Foundations of Accounting

Introduction

a) Definition of accounting
Accounting is often said to be the language of business. It is used in the business
world to describe the transactions entered into by all kinds of organisations.
Accounting terms and ideas are therefore used by people associated with
business, whether they are managers, owners, investors, bankers, lawyers, or
accountants.

The actual record-making phase of accounting is usually called book-keeping.

However, accounting extends far beyond the actual making of records.
Accounting is concerned with the use to which these records are put, their
analysis and interpretation. An accountant should be concerned with more than
the record making phase. In particular he should be interested in the relationship
between the financial result and the events which have created them. He should
be studying the various alternatives open to the business and be using his
accounting experience in order to aid the management to select the best plan of
action for the business.

b) Probably these are two main questions that the manager or owners of a business
want to know. First, whether or not the business is operating at a profit, second,
they will want to know whether or not the business will be able to meet its
commitments as they fall due, and so not have to close down owing to lack of
funds.

Users of Accounting Information

1. Managers: They use this information for decision making purposes and to aid
them running the business efficiently. By analysing accounting information they
are able to tell how well their policies have converted into higher earnings and
profits for the firm.

2. Owners or shareholders: Accounting information is used by shareholders to

determine if they are making a good return on their investment in the company.
Shareholders invest in a company in order to earn high dividends and capital
gains on their shares and this information on the company is normally given by
analysing a company’s financial statement.

3. Potential Investors: Those who are interested in investing in a business need to

have an idea of its performance before they make an investment in the
 company’s shares. This information is normally given in the company’s final
accounts or financial statement.

4. Banks: When a firm requires capital to run or expand its business it looks to
getting a loan from a bank. The bank needs to be sure the firm will not default on
the loan and is assured of this by studying the company’s accounts over a period
of years to gauge its profitability. In this way the bank is able to decide whether
or not to extend a loan.

5. Employers: On another level, employees may use accounting information

when trying to compare companies to apply for work, companies that have
sustained profitability have more job security and promise to maintain the
employee for the foreseeable future.

Overview of accounting principles and concepts

The cost concept: it means that assets are normally shown at cost price, and that
this is the basis for assessing the future usage of the asset.

The money measurement concept: Accounting is only concerned with those facts that
can be measured in momentary terms with a fair degree of objectivity. This means that
accounting can never show the whole of the information needed to give you a full
picture of the state of the business or how well it is being conducted. Accounting does
not record that the firm has a good or bad management team. It does not show that the
poor morale prevalent among the staff is about to lead to a serious state or that various
managers will not co-operate with one another.

The going concern concept: Unless the opposite is known, accounting always assumes
that the business will continue to operate for an indefinitely long period of time. Only if
the business was going to be sold or closed down would it be necessary to show how
much the assets would fetch.

The business entity concept: The transactions recorded in a firm’s book are the
transactions that affect the firm. The only attempt to show how the transactions affect
the owners of a business is limited to showing how their capital in the firm is affected.
For instance a proprietor puts Shs. 100,000 more cash into the firm as capital. The books
will then show that the firm has shs. 100,000 more cash and that its capital has
increased by shs. 100,000. They do not show that he has shs.100,000 less cash in his
private resources.

The realisation concept: In accounting, profit is normally regarded as being entered

at the time when the goods or services are passed to the customer and he incurs liability
for them; i.e. this is the point at which the profit is treated as being realised. Note that
this is not when the order is received nor the contract is signed, neither is it dependent
on waiting until the customers pays for the goods or services.

It can mean that profit is brought into account in one period and it is found to have
been incorrectly taken as such when the goods are returned in a later period because of
some deficiency. Also the services can turn out to be subject to an allowance being
given in a later period owing to poor performance. If the allowance, or returns can be
reasonably estimated an adjustment may be made to the calculated profit in the period
when they passed to the customer.

The dual aspect concept: this states that there are two aspects of accounting, one
represented by the assets of the business and the other by claims against them. The
concept states that these two aspects are always equal to each other. In other words;

Assets = Liabilities + Capital

Double entry is the name given to the method of recording the transactions so that the
dual aspect concept is upheld.

Accruals (Matching) concept. The fact that net profit is said to be the difference
between revenues and expenses rather than between cash receipts and expenditures is
known as the accruals concept.

This concept is particularly misunderstood by people not well versed in accounting. To

many of them, actual payment of an item in a period is taken as being matched against
the revenue of the period when the net profit is calculated. This is not the case because
expenses consist of the assets used up in a particular period in obtaining revenues of
that period and expenses of a period. There is a difference between cash paid in a
period and expenses of a period.

Further overriding concepts.

The following concepts are also important in accounting, however, are capable of being
interpreted in many ways as opposed to generally accepted approaches to the earlier
concepts.

Materiality : firms fix all sorts of arbitrary rules to determine what is material and
what is not. There is no law that lays down what these should be, the decision as to
what is material and what is not is dependant upon judgement. A firm may well decide
that all items under Shs. 10,000 should be treated as expenses in the period which they
were bought even though they may well be in use in the firm for the following ten years.
Another firm especially a large one, may fix the limit of shs. 100,000. Different limits
may be set for different types of items.

Consistency: this concept is that when a firm has once fixed a method of the accounting
treatment of an item it will enter all similar items that follow in exactly the same way. A
firm may change the method used but when such a change occurs and the profits
calculated in that year are affected by a material amount, then either in the profit and
loss account itself or in one of the reports accompanying it, the effect of change should
be stated.

Prudence: very often an accountant has to make a choice as to which figure he will take
for a given item. The prudence concept means that normally he will take the figure
which will understate rather than overstate the profit. Alternatively, this could be
expressed as choosing the figure which will cause the capital of the firm to be shown at
a lower amount rather than at a higher one. This could also be said to be to make sure
that all losses are recorded in the books, but that profits should not be anticipated by
recording them prematurely.

The Going Concern, Accruals, Prudence and Consistency concepts are considered so
important that they have been enforced through accounting standards and the
Companies Act. They are therefore known as Fundamental Accounting Concepts.

Forms of Business Ownership

Sole trader/proprietor

One person in a business alone with a view to making a profit is known as a sole trader.
The business may simply be in the name of the person or may have a business name
such as ‘Quickclean Windows’. The business trading name does not have to be
registered, but if one is used the owner’s name should appear on all letterheads and so
forth.

If you start a business as a sole trader you are the owner of that business, taking all the
profits but suffering any losses. You are totally responsible for the business.

The advantages of being a sole trader are:

  It is very simple to start the business; there are no legal
formalities.
 You make all the decisions without having to consult any other
person.
 You enjoy all the profits
 You have total control over the business.

The disadvantages of being a sole trader are:

 You may not have sufficient money to start the business and you
may not be able to borrow what you need.
 If the business makes a loss, you will suffer all of it.
 You will have to provide all the management expertise, unless you
can afford to employ other people.
 You are personally responsible for the debts of the business, which
means you can be made legally bankrupt if you are unable to pay.
 You are liable to pay tax on the profits of the business.

Partnerships

A partnership can be defined as two or more people carrying on business with a view to
profit. The maximum number of partners allowed is 20, apart from professional firms
such as accountants and solicitors who can exceed this number.

It is quite usual for professional people such as dentists, doctors, solicitors and accounts
to offer services not by themselves but with two or more colleagues.

The partners are all owners of the business; they jointly share in the decisions and the
running of the business. As in the case of a sole trader, they may operate under a
business name which does not have to be registered and need not include any wording
to show it is a partnership. Partners normally ask a solicitor to draw up a legal
agreement showing the proportions in which they will share any profit or loss and other
matters. This is a Partnership Agreement also known as a Partnership deed.

The advantages of a partnership are:

 More capital can be raised to start the business.
 The pressures of running and controlling the business are shared.
 Legal requirements are few.
 If the business makes a loss it is shared amongst the partners.

The disadvantages of a partnership are:

 You do not have sole control and the other partners may overrule
your decisions.
 You do not enjoy all the profits but have to share them.
  If the business runs into financial problems, you will be personally
responsible for the debts of the partnership.

Limited liability companies/ Corporations

A limited liability company (often just referred to as a limited company) can be defined
as a ‘legal person’ and is separate from the owners.

Because a limited company is regarded as being separate from its owners it is often
referred to as a legal entity. The most important consequence of this is that the
company is responsible for the debts incurred in trading. If the business is unable to pay
its debts, then the company can be sued in its own name. The owners of the company
(the shareholders) are responsible for the amount of money they have invested and /or
agreed to invest in the company, but their liability is limited to that amount. Although
they may lose the amount they have agreed to invest in the company they will not be
expected to sell their personal possessions. In some countries the term stockholder is
used instead of shareholder.

On the formation of the company certain documents must be registered with the
Registrar of Companies. In addition, every year a limited company must send certain
financial information to all its shareholders and register certain information with the
Registrar. Companies whose shares can be offered to the public are known as public
limited companies. As well as public limited companies, there are private limited
companies whose shares may not be offered to the public. A public company can choose
to offer its shares to the public through the stock exchange; a private company cannot
to this.

The advantages of limited companies are:

 The liability of the owners (also known as members) of a company
for the debts it incurs is limited to the amount they have agreed to subscribe for
shares.
 It can be easier to raise large sums of money.
 The company can be professionally managed by directors.
 Owners can sell their shares in a public limited company if they
wish to relinquish their ownership because the Stock Exchange is a market place
for dealings in shares.

The disadvantages of limited companies are:

 It is more expensive to start business as a limited company than as
a partnership or sole trader.
 Any decision you make about the company may be vetoed by
other shareholders.
 It involves a number of legal formalities, which may discourage the
formation of a company by prospective shareholders