Chapter One

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Overview of Financial Accounting
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 Introduction
 Financial reporting: Deals with the preparation of financial statements.
 Statements provide information about the financial performance and
financial position of the business to which they relate and may be of value to
a wide range of user groups
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 Financial accounting—Provide general-purpose financial information to 2

external users such as investors and creditors.

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• General-purpose financial reports: Reported to a broad group of users

• A special-purpose financial statement: Intended for presentation to a
limited group of users.
• IFRS guide the preparation of General purpose financial statements
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 The conceptual framework for financial reporting (IASB)
What is the Conceptual Framework?
 Defines the purpose and nature of accounting.
 It is a practical tool that assists
International accounting standards Board (IASB): To develop
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Standards 3

Preparers: to develop consistent accounting policies

All: To understand and interpret Standards
 The conceptual framework establishes the concepts that underlie financial
reporting.
 The conceptual framework for financial reporting…
The Conceptual Framework
 Addresses fundamental issues
What is the objective of financial reporting?
What makes financial information useful?
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they be recognised and how should they be measured, presented and
disclosed?
 The conceptual framework for financial reporting…
Objective of financial reporting
 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
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 Users’ decisions involve decisions about 5

Buying, holding or selling shares

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Providing or settling loans

Voting and influencing management
 To make these decisions, users assess
Prospects for future net cash inflows to the entity
Management’s stewardship of the entity’s economic resources
 The conceptual framework for financial reporting…
 To make both these assessments, users need information about both
Economic resources, claims and changes in those resources and claims
How efficiently and effectively management has discharged its
responsibilities
Fundamental qualitative characteristics of useful information
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 Relevance: Information is relevant if it is capable of making a difference to

the decisions made by users (it has predictive value or confirmatory value)
 Faithful representation: Information must faithfully represent the
substance of what it purports to represent (A faithful representation would be
complete, neutral and free from error).
 The conceptual framework for financial
reporting…
Enhancing Qualitative Characteristics
• Provides users with information that is readily
Comparability comparable

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• Independent and knowledgeable observers should
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• Accounting information is prepared for

stakeholders with ‘reasonable understanding of
Understandability business’. (Incomprehensible information would
have no value)

• Made available to users in time for it to be

Timeliness capable of influencing their economic decisions.
 Information Perspective
• Signaling theory posits that the agent (the management) voluntarily
provides information to the principal (Spence, 1973)
• Managers with a comparative advantage on information about their firms
are compensated for their ability to provide information on the future cash
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flows of these firms (Holthausen and Leftwich, 1983)
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• What is the need to regulate financial reporting?

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 Agency theory
• There is principal and agent relationship between shareholders and managers
and creditors and managers (Jensen and Meckling, 1976)
 Agency relationship
– a contract under which one or more (principals) engage another person
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(the agent) to perform some service on their behalf which involves
delegating some decision-making authority to the agent
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 Principal (P) and agent (A)

• Owners/shareholders (P) vs. Managers (A)
• Managers (the firms) (A) vs. Creditors (P)
 Agency theory…
Rationality:
 Utility maximization drives actions of individuals
• Principal and agent aim to maximize their respective benefits
• Agent works for compensation--no love for job or charity
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• There is no place for, loyalty, trust, morality 10
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Agency problems
 Under situations of information asymmetry, A is prone to taking
opportunistic actions at P’s expense:
 Agency theory…
• Principal and agents design contracts that would align the interests of P and
A.
• There is information asymmetry between P and A
• Accounting serves to reduce information asymmetry
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• To align interests of principal with those of the agent-accounting 11
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numbers as a monitoring mechanism
• Hence, by reducing information asymmetry we can minimize Adverse
selection (ex-ante) (Akerlof, 1978) and Morale hazard (ex-post)
(Hölmstrom, 1979) problems.
 Integrity of accounting information
 What enables investors and creditors to rely on financial accounting
information without fear that the management of the reporting enterprise has
altered the information to make the company’s performance look better than
it actually was?
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 How can management be sure that internally generated information is
free from bias that might favor one outcome over another?
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 The word integrity refers to the following qualities: complete, unbroken,

unimpaired, sound, honest, and sincere.
 Integrity of accounting information…
 The integrity of accounting information is enhanced in three primary
ways.
A. Institutional features add significantly to the integrity of accounting
information. These features include standards for the preparation of
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accounting information, an internal control structure, and audits of
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B. Several professional accounting organizations play unique roles in

adding to the integrity of accounting information.
C. Personal competence, judgment, and ethical behavior of
professional accountants.
 Integrity of accounting information…
 These come together to ensure that users of accounting information –
investors, creditors and others – can rely on the information to be a fair
representation of what it purports to represent.
 Different professional associations develop code of conduct for their
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members (see the following) 14
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• IFAC Code of Ethics for Professional Accountants
• Ethiopian Professional Association of Accountants & Auditors
(EPAAA) Code of Ethics
• Ethiopian Code of Ethics for Professional Accountants, Issued by
Office of Federal Auditor General (OFAG)
 The International Code of Ethics for Professional Accountants
The Fundamental Principles
 General 110.1 A1 There are five fundamental principles of ethics for
professional accountants:
a) Integrity – to be straightforward and honest in all professional and
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b) Objectivity – not to compromise professional of business judgments

because of bias, conflict of interest of undue influence of others.

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 The International Code of Ethics for Professional Accountants
The Fundamental Principles
c) Professional Competence and Due Care – to:
i. Attain and maintain professional knowledge and skill at the level required to ensure
that a client or employing organization receives competent professional service,
based on current technical and professional standards and relevant legislation; and
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standards.
d) Confidentiality – to respect the confidentiality of information acquired as a result of
professional and business relationships.
e) Professional Behavior – to comply with relevant laws and regulations and avoid any
conduct that the professional accountant knows or should know might discredit the
profession.
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 Common Set of Global Accounting Standards
 IASB is currently attempting to establish greater uniformity among the
accounting principles in use around the world in order to facilitate business
activity that increasingly is carried out in more than one country.
 Do we need a common set of global accounting standards?
 As a result of globalization, financing now have substantially increased
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borders.
 Various GAAPs have been developed in many countries due to differences
in the legal, regulatory, social, economic, and cultural environments.
 Results in financial statements that are not comparable and difficult for
users to interpret
 This acts as a barrier for global capital movement
 Common Set of Global Accounting Standards…
Political and Regulatory Issues
 One issue with convergence is enforcement
 Once standard setting moves to a global arena, this fragmented regulatory
environment will prove to be a challenge
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 With so many entities regulating the markets, is it possible to be 18
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consistent?
 In October 2005, IOSCO announced that it would create an IFRS
database
 Is there for there
or can regulators to share
ever be decisions onofthe
total acceptance application of IFRS
IFRS?
 It may be required only for consolidated financials and for public
companies
 National GAAPs are still in existence and are widely used
 Common Set of Global Accounting Standards…
Can one set of standards meet the needs of all users?
 There is a concern that private companies would not benefit from using IFRS
 Many operate in a local market and have more simplified business models
 On the international front, there is a move to establishing more simplistic
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• IFRS for Small and Medium Enterprises (IFRS for SMEs) is More
simplified than full IFRS
 Rule based Vs Principle based standards
 At the other end of the spectrum is a rules-based US-GAAP model that is
more prescriptive
• Provides a rule for every situation
• Body of knowledge too large and complicated
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ensure that the standards are all consistent.

 Rule based Vs Principle based standards…
Principles or rules—which are better?
 IFRS is referred to as being principles-based
• They are more loosely framed, allowing for professional judgment to be
applied
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• Results in accounting that is more flexible to deal with unique economic 21

and business circumstances

• Some argue that allowing professional judgment introduces bias
 Financial reporting standards in Ethiopia
Financial Reporting Proclamation 847/2014
 Art 5 specifies applicable financial reporting standards:
 The financial reporting standards to be used when
preparing financial statements shall be:
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1. International financial reporting standards (IFRS), or 22

2. International financial reporting standards for small and medium

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enterprises (IFRS for SMEs),

3. International public sector accounting standards applicable to charities
and societies( IPSAS)
 Financial reporting in Ethiopia…
To understand financial reporting legal grounds in Ethiopia see
 Financial reporting Proclamation 847/2014 of the government of Ethiopia
 Council of Ministers Regulation 332/2014: Establishment and
determination of procedures of the accounting and auditing board of
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 Visit the following website http://www.aabe.gov.et/

 Roles of financial accountants in modern organization
1. Financial Data Management
 One of the primary roles of an accountant usually involves the
collection and maintenance of financial data, as it relates to a company.
 Managing the financial data of an organization can also include more
A sophisticated duties, such as developing, implementing and maintaining
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procedures.
 Roles of financial accountant…
2. Analysis And Advice
 Advising on business operations can include issues, such as revenue
and expenditure trends, financial commitments and future revenue
expectations.
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 The accountant also analyzes financial data to resolve certain 25
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discrepancies and irregularities that may arise.
 Recommendations may also involve developing efficient resources and
procedures, while providing strategic recommendations for specific
financial problems or situations.
 Roles of financial accountant…
3. Financial Report Preparation
 Accountants typically prepare financial statements that may include
monthly and annual accounts based upon the financial information that is
compiled and analyzed.
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 An accountant may also be responsible for ensuring that all financial

reporting deadlines are met, internally and externally.
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END OF CHAPTER

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