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CHAPTER ONE
DEVELOPMENT OF ACCOUNTING PRINCIPLES AND PROFESSIONAL PRACTICE

1.1.   Introduction
Fair presentation of financial affairs is the essence of accounting theory and practice.  With the
increasing size and complexity of business enterprises and the increasing economic role of
government, the responsibility placed on accountants is greater today than ever before.  If
accountants are to meet this challenge, they must have a logical and consistent body of
accounting theory to guide them.  This theoretical structure must be realistic in terms of the
economic environment and must be designed to meet the needs of users of financial statements.

Financial statements and reports prepared by accountants are vital to the successful working of
society.  Economists, investors, business executives, labor leaders, bankers, and government
officials all rely on these financial statements and reports as fair and meaningful summaries of
day-to-day business transactions In addition, these groups are making increased use of
accounting as a base for forecasting future economic trends.

1.1.2. Environmental Factors that Influence Accounting

Accounting, like other social science disciplines and human activities, is largely a product of its
environment. The environment of accounting consists of social, economic, political and legal
conditions, constraints, and influences, which have varied from time to time. Accounting theory
and practices have evolved to meet changing demands and influences. Modern accounting is the
product of many influences and conditions, three of which deserve special consideration are:
First, accounting recognizes that people live in a world of scarce resources. Because resources
exist in limited supply, people try to concern them, to use them effectively and efficiently, and to
identify and encourage those who can make effective and efficient use of them. Accounting
plays a useful role in obtaining a higher standard of living because it helps to identify efficient
and inefficient users of resources.

Second, accounting recognizes and accepts society’s current and ethical concepts of property
and other rights when determining equity among the varying interests in an enterprise or entity.
Accounting looks to its environment for direction with regard to what property rights society
protects, what society recognizes as value, and what society acknowledges as equitable and fair.
Third, accounting recognizes that in highly developed, complex economic systems, some
(owners and investors) entrusts the custodianship of and control over property to others
(managers). One of the results of the corporate form of organization has been the tendency in
large enterprises to divorce ownership and management. Thus, the function of measuring and
reporting information to absentee investors (e.g. Shareholders) has been added to that of

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recording and presenting financial data for owner – manager use. This development greatly
increased the need for accounting standards (rules of practice governing the contents,
measurements, and disclosures in financial statements).

1.1.2. Nature and Environment of Financial Accounting

For purposes of study and practice, the discipline of accounting is commonly divided into the
following areas or subsets: financial accounting, managerial (cost) accounting, tax accounting,
and not- for- profit (public sector) accounting. This handbook concentrates on financial
accounting. Financial accounting has characterized as “that branch of accounting concerned with
the classification, recording, analysis, and interpretation of the overall financial position and
operating results of an organization. Financial accounting encompasses the process and decisions
that culminate in the preparation of financial statements relative to the enterprise as a whole for
use by parties both internal and external to the enterprise. These statements provide a continual
history qualified in money terms of economic resources and obligations of a business enterprise
and of economic activities that change these resources and obligations.

1.1.3. Users of Accounting Information

The basic assumptions that underlie current accounting practice have evolved over many years
in response to the needs of various users of accounting information. The users of accounting
information may be divided into two broad groups: internal users and external users.

Internal users include all the management personnel of a business enterprise who use
accounting information either for planning and controlling current operations or for formulating
long-range plans and making major business decisions. The term managerial accounting relates
to internal measurements and reporting; it includes the development of detailed current
information helpful to all levels of management in decision-making designed to achieve the
goals of the enterprise.

External users of accounting information include stockholders, bondholders, potential

investors, bankers and other creditors, financial analysts, economists, labor unions, and
numerous government agencies. The field of financial accounting is directly related to external
reporting because it provides investors and other outsiders with the financial information they
need for decision-making.

As stated above, two branches of accounting are used to meet the needs of external and internal
users.
 Financial accounting is the information accumulation, processing, and
communication system designed to provide investment and credit decision-
making information for external users. Financial accounting information is

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communicated (reported) through published financial statements and must follow the
pronouncements of several policy-making groups.
 Managerial accounting is the information accumulation, processing, and
communication system designed to provide decision-making information for
internal users. Managerial accounting information is communicated via internal company
reports and is not subject to the policy standards for externally communicated information.

It is restricted by how useful the information is for a specific decision, and by the cost of
providing that information. Financial accounting and managerial accounting thus have somewhat
different objectives because they provide information for different decisions. The company’s
accountants prepare both the financial accounting and the managerial accounting reports, and the
information comes from the same information system. The differences lie in selecting and
presenting the communicated information.

1.2. The IASB and its governance structure

IFRS refers to set of accounting rules which specify in detail how companies must maintain their
records and report their expenses and income. It was established to create a common accounting
language that could be understood globally by investors, auditors, government regulators, and
other interested parties.

The main international standard-setting organization is based in London, United Kingdom, and is
called the International Accounting Standards Board (IASB). The IASB issues
International Financial Reporting Standards (IFRS), which is presently used or permitted in over
149 countries including Ethiopia and is rapidly gaining acceptance in other countries as well.

The standard-setting structure internationally is composed of the following four organizations:

1. The IFRS Foundation provides oversight to the IASB, IFRS Advisory Council, and
IFRS Interpretations Committee. In this role, it appoints members, reviews effectiveness,
and helps in the fundraising efforts for these organizations.
2. The International Accounting Standards Board (IASB) develops, in the public
interest, a single set of high-quality, enforceable, and global international financial
reporting standards for general-purpose financial statements.
3. The IFRS Advisory Council (the Advisory Council) provides advice and counsel to
the IASB on major policies and technical issues.
4. The IFRS Interpretations Committee assists the IASB through the timely
identification, discussion, and resolution of financial reporting issues within the
framework of IFRS.

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Figure 1: International Standard-Setting Structure

1.3. List of IASB pronouncements

The IASB issues three major types of pronouncements:
1. International Financial Reporting Standards.
2. Conceptual Framework for Financial Reporting.
3. International Financial Reporting Standards Interpretations

International Financial Reporting Standards

Financial accounting standards issued by the IASB are referred to as International Financial
Reporting Standards (IFRS). The IASB has issued 17 of these standards to date, covering such
subjects as business combinations, share-based payments, and leases. Prior to the IASB (formed
in 2001), standard-setting on the international level was done by the International Accounting
Standards Committee, which issued International Accounting Standards (IAS). The committee
issued 41 IASs, many of which have been amended or superseded by the IASB. Those still
remaining are considered under the umbrella of IFRS.

1.4. The IASB’s conceptual framework for financial reporting

The Framework's purpose is to assist the IASB in developing and revising IFRSs that are based
on consistent concepts, to help preparers to develop consistent accounting policies for areas that
are not covered by a standard or where there is choice of accounting policy, and to assist all
parties to understand and interpret IFRS.

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Figure 2 : Conceptual Framework for Financial Reporting

The first level- Objective of financial reporting
The first level identifies the objective of financial reporting—that is, the purpose of
financial reporting.

The objective of financial reporting is the foundation of the Conceptual Framework. Other
aspects of the Conceptual Framework qualitative characteristics, elements of financial
statements, recognition, measurement, and disclosure—flow logically from the Objective. Those
aspects of the Conceptual Framework help to ensure that financial reporting achieves its
objective.
The objective of general-purpose financial reporting is to provide financial information about the
reporting entity that is useful to present and potential equity investors, lenders, and
other creditors in making decisions about providing resources to the entity.

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The second level- Qualitative characteristics of accounting information and

elements of financial statements

The second level provides the qualitative characteristics that make accounting
information useful and the elements of financial statements (assets, liabilities, and so
on).
How does a company choose an acceptable accounting method, the
amount and types of information to disclose, and the format in which to present it? The answer:
By determining which alternative provides the most useful information for decision-making
purposes (decision-usefulness). The IASB identified the qualitative characteristics of accounting
information that distinguish better (more useful) information from inferior (less useful)
information for decision-making purposes.

1. Fundamental qualities
Fundamental qualities are classified in to
A. Relevance
B. Faithfull presentation

A. Fundamental Quality—Relevance
To be relevant, accounting information must be capable of making a difference in a decision.
Information with no bearing on a decision is irrelevant. Financial information is capable of
making a difference, when it has predictive value, confirmatory value, or both. Relevance and
related ingredients of this fundamental quality are shown below.

Figure 3: Relevance of information and its ingredients

Financial information has predictive value if it has value as an input to predictive

processes used by investors to form their own expectations about the future.

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Relevant information also helps users confirm or correct prior expectations; it has
confirmatory value. For example, when Nippon issues its year-end financial
statements, it confirms or changes past (or present) expectations based on previous
evaluations.

Materiality is a company-specific aspect of relevance. Information is material if

omitting it or misstating it could influence decisions that users make on the basis of the
reported financial information
Assessing materiality is one of the more challenging aspects of accounting because it requires
evaluating both the relative size and importance of an item.

Figure 4: Relative size for assessing materiality

During the period in question, the revenues and expenses, and therefore the net incomes of
Company A and Company B, are proportional. Each reported an unusual gain. In looking at the
abbreviated income figures for Company A, it appears insignificant (Immaterial) whether the
amount of the unusual gain is set out separately or merged with the regular operating income.
The gain is only 2 percent of the operating income. If merged, it would not seriously distort the
income figure. Company B has had an unusual gain of only $5,000.

However, it is relatively much more significant than the larger gain realized by Company A. For
Company B, an item of $5,000 amounts to 50 percent of its income from operations. Obviously,
the inclusion of such an item in operating income would affect the amount of that income
materially. Thus, we see the importance of the relative size of an item in determining its
materiality.

B. Fundamental qualities - Faithful representation

Faithful representation means that the numbers and descriptions match what really existed or
happened. Faithful representation is a necessity because most users have neither the time nor the
expertise to evaluate the factual content of the information. For example, if BGI’s income
statement reports sales of Birr 92,403 million when it had sales of Birr 79,644 million, then the
statement fails to faithfully represent the proper sales amount. To be a faithful representation,
information must be complete, neutral, and free of material error.

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i. Completeness: Completeness means that all the information that is necessary for faithful
representation is provided. An omission can cause information to be false or misleading and
thus not be helpful to the users of financial reports.
ii. Neutrality: Means that a company cannot select information to favor one set of interested
parties over another. Providing neutral or unbiased information must be the overriding
consideration.
iii. Free from error: An information item that is free from error will be a more accurate
(faithful) representation of a financial item.

2. Enhancing qualities
Enhancing qualitative characteristics are complementary to the fundamental qualitative
characteristics. These characteristics distinguish more useful information from less useful
information. Enhancing characteristics, shown in the following diagram, are comparability,
verifiability, timeliness, and understandability.

Comparability: Information that is measured and reported in a similar manner for

different companies is considered comparable. Comparability enables users to identify
the real similarities and differences in economic events between companies.
Verifiability occurs when independent measurers, using the same methods, obtain
similar results.
Timeliness: means having information available to decision-makers before it loses its
capacity to influence decisions. Having relevant information available sooner can
enhance its capacity to influence decisions, and a lack of timeliness can rob information
of its usefulness.
Understandability: is the quality of information that lets reasonably informed users see
its significance.

Elements of financial statements

The elements directly related to the measurement of financial position are assets, liabilities,
and equity. These are defined as follows.

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 Asset. A present economic resource controlled by the entity as a result of past events.
(An economic resource is a right that has the potential to produce economic benefits).
 Liability. A present obligation of the entity to transfer an economic resource as a result
of past events.
 Equity. The residual interest in the assets of the entity after deducting all its liabilities.
The elements of income and expenses are defined as follows.
 Income. Increases in assets, or decreases in liabilities, that result in increases in equity,
other than those relating to contributions from holders of equity claims.
 Expenses. Decreases in assets, or increases in liabilities, that result in decreases in
equity, other than those relating to distributions to holders of equity claims.

The third level- recognition, measurement, and disclosure concepts

The third level identifies the recognition, measurement, and disclosure concepts used in
establishing and applying accounting standards and the specific concepts to implement the
objective. These concepts include assumptions, principles, and a cost constraint that
describe the present reporting environment. We examine these three levels of the Conceptual
Framework next.

A. Assumptions
i. Economic Entity – requires that activities of the entity be kept separate and
distinct from the activities of its owner and all other economic entities.
ii. Going Concern – assumes that the business will have a long life.
iii. Monetary Unit - requires that companies include in the accounting records
only transaction data that can be expressed in terms of money.
iv. Periodicity – implies that a company can divide its economic activities into
time periods (i.e., to report information periodically).
v. Accrual Basis of Accounting – transactions are recorded in the periods in
which the events occur.
B. Basic Principles of Accounting

We generally use four basic principles of accounting to record and report transactions:

1. Measurement,
2. Revenue recognition,
3. Expense recognition, and
4. Full disclosure.

1. Measurement Principles

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 Historical Cost Principle: IFRS requires that companies account for and report many
assets and liabilities on the basis of acquisition price. This is often referred to as the historical
cost principle. Cost has an important advantage over other valuations: It is generally thought
to be a faithful representation of the amount paid for a given item.
 Fair Value Principle:

Fair value is defined as “the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date.” Fair
value is therefore a market-based measure. Recently, IFRS has increasingly called for use of fair
value measurements in the financial statements. This is often referred to as the fair value
principle. Fair value information may be more useful than historical cost for certain types of
assets and liabilities and in certain industries. For example, companies report many financial
instruments, including derivatives, at fair value.
Fair Value states that assets and liabilities should be reported at fair value (the price received to
sell an asset or settle a liability).

2. Revenue recognition:

Recognition is the process of capturing for inclusion in the statement of financial position or
the statement(s) of financial performance an item that meets the definition of one of the elements
of financial statements—an asset, a liability, equity, income, or expenses.

When a company agrees to perform a service or sell a product to a customer, it has a

performance obligation. When the company satisfies this performance obligation, it
recognizes revenue. The revenue recognition principle therefore requires that companies
recognize revenue in the accounting period in which the performance obligation is satisfied.

3. Expense recognition

Expenses are defined as outflows or other “using up” of assets or incurring of liabilities (or a
combination of both) during a period as a result of delivering or producing goods and/or
rendering services. It follows, then, that recognition of expenses is related to net changes in
assets and earning revenues. In practice, the approach for recognizing expenses is, “Let the
expense follow the revenues.” This approach is the expense recognition principle.
To illustrate, companies recognize expenses not when they pay wages or make a product, but
when the work (service) or the product actually contributes to revenue.

4. Full disclosure Principle

In deciding what information to report, companies follow the general practice of providing
information that is of sufficient importance to influence the judgment and decisions of an
informed user. Often referred to as the full disclosure principle, this practice recognizes that the

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nature and amount of information included in financial reports reflects a series of judgmental
trade-offs. These trade-offs strive for (1) sufficient detail to disclose matters that make a
difference to users, yet (2) sufficient condensation to make the information understandable,
keeping in mind costs of preparing and using it.
Users find information about financial position, income, cash flows, and investments in one of
three places: (1) within the main body of financial statements, (2) in the notes to those
statements, or (3) as supplementary information.
 The notes to financial statements generally amplify or explain the items presented in the
main body of the statements. If the main body of the financial statements gives an incomplete
picture of the performance and position of the company, the notes should provide the
additional information needed. Information in the notes does not have to be quantifiable, nor
does it need to qualify as an element. Notes can be partially or totally narrative.
Examples of notes include
 Descriptions of the accounting policies and methods used in measuring the elements
reported in the statements,
 Explanations of uncertainties and contingencies, and
 Statistics and details too voluminous for presentation in the financial statements.
 Supplementary information may include details or amounts that present a different
perspective from that adopted in the financial statements. It may be quantifiable information
that is high in relevance but low in reliability.

An example of supplementary information is an expanded table containing the details for
any line item in the financials. Thus, a breakdown of the cost of goods sold could be
presented, or a breakdown of the components of the fixed assets line item.

1.5. . IFRS-based Financial Statements (IAS 1)

IAS 1 Presentatio n of Financial Statements sets out the overall requirements for fin ancial statements, inclu ding how they should be structured, the minimum requirements for their content and overriding concepts such as goin g concern, the accrual basis of accounting and the current/non-current distin ction. The standard requires a complete set of fin ancia l statements to comprise a statement of fin ancial position, a statement of profit or loss and other comprehensive income, a statement of changes in equity and a statement of cash flo ws.

IAS 1 Presentation of Financial Statements sets out the overall requirements for financial
statements, including how they should be structured, the minimum requirements for their content
and overriding concepts such as going concern, the accrual basis of accounting and the
current/non-current distinction. The standard requires a complete set of financial statements to
comprise a statement of financial position, a statement of profit or loss and other comprehensive
income, a statement of changes in equity and a statement of cash flows.

1.5.1. Objective of financial statements

The objective of general purpose financial statements is to provide information about the
financial position, financial performance, and cash flows of an entity that is useful to a wide
range of users in making economic decisions. To meet that objective, financial statements
provide information about an entity's: [IAS 1.9]

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 Assets
 Liabilities
 Equity
 Income and expenses, including gains and losses
 Contributions by and distributions to owners (in their capacity as owners)
 Cash flows.
That information, along with other information in the notes, assists users of financial statements
in predicting the entity's future cash flows and, in particular, their timing and certainty.

1.5.2. Components of financial statements

A complete set of financial statements includes: [IAS 1.10]
 A statement of financial position (balance sheet) at the end of the period
 A statement of profit or loss and other comprehensive income for the period (presented as
a single statement, or by presenting the profit or loss section in a separate statement of
profit or loss, immediately followed by a statement presenting comprehensive income
beginning with profit or loss)
 A statement of changes in equity for the period a statement of cash flows for the period
 notes, comprising a summary of significant accounting policies and other explanatory
notes
 Comparative information prescribed by the standard.
 For more information please visit https://www.iasplus.com/en/standards/ias/ias1

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