Part A: Foundations
Introduction to accounting
Key takeaways
- Accounting identifies, measures, records, summarises and communicates an entity's transactions so that the people who rely on it can make economic decisions.
- Bookkeeping records the transactions, management accounting turns them into information for the owner's own decisions, and financial accounting presents them to outsiders under a common rulebook such as IFRS.
- Every financial statement is built from five elements: assets, liabilities, equity, income and expenses.
- Assets = Liabilities + Equity holds after every transaction; double entry is that equation enforced one transaction at a time.
- Capital put in and drawings taken out change equity directly; only income and expenses change it through profit.
This opening chapter sets out why accounting exists, what a set of financial statements is actually built from, and who relies on it, in Kenya from a smallholder trader in Gikomba market to a bank underwriting a corporate loan at KCB. Everything later in this paper, and in the two accounting/reporting papers that build on it (CPA Financial Reporting and Analysis, and its advanced counterpart), rests on the definitions fixed here.
Nature and purpose of accounting
Accounting is the process of identifying, measuring, recording, classifying, summarising, interpreting and communicating the financial transactions and events of an entity, so that the people who rely on that information can make informed economic decisions about it. A butchery in Kutus keeping a simple exercise book of daily takings and a bank reconciliation, and Safaricom PLC preparing a full IFRS-compliant annual report for the Nairobi Securities Exchange (NSE), are doing the same fundamental thing at very different scales.
The three branches are not three separate jobs done by three separate people in most Kenyan businesses; they are three different uses of the same underlying data, produced on three different rhythms.
A shop's till roll and supplier invoices are bookkeeping, recorded daily. Once a month, that same data is summarised into management accounts (a simple profit summary, stock levels, cash position) the owner uses to decide whether to reorder or cut costs, information that never leaves the business and follows no external rulebook. Once a year, the same underlying transactions, now adjusted, classified and presented to a prescribed structure (see the chapters on financial statements), become the financial accounts a bank, KRA or an investor actually reads. The raw data is identical throughout; what changes is who it is for, how often it is produced, and how strictly its format is prescribed.
Financial accounting sits at the strict end of that spectrum on purpose. Because its output is read by people outside the business, who cannot verify the underlying figures for themselves and who each bring different assumptions and interests, it follows a common rulebook (the accounting concepts, and IFRS itself) so that a Nyeri agro-dealer's accounts and a Mombasa clearing agent's accounts, though produced by unrelated bookkeepers, mean the same thing to the reader. Management accounting carries no such obligation, since the only reader is the person who already knows the business.
The same transaction through all three branches: Otieno's electronics stall
Otieno sells a phone charger on credit to a regular customer for KES 500, cost KES 300.
Bookkeeping: the sale is written into the day book/receipt pad on the day it happens.
Management accounting: at month end, Otieno's own running tally shows chargers are his
best-margin line (KES 200 gross profit per unit), so he decides to stock more of them,
a decision made from the raw numbers with no IFRS rule involved.
Financial accounting: at year end, the same sale is one line inside 'sales revenue' and
'cost of sales' in a formal statement of profit or loss that a bank reviewing his
loan application, or KRA assessing his tax, can read using a shared, prescribed format.
Common mistake
Treating a business's internal management accounts as though they must follow IFRS, or expecting a bank to accept them in place of properly prepared financial statements, are both real, examinable errors. Management accounts follow no external rule at all precisely because no external party relies on them; financial accounts must follow IFRS (or an equivalent framework) precisely because external parties do.
The objective of financial accounting
The objective of general-purpose financial reporting, as set out in the IASB's Conceptual Framework for Financial Reporting, is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Financial accounting exists to serve that single objective: everything from double entry to a published set of accounts is in service of producing information that is decision-useful to someone who is not managing the business day to day.
This is deliberately a forward-looking, decision-oriented objective, not merely a backward-looking record of what happened. A loan officer at KCB reviewing a maize miller's application does not only want to know last year's profit; they want enough information, presented consistently with prior years and with other applicants, to judge whether the miller can service a new loan going forward. That is the test the objective sets: not 'is this a complete history', but 'is this useful for a resource-allocation decision'.
It also explains why the objective names investors, lenders and creditors specifically rather than everyone with an interest in the entity (the section on users of accounting information, below, gives the fuller list): general-purpose statements are built around the needs of the people who supply the entity's capital, since their decisions determine whether the entity can continue operating at all.
IFRS/IAS reference
The Conceptual Framework for Financial Reporting is not itself a numbered IAS or IFRS, it is the document the IASB uses to develop them, and the source of the objective, the elements and the qualitative characteristics this guide works with.
The elements of financial statements
The Conceptual Framework defines five elements that every financial statement is built from:
Assets, liabilities and equity make up the statement of financial position; income and expenses make up the statement of profit or loss. Every transaction recorded in this paper affects at least two of these five elements.
Notice the definitions of income and expense both run through assets and liabilities rather than being defined independently: income is fundamentally an increase in net assets from trading (other than the owner putting in more capital), and an expense is fundamentally a decrease in net assets from trading (other than the owner taking money out). This is why double entry never needs a sixth or seventh 'type' of account: every account a business keeps is one of these five elements, or a sub-division of one.
Classifying five real transactions by element
A Thika textile wholesaler buys a delivery pickup for cash -> Asset (pickup) up, Asset (cash) down, no net change
The same wholesaler takes a KES 400,000 overdraft from the bank -> Asset (bank) up, Liability (overdraft) up
A shareholder injects fresh capital into the business -> Asset (bank) up, Equity up (a contribution from owners, so NOT income)
The business earns KES 90,000 commission for referring a customer -> Asset (bank/receivable) up, Equity up through Income
The business pays KES 25,000 electricity for the month -> Asset (bank) down, Equity down through Expense
Common mistake
Confusing a capital contribution from an owner with income, or a drawing/dividend with an expense, is one of the most common Foundation-level errors. Both capital and drawings move equity directly; income and expenses move equity only through profit. Ask first: did this arise from trading, or from the owner's own capital account? That single question resolves the classification every time.
The accounting equation
The five elements always relate to each other through the accounting equation, the single identity that never breaks, no matter how complex the entity:
The accounting equation
Assets = Liabilities + Equity
or, expanded over a period:
Assets = Liabilities + (Opening equity + Income - Expenses - Drawings/Dividends)
Because the equation must always balance, it is often easier to think of it the other way round from how it is usually written: whatever happens to one side must be matched, in the same amount, somewhere else. A transaction that only touched one side of the equation, increasing assets with nothing else changing, would mean money had appeared from nowhere, which is exactly why double entry exists: it is simply this equation enforced transaction by transaction.
Applying the equation: Wanjiku starts a stationery shop in Kerugoya
1. Wanjiku deposits KES 300,000 of her own savings into the business bank account.
Assets (Bank +300,000) = Liabilities (0) + Equity (Capital +300,000)
2. She borrows KES 150,000 from a Sacco to buy a delivery motorbike.
Assets (Bank +150,000, then Motorbike +150,000, Bank -150,000) = Liabilities (Loan +150,000) + Equity (unchanged)
3. She buys stationery stock worth KES 80,000 on credit from a Nairobi wholesaler.
Assets (Inventory +80,000) = Liabilities (Trade payable +80,000) + Equity (unchanged)
4. She sells half that stock for KES 60,000 cash.
Assets (Bank +60,000, Inventory -40,000) = Liabilities (unchanged) + Equity (Profit +20,000)
5. She pays herself KES 15,000 in drawings, and pays KES 10,000 shop rent for the month.
Assets (Bank -25,000) = Liabilities (unchanged) + Equity (Drawings -15,000, Expense -10,000)
Running totals after all five of Wanjiku's transactions
Bank: 300,000 (capital in) + 150,000 (loan in) - 150,000 (motorbike bought) + 60,000 (sale)
- 25,000 (drawings 15,000 + rent 10,000, both paid in cash) = 335,000
Motorbike = 150,000
Inventory = 80,000 - 40,000 (cost of the half sold) = 40,000
Total assets = 335,000 + 150,000 + 40,000 = KES 525,000
Sacco loan = 150,000; Trade payable = 80,000
Total liabilities = KES 230,000
Capital 300,000 + Profit on the sale 20,000 - Drawings 15,000 - Rent expense 10,000
Total equity = KES 295,000
Check: Liabilities + Equity = 230,000 + 295,000 = 525,000, matching total assets exactly.
Users of accounting information
These users do not all want the same thing from the same set of numbers, which is exactly why financial accounting needs the neutral, rule-bound qualities of useful information rather than being written to please any one of them.
Their interests differ:
- Management: may be tempted to present the business in the best possible light.
- A bank: wants a conservative, worst-case-tested picture before it lends.
- KRA: wants an accurate, undistorted picture of taxable profit.
- A prospective investor: wants enough detail to compare the business against alternatives.
A single set of general-purpose financial statements, prepared under one consistent rulebook rather than tailored to any one reader, is what lets all of these different, sometimes conflicting, interests be served from the same document.
Exam tip
The accounting equation above is the one identity every later chapter assumes without restating it, whenever a transaction confuses you, work it directly from the equation rather than trying to recall a rule, it always resolves correctly.
Common mistake
A very common Foundation-level slip is treating 'the users of accounting information' as a list to memorise in isolation. Examiners more often ask which specific user, and why, would care about a given fact pattern, so practise reasoning from a scenario to the user, not just reciting the eight-item list.
Self-check
Kiptoo opens a hardware shop in Eldoret on 1 March. During the month: (1) he deposits KES 500,000 of his own savings into the business bank account; (2) he takes a KES 200,000 bank loan, which he uses in full, the same day, to buy a pickup truck; (3) he buys hardware stock worth KES 150,000 on credit from a Nakuru supplier; (4) he sells three-quarters of that stock for KES 175,000 cash.
Using the accounting equation, determine Kiptoo's total assets, total liabilities and total equity at the end of March.
Show worked answer
1. Capital introduced: Bank +500,000; Equity (Capital) +500,000.
2. Loan drawn and spent on the truck: Bank +200,000 then -200,000 (net Bank effect nil);
Truck +200,000; Liabilities (Loan) +200,000.
3. Stock bought on credit: Inventory +150,000; Liabilities (Trade payable) +150,000.
4. Sale: cost of the three-quarters sold = 150,000 x 75% = 112,500.
Bank +175,000; Inventory -112,500; Equity (Profit) +175,000 - 112,500 = +62,500.
Totals:
Bank = 500,000 + 175,000 = 675,000
Truck = 200,000
Inventory = 150,000 - 112,500 = 37,500
Total assets = 675,000 + 200,000 + 37,500 = KES 912,500
Total liabilities = 200,000 (loan) + 150,000 (payable) = KES 350,000
Total equity = 500,000 (capital) + 62,500 (profit) = KES 562,500
Check: 350,000 + 562,500 = 912,500, which equals total assets. The equation balances.