Hope University College

Department of Accounting &

Finance

1. Development of Accounting Principles & Professional Practice

1.1 The Environment of Financial Accounting
1.1.1 What is Accounting
Accounting is the process of identifying, measuring, recording & communicating economic
information to permit informed judgment & decisions by users of the information. Accounting is
the process of or skill in keeping and verifying accounts. It includes not only maintenance
accounting records but also the preparation of financial and economic information, which
involves the measurement of transaction and other events pertaining to a business.
Fair presentation of financial affairs is the essence of accounting theory& practice. With the
increase size & complexity of business enterprise & the increasing size of economic role of
government, the responsibility place or accountant is greater today than ever before. To meet this
challenge, accountants must have a logical & consistent body of accounting theory to guide
them. This theoretical structure must be realistic in terms of the economic environment. Financial
statement & reports prepared by accountants are vital to the successful working condition.
Information users are depends on the information provided by accountants.
1.1.2

Users of Accounting Information

The purpose of accounting information is to provide inputs for decision making. Accounting is
the information system that identifies, records, & communicates the economic events of an
organization to interested users. Many people have an interest in knowing about the ongoing
activities of the business. These people are users of accounting information. The users of
accounting information can be divided broadly into two groups:
A. INTERNAL USERES
Internal users are the managers at different levels which are involved in routine and long
range decisions. Internal users include all the management personnel of a business
enterprise who use accounting information for planning & controlling correct operations,
formulating long rang plan, making major business decisions.
B. EXTERNAL USERS
The external users are stockholders, bondholders, potential investors, bankers & other creditors,
labor unions, financial analysis, government agencies etc.
1.1.3

Financial Accounting versus Management Accounting

The term financial accounting is directly related to external reporting because it provides
investors & other outsiders with the financial information they need for decision making.
Financial accounting is used by external parties. On the other hand management accounting
relates to internal measurements & reporting useful to all levels of management in decision
making designing to achieve the goals of the enterprise. Management accounting is used by
internal parties.

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1.1.4

Department of Accounting &

Finance

Goal, purpose or objective of Accounting

Accounting is often called the language of business because its underlying purpose is to provide
economic information about economic information about an economic entity which is useful in
making various economic divisions. In brief accounting serves as a link between an enterprise
economic activities & decision makers.
1.1.5 Organization & laws of Accounting
Certain professional organizations, government agencies, legal legislatures 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:
i.

ii.

iii.

iv.

v.

vi.

American Institution of Certified Public Accountant (AICPA): It is a professional

organization of practicing certified public accountants. It is concerned with developing
standards of professional practice. It publishes like Journals like Journal of Accounting &
Bulleting.
Accounting Principles Board (APB): It is formed in 1959 based on the comprehensive
research program of AICPA into the problem of financial accounting &b reporting. The
APB was established with the responsibility of formulating financial accounting &
reporting responsibility. Different types of opinions were issued by APB. But it could not
satisfy the needs of different firms. responsibility
Financial Accounting Standard Board (FASB): It is established in 1972 & it replaces
APB & it is established to develop financial accounting standards for business enterprises
& non-profit organizations. The FASB is authorized o issue statements of financial
accounting standards as well as interpretations to guide & organizations in preparing &
auditing financial statements.
American Accounting Association (AAA): It is an organization of accounting educators
practitioners. Its role is to develop accounting principles. AAA emphasized in the
development of a theoretical foundation for accounting. It encourages accounting
research & continuous appraisal of accounting concepts through committee reports & the
publication of a quarterly source.
Security & Exchange Commission (SEC): It is established in 1934 by congress to
regulate issuance of securities to the public & the trading of securities listed on stock
exchanges. To issue securities - continual review of financial statements, issuance of
regulation & publication release. SEC has become more active in its role as the
watchdogs for investors. The primarily concern of the SEC is disclosure of all relevant &
material facts about the about the financial affairs of publicity owned business
enterprises.
Cost Accounting Standard Board (CASB): A U.S. federal government body that has the
mandate of promoting consistency and uniformity in cost accounting activities involving
government grants and contracts. Established by Congress in 1970, The Cost Accounting

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Department of Accounting &

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Standards Board (CASB) was dissolved in 1980, was dissolved in 1980, but was
permanently re-established in 1988.
1.2 Conceptual Framework for Financial Accounting Reporting
1.2.1 Nature of Conceptual Framework
The conceptual framework is like a constitution. A conceptual framework for financial
accounting is a coherent system of interrelated objectives & fundamentals that can lead to
consistent standards & that prescribes the nature, function, & limits of financial accounting &
financial statements.
Conceptual framework is important to establish body of concepts & objectives, to increase
financial statement user understands of & confidence in financial reporting, enhance
comparability among the financial statements of different companies & to solve new emerging
problems by referring to an existing framework.
1.2.2 Level of Conceptual Framework
Development of a conceptual framework
The expanded conceptual framework project under taken by the FASB resulted in the publication
of the following related to finalize reporting for business enterprise. The FASB has issued seven
Statements of Financial Accounting Concepts (SFAC) to describe its conceptual framework.
Among it the four conceptual frameworks the following are as follows:
SFAC No. 1: Objective of financial reporting by business enterprise.
SFAC No. 2: Qualitative characteristics of accounting information.
SFAC No. 5: Recognition & measurement in financial statements of business enterprise.
SFAC No. 6: Elements of financial statements.
There are three levels of conceptual framework
First Level: The specific objectives of financial statements are to provide:
i.
Information that is useful for making investment, credit & other decision,
ii.
Information that is useful in assessing cash flow prospects, &
iii.
Information about enterprise resources claims to those resources & changes in them.
All objectives of financial reporting focused on providing information needed by current
prospective investors & creditors of a business enterprise in their decision making.
Second Level: Fundamental Concept
It is a building block that explains the qualitative characteristics of accounting information &
defines the elements that financial statements comprise. It is a bridge between first level & third
level.
1.2.3 Qualitative characteristics of Accounting Information
It represents the information usefulness for decision making & understandability of financial
information by decision makers. A decision makers ability could vary from being simplistic to
expert.
1. Primarily Qualities
A. Relevance: Accounting information is relevant when it can influence the decision of
users. Relevance is the capacity of accounting information to make a difference to the
external decision makers who use financial reports. Relevance can be evaluated
according to three qualitative criteria:

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Department of Accounting &

Finance

Predictive Value: to evaluate the past, present, & future

Feedback Value: to confirm or correct expectation
Timeliness: is also an important component of relevance. Information
is timely available to users early enough to allow its use in decision
process.
B. Reliability: is the nature of financial information in which decision makers depends on
or trust. Reliability information is information that is reasonably free from error & bias
& faithful represents what it is intended to represent. It can be evaluated according to
three qualitative criteria:
Variability: justified by objective evidence. It implies a consensus among
different measures.
Representational faithfulness or validity: show what its purposes
Neutrality: reasonably free from error & bias.
2. Secondary Quality
A. Comparability: Information that has been measured & reported in a similar manner for
different enterprises in a given year or for the same enterprises in a different year is
considered comparable.
Intercompany comparison: comparing financial statements of different
enterprises but for the same year.
Intra Company: comparing financial statements of the same company but for
different year.
B. Consistency: conformity from period to period with application of accounting methods. It
results in enhancing comparability of financial statements from year to year.
1.2.4. Elements of Financial Statements of Business Enterprise
Definitional frameworks for the elements of accounting provide guidance for identifying what to
include & what to exclude from the financial statements. SFAC No. 6defines 10 elements of
financial statements as follows:
1. Assets: are probable future economic resources controlled by an entity as a result of past
transactions or events from which future economic benefits may be obtained.
2. Liabilities: are probable future sacrifices of economic benefits arising from present
obligation of a particular entity to transfer Asset or provide services to other entities in the
future as a result of past transactions or events.
3. Owners Equity or Net Assets, called Shareholders Equity or Stockholders Equity for a
corporation: is residual interest in the Assets of a business entity that remains after deducting
the liabilities. For a corporation, Equity arises primarily from two sources:
(i) Amounts invested by shareholders in the corporation reported as Paid in - Capital &
(ii) Amounts earned by the corporation on behalf of its shareholder & reported as Retained
Earnings.

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4. Investment to Owners: are increases in equity resulting from transfer of resources (usually
cash) to a company in exchange for ownership interest.
5. Distribution by Owners: are decreases in equity distribution of Assets to owners. A cash
dividend paid by a corporation to its shareholders is the most common distribution to owners.
6. Revenues: are increase in Assets & or settlement of liabilities from delivering or producing
goods, rendering services or other activities that constitute the entitys ongoing major/ central
operation.
7. Expenses: are decrease in Assets & or incurrence of liabilities from delivering or producing
goods, rendering services or other activities that constitute the entitys ongoing major/ central
operation.
8. Gains: are the increases in equity from peripheral or incidental transactions of the entity.
9. Losses: are the decreases in equity from peripheral or incidental transactions of the entity.
10. Comprehensive Income: is change in equity (net assets) of entity during a period from
transactions & other events & circumstances from non owner sources. It includes all changes
in equity during a period except those resulting from investment by owners & distributions to
owners.
Third Level: Recognition & Measurement Concepts
Recognition: is the process of formally recording an item & eventually reporting it to on the
financial statements. I refer to the process of admitting information into the basic financial
statements.
Measurements: is the process of determining the amount at which an item should be recognized.
It is the process of associating numerical amounts to the elements.
1.2.5. Basic Assumptions
A) Economic Entity Assumption
It assumes that the financial affairs & activities of a business enterprise should be kept separate
from its owners & other business unit. It is applicable regardless of the form of organization. All
accounting records & reports are developed from the view point of a single entry.
B) Continuity or Going Concern Assumption
Accountants assume that business enterprises will continue indefinitely rather than be terminated
in the near future.
It is a basis for classification of asset & liabilities between current & noncurrent.
It supports the measurement & recording of assets & liabilities at historical costs.
If there is evidence that an entity terminate its organization, quitting concern rather than
going concern is used.
C) Monetary Unit Assumptions
A common denominator is needed to measure all elements. Birr & cents in Ethiopia is assumed
to be the common denominator or basis for accounting measurement & analysis. One problem is
that this monetary unit concept assumes that the monetary unit is stable overtime & it limits the
scope of reports.
D) Periodicity or Time Period Assumptions

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The result of enterprise activity would be most accurately measurable at the time of the
enterprise eventual liquidation. But user groups cannot wait indefinitely for such information.
Therefore, for financial reporting purposes, the life of business must be divided into a series of
relatively short accounting periods of equal length.
1.2.6. Basic Principles
There are four important accounting principles that provide significant guidance for accounting
practice:
A) Historical Cost Principle
Measure Assets & Liabilities based on their original transactions value, that is, their historical
costs. In general, historical cost measurement provides relevant cash flow information & also is
highly verifiable.
B) Revenue Recognition
This principle provides guidance in answering the question when & at what amount revenue
should be recognized. Revenue should be recognized when it is earned & it is realized or
realizable or revenue should be recognized when the earnings process is virtually complete &
collection is reasonably assured.
C) Matching Principles
Expenses are recognized in the same period as the related revenues. Expenses recognition is tied
to revenue recognition. That means the expenses are recognized when the work (service) or the
product actually makes its contribution to revenues. Efforts be matched with accomplishment.
D) The Full Disclosure Principles
This means that the financial reports should include any information that could affect the
decisions made by external users. Accounting information may be discloses:
In the main body of financial statement
In the notes to the financial statement
In supplementary scheduled & other formulas
1.2.7. Basic Constraint
A) Cost Benefit Constraint
The cost of providing information must be weighted against the benefits that can be derived from
using it. The benefits should exceed the costs.
B) Materiality Constraint
It describes the significance of financial statement information to decision makers. An item is
material if it is probable that its omission would influence or change decision.
C) Industrial Practice Constraint
The peculiar nature of some industry or business concerns may require a departure from the
basic theory.

D) Conservatism Constraint
When an accountants are in doubt in choosing in between two acceptable alternative accounting
methods, they should choose the alternative having less favorable effect on the income & total

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Department of Accounting &

Finance

assets. Investors prefer information that does not unnecessarily raise expectations. But it does not
provide reason to justify a deliberate understatement of net assets & net income.
1.2.8 Cash Flows & Income Measurement
Investors & creditors are interested in cash flow information when evaluating investment
opportunity. It is an Accounting system based on the timing of cash payment & receipts.
What is cash flow?
Cash flow is the inflow & outflow of cash. Business records the prospect of future cash inflows
as increase in Assets & as revenue. Cash inflow may also result in increase in liabilities. Cash
outflows decrease in Asset, decrease in liabilities, & increase in expense.
Accrual versus Cash-Basis Accounting
There are two ways companies can keep their accounting books - Accrual- and Cash-Basis. The
accrual basis is used by most companies; only very small businesses use cash-basis. Under the
accrual method, expenses and revenue are recognized in the period they occur regardless of
whether a cash transaction has occurred.
Net Income = Earned Revenue Incurred Expenses.
For example, if a sale is made in January but payment is not expected until February, the revenue
from the sale would be recognized in January (when it was earned) and the amount due to the
company is recorded (accrued) in accounts receivable.
Net Income = Collection of Revenue Payment of Expenses
Four types of timing differences:
a. Accrued Revenue: Revenue is recognized before cash is received.
b. Accrued Expense: Expense is recognized before cash is paid.
c. Deferred Revenue: Revenue is recognized after cash is received.
d. Deferred Expense: Expense is recognized after cash is paid.
Modified cash basis of accounting (Mixed of cash accrual basis)
It is used for income tax purpose. Cost of property having economic life of more than one year
may not be deducted in acquisition. It depreciated over its economic life. Prepaid expenses are
also recorded as assets & are deducted only in the year to which they apply. Expenses paid after
incurred are deducted only in the year paid. Revenue is reported in the year received.
For merchandizing business enterprises, purchases, & sales of merchandise must be reported in
accrual basis. Thus, revenue cost of goods sold & gross profit on sales could be the same in
accrual & modified cash basis of accounting.
The modified cash basis of accounting uses elements of both the cash basis and accrual basis of
accounting. Under the cash basis, you recognize a transaction when there is a change in cash;
thus, the receipt of cash from a customer trigger the recordation of revenue, while the payment of

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a supplier triggers the recordation of an asset or expense. Under the accrual basis, you record
revenue when it is earned and expenses when they are incurred, irrespective of any changes in
cash.
The modified cash basis establishes a position part way between the cash and accrual methods.
The modified basis has the following features:
Record short-term items when cash levels change (the cash basis). This means that nearly all
elements of the income statement are recorded using the cash basis, and that accounts receivable
and inventory are not recorded in the balance sheet.
Record longer-term balance sheet items with accruals (the accrual basis). This means that fixed
assets and long-term debt are recorded on the balance sheet, and depreciation and amortization in
the income statement.
The modified cash basis provides financial information that is more relevant than can be found
with cash basis record keeping, and generally does so at less cost than is needed to maintain a set
of full-accrual accounting records. Thus, it can be considered a cost-effective approach to
bookkeeping.
There are no exact specifications for what is allowed under the modified cash basis, since it has
developed through common usage. There is no accounting standard that has imposed any rules
on its usage.

Note:
1. The amount of accrued liabilities on December 31, of the first year, represents expenses
incurred in year first that will be paid in year second, & the amount of short term
prepayments on January 1, year first , represents services paid for in the previous year
from the first year that were consumed in the first year. Therefore, both amounts are
added to the amount of cash paid to restate the operating expenses for year first to the
accrual basis of accounting.
2. The amount of accrual liabilities on January 1, year second, represents expense of the
previous year from year second paid for in the second year, & the amount of short term
prepayments on December 31, year second for service that will be consumed in second
year. Therefore, both amounts are deducted from the amount of cash paid to restate the
operating expenses for year second to the accrual basis of accounting.

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