Financial and Managerial

Accounting
Chapter One
Introduction to Accounting

Getaneh Y.( Asst. Professor, MBA in Finance)

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 Chapter Contents
 Meaning of Accounting
 Specialized fields of accounting
 Objectives of accounting
 Fundamental concepts
 Principles and rules of accounting
 Double entry Book keeping
 Classification of accounts

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 Chapter one: Introduction to Accounting

Meaning of Accounting

Accounting is famously known as the "language of business". Through the financial statements, the end-product
reports in accounting, it delivers information to different users.

Accounting is a means through which information about a business entity is communicated.

Accounting is widely used to describe all types of business activity, Costs, prices, sales volume, profits, and return
on investment are all accounting measurements

Technical definitions of accounting have been published by different accounting bodies. The American Institute of
Certified Public Accountants (AICPA) defines accounting as:

the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and
events which are, in part at least of financial character, and interpreting the results thereof.

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Accounting consists of three basic activities—it identifies, records, and
communicates the economic events of an organization to interested users.

Three Activities
As a starting point to the accounting process, a company identifies
the economic events relevant to its business.
Examples of economic events are the sale of food and snacks by a
hotel/resturant
Once a company identifies economic events, it records those events
in order to provide a history of its financial activities.
Recording consists of keeping a systematic, chronological diary of
events, measured in monetary units. In recording, a company also
classifies and summarizes economic events.

Finally, a company communicates the collected information to

interested users by means of accounting reports. The most common
of these reports are called financial statements.
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 Cont.…

The accounting process is beyond the

bookkeeping function.
Bookkeeping usually involves only the
recording of economic events. It is therefore
just one part of the accounting process.
Accounting involves the entire process of
identifying, recording, interpreting and
communicating economic events.

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Accounting Concerned with transactions and events having financial
character

For example, hiring an additional employee is qualitative information

with no financial character. Hence, it is not recorded. However, the
payment of salaries, acquisition of an office building, sale of goods,
etc. are recorded because they involve financial value.

Business transactions are expressed in terms of money

They are assigned amounts when processed in an accounting system.

Using one of the examples above, it is not enough to record that the
company paid salaries for April. It must include monetary figures –
say for example, Br20,000 salaries expense.
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 Interpreting the results
Interpreting results is part of the phases of accounting. Information is useless if
they cannot be interpreted and understood. The amounts, figures, and other data in
the financial reports have meanings that are useful to the users.

By studying the definition alone, we learned some important concepts in

accounting. It also gave us an idea of what accountants do.

You may not notice but the simple things you do and encounter everyday can
actually be related to some level of accounting. You make budgets, count change
and check the receipts from the shops/supermarket. You may also have listed things
you spent your money with at one point in your life.

We are surrounded by business – from managing our own money to seeing profit
statements of big corporations. And where there is business, there sure is
accounting.
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 ACCOUNTING FROM A USER’S
PERSPECTIVE
• Accounting practiced by everyone in his daily life.
• Accounting information is the means by which we
measure and communicate economic events.
• Whether you manage a business, make investments,
or monitor how you receive and use your money, you
are working with accounting concepts and accounting
information.
• In reality, nearly everyone uses accounting
information daily.

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 Accounting…..Cont’d
• Primary goal of this course is to develop your
ability to understand and use accounting
information in making economic decisions.
• To do this, you need to understand the following:
 The nature of economic activities that accounting
information describes.
 The assumptions and measurement techniques involved
in developing accounting information.
 The information that is most relevant for making various
types of decisions.

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Accounting…..Cont’d

Accounting links
decision makers
with economic
activities and with
the results of their
decision.

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 Branches of Accounting
As a result of economic, industrial, and
technological developments, different
specialized fields in accounting have
emerged.
• Financial Accounting,
The famous • Managerial Accounting,
•
branches or •
Cost Accounting,
Auditing, Taxation,
types of • AIS,
accounting • Not for profit & Government
Accounting, and
include: • Forensic Accounting. 11
 1. Financial Accounting
 Financial accounting involves recording and classifying business
transactions, and preparing and presenting financial statements
to be used by external users.
 The preparation of financial statements is in compliance with
accounting standards/principles. Common standards
1. International Financial Reporting Standards /IFRS/: more than
130 countries world wide /Including our country Ethiopia/
2. Generally accepted accounting principles or GAAP in US & other
countries.
 Financial accounting is primarily concerned in
processing historical data.

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 What is IFRS?
IFRS is a globally recognized set of Standards for the preparation of financial statements by business entities.

• single-set of high quality

• globally accepted and enforced set of standards that require high quality, transparent
and Comparable information in financial statements

Those 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.

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 Cont…

Ethiopia passed a financial reporting law in 2014 which requires

the use of IFRS by commercial businesses operating in Ethiopia.

Proclamation No. 847/2014

Regulation No. 332/2014

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 2. Managerial Accounting

 Focuses on providing information for internal users

use; i.e. the management.
 It deals with the needs of the management rather
than compliance with predetermined accounting
standards.
 Managerial accounting involves financial analysis,
budgeting and forecasting, cost analysis, evaluation
of business decisions, and similar areas.

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How Managerial Accounting Adds Value to the Organization

Providing information for decision making and

planning.
Assisting managers in directing and controlling
activities.
Motivating managers and other employees
towards organization’s goals.
Measuring performance of activities, managers,
and other employees.
Assessing the organization’s competitive position.
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 Managerial versus Financial Accounting

Accounting
Accounting System
System
•• (accumulates
(accumulates financial
financial and
and
managerial
managerial accounting
accounting data)
data)

Managerial
Managerial Accounting
Accounting Financial
Financial Accounting
Accounting
Information
Information for
for decision
decision Published
Published financial
financial
making,
making, and
and control
control statements
statements andand other
other
of
of an
an organization’s
organization’s financial
financial reports.
reports.
operations.
operations.

Internal External
Users Users
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 Managerial versus Financial Accounting
Areas of Managerial Financial
Difference Accounting Accounting
Users of Information Managers within company Interested outside parties

Regulation Not required because for Required. Must conform

internal use only IFRS which is regulated
by AABE
Source of Data Basic accounting system Almost exclusively from
plus various other sources the basic accounting
system
Nature of Reports & Reports often focus on Reports focus on the
Procedures subunits. enterprise in its entirety.
Based on a combination of Based on historical
historical data, estimates, transactions
and projections of future
events
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3. Cost Accounting
Sometimes considered as a subset of management accounting,
Involves the recording, presentation, and analysis of manufacturing costs.
Very useful in manufacturing businesses since they have the most complicated
costing process.
Cost accountants also analyse actual and standard costs to help managers
determine future courses of action regarding the company's operations.

4. Auditing
External auditing refers to the examination of financial statements by an independent
party with the purpose of expressing an opinion as to fairness of presentation and
compliance with predetermined accounting standard.
Internal auditing focuses on evaluating the adequacy of a company's internal control
structure by testing segregation of duties, policies and procedures, degrees of
authorization, and other controls implemented by management. 19
 5. Tax Accounting
Tax accounting helps clients follow rules set by tax authorities.

It includes tax planning and preparation of tax returns.

It also involves determination of income tax and other taxes, tax advisory services such as ways to
minimize taxes legally, evaluation of the consequences of tax decisions, and other tax-related matters.

6. Accounting Information Systems

Involves the development, installation, implementation, and monitoring of

accounting procedures and systems used in the accounting process.
It includes the employment of business forms, accounting personnel direction,
and software management.

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7. Government and Not-for Profit Accounting
Government and nonprofit organizations aren't interested in making money, so
they use an accounting system called fund accounting.

Fund accounting essentially groups financial data together into funds or accounts
that share a similar purpose.

IPSAS/International Public Sector Accounting Standard/:

used for preparation of statements.
8. Forensic Accounting
Involves court and litigation cases, fraud investigation, claims and dispute
resolution, and other areas that involve legal matters.

This is one of the popular trends in accounting today.

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 Objectives of Accounting
• The primary objective of accounting
– is to provide information that is useful for decision making
purposes.
• Accounting is not an end, but rather it is a means to an end.
• The final product of accounting information is the decision
that is enhanced by the use of that information, whether the
decision is made by owners, management, creditors,
governmental regulatory bodies, labor unions, or the many
other groups that have an interest in the financial
performance of an enterprise

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 Objectives of Accounting…..cont’d
 Every activity that a business firm does must be done for a reason and accounting is no
exception.
Accounting helps the company achieve a myriad of objectives.

To mention some of objectives

1. Permanent Record
 Any business firm needs a permanent record of the transactions that
it engages in.
 required for internal purpose,
 for taxation purpose or
 for any other purpose.
 Accounting serves this function. Whenever the organization commits
any resource of monetary value either within the firm or outside the
firm, a record is made.
 This permanent record is held on for years and can be retrieved as and
when need be. 23
 Cont…
2. Measurement of Outcome
 A business firm may indulge in numerous transactions
every day.
 It may make profit in some of these transactions
while it may make losses in some other transactions.
 However, the effect of all these transactions needs to
be aggregated over a period of time.
 There must be daily, weekly and monthly reports
which provides information to the organization about
how well it is performing its activities.
 Accounting serves this purpose by providing periodic
financial statements which help the firm adjust their
operations accordingly.
 Cont…
3. Creditworthiness
 Firms need resources for their functioning.
 Firms do not have any capital stock at hand and
need to obtain them from investors.
 Investors will give money to the firm only if they
have reasonable assurance that the firm will be
able to generate enough profit.
 Past accounting records help a great deal in proving this.
 All kinds of investors from banks to shareholders ask
for past accounting details before they trust the
management with their money.
 Cont…
4. Efficient Use of Resources
 Firms can also conduct useful internal analysis with the help of accounting
data.
 Accounting records tell the firm what resources were committed to
what activity and what time.
 These records also summarize the return that was obtained from
these activities.
 Management can then analyze past behavior and draw lessons
about how they could have performed better and used resources
more efficiently.
5. Projections
 Accounting helps management and investors look forward. Costs and
revenue growths can be projected after substantial data has been
accumulated.
 The assumption made is that the company is likely to behave exactly as it
has done in the past.
 Thus, analysts can make reasonable assumptions about the future
 Fundamental Concepts or Elements of Accounting
 The elements of accounting pertain to assets, liabilities, and capital, Income
and Expenses.
 Assets: resource controlled by the entity result of past event expected inflow of
economic benefits
 Liabilities are obligations to creditors and lenders; and
 Capital refers to the interest of the owners in the business after deducting all
liabilities from all assets (or, what is left for the owners after all company
obligations are paid).
A. Assets
 Assets can be classified as current or non-current.
 An asset is considered current if it is for sale, if it can be realized within 12
month from the end of the accounting period or within the company's normal
operating cycle if it exceeds 12 months. In addition, cash is generally
considered current asset.
• Current assets include: Cash and Cash Equivalents, Marketable Securities,
Accounts Receivable, Inventories, and Prepaid Expenses. Assets that do not
meet the criteria to be classified as current are, by default, non-current assets.
• Examples of non-current assets are: Long-term Investments; Property, Plant
 Cont…
B. Liabilities
 Liabilities can also be classified as current or non-current.
 A liability is considered current of they are payable within
12 months from the end of the accounting period, or within
the company's normal operating cycle if the cycle exceeds
12 months.
• Current liabilities include: Accounts Payable, Short-term
Notes Payable, Tax Payable, Accrued Expenses, and other
short-term obligations.
• Non-current liabilities include those that do not meet the
above criteria. Examples of non-current liabilities
are: Loans Payable and Bonds Payable which are long-term
in nature, and Deferred Tax Liabilities.
 Cont..
C. Capital
 Capital refers to the interest of the owner/s of the business. The owner's
interest is the value of total assets left after all liabilities to creditors and
lenders are settled.
 Capital is increased by contributions by the owner/s and income. It
is decreased by withdrawals by owners (dividends in
corporations) and expenses.
D. Income
 Income refers to an increase in assets or decrease in liability, and an
increase in capital other than that arising from contributions made by
owner/s.
 Examples of income accounts include: Sales, Service Revenue,
Professional Fees, Interest Income, Rent Income, and others.
E. Expense
 Expenses result in decrease in assets or increase in liabilities, and decrease
in capital other than those arising from withdrawals of the owner/s.
 Some examples are: Cost of Sales, Salaries Expense, Rent Expense,
 Principles and Rules of Accounting
 Accounting Principles:
 Accounting assumptions and principles provide the bases in
preparing, presenting and interpreting general-purpose
financial statements.
1. Accrual
 Income is recognized when earned regardless of when
collected, and expenses are recognized when incurred
regardless of when paid.
2. Going Concern
 Also known as continuing concern concept or continuity
assumption, it means that a business entity will continue to
operate indefinitely.
 Cont…
3. Accounting Entity Concept
 A specific business enterprise is treated as one
accounting entity, separate and distinct from its owners.
4. Time Period Assumption
The indefinite life of an enterprise is subdivided into
time periods or accounting periods
 which are usually of equal length for the purpose
of preparing financial reports.
5. Monetary Unit Assumption
Transactions are recorded in terms of
money (quantifiability).
 Rules of Accounting
 Golden Rules of Accounting
1. Debit The Receiver, Credit The Giver
 This principle is used in the case of personal accounts.

When a person gives something to the

organization, it becomes an inflow and therefore the
person must be credit in the books of accounts.
The converse of this is also true, which is why the
receiver needs to be debited.

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 Cont…
2. Debit What Comes In, Credit What Goes Out
 This principle is applied in case of real accounts.
 Real accounts involve machinery, land and
building etc.
 They have a debit balance by default.
 Thus when you debit what comes in, you are adding
to the existing account balance. This is exactly what
needs to be done.
 Similarly when you credit what goes out, you are
reducing the account balance when a tangible asset
goes out of the organization.

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 Cont…
3. Debit All Expenses And Losses, Credit All Incomes And Gains
 This rule is applied when the account in question is a
nominal account.
 The capital of the company is a liability. Therefore it has a
default credit balance.
 When you credit all incomes and gains, you increase the
capital and by debiting expenses and losses, you decrease
the capital. This is exactly what needs to be done for the
system to stay in balance.
 The golden rules of accounting allow anyone to be a
bookkeeper. They only need to understand the types of
accounts and then diligently apply the rules.

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 The General Rules of Debit And Credit
Accounting Element To Increase To Decrease

1.Assets Debit Credit

2. Liability Credit Debit
3. Capital Investment Credit Debit
4. Capital - Debit Credit
Withdrawal
5. Income Credit Debit
6. Expense Debit Credit
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 Double Entry Bookkeeping System in Accounts

 The double entry system of bookkeeping is said to have

revolutionized growth in modern business.
 It is only because businesses are able to keep track of their
growing scale of transactions efficiently that they grow
further.
 This has been facilitated by a well designed, error
preventing accounting system called the double entry
system.
 What Is Double Entry System ?
 In a double entry bookkeeping system there are two
sides to every transaction.
 The sides are equal in magnitude i.e. the debits
must always equal the credits.
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 Cont..
 Large Firms
 When a firm grows beyond a certain size it has to use double
entry system of accounting. This is both because it is
mandated by law as well as because it is the most efficient
system.
 Complete Records
 Double entry accounting system keeps a record of all major
accounting transactions.
 These could be transactions outside the firm with third
parties.
 Or they could be intra firm transactions where raw
material has now been converted to Work In Progress
(WIP).
 By making sure every record about credit as well as intra firm
transactions is being accounted for, double entry system 37
 Cont…
 Automatic Reconciliation
• As the scale of a business grows, it becomes more prone to
clerical errors.
• A clerk accounting for a large number of transactions all
day is bound to make some mistakes.
• However, the double entry system does not allow these
mistakes to have a cascading effect.
• This is because the system is constantly checking whether
total debits equal total credits.
• When they are not, accountants know they are dealing with
an error.
• They can then find out the error, correct it and then move
forward. This saves a lot of time and builds incredible38
 Cont…
 However the double entry accounting system is not 100%
error proof. There is a possibility that an entry may have
been completely omitted or that there may have been
compensating errors done while passing the entry.
 Fraud is Difficult
 Just like reconciliation, when a business grows, more and
more responsibilities need to be entrusted to workers.
 Many times this leads to frauds by the workers as they
embezzle cash and make use of resources for personal
benefits.
 However, the double entry accounting system, when used
correctly prevents such situations from arising.
 The system has strong inbuilt controls to avoid misuse of
any resources. 39
 Classification of Accounts
 What is an Account?
 In accounting, an account is a descriptive storage unit
used to collect and store information of similar nature.
 For example, "Cash". Cash is an account that stores all
transactions that involve cash receipts and cash payments.
All cash receipts are recorded as increases in "Cash" and
all payments are recorded as deductions in the same
account.
 Types of Accounts
 All accounts within the organization can be split into
three types.
 An account can be of one and only one of the following
type and not more. Here are the various types of
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accounts.
 Cont…
1. Personal: Personal accounts make most intuitive sense.
 We keep a track of all the transactions that we have undertaken
with a particular person in them.
 We all maintain personal accounts like the money we owe our
friends, the grocer and so on.
2. Real: Real accounts are accounts which have been created to
account for tangible things.
 Accounts such as land and building, machinery a/c etc are called
real accounts.
3. Nominal: Nominal accounts are a special category of accounts.
 While the other accounts can hold balance and carry it forward,
nominal account are automatically reset to zero as soon as the
time period is over.
 Their balance is carried forward to other accounts and the books for
that period are closed. 41

End of Chapter one

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