Last updated November 20266 sectionsabout 10 min read
Key takeaways
Accounting identifies, records, classifies, summarises and communicates financial information about a business so that its users can make informed decisions.
Every financial statement is built from five elements: assets, liabilities, equity, revenues and expenses.
Assets = Liabilities + Equity must balance after every transaction, which is what makes double-entry bookkeeping work.
Eight concepts guide how a transaction is treated: accrual, conservatism, consistency, cost, economic entity, full disclosure, going concern and matching.
Real accounts hold assets, personal accounts record dealings with a named person or organisation, and nominal accounts hold income and expenses that close to profit or loss each period.
This opening chapter fixes the vocabulary and principles every later chapter assumes:
What accounting is.
The five elements every financial statement is built from.
The concepts that guide how a transaction is treated.
Who actually reads the resulting statements.
Key terms
Accounting
The process of identifying, recording, classifying, summarising and communicating financial information about a business, so that its users can make informed decisions.
Accounting period
The span of time, typically a financial year, over which an entity's financial performance is measured and reported.
Accrual basis of accounting
Transactions are recognised when they occur, not when cash changes hands, so revenue is recorded when earned and expenses when incurred, regardless of when the related cash is received or paid.
Credit
An entry recorded on the right-hand side of an account, increasing a liability, equity or income account, or decreasing an asset or expense account.
Debit
An entry recorded on the left-hand side of an account, increasing an asset or expense account, or decreasing a liability, equity or income account.
Accruals
Expenses incurred, or income earned, in the current period but not yet paid or received in cash, recognised anyway under the accrual basis.
Closing the books
The end-of-period process of transferring the balances on income and expense accounts into the statement of profit or loss, leaving only the permanent asset, liability and equity accounts open to carry forward into the next period.
Introduction to accounting
Accounting exists to record an entity's transactions in a structured way (its nature and purpose) so that a true and fair view of its financial performance and position can be reported to the people who need it (the objective of financial accounting).
The elements of financial statements
Assets
Resources controlled by an entity, as a result of past events, from which future economic benefit is expected to flow to it.
Liabilities
Present obligations of an entity, arising from past events, the settlement of which is expected to result in an outflow of economic benefit.
Equity
The residual interest in an entity's assets after deducting all its liabilities, the owner's stake in the business.
Revenues
Increases in economic benefit during the period, in the form of inflows or enhancements of assets, that increase equity, other than contributions from owners.
Expenses
Decreases in economic benefit during the period, in the form of outflows or depletions of assets, that decrease equity, other than distributions to owners.
The accounting equation restated
Assets = Liabilities + Equity
Equity = Assets - Liabilities
Every transaction affects at least two of these five elements, which is what makes double entry (see the next chapter) possible.
Accounting concepts
Eight underlying concepts recur throughout this paper, giving a preparer a defensible basis for how a transaction is treated.
Accrual principle
Transactions are recognised when they occur, not when cash is received or paid, so revenue and the expenses incurred in earning it fall in the same period.
Conservatism principle
Where there is genuine uncertainty, expenses and liabilities are recognised as soon as they are reasonably possible, but income and assets only once they are reasonably assured.
Consistency principle
An accounting policy, once chosen, is applied the same way period after period, so figures stay comparable; a change is only justified by a more reliable presentation, and must be disclosed.
Cost principle
An asset is recorded at its original cost at acquisition, not at its current market value, giving a verifiable, objective starting figure.
Economic entity principle
A business's transactions are recorded separately from the personal transactions of its owner, even where the business has no separate legal personality of its own.
Full disclosure principle
Financial statements disclose all information material enough to influence a user's decisions, whether in the statements themselves or in accompanying notes.
Going concern principle
Financial statements are prepared on the assumption the entity will continue operating for the foreseeable future, unless there is clear evidence otherwise.
Matching principle
An expense is recognised in the same period as the revenue it helped generate, rather than in the period it happened to be paid.
Types of accounts
Real accounts
Accounts for assets, tangible items such as land, buildings and equipment, that an entity owns and continues to hold across accounting periods.
Personal accounts
Accounts recording an entity's dealings with a specific person or organisation, a supplier, a customer, or the owner, such as a trade receivable or trade payable account.
Nominal accounts
Accounts for income and expenses, closed off to the statement of profit or loss at the end of each period rather than carried forward.
The accounting equation
The accounting equation, Assets = Liabilities + Equity, must balance after every single transaction, no exceptions. It is the reason double-entry bookkeeping works at all: recording a transaction on both a debit and a credit side keeps the equation in balance automatically.
The accounting equation after a transaction
A business buys inventory worth KES 50,000 on credit.
Assets (inventory) increase by KES 50,000.
Liabilities (trade payables) increase by KES 50,000.
The equation still balances: the increase is on both sides.
Users of accounting information
Users of accounting information split into two broad groups.
Creditors
Suppliers and lenders, who assess whether the entity can pay what it owes when it falls due.
Investors
Existing and potential shareholders, who assess the return and risk of investing in the entity.
Government
Tax authorities and other government bodies, who assess tax liability and compliance with regulation.
Trading partners
Customers and suppliers assessing whether the entity is a reliable party to continue doing business with.
Regulatory agencies
Bodies overseeing a specific industry, assessing compliance with sector-specific reporting and conduct requirements.
International standardisation agencies
Bodies such as the IASB that use aggregated financial reporting practice to inform how accounting standards themselves develop.
Journalists
Financial and business media, who use published financial statements to inform public reporting on an entity's performance.
A second group sits inside the entity itself, using the same information for day-to-day decisions.
Owners
Assess how well the business they own is performing and how much can safely be withdrawn or reinvested.
Directors
Use financial information to set strategy and to account to shareholders for their stewardship of the entity.
Managers
Use financial information for planning, budgeting and controlling the operations they are responsible for.
Employees
Assess job security and the entity's ability to pay wages, bonuses and pensions.
Exam tip
A question naming a specific user and asking what they would look for in the statements is testing whether you can match the user to their own interest, a creditor cares about liquidity, an investor about return, a manager about operational detail, not whether you can list every user from memory.
Self-check
(a) A business has total assets of KES 850,000 and total liabilities of KES 320,000. Compute its equity. (3 marks)
(b) Distinguish between the accrual principle and the conservatism principle, giving one example situation where the two might pull in different directions. (5 marks)
(c) Distinguish between a real account, a personal account and a nominal account, giving one example of each. (5 marks)
(d) A bank considering a loan application, and a manager deciding whether to expand a product line, are both users of the same set of financial statements. Explain what each would primarily look for, and why the two differ. (5 marks)
(e) Explain why the economic entity principle applies even to a sole proprietorship with no separate legal personality from its owner. (4 marks)
(b) The accrual principle recognises transactions when they occur, not when cash is received or paid, so revenue and expenses fall in the period they actually relate to. The conservatism principle requires that expenses and liabilities be recognised as soon as reasonably possible, but income and assets only once reasonably assured. The two can pull in different directions where a genuinely earned but uncertain amount of revenue exists, the accrual principle would recognise it once earned, while conservatism would delay recognition until it is reasonably assured, favouring caution over strict timing where genuine uncertainty exists. (5 marks)
(c) A real account is for assets, tangible items such as land, buildings and equipment held across periods, for example a Motor Vehicles account. A personal account records dealings with a specific person or organisation, for example a named customer's trade receivable account. A nominal account is for income and expenses, closed off to the statement of profit or loss at period end, for example a Rent Expense account. (5 marks)
(d) The bank would primarily look at liquidity and the entity's ability to repay the loan, current assets relative to current liabilities, cash flow, and existing debt levels, since its interest is in getting its money back with interest. The manager would primarily look at operational detail, product-line profitability, cost trends, and capacity, since their decision concerns internal resource allocation, not creditworthiness. The two differ because each user's decision depends on a different aspect of the same underlying financial reality, external solvency for the bank, internal operational performance for the manager. (5 marks)
(e) The economic entity principle applies even without separate legal personality because accounting exists to report on the performance and position of the BUSINESS specifically, mixing the owner's personal transactions (personal spending, personal assets) into the business's own records would make the business's financial statements meaningless as a measure of the business's own performance, regardless of whether the law itself treats the business and owner as one and the same person. (4 marks)