Definition of accounting

Accounting is defined as the process of identifying, measuring and reporting economic

information to the users of this information to permit informed judgment.

It is a systematic process of identifying recording, measuring, classifying, verifying,

summarizing, interpreting and communicating financial information. It reveals profit or loss
for a given period, and the value and nature of a firm’s assets, liabilities and owners ‘equity.

Accounting provides information on the:-

 Resources available

 The means employed to finance those resources, and

 The results achieved through their use

a) USERS OF ACCOUNTING INFORMATION

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. 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.
iv. 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.

v. 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.

vi. 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.

vii. 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.

viii. 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.

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.

Qualities of Useful Financial Information

The four principal qualities of useful financial information are understandability, relevance,
reliability and comparability.

Understandability: an essential quality of the information provided in the financial statements

is that it is readily understandable by users. For these 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. The relevance of information is affected by its nature and
materiality.
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 purports to represent or could
reasonably be expected to represent. To be reliable then the information should:

a) Be represented faithfully,
b) Be accounted for and presented in accordance with their substance and economic reality and
not merely their legal form,
c) Be neutral i.e. free from bias,
d) Include some degree of caution especially where uncertainties surround some events and
transactions (prudence),
e) Be complete i.e. must be within the bounds of materiality and cost. An omission can cause
information to be false.
Comparability: users must be able to compare the financial statements of an enterprise through
time in order to identify trends in its financial position and performance. Users must also be able
to compare the financial statements of different accounting policies, changes in the various
policies and the effect of these changes in the accounts. Compliance with accounting standards
also helps achieve this comparability.

ACCOUNTING CONCEPTS
 It is a common misconception for financial statements to be considered as ‘right’ in an
absolute sense, especially as regards profit. There is, as yet, no universally accepted
measure of profit as there is for, say, weight (though even this is subject to different units
of measurement, which may need to be converted). Because of this, accountants have, in
the light of experience, identified certain broad assumptions on which the financial
 results of a business are prepared. These assumptions, also known as ‘accounting
concepts’, define the rules under which the financial statements of an entity should
be prepared.
 These are the common basis for the preparation and reporting of financial information
usually referred to as “the generally accepted accounting principle”.(GAAP)
 Accounting concepts may be considered as postulates i.e. basic assumptions or conditions
upon which the science of accounting is based.
 ‘Accounting policies encompass many principles, bases, conventions, rules and
procedures adopted by managements in preparing and presenting financial statements.
There are many different accounting policies in use even in relation to the same subject
and judgment is required in selecting and applying those which are appropriate to the
circumstances of the enterprises and are best suited to present properly its financial
position and the results of its operation’.
 Three considerations should govern the selection and application by management of the
appropriate accounting policies and the preparation of financial statements:
 Prudence: uncertainties inevitably surround many transactions. This should be recognised
by exercising prudence in preparing financial statements. Prudence does not, however,
justify the creation of secret or hidden reserves.
 Substance over form: transactions and other events should be accounted for and presented
in accordance with their substance and financial reality and not merely with their legal
form.
 Materiality: financial statements should disclose all items which are material enough to
affect evaluations or decisions.
Five principles are laid down in the Companies Act Cap 486, and "conventions" to mean all
other principles, which are conventionally recognized. The concepts include

 Prudence
 Accruals
 Consistency
 Going Concern
 Separate valuation
 Accounting Concepts Are:

 Business entity concept/Separate Entity Concept

This concept implies that a business is separate and distinct from the person who supplies capital
to it. Irrespective of the form of organization, a business unit has got its own individuality as
distinguished from the person who own or control it. The accounting equation (i.e. assets =
liabilities + capital) is an expression of the entity concept because it shows that the business itself
owns the assets and in term owns the various claimants. Business is kept separate from the
proprietor so that transactions of the business may also be recorded with him.
Separate entity concept already exists, legally, in a joint stock company. Even in the
sole proprietor and partnership firms, this concept of separate entity, though does
not legally exist, is presumed to exist for accounting treatment
Separate entity concept has given birth to the concept of responsibility accounting for
determining the operational results of each responsibility centre

 Money/Monetary measurement concept

Money is the only practical unit of measurement that can be employed to achieve the
homogeneity of financial data, so accountants’ records only those transactions which can be
expressed in terms of money though quantitative records are also kept. The advantages of
expressing business transactions in terms of money is that money serves as a common
denominator by means of which heterogeneous facts about a business can be expressed in terms
of numbers (i.e. money) which are capable of additions and subtractions.
The money concept measurement increases the true understanding of the state of
affairs of the business
If a business has cash balance of ksh 20,000, a plot of 5000sq meters, two air
conditioner,1000kg of raw materials,20 machines, 50 chairs and tables. Here there is absence of
money measurement concept
 Going concern concept
It is assumed that a business unit has a reasonable expectation of continuing business at a
profit for an indefinite period of time. A business unit is deemed to be a going concern
and not a gone concern. It will continue to operate in the future. Transactions are
recorded in the books keeping in view the going concern aspect of the business unit.
This assumption provides much of the justification for recording fixed assets at original
cost (i.e. acquisition cost) and depreciating them in a systematic manner without
reference to their current realizable value. It is useless to show fixed assets in the
Statement of financial position at their estimated realizable values if there is no
immediate expectation of selling them. Fixed assets are acquired for use in the business
for earning revenues and are not meant for resale, so they are shown at their book values
and not at their current realizable values. But when the concern is not a going concern
and is to be liquidated, current realizable values of fixed assets become relevant.
o It is to be noted that the going concern concept does not imply permanent
contribution of the enterprise, indefinitely

 Cost concept
A fundamental concept of accounting closely related to the going concern concept, is that
an asset is recorded in the books at the price paid to acquire it and that this cost is the
basis for all subsequent accounting for the asset. This concept does not mean that the
asset will always be shown at cost but it means that cost becomes basis for all future
accounting for the asset. Asset is recorded at cost at the time of its purchase but is
systematically reduced in its value by charging depreciation.
o If a plot of land is purchased at ksh 1,000,000 it has to be shown at that amount,
even though the subsequent market price becomes ksh 1,500,000. In other words
the subsequent changes in the market price are ignored. Even the price fall,
equally we ignore the respect of the fixed asset
 Cost concept brings the advantage of objectivity in the preparation and presentation
of financial statements. In the absence of this concept, accounting records would
have depended on the subsequent views of the persons
Cost concept is applied to fixed assets only. Current assets are not affected by this
concept

 Dual aspect concept

There must be a double entry to have a complete record of each business transaction, an
entry being made in the receiving account and an entry of the same amount in the giving
account. Every debit must have a corresponding credit and vice versa and upon this dual
aspect has been raised the whole super structure of Double Entry System of accounting.
The accounting equation (i.e. assets = equities (or liabilities + capital)) is based on dual
aspect concept.e.g. if capital is ksh 1,000,000 + creditors ksh 50,000 = cash ksh
1,000,000 + machinery ksh 50,000
If the business has acquired an asset, the source could be any of the following:
 New asset is in place of an asset given up or
 Liability has been created for its acquisition or
 There has been profit to purchase or
 The proprietor has contributed more capital to finance
 Similarly, if there is an increase in liability, there must have been an increase in asset.
Alternatively, loss would have reduced the capital, to that extent, with a similar reduction
in assets
o Thus, at any time
o Asset = Capital + Liabilities
The term accounting equation is used to denote the relationship of equities to assets

 Accounting period concept

Under the going concern concept it is assumed that a business entity has a reasonable
expectation of continuing business for an indefinite period of time. This assumption
provides much of the justification that the business will not be terminated, so it is
reasonable to divide the life of the business into accounting periods so as to be able to
 know the profit or loss of each such period and the financial position at the end of such a
period. Normally accounting period adopted is one year as it helps to take any corrective
action, to pay income tax, to absorb the seasonal fluctuations and for reporting to the
outsiders. A period of more than one year reduces the utility of accounting data.
o After each period, it is necessary to stop and see back how things have been
going. So, it is necessary to maintain accounts with reference to a specific
period

 Matching concept
This concept is based on the accounting period concept. The most important objective of
running a business is to ascertain profit periodically. The determination of profit of a
particular accounting period is essentially a process of matching the revenue recognized
during the period and the costs to be allocated to the period to obtain the revenue. It is, thus, a
problem of matching revenues and expired costs, the residual amount being the net profit or
net loss for the period.
o Efforts and accomplishments are to be matched for proper presentation of
operational results. Matching concept requires suitable adjustment for
deferred expenditure. Deferred expenditure is that amount of expenditure
that has been incurred but not charged to profit and loss account and
postponed for charging against a future period

 Realization concept
According to this concept, revenue is considered as being earned on the date at which it is
realized i.e. on the date when the property in goods passes to the buyer and he becomes
legally liable to pay.
o Sale is deemed to have taken place, when the title to the property or goods
passes from the seller to the buyer
 Example. Radi co. Botique shop owner has placed an order with Dera Co. for supply of
readymade garments. On receiving the order, Dera Co. has purchased the required cloth
engage labour and started manufacture too. As per the terms and agreement Dera has
received advance too fro Radi before execution of the order. Now the issue is what is the
actual time of sale? Is it at the time of receiving the order, time of receiving the advance,
placing the order for supply of cloth and engaging the labour? The actual time of sale is
when the goods are delivered by Dera Co. to Radi Co. Till such time no profit can be
recognized
o Time of transfer of property is material as that point determine the time of
recognition of profit

 Objective evidence concept

Objectivity connotes reliability, trustworthiness and verifiability, which means that there is
some evidence in ascertaining the correctness of the information reported. Entries in
accounting records and data reported in financial statements must be based on objectively
determined evidence, without close adherence to this principle; the confidence of many users
of the financial statements could not be maintained. Invoices and vouchers for purchases and
sales, bank statements for amount of cash at bank, physical checking of stock in hand etc. are
examples, of objective evidence, which are capable of verification. As far as possible, some
objective evidence should support every entry in accounting records.

 Accrual concept
Under this basis, the effects of transactions and other events are recognized when they
occur (and not as cash or its equivalent is received or paid) and they are recorded in the
accounting records and reported in the financial statements of the periods to which they
relate.
The essence of the accrual concept is that revenue is recognized when it is realized, that
is when sale is complete or services are given and it is immaterial whether cash is
 received or not. Similarly, according to this concept, expenses are recognized in the
accounting period in which they help in earning the revenue whether cash is paid or not.
Thus to ascertain correct profit or loss for an accounting period and to show the true and
fair financial position of the business at the end of the accounting period, we make record
of all expenses and incomes relating to the accounting period whether actual cash has
been paid or received or not. Therefore, as a result of the accrual concept, outstanding
expenses and outstanding incomes are taken into consideration while preparing final
accounts of a business entity.

 Substance over form

It can happen that the legal form of a transaction can differ from its real substance. Where this
happens accounting should show the transaction in accordance with its real substance which is
basically how the transaction affects the economic situation of the firm. In this case, it will not
reflect the exact legal position concerning that transaction.
e.g Hire purchased vehicle
Under normal circumstance, it belongs the personal using it , but the exact legal position it
belongs to the seller until the buyer finishes paying the installments.