Introduction to Accounting notes – Financial Accounting

INTRODUCTION TO ACCOUNTING

This lesson introduces you to Accounting showing clearly the broad accounting systems and the underlying accounting principles. At the end of the lesson you should be able to:-

  • Define accounting
  • Understand the purpose of accounting
  • Know the users and purpose of accounting information
  • Know and understand the underlying accounting principles
  • Understand the career prospects of accountants

Nature and Scope of Accounting

Accounting has often been called the “language of business” people in the business world i.e owners, managers, bankers, stockbrokers, attorneys, engineers, investors – use accounting terms and concepts to describe the events that make up the day-to-day existence of every business, large or small. Since a language is a man-made means of communication , it is natural that languages should change to meet the changing needs of society. Accounting too, is a man-made art, one in which changes and improvements are continually being made in the process of communicating business information.

Definition of terms used in Financial Accounting:




Book Keeping
This is the analysis classification and recording of financial transactions in books of Account. Hence its merely concerned in making records of business transactions.
Accounting
Accounting is the process or art of recording classifying and summarizing financial information and interpreting the results thereof. This information is used in making economic decisions. The accounting information is financial data about business transactions expressed in monetary terms. Or Accounting has been referred to as the process of identifying, measuring and communicating economic information to permit informed judgement and decisions by the users of information.

The distinction between Accounting and book-keeping. Book-keeping means the recording or of transactions , the record making phase of accounting. To keep books is to record transactions, and a bookkeeper is one who records transactions either manually with pen and ink or with a book keeping machine. The work is often routine and primarily clerical in nature.

Accounting system can be classified broadly into

  • Financial accounting
  • Cost accounting
  • Management accounting

Financial Accounting

Financial Accounting can be defined as the analysis classification and recording of financial transactions and the ascertainment of their effect on the performance and financial position of an organisation /business/ firm / economic entry.

This gives general purpose financial information which describe financial resources, obligations and activities of an economicentity.

Management Accounting

Management Accounting involves the development and interpretation of accounting information which is intended to aid management is running the business. This gives specific financial information to meet the demands of the management.

Cost Accounting
This is the establishment of budgets, standard costs and actual costs of operations, processes, activities or products; and the analysis of variances, profitability or social use of funds.

Business Transactions
These are the economic activities of a business. Accountants classify these transactions into two types:

External transactions: (often called exchange transactions) are those involving economic events between two or more independent firms.

Internal transactions are those economic events that take place entirely within one firm.

  • Transactions constitute inputs to accounting information system and it should be noted that before the effect of Transaction can be recorded however, they must be measured. To be useful, accounting data must be expressed in terms of a common denominator.

So that the effect of transactions can be combined. Business transactions are therefore expressed in terms of a common measuring unit-money.

Users of Accounting Information

Accounting extends beyond the process of creating records and reports. The ultimate objective of accounting is the use of this information, its analysis and interpretation. Accountants are always concerned with the significance of the figures they have produced. They look for meaningful relationships between events and financial results they study the effect of various alternatives they search for significant trends that may throw some light on what will happen in future.

Interpretation and analysis are not the sole province of the accountant. If managers, investors and creditors are to make effective use of accounting information, they too must have some understanding of how the figures will be put together and what they mean. An important part of this understanding is to recognize clearly the limitations of accounting reports.

Purpose Of Accounting
Accounting information is useful to the following groups of people.

  1. The shareholders who provide capital and carries the risk of the firm /business.
  2. Creditors who provide loans to the business.
  3. Government and government agencies provide security
  4. Public at large – financial analyst / economist / labour union / potential investors.
  5. Management – who manage the business.

The above group of people use accounting information to make financial / economic decisions about the firm which includes.

  • For the investors they are interested with the profitability of the firm to know that they are earning the required return. The profitability firm can be improved by using accounting as a tool of control where the unnecessary costs/expenses are checked and potential income generating venture / projects are under taken. The accounting information also helps the investors to decide where to invest their scarce resources.
  • The creditors needs the accounting information so that they can be sure that they will receive back their money.
  • For the government it has to regulate the activities of the business to be in line with the over all objective of the government. The government also imposes various type of tax. The accounting information (mostly financial accounting) is used as a base for tax returns. Note more often than not this information is reorganized or adjusted to confirm with income tax reporting requirements.
  • Managers of business enterprises use the management (managerial) accounting information in setting the overall goals, evaluating the performance of departments and individuals deciding whether to introduce a new line of products etc – used a base for further or future planning. The financial information provided by an accounting system is needed by managerial decision makers to help them plan and control activities of the economic entity.

This means that the underlying purpose of Accounting is to provide financial information about an economic entity (business enterprise




A system for creating accounting information
In order to provide up-to-date financial information about a business, it is necessary to create a systematic record of the daily business activity in terms of money. For example, goods and services are purchases and sold, credit is extended to customers, debts are incurred, and cash is which can be expressed in monetary terms, and must be entered in accounting records. The recording process may be performed in many ways: that is, by writing with pen or pencil, by printing with mechanical or electronic equipment, or by punching holes or making magnetic impressions on cards or tape.

It should be noted that not all business events can be measured and described in monetary terms. As such we do not show in the accounting records the appointment of a new chief executive or the signing of a sale contract, except as these happenings in turn affect  future business transactions. In addition to compiling a narrative record of events as they occur, we classify various transactions and events into related groups or categories. Classification enables us to reduce a mass of detail into compact and usable form. For example, grouping all transactions in which cash is received or paid out is a logical step in developing useful information about the cash position of a business enterprise.

To ensure the created accounting information is in a form which will be useful to the users of the information, we summarize the classified information into financial reports, called financial statements. These financial statements are concise, perhaps only three or four pages for a large business. They summarize the business transactions of a specific time period such as a month or a year. Financial statements show the financial position of the business at the time of the report and the operating results by which it arrived at this position.

These three steps we have described i.e recording, classifying, and summarizing- are the means of creating accounting information. Thus one part of accounting is a system for creating financial information.

Characteristics of Useful Information

  1. Relevance – should satisfy the need of the user and /or purpose intended.
  2. Reliability – increased by being checked by an independent person like the auditor
  3. Objectivity – free from personal bias -should be checked for subjectivity
  4. Ability to understand / Under stability – presentation should be understood by the users or recipients.
  5. Comparability–year to year of the same company and with other companies i.e inter-period and inter company comparison.
  6. Realism – Accounts should show a true and fair view information should show economic realities.Its not necessary to give a precision which is not practical.
  7. Consistency business should observe consistency in applying various methods and policies but changes in policies can be disclosed and their effect.
  8. Timeless – up-to-date information is of more useful.
  9. Economy of Presentation / Detail – too much or too summarized A/c – not good. Too detailed can obscure or hind some important factors – cause difficulties in understanding. Amount of detail should be that which is sufficient for the intended purpose.
  10. Completeness – a summarised picture of the companies activities is needed.
  11. Accuracy – should be sufficiently accurate for the internal purpose. Information prepared according to correct principles that can be relied upon for the intended purpose. This may mean that a realistic speedily prepared estimate may be more useful than a more precise answer produced some time latter.

The Fundamental Accounting Concepts, Principles And Assumption (GAAP)

 GAAP which means Generally accepted accounting principles constitute the ground roles for financial reporting. Accounting principles may also be termed as standards assumptions conventions or concepts. Accounting principles do not exist in nature but  are developed considering the most important objective of financial reporting. Hence  they vary from one country to another.

The broad concepts include:
1) The business or Accounting entity concept
If the transactions of a business are to be recorded, classified and summarized into financial statements the accountants must be able to identify clearly the boundaries of the unit being accounted for. Under the accounting entity concept the business is considered a separate entity distinguishable from its owners and from all other entities. Each entity is assumed to own its assets (resources) and incur its liabilities(obligations). The assets liabilities and activities of the business are kept completely separate from those of the owner of the business and from those of other businesses.

2) The going – concern assumption / continuity principle.
Financial statements are prepared on the assumption that the existing business will continue to operate into the future. Its assumed that the business will not be sold in the near future but will continue to use its resources in operating activities. For this reason therefore the current market value of the assets are of little importance to  decision makers. In the event that management is planning the sale or liquidation of the business, the going concern assumption and the cost principle are set aside and financial statements are prepared on the basis of estimated sales or liquidation values. When this is the case the statement should identity clearly the basis upon which the values are determined.

3) The Cost Principle or Asset Valuation Principle
Resources of a business are recorded initially at their cost under the cost principle. Cost  is determined by the exchange price agreed upon by the parties and is measured by the amount of cash to be given in exchange for resources received. If the consideration given is something other than cash, cost is measured by the fair (market) value of what is given or the fair value of the asset or service received whichever is more clearly evident. It is important therefore, to remember that the amount reported in financial statements do not show the amount that would be received if the assets were sold but the costs of the assets on the date that they were acquired.

4) Objective Principle
The objectivity principle holds that accounting data should be reported on a factual basis ie free from personal bias. Cost of the resources acquired is determined objectively on the basis of the exchange price negotiated by the independent parties to the exchange. The recording of current market values require use of estimates, appraisals or opinions all of which are much more subjective. Users of accounting information should be given the most objective factual data available. In other words the transactions to be recorded should be at a arms length.

5) The Stable Shilling or Dollar Assumption
Under this principle or assumption changes in the purchasing power of money are ignored. As a result 1980 shilling is added to 1999 shilling as though all represent the same purchasing power. Unfortunately this is not, realistic when the general purchasing power of a shilling / dollar changes the value of money declines. Although this is recognised by accountants its ignored. As a result gains are reported on sale of assets where there has, infact ,been little or no gain in purchasing power.

6) Time Period Principle / periodicity Principle
The life of a business must be divided into a series of relatively short accounting period  of equal length. This assists the users of accounting information who need reasonably current and comparable information-relating to prior accounting periods. The need for periodic reporting is one of the most challenging problems of accountants . The life of a business is usually divided into segments of a year or quarter which calls for various estimates such as:-useful life of depreciable assets, methods of depreciation to be used etc. The tentative nature of periodic measurements should be understood by those who rely on periodic accounting information.

7) Revenue Recognition or The Realization Principle
Accountants should recognize revenue when it has been realizedi.e.
-the earning process is essentially complete
-Objective evidence exists as to the amount of revenue earned.
Revenue should be recognized at the time goods are sold or services are rendered. NB. Cash basis of accounting does not conform to GAAP.

8) Matching Principle or Expenses reorganization
To measure the profitability of an economic activity we must consider not only the revenue earned but also all the expenses incurred in the effort to produce this revenue. The accountants thus try to match the revenue appearing in the income statement will all the expenses incurred in generating that revenue. The matching principle governs the timing of expense recognization in financial statements. This principle underlie such practises as:-

  • -depreciating plant assets
  • -Computation of cost of goods sold each period
  • -Amortization of cost of unexpired insurance policy
  • -Recording revenue when earned but not received and expenses when incurred but not paid.

9) Materiality Principle

Materiality refers to the relative importance  of an item or an event.  An item is “material “ if knowledge of the item might reasonably influence the decisions of users of the financial statements. Accounts must ensure that all material items are properly reported  in the financial statements. This should be based on cost-effectiveness e.g. tools waste paper basket etc-deferred benefits or future benefits but expensed in the period of purchase.

10) Consistency Principle
This principle implies that particular accounting method once adopted will not be changed from period to period. This assists the users in interpreting changes is financial position and changes in net income. In case of changes full disclosure principle should be applied.

11) Disclosure Principle
Adequate disclosure means that all material and relevant facts concerning financial position and the results of operation are communicated to the users. This can accomplished either in the financial statement or in the notes accompanying the statements. This increases the usefulness of the statements and makes them less  subjective to misinterpretation.

Example of information disclosed include

  • A summary of the accounting methods used
  • -Dollar / shilling effect in the changes of these accounting methods during the current period.
  •  -Any loss contingencies that may have a material effect upon the financial position of the organisation.
  • -Contractual provisions that may affect future cash flows eg terms and conditions of borrowing agreements commitments to buy or sell material amounts of assets.

12) Conservatism
May not qualify as an accounting principle but implies that Accountant must be conservative in their estimates and opinions. They should base their estimates on sound logic and select those accounting methods which either overstate nor under state the facts. In case of alternatives should chose those that have the least favourable effect / situation.

13)Prudence
Holds that accountants have the duty of ensuring that people get the proper facts abort a business. Assets should not be over valued and liabilities or obligations should not be under valued. Prudence concept means that the figure taken should understate profits rather than overstating the profits. In other words anticipate loss but not profit.



The Work of an Accountant

Accountants are employed in three main fields: In a public accounting, In private accounting, or in government

Public Accounting
Public accountants are individuals who offer their professional services and those of their employees to the public for a fee, in much the same manner as a lawyer or a consulting engineer. This can be done in such as Auditing, Management Advisory services and tax services.

Auditing
The principal service offered by a public accountant is auditing. Banks  commonly require an audit of the financial statements of a company applying for a suitable loan, with the audit being performed by a CPA who is not an employee of the audited concern but an independent professional person working for a fee. Companies whose securities  are offered for sale to the public generally must also have such an audit before the securities may be sold. Thereafter, additional audits must be made periodically if the securities are to continue being traded.

The purpose of an audit is to increase credibility to a company’s financial statements. In making the audit, the auditor carefully examines the company’s statements and the accounting records from which they were prepared. In the examination, the auditor seeks to assure that the statements fairly reflect the company’s financial position and operating results and were prepared in accordance with generally accepted accounting principles from records kept in accordance with such principles. Banks, investors, and others rely  on the information in a company’s financial statements in making loans, in granting credit, and buying and selling securities. They depend on the auditor to verify the dependability of the information the statements contain.

Management Advisory Services
In addition to auditing , accountants commonly offer management advisory services. An accountant gains from an audit an intimate knowledge of the audited company’s accounting procedures and its financial position. Thus, the accountant is in an excellent position to offer constructive suggestions for improving the procedures and strengthening the position. Clients expect these suggestions as a useful audit by-product. They aslo commonly engage CPAs to conduct additional investigations for the purpose of determining ways in which their operations may be improved . Such investigations and the suggestions growing from them are known as management advisory services.

Management advisory services include the design, installation, and improvement of a client’s general accounting system and any related information system it may have for determining and controlling costs. They also include the application of machine and computer to these systems, plus advice in financial planning, budgeting , forecasting, and inventory control.

Tax Services
In this day of increasing complexity in income and other tax laws and continued high tax rates, few important business decisions are made without consideration being given to their tax effect. A CPA, through training and experience, is well qualified to render important service in this area. The service includes not only the preparation and filing of tax returns but also advice as to how transactions may be completed so as to incur the smallest tax.

Private Accounting
Accountants employed by a single enterprise are said to be in private accounting. A small business may employ only one accountant or it may depend upon the services of a public accountant and employ none. A large business, on the other hand, may have more than a hundred employees in its accounting department. They commonly work under the supervision of a chief accounting officer, commonly called the controller, who is often a CPA. The title controller results from the fact that one of the chief uses of accounting  data is to control the operations of a business.

The one accountant of the small business and the accounting department of a large business do a variety of work, including general accounting, cost accounting, budgeting, and internal auditing.

General Accounting
General accounting has to do primarily with recording transactions, processing the recorded data, and preparing financial and other reports for the use of management, owners, creditors, and governmental agencies. The private accountant may design or help the public accountant design the system used in recording the transactions. He or she will also supervise the clerical or data processing staff in recording the transactions and preparing the reports.

Cost Accounting
The phase of accounting that has to do with collecting, determining and controlling costs, particularly costs of producing a given product or service, is called cost accounting. Knowledge of costs and controlling costs is vital to good management. Therefore, a large company may have a number of accountants engaged in this activity.

Budgeting
Planning business activities before they occur is called budgeting. The objective of budgeting is to provide management with an intelligent plan for failure operations. Then, after the budget has been put into effect, it provides summaries and reports that can be used to compare actual accomplishments with the plan.

Internal Auditing
In addition to an annual audit by an independent firm of CPAs , many companies maintain a staff of internal auditors, who constantly check the records prepared and maintained in each department or company branch. It is their responsibility to make sure that established accounting procedures and management directives are being followed throughout the company.

Government Accounting
Furnishing governmental services is a vast and complicated operation in which accounting is just as indispensable as in business. Elected and appointed officials must rely on data accumulated by means of accounting if they are to complete effectively their administrative duties. Accountants are responsible for the accumulation of these data. Accountants also check and audit millions of income, payroll, and sales tax returns that accompany tax payments upon which governmental units depend.

This means Accounting includes the design of accounting systems, preparation of financial statements, audits, studies , development of forecasts, income tax work, computer applications to accounting processes, and the analysis and interpretation of accounting information as an aid to making business decisions.

A person might become a reasonably proficient book-keeper in a few weeks or months but to become a professional accountant, however, requires several years of study and experience.



Accounting Equation and Statements

Accounting statements are the end products of the accounting process, but a good place to begin the study of accounting. They are also referred to as financial statements.

Financial statement

  • Means of conveying to management and to interested outsiders a concise picture of the profitability and financial position of a business. Financial statements are set of accounting reports. The principal purpose of financial statement is to communicate to users (person receiving these reports) the effect of operating activities during a specific time and the financial position at the end of the period for a specific business.
  • A set of financial statements consist of four related accounting reports summarizing
  • financial resources
  • obligations
  • profitability
  • cash transactions of a business

The type of financial statement most generally prepared are:-

  • balance sheet
  • income statement
  • cash flow statements
  • statement of owners equity

1. Balance Sheet

  • The balance sheet reports the financial position of a business at a specific point in time.
  • It is sometimes called statement of financial position. The financial position is reflected by the amount of business assets (resources owned), the amount of liabilities or debts owed and the amount of its owners equity(investment).

The title/header consist of

  • The name of business
  • The name of the statement “Balance Sheet”
  • The date of the Balance sheet

The body of the Balance Sheet consist of:

  • Assets, liabilities, and owners equity.

Example

Assets
Assets are economic resources (cash and non-cash resources owned by a business. They may be tangible assets e.g land, building and equipment or intangible assets e.g legal right such as accounts receivable, patent rights or rights to use leased assets). Assets have economic value because they contain service benefits that can be used in future  operations or sold to another entity.

Liabilities
Liabilities are debts owed by a business to outside parties (called creditors). Liabilities include such thins as amount owed to suppliers for goods or services purchases on credit ( accounts payable) , amount borrowed from Banks or other lenders (notes payable), amount owed to employees for salaries and wages etc. Cancellation of liabilities requires either an outlay of assets (generally cash), or the performance of future services. Liabilities may also be thought of as creditors claim against the assets of the business.

Owners equity
Owners equity is the owners interest in the assets of the business. It may be thought of as the owners claim against these assets. The equity of the owner is the residual claim because the claim of the creditors usually comes first.

Increase in owners equity
The owners invests cash or other assets to get the business started. Whenever the owner of the business transfers cash or other assets to the business, the owner’s equity increase. Two ways:

  1. owner’s investment
  2. earnings from profitable operations of the business

Decrease in owner’s equity

  • In single proprietorship, the owner has right to withdraw cash or other assets from the business at any time. This can be through the Bank, or getting some company’s equipment for personal use, or paying a personal debt using the business cash. Two ways:-
  • Withdrawal of cash or other assets by the owner.
  • Losses from unprofitable operations of the business.

Accounting Equation (Balance Sheet Equation)

A balance sheet is so called because its two sides must always balance. The sum of the assets shown on the balance sheet must equal liabilities plus the equity of the owner or owners of the business. This equality may be expressed in equation form for a single proprietorship business as follows:

Assets = Liabilities + Owner’s equity
When balance sheet equality is expressed in equation form, the resulting equation is called the balance sheet equation. Or the accounting equation, since all double entry accounting is based on it.

In other words the two sides are the same view of the business property. The list of assets show what resources the business own and the liabilities and owner’s equity shows who/what supplied them (and how much each group supplied).

Effects of transactions on the Accounting Equation. A business transaction is an exchange of goods or services, and business transactions effect the elements of an accounting equation. However,regardless of what transactions a business completes, its accounting equation must remain in balance. Also, its assets always equal the combined claims of its creditors and its owner or owners.

This may be demonstrated with the transactions below:

Effect of business transactions upon the Balance Sheet

 Assume that Robert started a business under the name Robert Real Estate Company and deposited Kshs. 60,000 under the name of the business.

Initial Balance Sheet

 Robert Real Estate Company Balance Sheet

As at 1st Sept 2000

Assets                                                              Owner’s equity

Cash……………60,000                                        Robert,capital………….. 60,000

Purchase of an asset for cash

3rd Sep. purchase of land           –           Kshs21,000

  • Cash decreased by the amount paid out
  • A new asset land –acquired

Robert Real Estate Company Balance Sheet

As at 3rd Sept 2000

Assets Owner’s Equity
Cash 39,000 Robert, Capital 60,000
Land 21,000
  60,000  60,000

Purchase of an asset and incurring of liability

Sept 5, an opportunity arose to buy from xyz company a complete office building which had to be removed to permit the construction of a freeway. A price of 36,000/= was agreed upon which involved the cost of moving the building and installing it upon Roberts Company Ltd. It could have costed 60,000/= to build. This was very fortunate purchase.

The terms provided were:-

–     Immediate payment of 15000/= and payment of the Balance of 21,000/= within 90 days.

Effect
Cash decreased by 15,000 but a new asset, building was recorded in the amount of 36,000.  Total assets were increased by 21,000 and total liabilities and owners equity was also increased by 21000/=as a result of recording 21000/=.                      Accounts payable as a liability.

Sale of an asset
Sept 10: Sold the unused part of the lot to Carter’s Drugstore for a price of 6000. Agreed that the whole amount to be paid in three months. By this transaction an new asset, A/C receivable was acquired but the Asset land was decreased by the same amount.- No charge in total assets.

Purchase of an asset on credit

14th Sept purchased office furniture and equipment on credit form general equipment inc. for 5,400 – new asset and incurrence of liabilities.

Robert Real Estate Company Balance Sheet

As at 14th Sept.2000

Assets                                                  Liabilities & Owner’s Equity Cash                 24000              Liabilities

A/C Rec.                        6000                          A/C payable                 26400

Officee quipment           5400

Land                            15000              Owner’s Equity

Building                      36000                          Capital, Robert            60,000

86,4000                                                           864,000

 

Collection of Accounts Receivable

Sept 20: Cash of Kshs. 1500 received from the drugstore. Increase cash and decrease  A/C receivable .

Robert Real Estate Company Balance Sheet

As at 20th Sept.2000

Assets

Cash

 

25500

Liabilities & Owner’s Equity

Liabilities

A/C Rec. 4500 A/C payable 26400
Office Equip. 5400 Owner’s Equity
Land 15000 Capital, Roberts 60,000
Building 36000
86400 86400

Payments of a liability

On Sept 30 Robert paid 3,000 in cash to general equipment.

Robert Real Estate Company Balance Sheet

As at 30th Sept.2000

Assets

Cash

 

22,500

Liabilities & Owner’s Equity

Liabilities

A/C Rec. 4,500 A/C payable 23400
Off. Equip. 5,400 Owner’s Equity
Land 15,000 Capital 60,000
Building 36,000
83,400 83400

Effect of business transactions upon the accounting equation

  • A balance sheet is a detailed expression of the accountingequation.
  • The Sept. transactions are summarized below and the effects Date:

Sept 1 Started a business by depositing Ksh. 60,000 in a Company Bank Account Sept 3 Purchased land for 21000/= cash.

Sept5    Purchased a building at a price of 36,000/= paying 15,000/= cash and incurring a liability of 21,000/=

Sept 10 Sold part of land for a price of 6000/=, collectible within three months. Sept 14 Purchased office equipment on credit for 5,400/=

Sept 20 Received 1500/= as partial collection of the 6000/= account receivable Sept 30 Paid 3000/= on the accounts payable

In the table below, each transaction is identified by date; its effect on the accounting equation and also the new balance of each item are shown. Each of the times labeled Balances contains the same items as the balance sheet previously illustrated for the particular date. The final line in the table corresponds to the amounts in the balance sheet at the end of September. Note that the equality of the two sides of the equation was maintained throughout the recording of the transactions.




EFFECTS OF TRANSACTIONS ON THE ACCOUNTING EQUATION

NB/ The Balance at every date is the same as the Balance Sheet prepared on the same date in the previous section.

The Income Statement

It shows whether or not the business achieved or failed to achieve its primary objective i.e earning a ‘profit’ or net income. A net income is earned when revenues exceed expenses, but a net loss is incurred if the expenses exceed the revenues. An income statement is prepared by listing the revenues earned during a period of time, listing the expenses incurred in earning the revenues, and substracting the expenses from the revenues to determine if a net income or a net loss was incurred.

This means that the income statement indicates/reports the results of earnings activities for a specific time period, usually one year.

The heading of an income statement consist of: name of business, name of statement i.e income statement and the time period covered by the statement.

Below is specimen of an income statement showing the components.

Illustration 1-1

Now we shall describe or explain each of the major components.

1. Revenues
Revenues are increases in owners equity from the sale of goods or performance of services. They are measured by the amount of cash or other assets received. Although revenue often consist of cash, it may consist of any asset received such as customers promise to pay in the future (an account receivable) or the receipt of property from a customer. Regardless of type of asset, it represents revenue. It must reflect compensation for the sale of goods or the performance of services.  Other types of revenue are –  interest, dividends, received on shares owned and rent received.

2. Expenses
 Expenses are decreases in owner’s equity resulting from the cost incurred in order to earn revenue.

  • Expenses are measured by the amount of assets consumed or the amount of liabilities incurred.
  • They may be immediate cash payment such as wages and salaries or promise to pay cash in the future for services received such as advertising. In some cases cash may be paid out before the expense is incurred as for example payment for next years rent.
  1. Statement of owner’s equity

 Statement explaining certain changes in the amount of owner’s equity (investment) in the business. In corporation this statement is replaced by statement of retained earnings.

  1. Statement of Cash Flow

Statement summarizing cash receipts and payments of the business over the same period covered by the income statements.

NB/ In addition financial statements include notes to the accounts which contain additional information useful to the interpretation of the statements.

KEY WORDS

  • Booking Keeping
  • Accounting
  • Business transactions
  • Financialstatements
  • GAAP
  • Public accountant
  • Privateaccountant
  • Government accountant
  • Balance sheet
  • Assets
  • Expenses
  • Revenue
  • Owner’sequity
  • Incomestatement
  • Netincome




Questions, Exercises and Problems

Questions

  1. Why is the knowledge of accounting useful to persons other than management of business entities?
  2. Briefly explain the purpose of accounting.
  3. Clearly distinguish internal and external business transactions.
  4. Accounting system can be classified broadly into two main categories. Explain them showing clearly their scope of use.
  5. Explain the system of creating accounting information stating clearly major sources of such information.
  6. Explain briefly clearly the concept of business entity giving appropriate examples.
  7. Accounting information provides a basis for decision making by various users. State three such decisions made by:
  • Management
  • Creditors
  • Government
  • Public

7. Not all happenings of a business can be expressed in monetary terms although they may significantly affect the business. Name two examples of such happenings which may not be measured satisfactorily be recorded in books of account.

8. Clearly state the main functions of a public and private accountants.

9. Explain consistency as a characteristic of useful information and secondly as a accounting principle.

10. Discuss the need of generally accepted accounting principles. What factors determine the development of these principles.

EXERCISE

1. a) Beta Company has total assets of $256,000 and the owner’s equity amounts to $64,000. What is the amount of the liabilities?

b) The balance sheet of Border Inc. shows  that the owner’s  equity is  $192,000:  It  is equal to two-third the amount to total assets. What is the  amount  of  the liabilities?
.The assets of Joytech Company amounted to $96,000 on December 31 of year 1, but c) increased to $136,000 by December 31 of Year 2. During this same period, liabilities increased by $20,000. The owner’s equity at December 31 of Year 1 amounted to $66,000. What was the amount of owner’s equity at December 31 of Year 2? Explain the basis for your answer and support with the necessary calculations.

2. The items included in the balance sheet of Daily Company at December 31 2001  are listed below in random order. You are to prepare a balance sheet (including a complete heading). Arrange the assets in the sequence. You must compute  the amount for Shah Daily,capital.

$
Land 36,000
Accounts payable 44,800
Accounts receivable 18,900
Shah Daily, Capital ?
Office equipment 3,400
Building 80,000
Cash 42,100
Notes payable 75,000

3. Indicate the effect of each of the following transactions upon the total assets of a business by use of the appropriate phrase: “increase total assets”, “decrease total assets”, “no change in total assets”.

  • Investment of cash in the business by the owner.
  • Collected an account receivable
  • Made payment of a liability.
  • Purchase an computer desk on credit.
  • Borrowed money from a bank
  • Sold equipment on credit for a price equal to its cost.
  • Sold equipment for cash at a price equal to its cost.
  • Sold equipment for cash at a price below its cost.
  • Sold equipment for cash at a price above its cost.
  • Purchased a motor van at a price of $7,000 terms $1,000 cash and the balance to be paid in 30 equal monthly installments.

4. For each of the following, describe a transaction that will have the required affect of elements of the accounts equation.

  • Increase an asset and increase owner’s equity
  • Increase an asset and increase a liability.
  • Increase one asset and decrease another asset.
  • Decrease an asset and decrease a liability.
  • Increase one asset, decrease another asset, and increase a liability.

5. Certain transactions of Kresty Company are listed below. For each transactions you are to determine the effect on total assets, total liabilities, and owner’s Prepare your answer in tabular form identifying each transactions  by  letter  and  using the symbols (+) for increase (-) for decrease , and (NC) for no change. An answer is provided for the first transaction to serve as an example. Note that some of the transactions concern the personal affairs of the owner, Joan Cresty rather than being strictly transactions of the business entity.

Total        Liabilities                   Owner’s Assets                                           Equity

+                 NC               +

  1. Owner invested cash in the business
  2. Purchased office furniture on credit………………
  3. Purchased a motor vehicle truck for cash……………….
  4. Owner withdrew cash from the business……………
  5. Paid a liability of the business………………………..
  6. Returned for credit some defective office furniture Which had been purchased on credit but not yet paid For……………………………………………………….
  7. Obtained a short term loan from the bank for business use
  8. Owner wrote gave a typewriter used in the business to:-
  9. -His son as a birthday present………………………….
  10. -Owner paid his daughter fees using business money……………………….

6. List the following four column headings on a sheet of paper as follows: Transaction Total assets Liabilities                          Owner’s Equity

On the first column identify each of the following transactions by number. Then indicate the effect of each transactions on the total assets liabilities and owner’s equity by placing a plus sign (+) for an increase a minus sign (-) for a decrease or the letters (NC) for no change in the appropriate column.

  • Purchased office supplies on credit
  • Owner invested cash in the business
  • Purchased office equipment for cash
  • Collected an account receivable
  • owner withdrew cash from the business
  • Paid a supplier who had supplied goods on credit
  • Returned for credit some of the  office equipment  previously purchased on credit  but not yet paid for.
  • Sold land for a price in excess of cost.

As an example, transaction (1) would be shown as follows: Transaction      Total                Liabilities        Owner’s Equity

Assets

(1)                          +                        +                      NC

PROBLEMS

1. The items to be included in the balance sheet of Mwanzo Estate Ltd as at September 30, 2000 are listed below in random order. Prepare a balance sheet include a figure for the total liabilities and owners equity.

$                                                                      $

Accounts Payable        26,000           Delivery truck                                    76,920 Accounts receivable                                    19,840            George Klein, capital                     ?

Land                            89,200             Office Equipment                    26,240

Building                      24,000               Cash                                      10,008

Notes payable              30,200

2. The transactions listed below occurred during the organization of sub expert service, a refrigeration repair business. You are to show the effects of business transactions upon the balance sheet by preparing a new and separate balance sheet for expert service at each of the four dates listed below. Each balance sheet should reflect all transactions completed to date.

  • On June 1 Dan Robert deposited $68,000 cash in a bank account in the name of the new business, expert Service.
  • OnJune5landandabuildingwereacquiredatacostof$9,400forthelandand $13,600 for the building. Full payment was made on this date.
  • On June 15,expert Service purchased tools and equipment to do repair work for a down payment of 31,440 cash and final payment of $2,800 due in 30days.
  • On June 30, expert Service bought a motor van at a cost of $4,320. A cash 50%  down payment was made with payment of the balance to be made within 60days. Also on this date the account payable incurred by the purchase of tools and  equipment on June 5 paid in full.

3. Five transactions of Bruno Company are summarized below in equation form, with each of the five transactions identified by a letter. For each of the transactions (a)through (e) you are to write a separate sentence explaining the nature of the transaction.

4. After several years of experience with a practicing firm of certified public accountants, Jostone resigned from his position on September 1, 2001, in order to begin a public accounting practice of his own, named Jostone $ Sons. The following events occurred during September, some of these relate to the business entity, Jostone & Co CPA, and other are personal in nature and do not affect the business entity.

Sept 1:.Sold personal investments consisting of an apartment building and some IBM stock for a total of $198,000 cash.Deposited $80,000 of this cash in a bank account in the name of the practice Jostone& Co CPA.

Sept 2: Purchased land with a small office building suitable for his accounting practice. Total cost was $290,000 of which $50,000 was paid from the business bank account as a cash down payment. Jostone signed a note payable for the balance calling for payment in three years or less. The  property valuer had indicated  that the land had a current fair value 50% greater than  the  office building.(divide the total cost between land and office building.)

Sept 3: Purchased office equipment for cash $5,200

Sept 5: Signed an agreement to employ a college graduate as staff assistant at a monthly salary of $1,000. The staff assistant was to report for work on October 1.

Sept 6: Johnstone purchased a dirt track motorcycle which he planned to  use  on weekend trips. He turned in an old motorcycle and paid a balance of $800 in cash.

Sept 7: Returned a defective chair included in the September 3 purchase of office equipment for full credit of $20. Received in exchange another model chair priced at $ 185 and a cash refund of $25.

Step 8: On Sunday while visiting a friend who was going out of business and entering military service, Johnstone had an opportunity to buy for $600 cash some office supplies which had originally cost $1,000. Used a personal check to pay for the supplies.

Sept 9: Johnstone brought to his office supplies purchased the previous day.

Required

  1. Prepare a list of those transactions which are personal in nature, do not affect the business entity and should not be included in the balance sheet of Johnstone& Sons CPA
  2. Prepare a balance sheet for the business entity Johnsstone& Sons CPA at September 9,2001.

5.    Jane graduated from the University with a degree in a Business Administration. She decided to put in practice the skills acquire during the four-year programme.

Jan 2. Jane Invested Kshs. 100,000 in a business, she planned to start under the name Jane enterprises.

Jan 3. Purchased Equipment costing Kshs. 35,000/= from Furniture Ltd. paid Kshs 20,000/= cash and the balance to be paid within 30 days.

Jan5.     Performed services and was paid cash amounting to Kshs5,000/=

Jan 15. Purchased a van for Kshs. 200,000 paid a deposit of Kshs 50,000/= and signed 1 year notes payable for the balance.

Jan 25. Performed services for credit customer for Kshs7,000 Jan 30 Paid the Accounts payable to furniture Ltd. in full.

Jan 30 Paid rent Kshs 10,000/= for January

REQUIRED:

  • Journalize the above transactions.
  • Explain three advantage of using a journal