Chapter one

Introduction to Accounting and Business

Chapter objectives

Dear learners! After studying this chapter you should be able to:

 Describe the nature of a business, the role of accounting, and ethics in business.
 Summarize the development of accounting principles and relate them to practice.
 State the accounting equation and define each element of the equation.
 Describe and illustrate how business transactions can be recorded in terms of the
resulting change in the elements of the accounting equation.
 Describe the financial statements of a proprietorship and explain how they
interrelate.
1.1. The nature of a business
A business is an organization in which basic resources (inputs), such as materials and
labor, are assembled and processed to provide goods or services (outputs) needed by the
society. An organization is to mean a group of individuals who come together to pursue a
common set of goals and objectives. There are two types of organizations; namely, business
and non-business organizations. Businesses are those organizations which are established
to make profit for their owners. Whereas non-business organizations are those
organizations which do not have a motive of generating profit rather they are established
to fulfill other societal needs, and for this reason they are also known as not-for-profit
organizations. Non-business organizations may include charity organizations, hospitals,
religious organizations and etc. Profit, the difference between the amounts received from
customers for the goods or services provided and the amounts paid for the inputs used to
produce and provide the goods or services is, thus, distinguishing characteristics of
business organizations.
1.1.1. Types of businesses
Based on the type of business activities they perform, business organizations are
categorized into three types as follow:

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 1. Service businesses: they are business organizations engaged in service provision
activities, not tangible products. They perform services for fee. Examples of service
businesses are accounting firms, law firms, dry cleaning establishments.
2. Merchandising businesses: they are businesses involved in purchase, not make,
of goods that are ready for sale and then sell them to customers at some higher
prices. The Merchandising businesses include auto dealerships, boutiques, and
supermarkets.
3. Manufacturing businesses: those business organizations buy raw materials and
convert them in to finished goods, which can be sold to other businesses (such as
Merchandisers) or directly to final consumers. Manufacturing companies include
steel mills, auto manufacturers, and clothing manufacturers.
1.1.2. Forms of businesses
Based on the type of ownership in an entity, organizations are commonly classified in to
three forms of businesses. Those are sole proprietorship, partnership and corporation
forms of businesses.

1. Sole proprietorship is an unincorporated business owned by an individual and has no

separate legal entity because it is often managed by a same person owning that
business. Sole proprietors include physicians, lawyers, electricians, and other
people in business for themselves. Many small service businesses and retail
establishments are also single proprietorships. No legal formalities are necessary to
organize such businesses, and usually business operations can begin with only a
limited investment. The owner of such businesses is solely responsible for all liabilities
of the entity and hence, it has unlimited liability. If business of such type is not able to
pay its debt, then the owner is wholly responsible to pay the amount even in cases it is
greater than his/her personal resources.
2. Partnership is an unincorporated business owned by two or more persons associated
as partners. Like the sole proprietorship form of business it has no separate legal
entity and therefore, the same persons who own the business often manage the
business. Many small retail establishments and professional practices, such as
dentists, physicians, attorneys, and many CPA firms, are partnerships. Owners of such

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 business also have unlimited liability and each partner may be held liable for all the
debts of the partnership and for the actions of each partner within the scope of the
business. A partnership can be formed with a verbal or written agreement, nonetheless
written agreement is preferable over oral agreement because it provides a permanent
record of the terms of the partnership. The terms of partnership include the initial
investment of each partner, the duties of each partner, the means of profits or losses
distribution, and settlement of the business after a death or withdrawal of a partner.
3. Corporation is a business incorporated under the laws of a state and it can be owned
by a few or thousands of owners. The owners of such business are known as
shareholders or stockholders and they buy shares of stokes, which are unites of
ownership, of the corporation. Unlike the others, those forms of businesses have
separate legal entity and if a business fails the owners would only lose the amount they
have paid to purchase the shares of stocks. They are not liable for debt amounts in
the business, i.e. the corporate form of business protects the personal assets of the
owners from the creditors of the corporation. Owners of corporate businesses do not
manage their business directly rather they elect board of directors to represent them
on managing that business. Those boards of directors then select the officers of the
corporation, such as the president and vice presidents, who manage the corporation
for the stockholders.
1.2. The role of accounting in business

What is accounting?

Accounting is an information system that provides useful information to permit informed

judgments and decisions by users. Thus, from its very nature, accounting is defined as the
process of identifying, measuring, recording and communicating an organization’s
economic activities to interested users of the information. Users of accounting
information can be internal or external. Those internal users are persons who work for
the organization and are responsible for planning, organizing and operating the business
entity. It may include owners, managers at all level and employees working within it.
Whereas external users are those who do not work for the organization and include
investors, creditors, labor unions, customers, government, researchers and etc.

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Accounting, in general, is said to be the “language of business” because it is a means by
which business information is disseminated to users.

In general, the process by which accounting provides information to business

stakeholders passes through identifying, measuring, recording and then finally by
communicating the information to users. First a company identifies economic activities
relevant to its business operations. Examples of economic activities includes providing
telecommunication services by Ethio telcom, sales of beers by HBSC, salary and wage
payments by Salini construction company and etc. having identified its economic
activities, then, it measures them in monetary terms, expressed in dollar amounts, such as
a sales of Br. 100,000. The economic activities measured in monetary terms will be
recorded in order to provide a history of financial activities. Ultimately, the information
will be communicated to interested users through accounting reports, commonly known
as financial statements.

1.2.1. The difference between book keeping and accounting

Book-keeping is a part of accounting and is concerned with the recording of transactions
which is often routine and clerical in nature, whereas accounting performs other functions
as well, viz., measurement and communication, besides recording. An accountant is
required to have a much higher level of knowledge, conceptual understanding and
analytical skill than is required of the book-keeper. An accountant designs the accounting
system, supervises and checks the work of the book-keeper prepares the reports based on
the recorded data and interprets the reports.
1.2.2. Ethical behaviors of an accountant
To be useful, the information prepared by an accountant must be relevant and faithfully
represent a business’s economic activities. This requires an ethics, beliefs that enable us to
differentiate what is right and wrong, and involves living by the norms and rules of the
society. They are standards of conduct by which one’s actions are judged as right or wrong,
honest or dishonest, fair or not fair. Ethics are important ingredients in business because
the norms and rules identify appropriate behavior for managers, employees, investors, and
other stakeholders. If profits are overstated, for example, it may result in investors

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allocating more resources to a company than actual results would justify. This
misallocation results in a loss of value to society and often leads to financial harm for those
who use this information. Ethical behavior is particularly important for accounting because
the reliability of accounting information depends on the honesty of those who prepare,
report, and audit this information. In general, an accountant's most valuable asset is an
honest reputation, and ethical considerations are one building blocks of the accounting
profession.
1.3. The profession of Accounting
Accountants could engage in both private accounting and public accounting.
1. Private accounting: accountants employed by a business firm or a not-for-profit
organization are said to be engaged in private accounting. The scope of
activities and duties of private accountants varies widely. Private accountants
are frequently called management accountants. If they are employed by a
manufacturer, they may be referred to as industrial or cost accountants. The chief
accountant in a business may be called the controller. Various state and federal
agencies and other not-for-profit agencies also employ accountants.
2. Public accounting: accountants, along with their staff who provide services on
fee basis are said to be employed in public accounting. In public accounting, an
accountant may practice as an individual or as a member of a public accounting
firm. A public accountant may become a Certified Public Accountant (CPA) by
passing an examination prepared and graded by the American Institute of
Certified Public Accountants (AICPA). The exam is administered by computer. In
addition to passing the exam, CPA candidates must meet other requirements,
which include obtaining a state license.
1.4. Financial Accounting Vs. Managerial Accounting
An accounting information system provides data to help decision makers both outside and
inside the business. Decision makers outside the business are affected in some way by the
performance of the business and the decision makers inside the business are responsible
for the performance of the business. For this reason, accounting is divided into two
categories; namely financial accounting and managerial accounting. Financial accounting

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information appears in financial statements that are intended primarily for external use
(although management also uses them for certain internal decisions). Managerial
accounting information, on the other hand, is for internal use and provides special
information for the managers of a company. The information that managers use may range
from broad, long range planning data to detailed explanations of why actual costs varied
from cost estimates. In general, financial accounting is concerned with preparations of
financial information for external users and managerial accounting is concerned with
preparations of financial information which is usable by managers of the company to make
relevant decisions.
1.5. Accounting principles and practices

From the ongoing discussion it is clear that the accounting system provides useful
information, through financial statement, to users for making informed judgments. For
users to relay on the information, accountants should fairly, clearly and completely present
these financial statements containing the information needed by the users. To ensure that
financial statements are understandable to the users, the Accounting profession has
attempted to develop a set of standards that are generally accepted and universally
practiced. Otherwise, each enterprise would have to develop its own standards. Further,
readers of financial statements would have to familiarize themselves with every company’s
peculiar accounting and reporting practices. Thus, it would be almost impossible to prepare
statements that could be compared.
Presently, there are two sets of practices and rules for international use, international
reporting standards, namely; Generally Accepted Accounting Principles (GAAP) and the
international financial reporting standards (IFRS).

a set of practices, called Generally Accepted Accounting Principles (GAAP), has been
developed to provide guidelines for financial accounting. Generally accepted accounting
principles encompass the conventions, rules, and procedures necessary to define accepted
accounting practice at a particular time. Those conventions, rules, and procedures provide
a standard by which to measure financial presentations. GAAP arise from wide agreements
on the theory and practices of accounting at a particular time. These principles are not like

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the unchangeable laws of nature sciences rather they evolve to meet the needs of decision
makers, and they change as circumstances change or as better methods are developed.

1.6. The accounting equation and elements of the equation

A business is a composition of economic resources such as cash, inventories, land,
buildings, equipment, and etc. These resources owned by a business collectively are
termed as Assets. The claims on these assets are also divided in to two major components;
namely, liabilities and owner’s equity. Liabilities are present obligations of a business
that requires cash payment, asset transfer, or service provision in the future. They are
claims of those to whom the company owes money (creditors). On the other hand,
owner’s equity are claims over a business’s assets by its owners. The Accounting
equation is, therefore, a statement of equality between the assets, and the liabilities and
owner’s equity of a business, mathematically expressed as:
Assets = Liabilities + Owner’s Equity
This relationship is the Basic Accounting Equation stating that Assets must equal the
sum of liabilities and owner’s equity. In the equation liabilities must be placed before
owner’s equity because creditors have preferential right over the owners, in the business’s
assets in case of liquidation. Hence, owner’s equity is often called Residual Equity or Net
Assets because claims of creditors must be paid before ownership claim. The claim of the
owners is sometimes given greater emphasis only by transposing liabilities to the other
side of the equation as follow:
Assets - Liabilities = Owner’s Equity

The accounting equation applies to all economic entities regardless of size, nature of
business, or form of business organization. It equally applies from a simple proprietorship
business to today’s giant corporation arrangements. The equation provides the
underlying framework for recording and summarizing economic events of a business.

1.7. Business transactions and financial statements

Transactions or business transactions are a business’s economic events that are
measurable in monetary terms and can affect the financial position of the company. The
transactions can be external or internal transactions. External transactions involve

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economic events between the business and some outside enterprise. Example, payment of
monthly rent to the landlord, purchase of land, sale of merchandises, and etc. Internal
transactions, on the other hand, are economic events that occur entirely within one
company. Example, the use of cooking and cleaning supplies by a restaurant is an internal
transaction.

For an activity to qualify as a business transaction, each transaction must have a dual
effect on the accounting equation. For example, if an asset is increased the following must
occur correspondingly:

a) decrease in another asset

b) increase in a specific liability or
c) increase in owner’s equity

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