HARAMBE UNIVERSITY COLLEGE

PART I. INTRODUCTION TO ACCOINTING

THE ENVIRONMENT OF ACCOUNTING

A. What is Accounting
Accounting is the process of identifying, measuring, recording, and communicating
economic information to permit informed judgments and decisions by users of information.

The basic raw materials of accounting are business transaction data which are events or
conditions that must be recorded. Its primary end products are various summaries, analyses,
and reports.

Accounting performs the function of:

1. Identifying transactions: This stands for determining the great mass of selected events
and transactions that characterize the economic activity of an entity.
2. Measuring transactions: This means measuring the amount at which selected events
and transactions could be recorded in the accounting records.
3. Recording transactions: This refers to the actual entry of transactions into the
accounting system by first recording them in books of original entry.
4. Classifying transactions: Refers to placing similar transactions together by a process
known as posting.
5. Summarizing transactions: refers to reducing large amounts of information about
business enterprise into understandable segments that describe the entity’s financial
condition and results of operations. Transactions are summarized through the preparation of
such Financial Statements as:
(a) The balance sheet
(b) The income statement
(c) The statement of changes in financial position
(d) The retained earnings statement
6. Communicating results of transactions: Refers to providing economic information to
a wide variety of persons whose decisions and actions are related to the economic entity.
7. Interpreting reports of transactions: Refers to examining reports and understanding
the content and significance of the report to make economic decisions.

B. Purpose of Accounting
Accounting is often called the language of business because its underlying purpose is to
provide financial information about an economic entity that is useful for making various
economic decisions. Accounting serves, therefore, as a connecting link between an
enterprise’s economic activities and decision makers as shown by the following diagram:

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 Impact

External
External Decision
Enterprise Accounting user Making
Economic Accumulate Information Communicate
Activities Internal Internal
User Decision
Making

Impact

Users of accounting information (i.e. decision makers) are categorized into two groups. These are:
1. Internal users
2. External users

1. Internal users are the business enterprise managers who use accounting information for:
- Planning future operations using budgets.
- Controlling and evaluating current operations which includes:
. Comparing budgets with actual performance reports,
. Identifying favorable and unfavorable variances,
. Investigating the cause of variances, and
. Taking necessary actions for better future operations.
- Formulating long-range plans.
- Making major business decisions such as:
. Investing in equipment
. Pricing products and/or services
. Choosing which products and/or services to emphasize or de-emphasize.
. Allocating scarce resources to products and/or services efficiently and effectively.
. etc.
Management accounting is the specialized field of accounting which relates to internal measurement and
reporting. Stated differently, management accounting emphasizes on the provision of any detailed and
specific information to internal users. Management Accounting information is communicated via internal
Company reports and includes detailed information about specific departments, products, territories and the
business as a whole. Since management accounting relates to internal measurement and reporting it would
be better labeled as “Internal Accounting”.

2. External users are decision makers outside an economic entity that need financial information about
the entity so as to make informed and rational decisions. Among others, these users include:

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 Bankers and other creditors evaluate the financial soundness of a business organization and assess
the risk involved before making loans or granting credit. The reported information gives assurance
to the banker and other creditor that the loan can be repaid on the agreed date.
 Both existing and potential investors in a business enterprise need information about its financial
status and its future prospects. In other words, investors need information on the financial condition
and results of business operations in order to assess the profitability and riskiness of their investment
in the enterprise.
 Government Agencies are concerned with the financial activities of a business organizations for the
purpose of taxation and regulation. To determine the exact amount of income tax to be charged on
individuals and business organizations the Internal Revenue Service (IRS) requires businesses and
individuals to file annual income tax returns designed to measure taxable income. Therefore, all the
financial activities of an individual and a business organization should be properly recorded,
summarized, analyzed and reported to the concerned governmental agencies. The governmental
agencies need accounting information not only for the purpose of taxation but for the purpose of
regulation too. Over the years governments at various levels have intervened to an increasing extent
in economic and social matters affecting ever greater number of people. Accounting has played an
important role by providing the financial information needed to achieve the desired goals. As the
government exercised increasing control over economic activities, accounting information became
more essential as a basis for formulating legislation. Depending on accounting information the
government enacts many laws such as the following:
 Regulatory laws for the protection of investors.
 Regulatory laws for the protection of the public for excessive price charges by monopolies.
 Laws requiring regulated banks and savings and loan associations to meet record- keeping and
reporting requirements and permit periodic examination of their records by governmental agencies.
 Regulatory laws requiring labor unions to submit periodic financial reports as they became larger
and more powerful.
 Laws encouraging business organizations to contribute to charitable organizations and permitting
them to deduct what they have contributed in determining taxable income.
 Regulatory laws to control wages and prices in an attempt to control the economy by reducing the
rate of inflation, and etc.
 A labor union needs to be informed on a Company’s financial strength and profits before
beginning negotiations for a new labor contract. In other words, employees and their union
representatives are also vitally interested in the stability and the profitability of the organization
that hires them
 Credit Agencies.The job of credit agencies is to obtain financial reports from virtually all
business concerns in order to establish credit ratings for them. The conclusions reached by these
credit agencies are available to business managers willing to pay for credit reports about
prospective customers.
 Financial analysts and consultants need financial information of business organizations to
search for promising investment opportunities. For instance, they can compare the financial
reports of different companies to determine the Company that is more profitable, financially
stronger, and offers the best chance of future success. We can benefit personally by making this
kind of analysis of a Company which we are considering investing in or going to work for.
 Writers for business magazines make use of accounting data to write something which has an
economic importance to individuals, organizations, and the public .

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  Customers need accounting information to assess the stability of the enterprise with which they
make frequent transactions, know their outstanding balances etc.
The field of Financial Accounting is directly related to external reporting because it provides investors and
other outsiders with the financial information they need for decision making. In other word, financial
accounting provides financial information to both internal and external users but it focuses on the needs of
external users. Thus financial accounting would be better labeled as “External Accounting”.
The objectives of financial reporting and Financial Statements are derived from the needs of the external
users of accounting information. Financial Statements intended to serve all external users often are called
general-purpose financial statements. General-purpose Financial Statements are intended to provide
general and summarized financial information about the whole enterprises to external users. Stating the
objectives of Financial Statements would be simpler if all external users had the same needs and interests,
but they do not. For example, a bankers considering the granting of a 90-day loan is primarily interested in
the short-run debt-paying ability of the business enterprise, whereas the long-term investor in common
stocks is more concerned with earning capacity, potential growth in earnings per share, and the ability of the
enterprise to survive a going concern.
Because general-purpose financial statements serve a variety of users, the needs of some users receive more
emphasis than the needs of others. In present-day practice the needs of the potential investor or creditor are
subordinated to those who have already committed resources to the enterprise.
This emphasis leads management of the enterprise to stress the uses made of the resources entrusted to it. A
deep concern over reporting on management’s role as custodian of resources may be one reason for the
adherence to historical cost despite substantial changes in the general price level.
This tradition may also explain, in part, the omission from the financial statements of social costs, which
may be increasingly important to a society becoming more aware of the need for preserving the quality of its
environment.
In recent years the environment in which business enterprises operate has been changing at a rapid pace.
Changes in the economic, political, and social structure of society cause changes in the informational needs
of users of financial statements. Higher standards of measurement and reporting, along with a significant
expansion of the amount of information disclosed, have been foremost among the new needs of users of
financial statements.

The FASB issued Statement of Financial Accounting Concepts No. 1, “Objectives of Financial Reporting
by Business Enterprises,”to establish the objectives of general-purpose external financial reporting by
business enterprises. Summarizing, the FASB identified eight 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’s earnings.

In general, when providing information to external users of Financial Statements, the accounting profession
has relied on general-purpose Financial Statements. The intent of these is to provide useful information to
various user groups at reasonable cost. Underlying these objectives is the presumption that users have a
fairly sophisticated understanding of matters related to business and financial accounting this point is
important because it means that when preparing Financial Statements, accountants may assume that users
have a reasonable level of competence; this has an impact on the way and the extent to which information is
reported.

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The specific objectives of Financial Statements are to provide:

(1) information that is useful for making investment, credit, and other decisions,
(2) information that is useful in assessing cash flow prospects, and
(3) information about enterprise resources, claims to those resources, and changes in them.

While these objectives presuppose a variety of user groups, tradition has emphasized investors and creditors.
The broad concern for general information useful for such decision makers is frequently narrowed to their
interest in the prospect of receiving cash from their investments in, or loans to, business enterprises. Such
economic events as bankruptcies or serious cash flow problems of some companies have served to give
emphasis to the usefulness of Financial Statements to enable reasonable assessment of prospective cash
flows of a business enterprise. Nevertheless, while economic events at the time may be related to a
particular orientation regarding the usefulness of Financial Statements, the broad perspective of providing
useful information to various groups remains paramount.

C. QUALITATIVE CHARACTERISTICS OF ACCOUNTING

INFORMATION
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 of several possible
alternatives provide the best (i.e. Most useful ) information for decision-making purposes. Financial
reporting is concerned, in varying degrees, with decision making by financial statement users. As a
consequence, the overriding criterion by which accounting choices can be judged is that of decision
usefulness, that is, providing information that is the most useful for decision making.
The help distinguish superior (more useful) from inferior (less useful) information, the qualitative
characteristics which make information useful should be considered. Four qualitative characteristics are
identified as follows: understandability, relevance, reliability, and comparability. In order to complete this
list, the characteristic of consistency is added as enhancing comparability.

Pervasive Criterion of Decision Usefulness

Without usefulness, there would be no justification for accounting activity nor a basis against which to
assess the costs of providing reports. Usefulness is dependent on the appropriate linking of users and their
qualities with the qualities (primary and secondary) of the information, recognizing constraints.

Decision Makers (Users) and Understandability

Decision makers vary widely in the types of decisions 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. This linkage is the understandability of the information.
Understandability of financial statements, however, depends not only on the accountant’s skills and abilities
to communicate complex information, but also on the user’s ability to comprehend that information. In this
regard, a user’s ability could vary from being simplistic to expert.

The variability in users’ ability to understand creates a dilemma for accountants. For example, assume that a
certain Company issues a three-months’ earnings report (interim report) which is believed to provide
relevant, reliable, and comparable information useful for decision making. Unfortunately, some users may

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not understand the content and significance of the report. Thus, although the information could be highly
relevant, reliable, and comparable, it is useless to those who do not understand it, and potentially dangerous
to those who do use it but do not understand it.

To help resolve the dilemma for accountants, a base level of understandability ofusers must be
established. Consequently, users are assumed to have a reasonable understanding of business and
economic activities and accounting, together with a willingness to study information with reasonable
diligence. While this assumption is helpful to prepares, it is very subjective and one must think about
whether the disclosures made will be intelligible to the intended audience.

Primary Qualities

It is generally agreed that relevance and reliability are two primary qualities that make accounting
information useful for decision making. Each of these qualities is achieved to the extent that information
incorporates specific capabilities (ingredients) as discussed below.

RELEVANCE. Information is relevant when it can influence the decisions of users (i.e. it is capable of
making a difference in a decision). If certain information is disregarded because it is perceived to have no
bearing on a decision, it is irrelevant to that decision. Information is relevant when it helps users make
predictions about the outcome of past, present, and future events (predictive value), or confirms or corrects
prior expectations (feedback value). For example, when a certain Company issues an interim report, this
information is considered relevant because it provides a basis for forecasting annual earnings, and provides
feedback on past performance. It follows that for information to be relevant, it must also be available to
decision makers before it loses its capacity to influence their decisions (timeliness). For example, if a
certain Company did not report its interim results until six months after the end of the period, the
information would be much less useful for decision-making purposes. Thus, for information to be
relevant, it should have the ingredients of predictive value, feedback value, and timeliness.
RELIABILITY. Reliability means that users can depend on accounting information to represent the
underlying economic conditions or events that it purports to represent. Reliability of information is a
necessity for individuals who have neither the time nor the expertise to evaluate the factual content of
Financial Statements. It is especially important to the independent audit process. Auditors would have a
difficult time justifying their opinions about financial information if the information were not sufficiently
reliable. Information is reliable to the extent that it incorporates the ingredients of verifiability,
representational faithfulness, and neutrality (which is affected by the use of conservatism in making
judgements under conditions of uncertainty).

Verifiability of a representation on Financial Statements exists if knowledgeable and independent observers

would concur that it is in agreement with the actual underlying transaction or event with a reasonable degree
of precision. When measurements are based on objective evidence, such as invoices, they are likely to be
highly verifiable. Alternatively, when measurements require the making of estimates about which no or
little objective evidence exists (e.g. asset lives or uncollectibility of accounts), less verifiability can be
expected and the results are, to a large extent, based on the accountant’s judgement, observation, and
experience. Verifiability pertains to the correct application of a measurement basis rather than to the
appropriateness of a particular measurement base.

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Representational faithfulness means that transactions and events affecting an entity are presented in
financial statement in a manner that is in agreement with the actual underlying transactions and events. For
example, if a certain Company’s interim report presents sales of $1 billion when in fact it had sales of only
$800 million, the report would not represent what it purports to represent; that is, it would not be a faithful
representation. Similarly, if a Company reported an obligation which had all the characteristics of a debt
(liability) as a part of shareholders’ equity (because it was labeled as a special type of share), serious doubt
as to the representational faithfulness of the disclosure would result.
An important aspect of representational faithfulness is that accounts should account for transactions and
events in terms of their substance, which is not necessarily their legal or other form.

Neutrality means that a choice made between accounting alternatives is free from bias toward a
predetermined result. Bias in measurement occurs when a measure tends to consistently overstate or
understate the items being measured. When choosing an accounting method, bias may occur when the
selection is made with the interests of particular users or with particular economic or political objectives in
mind. For example, the applicability of a standard that requires a drug Company to disclose in its notes that
numerous lawsuits have been filed against it because of an inferior product should not be decided on the
basis of the harm that such disclosure might inflict on the drug Company. Similarly, neutrality precludes
the choice of accounting policies for the explicit purpose of smoothing out fluctuations in reported income,
thereby obscuring the amount of risk in a Company’s operations.

Secondary Qualities

The potential use of different acceptable accounting methods by one enterprise in different years, 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 is to be useful, it must first be relevant and reliable, but
achieving these primary qualities may require foregoing the secondary qualities. Ideally, financial
accounting information would satisfy both qualitative levels.

COMPARABILITY.Information that has been measured and reported in a similar manner for different
enterprises in a given year, or for the same enterprise in different years, is considered comparable. Thus,
comparability is a characteristic of the relationship between two pieces of information rather than of a
particular piece of information in itself. Comparability enables users to identify the real similarities and
differences in economic phenomena because these differences and similarities have not been obscured by
the use of non-comparable methods of accounting. For example, if Company A prepares its information on
an historical cost basis, but Company B uses a price-level-adjusted basis, it becomes more difficult to
compare and evaluate Company A relative to Company B. Resource allocation decisions involve
evaluations of alternatives, and a valid evaluation can be made only if comparable information is available,

CONSISTENCY. This characteristic is achieved by an enterprise when its uses the same selected
accounting policies from period to period; that is, these methods are consistently applied. Consistency
results in enhancing the comparability of Financial Statements of an enterprise from year to year.

Consistency does not mean that a Company can never switch from one method of accounting to another.
Companies can change methods, but the changes are restricted to situations in which it can be demonstrated

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that the newly adopted method is preferable to the old. Then the nature and effect of the accounting change,
as well as the justification for it, must be fully disclosed in the financial statements for the period in which
the change is made.

While consistency in applying the same methods across different enterprises (Uniformity) may improve
comparability, it has not become an aspect of practice. The difficulty associated with the notion of
uniformity is that dissimilar circumstance may be forced to be reported as being similar.

In summary, accounting reports for any given year are useful in them selves, but they are more useful if they
can be compared with reports from other companies, and with similar reports of the same entity for prior
years. For example, if ABC company were the only enterprise that prepares interim reports, the
information is less useful because the user cannot relate it to interim reports for any other enterprise; that is,
it lacks comparability. Similarly, if the measurement methods used to prepare ABC’s interim report change
from one interim period to another, the information is considered less useful because the user cannot relate it
to previous interim periods; that is, it lacks consistency.

Qualitative Characteristics, a Concluding Comment

The purpose of establishing qualitative characteristics of accounting information is to provide a framework

for accountants when making choices regarding measurements and disclosures in financial reports. Using
such a framework does not provide obvious solutions to accounting problems; rather, it simply identifies
and defines aspects that should be considered when reaching a solution. Indeed, many accounting choices
require trade-offs between the qualitative characteristics, For example, some believe that financial
reports based on current costs could provide more relevant information than reports based on historical
costs, which are more reliable. There is not, however, any clear-cut consensus on the relative weighting
(importance) of relevance and reliability (or other characteristics) that assists in deciding such issues.
Consequently, while awareness of the qualitative characteristics may help in choosing between alternatives,
the actual decisions, in most cases, require the exercise of professional judgment.

D. RECOGNITION AND MEASUREMENT GUIDELINES

While an item may meet the definition of an element, it may not be recognized in the financial statements.
Recognition is the process of including an item in the financial statements of an entity. In order to be
recognized, the following criteria must be met.

A. the item has an appropriate basis of measurement and a reasonable estimate can be made of the amount
involved; and
B. for items involving obtaining or giving up future economic benefits, it is probable that such benefits will
be obtained or given up.

Measurement is the process of determining the amount at which an item is recognized in the financial
statements. The first recognition criterion requires that an appropriate ( relevant) measurement basis be
established for items and that a reasonable (reliable) amount can be determined under that before items can
be recognized, whether an item is recognized and, if so, how it is recognized ( i.e. type of element) will be
dependent on the probability of future economic consequences.

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Recognition and measurement often depend on the exercise of professional judgment, but these criteria are
important to making such judgments. For example, suppose a company was being sued for providing faulty
service to a defined group of customers. The lawsuit was for $2,000,000 in claim for damages and
compensation and was currently before the courts. Should the lawsuit be recognized in the financial
statements? the $2,000,000 could be an appropriate measurement basis. It may not be a reasonable estimate
of the amount of the eventual settlement, however, as the settlement is dependent on a judge's ruling, or
possibly on an out-of-court settlement. Consequently, on the grounds that a reasonable amount cannot be
determined, the lawsuit would not be recognized in the financial statements.

Even if a reasonable amount could be identified, it would not likely be recognized because it could be
argued that its payment in the future would not be probable ( based on the fact that the company is fighting
the claim in court and its lawyers would be advising that the company will win the case). Although the
lawsuit would not be recognized in the financial statements, it may be considered sufficiently important to
disclose appropriate information about it in the notes to the statements ( note disclosure does not constitute
recognition as defined).

Recognition and measurement in accounting is influenced by many concepts that have evolved over time
and which are useful aids in developing rational responses to financial reporting issues. It has been chosen
to identify and discuss these under the categories of basic assumptions, principles, and constraints.

Basic Assumptions

What are the basic assumptions accounting? In most case, they are so obvious that we might ask why they
have to be stated at all. Nevertheless, they merit special attention because they are critical be the
development of appropriate and consistent accounting. If we don't understand the basic assumptions made
by accountants, we cannot understand why data are presented in a given manner.

Four basic assumption underlying the financial account structure are (1) an economic entity assumption,
(2) a going concern assumption, (3) a monetary unit assumption, and(4) a periodicity assumption.

Economic Entity Assumption. a major assumption in accounting is that economic activity kan be identified
with a particular unit of accountability. In other words, the activity of a business enterprise can be kept
separate and distinct from its owners and any other business unit. If there were no meaningful way to
separate all of the economic events that occur, no basis for accounting would exist..

The economic entity assumption does not apply solely to the segregation of activities among given business
enterprises. Although we usually think of entities as business enterprises, an individual, a department or
division, or an entire industry could be considered a separate entity if we chose to define the unit in such a
manner. thus the economic entity assumption is not necessarily a legal- entity concept; a parent and its
subsidiaries are separate legal entities, but merging their activities for accounting and reporting purposes
when providing consolidated financial statements in no a violation of the economic entity assumption.

Going concern Assumption. Most financial statements are prepared on the assumption that the business
enterprise will continue in operation for the foreseeable future and will be able to realize assets and
discharge liabilities in the normal course of operations. Experience indicates that, in spite of numerous

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business failures, companies have a fairly high continuance rate, and it has proved useful to adopt a going
concern or continuity assumption for accounting purposes. Although accountants do not believe that
business firms will last indefinitely, they do expect then to last long enough to fulfill their objectives and
commitments.

The implications of adopting the going concern assumption are critical: it provides credibility to the
historical cost principle, which would be of limited usefulness if liquidation were assumed. Under a
liquidation approach, for example, asset values are better stated at net realizable value ( sale price less costs
of disposal) than at acquisition cost. Only if we assume some permanence to an enterprise are
amortization policies justifiable and appropriate. If a liquidation approach were adopted, the current and
non-current classification of assets and liabilities would lose much of its significance. labeling anything a
fixed or long-term asset would be difficult to justify. The listing of the liabilities on the basis of priority in
liquidation is reasonable only if we assume continuity of business operations.

The going concern assumption is generally applicable in most business situations. Only where liquidation
appears imminent is the assumption inapplicable, and in these cases a total revaluation of the assets and
liabilities can provide information that closely approximates net realizable value of the entity. Monetary
Unit Assumption. Accounting is based on the assumption that money is the common denominator by
which economic activity is conducted, and thus provides an appropriate basis for accounting
measurement and analysis. this assumption implies that the monetary unit is the most effective means of
expressing to interested parties changes in capital and exchanges of goods and services. Support for this
assumption lies in the fact that the monetary nit is relevant, simple, universally available, understandable,
and useful. Application of this assumption is dependent on the even more basic assumption that
quantitative data are useful in communicating economic information and in making rational economic
decisions.

Financial accounting practice has chosen generally to ignore the phenomena of price-level change ( inflation
and deflation) by adopting the monetary unit assumption that the unit of measure- the dollar- remains
reasonably stable (often called the stable dollar assumption). This stable dollar assumption allows the
accountant to add 1982 birr to 1990 birr without any adjustment. Arguments submitted in support of the
stable dollar assumption are that the effects of price-level changes are not significant, and that presentation
or price-level-adjusted data is not easily understood.

Periodicity Assumption. the results of enterprise activity would be most accurately measurable at the time
of the enterprise's eventual liquidation. Investors, creditors, managers, governments, and various other user
groups, however, cannot wait indefinitely for such information periodically, someone else would.

The periodicity or time period assumption simply implies that the economic activities of an enterprise can
be divided into artificial time periods. These time periods vary, but most common are monthly, quarterly,
and yearly. It is because accountants have to divide continuous operations into arbitrary time periods that
they must determine the relevance of each business transaction or event to one specific accounting period.
The shorter the time period, the more difficult it becomes to determine the proper net income for the period.
Problems of allocation, mean the a month's results are usually less reliable than a quarter's results. This
phenomenon provides an interesting example of the trade-off between reliability and timeliness in preparing
financial data. Investors desire and demand that information be quickly processed and disseminated; yet the
quicker the information is released, the more it is subject to error.

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Basic Principles

In view of the qualitative characteristics of accounting information and the basic assumptions of accounting,
what are the principles that the accountant follows in deciding when and how to measure, record, and report
assets, liabilities, revenues, and expenses? We will now discuss four such principles: (1) the historical cost
principle, (2) the revenue realization ( recognition) principles, (3) the matching principle, and (4) the full
disclosure principle.

Historical cost Principle. the determination of the measurement base on which an item is to be recognized
in financial statements has been one of the most difficult problems in accounting. A number of bases exist
on which an amount for a single item can be measured: replacement cost, net realizable value ( net amount
received from selling an asset), present value of future cash flows, and original cost ( less depreciation,
where appropriate). which should the accountant use?

Traditionally, prepares and users of financial statements have found that the historical acquisition cost is
generally the most useful base for accounting measurement and reporting. As a result, existing GAAP
requires that most transactions and events be recognized in financial statements at the amount of cash or
cash equivalents paid or received or the fair value ascribed to them when they took place. This is often
referred to as the historical cost principle. Historical cost has an important advantage over other
valuations: it is reliable. To illustrate the importance of this advantage, consider the problems that would
arise if we adopted some other basis for keeping records. If we were to select net realizable value, for
instance, we might have a difficult time establishing a reliable sales value for a given item without selling it.
Every member of the accounting department might have his or her own opinion of the sales value of the
asset, and management might desire still another figure. Also, how often would it be necessary to establish
sales value? All companies close their accounts at least annually, and some compute their net income every
month. companies would find it necessary to place a sales value on every asset each time they wished to
determine income- a laborious task alone that would result in a figure of net income materially affected by
opinion on the sales value of the many assets involved. Similar objection have been leveled against current
replacement cost, present value of future cash flows, and other bases of valuation except historical cost.

Historical cost in usually definite and verifiable. Once established, it is fixed as long as the asset remains
the property of the company. These characteristics are of real importance to those who use accounting data.
to rely on the information supplied, both internal and external parties must know that the information is
accurate and based on fact. By using historical cost as their basis for record keeping, accountant can
provide objective and verifiable data in their reports.
The question " what is cost?" is not always easy to answer because of other questions that follow in its
wake. If fixed assets ate to be carried in the accounts at cost, are cash discounts to be deducted in
determining cost? Does cost include freight and insurance?
Does it include cost of installation as well as the price of machine itself? And what of the cost of
reinstallation if the machine is moved? when land, on which there are old structures, is purchased for a
building site, is the cost of razing these structures part of the cost of the land? these and similar questions
must be considered and answer to arrive at cost figures for assets purchased.

Furthermore, purchase is not the only method of acquiring assets. How do we determine the cost of items
received as gifts? It is not unusual for a developing community of offer plant sites free, or at nominal
amounts, as an inducement to companies to establish themselves in that locality. At what price should such

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assets be carried? Also, certain assets may be acquired by the issuance of share capital of the acquiring
company, or perhaps through the issuance of bonds or notes payable. If no cash price is stated in the
transaction, how is cost to be established?

The basic financial statements include liabilities and assets. It may seem strange that liabilities are
accounted for on the basic of cost, but this is because we ordinarily thing of cost as relating only to assets.
If we convert the term "cost" to " exchange price" we will find that it applies to liabilities as well.
Liabilities, such as bonds, notes, and accounts payable, are incurred by a business enterprise in exchange for
assets (or services) upon which an agreed price has usually been placed. this price, established by the
exchange transaction, is a "cost" of the liability and provides, under the historical cost principle, the figure at
which it should be recorded in the accounts and reported in financial statements.

Although there is general agreement that assets and liabilities should be accounted for on the basis of
acquisition cost, there is also considerable criticism of this practice. Criticism is especially strong during a
period when general and specific price levels are changing substantially. At such times historical
acquisition cost is said to go " out of date" almost as soon as it is determined.

In a period of rising or falling prices, the cost figures of the preceding year are viewed as not comparable
with current cost figures. For example, assuming a rate of inflation is 1% per month, a McDonald's
"quarter-pounder with cheese", which costs $2.10 today, would cost approximately $10 in 13 years if the
price directly followed the inflation rate. In a similar manner, financial statements that present the cost of
fixed assets acquired 10 or 20 years ago may be misleading, because readers of such statements my tend to
think in terms of current price levels, not in terms of the price levels at the time the fixed assets were
purchase. A further complication follows from the fact that depreciation figures are based on recorded
costs. As depreciation expense enters into income calculations, even the net income figure may be suspect
because of price-level changes.

Revenue Realization Principle ( or Revenue Recognition Principle). the revenue realization principle
provides guidance in answering the question of when revenue should be recognized. Revenue is generally
recognized when (1) performance is achieved and (2) reasonable assurance regarding the measurability
and collectibility of the consideration exists.

Generally, these two requirements are met when a sale to an independent party occurs. thus, recognition of
revenue ( recording in the accounts) would take place at that time. any basis for revenue recognition short
of actual sales opens the door to wide variations in practice. Conservative business individuals might wait
until sale of their securities; more optimistic individuals could watch market quotations and take up gains as
market prices increased; yet others might recognize increases that are merely rumored; and unscrupulous
persons could " write up" their investments as they please to suit their own purposes. To give accounting
reports uniform meaning, a rule for revenue recognition comparable to the cost rule for asset valuation is
essential. Recognition through sale provides a uniform and reasonable test in most cases.

There are, however, exceptions to the rule, and at times the basic rule is difficult to apply, as indicated
below.

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Percentage-of Completion Approach. Recognition of revenue is allowed in certain long-term construction
contracts before the contract is completed. The advantage of this method is that income is recognized
periodically on the basis of percentage of job completion, rather than at completion of the entire job.
Although technically a transfer or risks and rewards of ownership has not occurred, performance is
considered achieved at various stages as construction progresses. Naturally, if it is not possible to obtain
dependable estimated of price, cost, and progress, then the accountant should wait and recognize the
revenue at the completion date.

End of Production. At times, revenue might be recognized before sale, but after the production cycle has
ended. This is the case where the price is certain as well as the quantity. an example would be the mining
of certain minerals f which, once the mineral is mined, a ready market at a standard price exists. The same
holds true for some guarantees price supports set by the government in establishing agricultural prices.

Receipt of Cash. Receipt of cash is another basis for revenue recognition. the cash basis approach should
be used only when it is impossible to establish the revenue figure at the time of the sale because of the
uncertainty of collection. This approach is commonly referred to as the instalment sales method when
payment is required in periodic instalments over a long period of time. Its most common use is in the retail
field where various types of farm and home equipment and furnishings are sold on an instalment basis. The
instalment method is frequently justified on the grounds that the risk of not collecting an account receivable
may be so great that the sale is not some instances, this reasoning may be valid, but not in majority of such
transactions. If a sale has been completed, it should be recognized; if bad debts are expected, they should be
recorded as separate estimates of uncollectibles.

In summary, revenue is recognized ( recorded) in the period in which performance to earn it has been
achieved, it is reasonably measurable, and collectibilitly is reasonable assured. Normally, this is the date of
sale, but circumstances may dictate application of the percentage-of completion approach, the end-of
production approach, or the receipt-of-cash approach.

Conceptually, the proper accounting treatment for revenue recognition should be apparent and should ft
nicely into one of the conditions mentioned above, but often it does not. As examples, consider franchises
and motion picture sales to television.

Franchising operations have been established for a wide variety of businesses from restaurants to pet-care
centers. One need not travel too widely to appreciate the multitude of fast-food chains such as McDonald's
or Kentucky Friend Chicken. One of the problems that faced accountants of the franchisor ( seller of the
franchise) in the 196s and 1970s was when to recognize revenue from the sale of a franchise. In nearly all
cases, an soon as the franchisor found an individual franchisee ( buyer of the franchise) and received a down
payment ( no matter how small), the entire franchise price was treated as revenue. Consequently, to avoid
any income slump that could impair their growth reputation, many franchisors signed up franchisees at an
accelerating rate each year to perpetuate growth in earnings. This was necessary because the initial
franchise fees were treated immediately as revenue-even though in many situations those fees were payable
over a period of years, were refundable of uncollectible in the case of franchises that never got started, or
were earned only as certain services were performed by the franchisor. In effect the franchisors were
counting their fried chickens before they were hatched. Accountants had to change the basis for revenue
recognition from the date the franchise contract was signed to a basis that more clearly reflected the

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requirements of the revenue realization principle, because of the abuses that developed in the area of
franchise accounting.

How should motion picture companies such as the National Film Board of Canada, Metro-Goldwyn-Mayer
Inc., Warner Bros., and United Artists account for the sale of rights to show motion picture films on cable
television networks and the CBC, CTV, ABC, CBS, or NBC? Should the revenue from the sale of the
rights be reported when the contract is signed, when the motion picture film is delivered to the network,
when the cash payment is received by the motion picture company, or when the film is shown on television?
The problem of revenue recognition is compicated because the TV networks are often restricted to the
number of times the film my be shown in totals as well as to specified periods. for example, Metro-
Fodwyn-Mayer Inc. ( MGM) sold CBS the rights to show Gone With The Wind for $35 million. for this
$35 million, CBS received the rght to show this classic movie twenty times over a twenty-year period.
MGM contended that revenue reporting should coincide with the right to telecast on first and subsequent
showings as included in the license agreement. They argued that the right to show Gone with The Wind
twenty times over a twenty-year period was a significant contract restriction and, therefore, revenue
recognition should coincide with the showings. The accounting profession, on the other hand , argued that
when (1) the sales price and cost of each film are known, (2) collectibility is assured, and (3) the film is
available and accepted by the network, revenue recognition should occur. The restriction that Gone With
The Wind be shown only once a year for twenty years was not considered significant enough or appropriate
justification for deferring revenue recognition. It is interesting to note that MGM, in the appropriate first
quarter, reported essentially the entire $35 million in revenue in one period.

Matching Principle. In recognizing expenses, accountants attempt to follow the approach of "let the
expenses follow the revenues." Expenses are recognized not when wages are paid, or when the work is
performed, or when a product is produced, but when the work (service) or the product actually makes its
contribution to revenue. Thus, expense recognition is tied to revenue recognition. In some cases it is
difficult to determine the period in which an expense contributes to the generation of revenues, but many
expenses can be associated with particular revenues. this practice is referred to as the matching principle
because it dictated that efforts ( expenses) be matched with accomplishment ( revenues) whenever it s
reasonable and practicable to do so.

For those situations in which it is difficult to identify a cause-and effect relationship between the revenue
and expense, some other approach must be developed. Often, the accountant must use a "rational and
systematic" allocation policy that will approximate the matching principle. This type of expense recognition
always involves assumptions about the benefits that are being received as well as the cost associated with
those benefits. The cost of a long-lived asset, for example must be allocated over all of the accounting
periods during which the asset is used, because the asset contributes to the generation of revenue throughout
its useful life.

Some costs are charged to the current period as expenses ( or losses) simply because no future benefit is
anticipated or no apparent connection with future revenue is evident. Examples of these types of costs are
officers' salaries and advertising and promotion expenses.

Summarizing, we might may that costs are analysed to determine whether a relationship exists with revenue.
Where this association holds, the costs are expensed and matched against the revenue in the period when the
revenue is recognized. If no direct connection appears between costs and revenues, an allocation of cost on

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some systematic and rational basis may be appropriate. where such an allocation approach does not seem
appropriate or reasonable, the costs may be expensed immediately.

Costs are generally classified into two categories: product costs and period costs.Product costs such as
material, labour, and overhead attach to the product and are carried into future periods if the revenue from
the product is realized in subsequent periods.

Period costs such as officers' salaries and selling expenses are charged off immediately to income because
no direct relationship between cost and revenue can be determined.

The problem of expense recognition is as complex as that of revenue recognition. For example, at one time
a large oil company spent a considerable amount of money in an introductory advertising campaign. The
company obviously hoped that this advertising campaign would attract new customers and develop brand
loyalty. How many future periods would benefit? What would the amount of benefits be each year? How
can they be determined? Over how many years should this outlay be expensed? For another example, take
the video rental market. One major company amortizes the cost of its video tapes over three years, 36% the
first year, 36% the second, and 24% the third. Other video rental take a more conservative approach,
noting that Class A title ( expensive hits) average 28 rentals the first three months, 12 rentals the nest three
months, 12 more in the next six months, and 18 over the nest year. A result, some companies charge off
these tapes in one year, or at a maximum over two years. As an executive of one of the major video rental
companies noted, " If you ask twelve different people the useful life of a video tape, you get twelve
different answers. " In short, the basic issue is whether the revenue flow from a video rental justifies
differences in expense recognition.

The conceptual validity of the matching principle has been a subject of debate. A major concern is that
matching permits certain costs to be deferred and treated as assets on the balance sheet when in fact these
costs may not have future benefits. If abused, this principle permits the balance sheet to become a "
dumping ground" for unmatched costs. In addition, there appears to be no objective definition of systematic
and rational". therefore, while the matching principle is an important guideline for determining when
expenses are to be recognized, its application requires substantial judgment in may situations.

Full Disclosure Principle. In deciding what information to report, accountants follow the general practice
of providing information that is of sufficient important to influence the judgement and decisions of an
informed user. Often referred to as the full disclosure principle, this principle recognizes that the nature
and amount of information included in financial reports reflects a series of judgmental trade-offs. These
trade-offs strive for (1) sufficient detail to disclose matters that make a difference to users, and (2) sufficient
combination and condensation to make the information understandable, keeping in mind costs of preparing
and using it. The accountant can place information about financial position, income, and cash flows 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 following paragraphs provide some broad guidelines for deciding where
to place certain kings of financial information.

The financial statements are a formalized, structured means of communicating. To be recognized in the
main body of financial statements, an item should meet the definition of an element and the recognition
criteria. The item must have been measured, recorded in the books, and passed through the double-entry
system of accounting.

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The notes to financial statements generally amplify or explain the items presented in the main body of the
statements. If the information in the main body of the financial statements given an incomplete picture of
the performance and position of the enter-prise, additional information that is needed to compete the picture
should be included in the notes. Information in the notes does not have to be quantifiable. Notes can be
partially or totally narrative. Examples of notes re: 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 inclusion in the statements. Information provided in the notes
is not only helpful but also essential to an understanding of the performance and position of an enterprise.

Supplementary information may include information that presents a different perspective form that adopted
in the financial statements. this may be quantifiable information that is high in relevance but low in
reliability, or information that is helpful but not essential. A primary example of supplementary information
is the data and schedules provided by certain companies on the effects of changing prices ( constant dollar
and current cost information). Supplementary information may also include management's explanation of
the financial information and its discussion of the significance of the information.

The full disclosure principle is not always easy to put into operation because the business environment is
complicated and ever changing. For example, during the past decade many business combinations have
produced innumerable conglomerate-type business organizations and financing arrangements that demand
new and unique account and reporting practices and principles. Leases, investment credits, pension funds,
franchising, stock options, and mergers have had to be studied, and appropriate reporting practices have has
to be developed. In each of these situations the accountant is faced with the problem of making sure that
enough information is presented to ensure that the mythical reasonably prudent investor will not be misled.

A classic illustration of the problems of determining adequate disclosure guidelines is the past turmoil
related to bribes and political gifts to foreign countries. How much disclosure, if any, is necessary in the
financial statements for these types of expenditures? On the one hand, it is contended that payoffs are
unavoidable in business and should be looked upon as a cost of doing business. In addition, many of the
transactions are generally small in comparison with the corporation's revenues and are not considered
material in relation to its financial statements. conversely, others argue that these types of payoffs raise
questions about the quality of both management and earnings. They contend that shareholders have the
right to know if the continuation of a company's operations in a foreign country depends on making payoffs,
and what effect stopping the payoffs might have on the financial statements. The emergence of such a
problem demonstrates the complexity and subjectivity of devising disclosure rules that meet the needs of
society.

Basic constraints

In providing information with the qualitative characteristics that make it useful, two overriding constraints
must be considered: (1) the benefit-cost relationship and (2) materiality. Additional constraining aspects
impacting on financial statement reporting are industry practice and conservatism.

Benefit-Cost Relationship. too often, users assume that information is a cost-free commodity, but preparers
and providers of accounting information know that it is not. The costs of providing information must be
weighed against the benefits that can be derived from using it. Obviously, the benefits should exceed the

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costs. Practicing accountants have traditionally applied this constraint through the notions of expediency or
practicality.

The difficulty in benefit-cost analysis is that the costs and especially the benefits are not always evident or
measurable. The costs are of several kinds, including costs of collecting and processing, disseminating,
auditing, potential litigation, disclosure to competitors, and analysis and interpretation. Benefits accrue to
preparers ( e.g. in terms of greater efficiency, control, and financing) as well as users ( e.g. allocation of
resources, tax assessment, and rate regulation) but they are generally more difficult to quantity than are
costs. An increasing number of individuals and organizations are urging that benefit- cost analysis be
required as part of the accounting standards development process, because the costs are usually more
immediate and measurable while the benefits are not. Among both the providers and the users of
accounting information there are those who believe that the costs associated with implementing certain
accounting standards are too high when compared with the benefits received.
For example, some believe that some GAAPs are too cumbersome and expensive for smaller businesses to
adhere to relative to the perceived benefits resulting. Consequently, they have argued that the financial
statements of smaller businesses should be governed by less demanding standards. The issues are related to
what is called the " big GAAP, little GAAP" controversy which concerns the advantages and disadvantages
of having all enterprises adhere to the same standards, compared to having somewhat different standards
deemed acceptable for smaller versus larger enterprises. while the Accounting Standards Committee has
always maintained that its standards are applicable to all companies ( except for recommended disclosures
regarding current costs which are applicable to larger companies only), it has recognized that a benefit-cost
prospective should be employed when developing standards.

Materiality. Materiality is the term used to describe the significance of financial statement information to
decision makers. An item is material if it is probable that its omission or misstatement would influence or
change a decision. In short, it mustmake a difference or it need not be disclosed. It is difficult to provide
firm guidelines to determine when a given item is or is not material, because materiality varies both with
relative size ( the size of the item compared to the size of other items) and with importance ( the nature of
the item itself). The two sets of numbers presented below illustrate the importance of relative size.

During the period in question, the revenues and expenses and, therefore, the net incomes form operations of
Company A and company B have been proportional Each has had an usual gain which is not extraordinary.
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 costs and expenses of regular operating
income. It is only 2% of the operating income and, if merged, would not seriously distort the net operating
income figure.

Company B has had an unusual gain of only $5,000, but, as this amounts to 50% of its income from
operations, it is relatively much more significant than the larger gain realized by A. 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.

The nature of the item may also be important. of example, if a company violates a statute, the facts and
amounts involved likely should be separately disclosed. Or, a misclassification of assets that would not be
material in amount if it affected two categories of plant and equipment might be material if it changed the
classification between a non-current and a current category.

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Materiality is a difficult concept, as these practical examples indicate:
1. General dynamics disclosed that at one time its Resources Group had improved its earnings by $5.8
million at the same time that its Stromberg Datagraphix subsidiary had taken write-offs of $6.7 million.
Although both numbers were far larger than the $2.5 million that General Dynamics as a whole earned for
the year, neither was disclosed as a separate item in the annual report; apparently the effect on net income
was not considered material.
2. In the first quarter, GAC's earnings rose from 76 cents to 77 cents a share. Nowhere did the annual
report disclose that a favourable tax carry-forward of 4 cents a share prevented GAC's earnings from sliding
to 73 cents a share. The company took the position that this carry-forward should not be shown as an
extraordinary item because it was not material (6%). As one executive noted, "you know that accountants
have a rule f thumb which says that anything under 10% is not material".

These examples illustrate one point: in practice, the answer to what is material is not clear-cut, and difficult
decisions must be made each period. Only by the exercise of professional judgement can the accountant
arrive at answers that are reasonable and appropriate.

Industry Practice. Another practical consideration, which sometimes requires departure from basic theory,
is the peculiar nature of some industries and business concerns. For example, banks often report certain
investment securities at market value because these securities are traded frequently, and many believe a cash
equivalent price provides more useful information than historical cost. In the public utility industry ,
noncurrent assets may be reported first on the balance sheet to highlight the capital intensive nature of the
industry. In the agricultural industry, crops are often reported at market value because it is costly to develop
accurate cost figures on individual crops. Such variations from basic theory are few; yet they do exist, and
so, whenever we find what appears to be a violation of basic accounting theory, we should determine
whether it is explained by some peculiar feature of the type of business involved before we criticize the
procedures followed.

Conservatism (prudence)—As a guide in resolving uncertanities Conservatism, as an accounting

convention, has existed for a long time, but it is often misunderstood. As applied in accounting,
conservatism means that when there is reasonable doubt about an accounting issue, the solution which will
be least likely to overstate net assets and income should be chosen. Conservatisim is a legitimate
convention to employ when making judgments under conditions of uncertainty. Although it may affect the
neutrality of Financial Statements, it does so in an acceptable manner. Conservatism, however, does not
provide a reason to justify a deliberate understatement of net assets and income. In brief, the concept of
conservatism states that under conditions of uncertainty, risk, and doubt accountants should select the
accounting method that is least likely to overstate assets and income in the current accounting period.

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