FINANCIAL ACCOUNTING NOTES

INTRODUCTION TO ACCOUNTING
Definition

This is the process of identifying, measuring, classifying, summarizing, recording and communicating of financial
information
 Identifying - in accounting, this is the process of recognition or non-recognition of business
activities as accountable events. Stated differently, this is the process which determines if an
event has accounting relevance.
 Measuring - in accounting, this is the process of assigning monetary amounts to the
accountable events.
 Communicating - accounting information should be communicated to the different
decision makers. Communicating accounting information is achieved by the
presentation of different financial statements.
 Recording - The accounting term for recording is journalizing. All the accountable events are
recorded in a journal.
 Classifying - The accounting term for recording is posting. All accountable events that are
recorded in the journal are then classified or posted to a ledger.
 Summarizing - the items that are journalized and posted are summarized in the five basic
financial statements.

OBJECTIVES OF ACCOUNTING

1. Systematic recording of transactions - Basic objective of accounting is to systematically record the financial
aspects of business transactions i.e. book-keeping.
2. Ascertainment of results of above recorded transactions - Accountant prepares profit andloss account to
know the results of business operations for a particular period of time. If revenue exceeds expenses, then it is
said that business is running profitably but if expenses exceed revenue, then it can be said that business is
running under loss.
3. Ascertainment of the financial position of thebusiness - Businessman is not only interested in
knowing the results of the business in terms of profits or loss for a particular period but is also anxious to
know that what he owes (liability) to the outsiders and what heowns (assets) on a certain date.
4. Providing information to the users for rational decision-making - Accounting aims to meet the
information needs ofthe decision-makers and helps them in rational decision-making.
5. Toknow the solvency position: By preparing the balance sheet, management not only
reveals what is owned and owed by the enterprise, but also it gives the information regarding concern's
ability to meet its liabilities in the short run (liquidity position) and also in the long-run (solvency
position) as and when they fall due.

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 USERS OF ACCOUNTING INFORMATION AND THEIR NEEDS
1.Shareholders/owners
2.Management
3.Government
4.Employees
5.Creditors/suppliers
6.Investors
7. Public

8. Consumers/end users/customers/client

9.Financial analysts
10.Financial institutions/Lenders
11.Competitors
12. Trade unions

ACCOUNTING EQUATION

The accounting equation, also called the basic accounting equation, forms the foundation for all
accounting systems. In fact, the entire double entry accounting concept is based on the basic
accounting equation.

The accounting equation equates a company's assets to its liabilities and equity.

Here is the basic accounting equation.

Assets equal the sum of liabilities and owner's equity (Capital).

Assets

An asset is a resource that is owned or controlled by the company to be used for future benefits.
Some assets are tangible like cash while others are theoretical or intangible like goodwill or
copyrights.
Another common asset is a receivable. This is a promise to be paid from another party. Receivables
arise when a company provides a service or sells a product to someone on credit.
All of these assets are resources that a company can use for future benefits. Here are some common
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 examples of assets:

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  Cash
 Accounts Receivable
 Prepaid Expenses
 Vehicles
 Buildings
 Goodwill
 Copyrights
 Patents
Liabilities

A liability is an amount of money owed to another person or organization.

A common form of liability is a payable. Payables are the opposite of receivables. When a company
purchases goods or services from other companies on credit, a payable is recorded to show that the
company promises to pay the other companies for their assets.

Here are some examples of some of the most common liabilities:

 Accounts payable
 Bank loans
 Personal Loans
 Officer Loans
 Unearned income

Equity (Capital)

Equity represents the portion of company assets that shareholders or partners own.
Owners can increase their ownership share by contributing money to the company or decrease equity
by withdrawing company funds. Likewise, revenues increase equity while expenses decrease equity.
Here are some common equity accounts:
 Owner's Capital
 Owner's Withdrawals
 Reserves
 Paid-In Capital

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 Horizontal format

Name of business
Balance sheet as 31st December 20xx
Sh sh Sh
Non-Current Assets: Capital xxx
Land and buildings
xxx Non-current liabilities
Plant and machinery xxx Loan xxx

Fixtures, furniture and fittings xxx

Motor vehicle xxx

Current assets: Current liabilities

Stocks xxx Overdraft xxx
Debtors xxx Creditors xxx xxx
Cash at Bank xxx
Cash in hand xxx xxx
Total assets xxx xxx

Vertical format

Name of business
Balance sheet as 31st December 20xx
Sh sh
Non-Current Assets:
Land and buildings xxx
Plant and machinery xxx
Fixtures, furniture and fittings xxx
Motor vehicle xxx

Current assets:
Stocks xxx
Debtors xxx
Cash at Bank xxx
Cash in hand xxx xxx

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 Total assets xxx

Capital xxx

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 Non-current liabilities
Loan xxx

Current liabilities
Overdraft xxx
Creditors xxx
xxx
Illustration 1

Kamau has a business that has been trading for some time. You are given the following information
as 31.12.2014
Sh “000”
Building 22 000
Furniture 11 000
Motor vehicle 11 600
Stocks 17 000
Debtors 11 200
Cash at bank 3 000
Cash in hand 800
Creditors 5 000
Capital 61 600
Loan 10 000

You are required to prepare a balance sheet as at 31 December 2014

D Mwangi has the following assets and liabilities as on 31 April 2012:

Sh.
Creditors 15,800
Equipment 46,000
Motor Vehicle 25,160
Stock 24,600
Debtors 23,080
Cash at bank 29,120
Cash in hand 160

Required:
a) Determine the capital as at 1st May 2012.
b) Draw up a balance sheet after the above transactions have been completed.

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 REGULATORY FRAMEWORK OF ACCOUNTING

INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANT (ICPAK)

The Institute of Certified Public Accountants of Kenya (ICPAK) was established in 1978. The
Institute is a member of the Pan-African Federation of Accountants (PAFA) and the International
Federation of Accountants (IFAC), the global umbrella body for the accountancy profession. The
Vision of the Institute is ‘A world class professional accountancy institute‘, while the Mission is
‘To develop and promote internationally recognized accountancy profession that upholds public
interest through effective regulation, research and innovation’.

The Institute is guided by the following core values: Credibility, Professionalism and
Accountability. The Institute draws its mandate from the Accountants Act (no 15 of 2008).

Its mandate includes:

The Accountants Act No 15, 2008 prescribes the following as the functions of the Institute:

 To promote standards of professional competence and practice amongst members of the

Institute
 To promote research into the subject of accountancy and finance and related matters, and the
publication of books, periodicals, journals and articles in connection therewith;
 To promote the international recognition of the Institute.
 To advise the Examination Board on matters relating to examinations standards and policies;
 To advise the Minister on matters relating to financial accountability in all sectors of the
economy;
 To carry out any other functions prescribed for it under any of the other provisions of this Act
or any other written law and
 To do anything incidental or conducive to the performance of any of the preceding functions.

The International Federation of Accountants (IFAC)

The International Federation of Accountants (IFAC) was founded on 7 October 1977, in

Munich, Germany, at the 11th World Congress of Accountants. IFAC comprises 179 member
and associate member organizations in 130 countries, representing more than 2.5 million
accountants in public practice, education, government service, industry, and commerce.

IFAC has established the following boards. We maintain separate pages for each board, with a
history of developments for each board:

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 Body Function

International Public Sector Sets International Public Sector Accounting Standards (IPSAS) for
Accounting Standards Board use by the public sector
(IPSASB)

International Auditing and Sets International Standards on Auditing, Assurance Engagements

Assurance Standards Board and Related Services
(IAASB)

International Accounting Develops International Education Standard

Education Standards Board
(IAESB)

International Ethics Standards Develops the international Code of Ethics for Professional
Board for Accountants Accountants
(IESBA)

Public Interest Oversight Oversees IFAC's standard-setting activities, particularly with

Board (PIOB) respect to auditing, assurance, ethics, and independence. The
PIOB also oversees IFAC's compliance activities.

IFAC also supports the IASB with respect to setting accounting standards.

The International Accounting Standards Board (IASB)

The International Accounting Standards Board (IASB) is an independent, private-sector body
that develops and approves International Financial Reporting Standards (IFRSs). The IASB
operates under the oversight of the IFRS Foundation. The IASB was formed in 2001 to replace
the International Accounting Standards Committee. Currently, the IASB has 14 members.

The IASB's role

Under the IFRS Foundation Constitution, the IASB has complete responsibility for all technical
matters of the IFRS Foundation including:

- Full discretion in developing and pursuing its technical agenda, subject to certain
consultation requirements with the Trustees and the public
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 - The preparation and issuing of IFRSs (other than Interpretations) and exposure drafts,
following the due process stipulated in the Constitution
- The approval and issuing of Interpretations developed by the IFRS Interpretations
Committee

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 ACCOUNTING STANDARDS (IMPORTANCE AND LIMITATION)

Accounting standards is a set of standards, guidelines and procedures that are used when accounting
for the affairs of most governmental and non-governmental bodies. The interpretation of numbers
and the wherewithal to place them in the proper context are at the heart of accounting. Standards
exist to ensure that accounting decisions are made in a unified and reasonable way.

The objective of setting standards is to bring about uniformity in financial reporting and to ensure
consistency in the data published by enterprises. For accounting standards, to be useful tool to
enhance the corporate governance and responsibility, two criteria must be satisfied, i.e.

i. A standard must provide a generally understood and accepted measure of the phenomena of
concern.
ii. A standard should significantly reduce the amount of manipulation of the reported numbers
and is likely to occur in the absence of the standards.

Accounting standards facilities uniform preparation and reporting of general-purpose financial

statements published annually for the benefit of shareholders, creditors, employee and public at
large. They are very useful to the investors and other external groups in assessing the progress and
prospects of alternative investments in different companies in different countries.

Accounting standards can be seen as providing an important mechanism to help in the resolution of
potential financial conflicts of interest between the various important groups in society. It is essential
that accounting standards should command the greatest possible credibility among shareholders,
creditors, employee and public at large.

Their important can be summarized as follows:

Comparability

Paramount to the role of accounting standards is the universality that it brings to financial record
keeping. Governmental organizations must follow accounting procedures that are the same as their
counterparts, and non-governmental organizations must do the same. The result is that it is easy to
compare the financial standing of similar entities. All comparisons within groups are a matter of
comparing "apples to apples." This helps both external and internal observers weigh the state of an
entity in the context of other comparable entities. For instance, the financial standing of a town can
be measured against a neighboring town with the assumption that the pertinent numbers have been
reached in a similar fashion.

Transparency

Accounting standards are designed to enforce transparency in organizations. The principles,

procedures and standards that make up the generally accepted accounting principles were chosen
with the purpose of ensuring that organizations lean in the direction of openness when deciding how
to provide information to observers. This kind of transparency is especially important in the case of
public entities, such as governments or publicly traded companies. Standards limit the freedom and
flexibility of entities to use clever accounting to move items around or even to hide them.
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 Relevance

Standards work to help entities provide the most relevant information in the most reasonable way
possible. In this way, an organization guided by accounting standards will generate the kind of
financial information that observers are most interested in examining. Entities ultimately should
provide information in a way that most fairly and clearly represents the current financial standing of
the operation. The standards make it more difficult for organizations to misdirect observers and to
fool them with data that does not have sufficient relevancy.

Audiences

Ultimately, the importance of accounting standards lies in the value that it brings to financial
documents for the various audiences that view and make critical decisions based on it. An absence
of accounting standards would make the work of investors, regulators, taxpayers, reporters and
others more difficult and riskier. For instance, without standards, an investor who has studied the
financial statements of a large publicly traded company would not know whether to trust the
findings on those statements. Standards mean that taxpayers can see how their tax dollars are being
spent, and regulators can ensure that laws are followed.

Limitations of accounting standards

i. Alternative solutions to certain accounting problems may each have arguments to recommend
them. Therefore, the choice between different alternative accounting treatments may become
difficult.
ii. There may be a trend towards rigidity and away from flexibility in applying the accounting
standards.
iii. Accounting standards cannot override the statute. The standards are required to be framed
within the ambit of prevailing statutes.

PROFESSIONAL ETHICS
A professional accountant is required to comply with the following fundamental principles:

a. Integrity
A professional accountant should be straight forward and honest in all professional and business
relationships.

b. Objectivity
A professional accountant should not allow bias, conflict of interest or undue influence of others to
override professional or business judgments.

c. Professional Competence and Due Care

A professional accountant has a continuing duty to maintain professional knowledge and skill at the
level required to ensure that a client or employer receives competent professional service based on
current developments in practice, legislation and techniques. A professional accountant should act
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 diligently and in accordance with applicable technical and professional standards when providing
professional services.

d. Confidentiality
A professional accountant should respect the confidentiality of information acquired as a result of
professional and business relationships and should not disclose any such information to third parties
without proper and specific authority unless there is a legal or professional right or duty to disclose.

Confidential information acquired as a result of professional and business relationships should not
be used for the personal advantage of the professional accountant or third parties.

e. Professional Behaviour
A professional accountant should comply with relevant laws and regulations and should
avoid any action that discredits the profession.

ACCOUNTING CONCEPT/PRINCIPLES
Accounting Concepts and Principles are a set of broad conventions that have been devised
to provide a basic framework for financial reporting.

In order to ensure application of the accounting concepts and principles, major accounting standard-
setting bodies have incorporated them into their reporting frameworks such as the IASB Framework.

Following is a list of the major accounting concepts and principles:

 Relevance
 Reliability
 Matching Concept
 Timeliness
 Neutrality
 Faithful Representation
 Prudence
 Completeness
 Single Economic Entity Concept
 Money Measurement Concept
 Comparability/Consistency
 Understandability
 Materiality
 Going Concern
 Accruals
 Business Entity
 Substance over Form
 Realization Concept
 Duality Concept

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 Relevance:
Information should be relevant to the decision-making needs of the user. Information is relevant if it
helps users of the financial statements in predicting future trends of the business (Predictive Value)
or confirming or correcting any past predictions they have made (Confirmatory Value). Same piece
of information which assists users in confirming their past predictions may also be helpful in
forming future forecasts.

Reliability
Information is reliable if a user can depend upon it to be materially accurate and if it faithfully
represents the information that it purports to present. Significant misstatements or omissions in
financial statements reduce the reliability of information contained in them.

Faithful Representation
Information presented in the financial statements should faithfully represent the transaction and
events that occur during a period.
Faithfull representation requires that transactions and events should be accounted for in a manner
that represents their true economic substance rather than the mere legal form. This concept is known
as Substance Over Form.

Substance over form

Requires that if substance of transaction differs from its legal form than suchtransaction should be
accounted for in accordance with its substance and economic reality.
The rationale behind this is that financial information contained in the financial statements should
represent the business essence of transactions and events not merely their legal aspects in order to
present a true and fair view.
Prudence
Preparation of financial statements requires the use of professional judgment in the adoption of
accountancy policies and estimates. Prudence requires that accountants should exercise a degree of
caution in the adoption of policies and significant estimates such that the assets and income of the
entity are not overstated whereas liability and expenses are not under stated.

The rationale behind prudence is that a company should not recognize an asset at a value that is
higher than the amount which is expected to be recovered from its sale or use. Conversely, liabilities
of an entity should not be presented below the amount that is likely to be paid in its respect in the
future.

Completeness

Reliability of information contained in the financial statements is achieved only if complete financial
information is provided relevant to the business and financial decision-making needs of the users.
Therefore, information must be complete in all material respects.

Incomplete information reduces not only the relevance of the financial statements, it also decreases
its reliability since users will be basing their decisions on information which only presents a partial
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 view of the affairs of the entity.

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 Matching Principle & Concept

Matching Principle requires that expenses incurred by an organization must be charged to the
income statement in the accounting period in which the revenue, to which those expenses relate, is
earned.

Comparability/Consistency

Financial statements of one accounting period must be comparable to another in order for the users
to derive meaningful conclusions about the trends in an entity's financial performance and position
over time. Comparability of financial statements over different accounting periods can be ensured by
the application of similar accountancy policies over a period of time.

A change in the accounting policies of an entity may be required in order to improve the reliability
and relevance of financial statements. A change in the accounting policy may also be imposed by
changes in accountancy standards. In these circumstances, the nature and circumstances leading to
the change must be disclosed in the financial statements.

Financial statements of one entity must also be consistent with other entities within the same line of
business. This should aid users in analyzing the performance and position of one company relative
to the industry standards. It is therefore necessary for entities to adopt accounting policies that best
reflect the existing industry practice.
Understandability

Transactions and events must be accounted for and presented in the financial statements in a manner
that is easily understandable by a user who possesses a reasonable level of knowledge of the
business, economic activities and accounting in general provided that such a user is willing to study
the information with reasonable diligence.

Understandability of the information contained in financial statements is essential for its relevance to
the users. If the accounting treatments involved and the associated disclosures and presentational
aspects are too complex for a user to understand despite having adequate knowledge of the entity
and accountancy in general, then this would undermine the reliability of the whole financial
statements because users will be forced to base their economic decisions on undependable
information.
Materiality
Information is material if its omission or misstatement could influence the economic decisions of
users taken on the basis of the financial statements (IASB Framework).

Materiality therefore relates to the significance of transactions, balances and errors contained in the
financial statements. Materiality defines the threshold or cutoff point after which financial
information becomes relevant to the decision-making needs of the users. Information contained in
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 the financial statements must therefore be complete in all material respects in order for them to
present a true and fair view of the affairs of the entity.

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 Accruals Concept

Financial statements are prepared under the Accruals Concept of accounting which requires that income and
expense must be recognized in the accounting periods to which they relate rather than oncash basis. An
exception to this general rule is the cash flow statement whose main purpose is to present the cash flow effects
of transaction during an accounting period.

Business Entity Concept

Financial accounting is based on the premise that the transactions and balances of a business entity are to
be accounted for separately from its owners. The business entity is therefore considered to bedistinct from
its owners for the purpose of accounting.

Realization Concept (Revenue Recognition Principle)

In accounting, also known as revenue recognition principle, refers to the application of accruals concept
towards the recognition of revenue (income). Under this principle, revenue is recognized bythe seller
when it is earned irrespective of whether cash from the transaction has been received or not.
Dual Aspect Concept | Duality Principle in Accounting

Dual Aspect Concept, also known as Duality Principle, is a fundamental convention of accountingthat
necessitates the recognition of all aspects of an accounting transaction. Dual aspect concept isthe
underlying basis for double entry accounting system.

QUALITIES OF USEFUL ACCOUNTING INFORMATION

In order for accounting information to be useful, it must contain certain qualities and meet certain
standards. These qualities include:

1. Relevance

Relevance in accounting information is necessary for predictive and feedback value. If investors
cannot review accounting information for a company and assess its financial worthiness, then the
information is not relevant and fails the relevance test. If management cannot review accounting
information and use it to make decisions concerning business operations, then the information fails
the feedback test.

2. Timeliness

Timeliness is a quality subset of relevance. If you do not present accounting information in a timely
manner, its usefulness to investors and managers is diminished or completely eliminated. The
quality of timeliness requires both recording the financial transaction in the appropriate accounting
period and generating accounting reports as soon as all data are posted so that issues with business
operations are discovered before the problem grows.
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 3. Reliability

If accounting information is not reliable, it cannot be used to make quality business decisions. In
order to meet GAAP standards for reliability, accounting information must be verifiable, meaning
you should be able to prove the authenticity and show a paper trail for every income and expense
entry recorded to the accounting general ledger. In order for accounting information to be reliable, it
must also be neutral, meaning only GAAP standards were used when the accounting information
was recorded; that is, the information was not recorded to reflect better on the company’s financial
performance.

4. Consistency

In order for accounting information to be useful in decision making, it must be recorded

consistently, meaning the same accounting treatment must be applied at all times to a given type of
accounting data. Recording the same monthly expense in different expense accounts skews the
expense categories and makes it harder to determine the actual expense in any one category. Large-
scale accounting changes, such as changing inventory method, also affect consistency in accounting
data. You should make every attempt to limit large-scale changes altogether, and if they are
necessary, implement them at the beginning of a new accounting year.

5. Comparability

Comparability is a subset of consistency. If you cannot compare accounting information for one
period of time to another, then you cannot derive useful information in order to make operational
decisions. Without consistency, any comparison of accounting data is useless, as the data compared
will not have been created using the same methods or standards.

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