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FINANCIAL ACCOUNTING
INTRODUTION TO ACCOUNTING
a) DEFINITION
Accounting is defined as the process of identifying, classifying, measuring, summarizing,
interpreting and reporting economic information to the users of this information to permit
informed judgment.

The American Accounting Association also defines accounting as a process of identifying,

measuring and communicating economic information to permit informed judgment and decision
by the users of the information.

According to the American Institute of Certified Public Accountants, Financial Accounting is an

art of recording, classifying and summarizing in a significant manner and in terms of money,
transactions and events that are, in part at least, of a financial character interpreting the results
thereof.

b) NATURE OF ACCOUNTING

Many businesses carry out transactions. Some of these transactions have a financial implication
i.e. either cash is received or paid out. Examples of these transactions include selling goods,
buying goods, paying employees and so many others. Accounting involves identifying,
measuring (attaching value) and reporting on these transactions.

If a firm employs a new staff member then this may not be an accounting transaction. However,
when the firm pays the employee salary, then this is related to accounting as cash is involved.
This has an economic impact on the organization and will be recorded for accounting purposes.
A process is put in place to collect and record this information; it is then classified and
summarized so that it can be reported to the interested stakeholders.

c) FUNCTIONS AND LIMITATIONS OF ACCOUNTING

Functions of Financial Accounting

Accounting in modern times has two distinct functions to perform- historical function and
managerial function. The historical function is concerned with recording, classifying,
summarizing, analyzing and interpreting the past transactions for specified accounting period(s)
of an entity. The objective of the historical function of accounting is to report at regular intervals
to the users of the accounting information by means of financial statements. The managerial
function of accounting on then other hand is concerned with planning the future activities of an
entity and controlling its operations. In particular, this function helps the management in looking
forward, comparing pre-determined targets with the actual results with the objective of
promoting maximum operational efficiency.

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Historical Functions of Financial Accounting

Recording
This is the basic function of accounting involving the recording of transactions expressed in
monetary terms in an orderly manner. It is done in journals that are maintained according to the
size and nature of business. Examples of journals in which financial information is recorded
include cash journal, sales journal, purchases journal among others
Classifying
This is concerned with the systematic analysis of the recorded data with a view to grouping
transactions/entries of a similar nature under appropriate heads of accounts such as sales,
purchases, salaries, Assets and other the ledger books
Summarizing
This entails the presentation of classified data in a manner which is easily understandable and
useable for the internal as well as external users of accounting information. The process usually
leads to the preparation of financial statements such as the trial balance, income statement and
balance sheet.
Interpreting
Analysis and interpretation of the recorded financial data to enable the users to make meaningful
judgment about the financial conditions and profitability of business operations. The data helps
in preparing future plans and framing policies for executing such plans
Communicating
The accounting information has to be communicated in proper manner through the preparation
and distribution of accounting reports.

Limitations of Financial Accounting

i. It is of historical interest and only ‘post-mortem’ analysis of the past can be conducted as it
provides historical financial information in the form of statements usually prepared annually.
ii. Financial accounting permits alternative treatments for certain aspects which may lead to
different figures of profits for the year. Notable examples include inventory valuation,
ascertainment of depreciation, treatment of deferred revenues and expenditures etc
iii. It ignores important non-monetary information which may be very important for decision
making from management’s perspective.
iv. Financial accounting records fail to take into account the effect of changing prices.It is
implicitly assumed that the price level does not change over time leading to computation of
profits and maintenance of capital on nominal basis instead f real basis.
v. Financial accounting fails o depict the present market value of the business as assets are
shown on going concern basis by following the cost principle.
vi. When exact accounting principles are not strictly applied, Finanncial accounting cannot give
the correct picture of the business
vii. Financial accounting ignores some qualitative elements such as quality of management,
quality of labour force and public relations since it is confined to monetary matters only.

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d) THE USE OF ACCOUNTING INFORMATION

Accounting information is produced in form of financial statements which provide information
about an entity’s financial position, performance and changes in financial position. Financial
position of a firm is what the resources the entity has and how much belongs to the owners and
others. The financial performance reflects how the business has performed, whether it has made
profits or losses. Changes in financial positions determine whether the resources have increased
or reduced.

USERS OF ACCOUNTING INFORMATION

The users of accounting information are interested in the existence of the firm and therefore the
information contained in the financial statements will affect the decision making process. The
following are the users of accounting information:
i. Owners:
These are persons who have invested in the business including sole traders, partners and
shareholders. They would like to have information on the financial performance, financial
position and changes in financial position to enable them to assess how the managers of the
business are performing whether the business is profitable or not and whether to make drawings
or put in additional capital.
ii. Customers
Customers rely on the business for goods and services. They would like to know how the
business is performing and its financial position. This information would enable them to assess
whether they can rely on the firm for future supplies.
iii. Suppliers
They supply goods or services to the firm. The supplies are either for cash or credit. The
suppliers would like to have information on the financial performance and position so as to
assess whether the business would be able to pay up for the goods and services provided as and
when the payments falls due.
iv. Managers
The managers are involved in the day-to-day activities of the business. They would like to have
information on the financial position, performance and changes in financial position so as to
determine whether the business is operating as per the plans. In case the plan is not achieved then
the managers come up with appropriate measures (controls) to ensure that the set plans are met.
v. The Lenders
They have provided loans and others sources of capital to the business. Such lenders include
banks and other financial institutions. They would like to have information on the financial
performance and position of the business to assess whether the business is profitable enough to
pay the interest on loans and whether it has enough resources to pay back the principal amount
when it is due.
vi. The Government and its agencies
The Government is interested in the financial performance of the business to be able to assess the
tax to be collected in the case there are any profits made by the business. The other government
agencies are interested with the financial position and performance of the business to be able to
come with National Statistics. This statistics measure the average performance of the economy.
vii. The Financial Analyst and Advisors
Financial analyst and advisors interpret the financial information. Examples include stockbrokers
who advise investors on shares to buy in the stock market and other professional consultants like

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accountants. They are interested with the financial position and performance of the firm so that
they can advise their clients on how much is the value their investment i.e. whether it is
profitable or not and what is the value. Others advisors would include the press who will then
pass the information to other relevant users.
viii. The Employees
They work for the business/entity. They would like to have information on the financial position
and performance so as to make decisions on their terms of employment. This information would
be important as they can use it to negotiate for better terms including salaries, training and other
benefits. They also use it to assess whether the firm is financially sound and their jobs are secure.
ix. The Public
Institutions and other welfare associations and groups represent the public. They are interested
with the financial performance of the firm. This information will be important for them to assess
how socially responsible is the firm. This responsibility is in form the employment opportunities
the firm offers, charitable activities and the effect of a firm’s the activities on the environment.

e) ACCOUNTING PRINCIPLES
Accounting principles refer to a body of doctrines commonly associated with the theory and
procedures of accounting serving as an explanation of the current practices and as a guide for the
selection of conventions or procedures where alternatives exist. The accounting principles are
broadly classified into:
1. Accounting concepts and
2. Accounting conventions.

ACCOUNTING CONCEPTS
Accounting Concepts are broad basic assumptions that underlie the periodic financial accounts of
business enterprises.They include:
i) The going concern concept:
Implies that the business will continue in operational existence for a fairly long time, and that
there is no intention to put the company into liquidation or to make drastic cutbacks to the scale
of operations. Financial statements should be prepared under the going concern basis unless the
entity is being (or is going to be) liquidated or if it has ceased (or is about to cease) trading. The
main significance of the going concern concept is that the assets of the business should not be
valued at their ‘break-up’ value, which is the amount that they would sell for it they were sold
off piecemeal and the business were thus broken up.
ii) The historical cost convention:
A basic principle of accounting (some writers include it in the list of fundamental accounting
concepts) is that resources are normally stated in accounts at historical cost, i.e. at the amount
that the business paid to acquire them. An important advantage of this procedure is that the
objectivity of accounts is maximized: there is usually objective, documentary evidence to prove
the amount paid to purchase an asset or pay an expense. Historical cost means transactions are
recorded at the cost when they occurred.
iii) The accruals concept ( The Concept of Matching Costs and Revenues):
States that revenue and costs must be recognized as they are earned or incurred, not as money is
received or paid. They must be matched with one another so far as their relationship can be
established or justifiably assumed, and dealt with in the profit and loss account of the period to
which they relate.

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Assume that a firm makes a profit of £100 by matching the revenue (£200) earned from the sale
of 20 units against the cost (£100) of acquiring them. If, however, the firm had only sold
eighteen units, it would have been incorrect to charge profit and loss account with the cost of
twenty units; there is still two units in stock. If the firm intends to sell them later, it is likely to
make a profit on the sale. Therefore, only the purchase cost of eighteen units (£90) should be
matched with the sales revenue, leaving a profit of £90.
iv) The Separate Entity concept:
The concept is that accountants regard a business as a separate entity, distinct from its owners or
managers. The concept applies whether the business is a limited company (and so recognized in
law as a separate entity) or a sole proprietorship or partnership (in which case the business is not
separately recognized by the law.
v) The Money Measurement concept:
The money measurement concept states that accounts will only deal with those items to which a
monetary value can be attributed. Events or transactions which cannot be expressed in monetary
terms do not find place in books of accounts though they nay be very useful for the business. For
example, in the balance sheet of a business, monetary values can be attributed to such assets as
machinery (e.g. the original cost of the machinery; or the amount it would cost to replace the
machinery) and stocks of goods (e.g. the original cost of goods, or, theoretically, the price at
which the goods are likely to be sold).
vi) The realization concept:
Revenue and profits are recognized when realized. The concept states that revenue and profits
are not anticipated but are recognized by inclusion in the income statement only when realized in
the form of either cash or of other assets the ultimate cash realization of which can be assessed
with reasonable certainty.
vii) Dual Aspect:
Every transaction has two-fold effect on the accounts and is the basis of double entry
bookkeeping.
viii) Accounting Period Concept
According to this concept, the life of a business is divided into appropriate segments for studying
the results shown by the business after each segment. After each segment or time interval, the
business must review how things are going. In accounting, such a segment or time interval is
known as “accounting period’ and is usually of a year. In every accounting period, financial
statements are prepared, analysed and interpreted to guide decision-making and forward
planning.

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ACCOUNTING CONVENTIONS

The accounting conventions denote those traditions or customs which guide accountants in
preparing the financial statements. They include conservatism, full disclosure, consistency and
materiality.

i. Consistency:
Accounting practices should remain unchanged from one period to another. The concept states
that in preparing accounts consistency should be observed in two respects. Similar items within a
single set of accounts should be given similar accounting treatment. The same treatment should
be applied from one period to another for valid comparisons to be made from one period to the
next.
ii. Conservatism (Prudence)
Every business wants to play safe in the world characterized by uncertainty. Conservatism is a
quality of judgment exercised in evaluating the uncertainties and risks present in business to
ensure reasonable provisions are made for potential losses in the realization of recorded assets
and in the settlement of actual contingent liabilities. Conservatism advocates the power of
judgment of likely revenues and expenses since deliberate understatements are likely to produce
overstatements in subsequent periods thus undermining the usefulness of financial statements. To
summarize it:
1. Don’t count on the eggs, which are not hatched (ignore anticipated uncertain incomes)
2. But provide for an umbrella for the rainy day (don’t ignore likely expenses).
This concept allows accountants to show anticipated losses in the form of provisions yet it
violates the basic historical accounting, which emphasizes that an event should be recorded only
when it has occurred. Thus, this convention should be applied cautiously.
iii.Materiality
According to this convention, an accountant should attach importance to material details and
ignore insignificant details. An item is considered material if it’s omission or misstatement will
affect the decision making process of the users. Materiality depends on the nature and size of the
item. Only items material in amount or in their nature will affect the true and fair view given by a
set of accounts.
An error that is too trivial to affect anyone’s understanding of the accounts is referred to as
immaterial. In preparing accounts, it is important to assess what is material and what is not, so
that time and money are not wasted in the pursuit of excessive detail. However, determining
whether or not an item is material is a very subjective exercise. There is no absolute measure of
materiality. It is common to apply a convenient rule of thumb (for example to define material
items as those with a value greater than 5% of the net profit disclosed by the accounts). But
some items disclosed in accounts are regarded as particularly sensitive and even a very small
misstatement of such an item would be regarded as a material error. An example in the accounts
of a limited company might be the amount of remuneration paid to directors of the company.
Example:
a) If a balance sheet shows fixed assets of £2 million and stocks of £30,000 an error of £20,000
in the depreciation calculations might not be regarded as material, whereas an error of £20,000
in the stock valuation probably would be. In other words, the total of which the erroneous
item forms part must be considered.
b) If a business has a bank loan of £50,000 balance and a £55,000 balance on bank deposit
account, it might well be regarded as a material misstatement if these two amounts were

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displayed on the balance sheet as ‘cash at bank £5,000’. In other words, incorrect presentation
may amount to material misstatement even if there is no monetary error.
iv. Full Disclosure
Ccording to this convention, accounting reports should disclose fully and fairly the information
they purport to represent. They should be honestly prepared, and sufficiently disclose
information which is of material interest to the users of accounting information.
The directors of a company must also disclose any significant doubts about the company’s future
if and when they arise.
v. Substance over form
The principle that transactions and other events are accounted for and presented in accordance
with their substance and economic reality and not merely their legal form e.g. a non current asset
on Hire purchase although is not legally owned by the enterprise until it is fully paid for, it is
reflected in the accounts as an asset and depreciation provided for in the normal accounting way.

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)

Qualities of Useful Financial Information

Understandability: an essential quality of the information provided in the financial statements
is that it is readily understandable by users. For this reason users are assumed to have a
reasonable knowledge of business and economic activities and accounting.
Relevance: information has the quality of being relevant when it influences the economic
decisions of users by helping them evaluate past, present or future events or confirming or
correcting their past evaluations.
Reliability: information is useful when it is free from material error and bias and can be
depended upon by users to represent faithfully that which it is reasonably be expected to
represent. To be reliable then the information should be represented faithfully, free from bias, be
complete and accounted for and presented in accordance with their substance and economic
reality and not merely their legal form,
Comparability: The accounting information should be able to be compared with other
information from different organizations or of the same organization at different periods.
Timeliness: If the accounting information is not availed to the deserving user at the time of need,
it may be rendered useless. For accounting information to be useful, it must be presented to the
arty in need at the time of need.

Assignment 1(Due on 30th Jnuary, 2018):

1. Discuss the utility of accounting information (5 marks)
2. The accounting profession has for a long time relied on certain accounting concepts and
conventions to guide accounting practice. Yet the application of the same principles has been
the source of criticism of the quality and relevance of information contained in financial
reports. Discuss any five Generally Accepted Accounting Principles (10 marks)

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THE ACCOUNTING PROCESS AND ACCOUNTING EQUATION

The Accounting Process
The accounting process can be perceived as a cycle which starts with the occurrence of a
transaction, recording of the transaction, classifying the transactions and finally the preparation
of the financial statements for each and every financial period. The transaction is first recorded in
source documents e.d the cash sale receipt, invoices received from creditors, debit and credit
notes issued and received etc.

From the source documents, financial information is recorded in the daybooks (journals/ books
of original entry) and then filled in the ledger accounts and a trial balance is extracted as at the
end of the accounting period. From there, adjustments e.g for prepayments and accruals are made
and an adjusted trial balance is drawn reflecting these changes.

From this trial balance, the final statements (Statement of income and statement of financial
position) are prepared marking the end of the accounting cycle. The statement of income reveals
whether the company made a profit or loss from the transactions carried out in the year while the
statement of financial position (balance sheet)tells of the financial position of the business in
terms of its assets and liabilities as at the closing date.

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