College of Business and

Economics
Department of Accounting
and Finance

Financial accounting I (AcFn 2081)

Lecture Note
 Chapter 1
Development of
Accounting Principles
and Professional Practice
 1.1. The Environment Of Accounting
• The business world is experiencing unprecedented
changes, such as
• Globalization
• Deregulation, and
• Computerization
• In middle of this change the accounting profession is
expected to provide relevant and reliable information.
• The responsibility placed on accountants is greater today
than ever before, because of
• increasing size and complexity of business enterprises
• the increasing economic role of business enterprises
 Cont…
• With in this challenges, accountants must have a logical and
consistent accounting theory.
• This theoretical structure must be realistic in terms of
• the economic environment and
• meeting the needs of users of financial statements.
• Previously, the important innovation was the idea of generally
accepted accounting principles (US GAAP).
• But it would be even better if there is one common set of
accounting rules for the whole world
• Make it easier to compare the financial results of companies from different
countries.
• Now on ward, one set of international accounting standards,
IFRS, to be used by all companies
 1.2. Conceptual framework
• It is like a constitution
• It is a coherent system of interrelated objectives and
fundamentals
• It can lead to consistent standards and that prescribes the financial
accounting and financial statements:
• Nature,
• Function, and
• Limits
• Over the years, numerous organizations developed and published
their own conceptual frameworks.
• But no single framework was universally accepted and relied on
in practice.
 Cont…
• The FASB in 1976 issued a massive three part Discussion
Memorandum entitled
• Conceptual Framework for Financial Accounting and Reporting:
• Elements of Financial Statement and
• Their Measurement.
• The FASB has issued six Statements of Financial Accounting Concepts
(SFAC) that relate to business enterprises.
• SFAC No 1. “Objectives of Financial Reporting by Business Enterprises”
• SFAC No.2. “Qualitative Characteristics of Accounting Information,"
• Examines the characteristics that make accounting information useful.
• SFAC No.3. “Elements of Financial Statements of Business Enterprises,"
• Providing definition of items in financial statements.
• SFAC No.5. "Recognition and Measurement in Financial Statement of Business
Enterprises,”
 Cont…
• SFAC No.6: “Elements of Financial Statements", replaces SAFC No.3
and expands its scope to include NFP organizations.
• SFAC No. 7: “Using Cash Flow Information and Present Value in
Accounting Measurements,”
The FASB also issued SFAC No. 4: “Objectives of Financial
Reporting by Non-business Organizations,”
 FASB Vs IFRS
US GAAP: FASB iGAAP (IFRS)

Simpler and less stringent in

More detailed its accounting and disclosure
requirements

Focus on investors and

creditors Focus on investors, creditors
and also used to evaluate
management’s performance
(stewardship)
 Conceptual framework

Organized in a similar
manner

IFRS FASB

Makes two assumptions:

• Financial statements prepared Accrual accounting does not
on accrual basis; identify it as an assumption, and
• Reporting entity is a going it only briefly discusses the going
concern. concern concept.
 Income statement and related information

• Under iGAAP, companies must classify expenses by either nature or

function.
• Nature: salaries, depreciation expense, utilities expense, and so on.
• Function: administration, distribution, and manufacturing.
• If a company uses the functional classification, disclosure by nature is
required.
• Presentation of the income statement under U.S. GAAP follows either
• a single-step or
• multiple-step format

• But any approach is not mentioned in iGAAP

• Under U.S. GAAP, companies must report an item as extraordinary if it is
unusual in nature and infrequent in occurrence
• But prohibited under iGAAP.
 Cont…
• Under iGAAP, companies are required to prepare as a primary financial
statement either
• a statement of stockholders’ equity or
• a statement of recognized income and expense (called a SoRIE).
• Both iGAAP and U.S. GAAP have items that are recognized in equity as
part of comprehensive income but do not affect net income.
• U.S. GAAP provides three possible formats for presenting this information:
• single income statement,
• combined income statement of comprehensive income,
• the statement of stockholders’ equity.
• iGAAP allows either the statement of stockholders’ equity approach or the
SoRIE format.
• Under iGAAP revaluation of land, buildings, and intangible assets is
permitted.
 Statement of Cash flows

Both GAAP
specify that the
cash flows must
be classified as:

Operating
Investing

Financing
 Balance sheet
iGAAP US GAAP

• iGAAP requires that specific • No such general standard exists

items be reported on the balance in U.S. GAAP.
sheet. • However, public companies must
• Report property, plant, and follow SEC regulations*, which
equipment first in the balance require specific line items.
sheet. • Mandate certain forms of
• There is no prohibition for reporting balance sheet
reporting reserve information.
• Use of the term “reserve” is
discouraged

*SEC: Security exchange council

 Cont…
Both specifies minimum
• Accounting policies
note disclosures on: • Judgments
• Assumptions and estimation
Similarities

Comparative prior-period information must be

presented and financial statements must be prepared
annually.

Current/noncurrent classification for assets and

liabilities is normally required.
 Cash and receivables
• The accounting and reporting related to cash is the same under
both iGAAP and U.S. GAAP.
• In addition, the definition used for cash equivalents is the same.
• Recognition and measurement of receivables are essentially the
same between iGAAP and U.S. GAAP.
• the use of allowance accounts
• how to record trade and sales discounts,
• use of percentage-of-sales and receivables methods,
• pledging and
• factoring
 Cont…
• iGAAP implies that receivables with different characteristics
should be reported separately
• There is no standard that mandates this segregation under US
GAAP.
• In addition, there is no specific standard related to pledging,
assignment, or factoring.
• Both worked to implement fair value measurement for all
financial instruments,
• but both Boards have faced bitter opposition from various
factions.
 Cont …
• As a consequence, the Boards have adopted a piecemeal approach
in which:
• disclosure of fair value information in the notes is the first step.
• The second step is the fair value option which permits companies to
record fair values in the financial statements.
• iGAAP and U.S. GAAP standards on the fair value option are
similar but not identical.
• IFRS is subject to certain qualifying criteria but not in US GAAP
• Some difference in the financial instruments covered
 Cont…
• iGAAP and U.S. GAAP differ in the criteria used to
derecognize a receivable.
• iGAAP is a combination of an approach focused on risks and
rewards and loss of control and permits partial derecognition

• U.S. GAAP uses loss of control as the primary criterion and

does not permit derecognition.
 Inventory
• iGAAP and U.S. GAAP are the same in recognition of
• Who owns the goods—goods in transit,
• consigned goods,
• special sales agreement and
• costs to include in inventory.
 Cont…
US GAAP
• It has more detailed rules related
to the accounting for inventories
• Permits the use of LIFO for
inventory valuation.
• Certain agricultural products and
mineral products can be reported
at net realizable value.
iGAAP
• It is more principles-based.
• It prohibits the use of LIFO.
• Unlike property, plant, and
equipment, it does not permit the
option of valuing inventories at
fair value.
• Certain agricultural products and
mineral products can be reported
at net realizable value.
 Cont…
LCM test for inventory valuation,
iGAAP US GAAP
• Defines market as net realizable value. • Defines market as replacement cost
• Does not use a ceiling or a floor to subject to the constraints the ceiling and
determine market.
the floor.
• The write-down may be reversed in a
subsequent period up to the amount of • If inventory is written down, the new
the original cost.
basis is now considered its cost.
• Both the write-down and any
subsequent reversal should be reported • As a result, the inventory may not be
on the income statement.
written back up to its original cost in a
subsequent period.
 1.3. Objectives of financial reporting

FASB issued SFAC No.1, “Objectives of Financial Reporting by

Business Enterprises”:
• FR should provide information for making rational investment,
credit, and similar decisions.
• FR should be helpful to assessing the amount, timing, and
uncertainty of future cash flows such as dividends or interest
payments.
• FR should provide information about the economic resources of an
enterprise, the claims, the effects of transaction, events, and
circumstances.
• FR should provide information about how management of an
enterprise has discharged its stewardship responsibility to owners
for the use of enterprise resources entrusted to it.
 1.4. Qualitative characteristics of
accounting information
• Financial information is useful if
• there is connection between it and the users and the decisions
they make.
• This link can be described as understandability
Primary qualities: Relevance and Reliability
• In SFAC No.2. “the qualities that distinguish 'better'
information are primarily:
• relevance and
• reliability
• To be relevant, accounting information must be capable of
making difference in decision.
 Cont…
Feedback value
•Helps users confirm or correct
prior expectations;

Predictive value Timeliness

Predict the ultimate outcome of Relevant Available to decision makers
past, present, and future information before it loses its capacity to
events. influence their decisions.

For information to be relevant it needs

predictive or feedback value, or
presented on a timely basis.
 Cont…
• Reliability means that users can depend on accounting
information
• to represent the underlying economic conditions or

• events that it purports to represent.

• Reliability is a necessity, because most users have neither
• the time nor
• the expertise to evaluate the factual content of the information.
 Cont…
Verifiability:
Occurs when independent measurers obtain similar results.
e.g., Several independent auditors reach the same conclusion
about a set of financial statements.

Reliability

Representational faithfulness: Neutrality:

The numbers and descriptions A company cannot select
match what really existed or information to favor one set of
happened. interested parties over another.
e.g., a company must report sales e.g., a tobacco company should not
of $225 billion when it had sales suppress information about
of $225 billion not more or less. different lawsuits
 Cont…
It is a characteristic of relationship between
two pieces of information.
Comparability
Information that has been measured and
reported in similar manner
•For different enterprises in a given year, or
•For the same enterprise in different years is considered
comparable
Secondary
qualities

It is when an entity applies the same accounting

treatments or standards to similar events.
It is needed in order that the financial
Consistency statements of successive periods will be
comparable.
 1.5. Elements of financial statements of
business enterprise
• SFAC No. 6, which replaced SFAC NO.3, defines the ten
interrelated elements
• that are most directly related to measuring the performance and
financial status of an enterprise.
1. Assets: are probable future economic benefits obtained
or controlled by a particular entity as a result of past
transactions or events.
• To qualify as assets, there are three characteristics to be fulfilled
• Have future economic benefits (be capable of producing profits).
• Be under managements control (can be freely deployed or disposed of)
• Result from past transaction
 Cont…
2. Liabilities: are probable future sacrifices of economic benefits
arising from present obligations as a result of past transactions or
events.
• to transfer assets or
• provide services to other entity's in the future
• To qualify as liabilities, obligations must:
• Require transfer of assets having future economic benefit.
• Specify to whom the asset must be transferred
• the terms,
• parties, and
• conditions under which asset transfers will take place.
• Result from past transactions.
 Cont…
3. Equity: is the residual (ownership) interest in the assets of an entity
that remains after deducting its liabilities.
• It includes:
• share capital,
• contributed surplus and
• retained earnings.
4. Investment by owners: are increases in net assets or equity of a
particular enterprise resulting from transfer from other entities.
• Assets
• Services or satisfaction or
• Conversion of liabilities of the enterprise.
 Cont…
5. Distribution to owners: are decreases in net assets and ownership
interest of a particular enterprise resulting from
• transferring assets,
• rendering services, or
• incurring liabilities by the enterprise to owners.
• They are characterized as:
• Cash dividend payments or declarations
• Transfer of assets to owners
• Liquidating distribution (asset sale proceeds)
• Conversion of equity ownership to liabilities.
6. Comprehensive Income: is the change in equity from transactions and other
events and circumstances from non-owner sources.
It includes all changes in equity during a period except those resulting from
investments by owners and distribution to owners.
 Cont…
7. Revenues: are inflows of assets of an entity or settlement
of its liabilities from:
• delivering or producing goods,
• rendering services, or
• other activities that constitute the entity ongoing major or central
operations.
• The two essential characteristics of a revenue transaction
are
• It arises from the company's primary earning activity
• Not from incidental or investment transactions
• It is recurring
 Cont…
8. Expenses: are outflows or other using up of assets or incurrence of
liabilities during a period
• It constitute the entity's ongoing major or central operations.
• Arise from:
• delivering or producing goods,
• rendering services, or
• carrying out other activities
• It must be incurred in conjunction with the company's revenue-
generating process.
• Expenditures that do not qualify as expenses must be treated
• as assets (future economic benefit to be derived),
• as losses (no economic benefit), or
• as distribution to owners.
 Cont…
9. Gains: are increases in equity from peripheral or incidental
transactions
• except those that result from revenues or investment by owners.
10. Losses: are decreases in equity from peripheral of
incidental transactions
• except those that result from expenses or distributions to owners.
 1.6. Generally accepted accounting
principles.

Economic
(business) entity

Going
concern Basic assumptions Materiality

Periodicity
 Economic (Business) Entity Assumption

• Economic activity is carried on by various legal and economic

entities.

• There are three general kinds of business entities: single

proprietorships, partnerships, and corporations.

• Regardless of the form of organization the business affairs of

the entity are distinguished from those of its owners.
 Going Concern Assumption

• It means that accounts assume that a business entity will continue to exist
indefinitely.
• That is, it will stay in business for a period of time sufficient to carry out
contemplated operations, contracts, and commitments.
• There are many business failures however, companies are begun with the hope of
a long life.
• This assumption provides the logical basis for recording:
• probable future economic benefits as assets and
• probable future outlays as liabilities
• There are times when this assumption gives way to evidence that an
enterprise has a limited life or intends to terminate operations.
• In such cases accounts prepare financial statements under the
assumption of a quitting concern.
 Periodicity Assumption

• External users need periodic information to make various

decisions.
• This need the economic life of an enterprise be divided into
artificial time periods for financial reporting.
• Accordingly, financial statements are prepared at the end of
each year and disclosed in a company’s annual report.
• Furthermore the annual reporting period is used for reports
issued to government regulators.
• The periodic assumption is the basis for the adjusting entry
process in accounting.
 Monetary unit Assumption

• Recall that to measure financial statements elements a unit or

scale of measurement must be chosen.
• Thus, the result of business economic activities are reported
interims of a standard monetary unit such as
• dollar in U.S.A.,
• pound in England,
• birr in Ethiopia and etc.

• The common unit of measure enables dissimilar items to be

aggregated in to singe total.
• One problem with this assumption is that the monetary units
are presumed to be stable over time.
• Value of money is not constant
 Cont…

Historical cost

Realization
Accounting Matching
principles

Full disclosure
 The historical cost principles
• GAAP measure asset and liabilities based on their original
transaction value, that is, their historical costs.
• For an asset this is the fair value of what is given in exchange
(usually cash) for asset at its initial acquisition.
• For liabilities it is the current cash equivalent received in
exchange for assuming the liability.
• When an asset is acquired as a gift or in exchange for
stock/assets determining a realistic cost basis can be difficult.
• Use market value of the asset given up or received which ever is more
reliably determined.
 Cont…
• When an asset is acquired with debt then present value of the
debt is used
• There are occasions where a departure from measuring an asset
based on its historical cost is warranted.
• Some assets for instance are measured at their net realizable
value.
For example, initially account receivable is recorded at $10,000,
subsequently if $2,000 in bad debts were anticipated net
receivable should be valued at $8,000.
 Realization principle
• The realization principles require that two criteria be satisfied
before revenue can be recognized.
• The earning process is judged to be complete or virtually complete
• There is reasonable certainty as to the collectivity of the asset to be
received (usually cash)
• The revenue principle is pertain accrual basis of accounting
 Matching principle
• states that expenses are recognized in the same period as the
related revenues.
• It is a good indicator of future cash generating ability.
• An expense can be recognized:
• Based on an exact cause and effect relationship between a revenue and
expense event (e.g. Cgs).
• By associating on expense with the revenues recognized in a specific
time period (e.g. Salary to employee).
• By a systematic and rational allocation to specific time period (e.g.
Allocation of rent expense, deprecation)
• In the period incurred without regard to related revenue (e.g. cost of
advertising).
 Full Disclosure principle
• It means financial reports should include any information that
could affect the decision made by external users.
• Naturally there may be accounting information not included in
the primary financial statements which benefit users.
• Off course the benefits of that information should exceed the
cost of providing the information.
 Constraints of the financial reporting

• In providing information, companies must consider two

overriding factors that limit the reporting. These constraints are:
1. Cost-Benefit Relationship
• Companies must weigh the costs of providing the information
against the benefits that can be derived from using it.
E.g. disclosures
• The difficulty is the costs and especially the benefits are not
always evident or measurable.
E.g. Cost: collecting, processing, auditing… and
Benefit: greater management control
 Cont…
2. Materiality
• It concerns that an item’s impact on a company’s overall
financial operations.
• An item is material if its inclusion or omission would influence
or change the judgment of a reasonable person.
• It is difficult to provide firm guidelines in judging when a
given item is or is not material.
• Companies and their auditors generally adopt the rule of
thumb:
• anything under 5 % of net income is considered immaterial
 Cont…
• However, the SEC indicates that a company may use this
percentage for an initial assessment of materiality, but
• it must also consider other factors. Like:
• increase management compensation, or
• hide an illegal transaction like a bribe
• The SEC also indicated that in determining materiality,
companies must consider
• each misstatement separately and
• the aggregate effect of all misstatements.
 Cont…
3. Industry Practices
• The peculiar nature of some industries and business concerns
sometimes requires departure from basic theory.
• For example, public-utility companies report noncurrent assets first on
the balance sheet to highlight the industry’s capital-intensive nature.
• Agricultural companies often report crops at fair value because it is costly
to develop accurate cost figures on individual crops.
• Whenever we find what appears to be a violation of basic
accounting theory,
• we should determine whether some peculiarity of the industry explains
the violation before we criticize the procedures followed.
 Cont…
4. Conservatism
• It means when in doubt, choose the solution that will be least
likely to overstate assets and income.
• Note that the conservatism convention does not urge that net
assets or net income be understated.
• It provide a reasonable guide in difficult situations: Refrain
from overstatement of net income and net assets.
• E.g. use of the LCM approach in valuing inventories.
 1.7. Cash flow and income measurement
Accrual basis of accounting
• An event must be recorded in
the period in which the event
occurs
• rather than in the period
cash changes hands.
• Revenues and expenses are
reported when they are earned
and incurred respectively
• It is in line with the matching
principle
Cash basis of accounting
• It is based on the timing of cash
payments and receipts.
• Revenue is recorded only when
cash is received and
• Expenses are recorded only
when cash is paid.
• It is not compatible with the
matching principle.
• It is not in conformity with
GAAP.
 Illustration 1.1
The Revenue and Expense for Model Inc. under cash basis are
given to be Br.108, 000 and 52,000 respectively for the year
ended Dec.31, 2001. Data regarding Receivables, unearned
fees, accrued expense, and prepaid expense are given below at
the beginning and end of the year.
January 1, 2001 December 31, 2001
Prepaid expense Br. 6,000 Br. 4,000
Fees receivable 6,400 7,200
Unearned fees 8,400 9,000
Accrued liabilities 3,000 2,000
Determine the amount of net income under Cash basis and
accrual basis.
 Illustration 1.2
XYZ Company maintains its accounting records on cash basis of
accounting. During year 10, XYZ collected Br. 150,000 from
its clients and paid Br. 80,000 for operating expenses. XYZ
fees receivables accrued liabilities and short term prepayments
on January 1 and on December 31, Year 10 was as follows:
Jan, 1 year 10 Dec, 31 year 10
Fees receivable -------------------------- Br 18,200 Br 37,000
Accrued liabilities --------------------------- 6,200 4,000
Short term prepayment -----------------------3,500 2,500
Required: Income under cash basis and accrual basis of
accounting for the year ended December 31, year 10.
The end