UNIT ONE: THE THEORETICAL FRAMEWORK OF ACCOUNTING

INTRODUCTION

The main purpose of maintaining books of accounts is to enable the concerned

person or organisation to get information about the financial position and
performance of the business as and when it is needed. A business is an
establishment with the sole aim of making profits. Profit is the excess income over
expenditure. One of the jobs of an accountant is to measure income, expenditure
and profits but this has to be done through keeping proper books of accounts (i.e.
Bookkeeping). Bookkeeping provides an individual or organisation with the
information that can enable one to see the individual effect of each transaction and
the collective effect of all the transactions made in a particular period.

TYPES OF BUSINESS ENTERPRISES

There are 3 main types of business enterprises, namely:

(a) Sole proprietor
(b) Partnership
(c) Limited company.

Every business enterprise is started by its owners to increase their wealth by

making some business transactions. A business transaction of an enterprise is any
activity which takes place for business reasons. For example, the purchase goods,
sale of services, purchase of assets, payment of wages, salaries, rent and other
expenses etc.

It should be noted that the convention adopted in preparing accounts is

always to treat a business as a separate entity from its owners (i.e. A
business is considered a separate legal entity from its shareholders). This
principle applies even whether the business activity is carried out by a company
or by a sole trader. Businesses need to produce accounts in order communicate
economic measurements of their performance and information about the
resources and performance of the business enterprise (reporting entity) that is
useful to those who have reasonable rights to such information.

DISTINCTION BETWEEN BOOK-KEEPING AND ACCOUNTING

Book-keeping can be defined as the art of maintaining books of accounts of a

business or an individual. It involves 2 main activities:
1. Recording financial transactions of the business in the books of accounts.
2. Summarizing the information recorded in the books of accounts by way of
preparing periodical accounting statements.

The Chartered Institute of Management Accountants (CIMA) has defined

bookkeeping as “The analysis, classification and recording of financial transactions
in books of accounts”. This means book-keeping is concerned with the recording of
the financial information/transactions of a business in a systematic manner.

___________________________________________________________________
1
__SES: 2119- Accounting Fundamentals– Lecture Notes- Handout One
© Fred Barongo [M.A (DVS), PGDBM, BA.ED, ACIS, MCIPS]
Financial accounting has a wider scope and coverage than bookkeeping. It refers
to the recording of the financial transactions as well as ascertaining the effect of
these transactions on the financial position of the business. The Chartered
Institute of Management Accountants (CIMA) defines financial accounting as “The
analysis, classification and recording of financial transactions and the ascertainment
of how such transactions affect the performance and financial position of a
business”.

Therefore financial accounting is the art and science of recording and classifying
financial transactions in the books, summarizing and communicating the financial
information through the process of producing financial statements and
interpreting the information contained in the financial reports to assist those
involved in making vital decisions concerning a business. It is the process of
identifying; measuring and communicating information concerning the economic
position of the organization so as to enable the decision makers make rational
decisions.

Distinction between Book-Keeping and Financial Accounting

No. Book Keeping Financial Accounting
1. Bookkeeping is a record making phase Financial accounting on the other hand
is broader and includes bookkeeping
but also extends to financial reporting-
i.e. preparing financial reports
2. Bookkeeping is the clerical part of Financial accounting involves analyzing
accounting. The clerical tasks involved and interpreting the business financial
are preparing books of accounts such statement. NB Accountants authorize
as cash books, ledgers and preparing financial transactions and design
the trial balance. accounting systems.

NB: Accountants have higher academic or professional qualifications than the

bookkeepers.

BRANCHES/DISCIPLINES IN ACCOUNTING
Accounting is a medium through which information about a business is
communicated to those involved in decision making. Accounting is thus the
language of business that enables rational and informed decisions to be made.

A. Differentiate between the following:-

1. Financial accounting 4. Financial management
2. Management accounting 5. Auditing
3. Cost accounting

___________________________________________________________________
2
__SES: 2119- Accounting Fundamentals– Lecture Notes- Handout One
© Fred Barongo [M.A (DVS), PGDBM, BA.ED, ACIS, MCIPS]
6. Green accounting/Environment accounting or social responsibility accounting

B. Distinguish between the following

1. Private accounting
2. Public accounting
3. Government accounting

THE ROLE/FUNCTION OF ACCOUNTING IN ANY BUSINESS ENTERPRISE

Accounting plays a dynamic role in the success of any business enterprise in the
following ways:

1. Accounting provides information about the worth of the business: This

information may be necessary when a firm is to get an overdraft or loan. The business
has to provide evidence of financial health in the form of accounting statements.
Similarly the information is relevant when one decides to sell the business.

2. Accounting records assist a business in accurately calculating the profits and

losses made over a period of time. Profits is the sole motive of most business,
therefore the owners of the business must be well informed of how they are doing
towards achieving this objective. No business can survive in the long run without
making reasonable profits. Alternatively if one depends on the business entirely s/he
ought to know the exact amount of profits so that the drawings do not exceed profits.
Therefore a proper, accurate and complete recording of all business transactions has to
be made.

3. Accounting records keep a businessman informed about the financial position

of his business. One is able to know almost everything about the financial affairs of the
business enterprise simply by going through the books of accounts. A statement of
assets and liabilities can be prepared on any particular date which is known as a
balance sheet. It shows the financial position of the business as at a particular date.

4. Accounting is a tool of control. By making available information on movement of

assets, accounting helps the owners to exercise effective control over the assets and
employees. Without records it would be difficult to notice the theft or misappropriation
of cash, stock or other assets. Therefore a proper and accurate accounting system will
be helpful as a tool for control.

5. Accounting records/statements help in future or further planning. Basing on

accounting records available one can take decisions concerning expansion of the
business. The records required will relate to sales, profits, investments etc to determine
future programmes.

6. Accounting records are of particular importance to a business that trades on

credit. A business will rely on these records for prompt recovery of debts and
settlement of due debts to suppliers. Without credit transactions business cannot be
expanded beyond certain limits.

7. Accounting records are necessary for income tax purposes. Taxes are imposed by
the government in all countries. Records are necessary to prove to the Tax Authorities
the correct “income” on which tax could be levied otherwise a business may be required
to pay higher taxes to the government.
USERS OF ACCOUNTING INFORMATION

Accounting information is in the form of financial statements or reports. A number of

people might be interested in this financial information. These interested parties are
often referred to as stakeholders and are broadly divided into two groups: internal
users and external users or parties.

Internal Users of accounting information

They are referred to as internal users because they are directly involved in the day to
day running of the organization: These internal users are the managers and employees
of the organisation.

1. Managers of the business/company: Managers are appointed by the owners of the

business to supervise the day to day activities of the organization. They include;
directors, senior executives, top managers and managers at various levels. They are
charged with the task of increasing the wealth of the shareholders. The shareholders
are the investors or owners of the business. The managers run the business on the
behalf of the shareholders. Shareholders need information about the company’s
financial position/situation as it is currently and the future expectations. This
information will enable the shareholders to direct their business efficiently and to
take effective control and planning decisions such as expansion of business, entering
new markets, making strategies concerning competition etc.

2. Employees of the company and trade unions

The employees need information about the financial situation of the company
because of two main reasons. (a) Job security and professional careers of the
employees. If the employer is making losses continuously or is in poor financial
health, then the chances of employees losing their jobs is high and vice versa (e.g.
restructuring may take place). (b) The employees are interested in the package of
their wages and salaries. If the firm is making enough profits then the employees can
easily claim for an increase in salaries/wages.

External Users of accounting information

They are referred to as external users because they are not directly involved in the day
to day running of the organization; however as interested parties they have a stake in
the organization. The decisions they make affect the business. These include
shareholders (investors), creditors, government, donors, financial analyzers and
advisors, financiers (e.g. bank), general public etc.

3. Shareholders (investors) of the company: These are usually referred to as the

owners of the company. They contribute the capital that is used in running the
company but they are not directly involved in the day to day running of the
company. They entrust this task to the managers, so they are interested in, knowing
and assessing how effectively management is performing its stewardship function.
The shareholders will ask such questions as: What are the profits? Are the funds
being well utilized or misused? Is the wealth of the shareholders being maximized?
Is the organization going to survive into the future? etc. The shareholders invest the
capital so as to maximize their wealth and must therefore know how much profits
they can afford to withdraw from the business for their own use.

4. Providers of finance to the company: These include banks and other financial
intermediaries. They provide finances to the company in form of overdrafts or loans
that are long term. The financial institutions are interested in assessing the financial
 position of the company to ascertain whether the business will be in position to pay
interest on loans and eventually pay the principal amount borrowed. The financial
reports and forecasts provide this information.

5. Trade contacts: These are different categories of people or organizations with

which the organization/company deals with. They include; customers,
suppliers/creditors etc. Suppliers will want to know about the company’s ability to
pay its debts. Customers need to know that the company is a secure source of supply
for the products that they consume and will therefore not close down in the near
future.

6. Competitors: Competitors are also in business like any other organization or

company. They need information to judge whether they are competing well or they
are losing the market share. This information will assist in designing competitive
strategies in the market place. Companies are reluctant in providing information to
other people who are not entitled.

7. Financial analysts and advisors: These need financial information for their clients
and audience. Stock brokers will need information to be able to give correct advice
to investors in stocks and shares. Credit agencies have to provide financial
information to potential suppliers of goods to the company. Journalists have to
provide information to the reading public.

8. Government or Tax Authorities: Taxes are used to finance budgets of the

government. These taxes are assessed basing on the financial records of the
company. The government will want to know about the business profits in order to
assess the tax payable by the company. The company therefore has to file returns to
form a basis for tax assessments.

9. Donors and other Funding Agencies: Donors or partners are interested in

ensuring that the funds advanced/released/donated achieve the objective (s) for
which they are given. Financial records have to be monitored or examined for
accountability purposes. Without proper accountability funding for future activities
may be withheld (for example the Global Fund at one time withheld funding due to
gross mismanagement of funds in Uganda).

10.General public: Individuals/organizations should ensure that the businesses make

profits in a socially acceptable manner without negative effects to the environment
and consumers health. Social responsibility of business is gaining attention these
days. Businesses have to give something in return to the public since they are
making profits from the public e.g. Telecom companies do provide sponsorship of
motor rally sports, sensitization on environment, music stars, etc. The public,
including the local community, may therefore be interested in information that is
useful in assessing the trends and recent developments in the entity prosperity and
the range of its activities.

DESIRABLE QUALITIES OF ACCOUNTING INFORMATION

If this information is to be useful to different users of accounting information it should

have the following characteristics.
1. Relevance: Information is relevant if it has the ability to influence the economic
decisions of users. The information that is provided should be that which is required to
satisfy the needs of information users (i.e. the users already identified above).

2. Timeliness: Information should be provided in time to influence those economic

decisions. The usefulness of information is reduced if it does not appear until long after
the period to which it relates is past or if it is produced at unreasonably long intervals.
For example, managers may need information on a daily basis to take decisions,
whereas shareholders may be contented with annual reports.

3. Reliability: Information is reliable if it:

(a) Is free from material errors.
(b) Can be depended upon by users to represent faithfully what it either purports to
represent or could reasonably be expected to represent.
(c) Is free from deliberate or systematic bias (i.e. it is neutral). Information is not
neutral if it is presented in such a way as to influence the making of a decision or
judgment to achieve given results. Reliability of information will be enhanced if it is
independently verified by e.g. Auditors who hold approved qualifications.

4. Completeness: A company’s accounts should present a round picture of its

economic activities. This completeness will be achieved if the accounts are
presented in a format that is acceptable and recommended by relevant professional
bodies/authorities.

5. Objectivity: Information will be useful if it contains a minimum of subjective

judgment. The information should be presented without any bias or an intention to
give a rosy picture of the company’s profit level. (i.e. given with an intention to
impress other people about the performance of the company)

6. Comprehensibility/Understandability: It is no good having all the above points

considered, if the financial statements are then presented in a way that is difficult for
users to understand. Information may be difficult to understand because it is scanty
or incomplete, but too much detail may also cause difficulties of understanding. The
information presented must be material (materiality concept).

7. Comparability: Financial information will be useful if it can be compared with

similar information about the organization/enterprise for some period or point in
time in order to identify trends in financial performance and financial position. It is
also useful if it can be compared with information produced by other sources (e.g.
the accounts of similar companies operating in the same line of business should be
comparable).

ACCOUNTING PRINCIPLES/CONCEPTS/CONVENTIONS

These are basic ground rules / regulations which must be followed when financial
accounts are being prepared and presented. These include the following:-

a) Business concept: This concept requires recognizing and recording of transactions

relating to the entity or organization only in question and excludes private
transactions of the owners or those running it. Record is only made for what the
entity owes the owner (capital) and what the owners owes the entity (drawings).
b) Monetary/ money measurement: According to this concept all transactions to be
recorded must be quantified in monetary terms or language of money. This concept
limits recognition of business transactions to those that can be expressed in
monetary terms whereas whatever cannot be monetized is not recorded.

c) Going concern concept: This concept states that an entity is assumed to continue in
operational existence in the foreseeable future. In other wards the entity is not likely
to collapse unless there are indications to suggest so. This assumption is very
fundamental to preparation of accounts. Accounts are written on the assumption
and understanding that the business will continue in operation.

d) Historical cost: This is sometimes shortened as cost concept. It requires

accountants to record assets and liabilities at historical cost of their acquisitions. For
example; assets are recorded at their acquisition (invoice) cost even if the value
today is more than historical cost likewise liabilities are recorded at amounts they
were incurred.

e) Realization concept: This concept requires that accountants recognize income as

earned only when a sale has been made and the goods have been accepted by the
customer or services have been offered and enjoyed by the customer.
f) Accrual concept: According to this concept, income is recorded as earned even
though it might have not been received in cash provided there is a right to income.
The portion of income that has not been received in cash is recorded as an asset
(accrued income or debtors), likewise expenses or costs should be recorded and
recognized as incurred although cash might have not been paid in respect of those
expenses or costs. Incase those expenses or costs were not paid cash they should be
recorded as liabilities (accruals or accrued).

g) Matching concept. This concept requires accurate matching of expenses against

incomes by writing off only those costs or expenses that are incurred in generating
specific income for the period ended. Costs or expenses paid should be adjusted for
any part period that does not relate to the overall period. For example; whenever
there are alternative methods of valuing an asset, an accountant should choose the
one that leads to a lower value or profit and a higher liability.

h) Conservatism/ prudence: This concept requires that profit is not recognized until
a sale has been completed. Preparation of accounts involves estimations,
measurements and valuations according to the conservation or prudence concept. It
is always a good practice to follow a procedure at leads to understating things.

i) Consistency: The concept states that once a particular accounting method/base has
been selected and has become an accounting policy, it must be applied continuously
or consistently from year to year.

j) Periodicity and Disclosure: This concept makes financial reporting mandatory and
is contained in the Companies Act of Uganda and many other countries. At the end of
the financial year or accounting year a company must prepare and disclose financial
statements. Publishing annual accounts is made an obligation by this concept.

k) Materiality. This requires recognition of only material items and excluding

immaterial items in financial statements. Information is material if its omission is
able to influence the decisions. Financial statements should therefore show material
 items separately, but immaterial items may be aggregated with amounts of a similar
nature.

l) Objectivity. It states that whatever figure recorded in accounting books and

financial statements must have clear criteria or yardstick of its measurements. In
other wards figures must have a basis for arriving at them but not simply planted
into financial statements, accountants must be able to defend figures in financial
statements using objective evidence.

m) Duality/ Dual concept: This requires any transaction to be recorded twice (dual
recording). This concept is recognition of the fact that every transaction involves
giving and receiving aspect. In other wards the receiving side is debited while the
giving side is credited.

n) Substance over form. It states that transactions and other events should be
accounted for and presented in accordance with their substance and financial reality
and not merely with legal form.

ACCOUNTING REGULATORY FRAMEWORK

Accounting rules are imposed on accountants in order to make sure that their reporting
is free from bias. These rules require that final accounts be prepared and presented in
conformity with Generally Acceptable Accounting Principles (GAAP). The key terms
used in accounting regulatory framework include:-
 Accounting principles/concepts/conventions
 Accounting bases
 Accounting policies
 Accounting standards.

Accounting bases
These are methods developed for applying fundamental concepts to financial
transactions and items for the purposes of final accounts.

Accounting Policies
These are the specific accounting bases selected and consistently followed by a business
enterprise as being in the opinion of management, appropriate to its circumstances and
best suited to present fairly its results and financial position.

Accounting standards
These are guidelines statements or rules issued by professional bodies governing
accounting practice, relating to how accounts should be prepared and presented. In
Uganda the professional body responsible for issuing of accounting standards is the
Institute of Certified Public Accountants of Uganda (ICPAU).