created, there should be an agreement (written or oral) setting forth such terms as
initial investment of each partner, duties of each partner, division of net income (or net loss), and
settlement to be made upon death or withdrawal of a partner.

Characteristics:
 From the legal point of view, a partner is not a separate legal entity resulting in
unlimited liability.
 From accounting point of view a partnership is a separate entity from its owners.
 Limited life.
iii) Corporation
o A business organized as a separate legal entity under state corporation law. It is an artificial person
created with a separate legal entity. Owners (stockholders) do not directly control the corporation.
Rather elected BOD run the corporation.
Characteristics:
 Ownership is divided into transferable shares of capital stock. Shares are traded in a separate
market called the stock market (the capital market). Owners are called shareholders
(stockholders). This ease of transfer adds to the attractiveness of investing in a corporation.
 Separate legal entity legally and economically separate from its owners. It is an artificial
person and like a real person a corporation can own assets, owe a liability, enter into contracts
(in its own name), sue or be sued by itself without the involvement of its owners.
 Limited liability owners’ risk of loss is limited to the extent of their investment. Owners are not
personally liable for the obligations of the business. However, to protect the interest of lenders
and other creditors, a corporation shall have some minimum capital that is required by law.
 Unlimited life because ownership can be transferred without dissolving the corporation, the
corporation enjoys unlimited life.

Hence, there are several possible combinations of business organizations by considering the above bases
of classifications. Accounting cycle of a service giving and merchandising businesses will be discussed in
the forthcoming chapters assuming a sole proprietorship form of organization. Accounting cycle for a
manufacturing business will be illustrated under corporate form of organization in other courses.
Accounting for partnership and corporate form of business organization will be illustrated in the second
part of this course.

Chapter 1 – Part Two

Accounting Principles and Practices
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 1. Nature of Accounting Information
- Accounting is a system that processes an input (raw data) to change it into an output.
- Generally, information can be categorized into two:
Qualitative → Information which cannot be expressed in terms of figures for example experience,
skill, moral of employees etc
Quantitative → Information which can be expressed in terms of figures

Accounting deals with quantitative information (financial data expressed in terms of money).
Input ----------------> Processing ----------------> Output/end product
Business transactions - identifying, measuring, - accounting information
recording /summaries, reports,
analysis, etc/
- Both the inputs and outputs are of quantitative information types.
2. Accounting Concepts and Principles
- The accounting profession has attempted to develop a set of standards that is generally accepted and
universally practiced. Its efforts have resulted in the adoption of a common set of rules and procedures
called generally accepted accounting principles (GAAP).
- GAAPs: - Are guidelines for accountants in recording and reporting economic events.
- Bring uniformity and comparability in the reports prepared by different organizations.
- Also make financial statements be more reliable, particularly for external users.
- Are subject to change and revision.
- There are basic accounting concepts that serve as guideline in developing rational response to controversial
financial reporting issues. Some of these are briefly discussed below.
1. Economic (Business) Entity Concept
- It says for accounting purpose a business enterprise is treated as a separate economic unit from owners,
other business enterprises, and creditors. This requires that a separate set of accounting records be
maintained for each entity.
- Why? This is not to mix up the financial affairs of the company with that of the owner and other
enterprises. Otherwise the resulting financial statements would be misleading and would fail to describe
clearly the activities of the business entity.
- The economic entity assumption is an accounting concept, and not a legal construct. All three forms of
businesses are economically separate entities from their owners. But only the corporation is legally separate
entity from its owners
2. Historical Cost Concept
- This principle says properties and services acquired by a company should be recorded at their acquisition
price (cost)  measured in terms of money paid. At the time of acquisition, cost and fair market value are
the same. In subsequent periods, cost and fair market value may vary, but we continue to use the cost
amount.

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- Using the cost concept involves two other important accounting concepts objectivity and the monetary
unit concept.
3. Objectivity Concept
- This concept requires that the accounting records and reports be based upon objective evidence. By using
cost as a basis for record keeping, accountants can provide objective and verifiable data in their reports.
Information that is verifiable is reliable.
4. Monetary Unit Concept
- This concept requires that economic data be recorded in dollars. Money is a common unit of measurement
for reporting uniform financial data and reports. The monetary unit is relevant, simple, universally
available, understandable, and useful.
In addition to these concepts, there are other, more technical standards accountants must follow when
preparing financial statements which are left for more advanced courses.
3. The Accounting Equation and Business Transactions
The Accounting Equation
Assets: Assets are properties or economic resources owned by a business as a result of past transactions
and are expected to benefit future operations. The common characteristic possessed by all assets is
"service potential" or "future economic benefit". E.g. Cash, Supplies (office, store, delivery, etc.),
Equipment (office, store, delivery, etc.), Land, Building etc.
Equities: Equity refers to the rights (claims) against the assets of the business. Therefore, we can
develop a simple equation:

Assets = Equities
Another way to think about it is: Everything we own = Who Provided (Supplied) it
- The assets of a business are supplied (provided) or claimed by either creditors or owners.
- Equities are, therefore, further subdivided into:
Equities of creditors (claims of creditors) = Liabilities
Equities of owners (claims of owners) = Owner’s Equity
Liabilities: Liabilities are obligations arising from past transactions of the entity to transfer assets or
services to other entities or individuals in the future. To put it more simply, Liabilities are debts
owed by the business.
- Examples: Accounts Payable—when goods and services are purchased on credit
Loan Payable, Notes Payable—when money is borrowed from different parties
Salary payable—amounts owed to employees
Interest payable—for the use of money, Etc…
- Persons or entities to whom a company owes money are called creditors.
Owner's Equity: Equity is the owner’s claim on the assets of the business.
- It is often referred to as the residual claim (interest) in the assets of a business because creditors have
preferential claims on the assets of a business.
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- Also called Capital, Proprietorship, or Net Worth (Net Asset).
- Expansion of the above equation to give recognition to the two types of equities gives us the accounting
equation:

Asset = Liabilities + Equities

It is customary to place "liabilities" before "owners' equity" in the accounting equation because creditors
have preferential rights to the assets.
- To give emphasis to the residual claim of the owner or owners the equation can be written as:
Asset  Liabilities = Equities

The equality of the two sides the accounting equation must be always maintained.
- Theaccounting equation provides the underlying framework for recording and summarizing the
economic events of a business enterprise. It is the basis for double entry accounting.
A Closer Look at Owner’s Equity.
- In a sole proprietorship and partnership the owner’s equity is composed of a single type of item called
capital preceded by the name of the owner(s).
- Capital is affected by investment, revenues, expenses and withdrawals.
Investment:
o Investment is the transfer of cash or noncash assets into the business by the owner and they increase
capital.
Revenues:
o The inflows of assets from providing goods or services to other economic entities.
o May arise from different sources, and are identified by various names depending on the nature of the
business. E.g Fees earned/Professional fees Professional businesses, Rent incomeReal estate and
apartment owners, Sales revenue Department stores, retailers, Tuition Fees (revenues)  Academic
institutions.
o Revenues increase owner's equity.
Expenses:
o Cost of items and services used to produce revenue.
o Like revenues, expenses take many forms and are identified by various names depending on the type
of asset consumed or services used. E.g Salary expense, Advertising expense, Supplies expense, Rent
expense, Interest expense etc
o Expenses decrease owner's equity.
Withdrawals:
o Cash or noncash assets taken away from the business for personal use by the owner.
o Drawings decreases total owner's equity.
 In summary, the principal subdivisions (integral parts) of owner's equity are: Capital, Drawings,
Revenues, and Expenses. The later three are used to adjust Capital. No separate record is maintained for
investment by owners.
- The basic accounting equation can be expanded to include the above owner’s equity accounts.
A = L + Capital (beginning) + Revenues  Expenses  Withdrawal
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 Business Transactions
- Business transaction refers to the occurrence of an event that must be recorded. An accounting transaction
occurs when assets, liabilities, or owner’s equity items change as a result of an economic event.
- Business transactions may be identified as external or internal.
External transaction:
o These involve economic events between the company and some other enterprise or party. Examples
are: purchase of equipment from a supplier, the payment of monthly rent to a land owner, and sale of
goods to customers, borrowing money from a bank etc
Internal transactions:
o These are economic events that occur entirely within one company. Items are moved and utilized in
the company itself internally which shall be considered in the accounting process. Examples are the
use of office supplies, the consideration of the decrease in value of the building.
 But not all activities represent business transactions, such as hiring employees, talking with customers,
and placing an order for merchandise with a supplier. These activities, however, may eventually lead to a
business transaction when the employee has earned wages or when the merchandise is delivered by the
supplier.
Analysis of Transactions
- Transaction analysis is the process of identifying the specific effects of economic events on the accounting
equation. All transactions from simplest to the most complex must be analyzed in terms of its effect on the
components of the basic accounting equation. This analysis must also identify the specific items affected
and the amount of the change in each item.
- Since the equality of the basic equation must be preserved, each transaction must have a dual effect on the
equation. For example, if an individual asset is increased, there must be a corresponding:
1. decrease in another asset, or
2. increase in a specific liability, or
3. increase in owner's equity
- It follows that two or more items could be affected when an asset is increased. For example, if we purchase
asset (Eqt.) with some down cash payment and a promise to pay the remaining at some time in the future,
we will have increase in one asset (Eqt.), a decrease in another asset (cash), and an increase in a specific
liability. Note also that any change in an individual liability or ownership claim is subject to similar
analysis.
Illustration
- On January 1, 2007, Ato Sira started Smart Software Company which develops customer-specific
computer software. The following transactions took place during the first month:
Year 2007
Jan. 1 Ato Sira deposited Br.30,000 in the company’s bank account .
Jan. 2 Purchased supplies of flash disks, stationery etc for Br. 9,000 on credit
Jan. 5 Purchased for cash two computers each costing Br.6000.
Jan. 7 Received Br.15,000 in fees for software developed for a small retail store.
Jan 13 Paid creditor for supplies, Br.5,000
Jan.18 Took a loan of Br.12,000 from Dashen Bank.

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 Jan.22 Completed a software package for a shoe shop. The customer agrees to pay the price of
Br.19,000 in two weeks time.
Jan.27 Paid various business expenses for the month: office rent Br.2,500; Advertising Br.1,000;
Utilities Br.250; Miscellaneous Br 150; Electricity charges Br 1200.
Jan.29 Ato Sira withdrew cash of Br.4,000 from the company and bought a TV set to his family.
Jan.31 Paid salary for employees, Br 6,000
Jan.31 The cost supplies on hand is determined to be Br.5,000
Required:
1. Analyze the effects of these transactions on the accounting equation
2. Prepare financial statements
1)
Liabiliti Owner's
Assets = es + Equity
Supplie Sira,
Cash A/R s Off. Eqt A/p Loan Pay. Capital
Beg.
bal Br. 0 Br. 0 Br. 0 Br. 0 Br. 0 Br. 0 Br. 0
Jan.1 Br.30,000 Br.30,000
Jan. 2 Br.9,000 Br.9,000
Balanc Investment
e 30,000 9,000 9,000 30,000
Jan.5 (12,000) Br.12000
Balanc
e 18,000 9,000 12,000 9,000 30,000
Jan.7 15,000 15,000 Professional fee
Balanc
e 33,000 9,000 12,000 9,000 45,000
Jan. 13 (5,000) (5,000)
Balanc
e 28,000 9,000 12,000 4,000 45,000
Jan. 18 12,000 Br.12,000
Balanc
e 40,000 9,000 12,000 4,000 12,000 45,000
Jan.22 Br.19,000 19,000 Professional fee
Balanc
e 40,000 19,000 9,000 12,000 4,000 12,000 64,000
(2,500) Rent Expense
(1,200) Electr. Expense
(1,000) Adver. Expense
(250) Utilil. Expense
Jan. 27 (5,100) (150) Misc. Expense
Balanc
e 34,900 19,000 9,000 12,000 4,000 12,000 58,900
Jan.29 (4,000) (4,000) Withdrawal
Balanc
e 30,900 19,000 9,000 12,000 4,000 12,000 54,900
Jan. 31 (6,000) (6,000) Salary Expense
Balanc
e 24,900 19,000 9,000 12,000 4,000 12,000 48,900
Jan. 31 (4,000) (4,000) Supp. Expense
Balanc
e Br 24,900 Br 19,000 Br 5,000 Br 12,000 Br 4,000 Br 12,000 Br.44,900

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 4. Financial Statements
- Financial information comes in many forms, but the most important are the Financial Statements.
- Financial statements are the means of conveying to management and to interested outsiders a concise
(organized) picture of the profitability and financial position of the business. They are prepared on a
regular basis at the end of an accounting period. The accounting period typically is one year; however, it
can be any length of time for which records are maintained. Usually the minimum is one month and the
maximum length of time is one year for financial statements.
- Financial statements have generally agreed-upon formats and follow the same rules of disclosure.
- Since financial statements are in a sense the end products of the accounting process, having a clear
understanding of the content and meaning of financial statements will be crucial to appreciate the purpose
of the earlier steps of recording and classifying business transactions.
- All financial statements are inter-connected; therefore, the order of preparation is important.
i) Income Statement
- It is a summary of the revenues and expenses of a business entity for a specific period of time, such as a
month or a year. The net result of revenues and expenses show the profit (or loss) for the period. Net
Income is realized when revenue exceeds expenses. Net loss is realized when expenses exceed revenue.
- The income statement, which is sometimes called the statement of earnings or statement of operations, is
prepared first.
ii) Statement of Owner's Equity
- It shows the changes that occurred in the components of owners’ equity during a specific period of time,
such as a month or a year.
- It provides a link between the Income Statement and the Balance Sheet. It also reconciles the Owners'
Equity account from the start to the end of the year. In essence, the statement is nothing more than a
reconciliation or "bird's-eye view" of the bridge between the capital amounts appearing on two successive
balance sheets.
- The statement of owner's equity is prepared after the income statement.
iii) Balance Sheet
- A list of the assets, liabilities, and owner's equity of a business entity as of a specific date, usually at the
close of the last day of a month or a year. It is a detailed description of the basic accounting equation and
proves that the accounting equation (Assets = Liabilities + Owner's Equity) is in balance.
Assets = Liabilities + Equity

- The balance sheet shows the financial position of the business entity on a specific (particular) date and as a
result it is some times referred to as statement of financial position

Preparing Financial Statements

- All financial statements have headings that include: name of the organization, title of the statement, and
date or period covered by the statement

Smart Software Company

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 Income Statement
For the month Ended January 31, 2007
Revenues:
Professional Fees Br.34,000
Expenses:
Salary Expense Br.6,000
Supplies Expense 4,000
Rent Expense 2,500
Electricity Expense 1,200
Advertising Expense 1,000
Utilities Expense 250
Miscellaneous Exp. 150
Total expenses (15,100)
Br.18.90
Net income 0
- Note that there is a matching process → expenses are matched against revenues. Expenses are commonly
listed in the order of size, beginning with the larger item. Miscellaneous expense is usually listed as the last
item, regardless of the amount.

Smart Software Company

Statement of Owner's Equity
For the month Ended January 31, 2007
Investment During the Month Br.30,000
Add: Net income for the month 18,900
Less: Withdrawal 4,000
Net increase in Owner's Equity 14,900
Sira, Capital, Jan. 31,2007 Br.44,900
Look how the four types of transaction- revenue, expense, investment, and withdrawals- affect owner’s
equity.
Smart Software Company
Balance Sheet
As of January 31, 2007
Assets Liablilites
Cash Br.24,900 Accounts Payable Br.4,000
Accounts Receivable 19,000 Loan Payable 12,000
Supplies 5,000 Total Liabilites Br.16,000
Office Equipment 12,000 Owner's Equity
Total Assets Br.60,900 Sira, Capital 44,900
Total Liab. & OE Br.60,900

Remember that total assets must equal the sum of total liabilities and total equity.
The ending balance on the statement of owner's equity is used to report owner's equity on the
balance sheet.
Q. Does the owner’s equity total of Br.44,900 mean the business is worth Br.44,900? No! Why not?
Because:
- Many assets are not reported at current value. For example, although the equipment cost
Br.12,000, the balance sheet does not report its current worth.

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 - The business may have unrecorded resources such as goodwill (internally generated)
Therefore, users must also use nonfinancial information to make their decision. This observation tells us
that accounting statements are important in investment and credit decisions, but they are not the sole
source of information for making investment and credit decisions.
NB.
 Cash is listed first followed by receivables, supplies, prepaid insurance etc that will be converted
into cash in the near future. Assets which are of relatively permanent in nature, such as land,
building and equipment, follow in that order.
 The balance sheet is like a still photograph; it captures the financial position of a company at a
particular point in time.
 The balance sheet has two forms:
Report form  Liabilities and owner's equity are presented below the asset section
Account form  Lists the assets on the left and the liabilities and OE on the right
 It is commonly used and is so named because of its similarity to an account
(to be described in the next chapter)
iv) Statement of Cash flows
- Shows the sources of cash (cash inflows) and the uses of cash (cash outflows) of a business entity for a
specific period of time, such as a month or a year. A company’s activities are grouped into three categories.
The cash flow statement is prepared based on these classifications.
Operating Activities
o Cash flow related to the revenue generating business operations.
o Some examples are: selling goods and services, buying goods and services, paying taxes, interest,
salary etc
Investing Activities
o Cash flow related to the acquisition and sale of relatively long-term or permanent assets.
o Some examples are: buying resources such as land, building, equipment needed in the operation of
the business, selling these resources when no longer needed.
Financing Activities
o Cash flow related to obtaining adequate funds, or capital, to begin and continue operations
o Some examples are: owner investments, paying a return to owners, obtaining loans from creditors,
repaying principal amount to creditors, withdrawals

Smart Software Company

Statement of Cash Flows
For the Month Ended January 31, 2007
Cash flow from operating activities:
Cash received from customers Br.15,000
Less: Cash payments for expenses and payment to creditors 16,100
Net cash flow from operating activities Br.(1,100)
Cash flow from investing activities:
Cash payments for acquisition of Phot. Eqt. (12,000)
Cash flow from financing activities:
Cash received as owner's investment Br.30,000
Money borrowed from Bank 12,000
Less: Cash withdrawal by owner (4,000)
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 Net cash inflow from financing activities 38,000
Net cash flow and January
31,2007 Cash balance Br.24,900
- Notice that the cash provided by operations is not the same thing as net income found in the income
statement. This result occurs because some items hit income and cash flows in different periods. For
instance, service provided on Jan.22 increased income by Br.19,000 without a similar effect on cash. Also,
while only Br.5,000 was paid for supplies, Br.4,000 of supplies expense was reported in the income
statement. These differences tend to even out over time.
Financial Statement for Corporations
- The owners of a corporation are called stockholders (shareholders). As a result, the owners’ equity section
for a corporation is referred to as stockholders’ equity.
- In a corporation instead of withdrawals there is a formal way of distribution of income to stockholders
called Dividend. Dividends affect stockholders' equity in the same way that owner withdrawals affect
owner's equity in sole proprietorships and partnerships.
- Unlike a sole proprietorship and partnerships, however; the stockholders’ equity of a corporation provides
more detailed information by splitting stockholders’ equity into two.
a) Contributed Capital (Capital Stock)
- Representing ONLY investment by stockholders. Thus investment by owners is kept separately
from income retained by the corporation.
b) Retained Earnings
- Represents net income retained within the corporation for different purposes.
Retained earnings = Net income/Loss (Revenues – Expense) less Dividend.
- Note that investments, revenues, expenses and dividends are still part of owners’ equity(stockholders
equity).
- If Smart Software Company had been organized as a corporation, with ownership represented by shares of
stock its income statement would not be changed but the other financial statements would be different in
some respect.
Retained Earnings Statement
- Retained Earnings Statement reports changes in retained earnings that occurred during a period.
- A comprehensive statement that summarizes changes in all the components of the SHE, called Statement of
SHE, could be prepared. But we usually emphasize on change is REs as there is no frequent change in other
elements of the stockholders’ equity section.

Smart Software Corporation

Retained Earnings Statement
For the month Ended January 31, 2007
Retained earnings, Jan.1,2007 Br.0.00
Add: Net income for the month 18,900
Less: Dividends 4,000
Net increase in Owner's Equity 14,,900
Retained earnings, Jan.31,2007 Br.14,900

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 Smart Software Corporation
Balance Sheet
As of January 31, 2007
Assets Liablilites
Cash Br.24,900 Accounts Payable Br.4,000
Accounts Receivable 19,000 Loan Payable 12,000
Supplies 5,000 Total Liabilites Br.16,000
Stockholders’’
Office Equipment 12,000 Equity
Total Assets Br.60,900 Capital stock 30,000
Retained earnings 14,900
Total SHE Br.44,900
Total Liab. & SHE Br.60,900
- The only difference is on the stockholders’ equity section. Investment of the stockholders (Br.30,000
capital stock) and NI retained in the business (Br.14,900 retained earnings) are reported separately.
- The names of the stockholders (owners) are not shown.
Statement of Cash flows
- The statement of cash flows for a corporation differs from other forms of business enterprises only in the
financing activities section as follows:
o Cash received in the form of investments of stockholders (owners) arise from sale of capital stock
o Cash payments to stockholders (owners) are in the form of dividends(not withdrawal)
- The section of the cash flow statement where we have a little modification is as follows:

Cash flow from financing activities:

Cash received from sale of capital stock Br.30,000
Money borrowed from Bank 12,000
Less: Cash payments for dividends (4,000)
Net cash inflow from financing activities 38,000
NB.
 Each financial statement tells its own story. Together they form a comprehensive financial picture of the
company, the results of its operations, its financial condition, and the sources and uses of its money.
 Dollar signs, total lines, and double-ruled lines are important. These go out to external users. The
appearance is important
Inherent Limitations:
 Judgments and estimates are used in determining many of the items. So the balance sheet is not the exact
reflection of the financial position of the firm.
 It does not reflect the current fair value of many items. Most assets are reported at their historical cost.
While this enhances the "reliability" of reported data, it can also pose a limitation on its "relevance."
 It ignores items that are of financial value to the firm but which cannot be objectively determined. E.g
internally generated goodwill, human resources etc

5. Financial Statement Relationships and the Accounting Equation

- It is important for you to take note of the fact that the income statement, statement of retained earnings, and
balance sheet articulate.

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 Income Statement Statement of OE Balance Sheet

Revenues Beginning Capital Assets

Expenses +/ NI/NL
NI/NL Withdrawal Liabilities +
Ending Capital Owner’s Equity

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