Theoretical Framework of Accounting

What is financial accounting?

Financial Accounting is the art and science of recording and classifying financial
transactions in the books, summarizing and communicating financial information
through production of financial statements/reports, and interpretation of the operating
results portrayed in financial statements/reports to facilitate decision-making (Omonuk,
1999)

Financial Accounting is the process of identifying, measuring and communicating

economic information to permit informed and rational decisions to be made. Rational
decisions made by the organization include for example; working capital decisions,
capital budgeting decisions, investment decisions, etc. It is beyond the scope of this
book to go into details of these decisions. Without limiting accounting to finances, in
general use, accounting means explaining and defending or justifying actions or results
of those actions. All those who have been entrusted with safe custody of others
resources are usually required to account or submit accountability to the owners of the
resources.

Why accounting?
The ultimate role of accounting is to provide information to decision makers. Besides
that, preparation of accounts plays the following roles:
1. Ascertainment of profit and loss
One of the main purposes of any business is to make profits. For this reason,
accurate and complete recording of all business transactions is essential because
this information will be helpful to determine whether there was a profit or loss in any
trading period.
2. Assessment of tax
Governments in all countries impose taxes. For the accurate assessment of tax,
accurate records must be maintained properly; otherwise, a business enterprise may
be required to pay high taxes to the government. Accounting therefore forms an
objective and reliable basis of computing taxes.
3. To facilitate the credit transactions
Most business transactions are made on credit basis. In this case, goods are
purchased or sold without cash payment. For easy monitoring of debtors and
creditors, proper accounting records must be maintained. The also act as a Base for
credit facilities for example, a loan. A business enterprise can be able to acquire
credit from financial institution once it has proper and accurate accounting records.
4. A tool for control
A business enterprise can maximize its profits by increasing the gap between
income and expenses. Proper control of unnecessary expenses and
misappropriation of funds is essential. A proper and accurate accounting system will
be helpful to maintain this control.
5. Base for further planning
 For further expansion, a business enterprise can formulate its plans based on the
resent and past achievements. Accounting records can provide sufficient data
relating to sales, profit, investments etc, for making decision about the future
programme.
6. Monitoring of management
Preparation of accounts helps shareholders to monitor management and other
stakeholders to evaluate the performance of the organisation. The managers are not
the owners of the business and therefore accounting forms an objective basis for
monitoring the actions of managers by the owners of the business.
Who are the Users/interested parties of accounting information?

Internal users
These are involved in the day to day running of the organisation.
1. Management
The managers of the business will want to know how things are going. They need
financial information in order to plan for the future; they then need more up-to-date
information in order to check whether actual performance is on target. This process is
known as controlling the costs and finances. In accounting it is known as management
accounting. So, management accounting is done by the managers, for the managers,
for the purposes of planning and control.

2. Employees
Employees require information about the stability and continuing profitability of the
business. They are crucially interested in information about employment prospects and
the maintenance of pension funding and retirement benefits. They are also likely to be
interested in the pay and benefits obtained by senior management.
External users
They are external in the sense that they are not involved in the day to-day running of the
organisation.
1. Shareholders
These are the primary stakeholders of the business because they invest capital in
the business. Investors are concerned about risk and return in relation to their
investments. They require information to decide whether they should continue to
invest in a business. They also need to be able to assess whether a business will be
able to pay dividends, and to measure the performance of the business’
management overall.
2. Potential investors
These need accounting information in order to be able to decide whether investing in
a company is worthwhile. This may be with help of an analyst who analyses the
company’s past and projected financial performance before they can buy shares in
it.
3. Creditors
Suppliers and trade creditors require information that helps them understand and
assess the short-term liquidity of a business. They need accounting information to
 establish the credit worthiness of the customers or clients i.e. is the business able to
pay short-term debt when it falls due?
Banks and financial institutions who lend money to a business require information that
helps them determine whether loans and interest will be paid when they fall due

5. Debtors
Customers and trade debtors require information about the ability of the business to
survive and prosper. As customers of the company’s products, they have a long-term
interest in the company’s range of products and services. They may even be dependent
on the business for certain products or services.
6. Donor/funding agencies
Non profit making organisations like NGOs get funding from donor agencies. These
agencies are always interested in making sure that the money they donate is used to
achieve the objectives for which it was released. They monitor utilization of their money
by examining accounting records i.e. financial reports, books of accounts and
documents of the organisation that they support.
7. Government
There are many government agencies and departments that are interested in
accounting information. For example, the Inland Revenue needs information on
business profitability in order to levy and collect corporation tax. Value Added Tax; local
government need similar information to levy local taxes and rates. The government also
needs accounting information from state owned public companies existing alongside
private ones, to monitor their performance. It needs accounting information from
companies to enable it analyze the effect its policies have on business. This enables
formulation of policies that promote sector development.
8. Competitors
These need accounting information of firms in the same industry so as to judge whether
they are performing poorly or fairly in comparison with other players in the same
business.
9. General public
These include individuals and organisations which ensure that businesses make their
profits in a socially acceptable manner without damage to the environment and
consumers. They have specific interest in the activities and performance of businesses.
Environmental pressure groups push for minimization of pollution of the environment
while consumer groups like Uganda National Bureau of Standards (UNBS) try to ensure
that businesses offer safe products and don’t charge high prices for poor quality
products.

Accounting concepts/principles/postulates/assumptions/conventions
Business Entity Concept
This convention seeks to ensure that private financial transactions and matters relating
to the owner of a business is recorded and separated from financial transactions that
relate to the business. It should be noted that a business exists separate from its owner.
A business owner usually owns personal items as well as business items. The business’
financial records and reports should not be mixed with the owner’s personal records and
reports. For instance, a business owner may incur rent for his home and rent for the
business. Only the rent related to the business should be recorded in the business’
financial records while the home rent is recorded in the personal financial records. The
business entity concept ensures that the amount invested by the owners in the business
is defined (capital) and allows a return on capital employed to be computed to show
whether the investment is worthwhile.
Limitation
The main limitation of the concept is that the owner and the business are actually
inseparable. For instance if a sole trader sells and dwells on the same premises, then
rent and utilities paid will be difficult to apportion between the owner and the business
especially if there are no clear apportionment bases.

Monetary measurement / unit of measurement concept

According to this concept, all transactions to be recorded must be quantified in
monetary terms, since money is a common denominator for all transactions e.g. cost,
sales, the value of stocks, machinery, debts and investments. This is because a record
of transactions is quantified and assessed in a monetary unit. Thus it is assumed that
the monetary unit is capable of acting as the common denominator of the values to the
point of determining exchangeable equivalents

Financial data is generally quantified and the measurements expressed in units of

money. Presentation involves adding, subtracting, multiplying and dividing numbers
depicting economic things of value and events.
Limitations
 It assumes money has a stable value over time, yet actually money may lose
value with time.
 It limits recognition of transactions to those that can be quantified and leaves out
qualitative factors that can have a direct impact on the business e.g. workforce
skill, morale, market leadership, brand recognition, quality of management etc

Going Concern/ continuity

This requires the accounting records to be maintained in such a way that the business
is seen to continue in its foreseeable future. That is, the financial reports are prepared
with the expectation that a business will remain in operation indefinitely. This makes it
possible for the accountant to prepare or project estimates for a long period into the
future.

For example, a business bought machinery for shs 25,000,000/. This machinery is
expected to last for 10 years. The yearly depreciation therefore is recorded and reported
based on the expected life of the machinery. At the end of every year, the book value
(cost less accumulated depreciation) is reported.

A business is expected to continue indefinitely even if the owner retires or sells the
business. If a business is sold, the new owner is expected to continue the business’
operations. Continuity of operations facilitates the allocation of both revenues and
expenses to the pertinent accounting periods. Without this presumption, Accrual
Accounting (to be discussed here under) would have no foundation. As the accounting
entity stops being a going concern, the accounting approach changes from accrual to
realization and liquidation.

Periodicity and disclosure concept

This requires a company to prepare and disclose financial reports at the end of every
accounting or financial year. This enables comparability, timely performance
measurement and tax computations. Of course, the impact of transactions is measured
for a specific time period usually known as the financial year. Thus, it is assumed that
the continuous life time of the entity (see going concern assumption) can be broken
down into specific time periods. Then the results of operation for each time period can
be measured. At the end of each period, a “static” picture of the resources and claims to
those resources is taken. This depicts the financial position of the entity at that specific
point in the lifetime of the entity. In practice, this financial year has come to be 12
months period and in Uganda, this principle has been enshrined in law (see companies’
Act of Uganda).

Generally Accepted Accounting Principles

Let us now look at a second category of ideas that are in essence the basic guidelines
in the accounting process. Generally Accepted Accounting Principles (GAAP) is a term
used to describe broadly the rules and guidelines that governs the accounting for
financial transactions underlying the preparation of a set of financial statements.
Generally accepted principles are derived from a variety of sources, including
promulgations of the Financial Accounting Standards Board and its predecessor, the
Accounting Principles Board, and the American Institute of Certified Public Accountants.
Other sources include the general body of accounting literature consisting of textbooks,
articles, papers, etc.

Historical cost
This principle requires transactions to be recorded at the price ruling at the time, and for
assets to be valued at their original cost. That is, the actual amount paid for items
bought is recorded. The actual amount paid for an item in a business transaction may
be different from the value.

In the process of acquiring assets by an entity, such assets are valued and recorded in
books of accounts at the cost at which they were acquired i.e. the price paid. Thus,
assets are entered in accounting records at their cost. This is generally called historical
cost basically because it is always the valuation of a consummated transaction.

Limitation
During inflation, historical cost will not reflect the true value of the assets of the
business.
Realization concept
This concept requires that transactions are recognized and recorded at the point of sale
or transfer of legal ownership – rather than just when cash actually changes hands. For
example a company that makes a sale to a customer can recognize that sale when the
transaction is legal – at the point of contract. The actual payment due from the customer
may not arise until several weeks (or months) later – if the customer has been granted
some credit terms.

Note that a realization is when a sale is made to a customer. The basic rule is that
revenue is created at the moment a sale is made, and not when the price is later paid in
cash. Profit can be taken to the profit and loss account on sales made even though the
money has not been collected.

The gist of this concept is that in order to determine the nature and magnitude of the
impact of transactions on the financial position of the accounting entity, inflowing values
are recognized if and when the earning effort is substantially expended or completed.
Revenues represent actual or expected cash inflows or the equivalent from the ongoing
or central operations of the enterprise during the accounting period. Realization in the
most precise sense means the process of converting non-cash resources and rights into
money and most precisely used in financial accounting and reporting to refer to sales of
assets for cash or claims to cash. Recognition is the process of formally recording or
incorporating an item into the financial reports of an entity.

Materiality
This requires the recognition of only material items and excluding immaterial or trivial
items. Information is material if its omission or misstatement could influence the
economic decisions of users taken on the basis of the financial reports. Financial
statements should therefore show material items separately, but immaterial items may
be aggregated with amounts of a similar nature. For example buying furniture for shs
14,000,000/ represents an amount large enough to significantly affect the amount of net
income reported if recorded as an expense. Therefore, the furniture should be recorded
as an asset and depreciated each year of its useful life.

Consistency
According to this concept, transactions and valuation methods are treated the same
way from year to year, or period to period. Business decisions are often made by
comparing current financial reports with previous financial reports. Users of accounts
can therefore make more meaningful comparisons of financial performance from year to
year. Accounting information recorded and reported differently each accounting period
makes comparisons from one accounting period to another impossible. Where
accounting policies are changed, companies are required to disclose this fact and
explain the impact of any change.

Prudence/ conservatism
This concept requires the profits are not recognized until a sale has been completed. In
addition, a cautious vie should be taken for future problems and costs of the business
as soon as there is a reasonable chance that such costs will be incurred in the future
i.e. provide for all possible losses, for example, provision for bad debts. The concept
can be summarized by the phrase ‘anticipate no profit and provide for all possible
losses’. Further still, the concept tends to undervalue assets i.e. whenever there are
alternative methods of valuing an asset, an accountant should choose the one that
leads to a lower value or profit and a higher liability. This stems from the accountants’
fear that if they prepare the financial reports with too much optimism they may overstate
profits and cause dividends to be paid out of capital if these profits are not realized.

Accrual concept
This requires the recognition of items at the occurrence of the transaction and not when
cash is received or paid. For example, Income is recorded as earned even though it
might have not been received. The portion of income that has not been received is
recorded as an asset (accrued income or debtors). Expenses or costs should be
recorded as incurred although cash may not have been paid. For example, if rent
expenses paid by the year close was shs 1,500,000/ and yet some electricity equivalent
to shs 200,000/ was used but not paid for, the amount of rent expense be considered
should be shs. 1,700,000/ (i.e. 1,500,000/ + 200,000/). The unpaid shs. 200,000/ should
be recorded as an accrued expense. It should be recorded as current liability in the
balance sheet.

Matching
This concept requires that revenues from business activities and expenses associated
with earning that revenue are recorded in the same accounting period. Business
activities for an accounting period are summarized in financial reports. To adequately
report how a business performed during an accounting period, all revenue earned as a
result of business operations must be reported. Likewise all expenses incurred during
the same accounting period in producing the revenue must be reported. Matching
expenses with revenue gives a true picture of business operations for an accounting
period

Substance over form

This states that transactions and other events should be recorded in accordance with
financial and economic reality (substance) other than their legal form. E.g. in a hire
purchase, the buyer takes possession and use of the asset but does not become the
legal owner until the last installment has been paid. Though he is not the legal owner,
he has to recognize this transaction in his books.

Duality concept (dual aspect)

This is the basis of double entry book keeping and stems from the fact that every
transaction has a double (dual) effect on the position of a business as recorded in the
accounts. For example when as asset is acquired, either another asset (cash) is
reduced, or a liability (promise to pay) is acquired, at the same time. When a business
borrows money, a liability to the lender is created, and at the same time an asset (cash)
is increased. It follows that the assets of the business are equaled by claims on the
business, either by creditors or owners for the funds they have invested in the business
and which have been translated into assets for use by the business. The balance sheet
which summarizes assets and claims must therefore balance. The double entry system
is further explained in Topic three.

Accounting Regulatory Framework (Accounting Rules)

Having looked at the fundamental principles of accounts, qualitative characteristics,
users and so forth, we now have to summarize a number of rules that underlie
accounting practice.

Accounting rules are imposed on accountants in order to make sure that their reporting
is free from bias. Accounting legislation requires financial accounts be prepared and
presented in conformity with GAAP (Generally Accepted Accounting Principles). GAAP
refers to accounting principles or practices that are regarded permissible by the
accounting profession. It includes requirements of the company acts, stock exchange
etc. the key terms used in accounting regulatory framework include:
 Accounting principles/ concepts/conventions
 Accounting bases
 Accounting policies
 Accounting standards

Accounting principles
Also known as accounting concepts, conventions or postulates, are basic ground rules
which must be followed when financial accounts are being prepared and presented.
They are also referred to as assumptions or prepositions that underlie the preparation
and presentation of financial reports. Most of these have already been discussed
earlier.

Accounting bases
These are methods developed for applying fundamental concepts to financial
transactions and items for the purpose of final accounts and in particular:
 For determining the accounting periods in which revenue and costs should be
recognized in the profit and loss account.
 For determining the amounts at which material items should be stated in the
balance sheet.

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

Accounting standards
These are guideline statements or rules issued by professional accounting bodies
governing accounting practice, relating to how accounts should be prepared and
presented.

Fields of Accounting
Having looked at the major part of the conceptual framework of accounting, let us now
look at the particular fields of accounting. There are several accounting fields as a result
of varied uses of accounting information. The common fields are financial accounting,
managerial accounting, cost accounting, tax accounting, environmental accounting and
auditing.
Financial accounting
This is a field of accounting that is concerned with the classification, measurement and
recording of business transactions of an entity in monetary terms and in accordance
with Generally Accepted Accounting Principles. The major focus of financial accounting
is to provide information to external users. External users of financial accounting
information include shareholders, creditors, government, financial institutions, and the
public.

Managerial accounting
This deals with the analysis and interpretation of financial accounting information.
Managerial accounting provides management with information for internal decision
making concerning daily operations as well as planning and control of future operations.

Cost accounting
The determination and allocation of costs to products and services of a business
organization is called Cost Accounting. This field of accounting provides information for
internal decision making concerning the costs of operating service and manufacturing
businesses

Tax accounting
This is the preparation of tax returns as well as tax planning. Tax accountants use
financial statement information to prepare tax returns. These tax returns are filed with
the tax authorities like Uganda Revenue Authority in case of Uganda.

Environmental accounting
This is the reporting of environmental activities undertaken by an organisation.
Environmental accounting provides information for external users concerning
environmental achievements.

Auditing
The independent reviewing and issuing of an opinion on the reliability of accounting
records is called Auditing. This is usually the duty of an auditor. The auditor is supposed
to check whether the books of accounts are prepared and presented according to the
generally accepted accounting principles and whether policies and procedures
prescribed by management are being followed. The auditor’s opinion enables external
users to be confident of the information reported in the financial reports.

Accounting Profession
Accounting is a growing profession worldwide. Accounting employment is usually in:
 Private accounting
 Public accounting
 Government accounting

Private Accounting
This is where qualified accountants are engaged in accounting work of individuals,
corporations, non – profit making organizations and or otherwise. Persons employed in
private accounting work for only one business. These persons may perform a variety of
duties. In small organizations they do all of the summarizing, analyzing and interpreting
of financial information for management. In large organizations, accountants typically
specialize in one field of accounting such as Financial accounting, Cost accounting,
Management accounting, Tax accounting and Social responsibility/environmental/green
accounting

Public accounting
This is the provision of accounting services by highly qualified Certified Public
Accountants to various clients, which may include individuals, corporations and
government. Persons employed in public accounting may work independently or as a
member of a public accounting firm. Public accountants sell services to individuals,
businesses, government units and non profit making organizations. These services
include; auditing work, providing management advisory services, providing tax
consultancy services such as preparing income tax returns, etc.

Government Accounting
This is the accounting for government institutions e.g. central government, local
government, etc. government accounts are unique from private companies and other
organizations. Government officials rely on financial information to help them direct
affairs of their agencies.
Uganda Revenue Authority; is one of the government agencies that performs extensive
accounting work. It handles income tax returns filed by individuals and corporations, and
frequently performs auditing functions relating to these income tax returns and the
accounting records on which they are based.
Uganda Securities Exchange Commission is also another government agency involved
in accounting. USEC establishes the requirements regarding the content of financial
reports and the reporting standards, and the rules and regulations to be followed in
order to be listed on the exchange market.

Qualitative characteristics of useful financial information

Qualitative characteristics are the attributes that make the information provided in
financial statements useful to users.

The framework identifies fundamental and enhancing qualitative characteristics

(diagram).
 Qualitative characteristics

Fundamental Enhancing

Verifiability Underst.
Relevance Faithful representation Comparability Timelines

Completenes Neutrality Free from error

Fundamental qualitative characteristics

If financial information is to be useful, it must be relevant and faithfully represent what it
purports to represent.

Relevance
 Relevant financial information is capable of making a difference in the decisions
made by users. Information influences decisions if it has predictive value,
confirmatory value, or both.

 Financial information is capable of making a difference in decisions if it has

predictive value, confirmatory value or both.

 Financial information has predictive value if it can be used by users to predict future
outcomes.

 Financial information has confirmatory value if it provides feedback about previous

evaluations so that it is used to confirm or correct past evaluations and
assessments.
 The predictive value and confirmatory value of financial information are interrelated.
For example, one uses revenue information for the current year, as the basis for
predicting revenues in future years. One compares actual and the predicted revenue
made in past years in order to correct and improve the processes that were used to
make those previous predictions.

 For example, a bank will give a loan to a client if it can predict repayment of the loan
from the client’s financial statements.

 Materiality is an aspect of relevance specific to an entity. Information is material if

omitting it or misstating it could influence decisions that users make on the basis of
financial information about a specific reporting entity.

Faithful representation
Financial information is useful if it faithfully represent the economic aspects of an entity
in words and numbers that it purports to represent. Transactions and events are
accounted for in accordance with their substance and economic reality and not merely
their legal form.

Information faithfully represents the entity if it is:

 Complete – includes all necessary descriptions and explanations that is necessary
for a user to understand the item like the nature and amount (whether original cost,
or fair value) of an asset.

 Neutral – the information is presented without bias and is not manipulated to be

received favourably or unfavourably by users.

 Free from error – means:

 There are no errors or omissions in the description of the item
 The process used to produce the reported information has been selected and
applied with no errors in the process.

For example, a representation of an estimate of the value of an asset can be faithful

if the amount is:
 Described clearly and accurately as being an estimate
 The nature and limitations of the estimating process are explained, and
 No errors have been made in selecting and applying an appropriate process for
developing the estimate.

Faithful representation does not mean accurate in all respects.

Safeguards to ensure that the information is free from error include an effective
internal control system and external auditor

In applying the fundamental qualitative characteristics:

 Identify what is useful to users of the reporting entity’s financial information.
 Identify the type of information that is most relevant
 Determine whether that information is available and can be faithfully represented.

Enhancing qualitative characteristics

These enhance the usefulness of information that is relevant and faithfully represented.
These are:
Comparability
 Information about a reporting entity is more useful if users can compare it with
similar information:
 For earlier periods of the same business
 Of other businesses for the same period.
 In the budget or forecast.
 Comparability enables users to identify and understand similarities in and
differences among items.

 Consistency helps to achieve comparability. 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 improved by:

 Compliance with accounting standards.
 The disclosure of accounting policies used in the preparation of the financial
statements, any changes in those policies and the effect of such changes.
 Showing comparative financial statements of the preceding period.

 Information should be compared if it is relevant and faithfully represents the different

entities.

 Comparability is important in performance assessment. The assessment is improved

if the entity has used similar accounting policies or the effect of the different policies
can be identified.

Verifiability
 Verifiability helps assure users that information faithfully represents the economic
aspects 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.
 For example, cash is verified by counting it or inventory is verified by checking the
inputs (quantities and costs) and recalculating the ending inventory 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, characterizing, and presenting information clearly and concisely makes
it understandable.
 Some aspects are inherently complex and cannot be made easy to understand and
information should not be excluded from financial reports to make the reports easier
to understand as this would make it incomplete and therefore potentially misleading.

 Financial reports are prepared for users who have a reasonable knowledge of
business and economic activities and who review and analyze the information
diligently.