Chapter One: The environment and Conceptual Framework for Financial

Reporting

After studying this chapter, you should be able to:

1. Know the environmental factors that influence accounting
2. Understand the nature and environment of financial accounting
Learning Objectives

3. Know the users of accounting information

4. Explain organizations and laws affecting financial accounting.
5. Describe the usefulness of a conceptual framework.
6. Describe the FASB’s efforts to construct a conceptual framework.
7. Understand the objectives of financial reporting.
8. Identify the qualitative characteristics of accounting information.
9. Define the basic elements of financial statements.
10. Describe the basic assumptions of accounting.
11. Explain the application of the basic principles of accounting.
12. Describe the impact that constraints have on reporting accounting information.

Users of financial statements can face difficult questions about the recognition and measurement of financial
items. To help develop the type of financial information that can be used to answer these questions, financial
accounting and reporting relies on a conceptual framework. In this chapter, we discuss the basic concepts
underlying the conceptual framework, as follows.

1.1. The Environment of Accounting

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

Financial statements and reports prepared by accountants are vital to the successful working of society.
Economists, investors, business executives, labor leaders, bankers, and government officials all rely on these
financial statements and reports as fair and meaningful summaries of day-to-day business transactions. In
addition, these groups are making increased use of accounting as a base for forecasting future economic trends.

1.1.1. Environmental Factors that Influence Accounting

Accounting, like other social science disciplines and human activities, is largely a product of its environment.
The environment of accounting consists of social, economic, political and 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, three of
which deserve special consideration are:
® First, accounting recognizes that people live in a world of scarce resources. Because resources exist in
limited supply, people try to concern them, to use them effectively and efficiently, and to identify and
encourage those who can make effective and efficient use of them. Accounting plays a useful role in
obtaining a higher standard of living because it helps to identify efficient and inefficient users of resources.
® Second, accounting recognizes and accepts society’s current and ethical concepts of property and other
rights when determining equity among the varying interests in an enterprise or entity. Accounting looks to
its environment for direction with regard to what property rights society protects, what society recognizes as
value, and what society acknowledges as equitable and fair.
® Third, accounting recognizes that in highly developed, complex economic systems, some (owners and
investors) entrusts the custodianship of and control over property to others (managers). One of the results of
the corporate form of organization has been the tendency in large enterprises to divorce ownership and
management.

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Thus, the function of measuring and reporting information to absentee investors (e.g. Shareholders) has been
added to that of recording and presenting financial data for owner – manager use. This development greatly
increased the need for accounting standards (rules of practice governing the contents, measurements, and
disclosures in financial statements).

1.1.2. Nature and Environment of Financial Accounting

For purposes of study and practice, the discipline of accounting is commonly divided into the following areas or
subsets: financial accounting, managerial (cost) accounting, tax accounting, and not- for- profit (public sector)
accounting. This handbook concentrates on financial accounting. Financial accounting has characterized as “that
branch of accounting concerned with the classification, recording, analysis, and interpretation of the overall
financial position and operating results of an organization. Financial accounting encompasses the process and
decisions that culminate in the preparation of financial statements relative to the enterprise as a whole for use by
parties both internal and external to the enterprise. These statements provide a continual history qualified in
money terms of economic resources and obligations of a business enterprise and of economic activities that
change these resources and obligations. The following four environmental factors, although not as basic as the
three aspects described in environmental factors that influence accounting, shape financial accounting to a
significant extent:
® The many users and uses that accounting serves
® The nature of economic activity
® The economic activity in individual business enterprises
® The means of measuring economic activity

1.1.3. Users of Accounting Information

The basic assumptions that underlie current accounting practice have evolved over many years in response to the
needs of various users of accounting information. The users of accounting information may be divided into two
broad groups: internal users and external users.

Internal users include all the management personnel of a business enterprise who use accounting information
either for planning and controlling current operations or for formulating long-range plans and making major
business decisions. The term managerial accounting relates to internal measurements and reporting; it includes
the development of detailed current information helpful to all levels of management in decision-making
designed to achieve the goals of the enterprise.

External users of accounting information include stockholders, bondholders, potential investors, bankers and
other creditors, financial analysts, economists, labor unions, and numerous government agencies. 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.

As stated above, two branches of accounting are used to meet the needs of external and internal users.
 Financial accounting is the information accumulation, processing, and communication system
designed to provide investment and credit decision-making information for external users. Financial
accounting information is communicated (reported) through published financial statements and must follow
the pronouncements of several policy-making groups.
 Managerial accounting is the information accumulation, processing, and communication system
designed to provide decision-making information for internal users. Managerial accounting information
is communicated via internal company reports and is not subject to the policy standards for externally
communicated information.

It is restricted by how useful the information is for a specific decision, and by the cost of providing that
information. Financial accounting and managerial accounting thus have somewhat different objectives because
they provide information for different decisions.The company’s accountants prepare both the financial
accounting and the managerialaccounting reports, and the information comes from the same information system.

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The differenceslie in selecting and presenting the communicated information. The following table
summarizessome of the more important differences.

This course focuseson financial accounting and its usefulness in investors’, creditors’, and other users’ decision-
making. We generally do not discuss managerial accounting information (discussed in the course “cost and
management accounting”). On the otherhand, the rules of a game influence how the game is played. The
management of a companyoften is evaluated based on “performance criteria” (e.g., net income, rate of return)
that arebased on the accounting measures used in financial accounting reports. Thus, the financialaccounting
system may influence the managerial accounting system, or vice versa.

1.1.4. Organizations and Laws affecting Financial Accounting

Certain professional organizations, governmental agencies, and legislature acts have been extremely influential
in shaping the development of the existing body of financial accounting theory. Among the most important of
these are:
 International Accounting Standards Board (IASB),
 Financial Accounting Foundation (FAF)
 American Accounting Association (AAA),
 American Institute of Certified Public Accountants (AICPA),
 Association of Chartered Certified Accountants (ACCA),
 International Financial Reporting Standards (IFRS),
 Accounting Principles Board (APB),
 Generally Accepted Accounting Principles(GAAP),
 Financial Accounting Standard Board (FASB),
 Securities and Exchange Commission (SEC),etc.

Awareness of the roles of these institutional forces is helpful in gaining an understanding of current accounting
principles and practices. Efforts to improve existing principles of accounting will have a better chance of
success if they are made with full recognition of the needs of the various groups that use accounting
information.Let us discuss some of them one by one.

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Financial Accounting Standards Board (FASB)
After World War II, the process of setting accounting principles was increasingly criticized,and wider
representation in rulemaking was sought. In 1959, the AICPA formedthe Accounting Principles Board (APB)
as an attempt to (1) alleviate this criticism and (2) create a policy-making body whose rules would be binding on
companies rather thanoptional.

In several cases, the APBeither did not act on the recommendations or came to different conclusions.The
members of the APB were volunteers whose employers allowed them time toserve on the Board. However, by
the late 1960s, many people again criticized the developmentof accounting principles. This criticism centered on
three factors:
a) Independence - the members of the APB were part-time volunteers whose major responsibilities were to
the business, governmental, or academic organizations employing them.
b) Representation - the public accounting firms and the AICPA were too closely associated with the
development of accounting standards.
c) Response time - emerging problems were not solved quickly enough by the part-time members of the APB.

The AICPA reacted to those criticisms by appointing a committee to evaluate the method of establishing
accounting principles. This committee, called the Wheat Committee after itschairperson Francis Wheat,
recommended that the APB be abolished and that a new fulltime body be created with even wider
representation.

The AICPA adopted the recommendations of the Wheat Committee. The APB phased outand replaced in 1973
by the Financial Accounting Standards Board (FASB).The creation of a new standard-setting structure
composed of three organizations – FAF, FASB and FASAC (Diagram 1).FASB’smission is to establish and
improve standardsof financial accounting and reporting for the guidance and education of the public,which
includes issuers, auditors, and users of financial information.FASB is authorized to issue statements of
Financial Accounting Standards, InterpretationsandTechnical Bulletins, to guide individuals and organizations
in preparing and auditing financial statements.

FinancialAccounting Foundation (FAF) selects the members of the FASB and the AdvisoryCouncil, funds
their activities, and generally oversees the FASB’s activities.

Financial AccountingStandards Advisory Council(FASAC) consults with the FASB on majorpolicy and
technical issues and helps select task force members. Diagram 1 shows the current organizational structure for
the development of financial reportingstandards.

International Accounting Standards Board (IASB) - Companies are becoming more international in their
operations by producing, selling,and buying products and services in other countries. This globalization of
businessactivity has led to increased information in a company’s financial statements about itsinternational
operations. Investors and creditors in international markets, in turn, preferthat the information they use for
decisions be internationally comparable from company to company across countries. The International
Accounting Standards Committee(IASC) foundation is the parent organization of the International Accounting
StandardsBoard (IASB). The objectives of the foundation are to: (1) develop high-quality, understandable,and
enforceable global accounting standards that lead to useful, comparablefinancial reporting to help users in the
world's capital markets make informed economicdecisions, (2) promote the use and rigorous application of these
standards, and (3) bringnational accounting standards into agreement with international accounting
standards(convergence).

Governmental Accounting Standards Board (GASB)-The GASB was established in 1984 and operates under
the auspices of the Financial Accounting Foundation. The GASB operates in a manner similar to the FASB. It
consistsof a full-time chair and six other members, plus a supporting staff. The GASB’s responsibility is to

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establish financial accounting standards for state and localgovernmental entities. Its impact on accounting
principles for the private sector isminimal.

Diagram 1: Organizational Structure for Setting Accounting Standards

American Accounting Association (AAA) - The AAA is an organization primarily of academics and practicing
accountants. The mission of the AAA is to foster worldwide excellence in the creation, dissemination, and
application of accounting knowledge and skills. Its goals are to encourage excellence in accounting research and
accounting instruction, and to contribute to excellencein accounting practice. These goals are primarily
implemented through variousmeetings; the AAA’s journals—The Accounting Review, Issues in Accounting
Education,and Accounting Horizons; and the work of various committees such as the AAAFinancial Accounting
Standards Committee (FAS). The FAS responds to various documentsof the FASB and IASB relating to
proposed statements of concepts and standards.

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The AAA has no official stature in the development of financial accounting practice,so its impact is through
education and persuasion. However, its members haveserved on the APB, FAF, and the FASB, and have
appeared before the FASB in its hearingson particular issues.

American Institute of Certified Public Accountants (AICPA) - The AICPA date back to 1887 and is the
national professional organization for all certified publicaccountants in the United States. To be a member of the
AICPA, an individual musthave passed the Uniform CPA Examination, hold a CPA certificate, agree to abide
by itsbylaws and Code of Professional Ethics, and have 150 hours of higher education. The primarypurpose of
the AICPA is to provide the necessary technical support to assure thatCPAs serve the public interest in
performing quality professional services.To fulfill this purpose, the AICPA publishes numerous documents that,
in certain circumstances,may be considered as sources of generally accepted accounting principles.

Securities and Exchange Commission (SEC) - External financial reporting and auditing developed in tandem
with the growth ofthe industrial economy and its capital markets. However, when the stock marketcrashed in
1929 and the nation’s economy plunged into the Great Depression, therewere calls for increased government
regulation of business generally, and especiallyfinancial institutions and the stock market in U.S.

Because of these events, the federal government established the Securitiesand Exchange Commission (SEC)
to help develop and standardize financial informationpresented to stockholders. Hence, the SEC is a federal
agency in U.S, similar to National Bank of Ethiopia (NBE). It administers theSecurities Exchange Act of 1934
and several other acts. Most companies that issue securities to the public or are listed on a stock exchange are
required to file audited financial statements with the SEC. In addition, the SEC has broad powers to prescribe, in
whatever detail it desires, the accounting practices and standards to be employed by companies that fall within
its jurisdiction. The SEC currently exercises oversight over 12,000 companies that are listed on the major
exchanges (e.g., theNew York Stock Exchange).

International Financial Reporting Standards (IFRS) - Currently, there are two sets of rules accepted for
international use - GAAP and the IFRS, issued by the London based International Accounting Standards Board
(IASB). U.S. companies that list overseas are still permitted to use GAAP, and foreign companies listed on U.S.
exchanges are permitted to use IFRS. As you will learn, there are many similarities between GAAP and IFRS,
as discussed under conceptual framework in the next section.

Already over 115 countries use IFRS, and the European Union now requires alllisted companies in Europe (over
7,000 companies) to use it. The SEC laid out a road map by which all U.S. companies might be required to use
IFRS by 2015. Most partiesrecognize that global markets will best be served if only one set of accounting
standardsis used. For example, the FASB and the IASB formalized their commitment to theconvergence of
GAAP and IFRS by issuing a memorandum of understanding (oftenreferred to as the Norwalk agreement). The
two boards agreed to use their best efforts to:
• Make their existing financial reporting standards fully compatible as soon as practicable,and
• Coordinate their future work programs to ensure that once achieved, compatibilityis maintained.

Because of this agreement, the two Boards identified a number of short-termand long-term projects that would
lead to convergence.

Generally Accepted Accounting Principles (GAAP) - Generally accepted accounting principles are those
principles that have “substantial authoritativesupport.” The AICPA’s Code of Professional Conduct requires that
membersprepare financial statements in accordance with GAAP. The major sources of GAAP come from the
organizations discussedearlier in this chapter. It is composed of a mixture of over 2,000 documents that
havedeveloped over the last 60 years or so. It includes such items as FASB Standards,Interpretations, and Staff
Positions; APB Opinions; and AICPA Research Bulletins.The following Diagram 2highlights the many different
types of documents thatcomprise GAAP.

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 These documentsare known as House of GAAP

Diagram 2: House of GAAP

These documents are considered to have substantial authoritative support because the recognized
professionalbodies, after giving interested and affected parties the opportunity to react to exposuredrafts and
respond at public hearings, have voted their issuance.

1.2. Conceptual Framework (FASB Vs. IFRS)

A conceptualframework is like a constitution: It is "a coherent system of interrelated objectives and
fundamentals that can lead to consistent rules and prescribes the nature, function, and limits of financial
accounting and financial statements".Manyconsider the FASB’s real contribution to depend on the quality and
utility of the conceptual framework.

1.2.1. The Need for a Conceptual Framework - Why do we need a conceptual framework?
First, to be useful, rulemakingshould build on and relate to an established body of concepts and objectives. A
soundly developed conceptual framework thus enables the FASB to issue more useful and consistent
pronouncements over time. A coherent set of GAAP should result. The framework should increase financial
statement users’ understanding of and confidence in financial reporting. It should enhance comparability among
companies’ financial statements.

Second, the profession should be able to more quick solve new and emerging practical problems by referring to
an existing framework of basic theory. It is difficult, if not impossible, for the FASB to prescribe the proper
accounting treatment quickly for situations like this. Practicing accountants, however, must resolve such
problems on a daily basis. How?-through good judgment and with the help of a universally accepted conceptual
framework, practitioners can quickly focus on an acceptable treatment.

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 1.2.2. Development of a Conceptual Framework
Over the years, numerous organizations developed and published their own conceptual frameworks, but no
single framework was universally accepted and relied on in practice. In 1976, the FASB began to develop a
conceptual framework that would be a basis for setting accounting rules and for resolving financial reporting
controversies. The FASB has since issued seven Statements of FinancialAccounting Concepts that relate to
financial reporting for business enterprises.They are as follows.
SFAC No. 1, “Objectives of Financial Reporting by Business Enterprises,” presentsthe goals and purposes of accounting.
SFAC No. 2, “Qualitative Characteristics of Accounting Information,” examines thecharacteristics that make accounting
information useful.
SFAC No. 3, “Elements of Financial Statements of Business Enterprises,” providesdefinitions of items in financial
statements, such as assets, liabilities, revenues, andexpenses.
SFAC No. 4 “Objectives of Financial Reporting by Non-business Organizations”
SFAC No. 5, “Recognition and Measurement in Financial Statements of BusinessEnterprises,” sets forth fundamental
recognition and measurement criteria andguidance on what information should be formally incorporated into
financial statements and when.
SFAC No. 6, “Elements of Financial Statements,” replaces SFAC No. 3and expandsits scope to include not-for-profit
organizations.
SFAC No. 7, “Using Cash Flow Information and Present Value in Accounting Measurements,” provides a framework for
using expected future cash flows and present values as a basis for measurement.

SFAC = Statement of Financial Accounting Concepts

The first level identifies the objective of financial reporting - that is, the purpose of financial reporting. The
second level provides the qualitative characteristicsthat make accounting information useful and the elements
of financial statements (assets, liabilities, and so on). The third level identifies the recognition, measurement,
and disclosure concepts used in establishing and applying accounting standards and the specific concepts to
implement the objective. These concepts include assumptions, principles, and constraints that describe the
present reporting environment.

A) First Level: Basic Objective

The objective of financial reportingis the foundation of the conceptual framework. Other aspects of the
framework (2ndand 3rd levels) flow logically from the objective. Those aspects of the framework help to ensure
that financial reporting achieves its objective.The objective of general-purpose financial reporting is to provide
financial information about the reporting entity that is useful to present and potential equity investors, lenders,
and other creditors in making decisions about providing resources to the entity. Those decisions involve buying,
selling, or holding equity and debt instruments, and providing or settling loans and other forms of credit.

B) Second Level: Fundamental Concepts

This level provides conceptual building blocks that explain the qualitative characteristics of accounting
information and define the elements of financial statements.That is, it forms a bridge between the whyof
accounting (the objective) and the how of accounting (recognition, measurement, and
financialstatementpresentation).

C) Third Level: Recognition and Measurement Concepts

This level of the framework consists of concepts that implement the basic objective of level one. These concepts
explain how companies should recognize, measure, and report financial elements and events. The FASB sets
forth most of these in its Statement of Financial Accounting Concepts No. 5,“Recognition and Measurement in
Financial Statements of Business Enterprises.” According to SFAC No. 5, to be recognized an item (event or
transaction) must meet the definition of an “element of financial statements” as defined in SFAC No. 6and must
be measurable. Most aspects of current practice follow these recognition and measurement concepts.
The summary and relationship of these levels are given below in Diagram 3.

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 Diagram 3: An overview of the FASB’s conceptual framework

1.2.3. Conceptual Framework Differences between US GAAP and IFRS

The IASB and the FASB are working on a joint project to develop a common conceptual framework. This
framework is based on the existing conceptual frameworks underlying GAAP and IFRS. The objective of this
joint project is to develop a conceptual framework that leads to standards that are principles-based and internally
consistent and that leads to the most useful financial reporting.

Relevant Facts
 In 2010, the IASB and FASB completed the first phase of a jointly created conceptual framework. In this
first phase, they agreed on the objective of financial reporting and a common set of desired qualitative
characteristics.

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 The existing conceptual frameworks underlying GAAP and IFRS are very similar. That is, both organized
in a similar manner (objectives, elements, qualitative characteristics, etc.). There is no real need to change
many aspects of the existing frameworks other than to converge different ways of discussing essentially the
same concepts.
 The converged framework should be a single document, unlike the two conceptual frameworks that
presently exist; it is unlikely that the basic structure related to the concepts will change.
 Main areas of differences with U.S. GAAP are summarized below:

Level 1: Objectives of Financial Reporting Differences:

US GAAP IFRS
 To provide information useful for investment  Provide information about the financial position,
and credit decisions. performance and changes in financial position of
 To provide information useful for predicting an entity that is useful to a wide range of users in
the amount, timing, and uncertainty of future making economic decisions.
cash flows to the business.  Users are present & potential investors,
 To provide information about economic employees, lenders, suppliers & other trade
resources, claims against those resources, and creditors, customers, governments & their
changes in both. agencies & the public.

Level 2a: Qualitative Characteristics of Accounting Information

US GAAP IFRS
Relevance – Ingredients: Relevance - Ingredients:
 Predictive value - helps users predict  Predictive value
outcome of past, present, and future events  Confirmatory value
 Feedback value - helps to confirm or  Materiality
correct prior predictions
 Timeliness – available before loses
capacity to influence a decision
Reliability –Ingredients: Reliability
 Representational faithfulness  Faithful representation
 Neutral  Neutrality
 Verifiable  Substance over form
 Prudence (when there is uncertainty, err on the
side of providing more info and ensure
conservatism (lower assets/revenues, higher
liabilities/expenses))
 Completeness
Comparability Comparability& Verifiability
Consistency Timeliness &Understandability

Level 2b: Elements of Financial Statements

US GAAP IFRS
Assets Asset
Liabilities Liabilities
Equity Equity
Investment by Owners
Distributions to Owners Capital Maintenance (resulting from the revaluation
Comprehensive Income of assets and liabilities)
Revenues Income (Revenues and gains)
Gains
Expenses Expenses (Expenses and losses)
Losses

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Level 3a: Recognition and Measurement – Basic Assumptions
US GAAP IFRS
1. Going Concern 1. Going concern
2. Economic Entity 2. Accrual Basis
3. Monetary Unit
4. Periodicity

Level 3b: Recognition and Measurement – Basic Principles

US GAAP IFRS
1. Historical Cost 1. Historical cost
2. Current cost (what would have to be paid today
to acquire an equivalent asset. This often results
in the same valuation as fair value)
3. Realizable value (amount of cash that would be
currently obtained if asset is disposed of)
4. Fair value
2. Revenue Recognition 5. Revenue Recognition
3. Matching 6. Expense Recognition
4. Full Disclosure 7. Full disclosure

Level 3c: Recognition and Measurement – Constraints

IFRS (in reference to Level 2 Relevance &
US GAAP Reliability Qualitative Characteristics)
1. Cost benefit 1. Balance between benefit and cost
2. Materiality 2. Timeliness
3. Industry practices 3. Balance between qualitative characteristics
4. Conservatism 4. Understandability

1.3. Objectives of Financial Reporting (Level 1)

In an attempt to establish a foundation for financial accounting and reporting, a set ofobjectives of financial
reportingby business enterprises has been identified. Financial reporting should provide information that:
 Is useful to present and potential investors and creditors and other users in making rational investment,
credit, and similar decisions. The information should be comprehensible to those who have a reasonable
understanding of business and economic activities and are willing to study the information with reasonable
diligence.
 Helps present and potential investors, creditors, and other users assess the amounts, timing, and uncertainty
of prospective cash receipts from dividends or interest and the proceeds from the sale, redemption, or
maturity of securities or loans. Since investors’ and creditors’ cash flows are related to enterprise cash
flows, financial reporting should provide information to help investors, creditors, and others assess the
amounts, timing, and uncertainty of prospective net cash inflows to the related enterprise.
 Clearly portrays the economic resources of an enterprise, the claims to those re-sources(obligations of the
enterprise to transfer resources to other entities and owners’ equity), and the effects of transactions, events,
and circumstances that changeits resources and claims to those resources.

In brief, the objectives of financial reporting are to provide (1) information that is useful in investment and
credit decisions, (2) information that isuseful in assessing cashflow prospects, and (3) information about
enterprise resources, claims to those resources, and changes in them.

1.4. Qualitative Characteristics of Accounting Information (Level 2)

How does a company choose an acceptable accounting method, the amount and types of information to disclose,
and the format in which to present it? The answer: Bydetermining, which alternative provides the most useful
information for decision-making purposes (decision-usefulness). The FASB identified the qualitative

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characteristicsof accounting information that distinguish better (more useful) information frominferior (less
useful) information for decision-making purposes. In addition, the FASB identified a cost constraint as part of

the conceptual framework as Diagram 4shows; the characteristics may be viewed as a hierarchy.
Diagram 4: Hierarchy of Accounting Qualities (FASB)

Decision Makers (Users) and Understandability

Decision makers vary widely in the types of decisions they make, how they make decisions, the information
they already possess or can obtain from other sources, and their ability to process the information. 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 reasonably informed users sees its significance.

Primary Qualities: Relevance and Reliability

Relevanceand reliabilityare the two primary qualities that make accounting information useful for decision-
making.As stated in FASB Concepts Statement No. 2, “thequalities that distinguish ‘better’ (more useful)
information from ‘inferior’ (less useful)information are primarily the qualities of relevance and reliability, with
some othercharacteristics that those qualities imply.”

Relevance: to be relevant, accounting information must be capable of making a difference in a decision.

Information with no bearing on a decision is irrelevant. Relevantinformation helps users:
 To predict the ultimate outcome of past, present, and future events -it has predictive value.
 To confirm or correct prior expectations - it has feedback value.
 Available to decision makers before it loses its capacity to influence their decisions - it has timeliness.
Hence, for information to be relevant, it needs predictive or feedback value, presented on a timely basis.

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Reliability:accounting information is reliable to the extent that it is verifiable, is afaithful representation,
and is reasonably free of error and bias. Reliability is a necessity, because most users have neither the time nor
the expertise to evaluate the factual content of the information.
 Verifiability occurs when independent measurers, using the same methods, obtain similar results. For
example, would several independent auditors reach the same conclusion about a set of financial
statements? If not, then the statements are not verifiable. Auditors could not render an opinion on such
statements.
 Representational faithfulness means that the numbers and descriptions matchwhat really existed or
happened.
 Neutrality means that a company cannot select information to favor one set of interested parties over
another. Unbiased information must be the overridingconsideration.

Note: In the proposed converged conceptual framework, reliability is replaced with “faithfulrepresentation” as
one of the primary qualitative characteristics that must be present for information to be useful. Faithful
representation is attained when the substance of an economic phenomenon is depicted completely,
accurately,and neutrally. Look at the following Diagram 5:

Diagram 5: Hierarchy of Accounting Qualities (IFRS)

Secondary Qualities: Comparability and Consistency

Information about a company is more useful if decision makers can compare it withsimilar information about
another company and with similar information about thesame company at other points in time. The first of these
qualities is comparability, andthe second is consistency.
Comparability: information that is measured and reported in a similar manner fordifferent companies is
considered comparable. Comparability enables users to identify the real similarities and differences in economic
events between companies.A valid evaluation can be made only if comparable information isavailable.
Consistency: when a company applies the same accounting treatment to similar events,from period to period,
the company shows consistent use of accounting standards. Theidea of consistency does not mean, however, that

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companies cannot switch from oneaccounting method to another. A company canchange methods, but it must
first demonstrate that the newly adopted method is preferable to the old. If approved, the company must then
disclose the nature and effect of the accounting change, as well as thejustification for it, in the financial
statements for the period in which it made the change.When a change in accounting principles occurs, the
auditor refers to it in an explanatory paragraph of the audit report. This paragraph identifies the nature of the
changeand refers the reader to the note in the financial statements that discusses the changein detail.

1.5. Elements of Financial Statements of Business Enterprise

An important aspect of developing any theoretical structure is the body of basic elementsor definitions to be
included in it. Accounting uses many terms with distinctive and specific meanings. These terms constitute the
language of business or the jargon of accounting.

The FASB classifies the elements into two distinct groups. The first group of three elements - assets, liabilities,
and equity - describes amounts of resources and claims to resources at a moment in time. The other seven
elements describe transactions, events, and circumstances that affect a company during a period. The first
class,affected by elements of the second class, provides at any time the cumulative result of all changes. This
interaction is referred to as “articulation.” That is, key figures in one financial statement correspond to balances
in another.Definitions and explanations of these terms (elements) are summarized in the following the table.

Elements of Financial Statements

Assets: probable future economic benefits obtained or controlled by a particular entity because of past
transactions or events.
Liabilities: probable future sacrifices of economic benefits arising from present obligations of a particular entity
to transfer assets or provide services to other entities in the future because of past transactions/events.
Equity: is residual interest in the assets of an entity that remains after deducting its liabilities. In a business
enterprise, the equity is the ownership interest.
Investments By Owners: increases in net assets of a particular enterprise resulting from transfers to it from
other entities of something of value to obtain or increase ownership interests (or equity) in it. Owners
most commonly receive assets as investments, but that is received may also include services,
satisfaction, or conversion of liabilities of the enterprise.
Distributions To Owners: decreases in net assets of a particular enterprise resulting from transferring assets,
rendering services, or incurring liabilities by the enterprise to owners. Distributions to owners decrease
ownership interests (or equity) in an enterprise.
Comprehensive Income: change in equity (net assets) of an entity during a period from transactions and other
events and circumstances from non-owner sources. It includesall changes in equity during a period
except those resulting from investments by owners and distributions to owners.
Revenues: inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination
of both) during a period from delivering or producing goods, rendering services, or other activities that
constitute the entity’s ongoing major or central operations.
Expenses: outflows or other using up of assets or incurrence of liabilities (or a combination of both) during a
period from delivering or producing goods, rendering services, or carrying out other activities that
constitute the entity’s ongoing major or central operations.
Gains: increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other
transactions and other events and circumstances affecting the entity during a period except those that
result from revenues or investments by owners.
Losses: decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other
transactions and other events and circumstances affecting the entity during a period except those that
result from expenses or distributions to owners.

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1.6. Basic Assumptions, Principles and Constraints
Basic Assumptions
 Economic Entity – company keeps its activity separate from its owners and other business unit.
 Going Concern - company to last long enough to fulfill objectives and commitments
 Monetary Unit - money is the common denominator.
 Periodicity - company can divide its economic activities into time periods
 Accrual Basis of Accounting – transactions are recorded in the periods in which the events occur.
Measurement Principles
 Historical Cost is generally thought to be a faithful representation of the amount paid for a given item.
 Fair value is defined 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.”
IASB has given companies the option to use fair value as the basis for measurement of financial assets and
financial liabilities.
 Revenue Recognition
When a company agrees to perform a service or sell a product to a customer, it has a performance obligation.
Requires that companies recognize revenue in the accounting period in which the performance obligation is
satisfied.
 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.
 Full Disclosure-Providing information that is of sufficient importance to influence the judgment and
decisions of an informed user. Provided through:
 Financial Statements
 Notes to the Financial Statements
 Supplementary information
Cost Constraint
Companies must weigh the costs of providing the information against the benefits that can be derived from
using it.
Rule-making bodies and governmental agencies use cost-benefit analysis before making final their informational
requirements.
In order to justify requiring a particular measurement or disclosure, the benefits perceived to be derived from it
must exceed the costs perceived to be associated with it.

======End of chapter One====

Assignment 1: 10%
Q: Write an essay on the difference between Generally Accepted Accounting principles (GAAP)
& international financial reporting standard (IFRS)
Do it in-group
Max.pages-5+
Submission date=one week from this class.
Contents:
 Preliminary pages,
 Introduction,
 Body,
 Summary

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