CHAPTER ONE

INTRODUCTION TO ACCOUNTING AND BUSINESS

Objectives of the chapter

After successfully complete this chapter, you will be able to:

 Describe the nature of business

 Describe the types of business organization in Ethiopia
 Understand the role of accounting in business and accounting profession
 Describe International Financial Reporting Standards (IFRS)
 Understand financial reporting requirements in Ethiopia and AABE
 Explain the accounting equation and elements of the equation
 Describe business transactions and financial statements

Introduction
Dear students! well come to the new world of fundamental of Accounting. This course is designed with two parts
(I&II), and you will take snapshot of accounting concepts and profession in this course. Accounting as a profession
had emerged following the ever increasing needs of mankind in the social, economic and business environment. The
accounting profession has shown a continuous and tremendous growth in the business world. This evolution of the
accounting practice ranges from the ancient civilization periods of the Babylonians and Egyptians when payments
for daily workers were used to be calculated on clay, as today‘s practice where Computerized Accounting
Information Systems that are used for generation of financial information which is very useful for making reliable
business decisions. The significance as well as momentum of growth of the accounting discipline has increased after
the 18th century Industrial Revolution of the Great Britain which has brought a series of radical changes in the
Content, Concept and Context of many of the professional fields, particularly those under the shadow of Business
and Economics.
In the existing organizational dynamics and global integrations, the importance of vibrant Accounting and Finance
professionals is indisputable. The central role of accountancy and finance in society make them interesting
disciplines in their own right, especially for those who are interested in how economic or financial activities of any
economic players, both at the micro and macro level, influences and structures our lives.
Accounting is, an information and measurement system that identifies, records, and communicates relevant, reliable,
and comparable information about an organization‗s (a business‗s) economic activities. Currently, there are seven
types of business organizations in Ethiopia recognized by the Commercial Code. Those are general partnership,

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limited partnership, limited liability partnership, joint venture, share company, private limited company and one
person private limited company.
The Accountants and Auditors Board of Ethiopia (AABE) is the statutory body established with the primary purpose
of protecting the public interest. To achieve this, AABE is responsible for regulating the profession as well as for
issuing a national professional accountancy qualification that is recognized internationally.
International Financial Reporting Standards (IFRS) are a set of international accounting standards stating how
particular types of transactions and other events should be reported in financial statements.
In general, the nature of business, the types of business organization in Ethiopia, the role of accounting in business
and accounting profession, International Financial Reporting Standards (IFRS), financial reporting requirements in
Ethiopia and AABE, the accounting equation and elements of the equation and business transactions and financial
statements are covered this chapter. This course also discusses the fundamental principles involved in processing
accounting information of business enterprises. Understanding these fundamental principles is very important
because forthcoming courses that you are going to take in accounting will build on these principles. The study of
accounting, therefore, opens you new and exciting possibilities both in terms of becoming a professional accountant
and using accounting information in your daily life.

[Link] nature of a business

A business is an organization in which basic resources (inputs), such as materials and labour, are assembled and
processed to provide goods or services (outputs) to customers. A business is an organization or entity involved in
commercial, industrial, or professional activities providing goods or services to the public.

Business is a broad term but is usually referred to as the profit-generating activities which include the provision of
goods or services wanted or needed by people in exchange for a profit. Profit does not necessarily mean cash
payments. It can also mean other securities such as stocks or the classic barter system. All business organizations
have a few common characteristics: the formal structure, aim to achieve objectives, use of resources, the requirement
of direction, and the legal regulations controlling them. Based on the factors such as the degree of liability,
regulation on tax exemptions, business organizations are divided into the following: sole-proprietorship, partnership,
corporations, and limited liability companies which are discussed in detail in next section.

The nature of a business describes the type of business it is and what its overall goals are. It describes its legal
structure, industry, products or services, and everything a business does to reach its goals. It depicts the business‘s
problem and the main focus of the company‘s offerings. When we say nature of a business, we are alluding to:

 What type of products and services are sold by a company

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  The industry in which the company operations
 Its overall mission and purpose
 Other distinctive characteristics of the business

For example, to understand the nature of business, we can classify the ―nature‖ into different categories:

 By product or service
 By organizational setup
 By organizational structure
 By business type

List of natures of businesses

The characteristics grouped in the following categories help to describe the nature of businesses:

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 Figure 1: List of natures of businesses

It is a common misperception that businesses exist only to make a profit. Although this was the previous
understanding of business, this does not stand true anymore. Profit-creation is not a core reason for businesses to
exist but is a means for a businesses‘ existence - it can be considered a means to an end. Profits help a business to do
better and improve its quality. Businesses will not survive in the market without making a profit; thus, this is
considered a business objective. So businesses do not just exist to make a profit.

[Link] of business organizations in Ethiopia

A business organization under Ethiopian law refers to a legal entity that engages in business activities. Businesses
are typically thought to be a profit-oriented organization that aims to improve society as well as generate profits. A
for-profit organization is one that is solely focused on earning money.

The most common business organizations in general are sole proprietorships, partnerships, and corporations. Sole
proprietorships are the simplest form of business organization and are owned by one person. Partnerships are owned
by two or more people and can be either general partnerships, in which all partners are equally liable for the debts
and obligations of the business, or limited partnerships, in which only some partners are liable. Corporations are
more complex business organizations that are owned by shareholders and are managed by a board of directors.

Specifically, business organizations in Ethiopia can be basically categorized based on the following two parameters-
form wise and object wise. Form wise, there are two broad categories of business organizations (partnerships and
companies) and/or seven sub-categories of them- general partnerships, limited partnerships, limited liability
partnership, joint ventures, share companies, private limited companies and One person private limited company),
according to the Commercial Code (2021). Object wise, there are two types of such organizations- commercial and
noncommercial business organizations.

Those business organizations are regulated by the Ethiopian government through the Ethiopian Investment Board
and the Ethiopian Commercial Code. Businesses must comply with Ethiopian law in order to operate legally in
the country. Ethiopian law requires businesses to obtain a business license from the government in order to operate.
Businesses must also register with the Ethiopian Investment Board and the Ethiopian Commercial Code. Failure to
comply with these requirements can result in fines and other penalties.

The formation of a business organization, except joint venture, shall be of no effect unless established through a
memorandum of association. Each type of business organizations in Ethiopian are discussed here under, and so now
let‘s shade a light on them one by one.
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 1. General partnership;

Generally, a partnership is a business where two or more individuals have ownership. There are three types of
partnerships: limited partnership, general partnership, and limited liability partnership. he three forms differ in
various aspects, but also share similar features. In all forms of partnerships, each partner must contribute resources
such as property, money, skills, or labor to share in the business' profits and losses. At least one partner takes part in
making decisions regarding the business' day-to-day affairs.

A general partnership is a business organization consisting of partners who are each jointly and severally liable with
the partnership itself for the obligations of the partnership. Any agreement to the contrary may not be invoked
against third parties.

A general partnership is a partnership when all partners share in the profits, managerial responsibilities, and liability
for debts equally. If the partners plan to share profits or losses unequally, they should document this in a legal
partnership agreement to avoid future disputes.

In general partnership each partners contribute different resources either in cash or in kind. That is each partner shall
make a contribution in the form of money, movable or immovable property, skill, trademark, goodwill, patent,
copyright, lease right, usufruct or other contributions. In this regard, where the ownership of property is contributed,
the risks shall pass to the partnership in accordance with the provisions of the Civil Code relating to sale. On the
other hand, where only the use of property is contributed, the risks shall remain with the contributing partner unless
the risk is caused by the fault of the partnership.

The formation of a general partnership shall be of no effect unless established through a memorandum of
association. Thus, the memorandum of association of the partnership shall contain the following elements:

 The firm-name;
 The head office and branches, if any;
 The name, address and nationality of each partner;
 The business purpose of the firm;
 The amount of cash contribution of each partner, in the case of in-kind contributions, their value and method
of valuation;
 Where there is a partner contributing skill, the services required from him;
 The share of each partner in the profits and losses, and mode of allocation of profits;
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  The manager and agent, if any, of the partnership, and powers and duties of the manager;
 The period of time for which the partnership has been established;

Each partner shall have the right to participate and vote in meetings of the partnership and share the profits of the
partnership. Further, partners share the assets of the partnership when the firm is dissolved.

Taxes do not flow through a general partnership as they do with a corporation. Instead, each partner's "draw"
(percentage of profits) is declared as income on their respective personal income tax returns.

Regarding to the obligations of the partners, each partner shall pay his contribution to the partnership in due time;
work diligently and with due care to achieve the purpose of the partnership; refrain from handling, either for his own
benefit or for a third person, any business which would be prejudicial to the partnership; be jointly and severally
liable for the debts of the partnership; and discharge other obligations arising out of the memorandum of association
and membership.

Unless otherwise agreed, every partner shall have an equal share in the profits and losses, irrespective of the nature
and amount of contribution he made to the partnership.

2. Limited partnership (LP)

A limited partnership (LP) exists when two or more partners go into business together, but the limited partners are
only liable up to the amount of their investment. A limited partnership comprises partners with different types of
liability: general partners who are in full liable jointly and severally with the partnership itself for the obligations of
the partnership and limited partners who are liable for the obligations of the partnership only to the extent of their
pledged contributions.

A limited partnership (LP)—not to be confused with a limited liability partnership (LLP)—is a partnership made up
of two or more partners. The general partner oversees and runs the business while limited partners do not partake
in managing the business. However, the general partner of a limited partnership has unlimited liability for the debt,
and any limited partners have limited liability up to the amount of their investment.

LPs differ from other partnerships in that partners can have limited liability, meaning they are not liable for business
debts that exceed their initial investment. General partners are responsible for the daily management of the limited
partnership and are liable for the company's financial obligations, including debts and litigation. Other contributors,
known as limited (or silent) partners, provide capital but cannot make managerial decisions and are not responsible

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for any debts beyond their initial investment. Limited partners can become personally liable if they take a more
active role in the LP.

The memorandum of association of the limited partnership is similar with a general partnership memorandum.

LP is characterized by:-

 Composed of general partners and limited partners

 Limited partners can not be active in the daily management of the company
 General partners often have personal liability for the company
 LPs are taxed as a partnership
3. Limited liability partnership (LLP)

A limited liability partnership (LLP) is a type of partnership where all partners have limited liability. All partners can
also partake in management activities. This is unlike a limited partnership, where at least one general partner must
have unlimited liability and limited partners cannot be part of management.

A limited liability partnership is a business organization formed by two or more persons to render professional
service and services complementary there to in which the liability of partners is limited to the amount of their
contributions. Only professionals licensed by an appropriate organ to provide professional service or limited liability
partnerships which render a service that is similar or related to the one rendered by the partnership may become
partners. The general manager of the partnership shall be a natural person licensed to practice the profession in
which the partnership engages to provide service.

The partnership has legal personality distinct from that of the partners. The death, bankruptcy, departure from the
partnership or any other fact affecting the partners shall have no impact on the existence, rights or obligations of the
partnership.

LLP is characterized by:-

 Composed of owners often referred to as members,

 Unless otherwise stated, all members have the right to participate in management
 Members often have no liability for the company
 LLCs may be taxed as a partnership
 combines the attributes of a partnership and a corporation

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LLPs are often used for structuring professional services companies, such as law and accounting firms. However,
LLP partners are not responsible for the misconduct or negligence of other partners.

4. Joint venture

It is a secret (discreet) or clandestine type of partnership in that the joint venture agreement as among the venturers
lacks the characteristics of divulgation or publicity or registration or transparency to third parties. It is only one of
the partners (the manager) who is only known to the public as if he is doing his own individual [Link],
the agreement between the manager and the rest of the venturers or the venture per se does not have legal
personality. It can be considered as a partnership because it is subjected to the general principles of partnerships per
Article 271 of the code.

A joint venture is a business organization established by an agreement among two or more persons. It has no legal
personality and its existence is unknown to third parties. Registration formalities required of other business
organizations do not apply to a joint venture. Where a joint venture is made known to third parties (divulgence to
third parties), it shall, as of such date, be regarded, insofar as such parties are concerned, as a general partnership.
Additionally, a joint venture shall be managed by one or more managers who need not be partners. Where no
manager is appointed, all the partners shall have the powers of managers.

A joint venture is often a type of general partnership that remains valid until the completion of a project or a certain
period passes. All partners have an equal right to control the business and share in any profits or losses. They also
have a fiduciary responsibility to act in the best interests of other members as well as the venture.

What makes Joint venture from other types of business is its relation with third parties. Only the manager of a joint
venture is known to third parties. He shall alone be liable for the debts and liabilities of the joint venture. A partner
who is not a manager of a joint venture shall meet liabilities towards the manager of such joint venture only to the
extent fixed in the agreement between the partners. Where a partner who is not a manager takes part in the
management of a joint venture, he shall be jointly and severally liable with the manager to third parties. Every
partner of a joint venture shall deal with third parties in his own name only.

5. Share company (S.c)

Share Company is form of company used especially for commercial purpose to distribute profit to shareholders,
owned by shareholders, distributing the profit proportional to shareholders‘ shares.

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A share company is a company whose capital is fixed in advance and divided into shares and whose liabilities are
met only by the assets of the company. The obligation of the shareholders shall be limited to making the contribution
they pledged to make to the company.

Compared to the rest of business organizations in Ethiopia, this is the most modern and well organized corporate
form. Per Article 304 of the com. code, a share company is a company whose capital is fixed in advance and divided
into shares and whose liabilities are met only by the assets of the company. The concept of limited liability of
shareholders is well practiced here than the rest of the business organizations in that shareholder are liable only to
the extent of their contribution or shareholding. They are always (by their very form) commercial in nature.

It is only such companies in Ethiopia that can participate in a high profile business such as banking and insurance.
They have professional management, such as Board of directors, General Managers, Secretaries, and Auditors,
which is different from ownership (shareholders). Unlike partnerships, their existence is perpetual than contingent.
They are guided by their own statutes (the memorandum of association and articles of association) in addition to the
law and the general meeting of the shareholders. It is only share companies in Ethiopia that can issue negotiable
securities, such as equity instruments (shares) or debt instruments (debentures)

6. Private limited Company (PLC)

A private limited company is a business organization whose capital is fully paid in advance, divided into shares and
whose members are not liable for the debts of the company provided that they have paid up their contributions.
Unlike Share Company, the shares of the private limited company shall not be open for subscription by the public.
The company is characterized by may not having less than two or more than fifty members, and it may not issue
transferable securities.

PLC is the other variety of company in Ethiopia. But viewed under a microscope it is a hybrid of a general
partnership and a share company. For instance, on the one hand, like partnerships it cannot operate in a high-profile
business; it cannot even issue negotiable securities, and there is no ease of transfer of shares to a third party.

On the other hand, like share companies there is the concept of limited liability of partners. In terms of the ceiling
requirement of membership (which is 50) and the initial capital in need to be subscribed (which is 15,000 ETB), it
differs from share companies (where there is no ceiling requirement of membership and initial capital is 50,000
ETB).

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A private limited company is instituted when its capital is paid-up fully and the memorandum of association is
entered in the commercial register. The par value of shares sold in cash shall be deposited before the registration of
the company in a blocked bank account opened in the name of the company under formation.

7. One person private limited company (OPLC)

A one member private limited company is a business organization incorporated by the unilateral declaration of a
single person. A one-person company as a company has only one person as to its member. Furthermore, members of
a company are nothing but subscribers to its memorandum of association, or its shareholders. So, an OPC is
effectively a company that has only one shareholder as its member. An OPLC is a hybrid structure. It combines most
of the benefits of a sole proprietorship and a company from of business. Such companies are generally created
when there is only one founder/promoter for the business. Entrepreneurs whose businesses lie in early stages prefer
to create OPCs instead of sole proprietorship business because of the several advantages that OPCs offer.

The Company has its own legal personality separate and distinct from that of the member. The member shall not be
personally liable for debts due by the company in so far as he has fully made his contribution. Such company can be
formulated by one member private limited company with the capital shall not be less than 15,000 (fifteen thousand)
Ethiopian Birr.

Difference between OPLC and Sole Proprietorship

A sole proprietorship form of business might seem very similar to one-person companies because they both involve
a single person owning the business, but they‘re actually exist some differences between them.

The main difference between the two is the nature of the liabilities they carry. Since an OPC is a separate legal entity
distinguished from its promoter, it has its own assets and liabilities. The promoter is not personally liable to repay
the debts of the company.

On the other hand, sole proprietorships and their proprietors are the same persons. So, the law allows attachment and
sale of promoter‘s own assets in case of non-fulfillment of the business‘ liabilities.

Some major advantages of One Person Company:

 For incorporating an OPC only one person is required and that is the most predominant feature of an OPC.
Hence, we can say that it is a registered form of sole proprietorship. One person is responsible for decision-
making, controlling, and managing the affairs.

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  As it is a registered form of business entity it enjoys the same privileges as a Private Limited Company. The
legality of this type of business form makes it popular among banks and financial institutions
 An OPC can avail various benefits enjoyed by small scale industries like loans are available at a lower
interest rate.
 Any remuneration made to the director will be allowed under deduction under Income Tax Law, unlike
Proprietorship. Also, the benefits of Presumptive Taxation are available subject to Income Tax Law.
 An entrepreneur can take more risks without stressing over the loss of assets as an OPC has limited liability.
This is a sort of encouragement to new, young, and innovative business start-ups.
 All Companies are required to hold annual general meetings in addition to other meetings but One Person
Company is exempt from this. The Resolution signed by the Director and entered in the minutes book is
sufficient, instead of the annual general meeting.

Every Company is required to prepare and file statements that include the balance sheets, Profit and loss account,
cash flow statement, statement of changes in equity, and explanatory notes. In the case of an OPC, a cash flow
statement is not required.

1.3. The role of accounting in business

We live in the information age-a time of communication, and a time when information is a vital resource. In this
information era, how we live, whom we associate with, and the opportunities we have all depend on our access to
and understanding of information.

The same is true for businesses (businesses are one or more individuals selling products or services for profit).
Businesses that have better access to information and that process information more quickly and accurately do the
best. Global computer networks and telecommunications equipment now allow us to get access to all types of
business information. But to take advantage of these, we need knowledge of information systems.

A financial information system is the collecting, processing, and reporting of information to decision makers.
Understanding and processing information is the core of accounting. The kind of information processed in
accounting is financial i.e. of a monetary nature.

Providing information about what businesses own, what they owe, and how they perform is the aim of accounting.

Accounting is, an information and measurement system that identifies, records, and communicates relevant,
reliable, and comparable information about an organization‗s (a business‗s) economic activities.

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Therefore, a study of accounting helps people make better and informed decisions about assessing opportunities,
products, investments, and social and community responsibilities.

But the use of accounting information is not limited to accountants or people in business. You can use accounting
information in your daily life. You can use accounting information to get a loan for a house or to start a new
business.

1.3.1. DEFINITION, IMPORTANCE, AND USERS OF ACCOUNTING INFORMATION

i. Accounting Defined

As a financial information system, accounting is defined as a process of identifying measuring, recording and
communicating economic events of an organization (business or non- business) to interested users of the
information.

Let‗s take a closer look at the activities involved in the process:

The first part of the process – identifying – involves selecting those events that are considered evidence of economic
activity relevant to a particular organization. The sale of goods by Hadiya Super Market, the rendering of service by
Ethiopian Telecommunications Corporation, the payment of salary by the Commercial Bank of Ethiopia, and the
purchase of Building by Unity University are examples of economic events.

Once identified and measured in Birr and cents, economic events are recorded to provide a permanent history of the
financial activities of the organization. Recording consists of keeping a chronological diary of measured events in an
orderly and systematic manner.

In recording, economic events are also classified and summarized. (This will be discussed in detail in chapter-2)

This identifying and recording activity is of little use unless the information is communicated to interested users. The
information is communicated through the preparation and distribution of accounting reports, the most common of
which are called financial statements.

A Vital element in communicating economic events is the accountant‗s ability and responsibility to analyze and
interpret the reported in formation. Analysis involves the use of ratios, percentages, graphs and charts to show the
importance of financial trends and relationships. Interpretation involves explaining to the user the meaning, and
limitation of reported data. The analysis and interpretation part is left for advanced courses in accounting.

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As accounting plays an important role in the decision making process of business entities, it is often called the
language of business. As a result, whether you are an economist a marketer, investor, supplier or any other, to be
successful, you should be able to ―speak and be familiar with the basic terms used in the business environment.

ii. Importance of accounting

The main purpose of accounting is to provide financial information to be used for decision- making. For instance,
Business executives and managers need the financial information provided by the accounting system to help them
plan and control the activities of the business. Outsiders such as bankers, potential investors, and labor unions and
others also need accounting information.

In short the goal of the accounting system is to provide useful information to decision makers. Thus, accounting is
the connecting link between decision makers and business operations.

iii. Users of Accounting Information

Today‗s accountants focus on the ultimate needs of those who use accounting information, whether the users are
inside or outside the business. Accounting is not an end by itself. The information that accounting provides allows
users to make ―reasonable choices among alternative uses of scarce resources in the conduct of business‖

The people who use accounting information basically fall in to two categories: External Users, and Internal Users

A. External Users: External Users of accounting information are parties, which are not directly involved in running
the business enterprise. These include lenders, shareholders (stock holders), suppliers, employees and their
Unions, government (regulatory bodies) and others. External users rely (depend on) accounting information to
help them make better decisions in trying to achieve their goals.

The area of accounting aimed at serving external users is called Financial Accounting. Its main objective is to
provide to external users information through financial statements.

Each external user has its own specified information-need depending up on the decisions to be made. That is to say,
all external users do not have the same intentions (objectives) when they use the information.

In the following paragraphs we will try to discuss how some external users use accounting information.

a) Lenders /Creditors

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Creditors lend money or other resources to an organization. Lenders include banks, mortgage and finance
companies. Lenders look for information to help them assess the ability of borrowers to repay their debts.

b) Share- holders(Stockholders)

Shareholders have legal control over part or all of a corporation. When it comes to a corporation, shareholders are
not directly involved in the management of the corporation. However, as owners, they have claims over the
properties of the organization. Financial reports help to answer shareholders‗questions such as:

 What is the income of the organization for the current and past periods?
 Are the properties adequate to meet business plan?
 Will the business continue to be profitable in the future?

c). Employees and labor Unions

Employees and labor unions are interested in judging the fairness of their wages and assessing future job prospects.
They also use accounting reports as evidence to ask for bonuses, when the organization is successful.

d) Government

The Inland Revenue Authority requires organizations to prepare financial reports, in order to compute taxes.

B. Internal Users: These are persons that are directly involved in managing and operating an organization. They
include managers and other important decision makers. The internal role of accounting is to provide information
to help improve the efficiency and effectiveness of an organization.

The area of accounting aimed at serving the decision-making needs of internal users is called Management
Accounting. Internal users often have access to a lot of private and valuable information.

Internal reports aim to answer questions like:

What are manufacturing costs per-product?

Which service activities are most profitable?
What level of sales is necessary to break even?

1.3.2 BOOKKEEPING VERSUS ACCOUNTING

People often fail to understand the difference between accounting and bookkeeping. Bookkeeping is the process of
recording business activities, and keeping the records. It is the record- making phase of accounting.
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The recording of transactions in Bookkeeping tends to be mechanical and repetitive; it is only a small and probably
the simplest but important part of accounting.

Accounting, on the other hand, includes the design of an information system that meets users‗ needs. The major
goals of accounting are the analysis, interpretation, and use of information. Accounting includes system design,
budgeting, cost analysis, auditing and tax planning and preparation.

A person might become a reasonably proficient bookkeeper in a few weeks or months; however, to become a
professional accountant requires several years of study and experience.

Bookkeeping

Accounting
Figure 1: bookkeeping versus Accounting

[Link] profession of Accounting

If you just joined the accounting profession, you may be wondering what job you will be doing in the future. You
probably would apply your expertise in one of three major fields:

 Public Accounting
 Private Accounting or
 Not – for – profit Accounting

i) 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.

In this area, a certified Public Accountant (CPA) examines the financial statements of companies and expresses
opinion as to the fairness of presentation. When presentation is fair, users consider the statements to be reliable.

Management consulting is another area of public accounting. In this case, the accountant consults the management
generally about the growth and development of the business enterprise.

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ii) Private Accounting

Instead of working in public accounting, an accountant may be an employee of a business enterprise. In private
accounting, you would be involved in one of the following activities:

Cost Accounting: Determining the cost of producing specific products.

Budgeting: Assisting management in quantifying goals concerning revenues, costs of goods sold, and operating
expenses.

General Accounting: recording daily transactions and preparing financial statements and related information.

Accounting information systems: designing both manual and computerized data processing systems.

Tax Accounting: preparing tax returns (-forms to be filled by a company and returned to a taxing authority) and
engaging in tax planning for the company.

Internal Auditing: reviewing a company‗s operations to determine compliance with management policies and
evaluating efficiency of operations.

iii) Not for Profit Accounting

Like businesses that exist to make a profit, 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. In each of these cases, accounting expertise is highly valued.

ACCOUNTING PRINCIPLES AND CONCEPTS

In this chapter, we will discuss three of the accounting principles: Business Entity concept, Cost principle and
Monetary Unit Assumption.

i) Business Entity Concept

Accountants frequently refer to a business organization as an accounting or business entity. A business entity is any
business organization, such as a―supermarket, laundry, barberry, hotel, which exist as an economic unit. For
accounting purposes, each business enterprise has a separate existence from its owners, creditors, employees,
customers and other businesses.

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This separate existence of the business enterprise is known as the business entity concept. Thus, the business entity
should have a completely separate set of records and its financial records and reports should refer only about the
business enterprises.

For example, W/o Muna Mamo has got her own two business enterprises one called Munaye Super Market, and
another hotel called Budena Hotel. Each Business would be considered as an independent economic business unit.
The activities of each business are kept separately from each other and from the owner‗s personal records. Let say
W/O Muna bought a house to live in. This house would not be recorded and reported in the records of either the
supermarket or the hotel.

The personal saving account she has will not as well be included in the financial reports of either one of the
businesses. She must have to open separate bank accounts for the two businesses. The super market should not
record the payment of salary to employees of the hotel.

ii) The cost principle

The cost principle states ―properties and services acquired by business enterprises must be recorded at actual
amounts paid or assumed in acquiring the properties.

For example, Modern Advertising Company is considering the purchase of a building. The seller of the building
offered a price of Birr 10,000 while the buyer first offered a price of Birr 8000. However, after certain bargaining,
the seller agreed to sell the building for Birr 9000

And the buyer paid that amount. According to the―cost principle the buyer has to record the building in its records
at birr 9000- the actual amount paid to get the building.

The buyer may receive an offer of Birr 12,000 for the building a month after if has been acquired. This has no effect
on the accounting records because it doesn‗t originate from an actual exchange. It is simply a mere offer.

If the buyer sells the building for Birr 20,000 after purchasing it, a gain of Birr 11,000 would be realized. The new
owner would use Birr 20,000 as the cost of the building.

In an exchange between a buyer and a seller, both attempt to get the best price. Only amounts agreed up on and paid
are objective enough for accounting purposes.

17
iii). Monetary Unit Assumption

All business activities (events) are recorded in terms of money (-Birr, Dollar, Pound or any other currency). Of
course, information of a non -financial nature can be recorded, but it is only through the recording of dollar (Birr)
amounts that the activities of a business can be measured. Money is the only factor common to all business activities.
Therefore, it is the only practical unit of measurement that can produce financial data that can be compared.

The monetary unit used by a business depends on the country in which it exists. For example, in Ethiopia the basic
unit of measurement is the birr, as is the dollar in the U.S.A, and Pound Sterling in the United Kingdom.

1.5. Overview of International Financial Reporting Standards (IFRS)

Accounting is the universal language of business. One noted economist and politician indicated that the single-most
important innovation shaping capital markets was the development of sound accounting principles. The essential
characteristics of accounting are (1) the identification, measurement, and communication of financial information
about (2) economic entities to (3) interested parties. From this definition of accounting we can understand
accounting is all about recording transaction and communicating entities information to interested users. To
accomplish this accounting has various fields. For instance, financial accounting is the process that culminates in the
preparation of financial reports on the enterprise for use by both internal and external parties. In contrast, managerial
accounting is the process of identifying, measuring, analysing, and communicating financial information needed by
management to plan, control, and evaluates a company‘s operations. Hence, the preparation of that information
requires the use of some specified guideline (accounting standards). These accounting standards (criteria) include
generally accepted accounting principle (GAAP), International public sector accounting standard (IPSAS) and
International financial reporting standards (IFRS). These accounting standards make financial report consistent and
universally acceptable.

International Financial Reporting Standards (IFRS) are a set of accounting standards that govern how particular
types of transactions and events should be reported in financial statements. They were developed and are maintained
by the International Accounting Standards Board (IASB). The IASB‘s objective is that the standards be applied on a
globally consistent basis to provide investors and other users of financial statements with the ability to compare the
financial performance of publicly listed companies on a like-for-like basis with their international peers.

International Financial Reporting Standards (IFRS) are a set of international accounting standards stating
how particular types of transactions and other events should be reported in financial statements. IFRS specify
exactly how accountants must maintain and report their accounts. IFRS were established in order to have a
18
common accounting language, so business and accounts can be understood from company to company and country
to country.

The point of IFRS is to maintain stability and transparency throughout the financial world. This allows businesses
and individual investors to make educated financial decisions, as they are able to see exactly what has been
happening with a company in which they wish to invest.

IFRS Standards are now mandated for use by more than 143 countries, including Ethiopia and by more than two-
thirds of the G20. The G20 and other international organizations have consistently supported the work of the board
and its mission of global accounting standard. In the countries that have adopted IFRS, both companies and investors
benefit from using the system, since investors are more likely to put money into a company if the company's
business practices are transparent. Also, the cost of investments is usually lower. Companies that do a lot of
international business benefit the most from IFRS.

IFRS are sometimes confused with International Accounting Standards (IAS), which are older standards that IFRS
replaced in 2000. IAS was issued from 1973 to 2000. Likewise, the International Accounting Standards Board
(IASB) replaced the International Accounting Standards Committee (IASC) in 2001.

Accounting provides the companies, investors, regulators and others with a standardized way to describe the
financial performance of their respective entities. The Accounting standards present the preparers of financial
statements with a set of rules to abide by when preparing an entity‘s accounts, ensuring this standardization
across the market. The companies listed on public stock exchanges are legally required to publish financial
statements in accordance with the relevant accounting standards. These standards are known as International
Financial Reporting Standards. As we have already got involved with the globalization of business and we often
refer the world as a global village, hence it becomes very much important to speak about the business in a global
language which is understandable as well as comparable by many

IFRS cover a wide range of accounting activities. There are certain aspects of business practice for which IFRS set
mandatory rules.

 Statement of Financial Position: This is also known as a balance sheet. IFRS influence the ways in which the
components of a balance sheet are reported.
 Statement of Comprehensive Income: This can take the form of one statement, or it can be separated into a
profit and loss statement and a statement of other income, including property and equipment.

19
  Statement of Changes in Equity: Also known as a statement of retained earnings, this documents the
company's change in earnings or profit for the given financial period.
 Statement of Cash Flow: This report summarizes the company's financial transactions in the given period,
separating cash flow into Operations, Investing, and Financing.
 In addition to these basic reports, a company must also give a summary of its accounting policies. The full
report is often seen side by side with the previous report, to show the changes in profit and loss. A parent
company must create separate account reports for each of its subsidiary companies

The goal of IFRS is to provide a global framework for how public companies prepare and disclose their financial
statements. IFRS provides general guidance for the preparation of financial statements, rather than setting rules for
industry-specific reporting. Having an international standard is especially important for large companies that have
subsidiaries in different countries. Adopting a single set of worldwide standards will simplify accounting
procedures by allowing a company to use one reporting language throughout. A single standard will also provide
investors and auditors with a cohesive view of finances.

1.6. Overview of financial reporting requirements in Ethiopia and AABE

The Accountants and Auditors Board of Ethiopia (AABE) is the statutory body established in terms of the Financial
Reporting Proclamation 847/2014, with the primary purpose of protecting the public interest. To achieve this, AABE
is responsible for regulating the profession as well as for issuing a national professional accountancy qualification
that is recognized internationally. Among others, its responsibilities include setting accounting and auditing
standards and code of conduct to regulate the behaviour of professionals; register and certify professionals and firms
to provide such services; review and monitor the work of professionals and firms rendering accountancy and/or audit
services and reporting entities; providing professional qualification training, supporting education and continuous
professional development programs; enforcing the financial reporting law and taking disciplinary measures on those
who do not comply with the provisions of the law and the regulation set by the Government and directives, other
relevant policies and guidelines issued by the Board.

AABE has clear and realistic statutory objectives which are stated hereunder:

 Promote high quality reporting of financial and related information by reporting entities;
 Promote the highest professional standards among auditors and accountants;
 Promote the quality of accounting and auditing services;
 Ensure the accountancy profession is used in the public interest;

20
  Protect the professional independence of accountants and auditors.

In order to achieve the above statutory objectives, AABE will endeavour to:

 Support and promote building necessary institutional capacity to strengthen the accountancy profession;
 Support and promote the establishment of strong Professional Accountancy Organizations in Ethiopia;
 Build a strong accountancy profession;
 Support the establishment of a local strong CPA qualification with international recognition;
 Support and promote compliance with international standards by applicable reporting entities and auditors.

AABEs are aiming to be a robust oversight body of the accountancy profession with responsibilities including
standards setting, strengthening the accountancy profession, administering professional accountancy examinations,
and registration of reporting entities. It promote audit quality and protect the public interest through functions such
as authorization and registration of practicing accountants and auditors, determination of standards and other
professional requirements, as well as administrating of the practice monitoring programme, complaints and
disciplinary procedures. It desire to increase the number of qualified professional accountants in the country and
enhance the quality of financial reporting, necessary for protecting the public interest.

AABEs are a regulator as well as a facilitator to achieve high quality reporting of financial and related information
by reporting entities that will promote confidence in corporate reporting and ensure governance. As a governmental
arm, it will make use of its powers to achieve the ultimate objective which is enhancing the credibility of financial
reporting by improving the quality of accountancy and audit services. Such endeavour will produce a healthy
corporate environment which serves various stakeholders such as business community, investors, employees and
other interested parties and promotes investment.

Quality corporate reporting and governance will enhance the strength of the Ethiopian economy in a global market
which is increasingly becoming more complex and competitive. AABEs are committed towards the nation through
ensuring consistency and transparency in corporate reporting and governance. In all its activities it will seeks to act
in the public interest and we will adopt a consultative approach with all relevant stakeholders, such as, reporting
entities which include State Owned Public Enterprises, preparers of accounts and professional accountants. It will
works in close collaborations with other regulatory bodies and government agencies namely the National Bank of
Ethiopia, the Ethiopian Commodity Exchange Authority, the Ethiopian Revenue and Customs Authority,
Privatisation and Public Enterprises Supervisory Agency, trading license issuing bodies, etc. as there is a strong need

21
for the various regulatory bodies concerned with different aspects of financial reporting to improve the coordination
of their activities, all within a coherent and consistent legislative framework.

AABE will strive for an oversight regime that is comprehensive, efficient and effective, ensuring there are no
regulatory gaps and duplications and that stakeholder expectation are properly managed. Not all reporting entities
successfully manage the interface between the general purpose and the regulatory reporting. There is a need to
minimize the differences between them. This minimizes the incremental costs of multiple reporting and also
leverages the enforcement role of regulatory bodies with respect to the general purpose of financial reporting.

Existing regulatory institutions lack the resources and methodologies required to monitor and enforce accounting
and auditing requirements. Where such regulators are concerned primarily with the respect of their own special
purpose requirements, the contribution of their activities to the quality of the general purpose financial statements
made publicly available is constrained.

Additional problems arise in the case of public interest entities that do not operate in regulated activities. Learning,
training and capacity building will therefore be major areas of focus to ensure our oversight effectiveness and
success.

Its members trust the professional Accountants/Auditors/Consultants to support the reporting entities and the
business community at large in achieving quality in corporate reporting and governance. However, we also
acknowledge that it is practically impossible to achieve a system where there is a no corporate failure in reporting
and governance. Nevertheless, we will use all our powers and influence in order to come as close as possible to a
zero-failure system.

The five key elements (―pillars‖) are for AABE to be; relevant, sustainable, independent, reputable & reliable, and
adaptable.

The achievements of all the five key elements (Pillars) are critical for AABEs to deliver on our mandate and realise
its vision.

Key Element 1: Relevant

We will endeavour to be and remain contemporary and customer focused to meet the needs of our staff,
professionals, reporting entities, Government, other stakeholders and our mandate.

Key Element 2: Sustainable

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We will adopt practices that will ensure our continued viable existence without adverse effect on our people, finance,
customers and the public.

Key Element 3: Independent

We will remain to be independent and structurally free from any connections to the profession and manage the
complexities of such arrangement in order to deliver efficient and effective regulatory oversight avoiding any
potential perceptions of self-regulation.

Key Element 4: Reputable and Reliable

We will work hard to build strong professional reputation and reliability to ensure that we earn and maintain the
confidence of our stakeholders as the centre of excellence and source of authority on accounting, financial reporting,
and auditing issues and protector of the public interest. Key Element 5: Adaptable We will remain aware of
developments in the ever changing external environment and respond to changes in the environment and/or be able
to shape them.

Key Element 5: Adaptable

We will remain aware of developments in the ever changing external environment and respond to changes in the
environment and/or be able to shape them.

Financial reporting requirements in Ethiopia

The Accounting and Auditing Board of Ethiopia believes that it will be in the best interest of the nation to adopt
IFRS as issued by the International Accounting Standard Board. Accordingly, regarding to the financial reporting
requirements in Ethiopia all organization mandatory prepare their financial report according to established criteria.

Since July 8, 2016 all financial institutions and large public enterprises were recommended for adoption of IFRS in
preparing financial report. However, mandatory reporting for these reporting entities shall be July 7, 2017. This
means that all financial institutions and government owned (Federal and Regional) public enterprises in Ethiopia will
statutorily be required to issue IFRS based financial statements for the year ending July 7, 2017.

All other public interest entities (ECX member companies and reporting entities that meet the qualitative thresholds
for PIE) and Charities and Societies are expected to mandatorily adopt IFRS and IPSAs (for Charities and Societies),
for statutory purposes, by July 8, 2017. This means that all other public interest entities and Charities and Societies

23
in Ethiopia will statutorily be required to issue IFRS and IPSAs based financial statements respectively for the year
ending July 7, 2018.

Finally, IFRS for SMEs shall mandatorily be adopted as at July 8, 2018. This means that all Small and Medium-
sized Entities in Ethiopia will statutorily be required to issue IFRS based financial statements for the year ending
July 7, 2019.

1.7 The accounting equation and elements of the equation

Business transactions are economic events that should be recorded because they affect the financial position
of the business enterprise. These businesses transactions are the raw materials of accounting reports, as
cotton is a raw material for a textile factory.

A transaction can be an exchange (such as the purchase or sale of property, payment or collection of a loan
etc.) between two or more parties. A transaction can also be an event that has the same effect as an
exchange transaction but doesn‗t involve an exchange transaction. Some examples of ―non exchange‖
transactions are losses from fire, flood; physical wear and tear on equipment; donation of property and so
forth.
For a given transaction to qualify to be recorded it has:

 To be related to the business enterprise.

 To be measurable in terms of money.
 To be completed / happened/ action.

It should not be a mere promise or intention; it must be at least partially completed to be recorded

1.7.1 Elements of the equation: Assets, Liabilities and Owner’s Equity

A double-entry accounting system is based on the accounting equation. The elements of the equation are assets,
liabilities and owner‘s equity.

o ASSET. A resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity.
o LIABILITY. A present obligation of the entity arising from past events, the settlement of which is expected
to result in an outflow from the entity of resources embodying economic benefits.
o EQUITY. The residual interest in the assets of the entity after deducting all its liabilities

24
The elements of income and expenses are defined as follows. If you have noticed, in any organization you will find
properties such as a building, furniture, land, vehicles and the like. Such properties owned by business enterprises
are referred to as Assets. To buy these assets, businesses get money from two sources: investments made by owners
or amounts borrowed from creditors. Therefore, both owners and creditors have a claim over the assets of the
business enterprise. The claims or rights of owners are referred to as Equities. If the assets owned by a business
amount to Birr 50,000 the equities in the assets must also amount to Birr 50,000. The relationship between the two
may be stated in the form of an equation, as follows:

Economic Resources = claims over the resources

Assets = Equities.

Equity may be subdivided in to two principal types: the rights of creditors and the rights of owners. The
rights of creditors represent debts of the business and are called Liabilities. The rights of owners are called
Owners’ Equity (capital).

Assets = Equities

Equities = Liability + Owner’s equity

This equation can be written as:

Assets= liability + Owner’s Equity

It is customary to place ―liabilities ―before ―Owners equity in the accounting equation because
creditors have priority (preferential) rights to the assets. Because of this, the owners have a residual claim
over the assets.

To help you understand this, assume X Company has total assets of Br. 5000, liabilities of Br 2000 and
owner‗s equity of Br 3000. If the business is to be closed, the assets of the company will be sold and
distributed to the claimants. In accounting, the Owner‗s are given their share after the creditors are given
their entire share. For example, assume the assets are sold for Br 4,500. The creditors will be given their
share of Br. 2,000 and whatever remained (Br.2,500)is given to the owners. If the assets were sold for Br.
7,000, the creditors would have been given their share of Br. 2,000 and the remaining balance Br 5,000
would have been given to the owners.

25
 Assets Liabilities
&
Capital

As you can notice, the owners are given whatever is left (it could be greater or less than their share). That is
why we said owners have residual claim over the assets of the business whereas creditors are said to have
priority clam over the assets as they are paid first.

1.8 Business transactions and financial statements

Dear students, this section presents business transaction and financial statements. Transactions or events are
a prerequisite for preparing financial statements.

1.8.1 Business transactions

All business transactions from the simplest to the complex can be stated in terms of the resulting
effect on the three basic elements of the accounting equation.
However, it is important to remember that each transaction leaves the equation in balance. Assets
always equal the sum of liabilities and owner‗s equity.

Let‗s examine the effects of some of the most common business transactions on the accounting equation.
As a means of illustration, suppose Ato Dawit Gemechu establishes a sole proprietorship to be known as
Effective Garage, on September1,200x. During September, the business engages in the following
transactions:

Transaction (1) - Owner’s investment

AtoDawit starts business by depositing Br. 100,000in a bank account opened in the name of Effective
Garage. The transfer of cash from the owner to the business is on owner‗s investment. The effect of the
transaction is to increase the assets (Cash) on the left side of the accounting equation by Birr 100,000 and to
increase owner‗s equity by the same amount.

Assets = Liabilities+ Owner‗s Equity

Cash DawitGemechu, Capital

Tran.1 + Br. 100,000 +Br. 100,000
Balance Br. 100,000 Br. 100,000
26
At this point, the company has no liabilities; the only party having claim over the assets of the company is
the owner.
N.B. the equation relates only to the business enterprise. Ato Dawit‗s personal assets, such as his home and
personal bank account and personal liability are excluded from consideration. The business must be treated
as a separate entity.

Transaction (2)- Purchase of land for cash

Effective Garage bought land for Birr 20,000 in cash, to be used as a future site for the business. This
transaction changes the composition of the assets but it doesn‗t change the total amount of assets. It has no
effect on the liability and owner‗s equity of the business.
Assets = Liabilities + Owner‗s Equity
Cash + Land Dawit Gemechu, Capital.
Bal. Birr 100,000 Birr 100,000
Tran. 2 -20,000 +20,000 _-
[Link] 80,000+ Br.20,000 _100,000
After the above transaction, the company will have less cash but a new asset (land ). The total assets (cash
+ Land) amount to Birr 100,000, which is equal to the owner‗s equity.

Transaction (3) -Purchase of Supplies on credit

AtoDawit bought office supplies for birr 2,500 on credit, to be used by the business. Assets can be
purchased on credit (on account) basis, where the buyer promises to pay in the future. This type of
transaction is called a purchase on account and it results in a liability to the buyer; the liability created when
something is bought on credit is called Accounts Payable.

Assets = Liability + Owners Equity

Cash+ Supplies+ Land Accounts payable Dawit Gem, Captal
Bal. Birr 80,000 Br.20, 000 Birr 100,000
Tran (3) - +2,500 - + 2,500 -
Bal. Br. 80,000 2,500 20,000 2,500 100,000
Birr 102,500 Birr 102,500

Goods that are physical consumed, such as a chalk to a school, gas oil for car, and stationery materials for
an office, are called supplies.

27
Transaction (4) – Payment of liability
Effective Garage paid Birr. 1,500 to creditors on account. As you might have noticed, the business bought
the supplies in transaction ―C‖ by promising to pay in the future, and as per the promise made it is now
settling its liability. The effect of this transaction on the accounting equation is as follows:
Assets = Liability + Owners Equity
Cash+ Supplies+ Land Accounts payable Dawit Gem, Captal
Bal Br 80,000 Br. 2,500 Br.20, 000 Birr 2,500 Birr 100,000
Tran.4 -1,500 - - -1,500 -
Bal. Br.78,500 Br.2,500 Br.20,000 Birr1,000 Birr 100,000
Birr 101,000 Birr 101,000

As a result of the transaction, the total cash decreases by birr 1,500 because cash is paid and the liability of
the company also decreases by the same amount. After the above transaction is completed, the total amount
the company has to pay in the future is only birr 1,000. Please note that the transaction has no effect on the
supplies that were bought oncredit.

Transaction 5 – Selling of service

The amount charged to customers for goods or services sold to them is called revenue. For instance, the
amount of money that you pay to a shopkeeper after buying a pair of shoes or something is revenue to the
shopkeeper. Different titles may be used for revenue depending up on the source of revenue. For example, a
service fee for a garage, interest revenue for interest earned by a bank, rent income for revenues that result
from renting rooms, fares earned for revenues from a taxi service and others.

During the first month of operation, Effective Garage earned service Fees of Birr 30,000 receiving the
amount in cash for the garage services it rendered.

The effect of this transaction is to increase assets (because cash is collected) and to increase owner‗s equity
by the same amount as revenue is earned.
Assets = Liability + Owners Equity
Cash+ Supplies+ Land Accounts payable Dawit Gem, Captal
Bal Br 78,500 Br. 2,500 Br.20, 000 Birr 1,000 Birr 100,000
30,000 - - - 30,000
Bol. Br.108,500 Br.2,500 Br.20,000 Birr1,000 Birr 130,000
Birr 131,000 Birr 131,000
28
Service can be given for cash or on credit. In this example, the service is given for cash (i.e., the company
collects the cash on the spot service was given). But instead of requiring customers to pay at the time of
sale, a business may let the customers to pay in the future. Such expected collections in the future result in
an Accounts Receivable to the company.

An accounts receivable is as much an asset as cash to the business enterprise. And the revenue from the sale
of the service or good on credit is realized and recorded on the date of sale without waiting for the
collection of the cash.

Transaction (6) - Recording Expenses

To generate revenue, Effective Garage has to hire employees and pay salary, it has to consume electric
power and water resource and pay the bill, and so forth. The amounts of such cash payments and using up
of supplies are expenses to the business. That is, an expense is the amount of assets consumed or services
used in the process of generating revenue. Just as revenues are recorded when they are earned, expenses are
recorded when they are incurred (i.e. when the obligation to pay them arises).

During the month of September, Effective Garage paid Birr 15,000 for different types of expenses (birr
10,000 to salary of employees, birr 3000 Telephone, birr 1,500 for rent, and birr 500 for advertisement).

The effect of these transactions is to decrease assets (because cash is paid) and decrease owner‗s equity.
This can be stated on the accounting equation as follows:
Assets = Liability + OwnersEquity
Cash+ Supplies + Land Accounts payable DawitGem,Captal

Bal Br108,500 Br.2,500 Br.20,000 Birr1,000 Birr130,000

-15,000 - - - -15,000
[Link].93,500 Br.2,500 Br.20,000 Birr1,000 Birr115,000
Birr116,000 Birr116,000

Transaction – 7 Owner’s Withdrawal

Ato Dawit Gemechu, the owner, withdrew Birr 3000 for his personal from the business. Such assets taken
out of the business for the owner‗s personal use, by the owner are called withdrawals. Owners can
withdraw in cash or in kind. For example, an owner of a super market can withdraw soap or something for
his personal benefit instead of cash.

The effect of the transaction in our case is to decrease assets as cash is taken out, and decrease owner‗s

29
Equity by the same amount. This can be stated on the accounting equation as follows:

Assets = Liability + Owners Equity

Summary Cash+ Supplies+ Land Accounts payable Dawit Gem, Captal
Bal Br 93, 500 Br. 2,500 Br.20, 000 Birr 1,000 Birr 115,000
-3,000 - - - -3,000
Bol. Br.90,500 Br.2,500 Br.20,000 Birr1,000 Birr 112,000
Birr 113,000 Birr 113,000

The transactions of Effective Garage can be summarized in a tabular form as shown below. Number
identifies the transactions here and the balance of each item is shown after each transaction.
Type of
Tra. Accounts Dawit Gem. owner‗s
Cash+ Supplies + Land
No Payable Capital Transaction

1 +100,000 - - - + 100,000 Owners

Investment

Bal Birr 100,000 - - - Birr 100,000

2 -20,000 - + 20,000 - -
Bal Birr 80,000 - Birr 20,000 - Birr 100,000
3 - +2500 +2500
Bal Birr 80,000 Birr 2,500 Birr 20,000 Birr2500 Birr 100,000
4 -1,500 - -1500
Bal Birr 78,500 Birr 2,500 Birr 20,000 Birr1,000 Birr 100,000
5 + 30,000 - - - + 30,000 Service fee
Bal Birr 108,500 Birr 2,500 Birr 20,000 Birr1,000 Birr 100,000
6 -15,000 - - - -10,000 Salary Exp.
-3000 Teleph. Exp

- - - - -1500 Rent Exp.

-500 Adv. Exp.

Bal Birr 93,500 Birr 2500 Birr 20,000 Birr 1000 Birr 115,000
7 -3,000 - - - -3000 Owner‗s
withdrowal

30
 Bal Birr 90,500 Birr 2500 Birr 20,000 Birr 1,000 Birr 112,000
Total Assets =Birr 113,000 Total Liabilities and Owner‗s Equity = Birr
113,000

ASSETS LIABLITY OWNER DISCRIBTII

EQUETIES ON

The following Observations, which apply to all types of Businesses, should be noted:

The effect of every transaction can be stated in terms of increases and /or decreases in one or more of the elements of
the accounting equation.

Owner‘s Equity

Decreased by: Increased by:

Owner‗s withdrawals Owner‗s Investment
and Expenses and Revenues

The equality of the two sides of the accounting equation is always maintained.

The owner‗s investment and revenues increase the owner‗s equity. Withdrawals and expenses during the period
decrease the owner‗s equity. The effect of these four types of transactions on owner‗s equity can be illustrated as
follows:

The relationship of the above elements and their effect on the capital balance can be shown as:

EC=BC+I–W+R-E

Where:

EC – End Capital Balance W - Owner‗s Withdrawals

BC - Beginning Capital Balance R - Revenue

I-Owner‗s Investment E-Expense

1.8.2 Financial statements

Financial statements are written records that convey the business activities and the financial performance of a
company. Financial statements are often audited by government agencies, accountants, firms, etc. to ensure accuracy
and for tax, financing, or investing purposes. For-profit primary financial statements include the balance sheet,
31
income statement, statement of cash flow, and statement of changes in equity. Non-profit entities use a similar but
different set of financial statements.

Financial statements are a set of documents that show your company‘s financial status at a specific point in time.
They include key data on what your company owns and owes and how much money it has made and spent. There
are four main financial statements:

 balance sheet  Owner‘s Equity Statement

 income statement  cash flow statement

In addition to the above types of financial statements international financial reporting standard (IFRS) requires firms
to provide notes to financial statements.

Financial statements may be prepared for different timeframes. Annual financial statements cover the company‘s
latest fiscal year. Companies may also prepare interim financial statements on a monthly, quarterly or semi-annual
basis.

1. Income Statement

Often, the first place an investor or analyst will look is the income statement. The income statement shows the
performance of the business throughout each period, displaying sales revenue at the very top. The statement then
deducts the cost of goods sold (COGS) to find gross profit.

The income statement is a financial statement that summarizes the amount of revenues earned and expenses incurred
by a business over a period of time. It reports the profitability of the business by comparing revenues and expenses
for a stated period of time such as a month or a year. In accounting profitability is measured for a period of time than
on a daily basis. Though measuring daily could be possible, it will not be practical and beneficial to the business
enterprise.

If the revenue of a period is exceeds the expenses of that same period, net income results. If expenses are greater
than the revenues of a period, we say there is a net loss, that is, the business has operated unprofitably.

N.B. The determination of periodic net income (net loss) is a matching process involving two steps. First revenues
earned are recognized during the period. Second, the expenses incurred to generate revenues are matched
(compared) against revenues to determine net income or net loss.

All financial statements have a heading that you can find in any kind of a report. The heading of these statements
identifies the company, the type of statement, and the time period covered by the statement.

Note that the primary focus of the income statement is reporting the success or profitability of the company‗s
operations over a specified period of time. To indicate that it applies for a period of time, the income statement is
dated ―For the month ended.

The following is an income statement for Effective Garage for the month ended September 30, 200x.

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 Effective Garage

Income statement

For the Month Ended September 30,200x

Revenues:
Service Fee Birr 30,000.00
Less: - Expenses:
Salary Expense Birr 10,000.00
Telephone Expense 3,000.00
Rent Expense 1,500.00
Advertising Expense 500.00
Total Expenses 15,000.00
Net Income Birr 15,000.00

2. Balance Sheet
The balance sheet displays the company‘s assets, liabilities, and shareholders‘ equity at a point in time. The two
sides of the balance sheet must balance: assets must equal liabilities plus equity. The asset section begins with cash
and equivalents, which should equal the balance found at the end of the cash flow statement.

The balance sheet then displays the ending balance in each major account from period to period. Net income from
the income statement flows into the balance sheet as a change in retained earnings (adjusted for payment of
dividends).

The balance sheet, sometimes called the statement of financial Position, lists the company‗s assets, liabilities and
owner‗s equity as of a specific date- usually at the end of a month or year.

Shown below is the balance sheet for Effective Garage as of September 30, 200x. The balance sheet heading
contains the name of the company, the type of statement, and the specific date on which assets; liabilities and
owner‗s equity are identified and measured.

The total assets must equal the total liabilities and owner‗s equity. There are tow commonly used formats of the
balance sheet:

The account format

Which lists assets on the left side and equities (i.e. liability and owner‗s equity) on the right side? It resembles a
basic accounting format called an ‗account‗to be introduced in unit 2

Assets = Liability +Owner‘s Equity

The Report Format

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 -Lists assets, Liability and Owner‗s equity vertically

Assets
=
Liability
+
Owner’s Equity

You can choose either of the two formats for your balance sheet preparation. The following is a balance sheet
prepared for effective Garage based on the sample transactions illustrated in the chapter.

Effective Garage
Balance Sheet
September 30,200x

Assets : Liability:
Cash…............Birr90,500.00 Accounts payable…… Birr 1,000.00
Supplies ................... 2,500.00 Owner’s Equity:
Land ...................... 20,000.00 AtoDawit Gem., Capital Br12, 000.00.
TotalAssets.......... 113,000.00 Total Liabilities and
Owner’sequity ...........Birr 113,000.00

The double line is drawn only when the total assets on the left side are equal to total liabilities and Owner‗s
equity. In the Effective Garage illustration, only one liability- accounts payable- is reported on the balance
sheet. In most cases, there will be more than one liability. When two or more liabilities are involved, a
customary way of listing is asfollows:

Liabilities
Notes payable Birr 10,000.00
Accounts Payable 1,000.00
Salaries Payable 2,000.00
Total Liabilities Birr 13,000.00

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3..Owner’s Equity Statement
This is a statement that summarizes the changes in owner‗s equity for a specific period of
time. Data for the preparation of owner‗s equity statement are obtained from the owner‗s
equity column of the tabular summary (Illustration 1- ) and from the income statement. The
heading of this statement identifies the company, the type of statement, and the time period
covered by the statement. The time period is the same as that covered by the income
statement and therefore is dated ― For the Month Ended September 30, 200x.‖ The beginning
owner‗s equity amount is shown on the first line of the statement. Then, the owner‗s
investments, net income and the owner‗s drawings are identified in the statement.

The information provided by this statement indicates the reasons why owner‗s
equity has increased or decreased during the period. The Owner‗s equity statement
for effective Garage for the month of September is shown below:

Effective Garage

Statement of Owner’s Equity

For the Month ended September 30,200x

Dawit G. Capital,September1… ..................................................... Birr -0-
Add:Investments .................................................... Birr100,000.00
Netincome ........................................................ 15,000.00 115,000.00
IncreasingO. Equities………………………………………………………...115, 000.00
Less:Drawings…………………………………………………..3,000.00
DawitG. Capital, September30………………………………..Birr112,000.00

1. Cash Flow Statement

The cash flow statement then takes net income and adjusts it for any non-cash expenses. Then
cash inflows and outflows are calculated using changes in the balance sheet. The cash flow
statement displays the change in cash per period, as well as the beginning and ending balance
of cash.

The primary purpose of the statement of cash flows is to provide relevant information about
the cash receipts and cash payments of an enterprise during a period. To achieve this purpose,
the statement of cash flows reports the following: (1) the cash effects of operations during a

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period, (2) investing transactions, (3) financing transactions, and (4) the net increase or
decrease in cash during the period.

Reporting the sources, uses, and net increase or decrease in cash helps investors, creditors,
and others know what is happening to a company‘s most liquid resource. Because most
individuals maintain a check book and prepare a tax return on a cash basis, they can
comprehend the information reported in the statement of cash flows.

Companies classify cash receipts and cash payments during a period into three different
activities in the statement of cash flows—operating, investing, and financing activities,
defined as follows.
1. Operating activities involve the cash effects of transactions that enter into
the determination of net income.
2. Investing activities include making and collecting loans and acquiring and disposing
of investments (both debt and equity) and property, plant, and equipment.
3. Financing activities involve liability and equity items. They include (a) obtaining
resources from owners and providing them with a return on their investment, and
(b) borrowing money from creditors and repaying the amounts borrowed.

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