CONCEPTUAL FRAMEWORK OF ACCOUNTING

Accounting

Accounting is the art of recording, classifying and summarizing in a significant

manner and in terms of money, transactions and events which are, in part at least, of
a financial character, and interpreting the results thereof. (American Institute of
Certified Public Accountants)

Book keeping

There are distinctions between bookkeeping and accounting. The two processes are
closely related, but there is no universally accepted line of separation. Generally,
bookkeeping involves recording financial transactions of a business or an individual in
terms of money in a set of books in order to obtain necessary information when
needed; it is a sub set and record making phase of accounting. It may also mean the
systematic recording of business transactions in financial terms.

Accounting functions at a higher level; an accountant sets up the system that a

bookkeeper uses to record business transactions. An accountant may supervise the
work of the bookkeeper and prepare financial statements and tax reports. Although
the bookkeeper’s work is more routine, it is hard to draw a line where the
bookkeeper’s work ends and the accountant’s begins.

Financial accounting

This is a branch of accounting concerned with classification, measurement and

recording of business transactions of an entity in monetary terms and in accordance
with Generally Accepted Accounting Principles (GAAP). GAAP however refers to
accounting principles or practices that are normally allowed by the accounting
profession and it has support by the authority. OR the rules or guidelines used for
carrying out the accounting process. OR the accounting standards and concepts used
in the preparation of financial statements.

Objectives of financial accounting

The main objectives of financial accounting are:

 To record the amounts owed by debtors and to creditors

 To record the value of the assets and liabilities of the business as well as
increases and decreases in these assets and liabilities
 To record income and expenditure during the accounting period
 To record the profits and losses of the business during the accounting period
 To classify and summarize figures and groups of figures in same manner each
year so that they may be easily interpreted by those for whom they were
prepared
  To satisfy where required the legal requirements of the country in which they
operate and conform to the rules and regulations laid down by the accounting
regulatory bodies.

Financial Accountability

This refers to justifying and defining financial transactions carried out by accountants
and managers since they deal with money. This is done to the owners of the wealth
(share holders).

Methods of financial accountability

Managers and accountants are required to show evidence of good financial

management by submitting accountability of money received and spent. The following
are therefore methods of financial accountability:

1. Production of documentary evidence, this involves producing documents as

evidence of money received and well spent. The key accountability documents are:

 Receipts- is a document prepared as evidence of money received

 Voucher- is a document that shows details and supports payment
 Invoice- is a document submitted suppliers demanding payment for goods and
services provided on credit.

2. Books of accounts, transactions must be recorded properly in the books of

accounts e.g. cash book so that in case of inquiries or normal monitoring of
transactions they can be referred to.

3. Financial statements/ reports, accountants and managers should be prepared to

defend the results shown in the financial statements to the share holders as part of
the accountability process. The major financial statements are the income statement,
the balance sheet and the cash flow statement. Some monthly statements like bank
reconciliation statement, budget performance reports and monthly trial balance are
also required for accountability purposes in many organizations.

Output/ results, in management of finances, paper accountabilities are not enough.

Usually, there is need for tangible output and concrete results to show evidence of
money well utilized. E.g. if someone is given UGX 500 million for building classroom
blocks, the first accountability to be looked at are the classrooms themselves.

FUNCTIONS OF ACCOUNTING

Accounting plays a dynamic role in the success of any business enterprise. The
following are the main functions of accounting;-
  To provide information to decision makers, the overall role of accounting is
to provide information to decision makers. However, besides providing
information for decision making, it has the following specific roles.
 Monitoring of debtors and creditors is easy. If accounts are prepared
without records of debtors and creditors, it could be difficult to tell who owes
you money and to whom you owe money.
 Necessary for taxation, accounting records make assessment of tax easy and
advantageous to both the organization ant the tax authority. This can help in
charging the correct tax.
 A proof of financial position of the business, accounting information gives
proof of financial position of the business. This can assist in when a business
wants to acquire loans from financial institutions or invite applicants from the
general public to buy shares in case of a company.
 Acts as a tool of control, a business enterprise can maximize its profit by
increasing the gap between income and expenses. Proper control on
unnecessary expenses and misappropriation of funds is essential. A proper and
accurate accounting system will be helpful to maintain this control.
 Ascertainment of profit and loss, the main purpose of any business is to
make profit. For this reason, accurate and complete recording of all business
transactions is important because this information will be helpful to determine
whether there was profit or loss in any trading period. No business can survive
in the long period without making reasonable profit.
 Base for further planning, for the further expansion of any business, a
business enterprise can formulate its plans on the basis of present and past
achievements. Accounting records can therefore provide sufficient data relating
to sales, profit, investments etc for making decisions about the future
programmes.

USERS OF ACCOUNTING INFORMATION

Various groups will be interested in a company’s financial affairs and performance.

Each group will be interested in different aspects of the company’s structure and
performance, for different reasons

Internal parties;

Internal users include the proprietors, business management and employees. They are
therefore involved in the day- day running of the organization and they include;

(a) Management (directors, senior executives and top managers; Management

therefore requires financial information to assess:
 The viability of the firm
 The firm’s profitability
 The firm’s liquidity
 The performance of managers in using the firm’s assets
They will use the financial information to analyze increases in costs and revenues and
as a source for corrective action.

(b) Employees; they are those who work in the business and their representative
groups (trade union in this case). They will be interested in the financial information
produced by the company as a guide to the viability of the company and to its ability
to maintain the present levels of staff or to enhance levels of pay, as well as help them
to assess for ability of their employers to survive and prosper, and to provide
employment opportunities, remuneration and retirement benefits.

External parties; these include among others the following:

Share holders/ investors; Potential investors will be examining the company as an

investment opportunity and will be interested in the share price, the dividend yield,
the dividend policy and the dividend cover. They are interested in knowing how their
business is performing i.e. whether the organization is well managed; expanding etc.
this is achieved by examining accounting records.

Creditors; Creditors will be concerned that the level of working capital is sufficient to
pay them the amount due to them in accordance with their credit terms. They will also
be interested in how they rank for payment. Before a loan or any credit facility is
granted, the credit worthiness of the applicant is analyzed. Credit analysis can only be
possible if accounting information inform of financial statements exist.

Government; Through tax authorities like URA, government usually require the
relevant information to ensure that tax has been calculated properly and also that the
organization in question has paid taxes. All this information is obtained from financial
accounting statements or reports issued by the firm. The government, usually through
its regulatory institution such as Uganda Communication Commission (UCC), requires
accounting information to determine the level of performance and know whether the
firm in question has complied with the necessary regulatory requirements.

Competitors; they use financial information to determine the performance and

position of the firm. This enables them to effectively manage their own business in
order to remain competitive in the market.

Donors/ funding agencies; Non- profit making organizations like the NGOs obtain
funds from donors. These donors are normally interested in making sure that they
money they donate achieves the objective for which it was released. They therefore
monitor the use of their monies by examining the accounting records of the
organization that they support.

The public; members of public are affected in a variety of ways by enterprise

activities. The success and financial prospects of a business are relevant to the
economy including employment, use of local supplier, development of roads, housing,
the environment, and communication and so on. Financial information is likely to be
useful in keeping the public and their representatives informed.

QUALITIES OF FINANCIAL INFORMATION

In order to be of greatest benefit to the organization and to those with whom it deals
with, financial accounting information should be:

Consistent: that is, the information should be extracted in precisely the same way,
each time using the same formulae, headings and groupings so that the results will be
directly comparable.

Timeliness: accounting information must be prepared and submitted in time i.e.

when it is required.

Understandable: the information should be clear, unambiguous and capable of being

easily understood by the party for it was prepared.

Objectivity: financial information must be objective i.e. it must indicate a clear

yardstick of measurement. It should not be inclined towards the interest of any user
group.

Relevant: information should be designed to suit the requirements of the user. It

should convey the information sought concisely and precisely.

Reliable: the information produced should have the backing of a source document or
the certification of a competent authority such as a director or auditor.

Completeness: accounting information should include all the relevant information

needed by the users.

Comparability: the information should be expressed in terms which enable the users
to compare its entities over time and with other similar entities.

FUNDAMENTALS OF ACCOUNTING (Accounting Regulatory Framework or

Accounting Rules)

In order to show a true and fair view of a company the Companies (Amendment) Act
1986 prescribes that the company in producing its accounts follows the principles
generally known as accounting concepts.

Accounting concepts/ principles/ conventions/ postulates

Accounting concepts are defined as broad basic ground rules and assumptions which
must be followed when financial statements are being prepared and presented. They
are also referred to as assumptions or prepositions that underlie the preparation and
presentation of financial reports. At present four concepts are regarded as being
fundamental and having general acceptability. These four are:
  The going concern concept
 The accruals concept
 The consistency concept
 The prudence concept

There are however, other accounting concepts that are used and recognized in the
preparation of accounts but presently only the four listed above have legal backing.
Unless otherwise stated, it is assumed that the four fundamental concepts have been
used in the preparation of accounts. Accounting concepts are dealt with in more detail
later on in the chapter.

Accounting bases

Accounting bases are the methods that have been developed for expressing or applying
fundamental accounting concepts to financial transactions and items. Of necessity
they are more numerous and diverse than fundamental accounting concepts. When
faced with a choice between two or more suitable accounting bases the accountant
must use commercial judgement. Examples of accounting bases are:

 Depreciation of fixed assets over their useful economic life

 Writing off goodwill either in full immediately against reserves or amortization of
its life in the profit and loss account

Accounting policies

These are specific bases chosen and adopted by a business enterprise in preparing its
financial statements. A company is required to state in a note to the accounts its
accounting policies for treating items which are material or critical in the preparation
of financial statements. The explanations should be as clear, fair and brief as
possible./ when a particular accounting policy has been adopted, it should be used on
a consistent basis and should not be changed unless it is necessary in order to give a
true and fair view. Examples of accounting policies are:

 Depreciation policy used

 Method of stock valuation used
 Use of historical cost convention

These policies have a very definite effect on the accounts and results of a company. If,
for example, a company charges too little depreciation to the income statement, the
net profit and the net book value in the balance sheet will be overstated.

Overview

Accounting concepts e.g. accruals (matching)

Accounting bases e.g. depreciation of fixed assets

 over useful economic life

Accounting policies e.g. writing off of buildings at 2% of cost

using straight line method

Accounting standards

These are guideline statements or rules issued by professional accounting bodies

governing accounting practices in areas or countries under their control relating to
how accounts should be prepared and presented. Accounting standards spell out the
accounting principles and accounting bases to be applied. In Uganda, the professional
body responsible for issue of accounting standards is the Institute of Certified Public
Accountants of Uganda (ICPAU)

Fundamental accounting concepts

Going concern: this concept states that the business will continue to operate for an
indefinitely long period of time. The business is not on the verge of collapsing unless
there are indications to suggest so. Accounts are therefore prepared on the
assumptions and understanding that he business will continue to operate.

Accrual (matching) concept: it states that all incomes that are supposed to fall
within a particular period and the related expenses should be treated in such a period
whether cash has been received, paid out or not. The portion which is not received or
paid out remains an outstanding until it is received or paid out.

Consistency concept: this states that the treatment of accounting items will be
exactly the same from one accounting period to another. Therefore, once a given
accounting method or base has been selected and has become an accounting policy, it
should be applied consistently from year to year. This would enhance comparability
with previous periods and full disclosure. If however firms wish to change such
methods, mention should be made of the effects of the change and the reasons for the
change.

Prudence (conservatism) concept: this concept requires that accountants should not
anticipate revenue and profits until it is realized but should provide for all possible
losses. For this reason, provision for all bad debts are created and written off from the
profits. If there are two or more methods of valuing an asset, an accountant should
choose a method or base which leads to a lesser value.

Other accounting concepts and principles

As already mentioned accountants apply concepts other than the four fundamental
ones when preparing accounting information.
The Business entity concept: this concept sees the business as being distinct from
its owners, irrespective of the owner’s legal status. For example, a sole trader is
regarded in law as owner of a business but in the accounts the capital invested is
treated as a liability. Therefore, transactions recognized and recorded in the firm’s
books are transactions that affect the firm excluding private transactions of the
proprietor. Records are only made for what the entity owes the owner (capital) and
what the owner owes the entity (drawings).

The money measurement (monetary) concept: this states the fact that all
accounting deals only with transactions that can be expresses in monetary terms. This
means that the accounts alone will never be able to give a full picture of the state of
the business. This money is a common denominator for the transactions with fair
degree of objectivity, a unit of account and store of value.

The materiality concept: this concept requires recognizing only material items and
excluding immaterial ones. An item is said to be material if its omission, mis-
statement or non- disclosure will directly affect the accounts and financial statements
of an entity. Therefore, for an item to be considered material or not depends on;-

 the opinion and judgement of the accountant because what is immaterial in a

given firm may not be material in another firm.
 the value of the item in relation to the size of the firm.

The realization concept: it assumes that profit is earned at the time the goods or
services pass to the customer and not when they are paid for. It therefore demands
accountants to recognize incomes as earned only when a sale has been made and the
goods have been accepted by the customer or services have been offered and enjoyed
by the customer or where value has been created by transaction and legal rights and
obligations have resulted.

The double entry, duality/ dual aspect concept: this concept requires a business
transaction to be recorded twice. This concept recognizes that; every transaction
involves the giving and receiving effect. If one account is debited, the other one must
be credited.

Note: a business transaction is an event directly affecting an economic entity that can
be expressed in terms of money and that must recorded in the accounting records.

Substance over form concept: this concept states that transactions and other events
should be recorded in accordance with financial and economic reality (substance)
other than their legal form. E.g. in a hire purchase transaction, the buyer takes the
possession and use of the asset but does not become the legal owner until the last
installment has been paid. Though he is not the legal owner, he has to recognize this
transaction in his books of accounts.
Objectivity concept: this states that figures must have a basis for arriving at them
not simply be planted into financial statements. Accountants must be able to defend
figures in financial statements using objective evidence. It therefore aims at
eliminating subjectivity and free accounting information from biasness.

Periodicity and disclosure concept: this concept makes financial reporting

mandatory and it’s stipulated in the company’s Act of Uganda and other countries. A
company must prepare and disclose financial statements at the end of accounting
period; publishing annual accounts is obligatory but not disclosure even once a year is
illegal. All material items must be disclosed.

Cost/ historical concept: this concept states that accountants must record assets at
their acquisition costs even if the value today is more than the acquisition cost.
Likewise, liabilities are recorded at the amount they were incurred even if their true
value might have changed due to inflation, devaluation or foreign exchange. However
the focus is on recording the assets.

Relevance concept: it is sometimes co0mbined with material concept. It therefore

states that the overall message that the accounts are trying to put across may not be
clear if too much information is presented. As such, accounting statements should
contain only information that complies with the specific requirements of the user.

FIELDS OF ACCOUNTING

There are several accounting fields as a result of varied uses of accounting

information. The common fields are;-

Financial Accounting: this is concerned with the classification, measurement and

recording of business transactions of an entity in monetary terms and in accordance
with Generally Accepted Accounting Principles. However, the major focus of financial
accounting is to provide information to external users. External users of financial
accounting information include among others the following; shareholders, creditors,
government, financial institutions, the public to mention but a few.

Managerial or private accounting: this deals with the analysis and interpretation of
accounting information, management of accounting system, preparation of budgets,
determination of product’s costs and provision of financial information to managers
and owners for internal decision making concerning daily operations as well as
planning and control of future operations.

Cost accounting: it involves the determination and allocation of costs to products and
services of a business organization. This accounting field provides information for
internal decision making concerning the costs of operating service and manufacturing
businesses.
Environmental accounting: it is the reporting of environmental activities undertaken
by an organization. It provides information for external users concerning
environmental achievements.

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

Auditing, it is the independent reviewing and issuing of an opinion on the reliability of

accounting records by the auditor. The auditor is supposed to check whether the
books of accounts are prepared and presented according to the generally accepted
accounting principles and whether policies and procedures prescribed by management
are being followed. The auditor’s opinion enables external users to be confident of the
information reported in the financials reports.

CAREER OPPORTUNITIES IN ACCOUNTING

In terms of career opportunities, the field of accounting may be divided into three
broad areas: (1) the public accounting profession, (2) private accounting, and (3)
governmental accounting.

Public accounting

Public accounting firms are organizations which offer a variety of accounting services
to the public- which is done by highly qualified Certified Public Accountants. These
firms vary in size from one- person practices to large, international organizations with
several thousand professional accountants. Persons employed in public accounting
may work independently or as a member of a public accounting firm. Public
accountants sell services to individuals, businesses, government units and non- profit
making organizations. These services may include among others the following: audit
work, management advisory services, tax consultancy services like preparing income
tax returns, etc.

Private accounting

In contrast to the CPA in public practice who serves many clients, an accountant in
private industry is employed by a single enterprise. The accountants in a private
business, large or small, must record transactions and prepare periodic financial
statements from accounting records. Within this area of general accounting, a number
of specialized phases of accounting have developed. Among the more important of
these are: design of accounting system, cost accounting, financial forecasting, income
tax accounting, internal auditing, management accounting, etc.

Governmental accounting
It is the accounting for government institutions such as the central government, local
government, etc. government accounts are unique from private companies and other
organizations. Government officials however rely on financial information to help them
direct the affairs of their agencies. Universities, hospitals, churches and other not- for-
profit institutions also follow a pattern of accounting that is similar to governmental
accounting.

Uganda Revenue Authority; is one of the governmental agencies which performs

extensive accounting work. It handles millions of income tax returns filed by
individuals and corporations and frequently performs auditing functions relating to
these income tax returns and the accounting records on which they are based.

Securities and Exchange Commission: this is another governmental agency deeply

involved in accounting. The SEC establishes requirements regarding the content of
financial statements and the reporting standards to be followed. All corporations
which offer securities for sale to the public must file annually with SEC audited
financial statements meeting these requirements.

Exercises

1. Define financial accounting, emphasizing its most important functions.

2. What are the main objectives of financial accounting?

3. List the various parties that would be interested in a firm’s financial records and
explain the reasons for their interest.

4. (a) Explain what is meant by accounting concepts, bases and policies.

(b) Discuss what you consider to be the purpose of accounting

5. Name and explain what accountants regard as the four fundamental accounting
concepts

6. Explain the following concepts:

(a) Double entry (b) Realization (c) Money measurement (d) Business entity (e)
Objectivity (f) Materiality

7. Select the accounting concept which would apply to the following situations;

(i) An amount of Shs. 500 is due at the end of the accounting period for gas used
during the period

(a) going concern (b) materiality (c) accruals (d) prudence

(ii) A customer who owes Shs. 10,000 is likely to be declared bankrupt

 (a) consistency (b) materiality (c) accruals (d) prudence

(iii) The company owns Shs. 250,000 worth of shares in a quoted company but the
accountant thinks they are worthless.

(a) Objectivity (b) accruals (c) prudence (d) realization

(iv) Some good customers have indicated that they will be placing large orders even
though no sales have taken place

(a) Double entry (b) consistency (c) money measurement (d) prudence

(v) Special equipment costing Shs. 100,000 has been installed. This would be of very
little value if the firm were to go into liquidation.

(a) Prudence (b) going concern (c) consistency (d) money measurement

(vi) One of the sales persons plays for the international team and is achieving record
sales. The managing director thinks he is a very valuable asset and as such should be
regarded as a fixed asset on the company’s balance sheet.

(a) Objectivity (b) going concern (c) materiality (d) money measurement

(vii) At the end of the accounting year there were twenty litres of diesel in the company
van.

(a) Double entry (b) materiality (c) prudence (d) objectivity

(viii) The managing director wishes to change the method of stock valuation.

(a) Going concern (b) prudence (c) consistency (d) business entity

8. The observance of the following concepts is presumed in financial statements

unless otherwise stated: (a) going concern (b) accruals (c) consistency (d) prudence

 In light of the above statement, explain each of the above concepts, giving
examples of how each is observed in conventional financing statements.

(Association of Accounting Technicians)

 THE ACCOUNTING EQUATION

The fundamental characteristic of every balance sheet is that the total figure for assets
always equals the total figure for liabilities and owner’s equity. Accounting equation
therefore expresses the equality between the resources of the business (assets) and the
claims against those resources (liabilities). This agreement or balance of total assets
with the total of liabilities plus owner’s equity is one reason for calling this statement
of financial position (a balance sheet).

One side of the equation is expressed in monetary terms; the resources held by the
organization or the business and the other side describes how these resources have
been financed. Therefore, claims against the business assets can be financed by
owner’s equity and borrowed funds. But why do total assets equal the total of
liabilities and owner’s equity? The answer can be given in one short paragraph as
follows.

The shilling totals on the two sides of the balance sheet are always equal because these
two sides are merely two views of the same business resources. The listing of assets
shows us what resources the business owns; the listing of liabilities and owner’s
equity tells us who supplied these resources to the business and how much each
group supplied. Everything that a business owns has been supplied to it by the creditors
or by the owner. Therefore, the total claims of the creditors plus the claim of the owner
equal the total assets of the business.

The equality of assets on the one hand and of the claims of the creditors and the
owner on the other hand is expressed in the equation below:

Assets = liabilities + owner’s equity

A = L + O.E

However; Assets – owner’s equity = liabilities

Owner’s equity = assets – liabilities

NOTE: In cases where liabilities exceed assets, the accounting equation becomes;-

Deficiency = liabilities – assets

When such a situation occurs, it means that the organization or an individual is in a
state of insolvency.

ELEMENTS IN AN ACCOUNTING EQUATION

1. Assets: These are economic resources which are owned by the business and are
expected to benefit future operations. Or they may mean anything of value owned by
the business. Assets may have definite physical form like buildings, machinery or
merchandise while others may exist in tangible form, but in the form of valuable legal
claims or rights; e.g.

i. amounts due from customers

ii. patent rights
iii. Investments in government bonds, etc.

For profit making organizations, assets create more assets (wealth); while for non-
profit making organizations, assets are required for the smooth flow of activities.

Assets may be classified as; current assets and fixed or non- current assets

Current assets: These are short term assets which have useful life of only one
financial year and thereafter are expected to be used up; sometimes they may be
carried forward for subsequent financial years. These assets are used to meet the day-
day requirements of the business. These assets provide the liquid resources for the
purposes of making payments to the creditors and to the employees. Examples of
current assets include;

 Stock/ inventory held for resale

 Debtors/ accounts receivable
 bank
 Cash at hand
 Prepaid expenses
 Accrued income
 Short term investments and so forth.

Non- current assets (fixed assets): These are long- term assets that can benefit the
organization for more than one financial year; their useful lives extend beyond one
financial year. These assets are normally obtained at the start of the business. These
assets are required to conduct business transactions smoothly. Examples of non-
current assets include;

 Motor vehicles
 Plant and machinery
 Buildings/ premises
 Furniture and fittings
 Land
  Other automobiles
 equipments etc

Assets that are neither Current nor Non- current

There are some assets which are current nor non- current; these assets are shown
between fixed and current assets in the balance sheet. These assets are classified as
under:-

Intangible assets: These are assets which have no material existence e.g. goodwill,
trademarks, patent rights and copy rights. If a long established business is purchased
by a person then he is supposed to pay something for the reputation of this business.
This goodwill is sometimes shown in the balance sheet but the normal accounting
practice is that it should not be disclosed commonly.

Investments: Investments are made by a business enterprise in some cases in the

form of purchase of shares (stock) or debentures of a limited company. These
investments may be quoted or unquoted.

2. Liabilities: These are obligations/ debts that are to be discharged/ repaid by the
organization. If an organization for example needs to purchase assets but cannot
afford on its own, then it has to borrow so as to acquire those assets. If it borrows
then liabilities arise.

Liabilities may also be classified as;

Current liabilities: These are debts/ obligations which are discharged within the year
of incurring. In other words, they are to be settled within a period of one year. They
have no grace period because they require settlement within one financial year.
Examples include;

 Trade creditors (accounts payable)

 Bank overdraft
 Outstanding/ accrued expenses
 Taxation payable
 Incomes received in advance/ prepaid incomes
 1 year short term bank loan
 Other creditors falling due within one financial year

Long term liabilities/ non- current liabilities: These are obligations that require
settlement within a period of more than one financial year. They have a grace period of
more than one financial year. These liabilities consist of capital and long term loan.
Capital introduced by the owner is intended to remain to the business for as long as it
continues to exist. Examples of long term liabilities may include;

 Long term bank loans e.g. five years loan

 capital
  Debentures. A debenture is a type of debt instrument that is not secured by
physical assets or collateral. Debentures are backed only by the general
creditworthiness and reputation of the issuer. Both corporations and governments
frequently issue this type of bond to secure capital. Like other types of bonds,
debentures are documented in an indenture.
 Bonds etc Bonds are government-issued shares that are purchased by an
investor with the agreement that the principle and interest will be paid off at a
later date.

3. Owner’s equity: These are resources invested by owners in the organization/

business. It variously means claims from the business by the owners. It is the capital
introduced in the business by the owner and is intended to remain in the business for
as long as it continues to exist (going concern principle). For a company for example,
owner’s equity is composed of ordinary share capital, preference share capital
(although sometimes treated as long term liabilities), reserves e.g. retained earnings/
profits etc for a sole trade business; while in a sole proprietorship business owners
equity comprises of individual funds contributed.

Owner’s equity = capital + net profits – drawings.

However, capital can be defined as the amount invested by the owner in the business
or that wealth which is set aside to assist in the creation of further wealth. When a
person wants to start a business, he is required to invest money in that business. The
money invested at the start of the business is capital. This capital is used to buy fixed
assets like machines, tools, furniture etc some part of the capital is used to purchase
the goods for resale.

Types of capital

The term capital is also used in diversified ways. Some important types of capital are
as under;-

Equity capital: The capital invested by the owner of a business plus any profits
attributable to the owners is known as equity capital.

Loan capital: Is the amount borrowed by the business and its to be paid back at a
later date. The providers of the loan capital are normally paid a fixed rate of interest
and they do not share in the profit of a business.

Working capital: Working capital may be defined as the difference between current
assets and current liabilities of a business. It represents the liquid or cash resources
at the disposal of a business available to meet its immediate liabilities. There should
be enough working capital for the smooth flow of the business.

Thus; working capital = current assets – current liabilities

Capital employed: The term capital employed is used in two different meanings;-

a) Gross capital employed

b) Net capital employed

Gross capital employed consists of fixed assets plus current assets. Net capital
employed consists of fixed assets plus net current assets. Net current assets mean
current assets minus current liabilities. The term capital employed is normally used in
the sense of net capital employed.

In summary therefore;

Gross capital employed = fixed assets + current assets

Net capital employed = fixed assets + net current assets

But; Net current assets = current assets – current liabilities

Floating/ circulating capital: This represents the total of all current assets

Fixed capital: This refers to the total of all non- current assets

Sources of capital

From the above discussion, we can conclude that capital to start a business may be
obtained from;-

 Personal resources
 Borrowing from friends or banks
 Trade credit
 Bank overdraft and so on.

Personal resources of a person include his savings, personal property etc. the money
borrowed from friends or a bank is to be repaid after some time. But this money can
help a person to start his business. Trade credit means to purchase goods on a
promise to pay in future. The persons who supply goods on credit are known as
creditors. Bank overdraft is a temporary loan, which is repayable in short period. It is
granted to the businessmen who operate current account with a commercial bank.

ILLUSTRATION:

Example 1

Emma is a sole trader who set up his business in Kasana. The following were the
transactions that took place in the month of January. Amounts are in UGX

i. Started business with cash of 10,000,000 and cash at bank of 20,000,000

ii. Purchased stock of goods on credit of 3,000,000
 iii. Bought a motor vehicle for business operations using cash at bank of
2,000,000
iv. Sold goods to James for 600,000 cash which had cost him 500,000
v. Paid the shopkeeper 50,000 cash as salary
vi. Bought more stock of goods for 500,000 cash
vii. Used business cash of 300,000 to buy for his wife and children Christmas
clothes

Required: Construct an accounting equation for each of the transactions above and
extract a simple balance sheet at the end.

(i)

Assets = Liabilities + Owner’s equity

Bank 20,000,000 ------------------------- Capital 30,000,000
Cash 10,000,000
30,000,000 30,000,000

(ii)

Assets = Liabilities + Owner’s equity

Stock 3,000,000 Trade creditors 3,000,000 Capital 30,000,000
Bank 20,000,000
Cash 10,000,000
33,000,000 33,000,000

(iii)

Assets = Liabilities + Owner’s equity

M/ vehicle 2,000,000 Trade creditors 3,000,000 Capital 30,000,000
Stock 3,000,000
Bank 18,000,000
Cash 10,000,000
33,000,000 33,000,000

(iv)

Assets = Liabilities + Owner’s equity

M/ vehicle 2,000,000 Trade creditors 3,000,000 Capital 30,000,000
Stock 2,500,000 Profit 100,000
Bank 18,000,000
Cash 10,600,000
33,100,000 33,100,000
(v)

Assets = Liabilities + Owner’s equity

M/ vehicle 2,000,000 Trade creditors 3,000,000 Capital 30,000,000
Stock 2,500,000 Profit 50,000
Bank 18,000,000
Cash 10,550,000
33,050,000 33,050,000

(vi)

Assets = Liabilities + Owner’s equity

M/ vehicle 2,000,000 Trade creditors 3,000,000 Capital 30,000,000
Stock 3,000,000 Profit 50,000
Bank 18,000,000
Cash 10,050,000
33,050,000 33,050,000

(vii)

Assets = Liabilities + Owner’s equity

M/ vehicle 2,000,000 Trade creditors 3,000,000 Capital 30,000,000
Stock 3,000,000 Profit 50,000
Bank 18,000,000 Drawings (300,000)
Cash 9,750,000
32,750,000 32,750,000

EMMA’S

BALANCE SHEET

AS AT…………….

shs shs shs

Non- current assets
M/ vehicle 2,000,000 - 2,000,000
Current assets
stock 3,000,000 3,000.000
bank 18,000,000 18,000,000
cash 9,750,000 9,750,000
30,750,000
Total assets 32,750,000
Financed by: Equity &
Liabilities
capital 30,000,000
Add profits 50,000 30,050,000
Less drawings (300,000)
29,750,000
Current liabilities
Trade creditors 3,000,000
Total equity & liabilities 32,750,000

Example 2

Construct an Accounting equation for each of the following transactions and prepare a
simple balance sheet at the conclusion of all the transactions for the month of August
2015.

i. Emma started business with 5,000,000 cash at hand and 10,000,000 cash at
bank
ii. He purchased stock of goods for 3,000,000 paying 50% cash and 50% on credit.
Sold 2/3 of the goods at 2,500,000 on credit
iii. Paid rent 100,000 cash
iv. Received cash payment of 2,000,000 from debtors and paid 1,000,000 cash to
suppliers
v. Bought motor vehicle for 6,000,000, paid 2,000,000 by cheque and 1,000,000
cash and promised to pay the balance later.
vi. Sold half of the remaining stock of goods for 700,000 collecting cash of 200,000
immediately and the balance to be received later
vii. Paid electricity 200,000 by cheque
viii. Used business cash of 200,000 to buy a gomesi for his wife
ix. Acquired Entandikwa loan of 4,000,000 cash. The loan is to be repaid in 2
years’ time.

Solution

assets = liabilities + owner’s equity

Cash 5,000,000 + Capital 15,000,000

Bank 10,000,000
15,000,000 15,000,000

assets = liabilities + owner’s equity

Stock 1,000,000 Creditors 1,500,000 Capital 15,000,000

Cash 3,500,000 Add profits 500,000
Debtors 2,500,000
Bank 10,000,000
17,000,000 17,000,000
assets = liabilities + owner’s equity

Stock 1,000,000 Creditors 1,500,000 Capital 15,000,000

Cash 3,400,000 Add profits 400,000
Debtors 2,500,000
Bank 10,000,000
16,900,000 16,900,000

assets = liabilities + owner’s equity

Debtors 2,500,000 Creditors 500,000 Capital 15,000,000

Cash 4,400,000 Add profits 400,000
Stock 1,000,000
Bank 10,000,000
15,900,000 15,900,000
assets = liabilities + owner’s equity

M/ vehicle 6,000,000 Creditors 3,500,000 Capital 15,000,000

Bank 8,000,000 Add profits 400,000
Cash 3,400,000
Debtors 500,000
Stock 1,000,000
18,900,000 18,900,000

assets = liabilities + owner’s equity

Stock 500,000 Creditors 3,500,000 Capital 15,000,000

Bank 8,000,000 Add profits 600,000
Cash 3,600,000
Debtors 1,000,000
M/ vehicle 6,000,000
19,100,000 19,100,000

assets = liabilities + owner’s equity

Bank 7,800,000 Creditors 3,500,000 Capital 15,000,000

Stock 500,000 Add profits 400,000
Cash 3,600,000
Debtors 1,000,000
M/ vehicle 6,000,000
18,900,000 18,900,000

assets = liabilities + owner’s equity

Cash 3,400,000 Creditors 3,500,000 Capital 15,000,000
Bank 7,800,000 Add profits 400,000
Stock 500,000 Less drawings (200,000)
Debtors 1,000,000
M/ vehicle 6,000,000
18,700,000 18,700,000

assets = liabilities + owner’s equity

Cash 7,400,000 Creditors 3,500,000 Capital 15,000,000

Bank 7,800,000 Bank loan 4,000,000 Add profits 400,000
Stock 500,000 Less drawings (200,000)
Debtors 1,000,000
M/ vehicle 6,000,000
22,700,000 22,700,000

EMMA’S

BALANCE SHEET

AS AT ………….

shs shs shs

Non- current assets
M/ vehicle 6,000,000 - 6,000,000
Current assets
stock 500,000
bank 7,800,000
Debtors 1,000,000
cash 7,400,000 16,700,000
Total assets 22,700,000
Financed by: Equity &
Liabilities
capital 15,000,000
Add profits 400,000
Less drawings (200,000)
15,200,000
Current liabilities
2 years bank loan 4,000,000
Trade creditors 3,500,000 7,500,000
Total equity & liabilities 22,700,000

In conclusion, as demonstrated above the fundamental accounting equation is pivotal

to the understanding of the balance sheet (statement of financial position). It is a fact
that the totals of each side of the balance sheet will always equal one another, and
this will always be true no matter how many transactions there may be! The actual
assets, capital and liabilities may change, but the total of the assets will always equal
the total of capital and liabilities.

TEST YOUR SELF

Quiz 1. Josh is an Entrepreneur owning a manufacturing firm in the industrial area.

The following are the enterprises transactions for the month of August.

i. Started business with 100,000,000 on his bank account

ii. Bought a building of 60,000,000 by cheque
iii. Rented out part of the building and received 4,000,000 cash
iv. He bought a computer from Copy cat ltd for storing the company’s records
paying 2,000,000 cash and promising to pay the balance later of 500,000
v. The company’s assets were depreciated at 10% on cost
vi. He withdrew 600,000 to shop for his concubine in the Garden city
vii. Obtained a mortgage from housing finance of 22,000,000 cash
viii. Paid fuel of 200,000 cash and parking tickets of 40,000 cash
ix. Paid copy cat ltd its outstanding balance using cash
x. Invested a cheque of 20,000,000 in treasury bills

Required; construct an accounting equation for each of the above transactions and
extract a simple balance sheet at the end.

2. Emma commenced business with 18,000,000 cash in the bank; thereafter, the
following transactions occurred;

a) Purchased furniture worth 900,000 and paid by cheque

b) Bough stock for 7,200,000 on credit
c) Paid 3,600,000 from private savings into the bank account
d) Paid his creditors 5,400,000 by cheque
e) Withdrew 360,000 for entertaining his girlfriend from the village
f) Sold part of his stock worth 3,600,000 at 7,200,000 and banked the money
g) Sold the remaining stock at 2,880,000 and banked the deposits

Required;

Construct the accounting equation and extract a simple balance sheet for each of the
above transactions.

3. Construct the accounting equation which shows the following transactions and
prepare a balance sheet at the end of the accounting period.

i. Cock commenced business with cash of 40,000,000 from his own savings and a
further cash of 10,000,000 from his cousin. His cousin informs Cockroach that
he is not looking for interest or early repayment.
 ii. Cock buys the following assets for the business, Motor vehicle to transport him
to the latrine every morning worth 5,000,000 cash and stock 8,000,000 (half by
cash, half on credit).
iii. He sells half of the stock at 4,000,000; 50% cash and 50% 0n credit and pays
his creditors for stock in full.
iv. Cock buys second hand delivery van for 3,000,000 on credit to facilitate the
business.
v. He sells the remainder of stock for 4,500,000 by cheque and receives payment
of 1,000,000 in cash from his debtors.
vi. The Motor vehicle breaks down and requires 100,000 for repairs which
Cockroach pays in cash.
vii. At Christmas, Cock buys his wife a food mixer costing 100,000 and his
secretary a fur jacket costing 50,000. He pays for both items using his credit
card.
viii. Cock pays 400,000 cash for advertising his business to the flies and 200,000
cash for audit fees.
ix. His auditors advice him that he should write off the debt of 100,000 because in
their opinion it is now irrecoverable. They also recommend that he provides for
depreciation on motor vehicle at a rate of 25% on cost per annum. These assets
have been used for month only.
x. Cock withdraws 2,000,000 in cash to entertain his sweetheart.

4. Charlene finished Bachelors in Business Studies (BBA) in June and immediately set
up his own Accounting firm. During the first month of operation, he completed these
transactions.

a) Began the business by placing 2,000,000/= in a bank account established for

the business.
b) He purchased computers for 900,000/= cash.
c) Purchase office supplies for 400,000/= on credit.
d) Accepted 500,000/= in cash for completing a contract.
e) Billed clients 1,950,000/= for services rendered during the month.
f) Paid 200,000/= of the amount owed for office supplies.
g) Received 1,250,000/= in cash from one client who had been billed previously
for services rendered.
h) Paid rent expense for the month in the amount of 1,250,000/=
i) Withdrew 400,000/= from the business for personal use.

Required; Form an accounting equation for each of the above transactions.

 SYSTEMS USED IN RECORDING ACCOUNTING TRANSACTIONS

There are two main systems used in recording accounting transactions i.e.

 The Single entry system and

 The Double entry system

Single entry system is a system of recording in which the two fold aspect of the
transaction is ignored and in which only personal accounts are maintained and may
be the cash book. It needs a system which is not a complete double entry system.

THE CONCEPT OF DOUBLE ENTRY SYSTEM

The fundamental principle of the transactions is the concept of double entry. The two
fold aspect of business transactions has been evolved to provide the arithmetic check
regarding the accurate and complete record of these transactions. It is stated that
every business transaction involves two aspects i.e. give and take and it is recorded
twice in the ledger.

These two entries are named as Dr and Cr entries. Debit entry means to record the
receipt of value by an account and credit entry means to record the giving of value by
an account. It means from the receiving point of view it’s called Dr Entry and from the
giving point of view it’s called credit entry. These two entries are made in the ledger.

Double entry system is therefore, a system of book keeping where by every transaction
gives rise to two entries i.e. must be recorded twice in two or more accounts. The rule
of double entry system states that; “for every debit entry, there must be a corresponding
credit entry and for every credit entry there must be a corresponding debit entry”. For
each transaction, the amount entered in one account must be equal to the amount
entered in the other side i.e. totals in the debit side must be equal to the totals in the
credit side of the account.

Under double entry system, accounts are debited and credited. Debit and credit are
means of either increasing or decreasing and account depending on the nature and
the type of the account. Therefore, in order to explain the concept of double entry, we
should first understand the different types of accounts.

Advantages of double entry system

 A complete record of each transaction is kept

 It assists in the transaction activities
 It acts as a check upon the arithmetical accuracy
 It helps in the preparation of final accounts.
An Account (A/c)

An account is a record in a summarized form and in a chronological order of

transactions that took place in an organization. Or it may mean a separate record that
is kept of the increase and decrease in each asset, liability and each aspect of owner’s
equity. It takes the form of letter “T” in manual accounting because it resembles the
letter T as shown below:-

Title of Account

(Left) side (Right) side

Debit (DR) Credit (CR)

Any entry made on the left side of the account is a debit entry; and any entry made on
the right side of the account is a credit entry. The terms debit (abbreviated as Dr, from
the Latin word debere) and credit (abbreviated Cr, from the Latin word credere) are
simply the accountant’s words for “left” and “right” not for “increase” and “decrease”.

While in computerized accounting, an account is written with a running balance as

shown below:

Date Details F Debit Credit

Balance

Why do we need Accounts?

 A firm must have a well organized accounting system with detailed information
about the effects of transactions so that financial reports and statements can be
prepared.
 The effects of transactions can be recorded by updating the accounting
equation. However, this is not practical as it is highly tedious.

Types/ classification of Accounts

An account may be defined as a record of transactions of a particular type or with a

particular person usually expressed in financial terms and maintained in the ledger.
Each page of a ledger is given a heading or title and it is used to record transactions of
a similar nature. E.g. all sales of goods are recorded on one page and it is known as
sales account and so on.
In a ledger, various accounts can be classified as under;

Personal accounts – these are accounts that contain the name of a business, person
or firm. In a ledger, there may be three types of personal accounts.

 Capital accounts; this account records the transactions between the proprietor
and the business. Any amount invested or withdrawn by the proprietor is
recorded in this account.
 Creditor’s account; the persons to whom money is owed by a business are
called creditors. The goods purchased on credit basis from the suppliers create
a liability of the business. These amounts owing to creditors are recorded in
their personal accounts which are opened separately for each creditor.
 Debtor’s accounts; debtors are persons owing money to the business. This
money is owed to the business against the goods sold to the customers on
credit basis. A separate account is opened for each debtor.

Impersonal accounts- these are accounts which do not contain the name of any
person or business. They are of two kinds;

 Real accounts; these relate to tangible items. These accounts always represent
something we can see, touch or move. The accounts of assets like land and
buildings, plant and machinery, motor vehicles, furniture and fittings, cash are
real accounts.
 Nominal accounts; these relate to intangible items. These accounts record
transactions for which we have nothing tangible to show for example,
purchases, sales, rent, wages and salaries, electricity, printing, stationery etc.

Accounts and the dual (double entry) concept

The classification of accounts enables us to establish rules for making double entry in
case of different transactions. However, when faced with any transaction, the following
three points must be considered;

1) What two accounts are affected?

2) What type of accounts are they?
3) Which account is to be debited and which one to be credited?

The following table gives an idea of making double entry in case of different
transactions.

Account Debit (DR) Credit (CR)

Personal The Receiver The Giver
Real What comes in What goes out
Nominal Expenses and losses Incomes and gains
Rules of posting transactions into an account

The following rules are followed when recording transactions into an account based on
double entry system;

 Increase in the amount of Assets is recorded on the debit side of that asset
account while the decrease on the credit side.
 Increase in the amount of liability is recorded on the credit side of the liability
account while the decrease on the debit side.
 Increase in incomes is recorded on the credit side of the income account e.g.
rent received, commission received and so on while the decrease on the debit
side.
 Increase in expenses is recorded on the debit side of the expense where as the
decrease on the credit side.
 Increase in the amount of capital is recorded on the credit side of the capital
account and the decrease on the debit side.

Summary of the rules

Items Increase Decrease Normal Balance

Assets Debit Credit Debit
Expenses/ costs
Liabilities Credit Debit Credit
Incomes/revenue
Capital/ reserves
Note: it follows that at the beginning of the given period, assets and expenses have
debit balances while liabilities, incomes and capital have credit balances.

Steps followed when balancing accounts

 Find the total of the debit and credit side separately

 Subtract the smaller total in value from the large one and find out the
difference; the difference is either a credit or a debit balance.
 The difference is inserted as balance carried down (Bal. c/d) on the smaller side
so that both sides will have the same total
 Re- add the total on both sides. The two totals must be the same i.e. they must
balance.
 Bring the balance down at the beginning of the following period (month) as
balance brought down (Bal. b/d)

Advantages of balancing accounts

i. It prevents the accumulation of unnecessary large totals

ii. It assists in separating transactions from one financial period to those of other
periods
iii. It enables a trial balance to be easily extracted
iv. It provides information for the preparation of final accounts
v. It shows clearly the state of the account.

The Accounting Cycle/ Process