Financial Accounting

The general objective of this course is to equip the learners with skills and knowledge on
preparation of the financial statement.
Concept of Accounting
Expected learning outcomes
The learner should be able to:
1. Explain the concept of accounting.
2. Describe the history of accounting
3. Explain the relationship between book-keeping and Financial 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.

Background to accounting
The Father of Modern Accounting is Luca Pacioli (1494) because he wrote the first book that
described double-entry accounting processes.
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 only to business but also applies to domestic life.
This is because families normally record domestic transactions connected with money, on a
regular basis.
Ordinarily one will maintain a small dairy to record receipts on one page and all payments on
another page.
The number of receipts are not always many unlike the list of payments, which 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 Accounting to a Business

A businessman has to keep a systematic record of the financial activities of his firm so that he
can know where he stands in many respects:

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(i) What he owns? (assets),
(ii) What does he owe? (Liabilities).
(iii)Whether he has earned profit or suffered a loss over a period?
(iv) What is his financial position? Know if they were being financially successful, and is
he better off or moving towards bankruptcy.
Only Financial statements/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 (Book-keeping) 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 ledgers. 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-

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keeper.
The functions of an Accountant can be summarised as under:
(i) Examination of entries made in the books of accounts
(ii) Verification of trial balance
(iii) correction of errors, if any, in accounts
(iv) Recording the adjustments
(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.

Definition of 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,
Since Accountancy involves recording the transactions and maintaining books of
accounts in the prescribed manner, regularly, and according to certain rules and
regulations to achieve the objectives of the firm.
Definition of Accounting as per American Institute of Certified Public Accountants
The American Institute of Certified Public Accountants; Defines Accounting as: “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”.
This definition 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.

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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 systematic classification of data. All assets belonging to current
assets are to be grouped, similarly to all current liabilities. If current assets and current
liabilities are mixed, data would be confusing, meaning if unconnected data are
grouped, understanding is not possible.
Interpretation means drawing conclusions from the data and explaining the
conclusions in a simple language that is 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 comprehensive 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, statement of financial position, statement of cash flow and
statement of changes in equity.
2. Cost Accounting: Cost Accounting is concerned with the estimation of costs in
advance, and their subsequent detailed analysis for the purpose of control. Where the
management:
(a) Is interested to know the costs of the different products they make for the
purpose of determining the price.
(b) Use the information to take suitable decision for example when they receive a
special order at a lower price than the current market price, do they 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 is a branch of accounting that is involved in the assessment and determination of
taxes payable through preparation of statements of adjusted profit and loss for tax
purposes.

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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.

Purpose 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 information to be used for control and protect business assets/properties of
the business and ensure 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 financial 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.

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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.
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 general purpose financial reporting is to provide financial information about
the reporting entity that is useful to existing and potential investors, lenders and other
creditors in making decisions relating to providing resources to the entity, those decisions
involve decisions about:
(a) Buying, selling or holding equity and debt instruments;
(b) Providing or settling loans and other forms of credit; or
(c) Exercising rights to vote on, or otherwise influence, management’s actions that
affect the use of the entity’s economic resources
NB: The potential investors, lenders and other creditors need information about:
(a) The economic resources of the entity, claims against the entity and changes in those
resources and claims and
(b) How efficiently and effectively the entity’s management and governing board have
discharged their responsibilities to use 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
Financial reports provide information about the reporting entity’s economic resources,
claims against the reporting entity and the effects of transactions and other events and
conditions that change those resources and claims.

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Qualitative Characteristics of Useful Financial Information
The qualitative characteristics of useful financial information identify the types of
information that are likely to be most useful to the existing and potential investors, lenders
and other creditors for making decisions about the reporting entity on the basis of information
in its financial report (financial information).
If financial information is to be useful, it must be relevant and faithfully represent what it
purports to represent. The usefulness of financial information is enhanced if it is comparable,
verifiable, timely and understandable.

Fundamental qualitative characteristics

The fundamental qualitative characteristics are relevance and faithful representation.
Relevance
Relevant financial information is capable of making a difference in the decisions made by
users. Difference in this context means that financial information has predictive value,
confirmatory value or both, that is predict future outcomes by users using the information to
make their own predictions. Financial information has confirmatory value if it provides
feedback about (confirms or changes) previous evaluations.
For example, revenue information for the current year, which can be used as the basis for
predicting revenues in future years, can also be compared with revenue predictions for the
current year that were made in past years. The results of those comparisons can help a user
to correct and improve the processes that were used to make those previous predictions.

Materiality
Information is material if omitting, misstating or obscuring it could reasonably be expected to
influence decisions that the primary users of general purpose financial reports make on the
basis of those reports, which provide financial information about a specific reporting entity.

Faithful representation
Financial reports represent economic phenomena in words and numbers. To be useful,
financial information must not only represent relevant phenomena, but it must also faithfully
represent the substance of the phenomena that it purports to represent. In many
circumstances, the substance of an economic phenomenon and its legal form are the same. If
they are not the same, providing information only about the legal form would not faithfully
represent the economic phenomenon.
To be a perfectly faithful representation, a depiction would have three characteristics. It
would be complete, neutral and free from error.
A complete depiction includes all information necessary for a user to understand the
phenomenon being depicted, including all necessary descriptions and explanations (for

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example, historical cost or fair value).For some items, a complete depiction may also entail
explanations of significant facts about the quality and nature of the items, factors and
circumstances that might affect their quality and nature, and the process used to determine the
numerical depiction.
A neutral depiction is without bias in the selection or presentation of financial information.
Neutrality is supported by the exercise of prudence. Prudence is the exercise of caution when
making judgements under conditions of uncertainty. The exercise of prudence means that
assets and income are not overstated and liabilities and expenses are not understated.

Faithful representation does not mean accurate in all respects. Free from error means there
are no errors or omissions in the description of the phenomenon, and the process used to
produce the reported information has been selected and applied with no errors in the process.

When monetary amounts in financial reports cannot be observed directly and must instead be
estimated, measurement uncertainty arises. The use of reasonable estimates is an essential
part of the preparation of financial information and does not undermine the usefulness of the
information if the estimates are clearly and accurately described and explained.

Enhancing Qualitative Characteristics

Enhancing qualitative characteristics Comparability, verifiability, timeliness and
understandability are qualitative characteristics that enhance the usefulness of information
that both is relevant and provides a faithful representation of what it purports to represent.

Comparability
Information about a reporting entity is more useful if it can be compared with similar
information about other entities and with similar information about the same entity for
another period or another date.
Comparability is the qualitative characteristic that enables users to identify and understand
similarities in, and differences among, items. Unlike the other qualitative characteristics,
comparability does not relate to a single item. A comparison requires at least two items.

Consistency, although related to comparability, is not the same. Consistency refers to the use
of the same methods for the same items, either from period to period within a reporting entity
or in a single period across entities. Comparability is the goal; consistency helps to achieve
that goal.
Therefore, permitting alternative accounting methods for the same economic phenomenon
diminishes comparability.

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Verifiability
Verifiability helps assure users that information faithfully represents the economic
phenomena it purports to represent. Verifiability means that different knowledgeable and
independent observers could reach consensus, although not necessarily complete agreement,
that a particular depiction is a faithful representation. Quantified information need not be a
single point estimate to be verifiable. A range of possible amounts and the related
probabilities can also be verified.

Verification can be direct or indirect. Direct verification means verifying an amount or other
representation through direct observation, for example, by counting cash. Indirect verification
means checking the inputs to a model, formula or other technique and recalculating the
outputs using the same methodology. An example is verifying the carrying amount of
inventory by checking the inputs (quantities and costs) and recalculating the ending inventory
using the same cost flow assumption (for example, using the first-in, first-out method).

Timeliness
Timeliness means having information available to decision-makers in time to be capable of
influencing their decisions. Generally, the older the information is the less useful it is.
However, some information may continue to be timely long after the end of a reporting
period because, for example, some users may need to identify and assess trends.

Understandability
Classifying, characterising and presenting information clearly and concisely makes it
understandable. Some phenomena are inherently complex and cannot be made easy to
understand. Excluding information about those phenomena from financial reports might
make the information in those financial reports easier to understand. However, those reports
would be incomplete and therefore possibly misleading. Financial reports are prepared for
users who have a reasonable knowledge of business and economic activities and who review
and analyse the information diligently. At times, even well-informed and diligent users may
need to seek the aid of an adviser to understand information about complex economic
phenomena.

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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
The Conceptual Framework for Financial Reporting has provided standard definition of the
elements of financial statements which was revised in March 2018.
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
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;

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(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
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.
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

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 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

Equity
Equity is the residual interest in the assets of the entity after deducting all its liabilities.
Equity claims are claims on the residual interest in the assets of the entity after deducting all
its liabilities. In other words, they are claims against the entity that do not meet the definition
of a liability.
Such claims may be established by contract, legislation or similar means, and include, to the
extent that they do not meet the definition of a liability: (a) shares of various types, issued by
the entity; and (b) some obligations of the entity to issue another equity claim. Different
classes of equity claims, such as ordinary shares and preference shares, may confer on their
holders different rights, for example, rights to receive some or all of the following from the
entity: (a) dividends, if the entity decides to pay dividends to eligible holders; (b) the
proceeds from satisfying the equity claims, either in full on liquidation, or in part at other
times; or (c) other equity claims.

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