Inter FA_CH01

INTERMEDIATE FINANCIAL
ACCOUNTING I (ACFN3131)
1
I SEMESTER 2024/25 AY
AAU
Compiled by Andualem
2 Financial Accounting at the Intermediate Level
 COURSE DESCRIPTION & OBJECTIVE

3 CHAPTER 1
DEVELOPMENT OF ACCOUNTING STANDARDS
AND PROFESSIONAL PRACTICE
1. The Environment of Accounting
2. The Conceptual Framework for Financial Reporting

 Basic Objectives of Financial Reporting
 Fundamental Concepts
 Recognition, Measurement, and Disclosure Concepts
3. Cash Flows and Income Measurement

I. THE ENVIRONMENT OF ACCOUNTING
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 Definition, Objective, Importance of
Accounting
 The Accounting profession
 Development of Accounting Standards
 Financial Reporting Challenges

I. THE ENVIRONMENT OF ACCOUNTING…
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1.1 DEFINITION, OBJECTIVE, IMPORTANCE OF ACCOUNTING

 Accounting
 the production and transmission of information about an enterprise.
 identifies, measures, and communicates financial information about economic
entities to interested persons.

 is a service activity
 is a descriptive/analytical discipline, and
 is an information system.
 Objective – To provide financial information about the reporting entity that is
useful to current and potential decision makers (decision-usefulness approach)

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 Accounting …
 As a service activity – its function is to provide interested parties with
quantitative information, primarily financial in nature, about

economic entities that is intended to be useful in making economic
decisions (reasoned choices among alternative courses of action).
 As an information system – it collects and communicates
economic/financial information about an entity to a wide variety of

persons whose decision and actions are related to the activity.
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 Accounting …
 As a descriptive/analytical discipline, it defines the great mass of
events and transactions that characterize economic activity and

through measurement, classification, and summarization, reduces
those data to relatively small, highly significant, and interrelated
items that, when properly assembled and reported, describe the
financial condition, and results of operation of a specific economic
activity.
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 Accounting
…
 Accounting
information
system (AIS)
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 Accounting
…
 Accounting
information
system
(AIS)
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 Accounting …
 Role of Accounting in Capital Allocation
• Resources are limited – An effective process of capital allocation is critical to
a healthy economy; efficient, effective, and economical use of scarce
resources often determines whether a business thrives
• Accounting assists (key) in the efficient and effective use/allocation of scare
resources.
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Note the
interplay
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 Stakeholders in Financial Reporting
 Key stakeholders include traditional users of financial information and parties
with something at risk (at stake)
 Users that rely directly on the financial information for resource allocation
(investors and creditors)
 Users who help in the efficient allocation of resources (financial analysts and
regulators)
 Anyone who prepares, relies on, reviews, audits, or monitors financial
information
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 Stakeholders in Financial Reporting…
 What is at Stake for Each Stakeholder?

Stakeholder (User) What is at Stake (Use)?
Investors/creditors Investment/loan
Management/Employees Job, bonus, reputation, salary increase, access to capital
markets by company
Securities commissions and stock Reputation, effective and efficient capital marketplace
exchanges
Analysts and credit rating Reputation, profits
agencies
Auditors Reputation, proﬁts (companies are their clients)
Standard setters Reputation
Government Taxation, Regulation
Customers Production and delivery
Others Various
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 Fundamentals of Financial Accounting Theory
 Information: Evidence that can potentially affect an individual’s decisions.
 External parties’ decision-making needs create demand for financial
reporting.
 Supply and demand for financial reporting is due to the presence of
information asymmetry.
 Information Asymmetry
 A condition in which some people have more information than others.

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 Information Asymmetry…
 Some reasons for information asymmetry
• Efficient markets hypothesis suggests markets reflect publicly available
information
• Human behaviour sometimes motivated by maximizing self-interest
 Two types: Adverse selection and Moral hazard
 Adverse Selection
 A type of information asymmetry whereby one party to a contract has an
information advantage over another party – “hidden information from the past
and present”
 knowing that there is information asymmetry, capital markets may attract wrong
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 Adverse Selection…
 Example – buying a used car
• Seller has more information than you
• Rational buyers will always pay the lowest price of their own price range.
• Rational sellers will only accept a price that matched their expectation, thus
sellers who feel their cars are worth more than buyers’ price will never enter the
market. So, only bad cars are available on the market, or “ lemons”.
• Seller uses costly signalling (or signalling) – Information that is otherwise
unverifiable
• Seller uses cheap talk – Unverifiable disclosures.
• A costless signal is not credible.

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 Moral hazard
 A type of information asymmetry whereby one party to a contract cannot observe
some actions relating to the fulfillment of the contractual terms by the other party.
• “hidden actions and involves information about what happens in the future”
• concept that people will shirk responsibility if there is no accountability
• one party to a contract cannot observe some actions relating to the fulfillment of
the contractual terms by the other

• Example – a person buys insurance for a car – We call this moral hazard because
the insurance encourages less care and effort, and higher risk (it creates a hazard
to our morals). The higher risk is expected by both.

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 Application of Adverse Selection and Moral Hazard to Accounting
 To overcome the adverse selection:
• Hiring independent auditors to attest to the financial statements and paying

dividends (costly signalling)
 To overcome moral hazard:
• Measuring performance and incentive pay such as bonuses (principal-agent

problem: shareholders and CEO )
• Specifying covenants during the term of the loan (Banks and Firms)
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 Application of Adverse Selection and Moral Hazard to Accounting
 Moral Hazard in Action: The Financial Crisis of 2008
• Critical role in the financial crisis
• Banks packaged mortgages together and sold them to other investors: mortgage-
backed securities (MBS)
• Buying insurance through a financial instrument called a credit default swap (CDS)
• Passing on risk: result – bankers and lenders became careless

II. THE ACCOUNTING PROFESSION
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 Accountants may specialize in different accounting fields some of which

include the following (Branches in Accounting).
• Financial accounting – Provide information to external parties
• Managerial accounting – Reporting within the enterprise
• Tax accounting – Taxable amounts to government revenue authorities
• Cost accounting – a managerial accounting activity designed to help

managers in identifying, measuring and controlling operating costs.
• Governmental (Public) Accounting – refers to the type of accounting

information system used in the public sector.
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 Accountants specializations…
• Forensic Accounting – the use of accounting, auditing and investigative

techniques in cases of litigation or disputes.
• Social Accounting (Corporate Social Responsibility Reporting and

Sustainability Accounting) – the process of reporting implications of an
organization's activities on its ecological and social environment.
• Auditing – assure the credibility of accounting information

III. DEVELOPMENT ACCOUNTING STANDARDS
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 Need for Standards
• help reduce information asymmetry problems in financial reporting
• Transactions and events must be recognized, measured, presented and

disclosed in a specific way
• Standards are not rules, regulations or laws; they are recommendations
• Standards are intended to be generally accepted and universally practiced

- are written in general terms so that they can be applied to a variety of
businesses.
• In addition to set standards, some principles are generally accepted

because they are universally practiced
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 Standards Development Basics
 Two underlying premises for standards development
• Be responsive to the needs and viewpoints of the entire economic community
• Operate in full public view through due process
 Historical Perspective and Standards

• Standards set by private-sector
• Standards set by governmental body
 Parties involved in standard setting in Ethiopia
• The Accounting and Auditing Board of Ethiopia(AABE)
• The International Accounting Standards Board (IASB)

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 Ethiopia passed a financial reporting law in 2014 which requires the use of IFRS by
commercial businesses operating in Ethiopia.
 Proclamation No. 847/2014
 Regulation No. 332/2014
 The proclamation 847/2014 requires:
 Commercial organizations to follow
• International Financial Reporting Standards (IFRS), or
• International Financial Reporting Standards for Small and Medium Enterprises
(IFRS for SME)
 Charities and societies to follow International Public Sector Accounting Standards
(IPSAS)
 Public auditors to follow International Standards for Auditing.
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 International Accounting Standards

Board (IASB)
 Dominant global standard-setting body
 Tries to lessen differences among countries’

standards
 Aim to improve and harmonize regulations,
accounting standards and procedures
 Affiliates: IFRS Foundation, IFRS Advisory
Council, Accounting Standards Advisory
Forum, IFRS Interpretations Committee
(IFRIC)
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 International Accounting Standards Board (IASB)…

 IASB members include accounting profession, analysts, academics, regulators,
and government.
 IFRS Foundation selects members, oversees, and ensures adequate funding.
 IFRS Advisory Council advises on agenda and work priorities.
 IFRS Interpretations Committee seeks to resolve accounting issues and

interpret existing IFRS.
 International Organization of Securities Commissions (IOSCO) provides
regulatory oversight of IASB.
 IASB is a private and non-governmental body with no authority to enforce the
use of IFRS.
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 Role of International Accounting Standards Board (IASB)
 Develop, promote and coordinate the use of a single set of high-quality,

understandable, and enforceable global and harmonized accounting standards
known as IFRSs.
 Prior to 2003 standards were issued as International Accounting Standards
(IASs). In 2003 IFRS 1 was issued and all new standards are now designated as
IFRSs.
 IFRS used in over 115 countries.
 Standards used on most foreign exchanges.
 At present there are 41 IASs issued by IASC, predecessor body of IASB and 19
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 Under IFRS, GAAP includes
• International financial reporting standards (I F R S)
• International accounting standards (I A S)
• Interpretations (I F R I C or the former Standards Interpretation

Committee)
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 Due Process [Operating Procedures]
 The IASB due process has the following elements:
1. Independent standard-setting board;
2. Thorough and systematic process for developing standards;
3. Engagement with investors, regulators, business leaders, and the global

accountancy profession at every stage of the process; and
4. Collaborative efforts with the worldwide standard-setting community.

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 Due Process [Operating Procedures]
 The IASB due process has the following elements:
1. Independent standard-setting board;
2. Thorough and systematic process for developing standards;
3. Engagement with investors, regulators, business leaders, and the global

accountancy profession at every stage of the process; and
4. Collaborative efforts with the worldwide standard-setting community.

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 Due Process [Operating Procedures]…

Identify topic Conduct research Issue preliminary views
of pros and cons
Hold public hearings on Evaluates research and public

proposed standard response and issue exposure draft
Hold public Evaluate responses Final Standard

hearings and change exposure Issued
draft, if necessary
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 Hierarchy of IFRS
 Companies first look to:
1. International Financial Reporting Standards; International Financial

Reporting Standards, International Accounting Standards (issued by the
predecessor to the IASB), and IFRS interpretations originated by the IFRS
Interpretations Committee (and its predecessor, the IAS Interpretations
Committee)-IFRICs & SICs;
2. The Conceptual Framework for Financial Reporting; and
3. Pronouncements of other standard-setting bodies that use a similar

conceptual framework (e.g., U.S. GAAP).
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 User groups that influence the formulation of accounting standards

IV. FINANCIAL REPORTING CHALLENGES
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 Challenges and Opportunities for the Accounting Profession

 Short-term Standard setting in a political environment
 Stakeholder influence and special interest groups can have a significant
impact on accounting standards—some supporting, some opposing
 Principles versus rules
 Standards should be
• based on a cohesive set of principles and a conceptual framework that
are consistently applied;
• flexible to cover many industries;
• detailed enough to provide good guidance
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 Impact of technology
 Easy access to a significant amount of very timely company information
• Disclose more detail
• Access to a larger group of users
• Information can be targeted to specific users
 Drawbacks
• Equal access to all levels of users
• Quality and reliability
 New ways of communicating financial information (XBRL)
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 Integrated reporting
 A company’s ability to articulate its strategic vision and carry out that
vision affects financial performance
 Reporting extends beyond financial information and includes broader
business reporting (e.g. governance and compensation, as well as
sustainability reporting)
 The Expectations Gap
 The gap between what the public thinks accountants should do vs. what
accountants think they can do, is difficult to close.
 The development of highly transparent, clear, and reliable systems to
meet public expectations requires considerable resources.
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 Significant Financial Reporting Issues: lack of focus/failure to provide:

 Non-financial measurements
• customer satisfaction, backlog information, quality, etc
 Forward-looking information
• Opportunities and risks including those resulting from key trends
• Managements plans, including Critical Success Factors (CSFs)
 Soft assets
• know how, market dominance, brand image, well trained employees
 Timeliness
• Companies only prepared financial statements quarterly and provided
audited financials annually. Little or no real-time financial statement information
was available.
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 Centrality of Ethics
 Ethical dilemmas are common in accounting and other areas of business - Poor
ethical values on the part of management are at the heart of accounting abuses
and scandals.
 Companies that concentrate on “maximizing the bottom line,” “facing the
challenges of competition,” and “stressing short-term results” place accountants in
an environment of conflict and pressure.
 IFRS do not always provide an answer. Technical competence is not enough when
encountering ethical decisions. Ethical decisions often go beyond applying GAAP or
rules of the profession
 Globalization: is a move to global markets and global investors demanding a single
set of high-quality international accounting standards.
 New economy: A move from the traditional ‘resource’ based to a ‘knowledge based’
 Accountability: Driven by more sophisticated and varied investors
1 DEVELOPMENT OF ACCOUNTING PRINCIPLES
AND PROFESSIONAL PRACTICE…
43 1.2 THE CONCEPTUAL FRAMEWORK FOR FINANCIAL

REPORTING
The Conceptual Framework (CF) for Financial Reporting
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 Definition and Importance
 The Components of the CF
 Objectives of Financial Reporting
 Fundamental Concepts
 Foundational accounting principles (e.g. Recognition, Measurement, and

Disclosure Concepts)
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I. The Conceptual Framework - Meaning
and Importance
 Meaning of the CF (What)
 A coherent system of interrelated objectives and fundamentals that are the
foundation for consistent standards
 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.
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and Importance
 Meaning of the CF (What)…
 “... business plan to anticipate the demand for information and to
structure a reporting system to supply information that meets that
demand.”
 New framework issued by IASB; effective Jan 1, 2020
 Does not override specific I F R S
 Theoretical in nature but has highly practical final aims

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and Importance
 Importance of the CF (Why – The Rationale)…
 Aims/helps to address information asymmetry
 Create standards based on established concepts
 Increase users’ understanding of and confidence in financial reporting
 Enhance comparability of different companies’ financial statements
 Solve new and emerging practical problems more quickly
 Serve the public interest by providing structure and direction to financial
statements;
 Prescribes the nature, function and limits of financial accounting and reporting;
 Determine the bounds for judgment in preparing financial statements by providing
definitions of basic objectives, key terms, and fundamental concepts;
 Forms the theoretical basis for determining which events should be accounted and
how they should be measured and communicated to the users.
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I. The Conceptual Framework -
Outline/Development
a. Demand side (Assessing demand - The Question)
 Choose users of financial reporting and their needs
 Understand the information needs and objectives
 Identify the information characteristics
b. Supply side (Supply planning - The Answer)

 Identify elements of financial statements
 Consider whether these elements are reported (recognition)
 Consider how these elements should be measured

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I. The Conceptual Framework -
Outline/Development
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II. The Conceptual Framework -
Components
 the “Conceptual Framework for Financial Reporting” under IFRS (“IFRS
Conceptual Framework” )
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II. The Conceptual Framework -
Components
 The IFRS Framework
First level: the building blocks,

identifies goals and purposes
Second level: characteristics that

make accounting information useful
Third level: principles used in

establishing and applying accounting
standards
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II. The Conceptual Framework – FR
Objectives
 Objectives of Financial Reporting
 Provide/communicate financial information about the reporting entity that is useful
to existing and potential investors, lenders, and other creditors in making decisions
about providing resources to the entity.
• Information includes amount, timing, and uncertainty of cash flows – Useful in
assessing prospects for future cash flows (amount, timing, & uncertainty)
o Cash flows to present and potential investors (derived external user objective)
o Cash flows to the enterprise (derived enterprise objective)
Investors/
Cash flows Entity Cash flows
Creditors
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Objectives
 Objectives of Financial Reporting…
• Information on the entity’s resources, claims, and performance
• Information should be about financial position, changes in financial position,
performance and management stewardship
• Stewardship — how efficiently and effectively the entity’s management and
governing board have discharged their responsibilities to use the entity’s
resources – e.g. protecting the entity’s resources from unfavourable effects of
economic factors such as price and technological changes.

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Objectives
• Decisions include investment and lending decisions - buy, hold, sell equity
instruments; grant or deny a credit/loan

• Refers to General Purpose Financial Reporting, which are the financial reports
publicly available to outsiders

• Refers to investors and creditors as primary users
o Generally all parties who have provided financial resources to the firm
o Users who cannot require the reporting entity to provide information directly to
them
• The needs of other potential users (employees, suppliers, customers, auditors, and
governments) are less well served

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Objectives
• General purpose financial reporting…
o Adopts the entity perspective (rather than the proprietary perspective) - The
viewpoint that companies are viewed as separate and distinct from their owners
and therefore financial reporting should focus on the needs of the main users and
not just the owners.
• Special purpose financial reporting
o Responds to the requirements of users that have the authority to require the
reporting entity to provide the information that they need for their purposes
directly to them. Examples include: prudential regulation reporting requirements,
tax reporting requirements
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Objectives
 Test your understanding
For each user below choose one of: 1) the user is a primary user; or 2) the user is not a
primary user.
a) A retail investor deciding whether to buy shares in Company A.
b) A retail investor deciding whether to sell their insignificant holding of Company A

shares.
c) The controlling shareholder deciding whether to hold or sell her shares in Company
A.
d) The tax authority that requires Company A’s IFRS financial statements be submitted
in support of its tax filing.
e) The prudential regulator that requires Company A to reconcile the numbers in its
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II. The Conceptual Framework –
Fundamental concepts
1) Qualitative Characteristics of Accounting Information
 Determining the amount and types of information to present requires choosing
alternatives that provide the most useful information (decision usefulness)
 The second level of the conceptual framework has identified characteristics that
distinguish more useful (“better”) information from the less useful (“inferior”)
 Desirable characteristics of financial reports that help meet the users’ information
needs
a. Fundamental qualitative characteristics (the characteristics must be present for

information to be useful for decision making)
b. Enhancing qualitative characteristics (the characteristics that affect the

information’s degree of usefulness)
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1.Qualitative Characteristics of Accounting Information…
 For financial information to be useful it must be relevant and faithfully represent
what it purports to represent.
 Financial information without both relevance and faithful representation is not
useful, and it cannot be made useful by being more comparable, verifiable, timely
or understandable.
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i. Fundamental qualities
a) Relevance: The ability to influence users’ economic decisions/capability of making a

difference in a decision .
 Information is relevant if it has (ingredients/attributes):
1) Predictive value—helps users make predictions about past, present and future
events
2) Feedback/confirmatory value—helps users confirm or correct previous expectations
3) Materiality: Whether omitting, misstating, or obscuring a particular piece of

information about the reporting entity would influence primary users’ economic
decisions
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 Materiality
• All material items should be disclosed in the financial statements.
• A decision to disclose or not certain information may be made because users have
need or no need for that information (it is relevant or irrelevant) and because the
amount is large enough or too small to make a difference in a decision (i.e. it is
material or immaterial)
• Permit treatment of immaterial items in an expedient (convenient and cost effective)
manner.
• There is no absolute measure of materiality - Involves exercise of subjective judgment
to assess whether or not an item is material:
a) Nature of the item, i.e. arises from abnormal instead of normal circumstances, &
b) Value of the item, i.e. relative instead of absolute.

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 Materiality – Example
• If a statement of financial position shows non-current assets of Br.2 million and
inventories of Br.30,000, an error of Br.20,000 in the depreciation calculations
might not be regarded as material. However, an error of Br.20,000 in the inventory
valuation would be material. In other words, the total of which the error forms part
must be considered.
• If a business has a bank loan of Br.50,000 and a Br.55,000 balance on bank deposit
account, it will be a material misstatement if these two amounts are displayed on
the statement of financial position as 'cash at bank Br.5,000'. In other words,
incorrect presentation may amount to material misstatement even if there is no
monetary error.
• How would you treat the following items as assets in the accounts of a company?
(a) A box file; (b) A computer; (c) A plastic display stand
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i. Fundamental qualities…
b)Representational faithfulness
 The extent to which financial information reflects the underlying transaction,
resources, and claims of an enterprise (i.e. Validity)
 Correspondence or agreement between a measure or description and the underlying
economic event or resource.
 Substance over Form: the principle that transactions and other events are accounted
for and presented in accordance with their substance and economic reality and not
merely their legal form.

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i. Fundamental qualities
b)Representational faithfulness…
 Faithful representation of a transaction is only possible if it is accounted for
according to its substance and economic reality, not with its legal form. Substance
over form usually applies to transactions which are fairly complicated. It is very
important because it acts as a 'catch-all' to stop entities distorting their results by
following the letter of the law, instead of showing what the entity has really been
doing.
 Example: One party may sell an asset to another party and the sales documentation
may record that legal ownership has been transferred. However, if agreements exist
whereby the party selling the asset continues to enjoy the future economic benefits
arising from the asset, then in substance no sale has taken place.
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b)Representational faithfulness…
 Ingredients/Attributes
1. Completeness – include all information needed to portray underlying events and
transactions (e.g., level of detailed included)
2. Free from error – reliability – extent to which information is absent of errors or
omissions.
3. Neutrality – extent to which information is free from bias
 information does not favour one set of interested parties over another
 supported by the concept of conservatism/prudence
• exercising caution when making estimates under uncertainty.
• economic consequences argument
 Neutrality is lost if the financial statements are prepared so as to influence the user
to make a judgment or decision in order to achieve a predetermined outcome, i.e.
influence behavior in particular direction. It does not mean that information has no
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ii. Enhancing qualities
a)Comparability
 information is measured and reported in a similar way—company to company and

year to year (e.g., same accounting policies)
 IFRS requires comparative information to be disclosed for the previous period for
all numerical information.
 Intercompany (i.e. across companies or cross sectional analysis) or Intracompany

(i.e. across period within company or time series analysis).
 Ability to identify (discern) and explain similarities and differences between two or
more sets of economic facts or data.
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ii. Enhancing qualities…
b)Verifiability
 knowledgeable, independent users achieve similar results
 Means objectivity and consensus among measurers.
 Pertains to the correct application, (i.e. without errors or bias) of a measurement
basis.
 Ability to replicate or duplicate measurement results.
 Useful in eliminating or reducing both intentional and unintentional measurer bias
or errors.
c) Timeliness
 information is available in sufficient time to influence decisions - means having
information available to decision-makers before it loses its capacity to influence
decisions.
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ii.Enhancing qualities…
d) Understandability
 information must be of sufficient quality and clarity (onus on the preparer) so
reasonably informed users (onus on the user) can see its significance
 Provides a link/connection between user characteristics and decision specific
characteristics inherent in the information itself.
 It is the quality of information that enables users to perceive its significance - The
ease with which users are able to comprehend financial reports.
 Assume that users’ have prior reasonable knowledge of business or economic
activities and willingness to comprehend/study the information with reasonable
diligence.
 Understandability is enhanced when information is classified, characterized, and
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1) Qualitative Characteristics of Accounting Information…
 Trade-offs of Useful Information
• Both relevance and representational faithfulness must be present to ensure

decision-relevant information
• Not always possible to have all enhancing qualities,
• Trade-offs are necessary (e.g., adopting a new accounting policy to provide better
information but lose year to year comparability [consistency])
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2. Elements of Financial Statements
 Items or categories that appear in the financial statements
a. Elements relating to measuring financial position
b. Elements relating to measuring performance

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2. Elements of Financial Statements…
 Financial position
a) Asset: A resource controlled by the entity as a result of past events and from which
future economic benefits are expected to flow to the entity.
 Assets have three essential characteristics:
1) They represent a present economic resource—a right to use an asset that
produces economic benefit or that has the potential to produce economic
benefits
2) Entity has control over that resource – entity’s ability to decide how to use the
asset and receive economic benefits (through legal ownership or a contractual or
other right)
3) Resource results from a past transaction or event
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2) Elements of Financial Statements…
b) Liability: A 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.
 Liabilities have three essential characteristics:
1) They represent a present duty or responsibility—and there is no practical ability
to avoid them
2) Entity is obligated to transfer an economic resource
3) Obligation results from a past transaction or event
 Types of liability obligations:
• Contractual or statutory requirements
• Constructive—acknowledging a potential burden
• Equitable—from moral or ethical considerations
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c) Equity: A residual interest in an entity that remains after deducting liabilities from
assets
 Also known as net worth
 In business, equity is the ownership interest and is normally
• Common and preferred shares
• Retained earnings
• Accumulated other comprehensive income (IFRS)

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 Performance
a) Income (Increases in assets or decreases in liabilities that result in increases in

equity, other than those relating to contributions from equity participants.)
b) Expenses (Decreases in assets or increases in liabilities that result in decreases in

equity, other than those relating to distributions to equity participants.)
 Revenues and gains are grouped together under Income (they are not separately
defined), and expenses and losses are grouped together under Expenses.
 No distinction between ordinary revenue-generating activities and losses.

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III. The Conceptual Framework –
Foundational principles
 Implement the basic objectives of the first level of the conceptual
framework
 Concepts and constraints that help explain
 which, when, and how financial elements and events should be

recognized/derecognized, measured, and presented/disclosed
 Includes assumptions and conventions
 Guidelines for developing rational responses to controversial financial

reporting issues
 Must decide at which level it’s applied—define the unit of account

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1) Recognition/Derecognition
 Recognition is the act of including something on the statement of financial position
or income statement. Under I F R S, the element must
1. Meet the definition of an element
2. Provide relevant information that faithfully represents the underlying transaction
or event
 Control is an important concept when determining asset recognition
 Derecognition is the act of taking something off the statement of financial position
or income statement
 For assets: when control is given up
 For liabilities: when the obligation is extinguished
76
a) Economic Entity Assumption
 Also called entity concept
 Means an economic activity can be identified with a particular unit of

accountability, e.g., a company, a division, an individual
 An economic entity is not always a legal entity
 Legal entities can be merged into an economic entity for financial

reporting purposes (consolidated financial statements)
 Defining factor for an economic entity is “Who has control?”
77
b) Revenue Recognition Principle (I F R S)
 Balance sheet approach—transaction occurs when entity enters the
contract
 Follows a five-step approach
 Identify the contract with the customer
 Identify the performance obligations
 Determine the transaction price
 Allocate the price to each performance obligation
 Recognize revenue when each performance obligation is satisfied

78
c) Matching Principle
 Cause and effect relationship between money spent to earn revenues
and the revenues themselves
 The effort (expenditure) is matched to the accomplishments (revenues)
 Product costs are held in inventory until the costs (cost of goods sold) are
recorded at the same time as the revenue (sale)
 PPE costs, which benefit future periods, are matched to future revenues
through depreciation
 However, period costs are recognized immediately even if some of the
benefits are realized in the future—expenditures that do not meet the
definition of an asset are expensed
79
2) Measurement Basis
 Because of accrual accounting, measuring many elements of financial
statements requires the use of estimates
 Estimates give rise to uncertainty—uncertainty affects faithful
representation
 Measurement basis must provide relevant information that faithfully
represents the transaction or event
 Common choices: historical cost (including amortized cost); and current
cost (fair value, value in use or fulfilment value)
 Underlying assumptions: periodicity, unit of measure and going concern
80
a) Periodicity Assumption
 Economic activity of an entity can be divided into artificial time periods
for reporting purposes
 Most common: one month, one quarter, and one year
 For shorter time periods, more difficult to determine proper net income
(i.e. more likely errors occur due to more estimates)
 With technology and AI, investors use more online, real-time financial
information to ensure relevant information—continuous reporting
81
b) Monetary Unit Assumption
 Money is the common unit of measure of economic transactions
 Use of a monetary unit is relevant, simple and understandable,
universally available, and useful
 In Canada and the United States, the dollar is assumed to remain
relatively stable in value (effects of inflation/ deflation are ignored i.e.
price-level change is ignored)
 Monetary unit is relevant as long as it is assumed that quantitative data
are useful in communicating economic information
82
c) Going Concern Assumption
 Assumption that a business enterprise will continue to operate in the
foreseeable future
 There is an expectation of continuing long enough to meet objectives and
commitments
 Management must look out at least 12 months from balance sheet date
 If liquidation of the company is assumed to be likely, use liquidation
accounting (at net realizable value)
 Measuring financial statement elements at historical cost would have
limited usefulness if liquidation were assumed to be likely
83
c) Going Concern Assumption…
 Going concern concept assumes that, when preparing a normal set of
accounts, the business will continue to operate in approximately the
same manner for the foreseeable future (at least the next 12 months). In
particular, the entity will not go into liquidation or scale down its
operations in a material way.
 The main significance of a going concern is that the assets should not be
valued at their 'break-up' value; the amount they would sell for if they
were sold off piecemeal and the business were broken up.
84
c) Going Concern Assumption…
Example: A retailer commences business on 1 January and buys inventory of 20
washing machines, each costing Br.100. During the year he sells 17 machines at Br.150
each. How should the remaining machines be valued at 31 December in the following
circumstances?
 Case 1: He is forced to close down his business at the end of the year and the
remaining machines will realise only Br.60 each in a forced sale. If the business is to
be closed down, the remaining three machines must be valued at the amount they
will realise in a forced sale, i.e. 3 × Br.60 = Br.180.
 Case 2: He intends to continue his business into the next year. If the business is
regarded as a going concern, the inventory unsold at 31 December will be carried
forward into the following year, when the cost of the three machines will be matched
against the eventual sale proceeds in computing that year's profits. The three
85
d) Historical Cost Principle
 Transactions are measured at the amount of cash (or equivalents) paid or
received, or the fair value of the initial transaction
 Three basic assumptions of historical cost
1. Represents a value at a point in time
2. Results from a reciprocal exchange (i.e. a two-way exchange)
3. Exchange includes an outside arm’s-length party
 Sometimes the historical cost principle cannot be applied in determining
a value
86
d) Historical Cost Principle …
 Times when historical cost cannot be used …
• Nonmonetary or barter transactions (no cash or monetary consideration)
• Nonmonetary, non-reciprocal transaction (no exchange)
• Related party transactions
 In these types of situations, an attempt may be made to estimate the fair
value
 Principle also applies to financial instruments when issued in exchange
for assets or services; the price becomes the “cost” of the instrument
87
d) Historical Cost Principle …
 Initially, historical cost usually equals fair value
 Over time, this value may lose its predictive value
 Calls for subsequent remeasurement
• Can be based on different measurement values, but that means measurement
uncertainty
• With no external exchange, value may be subjective
 Trend is toward using a mixed valuation model: primarily historical cost
moving to a market valuation model
 Market valuation uses fair value measures
88
e) Fair Value Principle
 At acquisition, historical cost = fair value
 Subsequently, with market and economical conditions changing, the values
diverge
 Fair value (current value, market-based) measures provide more relevant
information than historical cost for some assets and liabilities
 Fair value reflects the current cash equivalent
 Fair-value option—to encourage using fair value
• There is an option to use fair value for most financial instruments (non-
strategic investments)
• Financial instruments are measured at fair value with gains and losses booked
to income
89
e) Fair Value Principle…
 I F R S defines fair value as “The price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market participants
at the measurement date”
 An exit price and a market-based measure
 Explicitly allowed for some non-financial assets (investment properties, PPE)
 Required for some assets (biological)
90
 To increase consistency and comparability in fair value measures, the IASB
established a fair value hierarchy that provides insight into the priority of valuation
techniques to use to determine fair value. As shown in the following illustration, the
fair value hierarchy is divided into three broad levels.
Level 1: Prices for identical assets or liabilities in Least subjective

observable inputs that reflect quoted active markets.
Level 2: Inputs other than quoted prices included in Level
1 that are observable for the asset or liability either directly
or through corroboration with observable data.
Level 3: Unobservable inputs (for example,
a company’s own data or assumptions). Most subjective
91
 Fair value can be measured using:
1. Market approaches.
2. Income approaches.
3. Cost approaches.
 Market approaches base valuation on market information. For example, the value of
a share of a company’s stock that’s not traded actively could be estimated by
multiplying the earnings of that company by the P/E (price of shares/ earnings)
multiples of similar companies.
 Income approaches estimate fair value by first estimating future amounts (for
example, earnings or cash flows) and then mathematically converting those amounts
to a single present value.
 Cost approaches determine value by estimating the amount that would be required
to buy or construct an asset of similar quality and condition.
92
 Market-Based versus Entity-Specific Value
• Fair value is a market-based measure as opposed to an entity-specific value
• Market-based value
o How market participants would value the item in question
o More objective and must be applied under IFRS for fair value situations
• Entity-specific value (value in use)
o Present value of the future cash flows expected from the asset
o More relevant for operating assets but is subjective

93
 Fair Value versus Value in Use
• Value in use is an entity-specific value (perspective of the entity)- defined as the
present value of the future cash flows expected from use of the asset
94
3) Full Disclosure Principle
 Only principle associated with presentation and disclosure
 General practice of providing information that is important enough to influence
an informed user’s judgement and decisions
 Recognizes a series of judgemental trade-offs
• Detailed enough to disclose matters that make a difference to users?
• Condensed enough to make the information understandable?
 Avoid information overload

95
3) Full Disclosure Principle…
 Information about an entity is presented in three places
1. Main body of financial statements—formalized structured way of communicating
financial information
2. Notes to the financial statements—amplify or explain items presented in the
main body of the statements
3. Supplementary documents including the Management Discussion and Analysis
(MD&A) Report—includes details or amounts that present a different perspective

96
 Notes to the Financial Statements
 Additional information needed to complete the picture of performance and
position
 Information does not have to be quantifiable; could include
• Descriptions of policies and methods
• Explanations of uncertainties and contingencies
• Details too voluminous to include in the statements
 According to guidance from I F R S conceptual framework for effective
communication
• Entity-specific over general information
• Duplication inhibits usefulness of information
97
 Management Discussion and Analysis
• Six disclosure principles for the MD&A
1. Provide a view through management’s eyes
2. Supplement and complement information in the financial statements
3. Provide fair, complete, and balanced information that is material to decision-
makers
4. Outline key trends, risks, and uncertainties that may affect the company in the
future
5. Explain management’s plan for long- and short-term goals
6. Be understandable, relevant, comparable, verifiable, timely
98
3) Full Disclosure Principle
 Management Discussion and Analysis…
• Provides management’s explanation of financial information and a
discussion of its significance
• Includes forward-looking information
• Five key elements included to give users greater insight into the business
o Core businesses
o Objectives and strategies
o Capability to deliver results
o Results and outlook
o Key performance measures and indicators
99
Summary - Expanded Conceptual Framework
Practice problem
100
Meadow Limited has hired you to review its accounting records prior to the closing of the revenue and expense accounts as
at December 31, the end of the current fiscal year. The company follows IFRS. The following information comes to your
attention.
1) During the current year, Meadow Limited changed its policy in regard to expensing purchases of small tools. In the past,
it had expensed these purchases because they amounted to less than 2% of net income. Now, the president has
decided that the company should follow a policy of capitalization and subsequent depreciation. It is expected that
purchases of small tools will not fluctuate greatly from year to year.
2) The company built a warehouse at a cost of $1 million. It had been depreciating the asset on a straight‐line basis over
10 years. In the current year, the controller doubled depreciation expense because the replacement cost of the
warehouse had increased significantly.
3) When the statement of financial position was prepared, the preparer omitted detailed information as to the amount of
cash on deposit in each of several banks. Only the total amount of cash under a caption “Cash in banks” was presented.
4) On July 15 of the current year, Meadow purchased an undeveloped tract of land at a cost of $320,000. The company
spent $80,000 in subdividing the land and getting it ready for sale. An appraisal of the property at the end of the year
indicated that the land was now worth $500,000. Although none of the lots were sold, the company recognized revenue
of $180,000, less related expenses of $80,000, for a net income on the project of $100,000.
5) For a number of years, the company used the FIFO method for inventory valuation purposes. During the current year,
the president noted that all the other companies in the industry had switched to the average‐cost method. The company
decided not to switch to average‐cost because net income would decrease by $830,000.
Instructions: State whether you agree or disagree with the decisions made by Meadow in each of the five items above.
Support your answers with reference, whenever possible, to the conceptual framework.
1 DEVELOPMENT OF ACCOUNTING PRINCIPLES
AND PROFESSIONAL PRACTICE…
101 1.2 CASH FLOWS & INCOME MEASUREMENT

…End of CH01.
102
Next CH02…

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INTERMEDIATE FINANCIAL

 COURSE DESCRIPTION & OBJECTIVE

1. The Environment of Accounting

2. The Conceptual Framework for Financial Reporting

 Recognition, Measurement, and Disclosure Concepts

3. Cash Flows and Income Measurement

 Definition, Objective, Importance of

 The Accounting profession

 Development of Accounting Standards

 Financial Reporting Challenges

1.1 DEFINITION, OBJECTIVE, IMPORTANCE OF ACCOUNTING

 the production and transmission of information about an enterprise.

 identifies, measures, and communicates financial information about economic

entities to interested persons.

 is a descriptive/analytical discipline, and

 Objective – To provide financial information about the reporting entity that is

useful to current and potential decision makers (decision-usefulness approach)

1.1 DEFINITION, OBJECTIVE, IMPORTANCE OF ACCOUNTING

 As a service activity – its function is to provide interested parties with

quantitative information, primarily financial in nature, about

economic/financial information about an entity to a wide variety of

1.1 DEFINITION, OBJECTIVE, IMPORTANCE OF ACCOUNTING

 As a descriptive/analytical discipline, it defines the great mass of

events and transactions that characterize economic activity and

 Stakeholders in Financial Reporting

 Key stakeholders include traditional users of financial information and parties

with something at risk (at stake)

(investors and creditors)

 Anyone who prepares, relies on, reviews, audits, or monitors financial

 Stakeholders in Financial Reporting…

 What is at Stake for Each Stakeholder?

 Fundamentals of Financial Accounting Theory

 Information: Evidence that can potentially affect an individual’s decisions.

 External parties’ decision-making needs create demand for financial

 Supply and demand for financial reporting is due to the presence of

 A condition in which some people have more information than others.

• Efficient markets hypothesis suggests markets reflect publicly available

• Seller has more information than you

• A costless signal is not credible.

• concept that people will shirk responsibility if there is no accountability

the contractual terms by the other

to our morals). The higher risk is expected by both.

 Application of Adverse Selection and Moral Hazard to Accounting

 To overcome the adverse selection:

• Hiring independent auditors to attest to the financial statements and paying

 To overcome moral hazard:

• Measuring performance and incentive pay such as bonuses (principal-agent

 Application of Adverse Selection and Moral Hazard to Accounting

 Moral Hazard in Action: The Financial Crisis of 2008

• Critical role in the financial crisis

• Passing on risk: result – bankers and lenders became careless

 Accountants may specialize in different accounting fields some of which

• Financial accounting – Provide information to external parties

• Managerial accounting – Reporting within the enterprise

• Tax accounting – Taxable amounts to government revenue authorities

• Cost accounting – a managerial accounting activity designed to help

• Governmental (Public) Accounting – refers to the type of accounting

• Forensic Accounting – the use of accounting, auditing and investigative

• Social Accounting (Corporate Social Responsibility Reporting and

• Auditing – assure the credibility of accounting information