HOSPITALITY FINANCIAL ACCOUNTING

1.1 INTRODUCTION

Business is an economic activity undertaken with the motive of earning profits and to maximize the
wealth for the owners. Business cannot run in isolation. Largely, the business activity is carried out
by people coming together with a purpose to serve a common cause. This team is often referred to
as an organization, which could be in different forms such as sole proprietorship, partnership, body
corporate etc. The rules of business are based on general principles of trade, social values, and
statutory framework encompassing national or international boundaries. While these variables
could be different for different businesses, different countries etc., the basic purpose is to add value
to a product or service to satisfy customer demand.

The business activities require resources (which are limited & have multiple uses) primarily in terms
of material, labour, machineries, factories and other services. The success of business depends on
how efficiently and effectively these resources are managed. Therefore, there is a need to ensure
that the businessman tracks the use of these resources. The resources are not free and thus one
must be careful to keep an eye on cost of acquiring them as well.

As the basic purpose of business is to make profit, one must keep an ongoing track of the activities
undertaken in course of business. Two basic questions would have to be answered:

(a) What is the result of business operations? This will be answered by finding out
whether it has made profit or loss.

(b) What is the position of the resources acquired and used for business purpose? How
are these resources financed? Where the funds come from?

The answers to these questions are to be found continuously and the best way to find them is to
record all the business activities. Recording of business activities has to be done in a scientific
manner so that they reveal correct outcome. The science of book-keeping and accounting provides
an effective solution.

Every stakeholder of the business is interested in a particular facet of information about the
business. The art and science of accounting helps to put together these requirements of information
as per universally accepted principles and also to interpret the results. It is interesting to note that
each one of us has an accountant hidden in us. We make a distinction between payment done for
monthly grocery and that for buying a house or a car. We understand that while grocery is a monthly
expense and buying a house is like creating a resource that has indefinite future use. The most
common accounting record that each one of us knows is our bank passbook or a bank statement,
which the bank maintains for us. It tracks each shilling that we deposit or withdraw from our
account. When we go to supermarket to buy something, the cashier at the counter will record things
we buy and give us a ‘bill’ or ‘cash memo’. These are source documents prepared for the transaction
between the supermarket and us. While these are simple examples, there could be more complex
business activities. A good working knowledge of keeping records is therefore necessary.

1.2 DEFINITIONS

In order to understand the subject matter with clarity, let us study some of the definitions which
depict the scope, content and purpose of Accounting. The field of accounting is generally sub-
divided into:

(a) Book-keeping
 (b) Financial Accounting

(c) Cost Accounting and

(d) Management Accounting

Let us understand each of these concepts.

(a) Book-keeping

The most common definition of book-keeping is that “Book-keeping is an art of recording business
transactions in a set of books.”

It is basically a record keeping function. One must understand that not all dealings are, however,
recorded. Only transactions expressed in terms of money will find place in books of accounts. These
are the transactions which will ultimately result in transfer of economic value from one person to
the other. Book-keeping is a continuous activity, the records being maintained as transactions are
entered into. This being a routine and repetitive work, in today’s world, it is taken over by the
computer systems. Many accounting packages are available to suit different business organizations.

Students to get names of accounting software packages for hotels/tourism businesses.

It is also referred to as a set of primary records. These records form the basis for accounting. It is an
art because, the record is to be kept in such a manner that it will facilitate further processing and
reporting of financial information which will be useful to all stakeholders of the business.

(b) Financial Accounting

It is commonly termed as Accounting. The American Institute of Certified Public Accountants defines
Accounting as “an art of recorgjghding, 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.”

The first step in the cycle of accounting is to identify transactions that will find place in books of
accounts. Transactions having financial impact only are to be recorded. E.g. if a businessman
negotiates with the customer regarding supply of products, this will not be recorded. The
negotiation is a deal which will potentially create a transaction and will have exchange of money or
money’s worth. But unless this transaction is finally entered into, it will not be recorded in the books
of accounts.

Secondly, the recording of the business transactions is done based on the rules of accounting (which
are explained later)and in a systematic manner. Transaction of similar nature are grouped together
and recorded accordingly. e.g. Sales Transactions, Purchase Transactions, Cash Transactions etc. One
has to interpret the transaction and then apply the relevant rule to make a correct entry thereof.

Thirdly, as the transactions increase in number, it will be difficult to understand the combined effect
of the same by referring to individual records. Hence, the art of accounting also involves the step of
summarizing them. With the aid of computers, this task is simplified in today’s accounting world. The
summarization will help users of the business information to understand and interpret business
results.

Lastly, the accounting process provides the users with statements which will describe what has
happened to the business. Remember the two basic questions we talked about, one to know
whether business has made profit or loss and the other to know the position of resources that are
used by the business.

(c) Cost Accounting

According to the Chartered Institute of Management Accountants (CIMA), Cost Accountancy is

defined as “application of costing and cost accounting principles, methods and techniques to the
science, art and practice of cost control and the ascertainment of profitability as well as the
presentation of information for the purpose of managerial decision-making.”

It is a branch of accounting dealing with the classification, recording, allocation, summarization and
reporting of current and prospective costs and analyzing their behaviours. Cost Accounting is
frequently used to facilitate internal decision making and provides tools with which management
can appraise performance and control costs of doing business. It primarily involves relating the costs
to the different products produced and sold or services rendered by the business. While Financial
Accounting deals with business transactions at a broader level, Cost Accounting aims at further
breaking it up to the last possible level to identify costs with products and services. It uses the same
Financial Accounting documents and records. Modern computerized accounting packages like ERP
systems (Enterprise resource planning softwares) provide for processing Financial as well as Cost
Accounting records simultaneously.

This branch of accounting deals with the process of ascertainment of costs. The concept of cost is
always applied with reference to a context. Knowledge of cost concepts and their application
provide a very sound platform for decision making. Cost Accounting aims at equipping management
with information that can be used for control on business activities.

(d) Management Accounting

Management Accounting is concerned with the use of Financial and Cost Accounting information to
managers within organizations, to provide them with the basis in making informed business
decisions that would allow them to be better equipped in their management and control functions.
Unlike Financial Accounting information (which, for public companies, is public information),
Management Accounting information is used within an organization (typically for decision-making)
and is usually confidential and its access available only to a selected few.

According to the Chartered Institute of Management Accountants (CIMA), Management Accounting

is “the process of identification, measurement, accumulation, analysis, preparation, interpretation
and communication of information used by management to plan, evaluate and control within an
entity and to assure appropriate use of and accountability for its resources. Management Accounting
also comprises the preparation of financial reports for non-management groups such as
shareholders, creditors, regulatory authorities and tax authorities”

Basically, Management Accounting aims to facilitate management in formulating strategies, planning

and constructing business activities, making decisions, optimal use of resources, and safeguarding
assets of business.

These branches of accounting have evolved over years of research and are basically synchronized
with the requirements of business organizations and all entities associated with them. We will now
see what are they and how accounting satisfies various needs of different stakeholders.

1.2.1 Difference between Book-keeping and Accountancy

The Significant difference between Book-keeping and Accountancy are : -

Sl Points of Book Keeping Accountancy

difference
No.

1. Meaning Book-keeping is considered as end. Accountancy is considered as

beginning.

2. Functions The primary stage of accounting function is The overall accounting functions are
called Book-keeping. guided by accountancy.

3 Depends Book-keeping can provide the base of Accountancy depends on Bookkeeping for
Accounting. its complete functions.

4. Data The necessary data about financial Accountancy can take its decisions,
performances and financial positions are prepare reports and statements from the
taken from Book-keeping. data taken from Book-keeping.

5. Recording of Financial transactions are recorded on the Accountancy does not take any principles,
Transactions basis of accounting principles, concepts concepts and conventions from Book-
and conventions. keeping.

1.2 .2 Difference between Management Accounting and Financial Accounting

The significant difference between Management Accounting and Financial Accounting are :

Management Accounting Financial Accounting

1. Management Accounting is primarily based on 1. Financial Accounting is based on the monetary

the data available from Financial Accounting. transactions of the enterprise.

2. It provides necessary information to the 2. Its main focus is on recording and classifying
management to assist them in the process of monetary transactions in the books of accounts
planning, controlling, and preparation of financial statements at the
performance evaluation and decision end of every accounting period.
making.

3. Reports prepared in Management Accounting 3. Reports as per Financial Accounting are meant
are meant for management and as per for the management as well as for
management requirement. shareholders and creditors of the concern.

4. Reports may contain both subjective and 4. Reports should always be supported by
objective figures. relevant figures and it emphasizes on the
objectivity of data.

5. Reports are not subject to statutory audit. 5. Reports are always subject to statutory audit.

6. It evaluates the sectional as well as the entire 6. It ascertains, evaluates and exhibits the
performance of the business. financial strength of the whole business.
1.3 ACCOUNTING CYCLE

When complete sequence of accounting procedure is done which happens frequently and repeated
in same directions during an accounting period, the same is called an accounting cycle.

Steps/Phases of Accounting Cycle

The steps or phases of accounting cycle can be developed as under:

ACCOUNTING CYCLE

(a) Recording of Transaction:- As soon as a transaction happens it is at first recorded in

subsidiary book.

(b) Journal: The transactions are recorded in Journal chronologically.

(c) Ledger: All journals are posted into ledger chronologically and in a classified manner.

(d) Trial Balance: After taking all the ledger account’s closing balances, a Trial Balance is
prepared at the end of the period for the preparations of financial statements.

(e) Adjustment Entries: All the adjustments entries are to be recorded properly and
adjusted accordingly before preparing financial statements.

(f) Adjusted Trial Balance: An adjusted Trail Balance may also be prepared.

(g) Closing Entries: All the nominal accounts are to be closed by the transferring to
Trading Account and Profit and Loss Account.
 (h) Financial Statements: Financial statement can now be easily prepared which will
exhibit the true financial position and operating results.

1.4 OBJECTIVES OF ACCOUNTING

The main objective of Accounting is to provide financial information to stakeholders. This financial
information is normally given via financial statements. For this information to be shared effectively
and be effective, the following “micro” objectives of accounting have to be met and will explain the
width of the application of the financial information

/y the business i.e. to compare the income earned versus the expenses incurred and the net result
thereof.

(a) To know the financial position of the business i.e. to assess what the business owns
and what it owes.

(b) To provide a record for compliance with statutes and laws applicable.

(c) To enable the readers to assess progress made by the business over a period of
time.

(d) To disclose information needed by different stakeholders.

Let us now see which are different stakeholders of the business and what do they seek from the
accounting information. This is shown in the following table.

Stakeholder Interest in business Accounting Information

Owners / Investors / Profits or losses Financial statements, Cost Accounting

existing and potential records, Management Accounting
reports

Lenders Assessment of capability of the Financial statement and analysis thereof,

business to pay interest and reports forming part of accounts,
principal of money lent. Basically, valuation of assets given as security
they monitor the solvency of
business

Customers and suppliers Stability and growth of the business Financial and Cash flow statements to
assess ability of the business to offer
better business terms and ability to
supply the products and services

Government Whether the business is complying Accounting documents such as vouchers,

with various legal requirements extracts of books, information of
purchase, sales, employee obligations
etc. and financial statements
Employees and trade Growth and profitability Financial statements for negotiating pay
unions packages

Competitors Performance and possible tie-ups in Accounting information to find out

the era of mergers and acquisitions possible synergies

1.4.1 Users of Accounting Information

Accounting provides information both to internal users and the external users. The internal users are
all the organizational participants at all levels of management (i.e. top, middle and lower). Generally
top level management requires information for planning, middle level management which requires
information for controlling the operations. For internal use, the information is usually provided in
the form of reports, for instance Cash Budget Reports, Production Reports, Idle Time Reports,
Feedback Reports, whether to retain or replace an equipment decision reports, project appraisal
report, and the like.

There are also the external users (e.g. Banks, Creditors). They do not have direct access to all the
records of an enterprise, they have to rely on financial statements as the source of information.
External users are basically, interested in the solvency and profitability of an enterprise.

1.4.2 Types of Accounting Information

Accounting information may be categorized in number of ways on the basis of purpose of accounting
information, on the basis of measurement criteria and so on. The various types of accounting
information are given below:

I. Accounting information relating to financial transactions and

events.

(a) Financial Position- Information about financial position is primarily provided

in a Balance Sheet.

The financial position of an enterprise is affected by different factors, like -

(i) Information about the economic resources controlled by the enterprise and its
capacity in the past to alter these resources is useful in predicting the ability of the
enterprise to generate cash and cash equivalents in the future.

(ii) Information about financial structure is useful in predicting future borrowing needs
and how future profits and cash flows will be distributed among those with an interest
in the enterprise; it is also useful in predicting how successful the enterprise is likely to
be in raising further finance.

(iii) Information about liquidity and solvency is useful in predicting the ability of
the enterprise to meet its financial commitments as they fall due. Liquidity refers to the
availability of cash in the near future to meet financial commitments over this period.
Solvency refers to the availability of cash over the longer term to meet financial
commitments as they fall due.

(b) Financial Performance- Information about financial performance is primarily

provided in a Statement of Profit and Loss which is also known as Income Statement.
 Information about the performance of an enterprise and its profitability, is required in order
to assess potential changes taking place in the economic resources that it is likely to control in the
future. Information about variability of performance is also important in this regard. Information
about performance is necessary in predicting the capacity to generate cash flows from its available
resource. It is an important input in forming judgments about the effectiveness of an enterprise to
utilize resources.

(c) Cash Flows- Information about cash flows is provided in the financial
statements by means of a cash flow statement.

Information concerning cash flows is useful in providing the users with a basis to assess the
ability of the enterprise to generate cash and cash equivalents and the needs of the enterprise to
utilise those cash and cash equivalent.

1.4.3 Qualitative Characteristics of Accounting Information

Qualitative characteristics are the attributes that make the information provided in financial
statements useful to its users.

Qualitative Characteristics of Accounting Information can be segregated in the following

categories

(i) Reliability

(ii) Relevance

(iii) Materiality

(iv) Understand-ability

(v) Comparability

(i) Reliability - To be useful, information must also be reliable. Information has the quality of
reliability when it is free from material error and bias and can be depended upon by users to
represent faithfully that which it either portrays to represent or could reasonably be expected
to represent. Information may be relevant but so unreliable in nature or representation that its
recognition may be potentially misleading and so it becomes useless. Reliability of the financial
statements is dependent on the following:

(a) Faithful Representation- To be reliable, information must represent

faithfully the transactions and other events which either portrays to represent or could
reasonably be expected to represent. Most financial information is subject to some
risks of being less than faithful representation of that which it purports to portray. This
is not due to bias, but rather can be enhanced by difficulties either in identifying the
transactions or other events to be measured; in devising or applying measurements
and presentation techniques that can convey messages that correspond with those
transactions and events.

(b) Substance Over Form-If information is to represent faithfully the

transactions and other events that it portrays to represent, it is necessary that they are
 accounted for and presented in accordance with their substance and economic reality
and not merely by their legal forms. The substance of transactions or other events is
not always consistent with that which is apart from their legal or contrived form.

(c) Neutrality - To be reliable the information contained in financial statements

must be neutral. Financial statements are not neutral if by selective presentation of
information, they influence the making of a decision or judgment in order to achieve a
predetermined result or outcome.

(d) Prudence - The preparers of financial statements have to contend with

uncertainties that inevitably surround many events and circumstances. Such
uncertainties are recognized by the disclosure of their nature and extent and by
exercise of prudence in the financial statements. Prudence is the inclusion of a degree
of caution. In the exercise of judgement needed in making the estimate required under
conditions of uncertainties so that assets or income are not overstated and liabilities or
expenses are not understated. However, the exercise of prudence does not allow the
creation of hidden reserves or excessive provisions, i.e. the deliberate understatement
of assets or income or deliberate over statement of liabilities or expenses.

(e) Completeness - To be reliable the information in the financial statements

must be complete within the bounds of materiality and cost. An omission can cause
information to be false or misleading and thus, unreliable and deficient in terms of its
relevance.

(ii) Relevance- To be useful, information must be relevant to the decision-making needs of

users. Information has the quality of relevance when it influences the economic decisions of the
users by helping them to evaluate past, present or future events or confirming or correcting
their past evaluation. For example, information about the current level and structure of asset-
holding has value to users when they endeavour to predict the ability of the enterprise to take
advantage of opportunities and its ability to react to adverse situations. The same information
plays a confirmatory role in respect of past prediction about, for example, the way in which the
enterprise would be structured or the outcome of planned operations.

(iii) Materiality- The relevance of information is affected by its nature and materiality.
Information is material if its omission or mis statement could influence the economic decisions
of users made on the basis of financial statements. Materiality depends on the size of the item
or error judged in the particular circumstance of its omission or mis-statement. Thus,
materiality provides a threshold or a cut-off point rather than being a primary qualitative
characteristic which information must have if it is to be useful.

(iv) Understand-ability- The information provided in financial statements must be easily

understandable by users. For this purpose, users are assumed to have a reasonable knowledge
of business and economic activities, accounting and a willingness to study the information with
reasonable diligence. However, information about complex matters that should be included in
the financial statements because of its relevance to the decision making needs of users and
should not be excluded merely on the grounds that it may be too difficult for certain users to
understand.

(v)Comparability- The financial statements of an enterprise should be comparable. For this

purpose users should be informed of the accounting policies, any changes in those policies and
the effects of such changes. This qualitative characteristic requires pursuance of consistency in
 choosing accounting policies. Lack of consistency may disturb the comparability quality of the
financial statement information. Accordingly, accounting standard on disclosure of accounting
policies consider consistency as a fundamental accounting assumption along with accrual and
going concern.

1.5 BASIC ACCOUNTING TERMS

In order to understand the subject matter clearly, one must grasp the following common expressions
always used in business accounting. The aim here is to enable the student to understand with these
often used concepts before we embark on accounting procedures and rules. You may note that
these terms can be applied to any business activity with the same connotation.

(i) Transaction: It means an event or a business activity which involves exchange of money or
money’s worth between parties. The event can be measured in terms of money and changes
the financial position of a person e.g. purchase of goods would involve receiving material and
making payment or creating an obligation to pay to the supplier at a future date. Transaction
could be a cash transaction or credit transaction. When the parties settle the transaction
immediately by making payment in cash or by cheque, it is called a cash transaction. In credit
transaction, the payment is settled at a future date as per agreement between the parties.

(ii) Goods/Services: These are tangible article or commodity in which a business deals. These
articles or commodities are either bought and sold or produced and sold. At times, what may
be classified as ‘goods’ to one business firm may not be ‘goods’ to the other firm. e.g. for a
machine manufacturing company, the machines are ‘goods’ as they are frequently made and
sold. But for the buying firm, it is not ‘goods’ as the intention is to use it as a long term resource
and not sell it. Services are intangible in nature which are rendered with or without the object
of earning profits.

(iii) Profit: The excess of Revenue Income over expense is called profit. It could be
calculated for each transaction or for business as a whole.

(iv) Loss: The excess of expense over income is called loss. It could be calculated for
each transaction or for business as a whole.

(v) Asset: Asset is a resource owned by the business with the purpose of using it for generating
future profits. Assets can be tangible and intangible. Tangible Assets are the Capital assets
which have some physical existence. They can, therefore, be seen, touched and felt, e.g. Plant
and Machinery, Furniture and Fittings, Land and Buildings, Books, Computers, Vehicles, etc. The
capital assets which have no physical existence and whose value is limited by the rights and
anticipated benefits that possession confers upon the owner are known as intangible Assets.
They cannot be seen or felt although they help to generate revenue in future, e.g. Goodwill,
Patents, Trade-marks, Copyrights, Brand Equity, Designs, Intellectual Property, etc.

Assets can also be classified into Current Assets and Non-Current Assets.

Current Assets – An asset shall be classified as Current when it satisfies any of the following:

(a) It is expected to be realised in, or is intended for sale or consumption in the

Company’s normal Operating Cycle,

(b) It is held primarily for the purpose of being traded ,

(c) It is due to be realised within 12 months after the Reporting Date, or

 (d) It is Cash or Cash Equivalent unless it is restricted from being exchanged or
used to settle a Liability for at least 12 months after the Reporting Date.

Non-Current Assets – All other Assets shall be classified as Non-Current Assets. e.g.
Machinery held for long term etc.

(vi) Liability: It is an obligation of financial nature to be settled at a future date. It

represents amount of money that the business owes to the other parties. E.g. when goods are
bought on credit, the firm will create an obligation to pay to the supplier the price of goods on
an agreed future date or when a loan is taken from bank, an obligation to pay interest and
principal amount is created. Depending upon the period of holding, these obligations could be
further classified into Long Term on non-current liabilities and Short Term or current liabilities.

Current Liabilities – A liability shall be classified as Current when it satisfies any of the
following:

(a) It is expected to be settled in the Company’s normal Operating Cycle,

(b) It is due to be settled within 12 months after the Reporting Date, or

(c) The Company does not have an unconditional right to defer settlement of
the liability for at least 12 months after the reporting date (Terms of a Liability that
could, at the option of the counterparty, result in its settlement by the issue of Equity
Instruments do not affect its classification)

Non-Current Liabilities – All other Liabilities shall be classified as Non-Current Liabilities. E.g. Loan
taken for 5 years, Debentures issued etc.

(vii) Internal Liability: These represent proprietor’s equity, i.e. all those amount which
are entitled to the proprietor, e.g., Capital, Reserves, Undistributed Profits, etc.

(viii) Working Capital: In order to maintain flows of revenue from operation, every firm
needs certain amount of current assets. For example, cash is required either to pay for
expenses or to meet obligation for service received or goods purchased, etc. by a firm. On
identical reason, inventories are required to provide the link between production and sale.
Similarly, Accounts Receivable generate when goods are sold on credit. Cash, Bank, Debtors,
Bills Receivable, Closing Stock, and Prepayments etc. represent current assets of firm.

Working capital is the excess of current assets over current liabilities. That is the amount of current
assets that remain in a firm if all its current liabilities are paid.

Working Capital (Net) = Current Assets – Currents Liabilities.

(ix) Capital: It is amount invested in the business by its owners. It may be in the form of
cash, goods, or any other asset which the proprietor or partners of business invest in the
business activity. From business point of view, capital of owners is a liability which is to be
settled only in the event of closure or transfer of the business. Hence, it is not classified as a
normal liability. For corporate bodies, capital is normally represented as share capital.

(x) Drawings: It represents an amount of cash, goods or any other assets which the owner
withdraws from business for his or her personal use. e.g. if the life insurance premium of
proprietor or a partner of business is paid from the business cash, it is called drawings.
 Drawings will result in reduction in the owners’ capital. The concept of drawing is not applicable
to the corporate bodies like limited companies.

(xi) Net worth: It represents excess of total assets over total liabilities of the business.
Technically, this amount is available to be distributed to owners in the event of closure of the
business after payment of all liabilities. That is why it is also termed as Owner’s Equity. A profit
making business will result in increase in the owner’s equity whereas losses will reduce it.

(xii) Debtor : The sum total or aggregate of the amounts which the customer owe to the
business for purchasing goods on credit or services rendered or in respect of other contractual
obligations, is known as Sundry Debtors or Trade Debtors, or Trade Receivable, or Book-Debts
or Debtors. In other words, Debtors are those persons from whom a business has to recover
money on account of goods sold or service rendered on credit. These debtors may again be
classified as under:

(i) Good debts : The debts which are sure to be realized are called good
debts.

(ii) Doubtful Debts: The debts which may or may not be realized are called doubtful
debts.

(iii) Bad debts: The debts which cannot be realized at all are called bad debts.

It must be remembered that while ascertaining the debtors balance at the end of the period certain
adjustments may have to be made e.g. Bad Debts, Discount Allowed, Returns Inwards, etc.

(xiii) Creditor: A creditor is a person to whom the business owes money or money’s
worth. E.g. money payable to supplier of goods or provider of service. Creditors are generally
classified as Current

Liabilities.

(xiv) Capital Expenditure: This represents expenditure incurred for the purpose of
acquiring a fixed asset which is intended to be used over long term for earning profits there
from. e. g. amount paid to buy a computer for office use is a capital expenditure. At times
expenditure may be incurred for enhancing the production capacity of the machine. This also
will be a capital expenditure. Capital expenditure forms part of the Balance Sheet.

(xv) Revenue expenditure: This represents expenditure incurred to earn revenue of the
current period. The benefits of revenue expenses get exhausted in the year of the incurrence.
e.g. repairs, insurance, salary & wages to employees, travel etc. The revenue expenditure
results in reduction in profit or surplus. It forms part of the Income Statement.

(xvi) Balance Sheet: It is the statement of financial position of the business entity on a
particular date. It lists all assets, liabilities and capital. It is important to note that this statement
exhibits the state of affairs of the business as on a particular date only. It describes what the
business owns and what the business owes to outsiders (this denotes liabilities) and to the
owners (this denotes capital). It is prepared after incorporating the resulting profit/losses of
Income Statement.

(xvii) Profit and Loss Account or Income Statement: This account

shows the revenue earned by the business and the expenses incurred by the business to earn
that revenue. This is prepared usually for a particular accounting period, which could be a
 month, quarter, a half year or a year. The net result of the Profit and Loss Account will show
profit earned or loss suffered by the business entity.

(xviii) Trade Discount: It is the discount usually allowed by the wholesaler to the retailer
computed on the list price or invoice price. e.g. the list price of a TV set could be Ksh 15000. The
wholesaler may allow 20% discount thereof to the retailer. This means the retailer will get it for
Kshs12000 and is expected to sale it to final customer at the list price. Thus the trade discount
enables the retailer to make profit by selling at the list price. Trade discount is not recorded in
the books of accounts. The transactions are recorded at net values only. In above example, the
transaction will be recorded at Ksh 12000 only.

(xix) Cash Discount: This is allowed to encourage prompt payment by the debtor. This
has to be recorded in the books of accounts. This is calculated after deducting the trade
discount. e.g. if list price is Ksh 15000 on which a trade discount of 20% and cash discount of 2%
apply, then first trade discount of Ksh 3000 (20% of Ksh 15000) will be deducted and the cash
discount of 2% will be calculated on Ksh 12000 (Ksh15000 – Ksh 3000). Hence the cash discount
will be Ksh 240/- (2% of Ksh 12000) and net payment will be Ksh11,760 (Ksh 12,000 - Ksh240)

1.6. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

A widely accepted set of rules, conventions, standards, and procedures for reporting financial
information. They are referred to as Generally Accepted Accounting Principles (GAAP). They are a
combination of standards (set by policy boards) and simply the commonly accepted ways of
recording and reporting accounting information.

GAAP is to be followed by companies so that investors have an optimum level of consistency in the
financial statements they use when analyzing companies for investment purposes.

As seen earlier, the accounting information is published in the form of financial statements. The
three basic financial statements are

(i) The Profit & Loss Account that shows net business result i.e. profit or loss for a certain
periods

(ii) The Balance Sheet that exhibits the financial strength of the business as on a particular dates

(iii) The Cash Flow Statement that describes the movement of cash from one date to the
other.

As these statements are meant to be used by different stakeholders, it is necessary that the
information contained therein is based on definite principles, concrete concepts and well accepted
convention.

Accounting principles are basic guidelines that provide standards for scientific accounting practices
and procedures. They guide as to how the transactions are to be recorded and reported. They assure
uniformity and understand-ability. Accounting concepts lay down the foundation for accounting
principles. They are ideas essentially at mental level and are self-evident. These concepts ensure
recording of financial facts on sound bases and logical considerations. Accounting conventions are
methods or procedures that are widely accepted. When transactions are recorded or interpreted,
they follow the conventions. Many times, however, the terms-principles, concepts and conventions
are used interchangeably.

A. BASIC ACCOUNTING ASSUMPTIONS

(a) Business Entity Concept

As per this concept, the business is treated as distinct and separate from the individuals who own or
manage it. When recording business transactions, the important question is how will it affect the
business entity? How they affect the persons who own it or run it or otherwise associated with it is
irrelevant. For example, if the owner pays his personal expenses from business cash, this transaction
can be recorded in the books of business entity. This transaction will take the cash out of business
and also reduce the obligation of the business towards the owner.

At times it is difficult to separate owners from the business. Consider an individual, who runs a small
retail outlet. In the eyes of law, there is no distinction made between financial affairs of the outlet
with that of the individual. The creditors of the retail outlet can sue the individual and collect his
claim from personal resources of the individual. However, in accounting, the records are kept as
distinct for the retail outlet and the individual respectively. For certain forms of business entities,
such as limited companies this distinction is easier. The limited companies are separate legal persons
in the eyes of law as well.

(b) Going Concern Concept

The basic principles of this concept is that business is assumed to exist for an indefinite period and is
not established with the objective of closing it down. So unless there is good evidence to the
contrary, the accountant assumes that a business entity is a ‘going concern’ - that it will continue to
operate as usual for a longer period of time. It will keep getting money from its customers, pay its
creditors, buy and sell goods, use assets to earn profits in future. This concept enables the
accountant to carry forward the values of assets and liabilities from one accounting period to the
other without asking the question about usefulness and worth of the assets and recoverability of the
receivables.

The going concern concept forms a sound basis for preparation of a Balance Sheet.

(c) Money Measurement Concept

A business transaction will always be recorded if it can be expressed in terms of money. The
advantage of this concept is that different types of transactions could be recorded as homogenous
entries with money as common denominator. A business may own Ksh 3 M cash, 1500 kg of raw
material, 10 vehicles, 3 computers etc. Unless each of these is expressed in terms of money, we
cannot find out the assets owned by the business. When expressed in the common measure of
money, transactions could be added or subtracted to find out the combined effect.
The application of this concept has a limitation. When transactions are recorded in terms of money,
we only consider the absolute value of the money. The real value of the money may fluctuate from
time to time due to inflation, exchange rate changes, etc. This fact is not considered when recording
the transaction.

(d) The Accounting Period Concept

We have seen that as per the going-concern concept the business entity is assumed to have an
indefinite life. As such, the business entity is supposed to be paused after a certain time interval.
This time interval is called an accounting period. This period is usually one year, which could be a
calendar year i.e. 1st January to 31st December or it could be a fiscal year. In Kenya this is as at 1st
July to 31st June of the following year. The business organizations have the freedom to choose their
own accounting year.

(e) The Accrual Concept

The accrual concept is based on recognition of both cash and credit transactions. In case of a cash
transaction, owner’s equity is instantly affected as cash either is received or paid. In a credit
transaction, however, a mere obligation towards or by the business is created. When credit
transactions exist (which is generally the case), revenues are not the same as cash receipts and
expenses are not same as cash paid during the period.

When goods are sold on credit as per normally accepted trade practices, the business gets the legal
right to claim the money from the customer. Acquiring such right to claim the consideration for sale
of goods or services is called accrual of revenue. The actual collection of money from customer could
be at a later date.

Similarly, when the business procures goods or services with the agreement that the payment will be
made at a future date, it does not mean that the expense effect should not be recognized. Because
an obligation to pay for goods or services is created upon the procurement thereof, the expense
effect also must be recognized.

Today’s accounting systems based on accrual concept are called as Accrual System or Mercantile
System of Accounting.

B. BASIC PRINCIPLES

(a) The Revenue Realisation Concept

While the conservatism concept states whether or not revenue should be recognized, the concept of
realisation talks about what revenue should be recognized. It says amount should be recognized only
to the tune of which it is certainly realizable. Thus, mere getting an order from the customer won’t
make it eligible to recognize as revenue. The reasonable certainty of realizing the money will come
only when the goods ordered are actually supplied to the customer and he is billed. This concept
ensures that income unearned or unrealized will not be considered as revenue and the firms will not
inflate profits.

Consider that a store sales goods for Ksh 2500 during a month on credit. The experience and past
data shows that generally 2% of the amount is not realized. The revenue to be recognized will be Ksh
2450. Although conceptually the revenue to be recognized at this value, in practice the doubtful
amount of Ksh 50 is often considered as expense.
 (b) The Matching Concept

As we have seen the sale of goods has two effects:

(i) Arevenue effect, which results in increase in owner’s equity by the sales value of the
transaction and
(j) An expense effect, which reduces owner’s equity by the cost of goods sold, as the goods go
out of the business. The net effect of these two effects will reflect either profit or loss. In order
to correctly arrive at the net result, both these aspects must be recognized during the same
accounting period. One cannot recognize only the revenue effect thereby inflating the profit or
only the expense effect which will deflate the profit. Both the effects must be recognized in the
same accounting period. This is the principle of matching concept.

To generalize, when a given event has two effects – one on revenue and the other on expense, both
must be recognized in the same accounting period.

(c) Full Disclosure Concept

As per this concept, all significant information must be disclosed. Accounting data should properly
be clarified, summarized, aggregated and explained for the purpose of presenting the financial
statements which are useful for the users of accounting information. Practically, this principle
emphasizes on the materiality, objectivity and consistency of accounting data which should disclose
the true and fair view of the state of affairs of a firm.

(d) Dual Aspect Concept

The assets represent economic resources of the business, whereas the claims of various parties on
business are called obligations. The obligations could be towards owners (called as owner’s equity)
and towards parties other than the owners (called as liabilities).

When a business transaction happens, it will involve use of one or the other resource of the business
to create or settle one or more obligations. e.g. consider Mr. Mwangi starts a business with the
investment of 2.5 Million. Here, the business has got a resource of cash worth 2.5 M (which is its
asset), but at the same time it has created an obligation of business towards Mr. Mwangi that in the
event of business closure, the money will be paid back to him. This could be shown as:

Assets = Liabilities + Capital

In other words,

Cash brought in by Mr. Mwangi (2.5 M) = Liability of business towards Mr. Mwangi (2.5 M)

We know that liability of the business could be towards owners and parties other than owners, this
equation could be re-written as:

Assets = Liabilities + Owner’s equity

Cash 2,500,000 = Liabilities nil + Mr. Mwangi’s equity 2,500,000

This is the fundamental accounting equation shown as formal expression of the dual aspect concept.
This powerful concept recognizes that every business transaction has dual impact on the financial
position. Accounting systems are set up to simultaneously record both these aspects of every
transaction; that is why it is called as Double-entry system of accounting.
 (f) Historical Cost Concept

Business transactions are always recorded at the actual cost at which they are actually undertaken.
The basic advantage is that it avoids an arbitrary value being attached to the transactions. Whenever
an asset is bought, it is recorded at its actual cost and the same is used as the basis for all
subsequent accounting purposes such as charging depreciation on the use of asset, e.g. if a
production equipment is bought for ` 1.50 crores, the asset will be shown at the same value in all
future periods when disclosing the original cost. It will obviously be reduced by the amount of
depreciation, which will be calculated with reference to the actual cost. The actual value of the
equipment may rise or fall subsequent to the purchase, but that is considered irrelevant for
accounting purpose as per the historical cost concept.

The limitation of this concept is that the Balance Sheet does not show the market value of the assets
owned by the business and accordingly the owner’s equity will not reflect the real value. However,
on an ongoing basis, the assets are shown at their historical costs as reduced by depreciation.

C. MODIFYING PRINCIPLES

(a) The Concept of Materiality

This is more of a convention than a concept. It proposes that while accounting for various
transactions, only those which may have material effect on profitability or financial status of the
business should have special consideration for reporting. This does not mean that the accountant
should exclude some transactions from recording. e.g. even Ksh 2,000 worth conveyance paid must
be recorded as expense. What this convention claims is to attach importance to material details and
insignificant details should be ignored while deciding certain accounting treatment. The concept of
materiality is subjective and an accountant will have to decide on merit of each case.

(b) The Concept of Consistency

This concept advocates that once an organization decides to adopt a particular method of revenue
or expense recognition in line with the other concepts, the same should be consistently applied year
after year, unless there is a valid reason for change in the method. Lack of consistency would result
in the financial information becoming non-comparable between the different accounting periods.

Consider an example. An asset of Ksh 10 M is purchased by a business. It is estimated to have useful

life of 5 years. It will follow that the asset will be depreciated over a period of 5 years at the rate of
Ksh 2 M every year. The estimate of useful life and the rate of depreciation cannot be changed from
one period to the other without a valid reason. Suppose the firm applies the same depreciation rate
for the first three years and due to change in technology the asset becomes obsolete, the whole of
the remaining amount could be expensed out in the fourth year.