CHAPTER ONE: Introduction to Financial Accounting and the

Conceptual Frame work

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. Creditors, 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.
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 chapter concentrates on financial
accounting. Financial accounting has been 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
ORGANIZATIONS AND LAWS AFFECTING FINANCIAL ACCOUNTING
Certain professional organizations, governmental agencies, and legislature acts have been
extremely influential in shaping the development of the existing body of financial accounting
theory. Among the most important of these have been the International Accounting standards,
the financial Accounting standards in U.K., the American Institute of certified public

1
Accountants, the Association of chartered certified Accountants (ACCA) in U.K., the
American Accounting Association etc.
Awareness of the roles of these institutional forces is helpful in gaining an understanding of
current accounting principles and practices.
The International Accounting Standards Board (IASB)
The International Accounting Standards Board (Board) is the standard-setting body of the
IFRS Foundation. Selected, overseen and funded by the IFRS Foundation, the Board has
complete responsibility for technical matters, including the preparation and issuing of IFRS
Standards. The Trustees of the IFRS Foundation are responsible for governance and
oversight. A Monitoring Board provides a formal accountability link between the Trustees
and public authorities.
What is IFRS?
IFRS is a globally recognized set of Standards for the preparation of financial statements by
business entities.
IFRS is a set of globally accepted standards for financial reporting allowed primarily by listed
entities in over 130 countries.

The overriding requirement of IFRS is for the financial statements to give a fair presentation
(or a true and fair view).
Individual standards and interpretations are developed and maintained by the IASB and the
IFRS interpretations committee.
 IFRS is designed for use by profit-oriented entities

 Those Standards prescribe:

 the items that should be recognized as assets, liabilities, income and expense
 how to measure those items;
 How to present them in a set of financial statements; and related disclosures about
those items.
Principles-Based vs. Rules-Based Standards

IFRS are referred to as being principles-based standards

 There is continued support for the objective of a single set of high-quality, globally
accepted accounting standards.

2
  Provide core principles (objectives) with minimum guidance.
 They are more loosely framed, allowing for professional judgment to be applied
 The judgments are expected to be consistent with clear conceptual framework
 Some argue that allowing professional judgment introduces bias

US GAAP are referred to as being rules-based standards:

 They are more prescriptive
 Provide a rule for every situation
 Body of knowledge too large and complicated
Difference between IFRS and US GAAP
 Great strides have been made by the FASB and the IASB to converge the content of
IFRS and U.S. GAAP.
 Inventory costing method
 US GAAP allows LIFO method
 IFRS doesn’t allow LIFO method
 Reversal of inventory write-downs
 US GAAP doesn’t allow
 IFRS allows
 Valuation of property, plant, and equipment
 U.S.GAAP: Cost less accumulated depreciation
 IFRS: Cost less accumulated depreciation (or) fair value(revaluation)
 Valuation of intangible assets
 U.S GAAP: Cost less accumulated amortization. Revaluation prohibited
 IFRS: Cost less accumulated amortization (or) fair value(revaluation)

Why IFRS?
 Investors are acting on a global market !!
 National standards don’t work on a global market
 Cross boarder business is hindered by national standards

Benefits of IFRS
 Credibility of local market to foreign investors
 More cross-border investment

3
  Comparability across political boundaries
 Facilitates global education and training
 Lower cost of capital
 Facilitates raising capital abroad
 One set of books + easier consolidation
 Better understanding of financial statements from business partners abroad

IFRS Adoption
 More than 110 countries
 International support to have global accounting standards
 G20 , WB , IMF , International Organization of Securities Commissions and
International Federation of Accountants

The Conceptual Framework

The search for a conceptual framework
Conceptual Framework is a statement of generally accepted theoretical principles which
form the frame of reference for financial reporting. It sets out the concepts that underlie the
preparation and presentation of financial statements.
The Conceptual Framework distinguishes between fundamental and enhancing qualitative
characteristics, for analysis purposes. Fundamental qualitative characteristics distinguish
useful financial reporting information from information that is not useful or that is misleading.
Enhancing qualitative characteristics distinguish more useful information from less useful
information.

a. FIRST LEVEL
OBJECTIVES OF FINANCIAL STATEMENTS
The objective of financial statements is to provide information about the financial position
(balance sheet), performance (income statement), and changes in financial position (cash
flow statement) of an entity; this information should be useful to a wide range of users for the
purpose of making economic decisions, focusing on users who cannot dictate the information
they should be getting.

4
The objective of general-purpose financial reporting is to provide financial information about
the reporting entity that is useful to existing and potential investors, lenders, and other
creditors in making decisions about providing resources to the entity.

b. SECOND LEVEL
QUALITATIVE CHARACTERISTICS OF FINANCIAL REPORTING
1. The fundamental qualitative characteristics
If financial information is to be useful, it must be relevant and faithfully represent what it
purports to represent (i.e. fundamental qualities). Financial information without both
relevance and faithful representation is not useful, and it cannot be made useful by being more
comparable, verifiable, timely or understandable.
 Relevance: Relevant information is capable of making a difference in the decisions made
by users. It is capable of making a difference in decisions if it has predictive value,
confirmatory value or both.
 Predictive value (input to predict future cash flows): 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.
 confirmatory value (confirm/disconfirm prior cash flow expectations): Accounting
information should be helpful to external decision makers who are confirming past
predictions or making updates, adjustments, or corrections to predictions.
 Materiality: Materiality is an entity specific aspect of relevance based on the nature
or magnitude, or both, of the items to which the information relates in the context of
an individual entity’s financial report. Consequently, an entity need not apply its
accounting policies to immaterial items; and disclose immaterial information.
 Faithful representation: Financial reports represent economic phenomena in words and
numbers. To be useful, financial information must not only represent relevant phenomena
but must faithfully represent the phenomena that it purports to represent.
 Completeness: A complete depiction includes all information necessary for a user to
understand the phenomenon being depicted, including all necessary descriptions and
explanations.

5
  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 this
means that information must not be manipulated in any way in order to influence the
decisions of users.
 Free from error: Free from error means there are no errors or omissions in the
description of the phenomenon and no errors made in the process by which the
financial information was produced. It does not mean that no inaccuracies can arise,
particularly where estimates have to be made
2. Enhancing qualitative characteristics
 Timeliness:
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.
 Understandability: Classifying, characterizing and presenting information clearly and
concisely make it understandable. Some phenomena are inherently complex and cannot
be made easy to understand. Excluding information about those phenomena from financial
reports might make the information in those financial reports easier to understand.
However, those reports would be incomplete and therefore potentially misleading.
Financial reports are prepared for users who have a reasonable knowledge of business and
economic activities and who review and analyses the information diligently. At times, even
well-informed and diligent users may need to seek the aid of an adviser to understand
information about complex economic phenomena.
 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.

6
 Comparability: Information should be presented in a consistent manner over time and in
a consistent manner between entities to enable users to make significant comparisons.
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 another date. Users’ decisions involve choosing between alternatives,
for example, selling or holding an investment, or investing in one reporting entity or
another.
ELEMENTS OF FINANCIAL STATEMENTS
An important aspect of the theoretical structure is the establishment and definition of the basic
categories of items to be included in financial statements. At present, accounting uses many
terms that have peculiar and specific meaning in the language of business. One such term is
asset. Is it something we own? If the answer is yes, can we assume that any asset leased
would never be shown on the balance sheet? Is it any thing of value used (or for which there
is a right to use) by the enterprise? If the answer is yes, then why the management of the
enterprise should not be reported as an asset? It seems necessary, therefore, to develop a
basic definitional framework for the elements of accounting. Such definitions provide
guidance for identifying what to include and what to exclude from the financial statements.
SFAC No.6 defines 10 elements of financial statements as follows:
1. Assets
Assets are probable future economic benefits obtained or controlled by a particular entity as a
result of past transactions or events. They have three essential characteristics:
a) They embody a future benefit that involves a capacity, singly or in combination
with other assets to contribute directly or indirectly to future net cash flows.
b) The entity can control access to the benefit
c) The transaction or event-giving rise to the entity’s right to, or control of, the
benefit has already occurred (result of past transactions).
2. Liabilities
Liabilities are probable future sacrifices of economic benefits arising from present obligations
of a particular entity to transfer assets or provide services to other entities in the future as
result of past transactions or events. They have three essential characteristics.

7
 a) They embody a duty or responsibility to others that entails settlement by future
transfer or use of assets, provision of services or other yielding of economic benefits,
at a specified or determinable date, on occurrence of a specified event, or on demand.
b) The duty or responsibility obligates the entity, leaving it little or no discretion to avoid
it.
c) The transaction or event obligating the entity has already occurred.
3. Equity
Equity is the residual (ownership) interest in the assets of an entity that remains after
deducting its liabilities. While equity in total is a residual, it includes specific categories of
items, for example, types of share capital, contributed surplus and retained earnings
4. Income
Income: Increase in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities those results in increases in equity, other
than those relating to contribution from equity participants.
5. Expenses
Expenses: decrease in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities those results in decreases in
equity, other than those relating to distribution to equity participants.
THIRDLEVEL: recognition, measurement and disclosure concepts
Recognition: The process of incorporating in the statement of financial position or statement
of profit or loss and other comprehensive income an item that meets the definition of an
element and satisfies the following
Criteria for recognition:
 it is probable that any future economic benefit associated with the item will flow to or
from the entity; and
 the item has a cost or value that can be measured with reliability
Measurement: 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 or loss and other comprehensive income.

8
Disclosure to compliance with IFRS: Most importantly, financial statements should present
fairly the financial position, financial performance and cash flows of an entity. Compliance
with IFRS is presumed to result in financial statements that achieve a fair presentation.
IAS 1 stipulates that financial statements shall present fairly the financial position, financial
performance and cash flows of an entity. Fair presentation requires the faithful representation
of the effects of transactions, other events and conditions in accordance with the definitions
and recognition criteria for assets, liabilities, income and expenses set out in the Conceptual
Framework.
The following points made by IAS 1 expand on this principle.
(a) Compliance with IFRS should be disclosed
(b) All relevant IFRS must be followed if compliance with IFRS is disclosed
(c) Use of an inappropriate accounting treatment cannot be rectified either by disclosure of
accounting policies or notes/explanatory material
IAS 1 states what is required for a fair presentation.
 Selection and application of accounting policies
 Presentation of information in a manner which provides relevant, reliable,
comparable and understandable information
 Additional disclosures where required

9
Summary of conceptual frame work for financial reporting

10