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CHAPTER 1: ACCOUNTING PRINCIPLES AND PROFESSIONAL PRACTICES

1.1. The Environment of Accounting
 Definition, Objective, & Importance of Accounting
Accounting is a/an:
As a service activity, it to provide interested parties with quantitative information, primarily financial
in nature, about economic entities that is intended to be useful in making economic decisions
[decisions about the deployment and use of resources in business and non-business entities and in the
economy]., in making reasoned choices among alternative courses of action.
 As a descriptive/analytical discipline, it defines the great mass of events and transactions that
characterize economic activity and through measurement, classification, and summarization,
reduces those data to relatively small, highly significant, and interrelated items that, when
properly assembled and reported, describe the financial condition, and results of operation of
a specific economic activity.
 As an information system, it collects and communicates economic information about a
business enterprise or other entity to a wide variety of persons whose decision and actions are
related to the activity.
1.3 Users of Accounting Information
The users of accounting information may be divided into two broad groups: internal users and
external users.
FINANCIAL REPORTING REQUIREMENTS IN ETHIOPIA
Ethiopia passed a financial reporting law in 2014 which requires the use of IFRS by commercial
businesses operating in Ethiopia.
 Proclamation No. 847/2014
 Regulation No. 332/2014
According to the proclamation
 Commercial organizations to follow International Financial Reporting Standards (IFRS)
 Charities and societies to follow International Public Sector Accounting Standards (IPSAS)
 Public auditors to follow International Standards for Auditing.
 Public interest entity (PIE) should use the full IFRS.
INTERNATIONAL ACCOUNTING STANDARDS BOARD (IASB) AND ITS
GOVERNANCE STRUCTURE
The standard-setting structure internationally is composed of the following four organizations:

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1. The IFRS Foundation provides oversight to the IASB, IFRS Advisory Council, and IFRS
Interpretations Committee. In this role oversees the work of the IASB, the structure, and strategy, and
has fund raising responsibility.
2. The International Accounting Standards Board (IASB) develops, Sole responsibility for
establishing International Financial Reporting Standards (IFRSs)
3. The IFRS Advisory Council (the Advisory Council) provides advice and counsel to the IASB on
major policies and technical issues.
4. The IFRS Interpretations Committee Develops interpretations for approval by the IASB, and
undertakes under tasks at the request of the IASB seeks to resolve accounting issues and interpret
existing IFRS.
In addition, as part of the governance structure, a Monitoring Board was created. The purpose of
this board is to establish a link between accounting standard-setters and those public authorities (e.g.,
IOSCO) that generally oversee them. The Monitoring Board also provides political legitimacy to the
overall organization. It also oversees the IFRS Foundation Trustees, participates in the Trustee
nomination process, and approves appointments to the Trustees. The following diagram shows the
organizational structure for the setting of international accounting standards.

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ROLE OF INTERNATIONAL ACCOUNTING STANDARDS BOARD (IASB)

 Designed for general purpose financial reporting by profit-oriented entities
 Develop, promote and coordinate the use of a single set of high-quality, understandable, and
enforceable global and harmonized accounting standards known as International Financial
Reporting Standards.
 Prior to 2003 standards were issued as International Accounting Standards (IASs). In 2003
IFRS 1 was issued and all new standards are now designated as IFRSs.
 Standards used on most foreign exchanges.

LIST OF IASB PRONOUNCEMENTS

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THE IASB’S CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

Definition:-It refers to the theoretical basis/foundation for financial accounting and reporting.
It provides a logical structure and direction to the development of accounting standards and
principles that guide the practices of financial accounting and reporting. A conceptual framework is a
coherent system of concepts that flow from an objective.
objective.
Why do we need a conceptual framework?
 To be useful, rule-making should build on and relate to an established body of concepts.
 To identify the purpose of financial reporting.
 To identify the boundaries of financial reporting;
 selecting the transactions, other events, and circumstances to be represented;
 how they should be recognized and measured;
measured; and
 How they should be summarized and reported.
reported.
IMPORTANCE OF THE CONCEPTUAL FRAME WORK
a) assist or guide the rule-making body in the standard setting process by providing basis for
developing new and revised accounting and reporting standards;

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b) serve the public interest by providing structure and direction to financial accounting
statements;
c) prescribes the nature, function and limits of financial accounting and reporting;
d) serve as frame of reference for resolving new & emerging practical issues not covered by
existing GAAP;
e) determine the bounds for judgment in preparing financial statements by providing definitions
of basic objectives, key terms, and fundamental concepts;
f) assist accountants and others in selecting from alternative accounting and reporting methods
that best represents the economic reality of a given situation;
g) increase users’ understanding of and confidence in financial statements;
h) enhance comparability through standardized accounting practice; and
The IASB has published the revised Conceptual Framework now contains a comprehensive set of
concepts, making some major changes to the previous version. The revised Conceptual Framework
introduces the following main improvements:
New
Measurement concepts on measurement, including factors to be
considered when selecting a measurement basis
Presentation and disclosure concepts on presentation and disclosure, including when
to classify income and expenses in other comprehensive
income
De-recognition guidance on when assets and liabilities are removed from
financial statements
Update
Definitions definitions of an asset and a liability
Recognition criteria for including assets and liabilities in financial
statements
The revised framework has updated the definition of the assets and liabilities reflecting the concepts
in the new standards developed by IASB.
Previous Definition of an asset Revised Definition of an asset
The resource controlled by entity as a result Present economic resource controlled by
of past events and from which future entity as result of past
economic benefits are expected to flow to the An economic resource is the right that has the
entity potential to produce economic benefit
The main changes to definition of asset clarifies that an asset is not an inflow of economic
benefits rather it is the economic resources controlled by the entity. The flow of

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economic benefits to the entity need to not be certain or even likely

Previous Definition of Liability Revised Definition of Liability
A present obligation of the entity due to past A present obligation of the entity to transfer
transaction or events, the settlement of which an economic resource due to past events.
is expected to result in out flow from the An obligation is a duty or responsibility that
entity of the resource embodying economic the entity has no practical ability to avoid it
benefit
A liability is an obligation to transfer economic resource not an ultimate flow of economic
resource, and entity should not have practical ability to avoid transfer of the resources, which
includes responsibilities that arise from the entity customary practices, published policies or
specific statements.
Components or Concepts of IASB revised Conceptual Framework are
 First Level = identifies basic Objectives of Financial Reporting
 Second Level = identifies fundamental concept: which include Qualitative
Characteristics and Elements of Financial Statements [Fundamental Concepts]
 Third Level relates to Recognition, Measurement, and Disclosure Concepts
First Level:
Level: Objectives of Financial Reporting and Financial Statements
 To provide information that is useful to present and potential investors and creditors
and other users in making rational investment, credit, and similar decisions.
 To provide information to help present and potential investors and creditors and other
users in assessing 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.
 To provide information about the economic resources of an enterprise, the claims to
those resources, and the effects of transactions, events, and circumstances that change
resources and claims to those resources.
 To provide information about an enterprise’s performance provided by measures of
earnings and its components.
 To provide information about how management of an enterprise has discharged its
stewardship responsibility to owners (stockholders) for the use of enterprise resources
interested to it.

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 To provide information that is useful to managers and directors in making decisions.

Second Level:
Level Qualitative Characteristics of Accounting Information
Qualitative characteristics - are the attributes that make financial information useful to users.

To be useful, information must full fill two qualities:

 Primary qualities are Relevance and Reliability of accounting information.
 Secondary qualities are Comparability and Consistency of reported information.
1. Primary Qualities
It is generally agreed that relevance and reliability are two primary qualities that make accounting
information useful for decision making.
A. Relevance
Relevance is the capacity of accounting information to make a difference to the external decision
makers who use financial reports. If certain information is disregarded because it is perceived to
have no bearing on a decision, it is irrelevant to that decision.
Relevance can be evaluated according to three qualitative criteria,
1. Timeliness – means available to decision makers before it loses its capacity to influence their
decisions. Accounting information should be timely if it is to influence decisions, like the news
of the world; state financial information has less impact than fresh information.
2. Predictive value – Accounting information should be helpful to external decision makers by
increasing their ability to make predictions about the outcome of future events. Decision makers
working from accounting information that has little or no predictive value are merely speculating.
For example, information about the current level and structure of asset holdings help users to
assess the entity’s ability to exploit opportunities and react to adverse situations
3. Feedback value:
value: Accounting information should be helpful to external decision makers who are
confirming past predictions or making updates, or corrections to predictions.
B. 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. Like relevance, reliability
must meet three qualitative criteria.
1. Representational faithfulness – Accounting information should represent what it purports to
represent and should ensure that the selected method of measurement has been used without

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error or bias. This attribute is some times called Validity:

Validity: - Information must give a faithful
picture of the facts and circumstances involved. Accounting information must report the
economic substance of transactions, not just their form and surface appearance.
2. Verifiability:- Verifiability pertains to maintenance of audit trials to information source
documents that can be checked for accuracy. It also pertains to the existence of alternative
information sources as backing. Verification implies a consensus and implies that independent
measures using the same measurement methods would reach substantially the same conclusions.
3. Neutrality: - Accounting information must be free from bias regarding a particular view point,
predetermined result, or particular party. Accounting information can not be selected to favor
one set of interested parties over another. It should be factual and truthful.
2. Secondary Qualities
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
A. Comparability: - Information that has been measured and reported in a similar manner for different
enterprise in a given year, or for the same enterprise in different years, is considered comparable. For
information to be comparable, it must be:
1. Measured and reported in a similar manner for different enterprises.
2. Useful in the allocation of resources to the areas of greatest benefit.
3. Useful to users in identifying real differences between enterprises
B. Consistency: - This characteristic is achieved by an enterprise when it 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 doesn’t mean that a company can never switch from one method of accounting
to another.
Accounting information is consistent, when the following conditions are met.
 If the same accounting principles are applied in a similar manner from one period to the
next. However, accounting principles may be changed,
 If the change results in better reporting.
 If principles are changed, the justification for, and the nature and effect of the change,
must be disclosed.

Components of Primary Qualities

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Relevance Reliability

Secondary
Predictive value Feedback Timelines Verifiability Represent Neutrality
value Faithfulness
Elements of Financial Statements
1. Assets.
Assets are probable future economic benefits obtained or controlled by a particular entity as a result
of past transactions or events.
2. Liabilities
Liabilities are 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 as result of past
transactions or events.
3. Equity
Equity is the residual (ownership) interest in the assets of an entity that remains after deducting its
liabilities. While equity in total is a residual, it includes specific categories of items, for example,
types of share capital, contributed surplus and retained earnings Are increases in net assets of a
particular enterprise resulting from transfers to it from other entities of some thing of value to obtain
or increase ownership interests (or equity) in it.
Are decreases in net assets of a particular enterprise resulting from transferring assets, rendering
services, or incurring liabilities by the enterprise to owners
4. Revenues
Revenues are inflows or other enhancements of assets of an entity or settlement of its liabilities (or
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.
5. Expenses
Expenses are outflows or other using up of assets or incurrence of liabilities (or combination of both)
during a period from delivering or producing goods, rendering services, carrying out other activities
that constitute the entities ongoing major or central operations.
Third Level:: Recognition and Measurement Criteria
Recognition Criteria:-
Criteria:- recognition pertains to the point in time when business transactions are
recorded in the accounting system. The term recognition is broadly defined as the process of

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recording and reporting an item as an asset, liability, revenue, expense, gain, loss or change in
owners’ equity. Recognition of an item is required when all four of the following criteria are met:
i) Definition:
Definition: the item in question must meet the definition of an element of financial
statements.
ii) Measurability:
Measurability: The item must have a relevant quality or attribute that is reliably
measurable (historical cost, current cost, market value, present value or net realizable
value).
iii) Reliability:-
Reliability:- The accounting information generated by the item must be representational
faithful, verifiable (Subject to audit confirmation or second – Source collaboration) and
neutral (bias – free).
iv) Relevance – The accounting information generated by the item must be significant, that
is, capable of making a difference to external users in making decision.
4 Basic Assumptions
Statements of financial Accounting concepts No5 addresses four basic environmental assumptions
that significantly affect the recording, measuring, and reporting of accounting information. They are:
1. Business entity Assumption – Accounting deals with specific, identifiable business entities, each
considered an accounting unit separate and apart from its owners and from other entities. A
corporation and its stockholders are separate entities for accounting purposes. Also partnership
and sole proprietorships are treated as separate from their owners, although this separation does
not hold true in a legal sense.
2. Going – Concern (continuity) Assumption –under this assumption the business entity in question
is expected not to liquidate but to continue operations for the foreseeable future. That is , it will
stay in business for a period of time sufficient to carry out contemplated operations, contracts and
commitments. This non liquidation assumption provides a conceptual basis for many of the
classifications used in account. Assets and liabilities, for example, are classified as either current
or long term on the basis of this assumption. If continuity is not assumed, the distinction between
current and long – term loses its significance, all assets and liabilities be come current.
Continuity supports the measurement and recording of assets and liabilities at historical cost.
3. Unit - of – measure Assumption – It states that the results of a business’s economic activities are
reported in terms of a standard monetary unit throughout the financial statements. Money
amounts are the language of accounting – the common unit of measure (yardstick) enables

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dissimilar items, such as the cost of a ton of coal and an account payable, to be aggregated into a
single total
4. Time – period Assumption.
Assumption. The operating results of any business enterprise can’t be known
with certainty until the company has completed its life span and ceased doing business. In the
meantime, external decision makers require timely accounting information to satisfy their
analytical needs. To meet their needs, the time period assumption requires that changes in a
business’s financial position be reported over a series of shorter time periods.
The time – period assumption recognizes both that decision makers’ need timely financial
information and that recognition of accruals and deferrals is necessary for reporting accurate
information. If a demand for periodic reports didn’t exist during the life span of a business, accruals
and deferrals would not be necessary.
4 Basic Principles:
Accounting principles assist in the recognition of revenue, expense, gain, and loss items for financial
statement reporting purposes. Income is defined as revenues plus gains minus expenses and losses.
The cost principle, the revenue principle, and the matching concept are employed in practice in the
process of determining income.
The four principles are
1. The cost principle:
principle: Normally applied in conjunction with asset acquisitions, the cost principle
specifies that the actual acquisition cost be used for initial accounting recognition purposes. The cash
– equivalent cost of an asset is used if the asset is acquired via some means other than cash.
The cost principle assumes that assets are acquired in business transactions conducted at arm’s
length, that is, transactions between a buyer and a seller at the fair value prevailing at the time of the
transaction. For non – cash transactions conducted at arm’s length the cost principle assumes that the
market value of the resources given up in a transaction provides reliable evidence for the valuation of
the item acquired.
When an asset is acquired as a gift, in exchange for stock, or in an exchange of assets, determining a
realistic cost basis can be difficult. In these situations the cost principle requires that the cost basis be
based on the market value of the assets given up or the market value of the asset received, which ever
value is more reliably determined at the time of the exchange.
When an asset is acquired with debt, such as with a note payable given in settlement for the purchase,
the cost basis is equal to the present value of the debt to be paid in the future.

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2. The revenue realization principle: This principle requires the recognition and reporting of
revenues in accordance with accrual basis accounting principles. Applying the revenue principle
requires that all four of the recognition criteria – definition, measurability, reliability and relevance
must be met. More generally, revenue is measured as the market value of the resources received or
the product or service given, whichever is the more reliably determinable.

The revenue principle pertains to accrual basis accounting, not to cash basis accounting. Therefore,
completed transactions for the sale of goods or services on credit usually are recognized as revenue
for the period in which the cash is eventually collected. Furthermore, related expenses are matched
with these revenues.
3. The matching Principle.
Like the revenue principle, the matching principle is predicated on accrual basis accounting, but
matching refers to the recognition of expenses. The principle implies that all expenses incurred in
earning the revenue recognized for a period should be recognized during the same period. If the
revenue is carried over (deferred) for recognition to a future period, the related expenses should also
be carried over or deferred since they are incurred in earning that revenue.
Application of the matching principle requires carrying on the books as asset outlays that under cash
basis accounting would be expensed at the time cash is disbursed. These expenditure are for fixed
assets, materials, purchased services and the like that are used to earn future revenue. Only later,
when the revenue is recognized, would the asset accounts be expensed. In this way revenues and
related expenses would be matched across accounting period.
4. Full – Disclosure Principle.
This principle stipulates that the financial statements report all relevant information bearing on the
economic affairs of a business enterprise. Many items, such as executory contracts, fail to meet the
recognition criteria but must still be disclosed for relevance and complete reporting.
Additionally, the full – disclosure principle stipulates that the primary objective is to report the
economic substance of a transaction rather than merely its form. This means that substance should
not be blurred by the way the transaction is presented. The aim of full disclosure is to provide
external users with the accounting information they need to make informed investment and credit
decisions. Full disclosure requires that the accounting policies followed be explained in the notes to
the financial statements.
4 basic Constraints

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Consistency in the application of accounting principles and uniformity of accounting practice within
the profession may not be achievable in all cases. Exceptions to GAAP are allowed in special
Situations categorized according to four constraints:
1. Cost –Benefit Constraint
Underlying the cost – benefit constrain is the expectation that the benefits derived by external users
of financial statements should outweigh the costs incurred by the preparers of the information. It
does not, however, try to estimate indirect costs, such as the cost of any altered allocation of
resources in the economy. The cost – benefit determination is essentially a judgment call.

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