CHAPTER ONE

DEVELOPMENT OF ACCOUNTING
PRINCIPLES AND PROFESSIONAL
PRACTICE
 LEARNING OBJECTIVES
• After studying this chapter, you should be able to:
1. Describe the growing importance of global financial
markets and its relation to financial reporting.
2. Identify the major financial statements and other means
of financial reporting.
3. Explain how accounting assists in the efficient use of
scarce resources.
4. Explain the need for high-quality standards.
5. Identify the objective of financial reporting.
6. Identify the major policy-setting bodies and their role in
the standard-setting process.
7. Explain the meaning of IFRS.
8. Describe the challenges facing financial reporting.
 Continuing Evolution of International Financial
Reporting
• The age of international trade and the interdependence
of national economies continue to evolve.
• Many of the largest companies in the world often do
more of their business in foreign lands than in their
home countries.
• Companies now access not only their home country
capital markets for financing, but others as well.
• With this globalization, companies are recognizing the
need to have one set of financial reporting standards.
• For globalization of capital markets to be efficient, what
is reported for a transaction in Beijing should be
reported the same way in Paris, New York, or London.
• In the past, many countries used their own sets of
accounting standards or followed standards set by larger
countries, such as those used in Europe or in the United
States.
• That protocol has changed through the adoption of a single set
of rules, called International Financial Reporting
Standards (IFRS).
• The use of IFRS has brought the following net benefits to capital
markets:
 IFRS was successful in creating a common accounting language
for capital markets (European Commission, 2015).
 Evidence suggests that IFRS adoption was largely positive for
listed companies in Australia (Australian Accounting Standards
Board, 2016).
 IFRS adoption helped to reduce investment risk in domestic
firms, mitigate the “Korea discount,” and attract foreign
capital via overseas shares listing, bond issuance, or mergers and
acquisitions (Korean Accounting Standards Board, 2016).
 IFRS improves the ability companies to compare operating
units in different jurisdictions by reducing the number of
different reporting systems.
 Japan adopted IFRS in 2010 because of its business efficiency,
enhanced comparability, and better communications with
international investors
 GLOBAL MARKETS
• World markets are becoming increasingly intertwined.
• International consumers drive Japanese cars, wear Italian shoes and
Scottish woolens, drink Brazilian coffee and Indian tea, eat Swiss
chocolate bars, sit on Danish furniture, watch U.S. movies, and use
Arabian oil.
• The tremendous variety and volume of both exported and imported
goods indicates the extensive involvement in international trade—for
many companies, the world is their market.
• In addition, due to technological advances and less onerous
regulatory requirements, investors are able to engage in financial
transactions across national borders and to make investment, capital
allocation, and financing decisions involving many foreign
companies.
• Also, many investors, in attempts to diversify their portfolio risk,
have invested more heavily in international markets.
• As a result, an increasing number of investors are holding
 Financial Statements and Financial Reporting
• Accounting is the universal language of business.
• One noted economist and politician indicated that the single most
important innovation shaping capital markets was the
development of sound accounting principles.
• The essential characteristics of accounting are (1) the identification,
measurement, and communication of financial information
about (2) economic entities to (3) interested parties.
 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.
 Managerial accounting is the process of identifying, measuring,
analyzing, and communicating financial information needed by
management to plan, control, and evaluate a company’s operations.
• Financial statements are the principal means through which a
company communicates its financial information to those outside
the business.
• These statements provide a company’s history quantified in money
terms.
• The financial statements most frequently provided are (1) the
statement of financial position, (2) the income statement (or
statement of comprehensive income), (3) the statement of cash
flows, and (4) the statement of changes in 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 company annual report, prospectuses, reports filed with
government agencies, news releases, management’s forecasts, and
social or environmental impact statements.
 Accounting and Capital Allocation
• Resources are limited- as a result, people try to conserve them
and ensure that they are used effectively.
• Efficient use of resources often determines whether a business
thrives.
• This fact places a substantial burden on the accounting
profession.
• Accountants must measure performance accurately and
fairly on a timely basis, so that the right managers and
companies are able to attract investment capital.
• For example, relevant financial information that faithfully
represents financial results allows investors and creditors to
compare the income and assets employed by companies.
• Because these users can assess the relative return and risks
associated with investment opportunities, they channel
resources more effectively.
• An effective process of capital allocation is critical to a
healthy economy.
• It promotes productivity, encourages innovation, and
provides an efficient and liquid market for buying and
selling securities and obtaining and granting credit.
• Unreliable and irrelevant information leads to poor
capital allocation, which adversely affects the securities
markets.
 High-Quality Standards
• To facilitate efficient capital allocation, investors need
relevant information and a faithful representation of that
information to enable them to make comparisons across
borders.
• For example, assume that you were interested in investing in
the telecommunications industry.
• Four of the largest telecommunications companies in the
world are Nippon Telegraph and Telephone (JPN), Deutsche
Telekom (DEU), Telefonica (ESP and PRT), and AT&T
(USA).
 How do you decide in which of these telecommunications
companies to invest, if any?
 How do you compare, for example, a Japanese company like
Nippon Telegraph and Telephone with a German company
like Deutsche Telekom?
• A single, widely accepted set of high-quality accounting
standards is a necessity to ensure adequate
comparability.
• Investors are able to make better investment decisions if
they receive financial information from Nippon
Telegraph and Telephone that is comparable to
information from Deutsche Telekom.
• Globalization demands a single set of high quality
international accounting standards.
• But how is this to be achieved? Here are some elements:
1. Single set of high-quality accounting standards
established by a single standard setting body.
2. Consistency in application and interpretation.
3. Common disclosures.
4. Common high-quality auditing standards and practices.
5. Common approach to regulatory review and
enforcement.
6. Education and training of market participants.
7. Common delivery systems (e.g., extensible Business
Reporting Language—XBRL).
8. Common approach to corporate governance and legal
frameworks around the world.
 Objective 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 making
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 useful to other users of
financial reporting who are not investors.
 Standard-Setting Organizations
• For many years, many nations have relied on their own
standard-setting organizations.
• For example, Canada has the Accounting Standards Board,
Japan has the Accounting Standards Board of Japan, Germany
has the German Accounting Standards Committee, and the
United States has the Financial Accounting Standards Board
(FASB).
• The standards issued by these organizations are sometimes
principles-based, rules-based, tax-oriented, or business-based.
• In other words, they often differ in concept and objective.
• The main international standard-setting organization is based in
London, England, and is called the International Accounting
Standards Board (IASB).
• The IASB issues International Financial Reporting Standards
(IFRS), which are used on most foreign exchanges.
• IFRS has the best potential to provide a common platform on which
companies can report, resulting in financial statements investors can
use to compare financial information.
• The two organizations that have a role in international standard-setting
are the International Organization of Securities Commissions
(IOSCO) and the IASB.
 The International Organization of Securities Commissions (IOSCO)
is an association of organizations that regulate the world’s securities and
futures markets.
• IOSCO does not set accounting standards.
• Instead, this organization is dedicated to ensuring that the global
markets can operate in an efficient and effective basis.
• IOSCO supports the development and use of IFRS as the single set of
high-quality international standards in cross-border offerings and listings.
• It recommends that its members allow multinational issuers to use IFRS
in cross-border offerings and listings, as supplemented by
reconciliation, disclosure, and interpretation where necessary to
address outstanding substantive issues at a national or regional level.
 International Accounting Standards Board (IASB) is
composed of the following four organizations:
 1. The IFRS Foundation provides oversight to the IASB,
IFRS Advisory Council, and IFRS Interpretations Committee.
In this role, it appoints members, reviews effectiveness, and
helps in the fundraising efforts for these organizations.
 2. The International Accounting Standards Board (IASB)
develops, in the public interest, a single set of high-quality,
enforceable, and global international financial reporting
standards for general-purpose financial statements.
 3. The IFRS Advisory Council (the Advisory Council)
provides advice and counsel to the IASB on major policies and
technical issues.
 4. The IFRS Interpretations Committee assists the IASB
through the timely identification, discussion, and resolution of
financial reporting issues within the framework of IFRS.
• In addition, as part of the governance structure, a
Monitoring Board was created.
• The purpose of this board is to establish a link between
accounting standard-setters and those public
authorities (e.g., IOSCO) that generally oversee them.
• The Monitoring Board also provides political legitimacy
to the overall organization.
 Due Process
• In establishing financial accounting standards, the IASB has
a thorough, open, and transparent due process.
• The IASB due process has the following elements:
1. an independent standard-setting board overseen by a
geographically and professionally diverse body of trustees
2. a thorough and systematic process for developing
standards;
3. engagement with investors, regulators, business leaders,
and the global accountancy profession at every stage of
the process; and
4. collaborative efforts with the worldwide standard-setting
community.
• To implement its due process, the IASB follows specific steps
to develop a typical IFRS,
• Furthermore, the characteristics of the IASB, as shown
below, reinforce the importance of an open, transparent, and
independent due process.
 Membership. The Board consists of 16 members. Members
are well-paid and appointed for five-year renewable terms.
The 16 members come from different countries.
 Autonomy. The IASB is not part of any other professional
organization. It is appointed by and answerable only to the
IFRS Foundation.
 Independence. Full-time IASB members must sever all ties
from their past employer. The members are selected for
their expertise in standard-setting rather than to represent
a given country.
 Voting. Nine of 16 votes are needed to issue a new IFRS.
 Types of Pronouncements
• The IASB issues three major types of pronouncements:
1. International Financial Reporting Standards.
2. Conceptual Framework for Financial Reporting.
3. International Financial Reporting Standards Interpretations.
 International Financial Reporting Standards. Financial accounting
standards issued by the IASB are referred to as International
Financial Reporting Standards (IFRS).
 The IASB has issued 17 of these standards to date, covering such
subjects as business combinations, share-based payments, and leases.
 Prior to the IASB (formed in 2001), standard-setting on the
international level was done by the International Accounting
Standards Committee, which issued International Accounting
Standards (IAS).
• The committee issued 41 IASs, many of which have been amended
or superseded by the IASB.
• Those still remaining are considered under the umbrella of IFRS.
 What is a conceptual framework?
• All financial statements are prepared in accordance
with a financial reporting framework.
• The term financial reporting framework is defined
as a set of criteria used to determine measurement,
recognition, presentation, and disclosure of all
material items appearing in the financial statements.
• The purpose of the conceptual framework is to sets
out the concepts that underlie the preparation and
presentation of financial statements, that is, the
objectives, assumptions, characteristics, definitions,
and criteria that govern financial reporting.
 Why is a conceptual framework necessary?
 To assist the Board to develop IFRS Standards
(Standards) based on consistent concepts,
resulting in financial information that is useful to
investors, lenders and other creditors
 To assist preparers of financial reports to develop
consistent accounting policies for transactions or
other events when no Standard applies or a
Standard allows a choice of accounting policies
 To assist all parties to understand and interpret
Standards
 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
• 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.
 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.
 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 2. Liabilities
Second level
3. Equity Bridge between
2. Enhancing
qualities 4. Income levels 1 and 3
5. Expenses

Conceptual Framework for
Financial Reporting
OBJECTIVE
Provide information
about the reporting
entity that is useful First level
to present and potential
The "why"—purpose
equity investors,
of accounting
lenders, and other
creditors in their
capacity as capital
providers.
 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
(e.g., whether to sell or hold an investment in the entity).
• Users include present and potential investors, employees,
lenders, suppliers and other trade creditors, customers,
governments and their agencies, and the public.
• Because investors are providers of risk capital, it is
presumed that financial statements that meet their needs
will also meet most of the needs of other users.
• General purpose financial reporting
– aims to provide useful financial information about the
reporting entity to primary users who cannot require the
reporting entity to provide information directly to them.
• Special purpose financial reporting
– responds to the requirements of users that have the
authority to require the reporting entity to provide the
information that they need for their purposes directly to
them.
– Examples include:
• prudential regulation reporting requirements
• tax reporting requirements

30
 REPORTING ENTITY:

• An economic entity may be an individual, a business, a

co-operative or a non-profit organization.
• A business is formed with the intention of making
profits through selling of goods and rendering of
services to members of an economic system.
• Non-profit organizations such as public service agencies
and charitable foundations are established to provide
services to various segments of society with no intentions
of earning profits.
• An entity that is required, or chooses, to prepare
financial statements.
31
• It can be:
A single entity – for example, one company;
A portion of an entity – for example, a division of one
company;
More than one entities – for example, a parent and its
subsidiaries reporting as a group.
• As a result, we have a few types of financial statements:
Consolidated: a parent and subsidiaries report as a
single reporting entity;
Unconsolidated: e.g. a parent alone provides reports, or
Combined: e.g. reporting entity comprises two or more
entities not linked by parent-subsidiary relationship.
32
 Qualitative characteristics of useful financial
information
• IASB identified the Qualitative Characteristics of
accounting information that distinguish better (more
useful) information from inferior (less useful) information
for decision-making purposes.
• Qualitative characteristics are either fundamental
or enhancing characteristics, depending on how they
affect the decision-usefulness of information.
• Regardless of classification, each qualitative
characteristic contributes to the decision-usefulness of
financial reporting information.
• However, providing useful financial information is
limited by a pervasive constraint on financial reporting—
cost should not exceed the benefits of a reporting practice.
33
34
 Fundamental Qualities

1.Relevant:-To be relevant, accounting information must be

capable of making a difference in a decision.
• Financial information is capable of making a difference when it
has predictive value, confirmatory value, or both.
1. 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.
• For example, if potential investors are interested in purchasing
ordinary shares in Dashen Bank , they may analyze its current
resources and claims to those resources, its dividend payments,
and its past income performance to predict the amount, timing,
and uncertainty of Dashen Bank ’s future cash flows.
2. Relevant information also helps users confirm or correct prior
expectations; it has confirmatory value. 35
3. Materiality is a company-specific aspect of relevance.
• Information is material if omitting it or misstating it
could influence decisions that users make on the basis
of the reported financial information.
• Information is immaterial, and therefore irrelevant, if it
would have no impact on a decision-maker.
• In short, it must make a difference or a company need
not disclose it.
• Assessing materiality is one of the more challenging
aspects of accounting because it requires evaluating
both the relative size and importance of an item.
• However, it is difficult to provide firm guidelines in
judging when a given item is or is not material.
36
2. Faithful representation means that the numbers and
descriptions match what really existed or happened.
• Faithful representation is a necessity because most users have
neither the time nor the expertise to evaluate the factual
content of the information.
• To be a faithful representation, information must be complete,
neutral, and free of material error.
a. Completeness. Completeness means that all the information
that is necessary for faithful representation is provided.
• An omission can cause information to be false or
misleading and thus not be helpful to the users of financial
reports.
b. Neutrality. Neutrality means that a company cannot select
information to favour one set of interested parties over another.
37
c. Free from Error. An information item that is free from error
will be a more accurate (faithful) representation of a financial
item.
• For example, if ABC misstates its loan losses, its financial
statements are misleading and not a faithful representation of
its financial results.
• However, faithful representation does not imply total freedom
from error.
• This is because most financial reporting measures involve
estimates of various types that incorporate management’s
judgment.
• For example, management must estimate the amount of
uncollectible accounts to determine bad debt expense.
• And determination of depreciation expense requires estimation
of useful lives of plant and equipment, as well as the residual
38
value of the assets.
 Enhancing Qualities
a. Comparability. Information that is measured and
reported in a similar manner for different
companies is considered comparable.
• Comparability enables users to identify the real
similarities and differences in economic events
between companies.
• Another type of comparability, consistency, is
present when a company applies the same
accounting treatment to similar events, from
period to period.
• Through such application, the company shows
consistent use of accounting standards. 39
b. Verifiability. Verifiability occurs when independent
measurers, using the same methods, obtain similar results.
• Verifiability occurs in the following situations.
1. Two independent auditors count PepsiCo’s inventory and
arrive at the same physical quantity amount for inventory.
• Verification of an amount for an asset therefore can occur
by simply counting the inventory (referred to as direct
verification).
2. Two independent auditors compute PepsiCo’s inventory
value at the end of the year using the FIFO method of
inventory valuation.
• Verification may occur by checking the inputs (quantity and
costs) and recalculating the outputs (ending inventory
value) using the same accounting convention or
methodology (referred to as indirect verification). 40
c. Timeliness. Timeliness means having information available to
decision-makers before it loses its capacity to influence
decisions.
• Having relevant information available sooner can enhance its
capacity to influence decisions, and a lack of timeliness can
rob information of its usefulness.
d. Understandability. Decision-makers vary widely in the types
of decisions they make, how they make decisions, the
information they already possess or can obtain from other
sources, and their ability to process the information.
• For information to be useful, there must be a connection
(linkage) between these users and the decisions they make.
• This link, understandability, is the quality of information that
lets reasonably informed users see its significance.
• Understandability is enhanced when information is classified,
41
characterized, and presented clearly and concisely.
 Basic Elements
Elements of Financial Statements

Asset A resource controlled by the

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

Expenses
Basic Elements
Elements of Financial Statements

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

Asset

Liability

Equity The residual interest in the assets

of the entity after deducting all
Income
its liabilities.

Expenses
Basic Elements
Elements of Financial Statements

Asset

Liability

Equity Increases in economic benefits during the

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

Asset

Liability

Equity
Decreases in economic benefits during the
accounting period in the form of outflows or
Income
depletions of assets or incurrences of
liabilities that result in decreases in equity,
Expenses
other than those relating to distributions to
equity participants.
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
CONSTRAINTS
2. Going concern 2. Revenue recognition
1. Cost
3. Monetary unit 3. Expense recognition
4. Periodicity 4. Full disclosure
5. Accrual

Conceptual Framework for Financial Reporting

 UNDERLYING ASSUMPTIONS
Accrual Basis
• Accrual basis accounting means that transactions that
change a company’s financial statements are recorded in
the periods in which the events occur.
• Items are recognized as assets, liabilities, equity, income,
and expenses (the elements of financial statements) when
they satisfy the definitions and recognition criteria for
those elements in the Framework.
• For example, using the accrual basis means that
companies recognize revenues when it is probable that
future economic benefits will flow to the company and
reliable measurement is possible (the revenue recognition
principle).
 Going Concern
• When financial statements are prepared on a going
concern basis, it is assumed that the entity has neither the
intention nor the need to liquidate or curtail materially the
scale of its operations, but will continue in operation for
the foreseeable future.
• If this assumption is not valid, the financial statements
may need to be prepared on a different basis and, if so, the
basis used is disclosed.
• The going concern assumption is also addressed in IAS 1,
which requires management to make an assessment of an
entity’s ability to continue as a going concern when
preparing financial statements.
 ECONOMIC ENTITY ASSUMPTION
• An economic entity can be any organization or unit in society.
• It may be a company, a governmental unit, a municipality, a school
district, or a church.
• The economic entity assumption requires that the activities of the
entity be kept separate and distinct from the activities of its owner and
all other economic entities.
1. PROPRIETORSHIP A business owned by one person is generally a
proprietorship.
• The owner is often the manager/operator of the business.
• Usually only a relatively small amount of money (capital) is
necessary to start in business as a proprietorship.
• The owner (proprietor) receives any profits, suffers any losses, and
is personally liable for all debts of the business.
• There is no legal distinction between the business as an economic unit
and the owner, but the accounting records of the business activities are
kept separate from the personal records and activities of the owner. 50
2. PARTNERSHIP A business owned by two or more persons
associated as partners is a partnership.
• Like a proprietorship, for accounting purposes the partnership
transactions must be kept separate from the personal activities of
the partners.
3. CORPORATION A business organized as a separate legal entity
under corporation law and having ownership divided into
transferable shares is a corporation.
• The holders of the shares (shareholders) enjoy limited liability;
that is, they are not personally liable for the debts of the corporate
entity.
• Shareholders may transfer all or part of their ownership shares
to other investors at any time (i.e., sell their shares).
• The ease with which ownership can change adds to the
attractiveness of investing in a corporation.
• Because ownership can be transferred without dissolving the
corporation, the corporation enjoys an unlimited life. 51
 MONETARY UNIT ASSUMPTION
• The monetary unit assumption requires that companies
include in the accounting records only transaction data that can
be expressed in money terms.
• This assumption enables accounting to quantify (measure)
economic events.
• The monetary unit assumption is vital to applying the historical
cost principle.
• This assumption prevents the inclusion of some relevant
information in the accounting records.
• For example, the health of a company’s owner, the quality of
service, and the morale of employees are not included.
• The reason: Companies cannot quantify this information in
money terms.
• Though this information is important, companies record only
52
events that can be measured in money.
 Periodicity Assumption
• Users need to know a company’s performance and
economic status on a timely basis so that they can evaluate
and compare companies, and take appropriate actions.
• Therefore, companies must report information
periodically.
• The periodicity (or time period) assumption implies that
a company can divide its economic activities into artificial
time periods.
• These time periods vary, but the most common are
monthly, quarterly, and yearly.

53
 Measurement Principles
• IFRS generally uses one of two measurement principles, the
historical cost principle or the fair value principle.
• Selection of which principle to follow generally relates to
trade-offs between relevance and faithful representation.
• Relevance means that financial information is capable of
making a difference in a decision.
• Faithful representation means that the numbers and
descriptions match what really existed or happened—they
are factual.
1. HISTORICAL COST PRINCIPLE
• The historical cost principle (or cost principle) dictates that
companies record assets at their cost.
• This is true not only at the time the asset is purchased, but
also over the time the asset is held. 54
2. FAIR VALUE PRINCIPLE
• The fair value principle states that assets and liabilities should be
reported at fair value (the price received to sell an asset or settle a
liability).
• Fair value information may be more useful than historical cost for
certain types of assets and liabilities.
• For example, certain investment securities are reported at fair value
because market value information is usually readily available for
these types of assets.
• In determining which measurement principle to use, companies
weigh the factual nature of cost figures versus the relevance of fair
value.
• In general, even though IFRS allows companies to revalue property,
plant, and equipment and other long-lived assets to fair value, most
companies choose to use cost.
• Only in situations where assets are actively traded, such as
investment securities, do companies apply the fair value principle 55
 Revenue Recognition Principle
• When a company agrees to perform a service or sell a
product to a customer, it has a performance obligation.
• Requires that companies recognize revenue in the
accounting period in which the performance obligation is
satisfied.

56
Basic Principles
of Accounting

Illustration: Assume
the Airbus (DEU) signs
a contract to sell
airplanes to British
Airways (GRB) for
€100 million. To
determine when to
recognize revenue,
Airbus uses the five
steps for revenue
recognition shown at
right.

The Five Steps of Revenue

Recognition
 Expense Recognition
• Outflows or “using up” of assets or incurring of liabilities
during a period as a result of delivering or producing goods and/or
rendering services.
• In practice, the approach for recognizing expenses is, “Let the
expense follow the revenues.”
• This approach is the expense recognition principle.
• To illustrate, companies recognize expenses not when they pay
wages or make a product, but when the work (service) or the
product actually contributes to revenue.
• Thus, companies tie expense recognition to revenue recognition.
• That is, by matching efforts (expenses) with accomplishment
(revenues), the expense recognition principle is implemented in
accordance with the definition of expense (outflows or other using
up of assets or incurring of liabilities).
Full Disclosure Principle
Providing information that is of sufficient importance to influence the
judgment and decisions of an informed user.
Provided through:
Financial Statements
Notes to the Financial Statements
Supplementary information
Cost Constraint

Companies must weigh the costs of providing the information

against the benefits that can be derived from using it.

 Rule-making bodies and governmental agencies use

cost-benefit analysis before making final their
informational requirements.
 In order to justify requiring a particular measurement or
disclosure, the benefits perceived to be derived from it
must exceed the costs perceived to be associated with
it.