INTRODUCTION TO ACCOUNTING: PART I

NATURE OF ACCOUNTING
Accounting is defined as the process of identifying, measuring, classifying, summarizing,
presenting (reporting) and interpreting financial information for the purpose of making decisions
by its users.

This definition can be better understood if it is broken down as follows:

Identifying: in an organization or business, there are many transactions that take place. These
transactions can be of financial (monetary) or non-financial (non-monetary) terms. Accounting
only deals with financial transactions and thus only those that are monetary in nature are
identified and isolated from the others.

Measuring: this deals with attaching value to the financial transaction taking place in an
organization or business. It is with the attached values that give the worth of a transaction.

Classifying: this deals with sorting the financial transactions as to whether they are incomes,
expenses, assets or liabilities. This will help in summarizing the financial transactions.

Summarizing: since the classified financial transactions can be many, there is need to condense
them to reduce their number. It is easy to deal with small number unlike a big one. For example,
sales are made daily. One can add up all the sales of each day for the whole year and have it as
one figure for the total sales of the year.

Presenting (reporting): this deals with putting the financial transaction in a form of report by
following a specified format. This involves putting the transactions in a statement form. The
statements include; statement of comprehensive incomes (income statement), statement of
financial position (balance sheet) and cash flow statement. Together, these statements are called
financial statements.
Interpreting: it is useless just to have the financial statements without explanation. This
therefore, involves giving meaning to the financial statements. For example, it is of no use to
have a figure of profit as 100,000 shillings without comparing the profit with other figures like
that of sales or assets. The interpretation is done using ratios; ratio analysis.

The Purpose of Accounting

The purpose of accounting is to accumulate and report on financial information about the
performance, financial position , and cash flows of a business. This information is then used
to reach decisions about how to manage the business, or invest in it, or lend money to it.
This information is accumulated in accounting records with accounting transactions , which
are recorded either through such standardized business transactions as customer invoicing or
supplier invoices, or through more specialized transactions, known as journal entries .

Types of Financial Statements

Once this financial information has been stored in the accounting records, it is usually
compiled into financial statements , which include the following documents:

a. Income statement

The income statement presents the financial results of a business for a stated period
of time. The statement quantifies the amount of revenue generated and expenses
incurred by an organization during a reporting period, as well as any resulting net
profit or net loss.

b. Balance sheet

A balance sheet lays out the ending balances in a company's asset, liability, and
equity accounts as of the date stated on the report. As such, it provides a picture of
what a business owns and owes, as well as how much as been invested in it. The
balance sheet is commonly used for a great deal of financial analysis of a business'
performance.

c. Statement of cash flows

 The statement of cash flows is one of the financial statements issued by a business,
and describes the cash flows into and out of the organization. Its particular focus is
on the types of activities that create and use cash, which are operations, investments,
and financing. A smaller organization may not release a statement of cash flows for
internal use, preferring to only issue an income statement and balance sheet.

d. Statement of retained earnings

The statement of retained earnings reconciles changes in the retained earnings

account during a reporting period. It is useful for understanding how management
utilizes the profits generated by a business. The statement begins with the beginning
balance in the retained earnings account, and then adds or subtracts such items as
profits and dividend payments to arrive at the ending retained earnings balance.

e. Disclosures that accompany the financial statements

THE PRINCIPLES, CONCEPTS AND CONVENTIONS UNDERLYING THE

ACCOUNTING REPORTS
Just like any other field of study, accounting has developed its own concepts that govern its
application. These concepts form the fundamental accounting assumptions underlying the
preparation of financial statements.

The Concepts
There are four main concepts:
1. Going concern
It is assumed that the organization 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

It is also known as the 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.

The Accounting Principles

1. Historical cost
It 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.
2. Monetary principle
This principle holds that accounting will only endeavor to deal with those items to which
monetary value can be attached. As such, financial statements reflect only the items that can be
measured in monetary terms. Goodwill for example is never shown in the statements because it
has no monetary measurement.
3. 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.

4. 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.
5. 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.

6. 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.

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.

7. 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.
8. 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.
9. 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.

International Accounting Standards (IAS) and International Financial Reporting

Standards (IFRS)
The foreword to accounting standards defines Accounting Standards as Authoritative statements
of how particular types of transaction and other events should be reflected in financial
statements. Accounting Standards are developed to achieve comparability of financial
information between and among different organizations. International Accounting Standards
(IAS’s) and International Financial Reporting Standards (IFRS) are meant to apply to most
organizations in the world. IAS’s and IFRS’s are produced by the International Accounting
Standards Board (IASB) whose objectives are:
 (a) To formulate and publish in the public interest accounting standards to be observed in
the presentation of financial statements and to promote their worldwide acceptance; and
(b) To work generally for the improvement and harmonization of regulations, accounting
standards and procedures relating to the presentation of financial statements.

The IASB is an affiliate of the International Federation of Accountants (IFAC) established in

1977 which co-ordinates the Accounting profession worldwide. Most accounting bodies of
countries are members of IFAC.
The IASC develops IAS’s through an international process that involves the worldwide
accountancy profession, the preparers, users of financial statements and national standard setting
bodies and other interested parties.
The IASB sets up a steering committee to develop a statement of principles, an Exposure Draft
and ultimately an Accounting Standards once a new topic is suggested. The process includes:

 Identifying and reviewing of all the issues associated with the topic,
 Studying national and regional accounting requirements and practice, consultation with
the member bodies’ standard setting bodies and other interested groups,
 Public Exposure of the draft Accounting Standard,
 Evaluation by the steering committee and the board of the comments received on
exposure drafts.

Currently the IASB has developed about 40 IASs. Examples include:

 IAS 1 Presentation of Financial Statements
 IAS 2 Inventories
 IAS 16 Property plant and equipment.

Previously new standards were called International Accounting Standards but from 2003 any
new standards will be called International financial Reporting Standards. However in the current
practice is to refer to all standards as International Financial Reporting Standard.
In Kenya, Accountants used to prepare the financial statements in accordance with Kenya
Accounting Standards (IASs), which were developed and published by ICPAK (Institute of
Certified Public Accountants of Kenya). This was later dropped and International Accounting
Standards adopted.
Reasons why Accountants should observe International Accounting Standards:

a) Use of IASs adds credibility to the financial statements as they can be compared with
others globally.
b) Facilitates communication within an enterprise that has foreign branches or subsidiaries
due to harmonized reporting by the separate entities in the group.
c) Adds value to the financial statements incase an entity is sourcing for foreign capital.
d) Incase an entity wishes to be quoted on the Stock Exchange Market more so for
companies.

Accounting Bases and Policies

A. Accounting Bases
Bases are the methods that have been developed for expressing or applying fundamental
accounting concepts to financial transactions and items. Examples include:

 Depreciation of Non current Assets (e.g. by straight line or reducing balance method)
 Treatment and amortization of intangible assets (patents and trade marks)
 Stocks and work in progress (FIFO, LIFO and AVCO)

B. Policies
Accounting policies are the specific accounting bases judged by business enterprises to be the
most appropriate to their circumstances and adopted by them for the purpose of preparing their
financial accounts.

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 firm’s 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 firm’s 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 company’s state of affairs.
f. Forensic accounting; concerns itself with investigation of potential financial crimes
g. Fiduciary accounting; concerns itself with accounting for invested funds
h. Human resource accounting; concerns itself with accounting for expenditures related to
human resources as assets

THE ELEMENTS OF FINANCIAL STATEMENTS

The elements of financial statements are the general groupings of line items contained within the
statements. These groupings will vary, depending on the nature and structure of the business.
Thus, the elements of the financial statements of a for-profit business vary somewhat from those
incorporated into a nonprofit business.

The main elements of financial statements are as follows:

1. Assets. These are items of economic benefit that are expected to yield benefits in future
periods. Examples are accounts receivable, inventory, and noncurrent assets.

2. Liabilities. These are legally binding obligations payable to another entity or individual.
Examples are accounts payable, taxes payable, and wages payable.

3. Equity/Capital. This is the amount invested in a business by its owners, plus any
remaining retained earnings.
 4. Revenue/Incomes. This is an increase in assets or decrease in liabilities caused by the
provision of services or products to customers. It is a quantification of the gross activity
generated by a business. Examples are product sales and service sales.

5. Expenses. This is the reduction in value of an asset as it is used to generate revenue.

Examples are interest expense, compensation expense, and utilities expense.

Of these elements, assets, liabilities, and equity/capital are included in the balance sheet.
Revenues and expenses are included in the income statement. Changes in these elements are
noted in the statement of cash flows.