INTRODUTION TO ACCOUNTING

a) NATURE OF 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.

b) 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
owner 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:

i. 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 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.

ii. 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.
iii 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.
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iv. 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.

v. The Lenders
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.

vi. The 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.

vii. The 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 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.

viii. The 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.

ix. 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.

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The general purpose of accounting

i. Helps in decision making

ii. Ascertain the value of the business
iii. Know the profit and or loss position
iv. Ascertain the assets and liabilities of the firm
v. Know the cash and wealth of the business

QUALITIES OF GOOD ACCOUNTING INFORMATION

For accounting information to be able to effect the purpose for which it was meant, there are
certain attributes that it must fulfill. These include:

(a) Understandability. For accounting information to be considered useful, it must be well

understood by the parties for which it was prepared for. The parties must be able to derive
satisfaction from the financial data represented by accounting.

(b) Relevance. The accounting information should be able to influence the important decisions
in the company. The information should be verifiable, neutral and truthful.

(c) Reliability. Reliability means that the accounting information should have differing methods
or ways of doing it and yet arrive at the same or similar conclusions.

(d) Comparability. The accounting information should be able to be compared with other
information from different organizations or of the same organization at differing periods.

(e) Timely. If the accounting information is not availed to the deserving user at the time of need,
then it may as well be useless. For accounting information to be useful, it must be presented to
the party in need at the time of the need.

LIMITATIONS OF ACCOUNTING INFORMATION

1 Historical

Accounting information is prepared based from past period monetary transactions. It is hardly
feasible that what happened in the past will hold on in the future and so the accounting
information may be considered irrelevant on that basis alone.

2 Too quantitative rather than qualitative

Accounting information consists of too many figures and less of explanations. For any system to
be useful, it must strike a balance between quantitative and qualitative measures.

3 Only comparable to similar businesses

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Accounting information makes it only comparable to businesses of similar nature. It isdifficult to
compare a service oriented organization to a manufacturing based firm.

1.3 THE PRINCIPLES, CONCEPTS AND CONVENTIONS

THE CONCEPTS

There are four main concepts:

1. Going concern

It is assumed that the operation will continue in operational existence into the foreseeable future.
This implies that the management should view all the available information in the light of the
foreseeable future, but not only for the current period.

2. Accounting period convention/ Time concept

It is assumed that the continuous lifetime of the entity is divided into small equal periods to ease
the burden of reporting. These subdivisions are called the financial year.

3. Business entity concept

The assumption is that the business is a separate legal entity; distinct from the owners and the
management. The financial affairs of the business entity are recorded and reported separately
from those of the owners of the capital or the managers

4. Monetary principle

It is assumed that the financial impact of the business entity is broken down into transactions that
are assessed and quantified in some unit of measure. The underlying assumption is that, for the
sake of commonness, the unit of measure is a monetary one.

5. Historical cost

Postulates that assets should be recorded at cost, at the purchase price or at the acquisition price.
This ignores the effects of inflation on cost as the assets are kept by the business over the years.

It recognizes that for example a building purchased 40 years ago for Sh 29,000 would be
reported today in the statement of financial position at that historical price even though its actual
worth today may be Sh 2.9 million.

However, this problem has been overcome by asset revaluation as an alternative to the historical
cost of accounting.

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 6. Accrual concept

The accruals concept is also known as matching concept.

In the principle, revenues and costs are recognized when earned or incurred and not as the
monetary attachment is received or paid. What this means is that the time when the revenue is
received or the expense is incurred is completely disregarded. This leads into two scenarios;
prepayments and accruals

Prepayments occur when money is received for a period that it has yet to be earned, or an
expense is paid for but has not yet been incurred.

Accruals occur when the expense for the money is being paid for has already been incurred i.e.
the expense belongs to a past period, or when an income is received way after the period of
earning has expired.

7. Revenue realization concept

It states that a sale should be recognized when the event from which it arises has taken place and
the receipt of cash from the transaction is reasonably certain. Revenue can be recognized at
different levels of selling such as when the inquiry is made, during delivery, at issue of invoice
or when payment is made.

Revenue realization demands that only when the money receivable is reasonably certain of
reception should accountants recognize it as income. For instance, it may not be prudent to
recognize a sale when a customer makes an inquiry because the requisition may be revoked well
before the goods are even ordered or delivered.

8. Prudence

Prudence states that where alternatives exist, the one selected should be one that gives the most
cautious presentation of the financial position of the business. Assets and profits should not be
overstated, but a balance must be achieved to prevent the material overstatement of liabilities and
losses.

Where a losses foreseen, it should be anticipated and taken immediately into account. In other
words, accountants should never anticipate for gains but must always provide for losses.

9. Consistency

The items in the financial statement should be presented and classified in the same manner from
one period to the next unless there is a significant change in the nature of the operations of the
business, or a review of its financial statement presentation demonstrates that relevance is better
achieved by presenting items in a different way, or a change is required by a new international
standard.

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For instance, an entity is not allowed to change form LIFO to FIFO or otherwise unless:

- there is a significant change in the business

- there is a new accounting order

- It helps present the information better.

10. Materiality

Information is material if its non-disclosure could influence the decisions of users. Materiality
depends on the size and the nature of the item being judged. Strict adherence to accounting rules
is not necessary in accounting for trivial items such as loose tools, e.g. a stapler should not be
capitalized, and a bribe cannot be itemized under expenses.

11. Duality

Duality principle emphasizes the double entry book-keeping entry that every transaction has two
effects, for every debit there is a corresponding, equal and opposite credit entry. As such it forms
the basis of the double entry system of book keeping.

12. Substance over form

Some transactions have a real nature that differs from their legal form. This principle states that
whenever it is legally possible, the real substance prevails over the legal form.

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 TOPIC: FINANCIAL ANALYSIS
This is the process of identifying the company strength and weakness by establishing the relationship
between financial statement items. Financial analysis can be achieved by use of ratios.
In financial analysis a ratio is used as a benchmark for evaluating the financial position and performance
of the firm. The absolute accounting figures reported in the financial statement do not provide a
meaningful understanding of the performance and financial position of the firm. Ratios help to summarize
large quantities of data and make qualitative judgment about a firm’s financial performance
Nature of Ratio Analysis
Ratio analysis is a powerful tool that uses financial analysis.
Users of ratio analysis
1. Shareholders – Actual owners are interested in the company’s both short and long term survival.
For this reason they will use ratio’s such as:
a) Profitability ratios – which seek to establish viability.
b) Dividend ratios – which seek to establish return to owners in form of dividends. The
common ratios include earning yield (E/Y), Dividend pay out ratio (DPO), dividend
yield, Price earning ratio, all of which will measure return to owner.
2. Creditors (trade) – these are interested in the company’s ability to meet their short-term
obligations as and when they fall due. For this reason they will use ratios such as:
a) Liquidity ratio – a qualitative measure of company’s liquidity position measured by acid
test ratio.
b) Current ratio – which is a measure of company’s quantity of current assets against current
liabilities.
3. Long term lenders – These include finances through loans, mortgages and debenture holders.
These have both short and long term interest in the company and its ability to pay not only
interest on debt but also principal as and when it falls due. These parties are interested in the
following:
a) Liquidity ratios – used to assess short-term liability to meet current obligations.
b) Profitability ratios – used to ascertain whether the company can pay its principal back.
c) Gearing ratio – used to gauge the company’s risk in the investment.
d) Investment coverage ratio – shows the company’s safety as regards the payment of
interest to the lenders of the debt.
4. Directors and management of company – They will therefore be interest in:
a) Efficiency of the company in generating profits.
b) The company’s viability from the investor’s point of view and the company’s ability to
generate sufficient returns to investors.
c) Gearing ratio to gauge the safety and risk associated with the company.

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5. Potential investors – these parties are interested in a company in total both on short and long term
basis in particular the company’s ability to generate acceptable return on their money.
Therefore, they will use:
a) Dividend ratios
b) Return ratios
c) Gearing ratios
6. Government – The Government is interested mostly in utility companies (e.g. KPLC, KPTC) and
those that will provide public services – in this case the government will be interested in their
survival and thus ability to provide those services. It may be interested in taxation derived from
these companies which is used for development. Government may also be interested in
employment level and as such it will use those ratios that can enable it to achieve such objectives
of particular importance are:
a) Profitability ratios
b) Return ratios
7. Competitors – These are interested in the company’s performance from the market share point of
view and will use the ratios that enable them to ascertain company’s competitive strength e.g.
profitability ratios, sales and returns ratio etc.
8. General public – Customers and potential customers – These are interested in the ability of the
company to provide good services both in the short and long run. To gauge the company’s ability
to provide goods and services on short and long term basis. We have:
a) Returns ratio
b) Sales ratio

CLASSIFICATION OF RATIOS
1. Liquidity ratios.
2. Turnover ratios.
3. Gearing ratios.
4. Profitability ratios.
5. Growth and valuation ratios.
Liquidity ratios
This measures the ability of the firm to meet its current financial obligation as they fall due. They include:
a) Current ratio
This ratio indicates the number of times current liabilities can be paid from the current asset
before the current asset can be exhausted.
Current ratio= Current assets
Current liabilities
b) Quick/Acid test ratio
This establishes a relationship between liquid asset and current liabilities. An asset is liquid if it
can be converted into cash immediately without loss of value. Inventories are considered to be
less liquid.
Quick ratio =Current asset- Inventories
Current liabilities

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 c) Cash ratio
This indicates the number of times current liabilities can be paid from available cash balance.
Marketable securities are considered to be a cash equivalent.
Cash ratio=Cash+ Marketable securities
Current liabilities

d) Net working capital ratio

This indicates the proportions of net asset which is liquid enough to meet current liabilities of the
firm.
Net working capital ratio=Net working capital
Net asset
e) Interval measures
This assess the firm’s ability to meet its regular cash expenses
Interval measures =Current assets- Inventories
Average daily operating expenses
Turnover/Activity ratios
Turnover ratios are employed to evaluate the efficiency with which the firm manage and utilize its asset.
They indicate the speed with which assets are been converted into sales. The ratios include:
a) Inventory turnover
The ratio indicates the number of times stock was turned into sales during the year
Inventory turnover= Cost of goods sold
Average stock
b) Stock holding period/Inventory conversion period
The ratio indicates the number of days stock was held before been sold

c) Debtors turnover/Accounts receivable turnover

This indicates the numbers of times which credit customer were turned into sales.
Debtor turnover= Credit sales
Average debtors
d) Debtors collection period
This refers to the credit period that was granted to the debtor

OR
=

e) Account payables/creditors turnover

The ratio indicates the number of times per annum the firm bought goods on credit
Creditors turnover= Credit purchases
Average creditors

f) Payables deferral period/Creditors payment period

This indicates the credit period granted by suppliers.

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 OR
=

g) Fixed asset turnover

This ratio indicates the amount of sales revenue per shilling of fixed asset employed. It’s a
measure of efficiency with which fixed assets were utilized to generate sales revenue.
Fixed asset turnover= Annual sales
Fixed assets

h) Total assets turnover

The ratio indicates the sales revenue generated per shilling of total assets employed
Total assets turnover= Annual sales
Total assets
Gearing/Leverage ratios
This ratio indicates the extent to which non-owner provided fund have been used in financing the
operations of firm. They indicate the mix fund provided by owners and lenders. The ratios include:
a) Debt/equity ratio=Long term debts
Equity net worth
Equity net worth=ordinary share capital + All reserves
b) Gearing ratio
The ratio indicates the proportion of fixed charge capital relative to total capital employed by the
firm.
Gearing ratio= Fixed charge capital
Total capital employed
Fixed charge capital= Interest bearing debt+ Preference share capital
Total capital employed= Equity+ Fixed charge capital
c) Debt ratio
This indicates the proportion of total assets that have been financed using long term and current
liabilities
Debt ratio= Total liabilities
Total assets
d) Time interest earned ratio
The ratio indicates the number of times interest charges can be paid from operating profit
Time interest earned ratio= Operating profit (EBIT)
Interest expenses

Profitability ratios
These ratios indicate the performance of the firm in relation to its ability to derive returns or profit from
the investment or from sales of goods. Profitability ratios are categorized into two categories:
1. Profitability in relation to sales
This ratio indicates the ability of the firm to control its cost of sales, operating and financing
expenses. The ratios include:
a) Gross profit margin
The ratio indicates the ability of the firm to control its cost of sales expenses

b) Operating profit margin

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 The ratio indicates the ability of the firm to control its operating expenses i.e cost of sales,
administration, and selling cost.

c) Net profit margin

The ratio indicates the ability of the firm to control its cost of sales, operating and financing
expenses

2. Profitability in relation to investment

This indicates the ability of the firm to derived returns from its investment. The ratios include:
a) Return on investment
This indicates the return from investment of shs.1 in total assets

b) Return on equity
This indicates the return on profitability for every shs of capital provided by the owners

c) Return on capital employed

This indicates the return on profitability for every shs of capital employed.

Growth and valuation ratios

This ratio indicates the growth potential of the firm. In addition it determines the value of the firm and
investment made by various investors. The ratios include:

a) Earnings per share(EPS)

This indicates the amount of earning attributable to every ordinary share held.
E.P.S=Earnings attributable to ordinary shareholders
Number of ordinary shares
b) Earning yield(EY)
The ratio indicates the returns on earnings for every shs.1 invested in the firm
Earning yield=Earnings per share
Market price per share
c) Dividend per share(DPS)
This indicates the cash dividend for every share held
DPS= Total dividend paid
Number of ordinary shares
d) Dividend yield
This indicates the returns inform of dividend for every shs.1 invested in the firm.
Dividend yield=Dividend per share
Market price per share
e) Dividend payout ratio
This indicates the proportion of earning that was paid out as dividend

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 Dividend payout ratio=DPS
EPS
Or Dividend payout ratio= Total dividend paid
Earnings attributable to ordinary shareholders
f) Retention ratio
This indicates the proportion of earnings that is retained within the firm
Retention ratio= 1-dividend payout ratio
g) Dividend cover
This indicates the number of times dividends can be paid from earnings attributable to ordinary
shareholders
Dividend cover= EPS
DPS
h) Price earnings ratio
It indicates the number of times it will take to recover the market price per share from the annual
earnings per share
P/E=MPS
EPS
i) Book value per shares(BVPS)
Indicates the amount /valuation of each share if the firm was liquidated and assets sold at their
market book value.
BVPS=Equity Net worth
Number of ordinary shares

j) Market to book value per share

This indicates the goodwill attached to the company shares
Market to book value per share= MPS
BVPS

ADVANTAGES OF RATIOS
1. To evaluate the efficiency of assets utilization to generate sales revenue (turnover ratios)
2. To evaluate the ability of the firm to meet its short term financial obligation (liquidity
obligation)
3. To determine financial risk of the firm (gearing ratios)
4. To compare the firms performance with the average industrial performance (industrial analysis).
5. To evaluate the performance 0f the firm over time (trend analysis).

LIMITATION OF RATIOS
1. In industrial analysis ratios ignore the size of the firm being compared
2. Ratios are computed only at one point in time but they are subjected to frequent changes after
computation.
3. Ratios ignores qualitative aspects of the firm’s performance e.g quality of the product.
4. Ratios are computed based on historical information thus may be irrelevant for future decision
making.
5. Rations ignore the effect of inflation on performance e.g increase in sales might have resulted
from an increase in selling price and not efficient utilization of assets as may be indicated by turn
over ratios

QUESTION ONE
An extract from the finance statements of Kenyango Fisheries Ltd is shown below:

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 Shs.
Issued share capital:
150,000 ordinary shares of Sh.10 each fully 1,500,000
paid
2,000,000
10% loan stock 1999
1,500,000
Share premium
7,000,000
Revenue Reserve
12,000,000
Capital employed

 The profits after 30% tax is Sh.600,000. However, interest charge has not been deducted.
 Ordinary dividend payout ratio is 40%.
 The current market value of ordinary shares Shs.36

Required
a) Return on capital employed
b) Earnings per share
c) Price earnings ratio
d) Book value per share
e) Gearing ratio
f) Market to book value per share

Answer
a) Return on capital employed: R.O.C.E
Since interest is tax allowable, it yield tax shield (interest x tax rate) profits after interest and tax =
600,000 – interest + tax shied
= 600,000 – (10% x 2M) + (10% x 2M x 30%)
= 600,000 – 200,000 + 60,000
= Sh.460,000
460,000
ROCE = x100 = 3.83%
12,000,000

460,000
b) Earnings per share = = Sh.3.07
150,000

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 36
c) Price earnings ratio = = 11.73 times
3.07

d) Book value per share = Equity (net worth)

Number of shares
Equity = 1,500,000 + 1,500,000 + 7,000,000 = 10,000,000
BUPS = Sh.10,000,000 = Sh.66.70
150,000
e) Earning = Fixed charge capital = Sh.2,000,000 x 100 = 16.7%
Total capital Sh.12,000,000
Or = Fixed charge capital = Sh.2,000,000 = 0.20
Equity Sh.10,000,000
This indicates low gearing.

f) Market to book value per share (MBVPS) ratio.

MBVPS = MPS
BVPS
= 36 = 0.54
66.70
QUESTION TWO
The following financial statements relate to the ABC Company:

Assets Shs. Liabilities & Net worth Shs.

Cash 28,500 Trade creditors 116,250
Debtors 270,000 Notes payable (9%) 54,000
Stock 649,500 Other current liabilities 100,500
Total current assets 948,800 Long term debt (10%) 300,000
Net fixed assets 285,750 Net worth 663,000
1,233,750 1,233,750

Income Statement for the year ended 31 March 1995

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 Shs.
Sales 1,972,500
Less cost of sales 1,368,000
Gross profit 604,500
Selling and administration expenses 498,750
Earning before interest and tax 105,750
Interest expense 34,500
71,250
Estimated taxation (40%) 28,500
Earnings after interest and tax 42,750

Required
a) Calculate:
i) Inventory turnover ratio; (3 marks)
ii) Times interest earned ratio; (3 marks)
iii) Total assets turnover; (3 marks)
iv) Net profit margin (3 marks)
Answer
a) i) Inventory turnover ratio = Cost of sales
Average stock (closing stock)
= 1,368,000 = 2.1 times
649,500
ii) Times interest earned ratio = Operating profit EBIT)
Interest charges
= 105,750 = 3.1 times
34,500
iii) Total assets turnover = Sales
Total Assets
= 1,972,500 = 1.6 times
1,233,750

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iv) Net profit margin = Net profit (profit after tax) x 100
Sales
= 42,750 x 100 = 2.2%
1,972,500
i.e 2.2% is the net profit margin
97.8% is the cost of sales

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