CHAPTER ONE

ACCOUNTING PRINCIPLES AND PROFESSIONAL PRACTICE

INTRODUCTION
The business world is experiencing unprecedented changes, such as globalization, deregulation, and
computerization, to name just a few. In the middle of this changing business world is the accounting
profession which needs, and is expected, to provide relevant and reliable information so that the
economies work efficiently.

Fair presentation is the essence of accounting theory and practice. With the increasing size and
complexity of business enterprises and the increasing economic role of business enterprises and
government, the responsibility placed on accountants is greater today than ever before. If accountants
are to meet this challenge, they must have a logical and consistent body of accounting theory to guide
them. This theoretical structure must be realistic in terms of the economic environment and must be
designed to meet the needs of users of financial statements.

Financial statement and reports prepared by accountants are the principal means through which
financial information is communicated to those inside and outside the enterprise. They are vital to the
successful working of the society. These statements provide the firm's history in quantitative terms.
Economists, investors, business executives, labor leaders, bankers, and government officials rely on
these financial statements and reports as fair and meaningful summaries of day-to-day business
transaction. In addition, these groups are making increased use of accounting information as a basis for
forecasting future economic trends. Consequently accountants and the theoretical principles they use
are at the centre of financial and economic activities.

1.1. THE ENVIRONMENT OF ACCOUNTING

Like other human activities and disciplines, accounting is largely a product of its
environment. The environment of accounting consists of social – economic – political - legal
conditions, restrictions and influence that vary from time to time. As a result, accounting
objectives and practices are not the same today as they were in the past. Accounting theory
has evolved to meet changing demands and influences.

Accounting communicates financial information about an economic entity to interested

persons. This characteristic has described accounting for hundreds of years. As economic
entities continued to increase in size and complexity, and the interested persons increased so
greatly in number and diversity, accounting had developed new concepts and techniques to
meet the ever increasing needs for financial information. Without such information, many
complex economic developments and social programs might never have been undertaken.

Because resources are scarce, people try to use them effectively and to identify and
encourage those who can make efficient use of them. Through an efficient use of resources,
our standard of living increases. An effective process of capital allocation is critical to a
healthy economy, which promotes productivity, encourages innovation, and provides an
efficient and liquid market. And it is the responsibility of the accounting profession to
measure performance accurately and fairly on a timely basis, so that the right managers and
companies are able to attract investment capital. To provide unreliable and irrelevant
information leads to poor capital allocation which adversely affects the economy. The
accounting numbers that are reported affect the transfer of resources among companies and
individuals.
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The financial statements are expected to present fairly, clearly, and completely the economic
facts of the existence and operations of the enterprise. In preparing financial statements,
accountants are confronted with the potential dangers of bias, misinterpretation, inexactness,
and ambiguity. In order to minimize these dangers, the accounting profession has attempted
to develop a set of standards that is generally accepted and universally practiced. With out
these standards, each enterprise would have to develop its own standards, and readers of
financial statements would have to familiarize themselves with every company's accounting
and reporting practice. As a result it would be almost impossible to prepare statements that
could be compared.

1.1.1. USERS OF ACCOUNTING INFORMATION

The basic assumptions that underlie current accounting practice have evolved over many
years in response to the needs of various users of accounting information. Organizations set
up an accounting information system to help them and others make better decisions. The
accounting system serves the information needs of various kinds of users (Stakeholders). The
information that a specific user needs depends on the kind of decision that user makes. The
difference in decisions divides the users in to two broad groups: the internal users and
external users.

Internal users include all the management personnel of a business enterprise who use
accounting information either for planning and controlling current operations or for
formulating long range plans and making major business decisions.
External users of accounting information include stockholders, bondholders, potential
investors, bankers and other creditors, financial analysts, economists, labor unions, and
numerous governmental agencies.

Due to the rapid technological advancement and economic growth, and diversity of users, a
number of specialized fields of accounting have evolved. The most important special
accounting fields are: Financial accounting, Auditing, Management accounting, Cost
accounting, and fund accounting.

Management accounting relates to internal measurement and reporting; it includes the

development of detailed current information helpful to all level of management (Internal
users) in decision making designed to achieve the goal of the enterprise. In contrast, financial
accounting is directly related to external reporting because it provides investors and other
outsiders with the financial information they need for decision making.

1.1.2. ORGANIZATIONS AND LAWS AFFECTING FINANCIAL ACCOUNTING

In the foregoing discussion we have seen the need for standards that are generally accepted
and universally practiced. Under this section we will see some of the different professional
organizations, governmental agencies, and legislative acts that have been extremely
influential in shaping the development of the existing body of financial accounting theory.
Among the most important of these have been the American Institute of Certified Public
Accountants, the Financial Accounting Standard Board, the American Accounting
Association, and the Securities and Exchange Commission. Other organization and laws that
have influenced the development of accounting principles are the New York Stock Exchange,
the National Association of Accountants, the Financial Executives Institute, the Cost

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Accounting Standards Board, the Institute of Internal Auditors, and the whole complex of
Federal, State, and Local income tax laws,

Awareness of the roles of these institutional forces is helpful in gaining an understanding of

current accounting principles and practices. Efforts to improve existing principles of
accounting will have a better chance of success if they are made with full recognition of the
needs of the various groups that use accounting information. So, let us see the roles of some
instrumental organizations in development of financial accounting standards.

Securities and Exchange Commission (SEC)

The disclosure of financial information prior to 1930 was limited. Prior to 1900, for example,
single ownership was the predominant form of business organization. Financial reports
emphasized solvency and liquidity and were limited to internal use scrutiny by banks and
other institutions. From 1900 to 1920, the growth of large corporations in the United States,
with their absentee owner, led to increasing investment and speculation in corporate stock.
Unfortunately, after a couple of days on which stock prices dropped rapidly, both individual
and institutional investors panicked, and sold over 16 million shares of stock at a huge
losses. The stock market crashed in 1929.

As a result of these events, the Federal Government established the Securities and Exchange
Commission, (SEC) to help develop and standardize financial information presented to stock
holders. Most companies that issue securities to the public or are listed on the stock exchange
are required to file audited financial statements with the SEC. In addition, the SEC had broad
powers to prescribe, in whatever detail it desires, the accounting standards and standards to
be employed by companies that far within its jurisdiction.

At the time the SEC was created, no group- public or private-was issuing accounting
standards. The SEC encouraged the creation of a private standard-setting body because it
believed that the private sector had the resources and talent to develop appropriate accounting
standards. As a result, accounting standards have generally developed in the private sector
either through the American Institute of Certified Public Accountant (AICPA) or the
Financial Accounting Standards Board (FASB)

The SEC partnership with the private sector has worked well. The SEC has acted with
remarkable restraint in the areas of developing accounting standards. Generally, it has relied
on the AICPA and FASB to regulate the accounting profession and develop and enforce
accounting standards.

The American Institute of Certified Public Accountants (AICPA)

The American Institute of certified public accountants is a professional organization of
participating public accountant. As a professional organization, the AICPA has been
concerned with developing standards of professional practice for its members. The AICPA
publishes the journal of accounting monthly as a forum for accountants.

Committee on Accounting Procedure

At the urging of the SEC, the AICPA appointed the Committee on Accounting Procedure in
1939. The committee on Accounting principles (CAP), composed of practicing Certified
Public Accountants (CPA) , issued 51 Accounting Research Bulleting dealing with a variety
of timely accounting problems during the years 1939 to 1959. But this problem-by-problem

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approach failed to provide the structured body of accounting principles that was both needed
and desired. In response, in 1959 the AICPA created the Accounting Principles Board.

Accounting Principles Board

The major purposes of the Accounting Principles Board (APB) were
1. to advance the written expression of accounting principles,
2. to determine appropriate practices, and
3. to narrow the areas of difference and inconsistency in practice.
To achieve these objectives, its mission was to develop an overall conceptual framework to
assist in the resolution of problem as they become evident and to do substantive research on
individual issues before pronouncements were issued.
The Board's official pronouncements, called APB opinions, were intended to be based mainly
on research studies and be supported by reasons and analysis. Between its inception in 1959
and its dissolution in 1973, the APB issued 31 opinions.

Unfortunately, the APB came under fire early, charged with lack of productivity and failing
to act promptly to correct alleged accounting abuses. In 1971 the accounting profession's
leaders, anxious to avoid governmental rule making, appointed a study group on
establishment of accounting principles. Commonly known as wheat committee for its chair
Fransis Wheat, this group was to examine the organization and operation of the APB and
determine what changers would be necessary to attain better results.

Financial Accounting Standards Board

The wheat committee's recommendations resulted in the demise of the APB and the creation
of a new standard setting structure composed of three organizations: the Financial
Accounting Foundation (FAF), the Financial Accounting Standards Board (FASB), and the
Financial Accounting Standards Advisory Council (FASAC). The FAF selects the members
of the FASB and the FASAC, funds their activities, and generally oversees the FASB's
activities.

The major operating organization in this three-part structure is the FASB. Its mission is to
establish and improve standards of financial accounting and reporting for the guidance and
education of the public, which includes issuers, auditors, and users of financial information.
The FASB is authorized to issue statements of Financial Accounting Standards, as well as
Interpretations and Technical Bulletins, to guide individuals and organizations in preparing
audited financial statements. Before a formal statement is drafted, the FASB frequently issues
a Discussion Memorandum that identifies and realizes the issues to be considered. Public
hearings then are held on the issues identified in the discussion memorandum. Next, an
Exposure Draft of the proposed statement is circulated. These procedures are designed to
encourage the widest participation possible by all interested parties before a new financial
accounting statement is issued.

1.2 CONCEPTUAL FRAMEWORK FOR FINANCIAL ACCOUNTING AND

REPORTING

A Conceptual framework is like a constitution: it is a coherent system of interrelated

objectives and fundamentals that can lead to consistent standards and that prescribes the
nature, function, and limits of financial accounting and financial statements. Many have

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considered the board’s real contribution and even its continued existence to depend on the
quality and utility of the conceptual framework.

First, to be useful, standard setting should build on and relate to an established body of
concepts and objectives. A soundly developed conceptual framework should enable the
FASB to issue more useful and consistent standard in the future. A coherent set of standards
and rules should be the result, because they would be built up on the same foundation. The
frame work should increase financial statement users understanding of and confidence in
financial reporting and it should enhance comparability among companies’ financial
statements.

Second, new and emerging practical problems should be more quickly solved by reference to
an existing framework of basic theory.

Having understood the need for conceptual framework, let us see its development. Over the
years, numerous organizations, committees, and interested individuals developed and
published their own conceptual frameworks. But no single framework was universally
accepted and relied on in practice. Perhaps the most successful was the Accounting principles
Board statement NO.4, "Basic Concepts and Accounting Principles Underlying Financial
Statements of Business Enterprises", which described existing practice but did not prescribe
what practice ought to be. Recognizing the need for generally accepted framework, 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. It set forth the major issues that must be addressed in establishing a conceptual
framework that would be a basis for setting accounting standards and for resolving financial
reporting controversies. Since the publication of that document, the FASB has issued six
Statements of Financial Accounting Concepts (SFAC) that relate to financial reporting for
business enterprises. They are:

- Statement of Financial Accounting Concepts (SFAC) No 1. “Objectives of Financial

Reporting by Business Enterprises” presents the goals and purpose of accounting
- Statement of Financial Accounting Concepts No 2. “Qualitative Characteristics of
Accounting Information," Examines the characteristics that make accounting
information useful.
- Statement of Financial Accounting Concept No.3. “Elements of Financial Statements
of Business Enterprises," Providing definition of items in financial statements, such as
assets, liabilities, revenues and expenses.
- Statement of Financial Accounting Concepts No.5. "Recognition and Measurement in
Financial Statement of Business Enterprises," sets forth recognition and measurement
criteria and guidance on what information should be formally incorporated in to
financial statements and when.
- Statement of Financial Accounting Concepts No.6. “Elements of Financial
Statements", replaces statement of Financial Accounting Concept No.3 and expands
its scope to include not-for –profit organizations.
The conceptual framework for financial accounting can be presented pictorially as the one on
presented on the next page.

At the first level, the objectives identify the goals and purpose of accounting and are the
building blocks for the conceptual framework.

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At the second level are the qualitative characteristics that make accounting information useful
and the elements of financial statements (assets, Liabilities, and so on).

At the final or third level are the measurement and recognition concepts used in establishing
and applying accounting standards. These levels are explained in the following sections.

Recognition and Measurement concepts

Third level: The
"how” implementation

Qualitative Elements of
Characteristics Financial
Of Accounting Statements Second Level:
Information Bridge between
level 1 and 3

Objectives First level:

of Financial The "Why"-
Reporting goals and
Purposes of
accounting

Fig. 1 A conceptual Framework for Financial Reporting

Source L Kieso & Weyganot, Intermediate Accounting, volume 1, Ninth Edition

1.2.1. FIRST LEVEL: Objectives of Financial Reporting And Financial Statements

The objectives of financial reporting and financial statements are derived from the needs of
external users of accounting information. Financial statements often intended to serve all
external users often are called general - purpose financial statements. Stating the objectives of
financial statements would be simpler if all external users had the same needs and interests,
but they do not. Because general purpose financial statements serve a variety of users, the
needs of some users receive more emphasis than the needs of others.

The FASB issued SFAC No.1, “Objectives of Financial Reporting by Business Enterprises,"
to establish the objectives of general purpose external financial reporting by business
enterprises. This concept defines the target audience as those who
1. Lack the authority to prescribe the information they want and must rely on the
information management communicates to them.

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 2. Have a reasonable understanding of business and economic activities and are willing
to study the information with reasonable diligence.
The objectives were the following.
1. Financial reporting should provide information that is useful to present and potential
investors and creditors and other users in making rational investment, credit, and
similar decisions.
2. Financial reporting should be helpful to current and potential investors and creditors
and other users in assessing the amount, timing, and uncertainty of future cash flows
such as dividends or interest payments.
3. Financial reporting should provide information about the economic resources of an
enterprise, the claims to those resources, and the effects of transaction, events, and
circumstances that change recourses and claims to those resources.
4. Financial reporting 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.
Summarizing, the FASB's defined objectives of financial reporting, all of which focused on
providing information needed by current and prospective investors and creditors of a business
enterprise in their decision making. The primary emphasis was placed on information
regarding the enterprise earnings.

1.2.2. SECOND LEVEL: Fundamental Concepts

The objectives (first level) are concerned with the goals and purposes of accounting. Later,
we will discuss the ways these goals and purposes are implemented (third level). Between
these two levels it is necessary to provide certain conceptual building blocks that explain the
qualitative characteristics of accounting information and define the elements of financial
statement. These conceptual building blocks form a bridge between the why of accounting
(the objectives) and the how of accounting (recognition and measurement).

1.2.2.1 Qualitative Characteristics of Accounting Information

How does one decide whether financial reports should provide information on how much a
firm's assets cost to acquire ( historical cost basis) or how much they are currently worth
( current value basis)?

Choosing an acceptable accounting method, the amount and type of information to be

disclosed, and the format in which information should be presented involves determining
which alternative provides the most useful information for decision making purposes
(decision usefulness). The FASB has identified the qualitative characteristics of accounting
information that distinguishes better (more useful) information from inferior (less useful)
information for decision making purpose. In addition, the FASB has identified certain
constraints (cost - benefit and materiality) as part of the conceptual frame work.

The Qualitative characteristics may be viewed as a hierarchy, as shown in the diagram on the
following page.

1.2.2.1.1. Decision makers (users) and understandability

Decision makers vary widely in the type of decision they make, the methods of decision
making they employ, the information they already possess or can obtain from other sources,
and their ability to process the information. Consequently, for information to be useful there
must be a connection (linkage) between it and the users and the decisions they make.

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 This link, understandability, is the quality of information that permits reasonably informed
users to perceive its significance. Understandability of financial statements, however,
depends not only on the accountant's skills and abilities to comprehend that information. In
this regard, a user's ability could vary from being simplistic to expert.

Users of accounting Decision makers and their characteristics

information

Cost <Benefits Materiality

Constraints
(Pervasive constraint) (Threshold for recognition)

User-specific Understandability
qualities

Decision Usefulness

Primary qualities Relevance Reliability

Ingredients
of primary Predictive Feedback Timelin Verifiabil Representational Neutralit
qualities value value ess ity faithfulness y

Secondary Comparability Consistency

qualities

Fig. 1.2 Hierarchy of accounting qualities

Source: KIESO & WEYGANOT, Intermediate accounting volume 1, Ninth Edition

1.2.2.1.2. Primary qualities: Relevance and Reliability

Relevance and reliability are the two primary qualities that make accounting information
useful for decision making. As stated in FASB concepts statement No.2. “the qualities that
distinguish 'better' (more useful) information from 'inferior ' (less useful) information are
primarily the qualities of relevance and reliability, with some other characteristics that those
qualities imply."

A. Relevance

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To be relevant, accounting information must be capable of making difference in decision. If
certain information has no bearing on a decision, it is irrelevant to that decision. Relevance
can be evaluated according to three qualitative criteria:-
1. Timeliness- for information to be relevant, it must be available to decision makers
before it loses its capacity to influence their decision. Outdated information is
irrelevant for the decision at hand.
2. Predictive value- accounting information should be helpful to external decision
makers by increasing their ability to make predictions about the outcomes of future
vents.
3. Feedback value- accounting information should be helpful to external decision
makers who are confirming past predictions or make updates, adjustments, or
corrections to predictions.

B. Reliability
Reliability means that users can depend on accounting information to represent the
underlying economic conditions or events that it purports to represent. Accounting
information is reliable if it is reasonably free from error and bias and faithfully represents
what it purports to present. Reliability of information is a necessity for individuals who have
neither the time nor the expertise to evaluate the factual content of financial statements. Like
relevance, reliability must meet three qualitative criteria
1. Representational faith fullness – accounting information should present what it purports
to represent and should ensure that the selected method of measurement has been used
without error or bias. This attributes is some times called validity. The numbers and
descriptions should represent what really existed or happened. For example, if NIB
International Bank reports an income of birr 50 million when it had an actual income of
birr 35 million, then the statements are not a faithful representation.
2. Verifiability- is demonstrated when independent measures, using the same
measurement method, obtain similar results. For example, would several independent
auditors come to the same conclusion about a set of financial statements? If outside
parties using the same measurement methods arrive at different conclusions, then the
statement are not verifiable. Auditors could not render an opinion on these statements.
3. Neutrality – Accounting information must be free from bias regarding a particular view
point, predetermined result, or particular party. Factual, truthful, unbiased information
must be the overriding consideration. Preparers of financial statement must not attempt
to induce a predetermined outcome or a particular mode of behavior (such as to
purchase a company's stock.)

Conservatism: Although not a qualitative characteristic of accounting information,

conservatism is a concept that may be discussed with reliability. It is a policy of “playing
safe”. Many accounting measurements do not have a single" correct answer"; when
alternatives exist, a choice must be made among these alternative assumptions under
conditions of uncertainty. The concept of conservatism holds that when reasonable support
exist for alternative accounting methods and for different measurement techniques,
accountants should select the method or technique with the least favorable effect on net
income and financial position in the current accounting period. Business transactions should
be recorded in such a manner that profits are not overstated. Conservatism is applied as
follows:

- If there is a choice between two acceptable asset values, the lower figure is selected.
Accordingly, inventories are values at the lower of cost or net relatable value.

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 - Contingent loss is recognized if the loss is probable and the amount can be reasonably
estimated.
- Contingent gain is not recognized but disclosed only.
Conservatism is not to be taken as a license for deliberately understate net income and net
asset.

Conservatism is synonymous with prudence. Prudence is the desire to exercise care and
caution when dealing with uncertainties in the measurement process. Consequently, the
accountant should be cautious enough not to overstate assets and not to understate liabilities
and expenses. Conservatism generally is regarded as a powerful influence stressing caution
against the danger of overstating earnings or financial position.

Many business enterprises however, are not in favor of conservative accounting policies.
What do you think is the reason behind? What do they benefit by overstating their reports?
Enterprises planning to issue securities to the public naturally try to project an image of
superior management and superior earnings. An enterprise that reports increased earning year
after year gains the reputation of being a "growing company" and the market price of its
common stock often rises to a high multiple of earnings per share. Once such a reputation is
established, an enterprise finds it easier to raise needed capital through the issuance of
additional securities or through bank loan. All these pleasant economic consequences of a
reputation for increasing earnings given enterprise management a powerful incentive to
choose accounting policies that maximize current net income.

However, enterprises must be alert to the possible economic consequences of following

unconstructive accounting policies. The issue we are raising relates to the quality of reported
earnings. The earnings of an enterprise using unconstructive accounting policies are viewed
as being of lower quality, and its common stock will tend to trade at a low price-earnings
ratio.

Ideally, accountants should make estimates and select accounting policies that neither
overstate nor understate the current net income and financial position of a business enterprise.
The concept of conservatism should not be distorted to the point of deliberate understatement.

1.2.2.1.3. Secondary Qualities: Comparability and consistency

The qualitative characteristic we have discussed above are not the only characteristics that
make accounting information useful. The potential use of different acceptable methods by an
enterprise in different year, or by different companies in a given year, would make
comparison of financial results difficult. Consequently, in order to enhance the usefulness of
accounting reports, the qualities of comparability and consistency are components of the
conceptual framework. They are considered to be secondary in our hierarchy to the qualities
of relevance and reliability.

If information to be useful, it must first be relevant and reliable but achieving these primary
qualities may require foregoing the secondary qualities. Information about an enterprise is
more useful if it can be compared with similar information about other enterprises and with
similar information about the same enterprise at other points in time.

A. 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. Thus,

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comparability is a characteristic of relationship between two pieces of information rather than
of a particular piece of information itself.

Comparability enables users to identify the real similarities and differences in economic
phenomena because these similarities and differences have not been obtained by the use of
non comparable financial statements. Comparability of the financial statements of a business
enterprise from one accounting period to the next is essential if favorable and unfavorable
trends in the enterprise are to be identified. If the financial statements for the current
accounting period show larger earnings than for the preceding period, the user assumes that
operations have been more profitable. However, if a material change in the accounting
principle has occurred, the reported increase in earnings could have been caused solely by the
accounting change, rather than any improvement in the underlying business activity.
Therefore, these statements are not comparable.

Comparability of financial statements of different enterprises with in the same industry

enables users make valid evaluation of alternatives in resource allocation decisions. For
example, if NIB international Bank capitalizes its marketing costs, but Abyssinia Bank
expenses these costs, it is more difficult to compare and evaluate the financial results of these
two companies. NIB international Bank may report a higher net income because it capitalized
its marketing costs. Therefore, a valid evaluation can be made only if comparable information
is available.

B. Consistency
When an entity applies the same accounting treatments to similar events, from period to
period, the entity is considered to be consistent in its use of accounting standards. The
consistent application of accounting principles for a business enterprise is needed in order
that the financial statements of successive periods will be comparable.

The consistency principle does not mean that particular method of accounting, once adopted,
should not be changed. Accounting methods and principles change in response to changes in
the environment of accounting. APB opinion No.30, “Accounting changes," stated that:
The presumption that an entity should not change an accounting principle may be
overcome only if the enterprise justifies the use of an alternative acceptable
accounting principle on the basis that it is preferable.

The nature of and justification for a change in accounting principle and its effect on
income should be disclosed... The justification for the change should explain why the
newly adopted accounting principle is preferable.

Constraints
In providing information with the qualitative characteristics that makes it useful, two
overriding constraints must be considered: (1) the const benefit relationship and (2)
materiality.

1. Cost Benefit Relationship

Users assume that information is a cost free commodity. But preparers and providers of
accounting information know that it is not. Therefore, the cost-benefit relationship must be
considered. The cost of providing the information must be weighted against the benefits that
can be derived from using the information. Obviously the benefit should exceed the costs. In
order to justify requiring a particular measurement or disclosure, the benefits perceived to be

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derived from it must exceed the costs perceived to be associated with it ( the benefit derived
from the information should exceed the cost incurred in obtaining the information).

The difficulty in cost-benefit analysis is that the cost and especially the benefits are not
always evident or measurable. The costs are of several kinds, including costs of collecting
and processing, costs of disseminating, costs of auditing, costs of potential litigation, costs of
disclosure to competitors, and costs of analysis and presentation. Benefits accrue to preparers
in terms of greater management control and access to capital and to users in terms of
allocation of resources, tax assessment, and rate regulation. But benefits are generally more
difficult to quantify than are costs. Thus, the evaluation of benefit and cost is substantially a
judgmental process. Assessing whether the cost of reporting outweighs or falls short of the
benefit is difficult and become a matter of professional judgment.

Recently, the AICPA Special Committee on Financial Reporting submitted constraints to

limit the costs of reporting. Some of them are the following:
1. Business reporting should exclude information outside of management's expertise or
for which managements is not the best source, such as information about competitors.
2. Management should not be required to report information that would significantly
harm the company's competitive position.
3. Management should not be required to provide forecasted financial statements.
Rather, management should provide information that helps users forecast for
themselves the company's financial future.

2. Materiality
The constraint of materiality relate to an items impact on the firm'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 immaterial and, therefore, irrelevant if it would have no
impact on a decision maker. In short, it must make a difference or it need not be disclosed.
The point involved here is one of relative size and importance. If the amount involved is
significant when compared with the other revenue and expenses, assets and liabilities, or net
income of the entity, sound and acceptable standards should be followed. If the amount is so
small that is quite unimportant when compared with other items, application of a particular
standard may be considered of less importance.

SFAC No.2 sets forth the essence of materiality: " The omission or misstatement of an item
in a financial reports is material if, in the light of surrounding circumstances, the magnitude
of the item is such that it is probable that the judgment of a reasonable person relying up on
the report would have been changed or influenced by the inclusion or omission of the item"

It is difficult to provide firm guides in judging when a given item is or is not material because
materiality varies both with relative amount and with relative importance. For example, the
two sets of numbers presented on the following page illustrate relative size.

Company A Company B
Sales $ 10,000,000 $ 100,000
Costs and expense 9,000,000 90,00
Operation Income $ 1,000,000 $ 10,000
Unusual gain $ 20,000 $ 5,000

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During the period in question, the revenues and expenses and, therefore, the net incomes of
company A and company B have been proportional. Each has had an unusual gain. In looking
at the abbreviated income figures for company A, it does not appear significant whether the
amount of the unusual gain is set out separately or merged with the regular operating income.
It is only 2% of the net income and, if merged, would not seriously distort the net income
figure. Company B has had an unusual gain of only 5,000, but it is relatively much more
significant than the larger gain realize by A. For company B, an item of 5,000 amounts to
50% of its net income, obviously, the inclusion of such an item in ordinary operating income
would affect the amount of that income materially. Thus we see the importance of the relative
size of an item in determining its materiality.

1.2.2.2. Elements of Financial Statements

An important aspect of developing any theoretical structure is the establishment and
definition of the basic elements or items to be included in the structure. At present,
accounting uses many terms that have peculiar and specific meanings. These terms constitute
the language of business or the jargon of accounting.

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 as follows:

Assets:
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
1. Have future economic benefits (be capable of producing profits).
2. Be under managements control ( can be freely deployed or disposed of)
3. Result from past transaction ( the transaction or event giving rise to the entity’s right
to, or control of, the benefit has already occurred)
Liabilities
Liabilities are probable future sacrifices of economic benefits arising from present obligations
of a particular entity to transfer assets or provide services to other entity's in the future as a
result of past transactions or events.
To qualify as liabilities, obligations must:
1. Require transfer of assets having future economic benefit.
2. Specify to whom the asset must be transferred (the terms, parties, and conditions
under which asset transfers will take place must be specified).
3. Result from past transactions.
Equity
Equity is the residual (ownership) interest in the assets of an entity that remains after
deducting its liabilities. While equity in total is a residual, it includes specific categories of
item, for example, type of share capital, contributed surplus and retained earnings.

Investment by owners
Are increases in net assets of a particular enterprise resulting from transfer to it from other
entities of something of value to obtain or increase ownership interest (or equity) in it. Assets
are most commonly received as investment by owners, but that which is received may also
include services or satisfaction or conversion of liabilities of the enterprise.

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Distribution to owners
Are decreases in net assets of a particular enterprise resulting from transferring assets,
rendering services, or incurring liabilities by the enterprise to owners. Distribution to owners
decreases ownership interest (or equity) in an enterprise. They are characterized as:
1. Cash dividend payments or declarations
2. Transfer of assets to owners
3. Liquidating distribution (asset sale proceeds)
4. Conversion of equity ownership to liabilities.
Comprehensive Income
Is the change in equity (net asset) of an entity during a period 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.
Revenues
Are inflows or other enhancements of assets of an entity or settlement of its liabilities (or a
combination of both) during a period from delivering or producing goods, rendering services,
or other activities that constitute the entity on going major or central operations. The two
essential characteristics of a revenue transaction are
1. It arises from the company's primary earning activity (main stream business lines) and
not from incidental or investment transactions (assuming that the entity is a non
investment company).
2. It is recurring

Expenses
Are outflows or other using up of assets or incurrence of liabilities (or a combination of both)
during a period from delivering or producing goods, rendering services, or carrying out other
activities that constitute the entity's on going major or central operations.
The essential characteristic of an expense is that 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.

Gains
Are increases in equity (net asset) from peripheral or incidental transactions of an entity and
from all other transactions and other events and circumstances affecting the entity during a
period except those that result from revenues or investment by owners.

Losses
Are decreases in equity (net asset) from peripheral of incidental transactions of an entity and
from all other transactions and other events and circumstances affecting the entity during a
period except those that result from expenses or distributions to owners.

Two important points should be noted about those definitions. First, the term comprehensive
income represents a new concept. Comprehensive income is more inclusive than the
traditional net income. It includes net income and all other changes in equity exclusive of
owners' investment and distributions. Second, the FASB classifies the elements in to two
distinct groups. The first group of three elements-assets, liabilities, and equity-describes
amounts of resources and claims to resources at a moment in time. The other seven elements
(comprehensive income and its components) describe transaction, events, and circumstances
that affect an enterprise during a period of time. The first class is changed by the elements of
the second class and at any time is the cumulative result of all changes.

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1.2.3. THIRD LEVEL: Recognition and Measurement concepts
The third level of the framework consist concepts that implement the basic objectives of level
one. These concepts explain which, when and how financial elements and events should be
recognized, measured, and reported by the accounting system.

Recognition pertains to the point in time when business transactions are recorded in the
accounting system. According to SFAC NO.5, to be recognized, an item (event or
transaction) must meet the definition of an “element of financial statements" as defined in
SAFC No.6 and must be measurable. SFAC No.5 suggests the use of different attributes
(historic cost, current cost, market value, etc) will continue and discusses the means by which
the board may select the appropriate attribute in a specific case.

The accounting profession continues to use the concepts in SFAC NO.5 as operational guide
lines. However, these concepts were not newly formulated by FASB, but were existing-
guidelines that the board reiterated in SFAC No.5. These concepts are discussed under the
section Generally Accepted Accounting principles:

1.3. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

Generally Accepted Accounting Principles are broad guidelines, conventions, rules, and
procedures of accounting. The term GAAP has long been used in financial accounting. This
term is also used by CPAs in their audit reports to indicate whether the business enterprise
being audited has prepared its financial statements in acceptable manner, so that they may be
compared with prior year’s statements and to some extent with the statements of other
enterprises.

The principles of accounting are not rooted in the laws of nature as the physical sciences.
Therefore, accounting principles must be developed in relation to the stated objectives of
financial reporting and financial statements.

Although a body of generally accepted accounting principles has long been recognized, no
complete list of such principles exists. The most authoritative sources of GAAP in recent
years have been the statement issued by the FASB, the opinions issued by the APB, the
Accounting Research Bulletin issued by the AICPA Committee on Accounting Procedures,
and Financial Reporting Releases issued by SEC. In the following sections we will discuss a
number of fundamental accounting principles and concepts which are considered as GAAP.

BUSINESS ENTITY PRINCIPLE

Because economic activity is carried on by various legal and economic entities, accounting
results are summarized in terms of these entities. Accounting deals with specific, identifiable
business entities, each considered an accounting unit separate and apart from its owners and
other entities. A corporation and stockholders are separate entities for accounting purposes.
Also, partnership and sole proprietorships are treated as separate from their owners, although
this assumption does not hold true in a legal sense.

Under the separate entity assumption all accounting records and reports are developed from
the viewpoint of a single entity, regardless of the form of the organization. The assumption is
that an individual’s transactions are distinguishable from those of the business he or she
might own. For example the personal residence of a business owner is not considered as an
asset of the business, even though the residence and the business are owned by the same

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person. The activities of an enterprise should be kept separate and distinct from any other
business unit so that it would be possible to know how the business is doing. For example, if
the activities and elements of East African Bottling Company could not be distinguished from
those of MOHA Soft Drinks Factory, then it would be impossible to know which company
outperformed the other.

Economic Entity (Unit) includes all business enterprises organized for profit or non profit
goals, governmental institutions, churches, schools, etc. Therefore, this principle can also be
applied to all entities other than those seeking for profit.

Accountant sometimes find it useful to prepare financial statements for economic entities that
do not coincide with legal entities. For example, consolidated financial statements often are
prepared for an economic entity that includes corporate entities operating under common
control exercised though common stock ownership. In contrast, separate financial statements
may be prepared for divisions or segments of a large corporation.

CONTINUIY OR GOING - CONCERN PRINCIPLE

Under this principle, the business entity in question is expected not to liquidate, but to
continue operations for the foreseeable future. That is, it will stay in the business for a period
of time sufficient to carry out contemplated operations, contracts and commitments.
Generally accountants assume that business entity will continue to exist indefinitely.

In deciding how to report various items in financial statements, accountants are often faced
with this issue: “shall we assume that the business enterprise (entity) will continue to
operate?, or shall we assume that the enterprise will be terminated within the near future?”.
The most probable situation for most enterprises in general is that they will continue to
operate for an indefinite period of time, and this is the most fundamental assumptions
underlying financial accounting. This no liquidation assumption provides a conceptual basis
for many of the classifications used in accounting. Assets and liabilities, for example, are
classified as either current or long term on the basis of this assumption. Continuity also
supports the measurement and recording of assets and liabilities at historical cost.

To illustrate the significance of the continuity principle, consider the possibility that if an
enterprise ceased operations, certain liability would mature immediately and require a
payment in excess of their carrying amount. Productive assets such as machinery might have
to be sold at a substantial loss. The assumption of continued existence provides the logical
basis for recording probable future economic benefits as assets and probable future outlays as
liabilities
There are times where the going concern principle gives way to evidence that an enterprise
has limited life or intends to terminate operations. In such cases, accountants prepare
financial statements under the assumption of quitting concern rather than going concern.

REVENUE REALIZATION PRINCIPLE

The revenue realization principle deals with the point of time at which the revenue is
considered as earned. It asserts that revenue is realized when goods are transferred or services
are rendered to a customer. Revenue is not realized when an order is received from a
customer. The realization of revenue takes place only on the execution of that order.
Likewise, an advance collection from customers is not treated as revenue earned. So when
revenue should be realized? These aspects will be discussed in detail in chapter three.

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VALUATION PRINCIPLE
Realization, which is a key principle in income measurement, forms the basis for
distinguishing methods of valuation used in the reporting of assets and liabilities in the
balance sheet.

A general class of assets called monetary assets usually is carried in the balance sheet at
amounts closely approximating current value. Examples of monetary assets are cash,
certificates of deposit, short-term investments, and receivables. All these assets represent
current purchasing power. Promissory notes receivables and notes payables that are non-
interest bearing, or that have an unrealistically low rate of interest, are not to be valued at face
amount, but at their present value. Present value is determined by discounting all future
payments on a promissory note at the current fair rate of interest. This requirement for
discounting receivables and payables to their present value applies principally to notes; it is
not applicable to receivables and payables arising from transactions with customers or
suppliers that are due within one year or less.

Another broad category of assets, termed non-monetary assets or productive resources, are
reported in the balance sheet at costs. Inventories and prepayments are examples of short-
term productive resources that will be realized (used) at an early date. Building, equipments,
patents, and investments in affiliated companies are examples of long term productive
resources that will be realized over a number of accounting periods. Until realization occurs,
productive resources are measured and reported in the balance sheet at historical costs; after
realization, valuations of the monetary assets received in exchange for productive assets
generally approximate current fair value. These valuation principles govern the accounting
for assets.

How should costs be measured when non-monetary assets or services are acquired in non-
cash transactions? For example, a land may be acquired in exchange for corporations’
common stock .Cost then is defined as the cash equivalent or the current fair value of the land
acquired or the cash equivalent of the common stock issued which ever is more clearly
evident.

Because a liability is an obligation to convey assets or perform services the appropriate

valuation of liabilities in a balance sheet is in terms of the cash or cash equivalent value
necessary to discharge the obligation on the balance sheet date. If payment is to be made
later, liabilities are measured at the present discounted value of the future payments necessary
to discharge the obligation.

MATCHING PRINCIPLE
The matching principle means that after the revenue (accomplishment) for an accounting
period has been determined, the cost (effort) associated with the revenue must be deducted
from the revenue to measure net income. The term matching refers to the close relationship
that exists between certain costs and the revenue recognized as a result of incurring those
costs. The matching of business enterprises expenses (or expired costs) with its revenue for
an accounting period is the primary activity in the measurement of the results of an
enterprise’s operations for that period.

All expenses incurred during the relevant period may not be related to that period alone.
Expenses relating to the previous period of the subsequent period might have been incurred

17
during the period under reference. Likewise, the entire amount of revenue received may not
be of the current period.

In the matching concept, only those expenses pertaining to the current accounting period
must be matched against the revenue relating to the same period. For example, expenditures
for advertising attract customers and generate sales. The outlay for advertising is one of the
expenses to be deducted from the revenue of the accounting period. Similarly, the recognition
of doubtful accounts expense illustrates the importance of the accounting period in the
matching of expenses and revenue. Doubtful accounts expense is caused by selling goods or
services on credit to customers who fail to pay their bills. To match this expense with the
related revenue, the expense must be recorded and deducted from the revenue in the
accounting period in which the sales are made and recorded, even though the receivables are
not determined to be un-collectable until the following period. Thus, the use of estimates is
necessary in this and many other situations in order to implement the matching principle.

MONETARY PRINCIPLE
The monetary principle states that money is the common denominator or a useful standard
measuring unit for reporting the effects of business transactions. It is used as a common
denominator throughout the accounting process. As per this principle, only transactions that
can be measured in terms of money are recorded in the books of account. The basic purpose
of using money is to maintain an element of uniformity among diversity. An event or
transaction that cannot be expressed in terms of money cannot be recorded in the books of
accounts.

The monetary principle, however, suffers from the following shortcomings:

It does not recognize the changes in the purchasing power of money
Human resources which are the greatest assets of the firm cannot be recorded in the
books of accounts since their value cannot be measured in terms of money. Examples
are the competence, health and morale of management and employees, and the effects
of the operations of the enterprise on the natural environment.

To complement the shortcomings of measurement units, a possible alternative method of

communicating additional information, which cannot be stated in monetary value, is to use
notes to the financial statements. Notes of information are included in the financial
statements.

DISCLOSURE PRINCIPLE
The disclosure principle requires that financial statements be complete in the sense of
including all information necessary to users of the statements. If the omission of certain
information would cause the financial statements to be misleading, disclosure of such
information is essential. All the accounting statements must be prepared honestly and must
contain all relevant and material information. But it does not mean that business sectors and
similar matters must be made public. It only implies that the public financial statements must
fully disclose the true and fair view of the state of affairs of the concern for a particular
period or on a particular date.

Published financial statements include detailed notes that are considered to be an integral part
of the statements. However, disclosure in the notes should supplement the information in the
body of the financial statements and should not be used to correct improper presentation of
information in the body of the statements. Typical examples of information often disclosed in

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notes to financial statements include the following: a summary of significant accounting
policies, related party transactions, descriptions of stock option and pension plans, status of
litigation in which the business enterprise is a party, amount and nature of loss contingencies
and commitments, and terms, and status of proposed business combinations.

The concept of disclosure applies not only transactions and events that have occurred during
the accounting period covered by the financial statements, but also to material subsequent
events that occur after the balance sheet date but before the financial statements are released.
Such events are disclosed in the note to the financial statements.

1.4. CASH FLOWS AND INCOME MEASUREMENT

This section clearly explains and contrasts the cash basis of accounting with the accrual basis
of accounting.

1.4.1 ACCRUAL BASIS OF ACCOUNTING

Accrual basis of accounting is a system of accounting that requires an event that alters the
economic status of the firm as represented in its financial statements be recorded (recognized)
in the period in which the event occurs rather than in the period cash changes hands.

When this system is used, revenues are reported in the income statement when they are
earned and expenses are reported in the income statement when they are incurred, without
regard to the timing of cash receipts or payments. When we say revenues are earned, it means
the service is rendered or the items are sold, and when we say expenses are incurred, it means
that employees are engaged or services are used or items are consumed.

Under the accrual basis of accounting, the accounting records are adjusted periodically to
ensure that all assets and liabilities (and thus revenue and expenses) are correctly stated. That
is, the accrual basis of accounting is inline with the matching principles therefore net income
under this method is determined as realized revenue minus incurred expenses.

Information concerning cash flows during an accounting period is valuable in judging the
ability of the business enterprise to pay its debts, to pay its regular dividends, to finance
replacement of productive assets, and to expand its scope of operations. However, the
increase or decrease in cash during a period is not useful in evaluating an enterprise’s
operating performance, because cash receipts and payments are not representative of the
economic activities carried on in specific periods.

1.4.2. CASH BASIS OF ACCOUNTING

The cash basis of an accounting system is an accounting system based on the timing of cash
payments and receipts. Under this system, revenue is recorded only when cash is received
and expenses are recorded only when cash is paid. The determination of income thus rests on
the collection of revenues and the payment of expenses, rather than on the realization of
revenue and the incurring of expenses. Use of the cash basis of accounting is not compatible
with the matching principle. Consequently, financial statements prepared under the cash basis
of accounting do not present the financial position or operating results of an enterprise in
conformity with GAAP.

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A strict cash basis of accounting seldom is found in practice and is usually implemented by
small enterprises, but a modified cash basis (mixed cash - accrual basis) may be used for
income tax purposes. Under the modified cash basis of accounting, tax payers who acquire
property having an economic life of more than one year may not deduct the entire cost in the
year of acquisition. They must treat the cost as an asset to be depreciated over its economic
life. Expenses such as rent or advertising paid in advance (prepayments) also are regarded as
assets and are deductible only in the year received. But expensed paid after the year of
incurrence (accrued expenses) are deducted only in the year paid. Individuals and personal
service businesses may report revenue in the year received for taxation purpose.

However, in any business enterprise in which the purchase, production, or sale of

merchandise is a significant factor, these transactions must be reported on an accrual basis.
For example, when merchandise is sold on credit, the revenue must be recognized
immediately. The cost of goods sold must reflect purchases on credit and inventories on hand,
whether paid for or not. Thus, for a merchandising enterprise the revenue from sales, the cost
of goods sold, and the gross profit on sales will be the same under the accrual basis of
accounting as under the modifies cash basis of accounting.

Let us clearly see the impact of the different bases of accounting on financial reporting with
the help of illustration.

Assume that a contractor begins business in period 1 and agrees to construct a building to an
insurance company for birr 100,000. During period 1, the contractor incurred costs of birr
50,000 on credit in constructing the building and delivered the completed building to the
client in the same year. In period 2, the contractor collected the contract price of birr 100,000
from the insurance company. In period 3, the contractor paid his creditors birr 50,000 due.
On the basis of the above data, the contractor's net incomes for each period under accrual and
cash basis of accounting are as follows:

Period
Cash basis of accounting 1 2 3 Total
Cash receipts 0 100,000 0 100,000
Cash disbursements 0 0 50,000 50,000
Net income 0 100,000 (50,000) 50,000
Accrual basis of
accounting
Revenues 100,000 - - 100,000
Expense 50,000 - - 50,000
Net Income 50,000 0 0 50,000
From the above, you can observe that accrual accounting and cash basis of accounting differ
in the timing of net income. However, accrual basis of accounting is superior to cash basis of
accounting from the view point of the definitions of financial statement elements.

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Converting Accrual basis to Cash basis of accounting or vice versa
Cash basis adjustments Accrual basis
o Cash received + A/R end – A/R beg =Net sales

o Rent received + Rent Rec. end – Rent Rec. beg

+ Prepaid rent beg – prepaid rent end = Rent revenue

o Cash paid for + Inve Beg – Inve .End + A/P End –A/P Beg = C.G.S
suppliers

o Cash paid for exp. + accrued liab. End – accrued liab. Beg
+prepaid expe beg – prepaid exp. end = Oper. Expenses

o None accumulated depn end – accum. Dep beg = Dep. expenses

(assume no sale of plant assets in the year)

Additional illustration is given below to show you how to restate from one basis of
accounting to another basis of accounting. In this case, we are going to convert a cash basis to
accrual basis of accounting.

Assume Rahel Johannes, a practicing lawyer who maintains accounting records on the cash
basis of accounting. During year 6, Rahel collected from her clients $200,000 and paid
$90,000 for operating expenses, resulting in a cash basis net income of $110,000 (200,000 -
90,000). Rahel's fees receivable, accrued liabilities, and short term prepayments on January 1
and on December 31, year 6, were as follows:

Jan, 1, year 6 Dec, 3 year 6

Fees receivable $ 26,000 50,000
Accrued liabilities 10,000 6,000
Short-term 8,000 3,000
prepayments

A working paper that shows the necessary adjustments to restate Rahel's income statement
from the cash basis of accounting to accrual basis of accounting is illustrated on the next
page.

Note that the revenue from fees under the cash basis does not include the fees receivable Dec.
31, which were realized in year 5. Therefore, this amount is added to the cash collected in the
restatement of revenue from fees to the accrual basis of accounting. Because fees receivable
on January 1 were realized in year 5 and collected in year 6, this amount is subtracted from
cash collections in the restatement of revenue from fees to accrual basis of accounting.

The amount of accrued liabilities on January 1, year 6, represents expenses of year 5 paid for
in year 6, and the amount of short-term prepayments on December 31, year 6, represents cash
out lays in year 6 for services that will be consumed in year 7. Therefore, both amounts are

21
 deducted from the amount of cash paid to restate the operating expenses for year 6 to the
accrual basis of accounting.

Rahel Yohannes, Lawyer

Working paper to restate Income Statement From
Cash Basis to Accrual Basis of Accounting
For Year Ended December 31, Year 6
Income Adjustments to restate Income
statement to accrual basis of statement
under cash accounting under
basis of accrual
accounting Add Deduct basis of
accounting

Revenue from fees received in cash…….. 200,000

Add: Fees receivable, Dec. 31 224,000

Year 6 …………………………….. 50,000
Less: Fees receivable, Jan.1 Year 6........... 26,000

Operating expenses paid in cash……….. 90,000

Add: Accrued liabilities, Dec. 31,
Year 6 …………………………. 6,000
Short-term prepayments Jan 1,
Year 6 ………………………… 8,000
91,000
Less: Accrued Liabilities, Jan 1 year 6 …. 10,000
Short term prepayments Dec.31,
Year 6 ……………………….. 3,000
Net income under cash basis of
accounting…………………………… 110,000
Net income under accrual basis of 133,000
accounting

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