FINANCIAL ACCOUNTING

CHAPTER 1. INTRODUCTION
Financial accounting is the field of accountancy concerned with the preparation of financial statements
for decision makers, such as stockholders, suppliers, banks, employees, government agencies, owners and
other stakeholders.
Financial capital maintenance can be measured in either nominal monetary units or units of constant
purchasing power. The central need for financial accounting is to reduce the various principal-agent
problems, by measuring and monitoring the agents' performance and thereafter reporting the results to
interested users.
Financial accountancy is used to prepare accountancy data for people outside the organization or for
those, who are not involved in the mundane administration of the company. Management accounting.
provides accounting information to help managers make decisions to manage and enhance the business
In short, financial accounting is the process of summarizing financial data, which is taken from an
organization's accounting records and publishing it in the form of annual or quarterly reports, for the
benefit of people outside the organization.
Financial accountancy is governed not only by local standards but also by international accounting
standard. 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 is involved with identifying these transactions measuring (attaching a 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 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 parties.
Accounting has got a very wide scope and area of application. Its use is not confined to the business
world alone, but spread over in all the spheres of the society and in all professions. Now-a-days, in any
social institution or professional activity, whether that is profit earning or not, financial transactions must
take place.
So there arises the need for recording and summarizing these transactions when they occur and the
necessity of finding out the net result of the same after the expiry of a certain fixed period. Besides. there
is also the need for interpretation and communication of that information to the appropriate persons. Only
accounting use can help overcome these problems.
In the modern world, accounting system is practiced not only in all the business institutions but also in
many non-trading institutions like Schools, Colleges, Hospitals, Charitable Trust Clubs, Co-operative
Society etc. and also Government and Local Self-Government in the form of Municipality. The
professional persons like Medical practitioners, practicing Lawyers, Chartered Accountants etc. also
adopt some suitable types of accounting methods. As a matter of fact, accounting methods are used by all
who are involved in a series of financial transactions.
The scope of accounting as it was in earlier days has undergone lots of changes in recent times. As
accounting is a dynamic subject, its scope and area of operation have been always increasing keeping
pace with the changes in socio-economic changes. As a result of continuous research in this field the new
areas of application of accounting principles and policies are emerged. National accounting. human
resources accounting and social Accounting are examples of the new areas of application of accounting
systems.
NATURE AND PURPOSE OF ACCOUNTING
Accounting is used to collect and report financial information regarding the performance, position, and
cash inflow or outflow of a company. Apart from making major decisions related to future investments,
fundraising, asset management, and dividend policies, these financial reports are also made available to
tax authorities, investors, and creditors of the firm. Let us take a look at the basic purposes of accounting
in the following paragraphs.
Basic Purposes
The aim of any business is to earn profit and remain solvent. Accounting helps the company keep track of
its profits or losses. The main function of an accounting system is to prepare financial statements in a
company, which helps them keep a record of their revenue and expenses. In order to bring worldwide
uniformity in the accounting process, the statements are prepared according to the Generally Accepted
Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
The four main financial statements that are prepared for accounting information are as follows
a) Statement of financial position
b) Statement of Cash Flows
c) Income Statement
d) Statement of Changes in equity
a) Statement of financial position
A statement of financial position is the most important financial statement of a company. The balance
sheet contains the assets, liabilities, as well as the owner's equity, and is considered a snapshot of the
company's business. Analysis of the balance sheet has many benefits such as:
 It gives a detailed report about the finances of a company at a certain point of time.
 A company takes asset management decisions after analyzing the balance sheet statement.
 Most creditors of any company analyze the previous year's balance sheet statements to know how
financially solvent the company is
Thus, it can be said that the balance sheet is prepared to obtain data which is used as a reference by the
company to make informed financial decisions.

b) Statement of Cash Flows

A cash flow statement presents the cash inflows and outflows of a company for a given period of time.
Cash inflows are the revenues earned by a company in a specified period, while cash outflows are the
expenses incurred during the same period. The basic purpose of a cash flow statement is
 To present the liquidity and solvency of the company at a given time.
 To provide extra information about the liabilities, assets and owners equity.
 To provide details for future cash flows in a company.
Analysis of the cash flow statement is very essential for the proper financial management of the
organization.
c) Income Statement
It is also known as the Profit and Loss Statement. It is helpful as it shows whether the company has made
a profit or loss in a given reporting period. It represents the difference between the revenues or gains of
the business, and the expenses or losses of the business. Thus, the purpose of an income
statement is:
 To provide the past performance records to investors and creditors of a company.
 To help in predicting the company's future performance.
 To assess the capability of a company in generating future cash flows through the incomes or
expenses report.
Income statement helps a company in deciding future investments (if it makes a profit), or adopting cost
cutting measures (if it incurs a loss).
d) Changes in equity
IAS I requires a statement of changes in equity. This shows the movement in the equity section of the
statement of financial position. A full set of financial statements includes a statement of changes in equity
THE OBJECTIVE OF FINANCIAL ACCOUNTING
Maintaining systematic records
It is a primary function of accounting to keep a proper and chronological record of transactions and
events, which provides a base for further processing and proof for checking and verification purposes. It
embraces writing in the original/subsidiary books of entry, posting to ledger, preparation of trial balance
and final accounts
Meeting legal requirements
Accounting helps to comply with the various legal requirements. It is mandatory for joint stock
companies to prepare and present their accounts in a prescribed form. Various returns such as income tax.
sales tax are prepared with the help of the financial accounts.

Protecting and safeguarding business assets

Records serve a dual purpose as evidence in the event of any dispute regarding ownership title of property
or assets of the business. It also helps prevent unwarranted and unjustified use. This function is of
paramount importance, for it makes the best use of available resources.
Facilitates rational decision-making
Accounting is the key to success for any decision-making process. Managerial decisions based on facts
and figures take the organization to heights of success. An effective price policy, satisfied wage structure,
collective bargaining decisions, competing with rivals, advertisement and sales promotion policy etc. all
owe it to well set accounting structure. Accounting provides the necessary database on which a range of
alternatives can be considered to make managerial decision-making process a rational one.
Communicating and reporting
The individual events and transactions recorded and processed are given a concrete form to convey
information to others. This economic information derived from financial statements and various reports is
intended to be used by different groups who are directly or indirectly involved or associated with the
business enterprise.
ELEMENTS OF FINANCIAL STATEMENTS
We know Accounting is the systematic recording of financial transactions and presentation of the related
information of the appropriate persons. The basic features of accounting are as follows:
1. Accounting is a process
A process refers to the method of performing any specific job step by step according to the objectives, or
target. Accounting is identified as a process as it performs the specific task of collecting, processing and
communicating financial information. In doing so, it follows some definite steps like collection of data
recording, classification summarization, finalization and
reporting.
2. Accounting is an art
Accounting is an art of recording, classifying, summarizing and finalizing the financial data. The word
'art' refers to the way of performing something. It is a behavioral knowledge involving certain creativity
and skill that may help us to attain some specific objectives. Accounting is a systematic method consisting
of definite techniques and its proper application requires applied skill and expertise. So, by nature
accounting is an art.
3. Accounting is means and not an end
Accounting finds out the financial results and position of an entity and the same time, it communicates
this information to its users. The users then take their own decisions on the basis of such information. So,
it can be said that mere keeping of accounts can be the primary objective of any person or entity. On the
other hand, the main objective may be identified as taking decisions on the basis of financial information
supplied by accounting. Thus, accounting itself is not an objective, it helps attaining a specific objective.
So it is said the accounting is 'a means to an end and it is not an end in itself."

4. Accounting deals with financial information and transactions

Accounting records the financial transactions and date after classifying the same and finalizes their result
for a definite period for conveying them to their users. So, from starting to the end, at every stage,
accounting deals with financial information. Only financial information is its subject matter. It does not
deal with non-monetary information of non-financial aspect.
5. Accounting is an information system
Accounting is recognized and characterized as a storehouse of information. As a service function, it
collects processes and communicates financial information of any entity. This discipline of knowledge has
been evolved out to meet the need of financial information required by different interested groups.
THE ACCOUNTING EQUATION
The ability to read financial statements requires an understanding of the items they include and the
standard categories used to classify these items. The accounting equation identifies the relationship
between the elements of accounting.
ASSETS = LIABILITIES + CAPITAL
Assets
An asset is something of value the company owns i.e. An asset is a resource controlled by a business
entity/firm as a result of past events for which economic benefits are expected to flow to the firm. An
example is if a business sells goods on credit then it has an asset called a debtor. The past event is the sale
on credit and the resource is a debtor. This debtor is expected to pay so that economic benefits will flow
towards the firm ie. in form of cash once the customers pays.
Assets are classified into two main types:
i) Non-current assets (formerly called fixed assets).
ii) Current assets.
Non-current assets are acquired by the business to assist in earning revenues and not for resale. They are
normally expected to be in business for a period of more than one year.
Major examples include:
Land and buildings
Plant and machinery
Fixtures, furniture. fittings and equipment
Motor vehicles
Assets can also be classified as tangible or intangible. Tangible assets are generally divided into three
major categories: current assets (including cash, marketable securities, accounts receivable, inventory. and
prepaid expenses); property, plant, and equipment; and long-term investments. Intangible assets lack
physical substance, but they may, nevertheless, provide substantial value to the company that owns them.
Examples of intangible assets include patents, copyrights, trademarks, and franchise
licenses.
A brief description of some tangible assets follows.
Current assets typically include cash and assets the company reasonably expects to use, sell, or collect
within one year. Current assets appear on the balance sheet (and in the numbered list below) in order,
from most liquid to least liquid. Liquid assets are readily convertible into cash or other a and they are
generally accepted as payment for liabilities.
 Cash includes cash on hand (petty cash), bank balances (checking, savings, or money-market
certificates of deposit and treasury bills, with maturities of ninety days or less at the time of
accounts), and cash equivalents. Cash equivalents are highly liquid investments, such as
purchase.
 Marketable securities include short-term investments in stocks, bonds (debt), certificates of
deposit, or other securities. These items are classified as marketable securities rather than long
term investments only if the company has both the ability and the desire to sell them within one
year.
 Accounts receivable are amounts owed to the company by customers who have received products
or services but have not yet paid for them.
 Inventory is the cost to acquire or manufacture merchandise for sale to customers. Although
service enterprises that never provide customers with merchandise do not use this category for
current assets, inventory usually represents a significant portion of assets in merchandising and
manufacturing companies.
 Prepaid expenses are amounts paid by the company to purchase items or services that represent
future costs of doing business. Examples include office supplies, insurance premiums, and
advance payments for rent. These assets become expenses as they expire or get used up.
Property, plant, and equipment is the title given to long-lived assets the business uses to help generate
revenue. This category is sometimes called fixed assets. Examples include land, natural resources such as
timber or mineral reserves, buildings, production equipment, vehicles, and office furniture. With the
exception of land, the cost of an asset in this category is allocated to expense over the asset's estimated
useful life.
Long-term investments include purchases of debt or stock issued by other companies and investments
with other companies in joint ventures. Long-term investments differ from marketable securities because
the company intends to hold long-term investments for more than one year or the securities are not
marketable
Liabilities
Liabilities are the company's existing debts and obligations owed to third parties. Examples include
amounts owed to suppliers for goods or services received (accounts payable), to employees for work
performed (wages payable), and to banks for principal and interest on loans (notes payable and interest
payable). Liabilities are generally classified as short-term (current) if they are due in one year or less e.g.
Bank Overdraft, Creditors/trade payables. Long-term (non-current) liabilities are not due for at least one
year. Examples include long-term loans from banks or other financial institutions.
Capital
It is also known as owners' equity. This is the residual amount on the owner's interest in the firm after
deducting liabilities from the assets.
It represents the amount owed to the owner or owners by the company. Algebraically, this amount is
calculated by subtracting liabilities from each side of the accounting equation. Owner's equity also
represents the net assets of the company.
In a sole proprietorship or partnership, capital equals the total net investment in the business plus the net
income or loss generated during the business's life. Net investment equals the sum of all investment in the
business by the owner or owners minus withdrawals made by the owner or owners. The owner's
investment is recorded in the owner's capital account, and any withdrawals are recorded in a separate
owner's drawing account. For example, if a business owner contributes shs2,000,000 to start a company
but later withdraws shs100,000 for personal expenses, the owner's net investment equals shs 1900.000.
Net income or net loss equals the company's revenues less its expenses Revenues are inflows of money or
other assets received from customers in exchange for goods or services. Expenses are the costs incurred to
generate those revenues.
The Accounting equation can be expressed in a simple report called the statement of financial position or
balance sheet
The Non-Current assets are listed in order of permanence as shown i.e. from Land and Buildings to motor
vehicles. The Current Assets are listed in order of liquidity i.c. which asset is far from being converted
into cash. Example, stock is not yet sold, (i.e. not yet realized yet) then when it is sold we either get cash
or a debtor (if sold on credit). When the debtor pays then the debtor may pay by cheque (cash has to be
banked) or cash.
The Current Liabilities are listed in order of payment i.c. which is due for payment first. Bank overdraft is
payable on demand by the bank, then followed by creditors.
USERS OF ACCOUNTING INFORMATION AND THEIR RESPECTIVE NEEDS
Accounting information is produced in form of financial statement. These financial statements provide
information about an entity financial position, performance and changes in financial position. Financial
position of a firm is what the resources the business 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. The users of
accounting information have an interest in the existence of the firm. Therefore the information contained
in the financial statements will affect the decision making process.
The following are the users of accounting information:
i. Owners
They have invested in the business and examples of such owners include sole traders, partners
(partnerships) and shareholders (company). They would like to have information on the financial
performance, financial position and changes in financial position.
This information will 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 fall 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 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 can also use it to assess whether the firm is financially sound and therefore 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 firm's activities on the environment.