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.
International Accounting Standard Board (IASB) and IFRS
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. If
so where shall Ethiopia rely on?

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)
Rules-based accounting standards versus 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 ob IFRS 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.
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;
 The definition, recognition and measurement of the elements from which financial
statements are constructed; and
 Concepts of capital and capital maintenance.
jectives-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
o 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. 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.
Underlying assumptions
a. Accrual basis
In order to meet their objectives, financial statements are prepared on the accrual basis of
accounting. Under this basis, the effects of transactions and other events are recognized when
they occur (and not as cash or its equivalent is received or paid) and they are recorded in the
accounting records and reported in the financial statements of the periods to which they relate.
Financial statements prepared on the accrual basis inform users not only of past transactions
involving the payment and receipt of cash but also of obligations to pay cash in the future and of
resources that represent cash to be received in the future. Hence, they provide the type of
information about past transactions and other events that is most useful to users in making
economic decisions.
b. Going concern
The financial statements are normally prepared on the assumption that an entity is a going
concern and will continue in operation for the foreseeable future.
Hence, it is assumed that the entity has neither the intention nor the need to liquidate or curtail
materially the scale of its operations; if such an intention or need exists, the financial statements
may have to be prepared on a different basis and, if so, the basis used is disclosed.
1.2 Qualitative characteristics of accounting information
Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users.
Primary Qualities

It is generally agreed that relevance and reliability are two primary 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
Relevance is the capacity of accounting information to make a difference to the external decision
makers who use financial reports. If certain information is disregarded because it is perceived to
have no bearing on a decision, it is irrelevant to that decision.

Relevance can be evaluated according to three qualitative criteria,

1. Timeliness – means available to decision makers before it loses its capacity to influence
their decisions. Accounting information should be timely if it is to influence decisions,
like the news of the world; state financial information has less impact than fresh
information.
2. Predictive value – Accounting information should be helpful to external decision makers
by increasing their ability to make predictions about the outcome of future events.
Decision makers working from accounting information that has little or no predictive
value are merely speculating. For example, information about the current level and
structure of asset holdings help users to assess the entity’s ability to exploit opportunities
and react to adverse situations
3. Feedback value: Accounting information should be helpful to external decision makers
who are confirming past predictions or making updates, adjustments, or corrections to
predictions.
B. Reliability
Reliability means that users can depend on accounting information to represent the underlying
economic conditions or events that it purports to represent. Reliability of information is a
necessity for individuals who have neither the time nor the expertise to evaluate the factual
content of financial statements. It is especially important to the independent audit process. Like
relevance, reliability must meet three qualitative criteria.

1. Representational faithfulness – Accounting information should represent what it purports

to represent and should ensure that the selected method of measurement has been used
without error or bias. This attribute is sometimes called Validity: - Information must
give a faithful picture of the facts and circumstances involved. Accounting information
must report the economic substance of transactions, not just their form and surface
appearance.
2. Verifiability:- Verifiability pertains to maintenance of audit trials to information source
documents that can be checked for accuracy. It also pertains to the existence of
alternative information sources as backing. Verification implies a consensus and implies
that independent measures using the same measurement methods would reach
substantially the same conclusions.
3. Neutrality: - Accounting information must be free from bias regarding a particular view
point, predetermined result, or particular party. Preparers of financial reports must not
attempt to induce a predetermined outcome or a particular mode of behavior (such as to
purchase a company’s stock). Accounting information cannot be selected to favor one set
of interested parties over another. It should be factual and truthful.
Secondary Qualities
The potential use of different acceptable methods by one enterprise in different years, or by
different companies in a given year, would make comparison of financial results difficult
consequently, in order to enhance the usefulness of accounting reports, the qualities of
comparability and consistency are components of the conceptual framework. They are
considered to be secondary in our hierarchy to the qualities of relevance and reliability. If
information is to be useful, it must first be relevant and reliable, but achieving these primary
qualities may require foregoing the secondary qualities. Ideally, financial accounting
information would satisfy both qualitative levels

A. Comparability: - Information that has been measured and reported in a similar manner for
different enterprise in a given year, or for the same enterprise in different years, is considered
comparable. Thus, comparability is a characteristic of the relationship between two pieces of
information rather than of a particular piece of information in itself. Comparability enables to
identify the real similarities and differences in economic phenomena because these differences
and similarities have not been obscured by the use of non-comparable methods of accounting.

B. Consistency: - This characteristic is achieved by an enterprise when it uses the same selected
accounting policies from period to period; that is, these methods are consistently applied.
Consistency results in enhancing the comparability of financial statements of an enterprise from
year to year.

Consistency doesn’t mean that a company can never switch from one method of accounting to
another. Companies can change methods, but the changes are restricted to situations in which it
can be demonstrated that the newly adopted method is preferable to the old. Then the nature and
effect of the accounting change, as well as the justification for it
1.3Elements 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.
 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

Recognition of the elements of financial statements

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.
Recognition of an item is required when all four of the following criteria are met:

i) Definition: the item in question must meet the definition of an element of financial
statements.
ii) Measurability: The item must have a relevant quality or attribute that is reliably
measurable (historical cost, current cost, market value, present value or net realizable
value).
iii) Reliability:- The accounting information generated by the item must be
representational faithful, verifiable (Subject to audit confirmation or second – Source
collaboration) and neutral (bias – free).
iv) Relevance – The accounting information generated by the item must be significant,
that is, capable of making a difference to external users in making decision.
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 balance sheet and income statement.
This involves the selection of the particular basis of measurement. A number of different
measurement bases are employed to different degrees and in varying combinations in financial
statements. They include the following:
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.
b) Current cost. Assets are carried at the amount of cash or cash equivalents that would have
to be paid if the same or an equivalent asset was acquired currently. Liabilities are carried
at the undiscounted amount of cash or cash equivalents that would be required to settle
the obligation currently.
c) Realizable (settlement) value. Assets are carried at the amount of cash or cash equivalents
that could currently be obtained by selling the asset in an orderly disposal. Liabilities are
carried at their settlement values; that is, the undiscounted amounts of cash or cash
equivalents expected to be paid to satisfy the liabilities in the normal course of business.
d) 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.