Accounting & Finance

Fundamentals of Accounting – I
(AcFn2011)

By: Dilayehu D
Introduction CHAPTER 1
to Accounting
LEARNING OBJECTIVES

After studying this chapter, you should be able to:

Explain the meaning of State the basic accounting

Accounting equation and explain the
Explain the meaning of elements of the equation.
“International Financial Reporting
Standard”, Analyze the effects of business
events on accounting equation,
Discuss the assumptions and
and prepare reports
principles in Accounting
Introduction

• ―To be good at your business, you have to know

the numbers.‖ Harold Geneen.

• In business, Accounting is the means for

communicating the numbers.

• If you don’t know how to read financial
statements, you can’t really know your business.

• The purpose of this chapter is to show you that

accounting is the system used to provide useful
financial information.
1.1. What is Accounting

• Accounting is defined as a process of identifying,

recording and communicating economic events
of an organization to interested users.

• Accounting is the financial information system

that provides information useful to understand
an organization of any type.
• Accounting – consists of three basic
activities—it identifies, records, and
communicates the economic events of an
organization to interested users.
A company identifies the events that are
economic and relevant to its business.
Examples of economic events are like: sale of items, providing
of telephone services, and payment of wages.
• Once a company identifies economic events, it
records those events in order to provide a
history of its financial activities.

• Finally, they communicate the collected

information to interested users by means of
accounting reports. The most common of these
reports are called financial statements.
Who Uses Accounting information

The specific financial information that a user

needs depends upon the kind of decisions the user
makes.
• There are two broad groups of users of financial
information:
₪ Internal users and
₪ External users.
Internal users
• Are mainly management personnel of an
organization who are responsible for the day-to-
day affairs of the organization.

In running a business, internal users must answer many important

questions like:
• Is cash sufficient to pay dividends to our shareholders? Finance
• What price for our product will maximize the company's net
income? Marketing
• Which product line is the most profitable? Should any product lines
be eliminated? Management

The area of Accounting aimed at serving the decision-making needs of

internal users is called Management Accounting.
External users

• Are outside an organization who are not directly

involved in the day-to-day affairs of the

organization but have some interest in the

financial and related affairs of the organization.

• Like: Existing and potential owners/investors, Existing and

potential suppliers and creditors, Government agencies, labor

unions, Investment analysts and consultants, Community

representatives, Competitors

Financial Accounting – It provides economic and

financial information for investors, creditors, and other

external users.
Qualitative Characteristic of
Accounting Information

• Accounting information is mainly quantitative

expressed in monetary terms.
• To be more useful for decision making,
accounting information must be:
Relevant and
Faithful
• Relevance – ability of accounting information
in making difference in users decisions
• Faithful representation- descriptions and
numbers match what has actual happened.
Represent facts, neutral, free of material errors
and bias
5. Bookkeeping versus Accounting

• Accounting process includes the bookkeeping function.

• Bookkeeping usually involves only the recording of
economic events.
• It is therefore just one part of the accounting process.
• In total, accounting involves the entire process of
identifying, recording, and communicating
economic events
1.4 Profession of Accountancy

You probably would apply your expertise in one of

three major fields:

i. Public Accounting

ii. Private Accounting or

iii. Not – for – profit Accounting

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

• Management consulting
Private Accounting

Instead of working in public accounting, an accountant

may be an employee of a business enterprise.

Like: Cost Accounting, Tax accountant, General

Accounting,
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.

1.5 International Financial Reporting
Standard(IFRS)
IFRS is a globally recognized set of Standards for the
preparation of financial statements by business
entities. These standards prescribe:
• the items that should be recognized as assets,
liabilities, income and expense;
• how to measure those items;
• how to present them in a set of financial statements;
and related disclosures about those items.
IFRS are referred to as being principles-based
standards:
▫ Provide core principles (objectives) with minimum
guidance.
▫ They are more loosely framed, allowing for
professional judgment to be applied
▫ The judgments are expected to be consistent with
clear conceptual framework
▫ Results in accounting that is more flexible to deal
with unique economic and business circumstances
▫ IFRS is developed by the International Accounting
Standards Board (IASB), which operates under the
oversight of the IFRS Foundation.
1. Basic Assumptions

Four basic assumptions underlie the financial

accounting structure:
(1) Economic entity,
(2) Going concern,
(3) Monetary unit, and
(4) Periodicity.
 Economic Entity Assumption:
• A company keeps its activity separate and distinct
from its owners and any other business unit.
• It states that the activities of the entity must be kept
separate and distinct from the activities of the owner.
• For accounting purposes, each business enterprise
has a separate existence from its owners, creditors,
employees, customers and other businesses
 Going Concern Assumption:

• The company will have a long life.

• It states that the business will remain in
operation in to the future.
• Of course, many businesses do fail, but in
general, it is reasonable to assume that the
business will continue operating.
 Monetary Unit Assumption:

• It requires that only those things that can be

expressed in money are included in the
accounting records.
• Money is the only factor common to all business
activities.
 Periodicity Assumption:
• Implies that a company can divide its economic
activities into artificial time periods.
• It states that the life of a business can be divided
into artificial time periods
• Otherwise, to measure the results of a company’s
activity accurately, we would need to wait until it
liquidates.
 Accrual Basis of Accounting

• Transactions are recorded in the periods in

which the events occur.
2. Basic Principles of Accounting
Four basic principles of accounting to record and
report transactions:
1) Measurement,
2) Revenue recognition,
3) Expense recognition, and
4) Full disclosure
A. Measurement Principle:

• Historical Cost: The historical cost principle

(or cost principle) dictates that companies record
assets at their cost. This is true not only at the time
the asset is purchased but also over the time the
asset is held.
• Fair Value: The fair value principle indicates
that assets and liabilities should be reported at fair
value
B. Revenue Recognition Principle:

• When a company agrees to perform a service or

sell a product to a customer, it has a
performance obligation.
• When the company satisfies this performance
obligation, it recognizes revenue.
C. Expense Recognition Principle:

• In practice, the approach for recognizing expenses

is, ―Let the expense follow the revenues.‖ This
approach is the expense recognition principle.
• That is, by matching efforts (expenses) with
accomplishment (revenues). It dictates that
efforts (expenses) be matched with results
(revenues). Thus, expenses follow revenues.
D. Full Disclosure Principle:
• Providing information that is of sufficient
importance to influence the judgment and
decisions of an informed user.
• It requires that companies disclose all
circumstances and events that would make a
difference to financial statement users.
 TYPES OF ECONOMIC ENTITIES

• Based on their legal form: There are three basic

forms of business organizations:
a. sole proprietorships,
b. partnerships, and
c. corporations.
Proprietorship

• A business owned by one person is generally a

proprietorship. The owner is often the manager
or operator of the business
• Usually only a relatively small amount of money
(capital) is necessary to start in business as a
proprietorship.
• The owner (proprietor) receives any profits, suffers
any losses, and is personally liable for all debts of
the business.
• There is no legal distinction between the business as
an economic unit and the owner, but the accounting
records of the business activities are kept separate
from the personal records and activities of the
owner.
Partnership

• A business owned by two or more persons

associated as partners is a partnership.
• Like a proprietorship, for accounting
purposes the partnership transactions
must be kept separate from the personal
activities of the partners.
Corporation

• A business organized as a separate legal entity

under corporation law and having ownership
shares is a corporation
• The holders of the shares (shareholders) enjoy
limited liability; that is, they are not
personally liable for the debts of the corporate
entity.
1.7 Basic Accounting Equation
• The two basic elements of a business are what it
owns and what it owes.

• This relationship is the basic accounting

equation. Assets must equal the sum of liabilities
and equity.
Assets
• Assets are resources business owns and
controls, with the capacity to provide future
services or benefits.
• Asset can be current and non-current.
Liabilities
• Are creditors claims against assets
• All of these persons or entities to whom a
business owes money are its creditors.
Equity
• The ownership claim on total assets is equity.
• To find out what belongs to shareholders, we
subtract creditors’ claims (the liabilities) from the
assets
• It is often referred to as residual equity—that is, the
equity ―left over‖ after creditors’ claims are satisfied.
Revenues
• Revenues are the gross increases in equity
resulting from business activities entered into
for the purpose of earning income.

• The effect of revenues is positive—an increase in

equity coupled with an increase in assets or a
decrease in liabilities.
Expenses
• Expenses are the cost of assets consumed or
services used in the process of earning revenue.
They are decreases in equity that result
from operating the business.
• The effect of expenses is negative—a decrease in
equity coupled with a decrease in assets or an
increase in liabilities.
Dividends
• The distribution of cash or other assets to
shareholders
• Dividends reduce retained earnings. However,
dividends are not an expense.
Transactions (Business transactions)

Transaction 1: Investment by shareholder

• Hailu and Najim decide to open a computer
programming company that they incorporate as Softbyte
Inc. On September 1, 2014, they invest €15,000 cash in
the business in exchange for €15,000 of ordinary shares.
Transaction 2: Purchase of equipment for cash
• Softbyte Inc. purchases equipment for €7,000 cash.
Transaction 3: Purchase of supplies on credit
• Softbyte Inc. purchases for €1,600 from AX Supply
Company computer paper and other supplies expected to
last several months. AX agrees to allow Softbyte to pay
this bill in the coming October.
Transaction 4: Services provided for cash

• Softbyte Inc. receives €1,200 cash from customers

for programming services it has provided.
Transaction 5: Purchase of advertising on credit

• Softbyte receives a bill for €250 from the Daily

News for advertising but postpones payment until a
later date.
Transaction 6: Services provided for cash and
credit

• Softbyte Inc. provides €3,500 of programming

services for customers. The company receives
cash of €1,500 from customers, and it bills the
balance of €2,000 on account.
Transaction 7: Payment of expenses
• Softbyte pays the following expenses in cash for
September: store rent €600, salaries and wages of
employees €900, and utilities €200.
Transaction 8: Payment of accounts payable
• Softbyte pays its €250 Daily News bill in cash.
Transaction 9: Receipt of cash on account
• Softbyte receives €600 in cash from customers who had been billed
for services
Transaction 10: dividends
• The corporation pays a dividend of €1,300 in cash to Hailu and
Najim, the shareholders of Softbyte Inc.

Required:
i. Analyze the above transactions in terms of their effect on the
elements of financial statement
ii. Prepare financial statements for the business for the month of
September 30, 2014.
1.7 Financial statements

Companies prepare four financial statements from

the summarized accounting data:
 An income statement
 A retained earnings
 A statement of financial position
 A statement of cash flows
Income Statement

• The income statement reports the success or

profitability of the company’s operations over a
specific period of time.
• Presents the revenues and expenses and
resulting net income or net loss for a specific
period of time.
A retained Earnings

• Statement summarizes the changes in retained

earnings for a specific period of time.
A statement of financial position
• Sometimes referred to as a (balance sheet)
reports the assets, liabilities, and equity of a
company at a specific date.
A statement of cash flows

• summarizes information about the cash inflows

(receipts) and outflows (payments) for a specific
period of time.
• The statement reports
(1) the cash effects of a company’s operations during a
period,
(2) its investing transactions,
(3) its financing transactions
 Chapter – Two
Accounting Cycle For Service-Giving
Business
The Nature of an Account
• An account is an individual accounting record of
increases and decreases in a specifi c asset,
liability, or equity item.
• An account consists of three parts:
(1) a title,
(2) a left or debit side, and
(3) a right or credit side.
• Debit and credit are commonly abbreviated as Dr. for
debit and Cr. for credit.
• They do not mean increase or decrease, as is
commonly thought. We use the terms debit and credit
repeatedly in the recording process to describe where
entries are made in accounts
The Normal balance of an Account
Normal balance refers to the side of an account (Dr. or
Cr.), which will have greater entries than the other. The
increasing side will be the normal balance for accounts.
▫ Example: The normal balance of all asset accounts is debit
Chart of Accounts
The number and name of accounts used by an organization
depends on the nature of its operation. The list of accounts used
by an organization and their codes is called the chart of accounts.
Journalizing
Illustrations
No Entry
Summary of journalizing
Posting
After the information about a business transaction has been journalized, that

information is transferred to the specific accounts affected by each

transaction. This process of transferring the information is called posting.

The Trial Balance

After the posting phase is completed, we have to

verify the equality of the debit and credit balances.
This is done through the use of the ‘Trial Balance’.

A trial balance is a two column listing of the accounts

in the ledger and their balance to make sure that the
total of debit balances equals the total of credit
balances.
 ADJUSTING THE ACCOUNTS

All the transactions recorded above in the journalizing step

are the result of daily transactions.

Other transactions result from the passage of time or from the

internal operations of the business. For example, insurance

premiums are paid for a certain period of time and expire

during that time period.

Adjusting entries are necessary because

1. Some events are not recorded daily because it is not

efficient to do so. Examples are the use of supplies and the
earning of wages by employees(Ignored until end of period)
2. Costs expire with the passage of time rather than as a result
of recurring daily transactions. Example: Deperciation
3. Some items may be unrecorded.
Time period assumption
An accounting time period that is one year in length is a fiscal year.

A fiscal year usually begins with the first day of a month and ends
12 months later on the last day of a month.
Most businesses use the calendar year (January 1 to December 31)
as their accounting period. Some do not.
The Accrual Basis and the Cash Basis of Accounting

The cash basis of Accounting

• Revenue if cash is received and expense if cash is
paid………Cash basis accounting is not in accordance
with International Financial Reporting Standards (IFRS).

The Accrual basis of Accounting

• Under this method revenues are reported in the period
in which they are earned, and expenses are reported
in the period in which they are incurred.
Types of Adjusting Entries
Adjusting entries are classified as either deferrals or accruals
a) Deferrals:
1. Prepaid expenses: Expenses paid in cash before they are used or
consumed.
2. Unearned revenues: Cash received before services are performed.
b) Accruals:
1. Accrued revenues: Revenues for services performed but not yet
received in cash or recorded.
2. Accrued expenses: Expenses incurred but not yet paid in cash or
recorded.
We assume that Pioneer Advertising uses an
accounting period of one month.

Thus, monthly adjusting entries are made. The

entries are dated October 31.
Deferrals
• Are expenses or revenues that are recognized at a
date later than the point when cash was originally
exchanged.
Types of Deferrals

1. Prepaid Expenses
Record as an asset called prepaid expenses or
prepayments. (Examples of common prepayments are
insurance, supplies, advertising, rent…..etc)

• …….an adjusting entry for prepaid expenses results

in an increase (a debit) to an expense account and a
decrease (a credit) to an asset account.
Examples

Supplies – The purchase of supplies, results in an

increase (a debit) to an asset account. During the
accounting period, the company uses supplies.
• An inventory count at the close of business on
October 31 reveals that 1,000 of supplies are still on
hand.
Insurance –The cost of insurance (premiums) paid in
advance is recorded as an increase (debit) in the asset
account-- Prepaid Insurance.

• On October 4, Pioneer Advertising paid 600 for a

one-year fire insurance policy. Coverage began on
October 1.
• Therefore, Insurance of 50 (600/12) expires each
month. The expiration of prepaid insurance decreases
an asset, Prepaid Insurance. It increases an expense
account, Insurance Expense.
Depreciation-- is the process of allocating the cost of
an asset to expense over its useful life.
• For Pioneer Advertising, assume that
depreciation on the equipment is 480 a year, or
40 per month.
2. Unearned Revenues
• When companies receive cash before services are
performed, they record a liability called unearned
revenue.
• In other words, a company now has a performance
obligation (liability) to transfer a service to one of its
customers.
• Pioneer Advertising received 1,200 on October 2
from R. Knox for advertising services expected to be
completed by December 31.
• From an evaluation of the service Pioneer performed
for Knox during October, the company determines

that it should recognize 400 of revenue in October.

Accruals
1. Accrued Revenues
Revenues for services performed but not yet recorded
at the statement date are accrued revenues
• In October, Pioneer Advertising identified 200 for
advertising services performed that were not billed
to clients on or before October 31. Because these
services are not billed, they are not recorded.
2. Accrued Expenses
Expenses incurred but not yet paid or recorded at the
statement date are called Accrued expenses. Interest,
taxes, and salaries are common examples of accrued
expenses.
• Therefore, an adjusting entry for accrued
expenses results in an increase (a debit) to
an expense account and an increase (a
credit) to a liability account.
INTEREST
• Pioneer Advertising signed a three-month note
payable in the amount of 5,000 on October 1. The
note requires Pioneer to pay interest at an annual
rate of 12%.
Therefore, Br. 150 (5,000 *12% *3/12), or 50 for one
month is interest expense.
Accrued Salaries and Wages
Pioneer paid salaries and wages on October 26 for its
employees’ first two weeks of work; the next payment
of salaries will not occur until November 9

Therefore, three working days remain in October

(October 29–31).
• Thus, accrued salary and wage at October 31 is 1,200
(400 * 3)
Preparing the Adjusted Trial Balance
Using a worksheet
• Worksheet is a multiple-column form used in the
adjustment process and in preparing financial
statements.
• As its name suggests, the worksheet is a working
tool. It is not a permanent accounting record.
• Financial statements can directly be prepared from
the worksheet.
Steps in Preparing a Worksheet
Step 1:-Prepare a trial balance on the worksheet.
Step 2:-Enter the adjustments in the adjustments columns
Step 3:-Enter adjusted balances in the adjusted trial
balance columns.
Step 4:-Extend adjusted trial balance amounts to
appropriate financial statement columns.
Step 5:- Total the statement columns, compute the net
income (or loss), and complete the worksheet.
Preparing Financial Statements from a Worksheet

• After a worksheet is completed , the company has at

hand all the data required for preparation of financial
statements
• The income statement is prepared from the income
statement columns.
• The statement of financial position and retained
earnings statement are prepared from the statement
of financial position column.
Closing the Books
• At the end of the accounting period, the company makes
the accounts ready for the next period. This is called
closing the books.
• In closing the books, the company distinguishes between
temporary and permanent accounts.
• Temporary accounts relate only to a given accounting
period. They include all income statement accounts and
the Dividends account.
• The company closes all temporary accounts at the end of
the period.
• In contrast, permanent accounts relate to one or more
future accounting periods. They consist of all
statement of financial position accounts, including
equity accounts.
• Permanent accounts are not closed from period to
period.
• Closing entries also produce a zero balance in each

temporary account.

• Companies close the revenue and expense accounts

to another temporary account, Income Summary,

and they transfer the resulting net income or net

loss from this account to Retained Earnings

Basic closing entries
• Debit each revenue account for its balance, and credit
Income Summary for total revenues.
• Debit Income Summary for total expenses, and credit
each expense account for its balance.
• Debit Income Summary and credit Retained Earnings for
the amount of net income.
• Debit Retained Earnings for the balance in the Dividends
account, and credit Dividends for the same amount
Preparing a Post-Closing Trial Balance

• The company has journalized and posted all closing

entries, and now it prepares another trial balance,
called a post-closing trial balance, from the ledger.
• The post-closing trial balance lists permanent
accounts and their balances after the journalizing and
posting of closing entries.
Reversing Entries—An Optional Step

• A reversing entry is the exact opposite of the

adjusting entry made in the previous period. Use of
reversing entries is an optional bookkeeping
procedure; it is not a required step in the accounting
cycle.
Correcting Entries—An Avoidable Step

• Unfortunately, errors may occur in the recording

process. Companies should correct errors, as soon as
they discover them, by journalizing and posting
correcting entries.
• If the accounting records are free of errors, no
correcting entries are needed.
 Chapter –Three
Accounting for Merchandising Businesses