Chapter- One

1. Development of Accounting Principles and Professional Practice

1.1 The environment of financial Accounting

The essential characteristics of accounting are the identification, measurement, recording and
communication of financial information about economic entities to interested parties.
Accounting, like other disciplines, is largely a product of its environment. The environment of
accounting consists of social-economic – political- legal conditions, constraints, and influences
which have varied from time to time. Accounting theory and practices have evolved to meet
changing demands and influences. Modern accounting is the product of many influences and
conditions.
Financial accounting is the process that culminates in the preparation of financial reports on the
enterprise for use by both internal and external parties. Users of these financial reports include
investors, creditors, managers, unions, and government agencies.
Financial statements are the principal means through which a company communicates its
financial information to those outside it. These statements provide a company’s history
quantified in money terms. The financial statements most frequently provided are the balance
sheet, the income statement, the statement of cash flows, and the statement of owners’ or
stockholders’ equity. Note disclosures are an integral part of each financial statement.
1.2 Financial information requirements in Ethiopia
The Ethiopian Income Tax Proclamation states that taxable business income shall be determined
on the basis of the profit and loss account, or income statement, which shall be drawn in
compliance with financial reporting standards. (in accordance with rules and regulations)
Proclamation no. 592/2008 Article 23 (1) states that the National Bank to direct banks to prepare
financial statements in accordance with international financial statements standards, whether
their designation changes or they are replaced, from time to time.
In Ethiopia the House of people’s representatives proclaimed Financial Reporting Proclamation
Number 847/2014. Part three, chapter one, sub article (5) of this proclamation states applicable
financial reporting standards as follows:
a. International financial reporting standards (IFRS); or
b. IFRS for a small and medium enterprises (IFRS for SMEs);

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 c. International public sector accounting standards (IPSAS) applicable to charities and
societies.
According to part two section 4 of this proclamation Board means the Accounting and Auditing
Board of Ethiopia (AABE) which is to be established by the regulation to be issued by the
Council of Ministers. The board has the power to issue standards and directives relating to
financial reporting and auditing and ensure compliance therewith.
In response to this proclamation the FDRE Council of Ministers issued regulation No. 332/2014
for the establishment and determination of the procedure of AABE.
Hence, as per Article 5(1) as read with Article 54(1) of the Financial Reporting Proclamation, the
Board hereby adopt the International Financial Reporting Standards (IFRS) issued by the
International Accounting Standard Board (IASB). The Roadmap for the adoption is specified
hereunder.
Illustration 1-1: Roadmap to IFRS Implementation

Mandatory Adoption of IFRS

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Phase 1: Significant Public Interest Entities - Financial Institutions and public enterprises
owned by Federal or Regional Governments
Phase 2: Other Public Interest Entities (ECX member companies and reporting entities that
meet PIE quantitative thresholds) and IPSAs for Charities and Societies
Phase 3: Small and Medium-sized Entities
1.3 The IASB and Its Governance Structure
The increase in international trade and the presence of large multinational companies in many
countries in the world has led to problems where different accounting standards govern
financial reporting in different countries. In response to this problem, the International
Accounting Standards Committee (IASC) was formed in 1973. The IASC reorganized itself in
2001 and created a new standards-setting body called the International Accounting Standards
Board (IASB). The main objective of the IASB is to develop a single set of high quality,
understandable, and enforceable global accounting standards to help participants in the world’s
capital markets and other users make economic decisions. The IASB issues standards called
International Financial Reporting Standards or IFRSs which are gaining support around the
globe.
IASB is:
 Comprised of 14 members (12 full, 2 part-time) 7 members are liaisons with a
national board.
 Standard development process is open.
 Standards are principles-based.
 Since establishment of IASB, focus is on global standard-setting rather than
harmonization in isolation.
International Accounting Standards Board (IASB) Composed of four organizations:-
 International Accounting Standards Committee Foundation (IASCF)
 International Accounting Standards Board (IASB)
 Standards Advisory Council
 International Financial Reporting Interpretations Committee (IFRIC)

Illustration 1-2: International Standard-Setting Structure

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To ensure that financial reporting continues to provide the most relevant and reliable financial
information to users, a number of financial reporting issues must be resolved. These issues
include such matters as adopting global standards, increasing fair value reporting, using
principles-based versus rule-based standards, and meeting multiple user needs.
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.

Illustration 1-2: International Standard-Setting Structure

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1.4 The IASBs Conceptual Framework for Financial Reporting
The Conceptual Framework has been described as an “Accounting Constitution.” It provides the
underlying foundation for accounting standards or sets out the concepts that underlie the
preparation and presentation of financial statements for external users.
The conceptual framework is a coherent system of concepts that flow from an objective. The
objective identifies the purpose of financial reporting. The other concepts provide guidance on
(1) identifying the boundaries of financial reporting; (2) selecting the transactions, other events,
and circumstances to be represented; (3) how they should be recognized and measured; and (4)
how they should be summarized and reported.
1.4.1. Need for a Conceptual Framework
Why do we need a conceptual framework? First, to be useful, rule-making should build on and
relate to an established body of concepts. A soundly developed conceptual framework enables
the IASB to issue more useful and consistent pronouncements over time, and a coherent set
of standards should result. Indeed, without the guidance provided by a soundly developed
framework, standard-setting ends up being based on individual concepts developed by each
member of the standard-setting body.
1.4.2. Development of a Conceptual Framework
Both the IASB and the FASB have a conceptual framework. The IASB’s conceptual framework
is described in the document, “Framework for Preparation and Presentation of Financial
Statements.” The FASB’s conceptual framework is developed in a series of concept statements,
which is generally referred to as the Conceptual Framework. The IASB and the FASB are now
working on a joint project to develop an improved common conceptual framework that provides
a sound foundation for developing future accounting standards. Such a framework is essential to
fulfilling the Boards’ goal of developing standards that are principles-based, internally
consistent, and internationally converged, and that lead to financial reporting that provides the
information investors need to make sound and effective decisions.
1.4.3. Development of a Conceptual Framework
The Conceptual Framework comprises an introduction and four chapters as follows.
• Chapter 1: The Objective of General Purpose Financial Reporting
• Chapter 2: The Reporting Entity (not yet issued)
• Chapter 3: Qualitative Characteristics of Useful Financial Information

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• Chapter 4: The Framework comprised of the following:
1. Underlying assumption—the going concern assumption;
2. The elements of financial statements;
3. Recognition of the elements of financial statements;
4. Measurement of the elements of financial statements; and
5. Concepts of capital and capital maintenance.
1.4.4. Overview of the Conceptual Framework
 First Level = Objectives of Financial Reporting
 Second Level = Qualitative Characteristics and Elements of Financial Statements
 Third Level = Recognition, Measurement, and Disclosure Concepts.

1.4.4.1. Objectives of Financial reporting (1st level)

The objective of general-purpose financial reporting is to provide financial information about the
reporting entity that is useful to present and potential equity investors, lenders, and other
creditors in making decisions about providing resources to the entity.
For example, a lender may need information in order to decide whether to loan money to a
company. Similarly, an equity investor may need information about a company’s profitability in
order to decide whether to purchase or sell shares.
1.4.4.2. Qualitative Characteristics of Accounting Information (2nd level)
The IASB identified the qualitative characteristics of accounting information that distinguish
better (more useful) information from inferior (less useful) information for decision-making
purposes.
Qualitative characteristics are either fundamental or enhancing characteristics, depending on
how they affect the decision-usefulness of information.
1. Fundamental Quality
I. Relevance: accounting information must be capable of making a difference in a
decision. Information with no bearing on a decision is irrelevant. Financial
information is capable of making a difference when it has predictive value,
confirmatory value and material.
Financial information has predictive value if it has value as an input to predictive
processes used by investors to form their own expectations about the future.

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 Relevant information also helps users confirm or correct prior expectations.
Information is material if omitting it or misstating it could influence decisions
that users make on the basis of the reported financial information.
II. Faithful Representation: Faithful representation is the second fundamental
quality that makes accounting information useful for decision-making. Faithful
representation means that the numbers and descriptions match what really existed
or happened. To be a faithful representation, information must be complete,
neutral, and free of material error.
2. Enhancing Qualities
Enhancing qualitative characteristics are complementary to the fundamental qualitative
characteristics. These characteristics distinguish more useful information from less useful
information.
I. Comparability: Information that is measured and reported in a similar manner for
different companies is considered comparable. Comparability enables users to identify
the real similarities and differences in economic events between companies.
II. Verifiability: Verifiability means that different knowledgeable and independent
observers could reach consensus, although not necessarily complete agreement, that a
particular depiction is a faithful representation.
III. Timeliness: Timeliness means having information available to decision-makers before it
loses its capacity to influence decisions. Having relevant information available sooner
can enhance its capacity to influence decisions, and a lack of timeliness can rob
information of its usefulness.
IV. Understandability: For information to be useful there must be a connection (linkage)
between these users and the decisions they make. This link, understandability, is the
quality of information that lets users to make an informed decision.
1.4.4.3. Elements of Financial Statements (2nd level)
The elements directly related to the measurement of financial position are assets, liabilities, and
equity. These are defined as follows.
Asset: a present economic resource controlled by the entity as a result of past events and from
which there is a probable future economic inflow to the entity.
Liability: A present obligation of the entity to transfer an economic resource as a result of past

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 events.
Equity: The residual interest in the assets of the entity after deducting all its liabilities.
Revenue: Increases in assets, or decreases in liabilities, that result in increases in equity, other
than those relating to contributions from holders of equity claims.
Expenses: Decreases in assets, or increases in liabilities, that result in decreases in equity, other
than those relating to distributions to holders of equity claims.
1.4.4. Measurement, Recognition, and Disclosure Concepts (3rd level)
The third level of the conceptual framework consists of concepts that implement the basic
objectives of level one. These concepts explain how companies should recognize, measure, and
report financial elements and events. Here, we identify the concepts as basic assumptions,
principles, and a cost constraint.
Assumptions
As indicated earlier, the Conceptual Framework specifically identifies only one assumption—the
going concern assumption. Yet, we believe there are a number of other assumptions that are
present in the reporting environment. As a result, for completeness, we discuss each of these five
basic assumptions in turn: (1) economic entity, (2) going concern, (3) monetary unit, (4)
periodicity, and (5) accrual basis.

1. Economic Entity Assumption

The economic entity assumption means that economic activity can be identified with a particular
unit of accountability. In other words, a company keeps its activity separate and distinct from its
owners and any other business unit.
2. Going Concern Assumption
Most accounting methods rely on the going concern assumption —that the company will have a
long life. Despite numerous business failures, most companies have a fairly high continuance
rate. As a rule, we expect companies to last long enough to fulfil their objectives and
commitments.
3. Monetary Unit Assumption
The monetary unit assumption means that money is the common denominator of economic
activity and provides an appropriate basis for accounting measurement and analysis.
4. Periodicity Assumption

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The periodicity (or time period) assumption implies that a company can divide its economic
activities into artificial time periods. These time periods vary, but the most common are monthly,
quarterly, and yearly. The shorter the time period, the more difficult it is to determine the proper
net income for the period.
Basic Principles of Accounting
We generally use four basic principles of accounting to record and report transactions: (1)
measurement, (2) revenue recognition, (3) expense recognition, and (4) full disclosure.
I. Measurement Principles: We presently have a “mixed-attribute” system in which one of
two measurement principles is used. The most commonly used measurements are based
on historical cost and current cost.
II. Revenue Recognition: When a company agrees to perform a service or sell a product to
a customer, it has a performance obligation. IFRS requires that companies recognize
revenue in the accounting period in which the performance obligation is satisfied.
III. Expense Recognition - Outflows or “using up” of assets or incurring of liabilities during
a period as a result of delivering or producing goods and/or rendering services.

Cost Constraint
Companies must weigh the costs of providing the information against the benefits that can be
derived from using it.
 Rule-making bodies and governmental agencies use cost-benefit analysis before
making final their informational requirements.
 In order to justify requiring a particular measurement or disclosure, the benefits
perceived to be derived from it must exceed the costs perceived to be associated
with it.
1.5. IFRS-based Financial Statements (IAS 1)
IAS 1 provides with a basic framework for the preparation of general- purpose financial
statements in accordance with IFRS. It intends to standardize the structure of financial statements
so that this information is presented in a similar manner by all entities, allowing meaningful
comparisons to be made across different entities.
IAS 1 is applicable to both consolidated and separate financial statements, but is not applicable
to the structure and content of interim financial statements.

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 1.6.1. Purpose of Financial statements
The purpose of financial statements is to provide information to users about financial position,
financial performance and cash flows by providing information about its assets, liabilities,
equity, income and expenses, other changes in equity, and cash flows.
1.6.2. Complete set of financial statement
a) Statement of Financial Position: This statement shows the assets, liabilities and equity of
the entity at the end of the reporting period. It aims at showing the financial position of the
entity.
b) Statement of comprehensive income: This statement shows the financial results of the
operation of the entity for a specific period of time. All items that qualify as income or
expense will be included in the profit or loss calculation for the period. Income/Expense
Items that are not realized yet are placed under other comprehensive income (OCI).
c) Statement of changes in equity: This statement shows the change in all equity accounts
d) Statement of cash flows: This statement shows the entity‘s operating, investing and
financing cash flows and how its cash balances have changed in the period.
e) Notes, comprising a summary of significant accounting policies & other explanatory
information: Notes to the accounts discloses the basis of preparation of financial statements,
and significant accounting policies and other information relevant to understand the financial
statements.
f) Opening Statement of Financial Position as at the beginning of the earliest comparative
period at date of transition on first time adoption of IFRS
1.6.3 Structure & Content (Presentation)
Financial statements should be clearly identified from other information in the same published
document (such as an annual report). Furthermore, the following information should be clearly
displayed:
- The name of the entity
- Whether the financial statements are consolidated or not
- The date of the statement or period covered
- The reporting currency and
- The level of rounding (e.g. 1000s)

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 1.6.4 Features of General Purpose Financial Statements (GPFSs)
2. Fair presentation and compliance with IFRS: representing faithfully the effects of
transactions, other events, and conditions in accordance with the definitions and
recognition criteria in the IASB Framework.
3. Going concern: Financial statements should be prepared on a going concern basis unless
management either intends to liquidate the entity or to cease trading, or has no realistic
alternative but to do so
4. Accrual basis of accounting: Financial statements, except for the statement of cash
flows, are to be prepared using the accrual basis of accounting.
5. Materiality & aggregation: Items that are of importance to the users of the financial
statements in making economic decisions should be separately identified within the
financial statements. items can be grouped together with similarities For example, the
purchase of large tangible assets may be common for a particular entity, and therefore it
would generally be appropriate to aggregate such items together as the purchase of plant.
However, a fairly small transaction with a director may be considered as important
information for users of the financial statements.
6. Offsetting: Assets and liabilities, or income and expenses, may not be offset against each
other, unless required or permitted by an IFRS.
7. Frequency of reporting: An entity should present a complete set of financial statements
(including comparative information) at least annually. If the reporting period changes,
disclosure is a must.
8. Consistency of presentation: consistent presentation and classification of items is
followed. The presentation should only be changed where a new or revised standard
requires such a change or where there has been a significant change in the nature of the
entity‘s operations. If there is a change, restate comparatives and disclose (nature, amount
and reason)
9. Comparative information: Unless IFRS permit or require otherwise, comparative
information of the previous period should be disclosed for all amounts presented in the
current period‘s financial statements. Comparative narrative and descriptive information
should be included when it is relevant to an understanding of the current period‘s
financial statements.

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