Chapter I: Accounting Principles and Practices

Accounting is often characterized as “the language of business.” The acceleration of change in

our society has contributed to increasing complexities in this “language,” which is used in
recording, summarizing, and interpreting basic economic data for individuals, businesses,
governments, and other entities. Sound decisions, based on reliable information, are essential for
the efficient distribution and use of the nation’s scarce resources. Accounting, therefore, plays an
important role in our economic and social system.

Accounting – is the process of identifying, measuring, and communicating economic information

to permit informed judgments and decisions by users of the information.

Characteristics of Accounting Information

Accounting information is composed principally of financial data about business
transactions, expressed in terms of money. Historical recording of transaction data may take
various forms, such as pen or pencil markings made by hand, printing by various mechanical and
electronic devices, or holes or magnetic impressions in cards or tape. The “basic raw materials”
of accounting are composed of business transaction data. Its “primary end products” are
composed of various summaries, analyses, and reports.

Users of Accounting Information

Internal Users: Management
External Users: Investors, government, stockholders/owners, employees, suppliers, creditors

Bookkeeping and Accounting

Bookkeeping – is the recording of business data in a prescribed manner. Accounting is primarily
concerned with the design of the system of records, the preparation of reports based on the
recorded data, and the interpretation of the reports.

Business Entity Concept

Business entity concept is based on the applicability of accounting to individual
economic units in society.

Forms of Business Organization

Sole Proprietorship – is owned by one individual.
Partnership- is owned by two or more individuals in accordance with a contractual agreement.
Corporation – is a separate legal entity in which ownership is divided into shares of stock.

Business Transactions
Business transaction – is the occurrence of an event or of a condition that must be recorded. For
example, the payment of a monthly telephone bill of 680 birr, the purchase of merchandise on
credit of 17,500 birr, and the acquisition of land and a building for 2,100,000 birr.

The Cost Principle

Properties and services purchased by a business are recorded in accordance with the cost
principle, which required that monetary record be in terms of cost. Cost is the transaction price
plus all incidental costs pertaining to the acquisition of the asset.

Assets, Liabilities, and Capital

Assets - are the properties owned by a business enterprise.
Equities – the rights or claims to the properties. Two types of equities: the rights of creditors and
the rights of owners.
The equities of creditors represent debts of the business are called liabilities. The equity of
owners are called capital or owner’s equity.

Accounting Equation
The elements of the accounting equation: Assets, Liabilities and Capital
Assets = Equities
Assets = Liabilities + Capital
Liabilities = Assets – Capital
Capital = Assets – Liabilities

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.

Transaction Analyses
a. Juan Miles establishes a sole proprietorship Assets Capital
to be known as Miles Taxi. Cash 100,000 Juan Miles, Capital 100,000

b. Purchase of land for 75,000 birr in cash. Cash 100,000 Juan Miles, Capital 100,000
( 75,000)
Land 75,000

c. Purchase 8,500 birr supplies on account. Cash 25,000 Juan Miles, Capital 100,000
Supplies 8,500 Accounts payable 8,500
Land 75,000

d. Payment of 4,000 birr to account in No. 3. Cash 21,000 Juan Miles, capital – 100,000
Supplies 8,500 Accounts payable 4,500
Land 75,000

The principal objective of the owner of a business is to increase capital through earnings.
For Juan Miles this means that the cash and other assets acquired through the sale of taxi services
must be greater than the cost of the gasoline and other supplies used, the wages of drivers, the
rent, and all other expenses of operating the business.

In general, the amount charged to customers for goods or services sold to them is called
revenue. Alternative terms used for revenue are: Sales is used for the sale of merchandise or
business services, fees earned for charges by a physician to patients, rent earned for the use of
real estate or other property, and fares earned for Miles Taxi.

In broad sense, the amount of assets consumed or services used in the process of earning
revenue is called expense. Expenses would include supplies used, wages of employees, and other
assets and services used in operating the business.

The excess of the revenue over the expenses incurred in earning the revenue is called net
income or net profit. If the expenses of the enterprise exceed the revenue, the excess is a net loss.

e. During the first month of operations Miles Taxi earned fares of 45,000 birr, receiving the
amount of cash.
 Assets Liabilities + Capital
Cash + Supplies + Land Accounts Payable Juan Miles, Capital
Bal. 21,000 8,500 75,000 4,500 100,000
+ 45,000 45,000 Fares earned
66,000 8,500 75,000 4,500 145,000

Instead of requiring the payment of cash at the time goods or services are sold, a business
may make sales on account or on credit, allowing the customer to pay later. In such cases the
firm acquires a claim against the customer, called an account receivable. An accounts
receivable is as much an asset as cash, and the revenue is realized in exactly the same manner as
if cash had been immediately received. At a later date, when the money is collected, there is only
an exchange of one asset for another, with cash increasing and accounts receivable decreasing.

f. Various expenses incurred and paid during the month were as follows: wages, 11,250 birr;
rent, 8,500 birr; utilities, 1,500 birr; miscellaneous, 750 birr. The effect of this group of
transactions is to reduce cash and to reduce capital, as indicated in the following manner:

Assets Liabilities + Capital

Cash + Supplies + Land Accounts Payable Juan Miles, Capital
Bal. 21,000 8,500 75,000 4,500 100,000
+ 45,000 45,000 Fares earned
66,000 8,500 75,000 4,500 145,000
- 22,000 - 11,250 Wages expense
- 8,500 Rent expense
- 1,500 Utilities expense
- 750 Misc. expense
Bal. 44,000 8,500 75,000 4,500 123,000

g. At the end of the month it is determined that the cost of the supplies on hand is 2,500 birr, the
remainder (8,500 – 2,500) having been used in the operations of the business. This reduction of
6,000 birr in supplies and capital may be shown as follows:

Assets Liabilities + Capital

Cash + Supplies + Land Accounts Payable + Juan Miles, Capital
44,000 8,500 75,000 4,500 123,000
- 6,000 - 6,000 Supplies exp.
44,000 2,500 75,000 4,500 117,000

h. At the end of the month Miles withdraws from the business 10,000 birr in cash for his personal
use.

Assets Liabilities + Capital

Cash + Supplies + Land Accounts Payable + Juan Miles, Capital
44,000 8,500 75,000 4,500 123,000
- 6,000 - 6,000 Supplies exp.
44,000 2,500 75,000 4,500 117,000
- 10,000 10,000 Drawing
34,000 2,500 75,000 4,500 107,000
Accounting Statements

For Sole proprietorships:

Balance Sheet – a list of assets, liabilities, and capital of a business entity as of a specific date,
usually at the close of the last day of a month or a year. The two forms of a balance sheet:
report form and account form.
Miles Taxi
Balance Sheet
August 31, 2010

Assets Liabilities
Cash 34,000 Accounts payable 45,000
Supplies 2,500
Land 75,000 Capital
______ Juan Miles, Capital 107,000
Total Assets 111,500 Total Liab. & Cap. 111,500
====== ======

Income Statement – a summary of the revenue and the expenses of a business entity for a
specific period of time, such as a month or a year.

Miles Taxi
Income Statement
For the Month Ended August 31, 2010

Fees earned 45,000

Less: Operating expenses:
Wages expense 11,250
Rent expense 8,500
Supplies expense 6,000
Utilities expense 1,500
Miscellaneous expense 750 28,000
Net Income 17,000
=====

Capital Statement – a summary of the changes in capital of a business entity that have occurred
during a specific period of time, such as a month or a year.

Miles Taxi
Capital Statement
For the Month Ended August 31, 2010
Capital, August 1, 2010 100,000
Add: Net Income 17,000
Less: Withdrawal 10,000
Increase in capital 7,000
Capital, August 31, 2010 107,000
=======
Name_______________________________ Score__________
Quiz – Accounting Essentials (Set C)
I. Multiple Choice:
1. A profit-making business that is a separate legal entity and in which ownership is divided into
shares of stock is known as:
a. sole proprietorship b. single proprietorship c. partnership d. corporation

2. The properties owned by a business enterprise are called:

a. assets b. liabilities c. capital d. owner’s equity

3. A list of assets, liabilities, and capital of a business entity as of a specific date is:
a. balance sheet b. income statement c. capital statement d. journal

4. If total assets increased 20,000 birr during a period of time and total liabilities increased by
12,000 birr during the same period, the amount and direction of the period’s change in capital is:
a. 32,000 increase b. 32,000 decrease c. 8,000 increase d. 8,000 decrease

5. If revenue was 45,000 birr, expenses were 37,500 birr, and the owner’s withdrawals were
10,000 birr, the amount of net income or net loss was:
a. 45,000 net income b. 7,500 net income c. 37,500 net loss d. 2,500 net loss

II. If the assets owned by a business enterprise total 200,000 birr, what is the amount of the
equities of the enterprise? __________________. What are the two types of equities? Equities
of creditors _____________________ and equities of owners ______________________.

III. Accounting equation: Assets = Liabilities + Capital

1. An enterprise has assets of 50,000 birr and liabilities of 15,000 birr. What is the amount of its
capital? _____________________
2. An enterprise has assets of 90,000 birr and capital of 40,000 birr. What is the total amount of
liabilities?______________________
3. An enterprise has liabilities of 75,000 birr and capital of 100,000 birr, what is the total amount
of its assets? __________________

IV. The following selected transactions were completed by Midtown Delivery Service during
November:
1. Received cash from owner as additional investment, 50,000 birr.
2. Purchased supplies of gas and oil for cash, 3,900 birr.
3. Paid advertising expense, 1,500birr.
4. Received cash from customers on account, 8,200 birr.
5. Received cash from cash customers, 9,500 birr.
6. Paid creditors on account, 8,800 birr.
7. Paid rent for November, 6,500 birr.
8. Charged customers for delivery services on account, 12,500 birr.
9. Paid cash owner for personal use, 11,000 birr.
10. Determined by taking an inventory that 3,200 birr of supplies of gas and oil had been
used during the month.

Required: 1. Indicate the effect of each transaction on the accounting equation by listing the
numbers identifying the transactions, (1) through (10), and writing the appropriate letters. 2.
Journalize the transactions.
a. Increase in one asset, decrease in another asset
b. Increase in an asset, increase in liability
c. Increase in an asset, increase in capital
d. Decrease in an asset, decrease in a liability
e. Decrease in an asset, decrease in capital