Chapter One

Development of Accounting Principles and Professional Practice

1.1 The environment of Accounting
The essential characteristics of accounting are the identification, measurement, and
communication of financial information about economic entities to interested parties.
The objective of financial accounting 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 in their capacity as capital providers.
General purpose financial statements are used to:
Provide financial reporting information to a wide variety of users.
Provide the most useful information possible at the least cost
Capital providers (Investors) are the primary user group because they are interested in
assessing the company’s ability to generate net cash inflows and management’s ability to
protect and enhance their investments.

Financial accounting is the process that culminates in the preparation of financial reports on
the enterprise for use by both internal and external parties. Users of these financial reports
include investors, creditors, managers, unions, and government agencies.
Financial statements are the principal means through which a company communicates its
financial information to those outside it. These statements provide a company’s history
quantified in money terms. The financial statements most frequently provided are the
balance sheet, the income statement, the statement of cash flows, and the statement of owners’
or stockholders’ equity. Note disclosures are an integral part of each financial statement.
Some financial information is better provided, or can be provided only, by means of financial
reporting other than formal financial statements. Examples include the president’s letter or
supplementary schedules in the corporate annual report, prospectuses, reports filed with
government agencies, news releases, management’s forecasts, and social or environmental
impact statements. Companies may need to provide such information because of authoritative
pronouncement, regulatory rule, or custom. Or they may supply it because management
wishes to disclose it voluntarily.
1.2 Financial reporting requirements in Ethiopia

In our country Ethiopia, until recent time there is no requirement for compliance with
accounting and auditing standards both in the Commercial Code 1960 and other laws and
regulations for specific sector entities. Some laws require compliance with generally accepted
accounting principles and generally accepted auditing standards, but these terms are not
defined.
The Income Tax Proclamation No. 286/2002 states that taxable business income shall be
determined per tax period on the basis of the profit and loss account, or income statement,
which shall be drawn in compliance with generally accepted accounting standards.
The problem in this case is that ‘generally accepted accounting standards’ is not defined, and
there are no accountings standards set or adopted in the country.
Banking business proclamation no. 592/2008 Article 23 (1) states that The National Bank
may direct banks to prepare financial statements in accordance with international financial
reporting standards, whether their designation changes or they are replaced, from time to
time.
Article 26 (1) also states that without prejudice to the duties imposed by other relevant laws,
the duty of the external auditor, appointed in accordance with the provisions of Article 24 of
this Proclamation shall be to report its audit findings and conclusions, carried out on the basis
of international auditing standards, to the shareholders of the bank and the National Bank.

According to Reports on Observance of Standards and Codes (ROSC, 2007) which is a World
Bank and IMF joint initiative that helps member countries strengthen their financial systems
by improving compliance with internationally recognized standards and codes of best
practice, there is no accounting and auditing standards set in Ethiopia.
ROSC also noted that the accounting practices in Ethiopia vary among institutions and differ
from IFRS.
In a sample of 35 sets of audited financial statements, 17 indicated that they applied IFRS, 10
applied GAAP (not defined), while 8 did not indicate applying any principles or standards.
The sample of 35 sets of audited financial statements comprised 7 banks (2 state-owned), 6
insurance companies (1 state-owned), 2 microfinance institutions, 1 privately owned share
company, 17 other state-owned enterprises, and 2 NGOs. All 35 financial statements were
analyzed by the ROSC team by comparing with IFRS requirements. Some noted specific
differences are documented below.
The following are selected differences between accounting practices in Ethiopia and IFRS
requirements. The ROSC review focused on issues of presentation and disclosure only, not
issues of recognition and measurement, which are not detectable through a review of financial
statements requirements:
IAS 1, Presentation of financial statements. Contrary to the requirements of IAS 1, 21
financial statements did not include a statement of recognized gains and losses or a statement
of changes in equity; 19 out of 20 nonfinancial institutions did not appropriately separate
current and noncurrent items in the balance sheet.
IAS 7, Cash flow statement: Contrary to IAS 7, 2 financial statements for NGOs did not have
a cash flow statement as an integral part of the financial statements; 8 financial statements did
not reconcile cash and cash equivalents in the cash flow statement to the amounts in the
balance sheet.
IAS 10, Events after balance sheet date. Twenty-three financial statements did not disclose
the date on which the financial statements were authorized for issue; IAS 10 requires the
disclosure.
IAS 21, Income Taxes. Contrary to IAS 21, 23 financial statements did not include deferred
income tax in their financial statements.
IAS 19, Employee benefits. None of the financial statements had adequate disclosures on
employee benefits in comparison to the requirements of IAS 19; 8 financial statements only
disclosed that the company has a defined contribution pension scheme.
IAS 21, the effect of changes in foreign exchange rates. Twenty-six financial statements
did not make disclosures about foreign exchange rates as required by IAS 21. So what is
the current status of Financial Reporting in Ethiopia?

Currently Ethiopia enacts Financial Reporting Proclamation No. 847/2014 which

requires Commercial organizations to follow

 International Financial Reporting Standards (IFRS), or

 International Financial Reporting Standards for Small and Medium Enterprises (IFRS
for SME)
 • Charities and societies to follow International Public Sector Accounting Standards
(IPSAS)
• Public auditors to follow International Standards for Auditing
• Public interest entity (PIE) should use the full IFRS.
• A PIE is a reporting entity that is of significant public relevance because of the nature
of its business, its size, its number of employees.
• PIE also includes banks, insurance companies, and any other financial institutions and
public enterprises.
In order to implement to proclamation Government of Ethiopia establishes Accounting and
Auditing Board of Ethiopia (AABE) by Regulation No. 332/2014
It is an autonomous government organ accountable to Ministry of Finance. it is headed by the
Director General, It has 12-member Board of Directors
It has the following Duties and responsibilities
• Issue standards and directives relating to financial reporting and auditing and ensure
their compliance.
• Receive and register financial statements of reporting entities
• Review and monitor the accuracy and fairness of FS to enforce compliance with the
reporting standards
• Register and license public auditors
• Oversee professional accountancy bodies
• Establish, publish and review a code of professional conduct and ethics for certified
public accountants and certified auditors
• Conduct or arrange for the conduct of professional examination for the purpose of
registering certified public accountants
To implement IFRS adoption AABE has set an IFRS implementation road map having 3
phase transition over 3 years:

• Phase 1: Significant Public Interest Entities (Financial Institutions and public

enterprises owned by Federal or Regional Governments- Adoption of IFRS)
– starting at the start of EFY 2009 (i.e. specifically July 8, 2017);
 • Phase 2: Other Public Interest Entities (ECX member companies and reporting
entities that meet PIE quantitative thresholds) adoption of IFRS and for and IPSAS
for Charities and Societies- Adoption of IPSAS
– start adoption of the standards at the start of EFY 2010 (i.e specifically July
8, 2018)
• Phase 3: Small and Medium-sized Entities adoption of the IFRS for SMEs
– start adoption of the standards at the start of EFY 2011 (i.e specifically July
8, 2019)
1.3 International Accounting Standard Board (IASB) and its governance structure
The accounting profession has attempted to develop a set of standards that are generally
accepted and universally practiced. Otherwise, each enterprise would have to develop its own
standards. Further, readers of financial statements would have to familiarize themselves with
every company’s peculiar accounting and reporting practices. It would be almost impossible
to prepare statements that could be compared.
The increase in international trade and the presence of large multinational companies in
many countries in the world has led to problems where different accounting standards
govern financial reporting in different countries. In response to this problem, the
International Accounting Standards Committee (IASC) was formed in 1973. The IASC
reorganized itself in 2001 and created a new standards-setting body called the International
Accounting Standards Board (IASB). The main objective of the IASB is to develop a single
set of high quality, understandable, and enforceable global accounting standards to help
participants in the world’s capital markets and other users make economic decisions. The
IASB issues standards called International Financial Reporting Standards or IFRSs which
are gaining support around the globe. According to the SEC Roadmap, IFRS may be
required by U.S. companies in 2015.
The objectives of the IASB are:
I. To develop, in the public interest, a single set of high-quality, understandable and
enforceable global accounting standards that require high quality, transparent and
comparable information in financial statements and other financial reporting to help
participants in the world's capital markets and other users make economic decisions;
II. To promote the use and rigorous application of those standards;
 III. In fulfilling objectives (i) and (ii), to take appropriate account of the special needs of
small and medium-sized entities and emerging economies;
IV. To bring about convergence of national accounting standards and International
Accounting Standards and International Financial Reporting Standards to high quality
solutions.
IASB is:
 Comprised of 14 members (12 full, 2 part-time) 7 members are liaisons with a
national board.
 Standard development process is open.
 Standards are principles-based.
 Since establishment of IASB, focus is on global standard-setting rather than
harmonization in isolation.
International Accounting Standards Board (IASB)
 Issues International Financial Reporting Standards (IFRS).
International Organization of Securities Commissions (IOSCO)
 Does not set accounting standards.
 Dedicated to ensuring that global markets can operate in an efficient and effective
basis
International Accounting Standards Board (IASB) Composed of four organizations:-
 International Accounting Standards Committee Foundation (IASCF)
 International Accounting Standards Board (IASB)
 Standards Advisory Council
 International Financial Reporting Interpretations Committee (IFRIC)
List of IASB standards and pronouncement
 Conceptual Framework for Financial Reporting: Not a standard.
 IFRS 1-16=16 Standards [Issued by IASB from 2001]
 IAS 1-41=24 Standards [Issued by IASC 1973-2001]
 IFRIC: IFRS Interpretation Committee’s interpretations. IFRIC 1-21=21
 SIC: IFRC Standing Interpretation Committee interpretations: SIC 7-32=10 SICs
It is not surprising, therefore, that there is a growing demand for one set of high-quality
international standards. Presently, there are two sets of rules accepted for international use:
GAAP and the International Financial Reporting Standards (IFRS), issued by the London-
based International Accounting Standards Board (IASB).
Already, over 115 countries have adopted IFRS, plus the European Union now requires all
listed companies in Europe (over 7,000 companies) to use it. The SEC laid out a roadmap,
shown below, by which all U.S. companies might be required to use IFRS by 2015.
To ensure that financial reporting continues to provide the most relevant and reliable financial
information to users, a number of financial reporting issues must be resolved. These issues
include such matters as adopting global standards, increasing fair value reporting, using
principles-based versus rule-based standards, and meeting multiple user needs.
Rules-based accounting standards versus principle (Objectives)-oriented approach
Investors and creditors rely on financial accounting information to make resource allocation
decisions. The accounting scandals at Enron and other companies involved managers using
elaborately structured transactions to try to circumvent specific rules in accounting standards.
One consequence of those scandals was a rekindled debate over principles-based, or more
recently termed objectives-oriented, versus rules-based accounting standards.
An objectives-oriented approach to standard-setting emphasizes using professional judgment,
as opposed to following a list of rules, when choosing how to account for a transaction.
A principle based approach
 Represents a contrast to a rules-based approach
 Attempts to limit additional accounting guidance (e.g., FASB, FASB Interpretations)
 Is designed to encourage professional judgment and discourage over-reliance on
detailed rules
1.5 ISAB Conceptual Frameworks for Financial Reporting
The Conceptual Framework has been described as an “Accounting Constitution.” It provides
the underlying foundation for accounting standards or sets out the concepts that underlie the
preparation and presentation of financial statements for external users.
A conceptual framework is a statement of generally accepted theoretical principles which
form the frame of reference for financial reporting. Therefore a conceptual framework will
form the theoretical basis for determining which events should be accounted for, how they
should be measured and how they should be communicated to the user. It is the basis for the
development of new accounting standards and the evaluation of those already in existence.
More formally, it is a coherent system of interrelated objectives and fundamentals that is
intended to lead to consistent standards and that prescribes the nature, function, and limits of
financial accounting and reporting. The fundamentals are the underlying concepts of
accounting that guide the selection of events to be accounted for, the measurement of those
events, and the means of summarizing and communicating them to interested parties.
The Framework identifies the concepts that underpin general-purpose financial statements
which are prepared and presented at least annually and are intended to serve the needs of a
wide range of external users. The main purposes of the Framework are as follows:
 To assist in the development of future international standards and review of existing
standards
 To provide a basis for reducing the number of alternative accounting treatments
permitted by international standards
 To assist national standard-setters in developing national standards
 To assist preparers of financial statements in applying international standards and in
dealing with topics which are not yet covered by international standards
 To assist auditors in forming an opinion as to whether financial statements conform
with international standards
  To assist users of financial statements in interpreting the information contained in
financial statements prepared in accordance with international standards.
The Framework deals with:
 The objective of financial statements;
 The qualitative characteristics that determine the usefulness of information in financial
statements;
 Recognition, Measurement, presentation and disclosure of the elements from which
financial statements are constructed; and

1.5.1 Objectives of financial reporting

What is the objective (or purpose) of financial reporting? 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 decisions about
providing resources to the entity. Those decisions involve buying, selling, or holding equity
and debt instruments, and providing or settling loans and other forms of credit. Information
that is decision-useful to capital providers (investors) may also be helpful to other users of
financial reporting who are not investors. These users need information about:
  The economic resources of the entity
 The claims against the entity
 Changes in the entity's economic resources and claims
In order to assess the entity's
 Prospect of future cash flow/return
 liquidity and solvency and
 its likely needs for additional financing
 Financial performance Let’s examine each of the elements of this objective.
The objective of financial statements
The objective of financial statements is to provide information about the financial position,
performance and changes in financial position of an entity that is useful to a wide range of
users in making economic decisions. Financial statements prepared for this purpose meet the
common needs of most users. However, financial statements do not provide all the
information that users may need to make economic decisions since they largely portray the
financial effects of past events and do not necessarily provide non-financial information.
1.1.1 Qualitative characteristics of financial reports
Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users. They are classified in to two. Fundamental qualities and enhancing
qualities
Fundamental Qualitative characteristics
Financial information must be both relevant and faithfully represented if it is to be useful
It is generally agreed that relevance and faithful representations are two fundamental qualities
that make accounting information useful for decision making. Each of these qualities is
achieved to the extent that information incorporates specific capabilities (ingredients)
A. Relevance
Relevant information is capable of making a difference in the decisions made by users. To be
relevant information must have predictive and confirmatory value.
predictive value, means that the financial information can be used as an input to processes
employed by users to predict future outcomes. (input to process to predict future cash flows)
confirmatory value, means that the financial information provides feedback about (i.e.
confirms or changes) (confirm/disconfirm prior cash flow expectations)
B. Faithful Representation
Faithful representation means that the numbers and descriptions match what really existed or
happened. To be a faithful representation information must be:
1. Complete - including all necessary descriptions and explanations
2. Neutral - depiction is without bias in the selection or presentation of financial
information
3. Free from error - means there are no errors or omissions in the description of the
phenomenon and in the process by which the financial information was produced.
Enhancing Qualitative Characteristics
The enhancing qualitative characteristics enhance the usefulness of information that is
relevant and faithfully represented. However, they cannot make information useful if that
information is irrelevant or not faithfully represented. They may also help to determine which
of two ways should be used to depict an economic phenomenon if both are considered equally
relevant and faithfully represented. Enhancing qualitative characteristics should be
maximized to the extent possible. However, one enhancing qualitative characteristic may have
to be diminished in order to maximize another qualitative characteristic.
A. Comparability - that enables users to identify and understand similarities in, and
differences among, items. Information about a reporting entity is more useful if it can
be compared with similar information about other entities and with similar information
about the same entity for another period or date
B. Verifiability - different knowledgeable and independent observers could reach
consensus that a particular depiction is a faithful representation.
C. Timeliness - Timeliness means having information available to decision-makers in
time to be capable of influencing their decisions. Generally, the older information is
the less useful it is.
D. Understandability Classifying, characterizing and presenting information clearly and
concisely makes it understandable.
1.5.3 Elements of financial statements of business enterprise
Financial statements portray the financial effects of transactions and other events by grouping
them into broad classes according to their economic characteristics. These broad classes are
termed the elements of financial statements. The elements directly related to the measurement
of financial position in the balance sheet are assets, liabilities and equity. The elements
directly related to the measurement of performance in the income statement are income and
expenses. The statement of changes in financial position usually reflects income statement
elements and changes in balance sheet elements; accordingly, this Framework identifies no
elements that are unique to this statement.
 An asset is a resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity.
 A liability is a present obligation of the entity arising from past events, the settlement
of which is expected to result in an outflow from the entity of resources embodying
economic benefits. Obligations may be legally enforceable as a consequence of a
binding contract or statutory requirement. Obligations also arise, however, from
normal business practice, custom and a desire to maintain good business relations or
act in an equitable manner. Constructive obligation
 Equity is the residual interest in the assets of the entity after deducting all its
liabilities.
 Income is increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases of liabilities that result in increases in
equity, other than those relating to contributions from equity participants.
 Expenses are decreases in economic benefits during the accounting period in the form
of outflows or depletions of assets or incurrence of liabilities that result in decreases in
equity, other than those relating to distributions to equity participants.
The definition of income encompasses both revenue and gains. Revenue arises in the course
of the ordinary activities of an entity and is referred to by a variety of different names
including sales, fees, interest, dividends, royalties and rent.
Gains represent other items that meet the definition of income and May, or may not, arise in
the course of the ordinary activities of an entity. Gains represent increases in economic
benefits and as such are no different in nature from revenue. Hence, they are not regarded as
constituting a separate element in this Framework.
Gains include, for example, those arising on the disposal of non-current assets.
The definition of income also includes unrealized gains; for example, those arising on the
revaluation of marketable securities and those resulting from increases in the carrying amount
of long-term assets. When gains are recognized in the income statement, they are usually
displayed separately because knowledge of them is useful for the purpose of making
economic decisions. Gains are often reported net of related expenses.
The definition of expenses encompasses losses as well as those expenses that arise in the
course of the ordinary activities of the entity. Expenses that arise in the course of the ordinary
activities of the entity include, for example, cost of sales, wages and depreciation. They
usually take the form of an outflow or depletion of assets such as cash and cash equivalents,
inventory, property, plant and equipment.
Losses represent other items that meet the definition of expenses and may, or may not, arise in
the course of the ordinary activities of the entity. Losses represent decreases in economic
benefits and as such they are no different in nature from other expenses. Hence, they are not
regarded as a separate element in this Framework.
Losses include, for example, those resulting from disasters such as fire and flood, as well as
those arising on the disposal of non-current assets. The definition of expenses also includes
unrealized losses, for example, those arising from the effects of increases in the rate of
exchange for a foreign currency in respect of the borrowings of an entity in that currency.
When losses are recognized in the income statement, they are usually displayed separately
because knowledge of them is useful for the purpose of making economic decisions. Losses
are often reported net of related income.
1.5.4 Recognition, measurement, and disclosure concepts
• Recognition is the process of incorporating in the balance sheet or income statement
an item that meets the definition of an element and satisfies the criteria for recognition.
It involves the depiction of the item in words and by a monetary amount and the
inclusion of that amount in the balance sheet or income statement totals. Items that
satisfy the recognition criteria should be recognized in the balance sheet or income
statement. Items which meet the definition of assets or liabilities may still not be
recognized in financial statements because they must also meet certain recognition
criteria.
The failure to recognize such items is not rectified by disclosure of the accounting policies
used nor by notes or explanatory material.
An item that meets the definition of an element should be recognized if:
a) It is probable that any future economic benefit associated with the item will flow to or
from the entity; and
 b) The item has a cost or value that can be measured with reliability.
Measurement of the elements of financial statements
• Measurement is the process of determining the monetary amounts at which the
elements of the financial statements are to be recognized and carried in the statement
of financial position and statement of profit and loss. This involves the selection of the
particular basis of measurement. A number of different measurement bases (models)
are employed to different degrees and in varying combinations in financial statements.
Measurement can be classified in to Initial Measurement and subsequent measurement
Initial Measurement includes, Historical Cost, Fair value, Others
Subsequent Measurement
A number of different measurement bases are used in financial statements. They include:
Historical cost, Cost model/modified historical cost, Fair value, Modified fair
value/Revaluation model, Net Realizable value, Present value of future cash flows
And Value in use
A. Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or
the fair value of the consideration given to acquire them at the time of their
acquisition. Liabilities are recorded at the amount of proceeds received in exchange
for the obligation, or in some circumstances (for example, income taxes), at the
amounts of cash or cash equivalents expected to be paid to satisfy the liability in the
normal course of business. Cost includes all costs directly attributable to bringing an
asset to the location and condition necessary for it to be capable of operating as
intended by management, including: (a) its purchase price, including import duties
and non-refundable purchase taxes, after deducting trade discounts and rebates.
• (b) any costs directly attributable to bringing the asset to the location and condition
necessary for it to be capable of operating in the manner intended by
management. They include, The cost of site preparation, Initial delivery and handling
costs, Installation and assembly costs, Testing (whether the asset is functioning
properly), Professional fees (architects, engineers) obligations incurred for
dismantling, removing and restoring the site, qualifying borrowing, costs of converting
raw material into finished goods (including an production allocation of fixed
overheads
 B. Cost Model. Carry the asset at its cost less depreciation and any accumulated
impairment loss. Cost model = Cost – Acc Depn – Acc Impairment
After initial measurement the historical cost of an asset may be modified to reflect, when
relevant: the consumption of its service potential (called depreciation or, if an intangible
asset, amortisation); and that part of the historical cost of the asset is no longer
recoverable because of impairment due to, for example deterioration of the asset quality;
or a decline in its economic value

C. The fair value model: the price that would be received to sell an asset (exit price) in an
orderly transaction (not a forced sale) between market participants (market-based
view) at the measurement date (current price) (IFRS 13 Fair Value Measurement)
The market value of an asset is: the amount for which the asset could be exchanged
between knowledgeable, willing parties in an arm’s length transaction
D. Revaluation Model: Carry the asset at its fair value at the date of the revaluation less
any subsequent accumulated depreciation and subsequent accumulated impairment
losses. Revaluation model = Fair Value – Acc Depn – Acc Impairment the
revaluation model is available only for items whose fair value can be measured
reliably
E. Present value. Assets are carried at the present discounted value of the future net cash
inflows that the item is expected to generate in the normal course of business.
Liabilities are carried at the present discounted value of the future net cash outflows
that are expected to be required to settle the liabilities in the normal course of
business.
Basic Assumptions
Statements of financial Accounting concepts No5 addresses four basic environmental
assumptions that significantly affect the recording, measuring, and reporting of accounting
information. They are:
1. Business entity Assumption – Accounting deals with specific, identifiable business
entities, each considered an accounting unit separate and apart from its owners and
from other entities. A corporation and its stockholders are separate entities for
accounting purposes. Also partnership and sole proprietorships are treated as separate
from their owners, although this separation does not hold true in a legal sense.
 Under the business entity assumption, all accounting records and reports are
developed from the viewpoint of a single entity, whether it is a proprietorship, a
partnership, or a corporation. The assumption is that an individual’s transactions are
distinguishable from those of the business he or she might own.
2. Going – Concern (continuity) Assumption –under this assumption the business entity
in question is expected not to liquidate but to continue operations for the foreseeable
future. That is , it will stay in business for a period of time sufficient to carry out
contemplated operations, contracts and commitments. This non liquidation
assumption provides a conceptual basis for many of the classifications used in
account. Assets and liabilities, for example, are classified as either current or long
term on the basis of this assumption. If continuity is not assumed, the distinction
between current and long – term loses its significance, all assets and liabilities become
current. Continuity supports the measurement and recording of assets and liabilities at
historical cost.
3. Unit - of – measure Assumption – It states that the results of a business’s economic
activities are reported in terms of a standard monetary unit throughout the financial
statements. Money amounts are the language of accounting – the common unit of
measure (yardstick) enables dissimilar items, such as the cost of a ton of coal and an
account payable, to be aggregated into a single total. Example, the unit of measure in
the United States is the dollar; in Japan it is the yen, in Ethiopia it is the birr.
Unfortunately, the use of a standard monetary unit for measurement purposes poses a
dilemma unlike a yardstick, which is always the same length, a currency experiences
change in value. During periods of inflation (deflation) dollars of different values are
accounted for without regard to the fact that some have greater purchasing power than
others.
4. Time – period Assumption. The operating results of any business enterprise can’t be
known with certainty until the company has completed its life span and ceased doing
business. In the meantime, external decision makers require timely accounting
information to satisfy their analytical needs. To meet their needs, the time period
assumption requires that changes in a business’s financial position be reported over a
series of shorter time periods.
 The time – period assumption recognizes both those decision makers’ need timely
financial information and that recognition of accruals and deferrals is necessary for reporting
accurate information. If a demand for periodic reports didn’t exist during the life span of a
business, accruals and deferrals would not be necessary.
Basic Principles:
Accounting principles assist in the recognition of revenue, expense, gain, and loss items for
financial statement reporting purposes. Income is defined as revenues plus gains minus
expenses and losses. The cost principle, the revenue principle, and the matching concept are
employed in practice in the process of determining income.
The four principles are
1. The cost principle: Normally applied in conjunction with asset acquisitions, the cost
principle specifies that the actual acquisition cost be used for initial accounting recognition
purposes. The cash – equivalent cost of an asset is used if the asset is acquired via some
means other than cash.
The cost principle assumes that assets are acquired in business transactions conducted at
arm’s length, that is, transactions between a buyer and a seller at the fair value prevailing at
the time of the transaction. For non – cash transactions conducted at arm’s length the cost
principle assumes that the market value of the resources given up in a transaction provides
reliable evidence for the valuation of the item acquired.
When an asset is acquired as a gift, in exchange for stock, or in an exchange of assets,
determining a realistic cost basis can be difficult. In these situations the cost principle
requires that the cost basis be based on the market value of the assets given up or the market
value of the asset received, which ever value is more reliably determined at the time of the
exchange.
When an asset is acquired with debt, such as with a note payable given in settlement for the
purchase, the cost basis is equal to the present value of the debt to be paid in the future.
2. The revenue realization principle: This principle requires the recognition and reporting
of revenues in accordance with accrual basis accounting principles. Applying the revenue
principle requires that all four of the recognition criteria – definition, measurability, reliability
and relevance must be met. More generally, revenue is measured as the market value of the
resources received or the product or service given, whichever is the more reliably
determinable.
The revenue principle pertains to accrual basis accounting, not to cash basis accounting.
Therefore, completed transactions for the sale of goods or services on credit usually are
recognized as revenue for the period in which the cash is eventually collected. Furthermore,
related expenses are matched with these revenues.
3. The matching Principle: Like the revenue principle, the matching principle is predicated
on accrual basis accounting, but matching refers to the recognition of expenses. The principle
implies that all expenses incurred in earning the revenue recognized for a period should be
recognized during the same period. If the revenue is carried over (deferred) for recognition to
a future period, the related expenses should also be carried over or deferred since they are
incurred in earning that revenue.
Application of the matching principle requires carrying on the books as asset outlays that
under cash basis accounting would be expensed at the time cash is disbursed. These
expenditure are for fixed assets, materials, purchased services and the like that are used to
earn future revenue. Only later, when the revenue is recognized, would the asset accounts be
expensed. In this way revenues and related expenses would be matched across accounting
period.
4. FULL – Disclosure Principle: This principle stipulates that the financial statements report
all relevant information bearing on the economic affairs of a business enterprise. Many items,
such as executor contracts, fail to meet the recognition criteria but must still be disclosed for
relevance and complete reporting.
Additionally, the full – disclosure principle stipulates that the primary objective is to report
the economic substance of a transaction rather than merely its form. This means that
substance should not be blurred by the way the transaction is presented. The aim of full
disclosure is to provide external users with the accounting information they need to make
informed investment and credit decisions. Full disclosure requires that the accounting
policies followed be explained in the notes to the financial statements. Accounting
information may be reported in the body of the financial statements, in disclosure notes to
these statements, or in supplementary schedules and other presentation formats for events that
fail to meet the recognition criteria.
Constraints Consistency in the application of accounting principles and uniformity of
accounting practice within the profession may not be achievable in all cases. Exceptions to
GAAP are allowed in special Situations categorized according to four constraints:
1. Cost –Benefit Constraint: Underlying the cost – benefit constrain is the expectation that
the benefits derived by external users of financial statements should outweigh the costs
incurred by the preparers of the information. Although it is admittedly difficult to quantify
these benefits and costs, the FASB often attempts to obtain information from preparers on the
costs of implementing a new reporting requirement. It does not, however, try to estimate
indirect costs, such as the cost of any altered allocation of resources in the economy. The cost
– benefit determination is essentially a judgment call.
2. Materiality Constraint: Materiality is defined as “the magnitude of an omission or
misstatement of accounting that, in the light of surrounding circumstances, makes it probable
that the judgment of a reasonable person relying on the information would have been changed
or influenced by the omission or misstatement”
The materiality constraint is also called a threshold for recognition. The assumption is that the
omission or inclusion of immaterial facts is not likely to change or influence the decision of a
rational external user. However, the materiality threshold does not mean that small items and
amounts do not have to be accounted for or reported. For example, Fraud is an important
event regardless of the size of the amount.
Materiality judgments are situation specific. An amount considered immaterial in one
situation might be material in another. The decision depends on the nature of the item, its birr
amount and the relationship of the amount to the total amount of income, expenses, assets, or
liabilities, as the case may be. Because materiality matters tend to be case – by – case
judgments, the FASB has not specified general materiality guidelines.
3. Industry peculiarities: One of the overriding concerns of accounting is that the
information in financial statements be useful. The problem is that certain types of accounting
information might be critical for decision making in one industry setting but not in another.
Basically, every industry has its own way of doing things, its own business practices. Under
the industry peculiarities constraint, selective exceptions to GAAP are permitted, provided
there is a clear precedent in the industry., Precedent is based on the uniqueness of the
situation, the usefulness of the information involved, preference of substance over form, and
any possible compromise of representational faith-fullness.
4. Conservatism: The conservatism constraint holds that when two alternative accounting
methods are acceptable and both equally satisfy the conceptual and implementation principles
set out by the FASB, alternatives having the less favorable effect on net income or total assets
are preferable. The reasoning is that investors prefer information that does not unnecessary
raise expectations.
Conservatism assumes that when uncertainty exists, the users of financial statements are
better served by under –statement of net income and assets. Prime examples include valuing
inventories at the lower of cost or current market and minimizing the estimated service life
and residual value of depreciable assets.
1.6 IFRS-based Financial Statements (IAS 1)
An entity’s financial statements consist of the following components (IAS 1.10):
 A statement of financial position (balance sheet).
 a single statement of comprehensive income (one statement approach), or a separate
income statement and a statement of comprehensive income (two statement approach).
 A statement of changes in equity.
 A statement of cash flows.
 Notes to the financial statements: The notes contain information supplementary to
that which is presented in the other components of the financial statements
1. statement of profit or loss and other comprehensive income
The entity is required to present a statement of profit or loss consisting of: revenue; gains
and losses arising from the de-recognition of financial assets measured at amortized cost;
finance costs; share of the profit or loss of associates and joint ventures accounted for
using the equity method; if a financial asset is reclassified so that it is measured at fair value,
any gain or loss arising from a difference between the previous carrying amount and its fair
value at the reclassification date (IFRS 9); tax expense; a single amount for the total of
discontinued operations ( IFRS 5).
The components of other comprehensive income include:
changes in revaluation surplus ( IAS 16 Property, Plant and Equipment and IAS 38 Intangible
Assets); gains and losses arising from translating the financial statements of a foreign
operation ( IAS 21 The Effects of Changes in Foreign Exchange Rates); gains and losses from
investments in equity instruments measured at fair value through other comprehensive
income.
Statement of Financial Position (Balance Sheet)
Apart from an exception that is generally relevant only for financial institutions, current and
non-current assets and current and non-current liabilities have to be presented as separate
classifications in the statement of financial position (IAS 1.60). Deferred tax assets and
deferred tax liabilities must not be classified as current
Assets and liabilities are classified as current when one of the following conditions is met
It is expected to realize the asset or intended to sell or consume it during the normal operating
cycle. In the case of a liability, it must be expected to settle the liability in the normal
operating cycle.
The asset or liability is held primarily for the purpose of trading.
It is expected to realize the asset or the liability is due to be settled within 12 months after the
reporting period. In the case of a liability, it is sufficient if the creditor has the right to demand
settlement within 12 months after the reporting period, even if this is not expected.
The asset is cash or a cash equivalent In the case of a manufacturing company, the operating
cycle is the time between the acquisition of materials that are processed during production,
and the realization of the finished goods in cash or cash equivalents. Sometimes (e.g. in the
building industry), the operating cycle may be longer than 12 months. When the normal
operating cycle of an entity is not clearly identifiable, it is assumed to be 12 months (IAS 1.68
and 1.70).
The statement of cash flows classifies cash receipts and cash payments by operating,
investing, and financing activities. Transactions and other events characteristic of each kind of
activity is as follows.
1. Operating activities involve the cash effects of transactions that enter into the
determination of net income, such as cash receipts from sales of goods and services,
and cash payments to suppliers and employees for acquisitions of inventory and
expenses.
2. 2.Investing activities generally involve long-term assets and include (a) making and
collecting loans, and (b) acquiring and disposing of investments and productive long-
lived assets.
3. Financing activities involve liability and stockholders’ equity items and include (a)
obtaining cash from creditors and repaying the amounts borrowed, and (b) obtaining
capital from owners and providing them with a return on, and a return of, their
investment.
FORMAT OF THE STATEMENT OF CASH FLOWS The three activities we discussed
above constitute the general format of the statement of cash flows. The operating activities
section always appears first. It is followed by the investing activities section and then the
financing activities section.
A company reports the individual inflows and outflows from investing and financing
activities separately. That is, a company reports them gross, not netted against one another.
Thus, a cash outflow from the purchase of property is reported separately from the cash
inflow from the sale of property. Similarly, a cash inflow from the issuance of debt is reported
separately from the cash outflow from its retirement.
The net increase or decrease in cash reported during the period should reconcile the beginning
and ending cash balances as reported in the comparative balance sheets. The general format of
the statement of cash flows presents the results of the three activities discussed previously–
operating, investing, and financing.
Illustration shows a widely used form of the statement of cash flows.