FINANCIAL

ACCOUNTING

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INTRODUCTION TO ACCOUNTING
OBJECTIVES
After studying this chapter, you should be able to:
• Define accounting and explain the phases of accounting
• Explain the branches of accounting
• Identify the users of financial information
• Understand the basic financial accounting equations and define assets, liabilities and capital
• Prepare an account in the T form
• Identify the characteristics of good information
• List and explain the principles, concepts and conventions underlying the accounting reports

DEFINITION OF KEY TERMS

1. Accounting: Accounting may be defined as the process of identifying, measuring, recording and
communicating financial information in order to permit users to make informed decisions.
2. Accounting equation: This is a mathematical description of the relationship between assets, liabilities
and capital.
3. Accounting policies are the specific principles, bases, conventions, rules and practices applied by an
entity in preparing and presenting financial statements.
4. Assets: Items of value to an organization.
5. Liabilities: Obligations by the organization to other parties.
6. Capital: Resources put into the business by its owners

PHASES OF THE ACCOUNTING PROCESS

From the above definition, we can clearly see that accounting is a process that can be divided into four
phases;
1. Recording phase: involves the routine and mechanical process of writing business transactions
and events in the books of accounts – also called books of original entry or simply journals - in a
chronological order in accordance with the entity‘s and other established accounting rules and
procedures.
2. Classifying phase: involves sorting and grouping of similar transactions into their respective
classes by posting them into a ledger. A ledger is a group of accounts of a similar nature. An
account is the basic record of accounting which measures increases or decreases in a particular
asset, liability, income or expense account.
3. Summarizing phase: this involves the preparation of financial statements or reports. It is usually
done periodically e.g. monthly, annually etc.
4. Interpretation: this refers to the analysis of the accounting information. It involves
communication of financial information to help users in making economic decisions.

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.

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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.

USERS OF FINANCIAL INFORMATION

1) Management – management of business entities need accounting information to assist for planning and
decision making. They will need the information to prepare budgets and compare with the actual results
of operations. They will also be interested in the cost consequences of a particular course of action to
assist them in making decisions
2) Present and potential investors – they need accounting information to assess the risk inherent in, and
the return provided by their investments. They need information to decide whether they should maintain,
increase, decrease of dispose altogether their investments.
3) Employees are interested about the stability and profitability of their employer. It is a source of
stability for them and they need to know whether to start searching for employment elsewhere or keep
their current postings. They are also concerned about the ability to provide remuneration, retirement
benefits and employment opportunities.
4) Lenders. They are the givers of some part of the company‘s capital. They need to know if the loans
and the corresponding interests will be paid when due.
5) Customers. They require financial data in order to anticipate price changes and to seek alternative
sources of supplies when necessary.
6) The government. Governments and their agencies require information to regulate the activities of the
enterprises. They also need the financial information to determine level of taxation and also in preparation
of national statistics.

The general purpose of accounting can therefore be summarized into five purposes;
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

FINANCIAL STATEMENTS AND ELEMENTS OF FINANCIAL STATEMENTS

There are two main financial statements available to users;
a) The statement of financial position and
b) The income statement.

Balance sheet
It shows the financial position of the entity at a given point in time. The accounting equation is reflected
in the balance sheet. The equation, normally called the book keeping equation is:
Assets = capital+liabilities
The equation shows that for a firm to operate, it needs resources (assets) which have to be supplied by
external parties including creditors (liabilities) and from the owner (capital).
Business transactions will always affect two items of the accounting system. Assets and liabilities are
valued according to accounting conventions.
1. Assets could be defined as being resources controlled by an enterprise as a result of past events
and from which future economic benefits are expected to flow to the enterprise.
a) Current assets are those assets whose benefits are expected to flow within a period of less than six
months. They form part of the enterprise‘s operating cycle or are held for trading purposes e.g.
inventory, accounts receivable (debtors), cash in hand and cash at bank.

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 b) Non-current assets have their benefits expected to flow for a period of more than 12 months.
They are tangible and intangible assets acquired for retention by an entity for the purpose of
providing a service to the business.
i. Examples of tangible non-current assets include buildings, equipment, and machinery.
ii. Intangible non-current assets include goodwill, copyrights, patents, royalties.
2. A liability is defined as a present obligation of the enterprise arising from past events, the
settlement of which is expected to result in an outflow of resources embodying economic benefits
from the enterprise. They represent claims on the business by the outsiders.
a) Current liabilities are expected to be settled in the normal course of the entity‘s operating cycle
and within 12 months.
b)
3. Equity is the residual interest in the assets of the enterprise after deducting all the liabilities.

THE ACCOUNTING EQUATION AND THE STATEMENT OF FINANCIAL POSITION

The accounting equation is the basis of financial accounting. Transactions are recorded using the double
entry system of book keeping showing the two-fold effect that is done to maintain equality of the
equation.
The double entry system requires the use of an account.
An Account is the most basic accounting record. It summarizes the increases and decreases in a particular
asset, liability, revenue, expense or a capital item.
An account is divided into two sides; the left being the debit and the other the credit side. To debit
therefore will mean to enter an amount on the left hand side of an account and vice-versa.
The double entry concept states that ―for every debit entry, there is a corresponding credit entry.
The basic double entry rules for accounts are:
Accounts To record Entry in the account
Assets An increase Debit
A decrease Credit
Liabilities An increase Credit
A decrease Debit
Capital An increase Credit
A decrease Debit
Revenue An increase Credit

Expenses An increase Debit

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 T 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 U 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.

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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 main concepts are:
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 [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.
This principle holds that accounting will only endeavor to deal with those items to which a
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.
5. 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
a) 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.
b) 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.
6. 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.
7. 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.
8. 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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 9. 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.
10. 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.

ACCOUNTING PROCEDURES AND TECHNIQUES

OBJECTIVES
After studying this chapter, you should be able to:
• Define bookkeeping and distinguish it from accounting
• Explain the accounting cycle
• Prepare book of original entry and the various ledgers
• Distinguish between real, nominal and personal accounts
• Record transactions with regard to assets, liabilities, capital, income and expenses
• Balance off accounts and extract a trial balance
• Identify the different types of errors

DEFINITION OF KEY TERMS

a) Assets: an asset can be defined as resources present in a business organization that have probable
future economic benefit. They include cash, land and buildings stock etc.
Assets can either be defined as current, non-current or intangible.
1) Current Assets: these are assets consumed in one year or are expected to benefit the firm
within a period of not more than one financial year e.g. stock, cash at hand, cash at bank,
debtors, prepayments etc.
2) Non-current Assets: these are assets whose economic benefits to the organization are
achieved for a period exceeding one financial year. Examples would be land and
buildings, motor vehicles, plant and machinery, computers etc.
3) Intangible Assets: these are assets of economic value to the business enterprise but cannot
be physically felt or seen e.g. goodwill, patents, copyrights etc.
b) Liabilities: These are obligations that a business is expected to meet within a certain duration.
They can also be defined as total funds owed for assets supplied to a business or expense incurred
but not paid yet. Liabilities can either be short term or long term.
i. Short term liabilities are those that are expected to be met within duration of one financial
year. Payment for accrued expense, creditors, dividends to shareholders etc.
ii. Long term liabilities are those payable within a period exceeding one financial year e.g.
long term loan, re-payment of debentures etc.
c) Capital: this is defined as the total of all resources invested and left in business by its owner.
d) Revenue/Income: this can be defined as the monetary value of all goods and services sold to
customers by a business enterprise
e) Expenses: This can be defined as the monetary equivalent of all resources/assets that have been
consumed during a given period to generate the revenues for the business organization in a given
accounting period.

BOOK KEEPING
Book keeping defined as the process of recording business transactions (data) in a systematic manner. It
can also be defined as that part of accounting that is concerned with recording data.
Book keeping is intended to record all the accounting data in such a way that one can make a deduction
based on it. The deductions could be such as:
• How much sales has been achieved over a given period of time, be it a day, a month, or a year.

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 • How much is owed to the creditors.
• How much is available in the bank, among others.
The whole process of book keeping is in the form of a cycle i.e. the accounting cycle.

THE ACCOUNTING CYCLE

The accounting process can be perceived as a cycle which starts with the occurrence of a transaction,
recording of the transaction and finally the preparation of the financial statements. Financial statements
are reports on results of all the transactions that occur during the year and the position of the business as
at the last date of the accounting period.
A transaction is an activity which involves the exchange of goods and services for another thing of value
e.g. when the business purchases goods for sale, sells goods to customers on credit, pays for services e.g.
telephone.
A transaction is first recorded in the source documents e.g. the cash sale receipt, the invoices received
from creditors, debit and credit notes issued and received etc.
The daybooks as the name suggests they are filled daily showing all the transactions that occurred during
the day. Such information is obtained from the source documents.
The data in the day books is then filled in the ledger accounts and a trial balance extracted as the end of
the accounting period. Adjustments e.g. for prepayments and accruals are then made and an adjusted trial
balance is drawn reflecting these changes.
From this trial balance, the final statements are prepared i.e. the statement of comprehensive income
which reveals whether the company made a profit or loss from the transactions carried out in the year, and
the statement of financial position which tells of the financial position of the business in terms of its
assets and liabilities as at that closing date.
After these, the closing entries are made to prepare the accounts to receive the data for the following
financial period and a closing trial balance extracted.
This marks the end of journals
For every transaction entered into the business enterprise, there is the primary book where it will be
initially recorded. This is known as books of original entry.

BOOKS OF ORIGINAL ENTRY

Books of original entry can be defined as the books in which we first record a transaction. These books
essentially record the following details of a transaction:
• date of the transaction
• the name of the person/ firm with whom the transaction took place
• the details of an item bought or sold e.g. a motor vehicle stock etc.
• details for cross referencing
• the amount (shown in monetary terms) of the transaction
Books of original entry are known as journals or daybooks. Both terms are used interchangeably. The
commonly used books of original entry are:
1) PURCHASES JOURNAL
This journal is used to record all purchases made on credit only.
Example
PURCHASES JOURNAL
Date Details Folio Amount (Sh)
1/12/2006 J. Chege PL 009 4,200
1/12/2006 A. Mbole PL 011 6,700
4/12/2006 J. Chege PL 009 9,200
5/12/2006 B. Gummo PL 010 2,100
8/12/2006 H.Njeri PL 014 4,100

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8/12/2006 A. Mbole PL 011 10,400
9/12/2006 J. Chege PL 009 8,500
10/12/2006 A. Mbole PL 011 6,100
51,300

2) SALES JOURNAL
A sales journal records credit sales only.
Example
SALES JOURNAL
Date Details Folio Amount (Sh)
1/4/2006 J. Kamau SL 001 5,000
1/4/2006 P. Otieno SL 002 4,000
2/4/2006 E. Muteti SL 003 3,200
3/4/2006 P. Otieno SL 002 4,700
4/4/2006 J. Kamau SL 001 4,200
5/4/2006 A. Kioko SL 005 6,700
6/4/2006 J. Kamau SL 001 2,800
30,600

3) RETURN OUTWARDS JOURNAL

It records goods returned by the business to the suppliers for the reason that they are either tampered
with, are not of the kind ordered for, are damaged, or are in excess of the amount ordered.
Example
RETURN OUTWARDS JOURNAL
Date Details Folio Amount (Sh)
9/12/2006 A. Mbole PL 011 1,100

4) RETURN INWARDS JOURNAL

This journal is used to record all the goods that are returned to the business by the customers because
they were not the kind ordered for or were in excess etc.
Example
RETURN INWARDS JOURNAL
Date Details Folio Amount (Sh)
8/4/2006 J. Kamau SL 001 800
9/4/2006 A. Akiko SL 005 500
1,300

5) CASH BOOK
This is a book of original entry that is used to record all cash received or paid out by the business via the
cash till or via the business‘ bank account. A cash book is a unique journal since it acts both as a book of
original entry as well as a ledger account where all transactions affecting cash are recorded.

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 6) GENERAL JOURNAL: (ALSO REFERRED TO AS THE JOURNAL PROPER)
All other transactions not falling into any of the above journals are recorded in this journal. In the
general journal the following details relating to the transaction are included; date, the name of the
account to be debited, the name of the account to be credited and a brief narration or description of the
transaction as illustrated below.
GENERAL JOURNAL
Date Details Debit(Dr) Credit(Cr)
_/_/_ Account to be debited *****
account to be credited *****
(a brief narrative to describe the above
transaction)

A general journal has the following uses:

• Recording the purchase or sale of fixed assets on credit
• Correction of errors in the ledger accounts
• Adjustment of ledger entries
• Writing off of bad debts

POSTING
When all transactions have been entered into the specific journals, they are then entered into their
respective accounts in the ledger in a process referred to as posting. An account is a place where all
details relating to a particular asset, liability or capital, is recorded.
There could be an account for motor vehicles, another for buildings, another one for a specific creditor
and yet other separate accounts for each debtor etc.
Accounts can be divided into two:
• Personal accounts
• Impersonal accounts.
Personal accounts are accounts dealing with customers and suppliers i.e. debtors and creditors.
Impersonal accounts on the other hand can further be divided into:
a) Real accounts used for recording possessions like land, motor vehicles, buildings, furniture and
fittings.
b) Nominal account used for recording capital, income and expenses.
All accounts are prepared in a T-format and thus generally referred to as T- accounts. The T-accounts
have two sides; the debit side on the left and the credit side on the right of the account as shown below.

Dr Name of the account Cr

DATE PARTICULARS FOLIO AMOUNT (Sh) DATE PARTICULARS FOLIO AMOUNT (Sh)

Every transaction in a business affects two accounts. One of the accounts is debited while the other is
credited by the same amount giving rise to double entry book keeping i.e. for each entry recorded in the
journals there will be a debit and a credit entry in two separate accounts in the ledger.

A brief example would be when we buy a motor vehicle for cash.

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Two items will be affected:
• We will have a new asset; known as a car (a motor vehicle)
• On the other hand, the asset cash will have reduced by the amount we pay for the car.
Generally a transaction either increases or decreases an asset, liability or capital. This is reflected in the
accounts as follows:
(i) When we increase an asset we make a debit entry to the asset account
(ii) When we decrease an asset we make a credit entry to that account
(iii) When we increase our liabilities or capital, we make a credit entry
(iv) When we decrease our liability or capital we make a debit entry to that account.

Uses of special journal

• They facilitate grouping transactions which are alike together, recording them to provide relevant
transaction details.
• It facilitates easier mechanization of the recording process
• It makes the posting work easier because numerous ledger accounts take the totals.
• They minimize possible errors.

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