Financial and Management Accounting

Chapter 1: Introduction to Accounting

and Business

Course leader : Kirubel Asegdew (Asst. prof.)

Learning Objectives
After studying this chapter, you should be able to:

1. Explain the concept of accounting.

2. Identify the users and uses of accounting.
3. Identify the different characteristic of Financial and Managerial
Accounting
4. Explain the about the IFRS setting Body.
5. Explain accounting standards and the measurement principles
(IFRS).
6. State the accounting equation, and define its components
 1.1. The nature of a business
What is a business?
 A business is the activity of making one’s living or
making money by producing or buying and selling
products (goods and services).
 The objective of most businesses is to maximize profits.
 But some organization operate with an objective other
than to maximize profit.
E.g. governmental units
 Types of Business

 Manufacturing businesses: change basic inputs into

products that are sold to individual customers.
E.g. Coca-cola, Sony, Nike, General Motors
 Cont…

 Merchandising businesses: also sell products to

customers. However, rather than making the products,
they purchase them from other businesses.
E.g. Wal-Mart, Amazon.com
 Cont…

 Service businesses: provide services rather than

products to customers.
E.g. Air Lines, Hospitals, Bus
 Forms of Business Organizations

 There are three

types of business
organizations
 Proprietorship
 Partnership
 Corporation
 Cont…
Proprietorship is owned by Advantage
one individual and usually ease in organizing
managed by the owner
low cost of organizing

Disadvantage
Abebe’s
limited source of
financial resources
unlimited liability
 Cont…
Partnership is owned by two Advantage
or more individuals. More financial resources
than a proprietorship.
Additional management
Abebe & Marta’s skills.

Disadvantage
Unlimited liability.
 Cont…
Corporation is organized Advantage
under state or federal The ability to obtain
statutes as a separate legal large amounts of
entity. resources by issuing
stocks.
A & M, Inc. Limited liability

Disadvantage
Double taxation.
What is Accounting?

Accounting consists of three basic activities - it

 Identifies,

 Records, and

 Communicates

the economic events of an organization to interested users.

LO 1 Explain what accounting is.

Cost Accounting Horngreen, Datar, Foster
What is Accounting?

Three Activities

The accounting process includes

the bookkeeping function.

LO 1 Explain what accounting is.

Who Uses Accounting Data

External
Internal Users
Human Taxing
Users
Resources Authorities
Labor
Unions
Finance
Management Customers

Creditors
Marketing Regulatory
Agencies
Investors

LO 2 Identify the users and uses of accounting.

 1.4. The profession of Accounting

 Accountants engage in either:

 Private Accounting: Accountants employed by a
business firm or NFP organization.
• They are frequently called management accountants or may be
referred to as industrial or cost accountants.
 Public accounting: Accountants and their staff who
provide services on a fee basis.
• A major portion of public accounting practice is involved with
Auditing.
 Different types of Accounting

Financial Accounting managerial Accounting

 It’s primarily  It uses both financial

concerned with the accounting and
recording & reporting estimated data to aid
of economic data and management in
activities for a running day-to-day
business to external operations and in
parties. planning future
operations.
 Helps to know how  Helps to know how to
well the business is run business
running.
 Different types of Accounting
Distinction between financial and management accounting
Financial Statements and Financial Reporting

Essential characteristics of accounting are:

1. the identification, measurement, and communication of

financial information about

2. economic entities to

3. interested parties.

LO 1
Objective of Financial LEARNING OBJECTIVE 2
Explain the objective of
Reporting financial reporting.

Objective: Provide financial information about the

reporting entity that is useful to
► present and potential equity investors,

► lenders, and

► other creditors

in making decisions about providing resources to the entity.

LO 2
Objective of Financial Reporting
General-Purpose Financial Statements
► Provide financial reporting information to a wide variety
of users.
► Provide the most useful information possible at the
least cost.

Equity Investors and Creditors

► Investors and creditors are the primary user group.

LO 2
Objective of Financial Reporting
Entity Perspective
► Companies viewed as separate and distinct from their
owners (shareholders).

Decision-Usefulness
► Investors are interested in assessing
1. the company’s ability to generate net cash inflows and
2. management’s ability to protect and enhance the
capital providers’ investments.

LO 2
 Standard-Setting Organizations

Main international standard-setting organization:

► International Accounting Standards Board (IASB)
● Issues International Financial Reporting Standards
(IFRS).
● Standards used on most foreign exchanges.
● IFRS used in over 149 countries.
● Two organizations that have a role in international
standard-setting are the International Organization of
Securities Commissions (IOSCO) and the IASB.

LO 3
 Conceptual Framework

Conceptual Framework establishes the concepts that

underlie financial reporting.

Need for a Conceptual Framework

► Rule-making should build on and relate to an established
body of concepts.

► Enables IASB to issue more useful and consistent

pronouncements over time.

LO 1
 Conceptual Framework
Development of a Conceptual Framework
Presently, the Conceptual Framework is comprises of the following.
• Chapter 1: The Objective of General Purpose Financial Reporting
• Chapter 2: The Reporting Entity (not yet issued)
• Chapter 3: Qualitative Characteristics of Useful Financial Information
• Chapter 4: The Framework, comprised of the following:
1. Underlying assumption—the going concern assumption;
2. The elements of financial statements;
3. Recognition of the elements of financial statements;
4. Measurement of the elements of financial statements; and
5. Concepts of capital and capital maintenance.

LO 1
Conceptual Framework

Overview of the Conceptual Framework

Three levels:
 First Level = Objectives of Financial Reporting

 Second Level = Qualitative Characteristics and

Elements of Financial Statements
 Third Level = Recognition, Measurement, and
Disclosure Concepts.

LO 1
 ASSUMPTIONS PRINCIPLES CONSTRAINTS
1. Economic entity 1. Measurement 1. Cost
2. Going concern 2. Revenue recognition
Third level
3. Monetary unit 3. Expense recognition The "how"—
4. Periodicity 4. Full disclosure implementation
5. Accrual

QUALITATIVE
CHARACTERISTICS ELEMENTS
1. Fundamental 1. Assets
qualities
Second level
2. Liabilities
3. Equity Bridge between
2. Enhancing
4. Income levels 1 and 3
qualities
5. Expenses

OBJECTIVE
Provide information
about the reporting
entity that is useful First level
ILLUSTRATION 2.7 to present and potential
Conceptual Framework for The "why"—purpose
equity investors,
Financial Reporting of accounting
lenders, and other
creditors in their
capacity as capital
providers.
 Basic Objective
“To provide financial information about the reporting entity
that is useful to present and potential equity investors,
lenders, and other creditors in making decisions about
providing resources to the entity.
 Provided by issuing general-purpose financial statements.
 Assumption is that users need reasonable knowledge of
business and financial accounting matters to understand
the information.

LO 1
Fundamental Concepts
Qualitative Characteristics of Accounting
Information
IASB identified the Qualitative Characteristics of
accounting information that distinguish better (more useful)
information from inferior (less useful) information for
decision-making purposes.

LO 2
Qualitative Characteristics

ILLUSTRATION 2.2
Hierarchy of Accounting
Qualities

LO 2
Relevance

ILLUSTRATION 2.7
Conceptual Framework for
Financial Reporting

LO 2
Qualitative Characteristics
Fundamental Quality—Relevance

To be relevant, accounting information must be capable of making

a difference in a decision.

LO 2
Qualitative Characteristics
Fundamental Quality—Relevance

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

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

LO 2
Qualitative Characteristics
Fundamental Quality—Relevance

Relevant information also helps users confirm or correct prior

expectations.

LO 2
Qualitative Characteristics
Fundamental Quality—Relevance

Information is material if omitting it or misstating it could influence

decisions that users make on the basis of the reported financial
information.

LO 2
Faithful Representation

ILLUSTRATION 2.7
Conceptual Framework for
Financial Reporting

LO 2
Qualitative Characteristics
Fundamental Quality—Faithful Representation

Faithful representation means that the numbers and descriptions

match what really existed or happened.

LO 2
Qualitative Characteristics
Fundamental Quality—Faithful Representation

Completeness means that all the information that is necessary for

faithful representation is provided.

LO 2
Qualitative Characteristics
Fundamental Quality—Faithful Representation

Neutrality means that a company cannot select information to favor

one set of interested parties over another.

LO 2
Qualitative Characteristics
Fundamental Quality—Faithful Representation

An information item that is free from error will be a more accurate

(faithful) representation of a financial item.

LO 2
Qualitative Characteristics
Enhancing Qualities

Information that is measured and reported in a similar manner for

different companies is considered comparable.

LO 2
Qualitative Characteristics
Enhancing Qualities

Verifiability occurs when independent measurers, using the same

methods, obtain similar results.

LO 2
Qualitative Characteristics
Enhancing Qualities

Timeliness means having information available to decision-makers

before it loses its capacity to influence decisions.

LO 2
Qualitative Characteristics
Enhancing Qualities

Understandability is the quality of information that lets reasonably

informed users see its significance.

LO 2
Basic Elements

LO 2
Basic Elements
Elements of Financial Statements

Asset A resource controlled by the entity as a

result of past events and from which
future economic benefits are expected to
Liability
flow to the entity.

Equity

Income

Expenses

LO 2
Basic Elements
Elements of Financial Statements

Asset
A present obligation of the entity arising
Liability from past events, the settlement of which
is expected to result in an outflow from the
entity of resources embodying economic
Equity benefits.

Income

Expenses

LO 2
Basic Elements
Elements of Financial Statements

Asset

Liability

Equity The residual interest in the assets of the

entity after deducting all its liabilities.

Income

Expenses

LO 2
Basic Elements
Elements of Financial Statements

Asset

Liability

Equity Increases in economic benefits during the

accounting period in the form of inflows or
Income enhancements of assets or decreases of
liabilities that result in increases in equity,
other than those relating to contributions
Expenses from equity participants.

LO 2
Basic Elements
Elements of Financial Statements

Asset

Liability

Equity Decreases in economic benefits during the

accounting period in the form of outflows
Income or depletions of assets or incurrences of
liabilities that result in decreases in equity,
other than those relating to distributions to
Expenses
equity participants.
LO 2
Recognition, Measurement, and Disclosure Concepts

These concepts explain how companies should recognize,

measure, and report financial elements and events.
Recognition, Measurement, and Disclosure Concepts
ASSUMPTIONS PRINCIPLES
1. Economic entity 1. Measurement
2. Going concern 2. Revenue recognition CONSTRAINTS
3. Monetary unit 3. Expense recognition 1. Cost
4. Periodicity 4. Full disclosure
5. Accrual

LO 3
Assumptions

Economic Entity – company keeps its activity separate from

its owners and other business unit.

Going Concern - company to last long enough to fulfill

objectives and commitments.

Monetary Unit - money is the common denominator.

Periodicity - company can divide its economic activities into
time periods.

Accrual Basis of Accounting – transactions are recorded

in the periods in which the events occur.

LO 3
Basic Principles of Accounting

Measurement Principles
 Historical Cost is generally thought to be a faithful
representation of the amount paid for a given item.

 Fair value is defined as “the price that would be received to

sell an asset or paid to transfer a liability in an orderly
transaction between market participants at the measurement
date.”

IASB has given companies the option to use fair value as the
basis for measurement of financial assets and financial
liabilities.
LO 4
The Basic Accounting Equation

Assets = Liabilities + Equity

Provides the underlying framework for recording and

summarizing economic events.

Applies to all economic entities regardless of size.

LO 6 State the accounting equation, and define its components.

The Basic Accounting Equation

Assets = Liabilities + Equity

Provides the underlying framework for recording and

summarizing economic events.

Assets
 Resources a business owns.
 Provide future services or benefits.
 Cash, Inventory, Equipment, etc.

LO 6 State the accounting equation, and define its components.

The Basic Accounting Equation

Assets = Liabilities + Equity

Provides the underlying framework for recording and

summarizing economic events.

Liabilities
 Claims against assets (debts and obligations).
 Creditors - party to whom money is owed.
 Accounts payable, Notes payable, etc.

LO 6 State the accounting equation, and define its components.

The Basic Accounting Equation

Assets = Liabilities + Equity

Provides the underlying framework for recording and

summarizing economic events.

Equity
 Ownership claim on total assets.
 Referred to as residual equity.
 Share capital-ordinary and retained earnings.

LO 6 State the accounting equation, and define its components.

The Basic Accounting Equation

Revenues result from business activities entered into for the purpose
of earning income.
Generally results from selling merchandise, performing services,
renting property, and lending money.

LO 6 State the accounting equation, and define its components.

The Basic Accounting Equation

Expenses are the cost of assets consumed or services used in the

process of earning revenue.
Common expenses are salaries expense, rent expense, interest
expense, property tax expense, etc.

LO 6 State the accounting equation, and define its components.