Chapter Two

Accounting Concepts and Principles

 The environment of Accounting
 Accounting functions in a dynamic environment.
 Changes in technology, economic and political factors
can significantly influence accounting practice.
 Four particularly important factors that influence the
environment in which accounting operates are:
• The development of GAAP
• International business
• Ethical Considerations
• and technology
 Need for high quality international standard
 To facilitate efficient capital allocation, investors need
relevant information and a faithful representation of that
information to enable them to make comparisons across
borders.
 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 a firm that is comparable
with other firms.
 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.
 The major standard-setters of the world, coupled with
regulatory authorities, now recognize that capital
formation and investor understanding is enhanced if a
single set of high-quality accounting standards is
developed.
 Significant changes in the financial reporting
environment are taking place
 International standard setting organization

 For many years, many nations have relied on their own

standard-setting organizations.
 For example; Japan, Canada, German and United states.
 The standards issued by the organizations in these
countries 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, United Kingdom, 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 is presently used or permitted in over 120 countries and
is rapidly gaining acceptance in other countries as well.
 IFRS has the best potential to provide a common platform on
which companies can report and investors can 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.

International Organization of Securities Commissions

(IOSCO)
 IOSCO is an association of organizations that regulate the
world’s securities and futures markets.
 Members are generally the main financial regulator for a
given country.
 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.
 International Accounting Standards Board (IASB)
 The standard-setting structure internationally is
composed of the following four organizations:
• The IFRS Foundation
• The International Accounting Standards Board (IASB)
• The IFRS Advisory Council (the Advisory Council)
• The IFRS Interpretations Committee
 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.
 The IASB develops, in the public interest, a single set of
high-quality, enforceable, and global international
financial reporting standards for general-purpose
financial statements.
 The IFRS Advisory Council (the Advisory Council)
provides advice and counsel to the IASB on major
policies and technical issues.
 The IFRS Interpretations Committee assists the IASB
through the timely identification, discussion, and
resolution of financial reporting issues within the
framework of IFRS.
 Discussion Questions

1. Discuss the environment of Accounting

2. Discuss the Need for high quality international
standard
3. Explain the role of different organizations in setting
international financial reporting standards
Conceptual Framework for Financial Reporting

 Everyone agrees that accounting needs a framework—a

conceptual framework, that will help guide the development
of standards.
 This Conceptual Framework for Financial Reporting sets
forth the fundamental objective and concepts that the Board
uses in developing future standards of financial reporting.
 A conceptual framework establishes the concepts that
underlie financial reporting.
 A conceptual framework is a coherent system of concepts
that flow from an objective.
 The objective identifies the purpose of financial reporting.
 The other concepts provide guidance on:
(1) identifying the boundaries of financial reporting
(2) selecting the transactions, other events, and
circumstances to be represented;
(3) how they should be recognized and measured; and
(4) how they should be summarized and reported.
Why do we need a conceptual framework?
• It provided a guideline
• Enable to more quickly solve new and emerging practical
problems by referring to an existing framework of basic
theory.
The IASB’s Conceptual Framework for Financial
Reporting
First level(Why): Objectives of financial reporting
Second level: qualitative characteristics of accounting
information and elements of financial statements
Third level(How): recognition, measurement and disclosure
concepts
 1. Objectives of financial reporting

 The objective of financial reporting is the foundation of

the Conceptual Framework.
 Other aspects of the Conceptual Framework—qualitative
characteristics, elements of financial statements,
recognition, measurement, and disclosure—flow logically
from the objective.
 Those aspects of the Conceptual Framework help to ensure
that financial reporting achieves its objective.
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.
 To provide information to decision-makers, companies
prepare general-purpose financial statements.
 General-purpose financial reporting helps users who lack
the ability to demand all the financial information they need
from an entity and therefore must rely, at least partly, on the
information provided in financial reports.
 Financial statement preparers assume a level of competence
on the part of users.
2. Qualitative Characteristics of Accounting
Information

 The IASB identified the qualitative characteristics of

accounting information that distinguish better (more useful)
information from inferior (less useful) information for
decision-making purposes.
 In addition, the IASB identified a cost constraint as part of
the Conceptual Framework.
 Qualitative characteristics are either fundamental or
enhancing characteristics, depending on how they affect
the decision-usefulness of information.
 Providing useful financial information is limited by a
pervasive constraint on financial reporting—cost should
not exceed the benefits of a reporting practice.
Fundamental Qualities
 Relevance
 Faithful Representation

1. Relevance
 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.
2. Faithful Representation
Faithful representation is the second fundamental quality that
makes accounting information useful for decision-making.

Faithful representation means that the numbers and

descriptions match what really existed or happened.
To be a faithful representation, information must be complete,
neutral, and free of material error.
Enhancing Qualities
 Enhancing qualitative characteristics are complementary to
the fundamental qualitative characteristics.
 These characteristics distinguish more-useful information
from less-useful information.
 Enhancing characteristics are:
 comparability,
 verifiability,
 timeliness, and
 understandability.
 Elements of financial statements
The elements directly related to the measurement of financial

position are assets, liabilities, and equity. These are defined as

follows.
 ASSET. Resource controlled by the entity as a result of past events
and from which future economic benefits are expected to flow to the
entity.
 LIABILITY. Present obligation of the entity arising from past events,
the settlement of which is expected to result in an outflow from the
entity of resources embodying economic benefits.
 EQUITY. Residual interest in the assets of the entity after deducting
all its liabilities.
The elements of income and expenses are defined as follows.
INCOME. Increases in economic benefits during the accounting
period in the form of inflows or enhancements of assets or
decreases of liabilities that result in increases in equity, other than
those relating to contributions from shareholders.
EXPENSES. Decreases in economic benefits during the
accounting period in the form of outflows or depletions of assets
or incurrences of liabilities that result in decreases in equity, other
than those relating to distributions to shareholders.
3. Recognition, Measurement and Disclosure
Concepts

 These concepts explain how companies should recognize,

measure, and report financial elements and events.
 Here, we identify the concepts as basic assumptions,
principles, and a cost constraint.
 The conceptual framework specifically identifies only
one assumption—the going concern assumption.
 However, there are a number of other assumptions
that are present in the reporting environment.
The five basic assumptions are:
1. Economic entity
2. Going concern
3. Monetary unit
4. Periodicity, and
5. Accrual basis
 Concept of measurement
 Money is the common denominator of economic activity
and provides an appropriate basis for accounting
measurement and analysis.
 That is, the monetary unit is the most effective means of
expressing to interested parties changes in capital and
exchanges of goods and services.
 Application of this assumption depends on the even more
basic assumption that quantitative data are useful in
communicating economic information and in making
rational economic decisions.
 Discussion Questions

1) Explain the purpose of financial reporting

2) Discuss the IASB’s conceptual framework for
financial reporting
3) Explain the general-purpose financial reporting
 Accrual and cash basis of accounting

Accrual Basis of Accounting

 Companies prepare financial statements using the accrual
basis of accounting.
 means that transactions that change a company’s financial
statements are recorded in the periods in which the events
occur.
 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).
 Companies recognize expenses when incurred (the expense
recognition principle) rather than when paid.

Cash basis of Accounting

 Companies record revenue only when cash is received. They
record expenses only when cash is paid.
 The cash basis of accounting is prohibited under IFRS.
 Because it violates revenue recognition principle and
expense recognition principle.
 Most companies use accrual-basis accounting.
 Some small companies and the average individual
taxpayer, however, use a strict or modified cash-basis
approach.
 The modified cash basis is a mixture of the cash basis
and the accrual basis. It is based on the strict cash basis
but with modifications that have substantial support, such
as capitalizing and depreciating plant assets or recording
inventory.
 Basic Principles of Accounting
We generally use four basic principles of accounting to record and
report transactions:
(1) measurement, (2) revenue recognition, (3) expense recognition,
and (4) full disclosure.
(1) Measurement Principle
 The most commonly used measurements are based on historical
cost and fair value.
 Selection of which principle to follow generally reflects a trade-
off between relevance and faithful representation.
 IFRS requires that companies account for and report many assets
and liabilities on the basis of acquisition price.
 Cost has an important advantage over other valuations:
 It is generally thought to be a faithful representation of
the amount paid for a given item.
 Fair value is therefore a market-based measure. Recently,
IFRS has increasingly called for use of fair value
measurements in the financial statements.
 Fair value information may be more useful than historical
cost for certain types of assets and liabilities and in certain
industries.
 The IASB believes that fair value information is more
relevant to users than historical cost.
 Fair value measurement, it is argued, provides better insight
into the value of a company’s assets and liabilities (its
financial position) and a better basis for assessing future
cash flow prospects.
 Recently, the Board has taken the additional step of giving
companies the option to use fair value (referred to as the fair
value option) as the basis for measurement of financial
assets and financial liabilities.
 The IASB considers fair value more relevant than historical
cost because it reflects the current cash equivalent value of
financial instruments.
 Use of fair value in financial reporting is increasing.
 However, measurement based on fair value introduces
increased subjectivity into accounting reports when fair
value information is not readily available.
2) Revenue Recognition Principle
 The revenue recognition principle requires that companies
recognize revenue in the accounting period in which the
performance obligation is satisfied.

3) Expense Recognition Principle

 Recognition of expenses is related to net changes in assets
and earning revenues.
 In practice, the approach for recognizing expenses is, “Let
the expense follow the revenues.”
 This approach is the expense recognition principle.
 The matching principle is applied to measure and recognize
the expenses of that period.
 The costs of those assets and services used up should be
recognized and reported as expenses of the period during
which the related revenue is recognized.
 Some costs, however, are difficult to associate with revenue.
 As a result, some other approach must be developed.
4) Full Disclosure Principle
 In deciding what information to report, companies follow
the general practice of providing information that is of
sufficient importance to influence the judgment and
decisions of an informed user. Often referred to as the full
disclosure principle,
 it recognizes that the nature and amount of information
included in financial reports reflects a series of judgmental
trade-offs.
Users find information about financial position, income, cash
flows, and investments in one of three places:
(1) within the main body of financial statements
(2) in the notes to those statements, or
(3) as supplementary information

The financial statements are the statement of financial

position, income statement (or statement of comprehensive
income), statement of cash flows, and statement of changes in
equity.
 The notes to financial statements generally amplify or explain
the items presented in the main body of the statements.
 If the main body of the financial statements gives an incomplete
picture of the performance and position of the company, the
notes should provide the additional information needed.
 Examples of notes include descriptions of the accounting
policies and methods used in measuring the elements reported in
the statements, explanations of uncertainties and contingencies,
and statistics and details too voluminous for presentation in the
financial statements.
 Supplementary information may include details or amounts
that present a different perspective from that adopted in the
financial statements.
 It may be quantifiable information that is high in relevance
but low in reliability.
 For example, oil and gas companies typically provide
information on proven reserves as well as the related
discounted cash flows.
 Supplementary information may also include management’s
explanation of the financial information and its discussion of
the significance of that 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.
 The difficulty in cost-benefit analysis is that the costs and
especially the benefits are not always evident or measurable.
 Discussion Questions

1. Explain accrual basis of accounting and cash basis

of accounting
2. Discuss the Basic Principles of Accounting