MAKERERE UNIVERSITY

COLLEGE OF BUSINESS AND MANAGEMENT SCIENCES

MASTERS IN BUSINESS ADMINISTRATION (MBA)
MBS 7101: FINANCIAL ACCOUNTING

No. NAME REG No. SIGNATURE

QUESTION ONE

THE FOLLOWING ARE THE ACCOUNTING CONCEPTS AND THEIR ROLE IN

THE DEVELOPMENT OF ACCOUNTING STANDARDS.

1. Business entity concept

The business entity, economic entity or separate entity concept assumes that a business is
independent of its owner. A business may not record its owner's personal expenses, income,
liabilities and assets. It aids in tracking a business's expenses, incomes and tax deductions
without any ambiguity. In addition, it safeguards a business owner's personal finances and helps
build their creditworthiness. It reflects cash flow and financial position more accurately. This
clear distinction helps stakeholders and creditors take appropriate business decisions based on
a company's performance rather than the owner's financial position. The financial records and
transactions of the business must be kept separate from those of the personal financial affairs
of the owners.

Example: If a sole proprietor owns a bakery, the personal expenses of the owner (such as
personal groceries or home utilities) should not be recorded in the business's financial records.
Only transactions related to the bakery (e.g., sales revenue, expenses on flour, wages for
employees) should appear in the bakery's financial statements. The business is treated as a
distinct "entity" from the owner.

2. Going concern concept

Going concern concept prescribes that accountants prepare financial statements on the
assumption that a business will continue its operations for the foreseeable future. Under this
concept, the definition of a foreseeable future is a period of 12 months from the end date of the
reporting period. If a business owner or the management is invested in scaling down business
operations to zero, they cannot apply the going concern concept for accounting. Accountants
may no longer apply the going concern concept if a company is:

• unable to pay dividends

• unable to raise credit from banks and financial services

• facing losses and negative operating cash flow

• facing an adverse financial position

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 • unable to pay back crucial debts

• facing an unfavourable legal or regulatory action against it

Standards such as IAS 1 (Presentation of Financial Statements) require companies to assess

whether there are any significant doubts about their ability to continue as a going concern. If
such doubts exist, they must disclose this in the financial statements.

Example: A company facing severe financial distress must assess its ability to continue
operating. If it is no longer a going concern, the company must adjust its financial statements
to reflect this, such as by valuing assets at liquidation value rather than going-concern value.

The going concern assumption underpins many accounting treatments, including asset
valuation and the recognition of liabilities. If a company is not considered a going concern, it
may need to report assets at their liquidation value, which is more conservative than reporting
at the value assuming continued operation.

3. Prudence (Conservatism) concept

The prudence concept suggests that accountants should be cautious in estimating revenues and
expenses, ensuring that liabilities and expenses are not understated, and revenues are not
overstated. Revenues and profits are not anticipated, only realised profits with reasonable
certainty are recognised in the profits and loss account. However, provision is made for all
known expenses and losses that are certain and justifiable.

Standards such as IFRS 9 (Financial Instruments) and IAS 37 (Provisions, Contingent

Liabilities, and Contingent Assets) incorporate prudence by guiding when and how provisions
should be made for uncertain liabilities.

Example: A company is uncertain about the amount of a warranty provision. Under the
prudence concept, the company estimates and records a provision based on the best available
information, without underestimating the potential liability.

Prudence helps prevent overstatement of financial health, protecting stakeholders from overly
optimistic views of a company's financial position. This supports reliability and trust in the
financial statements.

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4. Money measurement concept

This is an accounting concept based on assumption, and it stipulates that companies record
only those transactions that they can quantify and measure in terms of money. If they cannot
assign a monetary value to a transaction, they do not record it in their annual financial
statement. Though these transactions affect a company's financial performance, they may not
find a place in financial statements, as monetising them can be challenging. Some examples of
non-monetary value include employee competence, product quality, employee efficiency,
market sentiment, business productivity and stakeholder satisfaction.

5. Accounting period concept

The accounting period concept prescribes a timeframe within which a business records and
reports its financial performance for the purview of internal and external stakeholders. An
accounting period of a company may coincide with the fiscal year. A company can determine
a timeframe for internal reporting, like three or six months, or prepare monthly financial reports
to analyse their cash flow positions. The management can determine a convenient accounting
period for internal reporting, but the reporting for investor, government and tax purposes is
typically for the period of one year.

6. Accrual concept

Accrual is a fundamental concept that guides how a business can record cash or credit
transactions. Under this concept, a business records a financial transaction in the period it
occurs. It does not consider whether the business pays or receives cash at the time of the
transaction, or if it pays cash after a certain period. For example, a company records a credit
purchase at the time of purchase rather than when it pays back the seller. This helps record and
report income, expenses, liabilities and receivables accurately. All modern accounting systems
follow the accrual concept in recording financial transactions.

Accounting standards such as IFRS 15 (Revenue from Contracts with Customers) and IAS 18
(Revenue) are based on the accrual concept. These standards ensure that revenue is recognized
when the earning process is complete, not when cash is collected.

Example: A company sells goods on credit. According to the accrual concept, the company
records revenue when the sale occurs, not when the customer pays the invoice. This is reflected
in revenue recognition standards like ASC 606 (Revenue from Contracts with Customers under
US GAAP).

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Accrual accounting leads to more accurate financial statements because it reflects economic
events as they occur, regardless of cash flow timing. This helps users of financial statements
make better decisions.

7. Uniformity Concept

The uniformity concept refers to the consistency of accounting practices over time. For
accounting information to be useful, it should be presented in a uniform manner so that users
can compare financial information across periods and between different businesses. This
principle supports comparability and consistency in financial reporting.

If a company has adopted the straight-line method for depreciation, it should continue to use
the same method in subsequent years unless there is a justified reason for a change. If the
company were to suddenly switch to an accelerated depreciation method without explanation,
it would make it harder for stakeholders to compare the company’s financial performance over
time.

8. Relevance concept

Relevance is a key characteristic of accounting information that indicates how useful and
timely the information is to the users for decision-making purposes. Information is considered
relevant if it can influence the decisions of users by helping them assess past, present, or future
events, or by confirming or correcting prior evaluations. Relevant information which can
satisfy the needs of most users is selected and recorded in the financial statements.

In preparing financial statements, providing a company’s quarterly sales figures would be

highly relevant for potential investors because it provides insights into the company’s
performance, trends, and possible future outcomes. On the other hand, including irrelevant
details (such as personal information about employees) would distract from the financial
information that is critical to decision-making.

9. Objectivity Concept

The objectivity principle states that accounting information should be based on accounting data
and facts, rather than on personal whims, preconceived notions, or biased opinions. The
financial reports should not be subject to or exhibit personal judgment. This ought to be
supported by objective evidence in the form of invoices, contracts, receipts, and the like.

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The revenue booking should, therefore, be supported by an actual transaction evidenced
through a proper invoice or contract, not based on personal assumptions or expectations of
sales that might take place. This ensures that the financial statements are not based on arbitrary
estimates, but on verifiable information.

10. Revenue realisation concept

Under the concept of revenue realisation or revenue recognition, a seller records the
prospective revenue of a transaction that he has or has not received proceeds. In a sale of a
product, the ownership transfers from a buyer to a seller. The seller recognises such a
transaction by creating a receivable against the buyer's name in their ledger. An accountant
records another entry upon receipt of due amount in the future.

This will really help in giving a definite guideline on when revenue should be recognized. It
forms the very core of the revenue recognition standards, such as IFRS 15 and ASC 606, which
provide very specific criteria for recognizing revenue from contracts with customers.

For instance, in the case where a software license is sold in December for $10,000 but will not
be available to be used by the customer until January, recognition of revenues should not occur
in December simply because the payment was received when the software is not yet available
to the customer.

This ensures that income earned during the period, rather than receipts, is matched against the
financial statements.

11. Full disclosure concept

The full disclosure concept requires a business entity to present needed information that shall
benefit the users in reading financial statements and reports for investment, taxation, or auditing
purposes. This concept attempts to represent significant financial information to investors,
creditors, shareholders, clients, and other interested parties. Disclosure policies include revenue
recognition, depreciation, inventory, taxes, earnings, stock value, leases, and liabilities.

This concept ensures transparency in financial reporting. It allows the user to make informed
decisions as complete and comprehensive information is provided. Full disclosure helps
establish guidelines for what is included in the financial statements besides the primary reports.

Example: A company is being sued for $5 million. The full disclosure concept requires a
company to disclose the contingent liability in the notes to the financial statement even though

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the success of the lawsuit may be less than certain. This would allow the readers of the financial
statements to take into consideration that risk to which the company may be exposed.

International accounting standards, for example, IFRS or Generally Accepted Accounting

Principles, permit full disclosure to the extent that the books of accounts are complete and
present a true picture of the financial position of the organization.

12. Dual aspect concept

The dual aspect concept shows that every transaction influence two accounts of a business. A
business then records both aspects to enable accurate accounting. Every financial transaction
has an aspect of credit or debit or giver or receiver. An accounting process, which does not
represent both, may lead to faults in the final accounting record. The dual-aspect concept is the
very basis of the double entry system of bookkeeping, which today is one of the recognized
methods for audit and taxation:

Assets = Liabilities + Equity

This helps in developing a basis for consistent, balanced, and systematic recording of financial
transactions. It provides the basis for the structure of financial statements like the Balance Sheet
and the Income Statement.

Assume that a company purchases machinery valued at $10,000 with cash.

Debit: The Machinery account, which is an asset account, increases by $10,000

Credit: Cash, which is also an asset, decreases by $ 10 000

Doing so maintains the balance in the accounting equation.

The dual aspect concept plays a very important role in developing rules for journal entries. It
helps in laying down some sort of standard procedure as to how transactions should be
recognized and classified in a uniform manner across entities.

13. Materiality concept

This concept of materiality prescribes guidelines to identify if something of a financial nature

would be material and could influence the person reading a company's financial statements. An
accountant or a business can avoid, according to this concept, those transactions that are
negligible in nature and may not have a bearing on final accounts. This is a subjective concept
and the applicability of the concept of materiality rests on the size of an enterprise. Whereas a

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large enterprise may round off figures in the final accounts to crores, a small firm may round
off their figures to lakhs. The materiality concept applies if something is omitted that would
have influenced the economic decision of the user of the financial statements.

IAS 1 requires that a firm disclose all material information; materiality is a main concept in
deciding which items to include in the financial statements.

Example: An entity may not disclose an error in their financial statements if it is immaterial,
for it would not have any effect on the users' decisions. This is due to the materiality concept.

Materiality assists firms in not over-including trivial information on the financial statements,
only those that are significant enough to influence decisions.

14. Historical cost concept

The historical cost concept allows the business organization to record assets and liabilities at
their historical cost and not at current market or sale value. It is not for maintaining consistency,
reliability, and verifiability of financial information. If one includes the current value of an
entity, it may result in financial irregularities.

The Fair Value concept helps to establish a clear and reliable method of asset valuation. It
ensures consistency in asset reporting such that there is no subjective fluctuation in the
valuation of assets; thus, making statements comparable across time and entities.

Example: Land bought by an organization in 2010 for $100,000 should, according to the
historical cost principle, be continuously carried at that value without regard to any increase in
market value or economic factors such as inflation. Therefore, if it increases in market value to
$150,000 in 2024, it would still carry the original purchase price value of $100,000 in its
balance sheet.

This, therefore, helps financial statement users understand the historical investment made in
the assets, thus providing a stable basis upon which company performance is appraised.

15. Consistency concept

The consistency concept indicates that an entity should continue applying the method adopted
in accounting and apply it in subsequent periods where a change is not justified.

The consistency required, for instance, by the IAS 8, Accounting Policies, Changes in
Accounting Estimates, and Errors, among other accounting standards, involve the application

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of the same accounting principles in successive periods unless there is a change in some
standard that necessitates such an amendment or an improved accounting method.

Example: An entity has been depreciating its fixed assets using the straight-line method
consistently for years. If it decides to change to a reducing balance method, the reason for this
change along with its financial effect needs to be disclosed as guidance under IAS 8.

Comparability: This enhances the ability of users of financial statements to determine

performance across periods and guides them in finding trends.

16. Matching Concept

Matching convention requires that expenses be recognized in the same period as the revenues
to which they relate, even though the associated cash flows occur in different periods.

The standards like IAS 2 about Inventories, IAS 16 on Property, Plant and Equipment demand
the matching of expenses against revenues.

Example: A firm that has incurred costs through goods produced would see that expenditure-
which could be in raw materials, labor contributions, and overheads-is matched against
revenues gained when the produced goods are sold, using the matching principle.

Matching of expenses with the revenues earned implies that the financial statements present
true profitability. This helps the users of financial statements understand the cost structure and
performance of a business over time.

17. Substance over form concept

The said concept requires that transactions must be accounted for based on their economic
substance and not on their legal form.

In this respect, the standards contained in IFRS 10 on Consolidated Financial Statements take
precedence in terms of substance over form in representation.

Example A company leases an asset under a contract where legally it would be classified as an
operating lease. However, the lease arrangement is in substance a finance lease since risks and
rewards of ownership have shifted. Under the concept of substance over form, this lease would
be accounted for as if it were a finance lease.

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This principle ensures that the actual economic effect of the transactions is reflected in financial
reporting, thus preventing companies from structuring the transaction with only a desired
accounting outcome.

These underlying concepts form the very foundation on which any accounting standard, such
as IFRS or GAAP, prepares financial statements to be consistent and reliable. Such concepts
avoid any manipulation of financial data, hence giving clarity to the investor, regulator, and
other stakeholders. In this way, each entity can present financial reports on a consistent,
understandable, and reliable basis. This would make life much easier for users who try to
ascertain an entity's financial health.

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QUESTION TWO

REVIEWING ACCRUAL CONCEPT OF ACCOUNTING- ONE THAT MAKES UP

THE ACCOUNTING THEORY.

Accounting theory is the conceptual basis that underlines and guides the formulation and
implementation of financial accounting practices. It also helps explain the role of financial
accounting in setting financial statements and how the latter set of statements are made to help
arrive at decisions on resource allocation.

The accrual concept of accounting is one of the foundational principles underlying the
preparation of the financial statements. Accruals basis of accounting recognizes revenues and
expenses when they are earned or incurred, respectively, without regard to the actual receipt or
payment of cash. This is the building block for Generally Accepted Accounting Principles and
the International Financial Reporting Standards.

The accrual principle makes revenues and expenses report in the period of its occurrence
irrespective of the cash flow. An income statement, therefore, presents the exact revenue
received and the expenses incurred within a certain period, hence giving a realistic view of the
performance of a company.

KEY ELEMENTS OF THE ACCRUAL CONCEPT

1. Revenue Recognition: It is the recognition of revenues accrued and earned, not

necessarily when payment is received. For example, if a certain firm sells a product on
credit to a customer, it realizes the revenue upon delivery of that product even if the
payment for it is credited sometime later.
2. Accrual concept: The expense is recognized in the period in which it has been incurred
and not paid; for example, a company will book the expense of the month of October
for electricity used even though the bill would have been paid in November.
3. Matching Principle: This is the principle of accrual accounting. It states that revenues
and related expenses are matched to the same period. This gives a better figure on the
income statement concerning the profitability of a company in the period under
consideration.

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APPLICABILITY OF THE ACCRUAL CONCEPT

The accrual concept applies to businesses of all sizes that aim to provide an accurate and fair
picture of their financial position and performance. It is applicable in the following contexts:

1. Public vs. Private Companies: Publicly traded companies must use accrual
accounting under either GAAP or IFRS because such presentation allows for more
transparency and comparability. Private companies, while in some instances and
beneath specific thresholds able to use cash-based accounting, also use accrual
accounting for consistency and higher decision-making quality.
2. Accruals of Concepts in Financial Reporting: It ensures that the financial statement-
income statement and balance sheet-present the true financial condition of a company
irrespective of its cash flow. It aids external users, like investors, creditors, and analysts,
in making informed decisions.
3. Income Tax Reporting: Most countries, though with some few exceptions which apply
to small businesses, enforce that businesses apply the accrual accounting technique in
tax computation. Applying accrual accounting for tax purposes makes sure that
businesses report revenues and expenses within the period they occur, not when cash
changes hands.
4. Non-Profit Organizations: Non-profits also use accrual accounting to accurately
report revenues (e.g., grants, donations) and expenses (e.g., program costs,
administrative expenses), ensuring that their financial statements comply with reporting
standards and offer transparency.

RELEVANCE OF THE ACCRUAL CONCEPT

1. True Financial Picture: Accrual accounting presents a truer picture of the

representative financial position and performance of a company. In accrual accounting,
the revenues and expenses are recognized when they take place, not when cash changes
hands. Hence, it gives a better view of profitability and operational efficiency and
financial health.
2. Consistency: Accrual accounting provides for the recording of incomes and expenses
in financial books that makes comparability across periods suitable. This therefore,
allows stakeholders to track trends and make better-informed decisions.

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 3. Better Financial Planning and Analysis: Accrual accounting helps businesses track
obligations and expected revenues, enabling better budgeting, forecasting, and
planning. By matching revenues and expenses, businesses can more accurately estimate
profits, assess performance, and avoid underestimating liabilities.
4. Investor Confidence: Investors and creditors favor accrual accounting because it
shows a more realistic view of the continuing operations of a firm. Because it matches
revenues and expenses to periods when such revenue or expenses relate, investors are
more capable of evaluating the performance and profitability of the company, which
becomes critical for decision-making.
5. Complex Transactions: For businesses involved in complicated dealings-for instance,
long-term contracts, leases, or transactions between parties-the accrual accounting
system is most appropriate. This nature of transaction is hard to track down through the
cash-based accounting system.

LIMITATIONS OF THE ACCRUAL CONCEPT

1. Complexity: Accrual accounting is more complex than cash-basis accounting and

requires more detailed bookkeeping. It may be challenging for small-scale enterprises
that cannot afford professional accountants or accounting departments.
2. Potential for Misleading Information: If not properly managed, accrual accounting
can sometimes lead to misleading information. For example, recognition of revenues
without receiving them may result in very optimistic financial reports when those
customers may eventually default on payment.
3. Timing Differences: Because accrual accounting does not track the inflow and outflow
of money directly, a business may appear profitable on paper when it is struggling with
cash flow. For instance, a company could report a profitable quarter but at the same
time struggle to pay its bills due to delayed receipt of cash.
4. Resource-intensive: Maintaining accrual accounting systems demands more resources
in terms of time, effort, and expertise from smaller enterprises than simpler cash basis
systems would. This might overburden a startup or even an operational business with
an underdeveloped financial management capacity.

In Conclusion, the accrual concept of accounting is essential for providing a true, consistent,
and comprehensive picture of a business's financial health. Its applicability to businesses of all
sizes and sectors, particularly in the preparation of accurate financial statements, ensures that

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stakeholders can make well-informed decisions. Though it requires more complex tracking of
revenues and expenses, its relevance in ensuring transparency, consistency, and comparability
in financial reporting cannot be overstated.

Despite some challenges, such as increased complexity and potential for misrepresentation of
cash flows, accrual accounting remains the preferred method for businesses seeking to comply
with regulatory standards, attract investors, and plan effectively for the future.

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REFERENCES

1. Accounting Principles, 14th Edition, Jerry J. Weygandt, Paul D. Kimmel, Jill E.

Mitchell
2. Accounting Principles” by Jerry J. Weygandt, Paul D. Kimmel and Donald E. Kieso
3. Wild, J. J., & Shaw, K. W. (2019). Fundamental accounting principles. McGraw-Hill.

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