INTRODUCTION TO FINANCIAL ACCOUNTING

Nature and Scope of Accounting

Accounting
It refers to the following:
1. The process of collecting, recording, summarizing, classifying, interpreting and communicating financial
information to permit informed decisions.
2. The Art of communicating financial information about a business to users.
3. The field of accountancy concerned with preparation of financial statements
4. Reporting information in financial statements about firms’ financial performance and financial position to
internal and external users of financial statements and decision makers
Branches of Accounting
Accounting, in all its broadness, can be sub-divided into areas of specialization;
a. Financial accounting; concerns itself with the collection and processing of accounting data and reporting to
interested parties inside and outside the firm.
b. Tax accounting; deals with the determination of the firms’ tax liability which could be, Value added tax
(VAT), customs duty, pay as you earn (PAYE), corporation tax etc.
c. Cost accounting; helps establish costs relating to the production of a good or service and allocating it to the
various factors that contributed to the cost of production.
d. Managerial accounting; deals with the generation of accounting information to be used categorically by the
firms’ internal management in their day-to-day decision making.
e. Auditing; concerns itself with the vouching and verification of transactions from the financial accounting to
determine that they are a true representation of the business’ activity i.e. the true and fair view of the companys’
state of affairs.
Purpose of financial Accounting
1. Reporting information about firms’ financial performance, position, liquidity and profitability to users.
2. Necessary in decision making as it enables managers make optimum decision about a firm. (An optimum
decision is a decision that maximizes benefits and reduces cost).
3. Used for comparison purpose as follows
 Comparison between financial periods e.g. different years.
 Comparison between different businesses in the same industry.
4. Financial Accounts can be used as a reference point to show how the business used to perform in the past.
5. Summarizes a business financial aspect in a way that is understandable.
6. Satisfy the requirement of law especially for listed firms that are required to publish their accounts.
7. Internal control: this may include the safeguarding of organizations’ money and other property, regular
collection and payment of sum of money owing to and by it and prevention of inefficiency, dishonesty, and
wastage.

Limitations of financial Accounting

1. Requires one to be trained in financial accounts so as to understand financial statements.
2. Financial Accounts represent only the financial aspect of a business thus ignore other critical areas in
business like social or environmental aspects. Examples include firm reputation and employee morale
3. Financial Accounting is dynamic thus items in financial statements need to be adjusted regularly in the ever
changing economy. E.g. inflations results in change of prices of commodities.
4. Accounting process may differ between firms because it is influenced by accounting concept or judgement
of the accountant
5. Use of historical information: in financial statements reporting past information is used.
6. Snap-shot information: financial statements are reported as at a given date. This provides information of
‘
financial state which is a static picture’ on that particular day.
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Qualities of Good Accounting Information
 The accounting information must be accurate to enable the users make appropriate and correct business
decisions.
 The accounting information should be up-to-date and comprehensive.
 It should be relevant enough to influence the decision-making of users, that is, capable of making a
difference if it has predictive as well as confirmatory value.
 It should be objective i.e. based on accounting principles and standards.
 Reliable: It refers to the credibility of information to users. Good financial information should be one that
the user can trust and rely on.
 Comparable: It arises if information can be compared with similar information of another entity or the
same entity in different accounting periods.
 Verifiability: It helps assure users that information represents faithfully the economic phenomena it
purports to represent.
 Timeliness: Information is available to decision makers in time to be able to influence their decisions.
 Understandable: Classifying, characterizing and presenting information clearly and concisely makes it
understandable. Financial reports should be prepared by those with reasonable knowledge of business
because they can present information in an understandable way. Users also require having knowledge of
financial reports.

Users of financial information

Users of financial information can be classified into two main categories:
 Internal users
 External users
Internal users
1. Management: Information is used by the firms’ management in decision making of financial issues related to
the firm
2. Internal auditors review, scrutinize and analyze financial records while developing an opinion about
financial statements.
3. Employees: Guides employees on the remuneration they should get based on companys’ financial
performance.
External users
1. The general public: public is able to get an idea of firms’ financial performance and its position.
2. Potential investors and shareholders: they are able to know if a firm is worth investing in depending on its
performance and liquidity.
3. The government: Enables the government identify tax it should collect from a business.
4. Financial Lenders: these are able to identify whether a business is credit worthy. That is the firms’ solvency
in its ability to settle the interest payments and the principal.
5. Shareholders are able to identify dividends and other benefits they should receive depending firms’
performance.
6. External auditors: they normally scrutinize and review the books of accounts in order to find out if they
reflect true and fair information.
7. Suppliers or creditors: these wish to know the liquidity position of the firms. i.e. the ability to meet its
obligations as and when they fall due.
8. Customers: they require to be assured that the business is a steady source of supply in the delivering of
services and goods in times of demand.
9. Research Scholars: they require such information in order to fill the existing gaps of information and further
provide a better incite to existing information.
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Financial Statements
They refer to the end products of the accounting process. They contain the accounting information, which is
presented to the decision makers within or outside the organization. The financial statements are used to assist
the decision makers in evaluating the financial position, profitability and the future prospects of the business
organization.
The financial statements include the following
1. Balance sheet which is the statement showing financial position of a business as at a particular date i.e. It
shows the value of the assets, liabilities and capital of a business at a specific date.
2. Income statement (trading and profit and loss accounts). It shows the profit or losses generated by the
business during a given trading period, (financial performance).
3. Cash flow statements showing the cash inflows (receipts) and cash outflows (payment) of the business
during the trading period. It reconciles profit with cash balance.
4. Statements of retained earnings (profits). The business retains some profits to strengthen its financial base.

Elements of Financial Statements

 Assets
They refer to economic resources owned by the business entity and are expected to benefit the current and the
future operations of the business. e.g. buildings, motor vehicles, stock, furniture etc. Assets are anything of
value owned by a business.
They are classified as follows: i) Non-current assets or fixed assets e.g. premises, plants& machinery,
furniture and fittings, motor vehicle and ii) Current assets, e.g. accounts receivables, cash in hand, cash at
bank, prepayments iii) assets that are neither current nor non-current.
They are categorized as a) Investment assets b) intangible assets e.g. goodwill, patents, copyrights.

 Liabilities
They are debts (obligations) of an entity that have arisen from the past transactions. e.g. borrowed cash from a
bank or goods purchased on credit. They may be classified as: i) long-term liability e.g. long term debts or
loans ii) short-term or current liability e.g. accrued expenses, bank overdrafts, creditors, accounts payable.

 Capital or owner’s equity

This is the owners’ claim against the assets of the business. It consists of the value of economic resources
invested in the business by the owner.

 Income (revenue):
It refers to the amount earned as a result of operations of the business. It is added to capital or the inflow of
assets which results to an increase in owners’ equity. Examples include interest incomes and discount received.

 Expenses
They are amounts incurred in the process of earning revenue. Expenses must be matched to revenues of a
particular year. Examples include salaries & wages , rent, depreciation, advertising expenses, telephone
expenses, discount allowed etc.
The income Statement generated by the business is determined by comparing the income earned and the
expenses incurred within a specified period.

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Uses of the Accounting Information (information in financial statements)
 The accounting information shows the profit or losses generated by the business over a specified trading
period.
 It shows the amount of tax payable to the government which is based on the business profit.
 Provides information about the value of the resources owed to the business by others e.g. debtors.
 Accounting information is used to prepare a budget.
 Accounting information is used in controlling business expenditure.
 Accounting information acts as a management tool when making important decisions of the business.

Accounting Equation
The accounting equation shows the relationship between the value of the assets, capital and liabilities of a
business and this is expressed by the following formula.

ASSETS = CAPITAL + LIABILITIES

 Assets: These are economic resources owned by the business for the purpose of conducting its business
activities.
 Capital: This is the value of economic resources supplied to the business by the owner i.e. it is the owners’
investment in the business also known as owners’ equity.
 Liabilities: This is the value of economic resources borrowed by the business from persons other than the
owner of the business e.g. bank loan, goods bought on credit from suppliers (creditors)

Balance sheet
The accounting equation is presented in a financial statement known as a balance sheet. A balance sheet is a
financial statement showing the financial position of a business as at a particular date i.e. it shows the value of
the assets, liabilities and capital of a business at a specific date.

Below is an example of a simple balance sheet:

Balance Sheet

Assets xxx Capital xxx

Liabilities xxx
xxx xxx

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ACCOUNTING PRINCIPLES
Accounting principles
This refers to fundamental beliefs and guides to accounting practice.
They are classified into two: Accounting Concepts
Accounting Conventions

A. Accounting Concepts
They are basic assumptions in which accounting practice is based. They include the following
1. Accounting Entity or Business entity concept: A business is assumed to be separate and distinct from
individual or other entities. Transactions must therefore be recorded in reference to the business as they
occur. That is, a business and its activities are separate from persons forming it and should therefore be
treated separately.
2. Going concern/Continuity: Business activities and accounts are treated with the assumption that the
business intends to continue indefinitely into the future. Therefore the main significance of this concept is
that the assets of the business should not be valued at their break-up value which is the amount that they
should fetch if they were sold piecemeal.
3. Dual concept- every financial transaction is 2 fold. That is for every change one of the three components
(capital, assets or liability) there must be another change numerically equal but of opposite sign in another
elements.
4. Matching concept- revenue and cost in a specific period must be matched together in determining profit or
loss
5. Accounting period concept- every financial transaction be properly aligned with its financial period. The
indefinite life of an entity can be divided into artificial time periods where position and performance is
reported.
6. Money measurement concept- money is the only practical units of measurement used to achieve
homogeneity of financial data.
7. Cost concept or Historical cost concept: assets are recorded in books at original cost used to acquire
them. Cost therefore becomes the basis of accounting for the assets in future. That is, transactions are
recognized in financial statements at the amount paid or fair value ascribed to them.
8. Objective evidence concept- accounting entries should be based on facts and not personal opinion. An
opinion will be deemed more objective if more people can support it.
9. Periodicity: its’ assumed that the continuous lifetime of the entity can be broken down into specific time
periods. The results of operation for each period usually 12 months can be measured and reported
accordingly.
10. Accrual concept- effect of transactions are recognized when they occur and not necessarily when cash or
its equivalent is received or paid. The concepts states that revenues and expenses are accrued i.e.
recognized by inclusion in the profit and loss account when earned or incurred and not when cash is
received or paid.
11. Substance over form: When evaluating transactions, the substance (economic reality) of each transaction
should prevail over the legal formality. E.g. when acquiring a fixed asset on hire purchase the legal
formality is that the asset is not owned by the buyer until he pays the last installment. Therefore it should
not appear in the balance sheet of the buyer. However, the economic reality is that the buyer will use the
asset in generating revenue in the business. The asset should therefore be reflected in the balance sheet and
depreciated through the profit and loss account accordingly.

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B. Accounting conventions
This refers to circumstances or traditions that guide accountants in preparation of financial statements.
1. Consistency- accounting rules and policies followed by an entity should remain constant from one
financial period to another. E.g. if a business uses straight line method of depreciation, it should stick to that
method and not change to reducing balance method.
2. Prudence concept-uncertain expenses should be recognized while uncertain incomes are assumed not to
have occurred. If an accountant is faced with two situation affecting income and expenses, he should select
the alternative that understates revenue and overstates expenses.
3. Materiality- an item in financial statements is material if its presence or absence can influence decision of
financial statement user. All material facts must be accorded accounting treatments i.e. they should be
disclosed by inclusion in the financial statements or by way of notes to the accounts. A fact is material if its
omissions or misstatements can change the view presented by the financial statement. A fact can be material
in amounts or in nature e.g. a theft by a cashier of sh.100 is immaterial if the turnover is 2 billions shillings.
4. Full disclosure- all items of financial interest to user should be disclosed in financial statements at end of
financial period.

Accounting cycle

The process of accounting involves records drawn at successive stages and typically involves four
levels as follows:

Transaction Journals (day Ledgers Financial

documents book) statements