Financial Accounting

The general objective of this course is to equip the learners with skills and knowledge on
preparation of the financial statement of sole proprietors. occurred

Concept of Accounting
Expected learning outcomes
The learner should be able to:
1. Explain the concept of accounting.
2. briefly describe the history of accounting
3. Explain the relationship between bookkeeping and accounting
4. Outline the purpose of accounting
5. List the main users of accounting information and the accounting information for
interested.
6. Explain the accounting equation
7. explain the relationship between the accounting equation and the layout of the
statement of financial position
8. Explain the meaning of the terms assets, capital and liabilities.
The concept of accounting is not new. The Father of Modern Accounting is Luca Pacioli
(1494) because he wrote the first book that described double-entry accounting processes.
Where he defined “The Double-Entry Bookkeeping System as the practice of recording a
business transaction in two equal parts called debit and credit entries.
The role of accounting is not limited in business but also applies domestic life; since a family
will record domestic transactions, connected with money, regularly. Ordinarily one will
maintain a small dairy to record receipts on one page and all payments on another page.
Receipts are not always many unlike the list of payments is relatively more on different
items. This helps the family to conveniently find out how much it has spent on the different
items of expenditure by the end of the month.

Purpose and Role of Accounts for a Business

A businessman has to keep a systematic record of the financial activities of his firm so that he
can know the financial position. What it owns (assets), what it owes (liabilities).
It is necessary for every businessman to know where he stands in many respects:
(i) What he owns?
(ii) What does he owe?
(iii)Whether he has earned profit or suffered a loss over a period?

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(iv) What is his financial position? know if they were being financially successful, and Is
he better off or moving towards bankruptcy.
Only accounts give answers to these questions.

The purpose of accounting is narrow to many. Many consider the role of accounting is
limited to maintain books of accounts for a limited purpose of filing the income-tax return
to comply with tax laws or determine performance! With computerisation, the role
accounting of recording transactions in books of accounts (Bookkeeping) has diminished.

At present, the combined role of accounting and finance has assumed more prominence
than the individual role of accounting. This could infer that the finance manager can
change the fortunes of the organisation if he is competent. This is because he is associated
with every decision-making process starting from the recruitment of staff to the final
stage (liquidation). S/he should be practical in making the objectives of accounting and
finance to tailor the needs of the business.

Meaning of Book-Keeping and Accountancy

There is no universally accepted line of demarcation or division between Book-Keeping
and Accountancy. However, book-keeping is the art of recording business transactions in
a set of books of accounts. Transaction means any dealing, expressed in terms of money.
The books in which the transactions are recorded are called ‘Books of Accounts.
Book-keeping is concerned with the preparation of vouchers, recording transactions in a
journal and posting in the ledger. Book-keeper arrives at the final balances of different
accounts, after totalling the accounts. The job of a bookkeeper is to the extent of
preparing trial balance, duly balanced. Book-keeping is mainly clerical, but with the
advent of computerization, the activity is being diminished, although we still have a
substantial number of such activities in the MSEs Sector.
Conversely, accountancy requires deep knowledge of the principles and their application.
Implying that book-keeping and accountancy are different in several aspects; though they
are supplementary to each other. This means that book-keeping and accounting are not
synonymous terms. The job of an accountant commences where the work of a book-
keeper ends (Trial balance level). In other words, the accountant assumes the role of a
supervisor of a book-keeper.
The functions of an Accountant can be summarised as under:
(i) Examination of entries made in the books of accounts
(ii) Authentication of trial balance
(iii) correction of errors, if any, in accounts
(iv) Recording the adjustments

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(v) Preparation of statement of profit or loss account and other comprehensive income
(vi) Preparation of statement of financial position
(vii) Analysis of results and deriving conclusions and communication of the results.

Conceptualising the term Accounting

Accounting is prepared in accordance with certain basic principles and laws, which are
universally accepted (science). Similarly, accounting follows a prescribed process
through which the objectives are fulfilled; therefore viewed as an art.
The question is: Is accounting a science or an art? The American Institute of Certified
Public Accountants defines accounting as an art. Accountancy involves recording the
transactions and maintaining books of accounts in the prescribed manner, regularly,
according to certain rules and regulations for the achievement of the objectives of the
firm.

Definition and Explanation of Accounting

I borrow the standard definition of accounting from the American Institute of Certified
Public Accountants; which is “the Art of recording, classifying and summarizing in a
significant manner and in terms of money, transactions and events which are, in part, at
least, of a financial character, and interpreting the results thereof”.
Accounting can be broken down as follows:
1. Recording: Recording is the basic function of Accounting e.g. recording in a journal,
cash book etc.
2. Classifying: The objective of classification is to find a summary of the entries of same
nature at one place, e.g. in a ledger. This book ‘Ledger’ contains a different nature of
accounts. For example, there may be separate heads of accounts such as Salaries,
Traveling Expenses, Repairs, Printing and Stationery etc. We are interested to know
the total amount under each head of an account for our understanding and control.
3. Summarising: The individual accounts find a place in a summarised manner, which is
called ‘Trial Balance’. Normally when posting is complete in the ledger, totals are
made for debit and credit side in each head of an account and final balances are
arrived.
4. Deals with Financial Transactions: Only accounting transactions which are of
financial character are recorded in books of accounts. In other words, if a transaction
cannot be expressed in terms of money, they are not recorded in accounting books.
5. Analysis and Interprets: This is the final and important function of accounting —
Analysis refers to the methodical classification of data. If unconnected data are
grouped, understanding is not possible. All assets belonging to current assets are to be
grouped, similarly to all current liabilities. If current assets and current liabilities are

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 mixed, data would be confusing.
Interpretation means drawing conclusions from the data and explaining the
conclusions in a simple language, easy to understand and plan further course of
action. Analysis and interpretation are complementary to each other.
6. Communicates: Communication is the output of the accounting process. Where the
feedback of business operations are communicated in the form of financial statements
i.e. statement of Profit or Loss and other incomes and statement of financial position
(balance sheet). Modern management wants the data in a simple form, easy to
understand and ready to act, immediately.

Branches of Accounting
The discipline of accounting comprises the following branches:
1. Financial Accounting: This branch of accounting is limited to the preparation of
financial statements that is statement of Profit or Loss Account and other
comprehensive incomes and statement of financial position.
2. Cost Accounting: Cost Accounting is concerned with the estimation of costs, in
advance, and their subsequent detailed analysis for the purpose of control.
Management is interested to know the costs of the different products they make for
the purpose of determining the price. Secondly, management has to take suitable
decision, when they receive a special order at a lower price than the current market
price, for acceptance or rejection.
3. Management Accounting: Management accounting is a branch of accounting, which
furnishes useful data to the management in carrying out the various functions such as
planning, decision-making and controlling the activities of the business enterprise.
The information will be applied to discharge its functions in forecasting, budgeting,
control over costs and strategy formation.
4. Tax Accounting
This branch of accounting is involves the preparation of statement of adjusted
financial statement for tax purposes.
Financial Accounting
Financial accounting is the original form of accounting; which is the art of recording,
classifying and summarizing in a significant manner and in terms of money,
transactions and event which are, in part at least, of a financial character and
interpreting the result thereof.

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 Purpose of Accounting
Importance of financial accounting
1. Helps in keeping systematic records all financial transactions. It is not possible to
remember all transactions.
2. Ascertains the results of operations through preparing statement of profit or loss
account.
3. Ascertains the financial position of the business that is a statement listing assets,
liabilities and the owner’s capital.
4. Provides control and protect business assets by providing information and exercising
control over the properties of the business and their proper utilisation.
5. Provides information to the tax authorities. Financial Accounting enables the firm to
send the correct tax returns, in time to tax authorities.
6. Facilitates rational decision-making Management. Decision-making is the basic
function of the management therefore in the absence of information, there would be
no basis for decision.
Activity
1. Outline the objectives financial statements are intended to achieve.
2. State the difference between book-keeping and financial accounting.
USERS OF ACCOUNTING
There are several interested parties to accounting information. They include:
1. Creditors: These are suppliers of goods and services on credit.
2. Shareholders: They are the owners and providers of capital.
3. Government: Government is a stakeholder, and interested on the accuracy of tax
declared and paid.
4. Investors: These are entities/individuals who are not owners of the business; but
interested in investing their money for a return.
5. Lenders: Are individuals/entities who lend money that is financial institutions or
banks. Their aim is to ascertain the ability to pay.
6. Management: They are interested in every aspect of accounting as their uses are
diverse for different purposes.
7. Employees: To ascertain the going concern of the entity in order to obtain assurance
of their jobs are secure.
8. Competitors: To compare themselves with a view of identifying their deficiencies
9. The public: To evaluate whether the entities will continue participating in Corporate
Social Responsibility.

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 10. Researchers/analyst: Information may be required for prospective client.
11. Potential buyer: The buy may want to know the value of the business in order to make
a buy decision.

The objective of financial statements is to provide financial information about the reporting
entity’s assets, liabilities, equity, income and expenses that is useful to users of financial
statements in assessing the prospects for future net cash inflows to the reporting entity and in
assessing management’s stewardship of the entity’s economic resources.
Financial statements include:
1. Statement of financial position, by recognising assets, liabilities and equity.
2. Statement of financial performance- Statement of profit or loss and other
comprehensive income, by recognising income and expenses.
3. Statement of cash flow
4. Statement of changes in equity
The Elements of Financial Statements
The elements of financial statements are:
(a) Assets, liabilities and equity, which relate to a reporting entity’s financial position; and
(b) Income and expenses, which relate to a reporting entity’s financial performance.

Definition of elements of financial statements

A) Asset
1. An asset is a present economic resource controlled by the entity as a result of past
events; where an economic resource is a right that has the potential to produce
economic benefits. They are resources of value owned and controlled by the entity/ or
properties owned by the firm.
Assets are broadly classified into:
 Non-current assets-are the assets owned by the firm for the purpose of
conducting business. Examples are Building, Plant and Machinery (motor
vehicles, furniture & fittings etc.
 Current assets- These are assets held by the firm for the purpose of carrying on
business. Examples are Cash, Bank, inventories, Debtors, Bills Receivable,
Accrued income etc.
Activity: List different types of Non-current assets and current assets.
Quiz

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 From this definition three aspects arise: right, potential to produce economic benefits and
control… Rights that have the potential to produce economic benefits take many forms
such as:
i. Rights that correspond to an obligation of another party
ii. rights that do not correspond to an obligation of another part
 Discuss what may constitute right under each of the above.
 What qualifies a right to meet the definition of an economic resource?
Quiz
1. Discuss the terms right, potential to produce economic benefits and control in the
context of an asset
2. Outline circumstances an economic resource could be said to be classified as asset
(producing economic benefits for an entity).
(i) Receive contractual cash flows or another economic resource;
(ii) Exchange economic resources with another party on favourable terms;
(iii)Produce cash inflows or avoid cash outflows by, for example:
 Using the economic resource either individually or in combination with
other economic resources to produce goods or provide services;
 Using the economic resource to enhance the value of other economic
resources; or
 Leasing the economic resource to another party;
(iv) Receive cash or other economic resources by selling the economic resource; or
(v) Extinguish liabilities by transferring the economic resource.
An economic resource derives its value from its present potential to produce future economic
benefits. The economic resource is the present right that contains that potential, not the future
economic benefits that the right may produce. For instance, a purchased option derives its
value from its potential to produce economic benefits through exercise of the option at a
future date.
However, the economic resource is the present right—the right to exercise the option at a
future date. The economic resource is not the future economic benefits that the holder will
receive if the option is exercised.
There is a close association between incurring expenditure and acquiring assets, but the two
do not necessarily coincide.
Hence, when an entity incurs expenditure, this may provide evidence that the entity has
sought future economic benefits, but does not provide conclusive proof that the entity has
obtained an asset.
Similarly, the absence of related expenditure does not preclude an item from meeting the

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definition of an asset.
Assets can include, for example, rights that a government has granted to the entity free of
charge or that another party has donated to the entity.

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Control: An entity controls an economic resource if it has the present ability to direct the use
of the economic resource and obtain the economic benefits that may flow from it. Control
includes the present ability to prevent other parties from directing the use of the economic
resource and from obtaining the economic benefits that may flow from it. It follows that, if
one party controls an economic resource, no other party controls that resource.

B) Liability
A liability is a present obligation of the entity to transfer an economic resource as a result of
past events. In other words, it is an obligation/claim by an outsider against entity assets.
There are two categories of liabilities:
 Non-current liabilities- Repayment period extends beyond one year. Examples are
Bank loans, Debenture stocks
 Current liabilities- Are liabilities which are settled with one accounting period (a
year). Examples are trade creditors, accrued expenses, bank overdraft etc.
Activity: List different types of Non-current liabilities and current liabilities.
Activity: Classify the following elements of the statement of financial position either as non-
current assets, current assets, non-current liabilities and current liabilities