TOPIC ONE: INTRODUCTION TO FINANCIAL ACCOUNTING

By the end of this topic, the leaner should be able to understand:

 Definition, Nature, and Scope of accounting

 Objectives / purpose of accounting

 Users of accounting information and their respective needs

 Qualities of useful accounting information

 Accounting principles

1.1 Definition, Nature, and Scope of Financial Accounting

Accounting is defined as the process of identifying, measuring and reporting economic

information to the users of this information to permit informed judgment. Many businesses carry

out transactions. Some of these transactions have a financial implication i.e. either cash is

received or paid out. Examples of these transactions include selling goods, buying goods, paying

employees and so many others. Accounting is involved with identifying these transactions

measuring (attaching a value) and reporting on these transactions. If a firm employs a new staff

member then this may not be an accounting transaction. However when the firm pays the

employee salary, then this is related to accounting as cash involved. This has an economic

impact on the organization and will be recorded for accounting purposes. A process is put in

place to collect and record this information; it is then classified and summarized so that it can be

reported to the interested parties.

The main purpose of Accounting is to provide financial information about an economic entity. It

provides a means where the steward reports to the owner how the funds entrusted to him are used

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to enhance the wealth of the business. Business transaction is an event which involves the

transfer of money or money’s worth of financial events. The following summarizes the business

transaction that a firm might have:

 Acquisition of assets from owners and other creditors

 Investing resources in assets to produce goods or services

 Using resources to produce goods and services

 Selling goods or services of the firm

 Paying those to whom money is owned

 Returning assets to owners

The primary purpose of accounting is to provide the information that is needed for sound

economic decision making. The main purpose of financial accounting is to prepare financial

statements that provide information about organization. Financial accounting is performed

according to generally acceptable accounting principles (GAAP) in America and IAS/IFRS in

rest of countries with in the laws and rules of particular country. The purpose of accounting in

any organization is to collect and report on financial information as it relates to the business,

which includes the company’s performance, cash flow and financial position.

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1.2 Objectives of Accounting / purpose of accounting

 Identification and recording of transactions

The primary object of accounting is to identify the financial transactions and to record these

systematically in the books of accounts. As a result, the true nature of each and every transaction

is known without much exercise of memory. With this end in view, the transactions are primarily

recorded in general and in a special journal and later on permanently various accounts are kept in

the ledger.

 Ascertainment of results

Every business concern is interested to know its operating results at the end of a particular

period. The amount of profit or loss for a particular period of a business concern can be

ascertained by preparing an income statement with the help of ledger account balances of

revenue nature. Surplus or deficit of revenue for a particular period of a non-trading concern can

also be ascertained by preparing income and expenditure account or statement.

 Ascertainment of financial affairs

Ascertainment of debts-liabilities, property, and assets i.e. total financial affairs of an

organization at a particular date is another important object of Accounting. Financial affairs of

concern at a particular date can be ascertained by preparing a balance sheet. The balance sheet is

the statement of assets and liabilities of concern at a particular date.

 Keeping accounts of cash

Cash book is a prominent book of the books of accounts. Cash receipts and cash payments are

accounted for in this book. A number of daily cash receipts, payments, cash in hand and cash at

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the bank can be known from this book. Fraud, forgery, and misappropriation of money are

reduced by keeping cash book scientifically and accurately.

 Control over assets and liabilities

For running a business successfully a businessman is to acquire various assets like land, building,

machinery, etc. He is to face various debts and liabilities like accounts payable, notes payable,

loan, bank overdraft, etc. The actual position of these debts-liabilities, property, and assets can

be ascertained through the proper keeping of accounts. A businessman can take the right steps

for controlling the quantity of assets decrease and liability increase.

 Controlling money defalcation and cost

Prevention of money defalcation through fraud and forgery and controlling the cost of concern

are also the main objects of Accounting. Prevention of money defalcation and cost control

become easier if accounts are kept scientifically.

 Providing economic data

Another noble object of accounting is to provide the concerned parties with all economic

information preparing financial statements and reports etc. in time.

 Helping tax fixation

Accounts prepared on the basis of accepted accounting principles in considered reliable to the

income tax and VAT authorities for easy determination and settlement of tax and VAT.

 Determination and evaluation of policy

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The object of accounting is to help the management in determining and evaluating the

management policies in running the business successfully by supplying necessary, information,

interpreting and analyzing the financial statements.

 Testing the arithmetical accuracy of accounts

One of the main objects of scientific methods of accounting is to make sure that accounts have

been kept in a proper way. The arithmetical accuracy of accounts kept in the ledger can be

assured by preparing a trial balance. Agreement of a trial balance is the proof of the arithmetical

accuracy of accounts.

 Acceptability to others

Banks or financial institutions are interested to know the accurate financial position of business

concern for sanctioning loans. On the other hand, the government or other authorities may also

ask about the financial position of business concern for various reasons. In these cases, the

accounts maintained in a disciplined way become easily acceptable to the interested institutions

or authorities.

 Creation of values and accountability

The object of accounts maintained in an acceptable way is to create higher values among

individuals and organizations and thereby creating awareness in preventing money defalcation,

misappropriation of fund and cost control by ensuring transparency and accountability.

 Following legal bindings and prohibition.

As all kinds of business organizations have to abide by some legal bindings and prohibitions,

they are to maintain their accounts accurately.

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For example;

Partnership law, income tax law, and company law, etc. compel business organizations to

maintain their accounts in an appropriate manner. The main objectives of accounting are

maintaining a complete and systematic record of all transactions and analyzing the financial

position of a business. Every individual or a business concern is interested to know the results of

financial transactions and their results are ascertained through the accounting process. A

businessman can ascertain the operating results and financial position of his business at any time

through Accounting.

1.3 Users of Accounting Information

Accounting information is produced in form of financial statement. These financial statements

provide information about an entity financial position, performance and changes in financial

position. Financial position of a firm is what the resources the business has and how much

belongs to the owners and others. The financial performance reflects how the business has

performed, whether it has made profits or losses. Changes in financial positions determine

whether the resources have increased or reduced. The users of accounting information have an

interest in the existence of the firm. Therefore the information contained in the financial

statements will affect the decision making process.

The following are the users of accounting information:

Owners: They have invested in the business and examples of such owners include sole traders,

partners (partnerships) and shareholders (company). They would like to have information on the

financial performance, financial position and changes in financial position. This information will

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enable them to assess how the managers of the business are performing whether the business is

profitable or not and whether to make drawings or put in additional capital.

Customers: Customers rely on the business for goods and services. They would like to know

how the business is performing and its financial position. This information would enable them to

assess whether they can rely on the firm for future supplies.

Managers: The managers are involved in the day-to-day activities of the business. They would

like to have information on the financial position, performance and changes in financial position

so as to determine whether the business is operating as per the plans. In case the plan is not

achieved then the managers come up with appropriate measures (controls) to ensure that the set

plans are met.

Lenders: Lenders are long term providers of capital to the firm. They have provided loans and

others sources of capital to the business. Such lenders include banks and other financial

institutions. They would like to have information on the financial performance and position of

the business to assess whether the business is profitable enough to pay the interest on loans and

whether it has enough resources to pay back the principal amount when it is due.

Government and its agencies: The Government is interested in the financial performance of

the business to be able to assess the tax to be collected in the case there are any profits made by

the business. The other government agencies are interested with the financial position and

performance of the business to be able to come with National Statistics. This statistics measure

the average performance of the economy.

Financial Analyst and Advisors: Financial analyst and advisors interpret the financial

information. Examples include stockbrokers who advise investors on shares to buy in the stock
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market and other professional consultants like accountants. They are interested with the financial

position and performance of the firm so that they can advise their clients on how much is the

value their investment i.e. whether it is profitable or not and what is the value. Others advisors

would include the press who will then pass the information to other relevant users.

Employees: They work for the business/entity. They would like to have information on the

financial position and performance so as to make decisions on their terms of employment. This

information would be important as they can use it to negotiate for better terms including salaries,

training and other benefits. They can also use it to assess whether the firm is financially sound

and therefore their jobs are secure.

Members of the Public: Institutions and other welfare associations and groups represent the

public. They are interested with the financial performance of the firm. This information will be

important for them to assess how socially responsible is the firm. This responsibility is in form

the employment opportunities the firm offers, charitable activities and the effect of firm’s

activities on the environment.

Suppliers: They supply goods or services to the firm. The supplies are either for cash or credit.

The suppliers would like to have information on the financial performance and position so as to

assess whether the business would be able to pay up for the goods and services provided as and

when the payment falls due.

1.3 Accounting Principles

Accounting is a science as well as an art. And like in any field of science there are certain rules

and regulations that accounting must follow. Otherwise, every accountant would have his own

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methods and interpretation of preparing books of accounts. So to standardize the process we

have accounting concepts, accounting principles, and accounting conventions. Accounting may

be defined as the process of recording, classifying, summarizing and interpreting the financial

transactions and communicating the results there of to the persons interested in such information.

In drawing up accounting statements, whether they are external "financial accounts" or

internally-focused "management accounts", a clear objective has to be that the accounts fairly

reflect the true "substance" of the business and the results of its operation. The theory of

accounting has, therefore, developed the concept of a "true and fair view". The true and fair view

is applied in ensuring and assessing whether accounts do indeed portray accurately the business'

activities. To support the application of the "true and fair view", accounting has adopted certain

concepts and conventions which help to ensure that accounting information is presented

accurately and consistently.

It is equally important that accounting users should have a basic understanding of the accounting

concepts to comprehend financial statements. The accountants must have a thorough knowledge

of these conventions to ensure that accounting information is presented accurately and

consistently. Accounting practices should be developed in a way as are consistent with the

generally accepted conventions. Though there is no universally agreed list of fundamental

accounting concepts and principles but in the following we will identify the basic accounting

conventions.

1.3.1 Generally accepted Accounting Principles

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It is a Technical concept that describes the basic rules, concepts, conventions and procedures that

represent accepted accounting practices at a particular time. Accounting principles can be

divided into two parts:

a) Accounting concepts

b) Accounting conventions

1.3.2 Key Differences between Accounting Concept and Convention

The difference between accounting concept and convention are presented in the points given

below:

 Accounting concept is defined as the accounting assumptions which the accountant of a

firm follows while recording business transactions and preparing final accounts.

Conversely, accounting conventions imply procedures and principles that are generally

accepted by the accounting bodies and adopted by the firm to guide at the time of

preparing the financial statement.

 Accounting concept is nothing but a theoretical notion that is applied while preparing

financial statements. On the contrary, accounting conventions are the methods and

procedure which are followed to give a true and fair view of the financial statement.

 While accounting concept is set by the accounting bodies, accounting conventions

emerge out of common accounting practices, which are accepted by general agreement.

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  The accounting concept is basically related to the recording of transactions and

maintenance of accounts. As against, the accounting conventions focus on the preparation

and presentation of financial statements.

 There is no possibility of biases or personal judgement in the adoption of accounting

concept, whereas the possibility of biases is high in case of accounting conventions.

Conclusion

To sum up, the accounting concept and conventions outline those points on which the financial

accounting is based. Accounting concept does not rely on accounting convention, however,

accounting conventions are prepared in the light of accounting concept.

1.3.3 Accounting Concepts and Conventions Advantages or Disadvantages

Merits/Advantages:

(i) Accounting concepts and conventions provide a solid foundation of accounting treatments.

(ii) They guide accountants a theoretical way of dealing with new accounting problems.

(iii) They ensure that financial accounting is developed in a logical and consistent way.

(iv) They provide a theoretical base for setting the accounting standards.

Demerits/Disadvantages:

(i) Accounting concepts and conventions guide accountants that what to do and how to do

without necessarily telling them why to do.

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(ii) The application of a convention relies on individual judgment so this can be used to

manipulate accounting reports.

(iii) One convention may be in conflict with another. For example prudence concept requires

writing off an expense immediately after it arises, whereas, matching convention may suggest

spreading this cost over its entire life which may be more than one year.

(iv) Conventions simply tell us that what accountants do which may be different from what

accountants ought to do.

Accounting Concepts can be understood as the basic accounting assumption, which acts as a

foundation for the preparation of financial statement of an enterprise. Indeed, these form a basis

for formulating the accounting principles, methods and procedures, to record and present the

financial transactions of business. These concepts provide an integrated structure and rational

approach to the accounting process. Every financial transaction that occurs is interpreted taking

into consideration the accounting concepts, which guides the accounting methods.

i. Business Entity Concept: According to this concept business is treated as a separate unit

and distinct from its owners or managers. The concept applies whether the business is a

limited company, partnership or sole proprietorship. If business affairs are mixed with

personal affairs the true picture of the business will not be availed.

ii. Dual Aspect Concept: According to this concept every transaction has two sides at least.

If one account is debited, any other account must be credited. Every business transaction

involves duality of effects. (i) Yielding of that benefit (receiving cash) (ii) The giving of

that benefit (giving the good). It is the basis of double entry bookkeeping.

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iii. Going Concern Concept: This concept assumes that the business will continue to exist

for a long period in the future i.e. for the foreseeable future and that there is no intention

to put the company into liquidation. Financial statements should be prepared under the

going concern basis unless the entity is being (or is going to be) liquidated or if it has

ceased (or is about to cease) trading. The directors of a company must also disclose any

significant doubts about the company’s future if and when they arise. The main

significance of the going concern concept is that the assets of the business should not be

valued at their ‘break-up’ value, which is the amount that they would sell for it they were

sold off piecemeal and the business were thus broken up.

iv. Accounting Period Concept: According to this concept the entire life of the concern is

divided in time intervals for the measurement of profit at frequent times. It was

universally accepted by the IASB that one year becomes the accounting period.

v. Money Measurement Concept: Only those transactions and events are recorded in

accounting which is capable of being expressed in terms of money eg the original cost of

the machinery or goods. The money measurement concept introduces limitations to the

subject matter of accounts. A business may have intangible assets such as the flair of a

good manager or the loyalty of its workforce. These may be important enough to give it a

clear superiority over an otherwise identical business, but because they cannot be

evaluated in monetary terms they do not appear anywhere in the accounts. Accountants

do not account for items unless they can be quantified in monetary terms. Items that are

not accounted for (unless someone is prepared to pay something for them) include things

like workforce skill, morale, market leadership, brand recognition, quality of

management etc.
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 The money measurement concept states that accounts will only deal with those items to

which a monetary value can be attributed. For example, in the statement of financial

position of a business, monetary values can be attributed to such assets as machinery (e.g.

the original cost of the machinery; or the amount it would cost to replace the machinery)

and stocks of goods (e.g. the original cost of goods, or, theoretically, the price at which

the goods are likely to be sold). The monetary measurement concept introduces

limitations to the subject matter of accounts. A business may have intangible assets such

as the flair of a good manager or the loyalty of its workforce. These may be important

enough to give it a clear superiority over an otherwise identical business, but because

they cannot be evaluated in monetary terms they do not appear anywhere in the accounts.

vi. Historical Cost Concept: According to this concept:

 An asset is ordinarily entered in the accounting records at the price paid to acquire it. An

important advantage of this procedure is that the objectivity of accounts is maximized.

There is usually objective, documentary evidence to prove the amount paid to purchase

an asset or pay an expense.

 Historical cost means transactions are recorded at the cost when they occurred. This cost

is the basis for all the subsequent accounting for the years

vii. Matching Concept (accrual concept): states that revenue and costs must be recognized

as they are earned or incurred, not as money is received or paid. They must be matched

with one another so far as their relationship can be established or justifiably assumed, and

dealt with in the profit and loss account of the period to which they relate. In determining

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 the net profit from business operations all cost which is applicable to revenue of the

period should be charged against that. Income should be properly "matched" with the

expenses of a given accounting period.

viii. Realization Concept: According to this concept, revenue is recognized when sale is

made and sale is considered to be made when a goods passes to the buyer and he

becomes legally liable to pay for. The concept states that revenue and profits are not

anticipated but recognized by inclusion in the income statement only when realized in the

form of either cash or of other assets the ultimate cash realization of which can be

assessed with reasonable certainity. With this convention, accounts recognise transactions

(and any profits arising from them) at the point of sale or transfer of legal ownership -

rather than just when cash actually changes hands. For example, a company that makes a

sale to a customer can recognise that sale when the transaction is legal - at the point of

contract. The actual payment due from the customer may not arise until several weeks (or

months) later - if the customer has been granted some credit terms.

ix. Objectivity (neutrality) Concept: an accountant must show objectivity in his work. This

means he should try to strip his answers of any personal opinion or prejudice and should

be as precise and as detailed as the situation warrants. The result oif this should be that

any other accountants will give the same answer independently of each other. Objectivity

means that accountants must be free from bias. They must adopt a neutral stance when

analyzing accounting data. In practice objectivity is difficult. Two accountants faced with

the same accounting data may come to different conclusions as to the correct treatment. It

was to combat subjectivity that accounting standards were developed.

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x. Prudence concept: the prudence concept states that where alternative procedures or

alternative valuations, are possible, the one selected should be the one that gives the most

cautious presentation of the business’s financial position or results. Do not overestimate

revenue or underestimate cost.

The prudence concept states that where alternative procedures, or alternative valuations,

are possible, the one selected should be the one that gives the most cautious presentation

of the business’s financial position or results. Therefore, revenue and profits are not

anticipated but are recognized by inclusion in the profit and loss account only when

realized in the form of either cash or of other assets the ultimate cash realization of

which can be assessed with reasonable certainty: provision is made for all liabilities

(expenses and losses) whether the amount of these is known with certainty or is best

estimate in the light of the information available. Assets and profits should not be

overstated, but a balance must be achieved to prevent the material overstatement of

liabilities or losses. The other aspect of the prudence concept is that where a loss is

foreseen, it should be anticipated and taken into account immediately. If a business

purchases stock for Sh.1, 200 but because of a sudden slump in the market only Sh.900 is

likely to be realized when the stock is sold the prudence concept dictates that the stock

should be valued at Sh.900. It is not enough to wait until the stock is sold, and then

recognize the Sh.300 loss; it must be recognized as soon as it is foreseen.

xi. Substance over form: it’s the principle that transactions and other events are accounted

for and presented in accordance with their substance and economic reality and not merely

their legal form eg a non current asset on hire purchase although is not legally owned by

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 the enterprise until it is fully paid for, it is reflected in the accounts as an asset and

depreciation provided for in the normal accounting way.

1.3.5 Accounting Conventions:

Accounting Conventions, as the name suggest are the practice adopted by an enterprise over a

period of time, that rely on the general agreement between the accounting bodies and helps in

assisting the accountant at the time of preparation of financial statement of the company. For the

purpose of improving quality of financial information, the accountancy bodies of the world may

modify or change any accounting convention. Given below are the basic accounting conventions:

i. Convention of Disclosure: According to this convention accounting reports should

disclose fully and fairly the information they purport to represent. The information

which are of material interest to various users. This principle state that the financial

statement should be prepared in such a way that it fairly discloses all the material

information to the users, so as to help them in taking a rational decision.

ii. Convention of Materiality: The accountant should attach importance to material

details and ignore insignificant. an item is considered material if it’s omission or

misstatement will affect the decision making process of the users. Materiality depends

on the nature and size of the item. Only items material in amount or their nature will

affect the true and fair view given by a set of accounts. In preparing accounts it is

important to assess what is material and what is not, so that time and money are not

wasted in the pursuit of excessive detail. Determining whether or not an item is

material is a very subjective exercise. There is no absolute measure of materiality. It

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 is common to apply a rule of thumb (for example to define material items as those

with a value greater than 5% of the net profit disclosed by the accounts).

iii. Convention of Consistency: This convention describes that accounting principles

and methods should remain consistent in order to enable the management to compare

the results of the two accounting periods. These principles should not be changed year

after year. The consistency concept states that in preparing accounts, consistency

should be observed in two respects.

a. Similar items within a single set of accounts should be given similar accounting

treatment

b. The same treatment should be applied from one period to another in accounting

for similar items. This enables valid comparisons to be made from one period to

the next.

iv. Convention of Conservatism: According to this convention, in the books of

accounts all anticipated losses should be recorded and all anticipated gains should

also be recorded.

1.4 Qualities of useful Financial Information

The four principal qualities of useful financial information are understandability, relevance,

reliability and comparability.

Understandability: an essential quality of the information provided in the financial statements

is that it is readily understandable by users. For these reason users are assumed to have a

reasonable knowledge of business and economic activities and accounting.

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Relevance: information has the quality of being relevant when it influences the economic

decisions of users by helping them evaluate past, present or future events or confirming or

correcting their past evaluations. The relevance of information is affected by its nature and

materiality.

Reliability: information is useful when it is free from material error and bias and can be

depended upon by users to represent faithfully that which it purports to represent or could

reasonably be expected to represent. To be reliable then the information should:

a) Be represented faithfully,

b) Be accounted for and presented in accordance with their substance and economic reality and

not merely their legal form,

c) Be neutral i.e. free from bias,

d) Include some degree of caution especially where uncertainties surround some events and

transactions (prudence),

e) Be complete i.e. must be within the bounds of materiality and cost. An omission can cause

information to be false.

Comparability: users must be able to compare the financial statements of an enterprise through

time in order to identify trends in its financial position and performance. Users must also be able

to compare the financial statements of different accounting policies, changes in the various

policies and the effect of these changes in the accounts. Compliance with accounting standards

also helps achieve this comparability.

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Difference between Book-Keeping and Accounting

Book-keeping means the recording of transactions of a business in methodical manner so that

information relating to them may be quickly obtained. It intends to be mechanical and repetitive.

Accounting includes the design of accounting system, preparation of financial statements, and

development of budgets, cost studies, audits, income tax work, and computer applications to

accounting processes and the analysis and interpretation of accounting information as an aid to

making business decision.

Types of Business Firms

 Proprietorship—a business owned by one person

 Partnership—co-owned by two or more persons

 Limited Companies—owned by investors called stockholders (The business—not the

owners—are responsible for the company’s obligations.)

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