Week Two

Introduction

This chapters continues with introduction to financial accounting provided in lesson one

Expected learning outcomes

By the end of the lesson the learner should be able to.

1. Explain the purposes of accounting

2. Outline limitations of accounting
3. Distinguish between book keeping and accounting
4. Identify and explain accounting concepts and conventions
5. Calculate values of assets, capital or Liabilities using the accounting equation

Purposes of accounting

1. Helps in decision making

2. Ascertain the value of the business
3. To know the profit or loss position
4. Ascertain the assets liabilities of a firm
5. Know the cash and wealth of a business
6. To keep systematic records of financial transactions
7. To protect business properties from unjustified use

Importance of bookkeeping and accounts

1. Ascertaining profit or loss

2. It facilitates credit transactions
3. Assessment of Tax
4. Evaluation of assets and liabilities
5. A tool for control
6. Base for further planning

Limitations of Accounting

1. Records only monetary transactions

2. It does not consider effects of price level changes i.e. they are historical
3. Control over cost is not possible i.e. it is only concerned with recording transactions
4. Does not reveal relative profitability of products
5. It does not assist in pricing i.e. it does not accumulate cost for a single product but rather
for the organization as a whole
6. Financial accounting is summarized and do not provide detailed information necessary
for evaluation and decision making.

Page 1 of 9
Distinction between Accounting and book keeping

Accounting- Refers to the Art of recording ,classifying and summarizing in a significant manner
and in monetary terms ,transactions and events which are in part of financial character and the
interpretation there of.

Book keeping – Refers to the analysis, classification and recording of financial transaction in a
systematic manner in the books of accounts

Book keeping is a part of Accounting that is concerned with the proper maintenance and
recording of transactions and any other relevant information while accounting consists of
analysis and interpretation of the recorded data to report the results to interested parties for
necessary decision making.

Accounting Equation

This equation is based on the basic dual accounting concepts. The equation forms the basis for
the preparation of the balance sheet. Broadly, the accounting equation is stated as: A=C+L where
A represents Assets (Fixed plus current), C represents Capital and L liabilities (both long-term
and short-term). The dual accounting concept states that each transaction affects the accounts of
an enterprise twice. These components of the accounting equation are explained as follows

Assets- These are resources owned and controlled by an entity or individual which will generate
future economic benefits. Assets are classified into two

a) Fixed / Non-Current Assets

These are assets which are expected to be used in the business for a long period of time, usually
longer than one year. These assets are further classified into two

1. Tangible Assets – These are assets with physical presence. They can be seen, felt and
they occupy space. These assets includes;
 Land and Buildings
 Plant and machinery
 Motor vehicles
 Furniture and fittings
 Equipment etc.
2. Intangible Assets- These are assets without physical presence. They cannot be seen nor
felt. Examples include
 Goodwill
 Patents
 Copyrights
 Brand names
 Trademarks etc.

Page 2 of 9
 b) Current Assets – these are assets that are expected to be used in the business for a period
of one year or less. Examples include
 Stocks or inventories
 Debtors or accounts receivable or Trade receivables
 Cash in hand
 Cash at bank
 Prepayments

Liabilities- These are obligations of a business entity. Liabilities just like assets are classified
into two

a) Non-current or long term liabilities- These are obligations of a business that are
expected to be repaid over a period longer than one year. Examples include
 Bonds
 Debentures
 Capital lease
 Bank loans (repayable over a period more than a year)
 Deferred tax liability
b) Current or short term Liabilities- These are obligations of a business that are expected
to be paid over a period less than a year. These includes
 Trade creditors or accounts payable
 Bank overdraft
 Bank loans (one year or less)
 Current tax
 Dividends payable

Capital – This is a resource put into the business by its owner(s). It can be in the form of an
assets or cash

Application of the Accounting Equation

Illustration One

1. Supposing Mr. Wagithomo starts a business with Sh. 100,000 in cash. Use the accounting
equation to illustrate the effect of this transaction

Assets Capital Liabilities

Cash in Hand 100,000 Capital 100,000 Liabilities None

100,000 100,000 0

Page 3 of 9
 2. Supposing again that Mr. Wagithomo purchases goods for resale (Stock) worth Sh.20,
000 in cash.

Assets Capital Liabilities

Cash in Hand 80,000 Capital 100,000 Liabilities None
Stocks 20,000

100,000 100,000 0

3. If Mr. Wagithomo further borrows Sh. 40,000 from Wakulima bank, the effect of this
transaction will be an increase in a liability (loan) and an increase in assets (cash at bank)

Assets Capital Liabilities

Cash in Hand 80,000 Capital 100,000 Bank Loan 40,000
Stocks 20,000
Cash at Bank 40,000

140,000 100,000 40,000

4. Supposing further that Mr. Wagithomo acquires a Motor vehicle on credit from Toyota K
ltd. at a value of Sh. 200,000 and the amount is due within 10 months. The effect will be
that both Assets and liabilities will increase by Sh. 200,000 and the effect will be as
follows

Assets Capital Liabilities

Cash in Hand 80,000 Capital 100,000 Bank Loan 40,000
Stocks 20,000 Toyota K. Ltd 200,000
Cash at Bank 40,000
Motor Vehicle 200,000

340,000 100,000 240,000

Page 4 of 9
 5. Supposing further that Mr. Wagithomo decides to pay the first installment on the loan
from Wakulima bank by drawing a Cheque Sh. 2,000, both liabilities and assets will
reduce as follows

Assets Capital Liabilities

Cash in Hand 80,000 Capital 100,000 Bank Loan 38,000
Stocks 20,000 Toyota K. Ltd 200,000
Cash at Bank 38,000
Motor Vehicle 200,000

338,000 100,000 238,000

6. Supposing now Mr.Wagithomo sells goods whose cost was Sh. 10,000 for Sh. 15,000 in
cash, the effect of this transaction will be illustrated as follows.
1. Mr wagithomo made a profit of sh. 5,000 which increases capital
2. Received cash sh. 15,000 which increases cash in hand
3. Sold goods worth sh. 10,000 reducing the stocks by sh. 10,000
4. Assets Capital Liabilities
Cash in Hand 95,000 Capital 105,000 Bank Loan 38,000
Stocks 10,000 Toyota K. Ltd 200,000
Cash at Bank 38,000
Motor Vehicle 200,000

338,000 100,000 238,000

From the accounting equation A=C+L, two further equations can be derived to compute capital
and Liabilities as follows

1. C = A-L
2. L = A-C

These equations can then be used to calculate any of the missing components of the accounting
equation. Now let’s look at the illustration below

Page 5 of 9
 Using the accounting equation concept, fill in the blank spaces in the table below

Item Assets Capital Liabilities

(i) 1,200,000 ? 350,000
(ii) ? 2,500,000 500,000
(iii) 3,600,000 ? 1,200,000
(iv) 5,200,000 2,000,000 ?
(v) 6,000,000 3,000,000 ?
(vi) 800,000 ? 300,000
(vii) 540,000 320,000 ?
(viii) ? 250,000 1,000,000
(ix) 250,000 50,000 ?

Accounting concepts and Conventions

Accounting Principles

These are rules of action or conduct which are adopted by the accountants universally while
recording accounting transactions. They can be classified into two

1. Accounting Concepts-These are basic assumptions or conditions upon which the science
of accounting is based.
2. Accounting conventions – This includes those customs or traditions which guide the
accountants while preparing the accounting statements

GAAP (Generally Accepted Accounting Practices) is the framework, rules and guidelines of the
financial accounting profession with a purpose of standardizing the accounting concepts,
principles and procedures.

Here are the basic accounting principles and concepts under this framework:

1. Business Entity or Separate entity concept

A business is considered a separate entity from the owner(s) and should be treated separately.
Any personal transactions of its owner should not be recorded in the business accounting book,
vice versa. Unless the owner’s personal transaction involves adding and/or withdrawing
resources from the business.

2. Going Concern

It assumes that an entity will continue to operate indefinitely. In this basis, assets are recorded
based on their original cost and not on market value. Assets are assumed to be used for an
indefinite period of time and not intended to be sold immediately.

Page 6 of 9
 3. Monetary Measurement concept

The business financial transactions recorded and reported should be in monetary unit, such as US
Dollar, Canadian Dollar, Euro, etc. Thus, any non-financial or non-monetary information that
cannot be measured in a monetary unit are not recorded in the accounting books, but instead, a
memorandum will be used.

4. Historical Cost concept

All business resources acquired should be valued and recorded based on the actual cash
equivalent or original cost of acquisition, not the prevailing market value or future value.
Exception to the rule is when the business is in the process of closure and liquidation.

5. Matching concept

This principle requires that revenue recorded, in a given accounting period, should have an
equivalent expense recorded, in order to show the true profit of the business.

6. Accounting Period

This principle entails a business to complete the whole accounting process of a business over a
specific operating time period. It may be monthly, quarterly or annually. For annual accounting
period, it may follow a Calendar or Fiscal Year.

7. Conservatism

This principle states that given two options in the valuation of business transactions, the amount
recorded should be the lower rather than the higher value.

8. Consistency

This principle ensures consistency in the accounting procedures used by the business entity from
one accounting period to the next. It allows fair comparison of financial information between
two accounting periods.

9. Materiality

Ideally, business transactions that may affect the decision of a user of financial information are
considered important or material, thus, must be reported properly. This principle allows errors or
violations of accounting valuation involving immaterial and small amount of recorded business
transaction.

10. Objectivity

This principle requires recorded business transactions should have some form of impartial
supporting evidence or documentation. Also, it entails that bookkeeping and financial recording
should be performed with independence, that’s free of bias and prejudice.
Page 7 of 9
 11. Accruals Concept

This principle requires that revenue should be recorded in the period it is earned, regardless of
the time the cash is received. The same is true for expense. Expense should be recognized and
recorded at the time it is incurred, regardless of the time that cash is paid

12. Duality or Double entry concept

According to this concept every business transaction has a double (dual) effect and must be
recorded twice in the books of accounts. For every debit entry there must be a corresponding
credit entry.

Accounting conventions

a) Full disclosure

According to this convention, accounts reports should disclose fully and fairly the information
they purport to represent. Meaning financial statements should be prepared to reflect a true and
fair view of the financial position and performance of the enterprise. All material and relevant
information must be disclosed in the financial statements

b) Consistency

According to this convention, accounting practices should remain unchanged from one period to
another. For example if stock is valued at cost or market whichever is less this principle should
be followed year after year. Meaning Companies should choose the most suitable accounting
methods and treatments, and consistently apply them in every period. Changes are permitted
only when the new method is considered better and can reflect the true and fair view of the
financial position of the company. The change and its effect on profits should be disclosed in the
financial statements. If a company adopts straight line and should not be changed to adopt
reducing balance method in other period. If a company adopts weight-average method as stock
valuation and should not be changed to other method e.g. first-in-first-out method

c) Materiality

According to this convention, the accountant should attach importance to material details and
ignores insignificant details. Meaning immaterial amounts may be aggregated with the amounts
of a similar nature or function and need not be presented separately Materiality depends on the
size and nature of the item. Small payments such as postage, stationery and cleaning expenses
should not be disclosed separately. They should be grouped together as sundry expenses. The
cost of small-valued assets such as pencils, sharpeners and paper clips should be written off to
the profit and loss accounts as revenue expenditures, although they can last for more than one
accounting period

d) Conservatism (prudence)

Page 8 of 9
 According to this convention, accountant should not take credit for revenue until it has been
realized in cash, but provide for all known liabilities whether known with certainty or reasonable
estimate. Meaning Revenues and profits are not anticipated. Only realized profits with
reasonable certainty are recognized in the profit and loss account. However, provision is made
for all known expenses and losses whether the amount is known for certain or just estimation this
treatment minimizes the reported profits and the valuation of assets

Review questions

1. List five purposes of accounting (5marks)

2. Outline five importance of book keeping and accounts (5marks)
3. Identify any four limitations of accounting (4marks)
4. Differentiate Accounting from Book keeping (4marks)
5. Explain the meaning of Accounting Equation (2marks)
6. Explain the meaning of the following terms as used in the accounting equation
i) Assets (2marks)
ii) Liabilities (2marks)
iii) Capital (2marks)
7. Identify and explain any Five Accounting concepts (10marks)
8. Using the accounting equation fill in the blank spaces (10marks)
No. Assets Capital Liabilities
1 1,500,000 ? 650,000
2 ? 450,000 350,000
3 1,000,000 600,000 ?
4 950,000 ? 375,000
5 945,000 455,000 ?
5 ? 648,000 402,000
7 450,000 ? 185,000
8 ? 275,000 195,000
9 900,000 400,000 ?
10 875,000 ? 325,000

Conclusion

At the end of this chapter the students should be able explain the various accounting terms, solve
the review questions and integrate week one and week to for a coherent flow of the contents

Page 9 of 9