FINANCIAL ACCOUNTING I

UNIT ONE: DEVELOPMENT OF ACCOUNTING PRINCIPLES

AND PROFESSIONAL PRACTICE

1.1The Environment of Accounting

Modern accounting is the product of many influences and conditions, three of which need
special consideration.
1. Accounting recognizes that people live in a world of scarce resources. Because resources
exist in a 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.
2. 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.
3. Accounting recognizes that in highly developed, complex economic systems some owners
and investors entrust the custodianship of and control over property to others (managers).
Nature and environment of financial accounting
The discipline of accounting is commonly divided into the following areas or subsets: financial
accounting, managerial accounting, tax accounting, and not for profit ( public sector) accounting.
This course concentrates on financial accounting. Financial accounting is a branch of accounting
which is concerned with the classification, analysis, and interpretation of the overall financial
position and operating results of an organization.
The following four environmental factors influence financial accounting to a significant extent
next to the three earlier mentioned factors. These are:
1. The users of accounting information
2. Nature of economic activity
3. Economic activity in individual business enterprises
4. Means of measuring economic activity

Users of Accounting Information

There are internal and external users of accounting. 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. On the other hand, external users of accounting information include: stock holders,
bond holders, potential investors, bankers and other creditors, financial analysts, economists,
labor unions and 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.

1.2. Conceptual Framework

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

Sitota Tadesse, MSc, Lecturer, Mettu University

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The 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 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 quickly solve new and emerging practical
problems by referring to an existing framework of basic theory.

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.

Parties Involved In Standard-Setting

Three organizations are instrumental in the development of financial accounting standards
(GAAP) in the United States:
1. Securities and Exchange Commission (SEC)
2. American Institute of Certified Public Accountants (AICPA)
3. Financial Accounting Standards Board (FASB)

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 Financial Accounting Concepts that relate to financial reporting for business
enterprises. They are as follows.

1. SFAC No. 1, “Objectives of Financial Reporting by Business Enterprises,” presents the goals
and purposes of accounting.
2. SFAC No. 2, “Qualitative Characteristics of Accounting Information,” examines the
characteristics that make accounting information useful.
3. SFAC No. 3, “Elements of Financial Statements of Business Enterprises,” provides definitions
of items in financial statements, such as assets, liabilities, revenues, and expenses.
4. SFAC No. 5, “Recognition and Measurement in Financial Statements of Business
Enterprises,” sets forth fundamental recognition and measurement criteria and guidance on what
information should be formally incorporated into financial statements and when.
5. SFAC No. 6, “Elements of Financial Statements,” replaces SFAC No. 3 and expands its scope
to include not-for-profit organizations.
6. 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.

In 2003 the SEC issued a report recommending that accounting rule-makers move away from a
rules-based approach toward a more principles-based approach. If the profession adopts this
approach, GAAP will be more conceptual in nature, and the financial reporting objective of each
pronouncement will be more clearly stated. Top management’s financial reporting responsibility

Sitota Tadesse, MSc, Lecturer, Mettu University

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will shift from demonstrating compliance with rules to demonstrating that a company has
attained financial reporting objectives.

The FASB also issued a Statement of Financial Accounting Concepts that relates to
Non business organizations: “Objectives of Financial Reporting by Non business Organizations,”

1.2 Objectives of Financial Reporting

1.3 The objectives of financial reporting are to provide information that is:
(1) Useful to those making investment and credit decisions, who have a reasonable
understanding of business and economic activities;
(2) Helpful to present and potential investors, creditors, and other users in assessing the
amounts, timing, and uncertainty of future cash flows; and
(3) about economic resources, the claims to those resources, and the changes in them.
The objectives, therefore, broadly concern information that is useful to investor and creditor
decisions. That concern narrows to the investors’ and creditors’ interest in receiving cash from
their investments in, or loans to, business enterprises.

Finally, the objectives focus on the financial statements, which provide information useful in
assessing future cash flows. This approach is referred to as decision usefulness.
To provide information to decision makers, companies prepare general-purpose financial
statements. These statements provide the most useful information possible at the least cost.

However, users do need reasonable knowledge of business and financial accounting matters to
understand the information contained in financial statements. This point is important. It means
that financial statement preparers assume a level of competence on the part of users. This
assumption impacts the way and the extent to which companies report information.

1.4 Qualitative Characteristics of Accounting Information

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: By determining
which alternative provides the most useful information for decision making purposes
(decision usefulness). The FASB identified the qualitative characteristics of accounting
information that distinguish better (more useful) information from inferior (less useful)
information for decision-making purposes. In addition, the FASB identified certain constraints
(cost-benefit and materiality) as part of the conceptual framework.

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 see its significance.

For example, assume that IBM Corp. issues a three-month’ report that shows interim earnings
have declined significantly. This interim report provides relevant and reliable information for
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decision-making purposes. Now say that some users, upon reading the report, decide to sell their
stock. Other users, however, do not understand the report’s content and significance. They are
surprised when IBM declares a smaller year-end dividend and the value of the stock declines.
Thus, although IBM presented highly relevant and reliable information, it was useless to those
who did not understand it.

Primary Qualities: Relevance and Reliability

Relevance and reliability are the two primary qualities that make accounting information useful
for decision making. As stated in FASB Concepts Statement No. 2, “the qualities that distinguish
‘better’ (more useful) information from ‘inferior’ (less useful) information are primarily the
qualities of relevance and reliability, with some other characteristics 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. Relevant information helps
users predict the ultimate outcome of past, present, and future events. That is, it has predictive
value. Relevant information also helps users confirm or correct prior expectations; it has
feedback value. For example, when UPS (United Parcel Service) issues an interim report, the
information in it is relevant because it provides both a basis for forecasting annual earnings and
feedback on past performance.

Finally, relevant information is available to decision makers before it loses its capacity to
influence their decisions. It has timeliness. If UPS waited to report its interim results until six
months after the end of the period, the information would be much less useful for decision-
making purposes. For information to be relevant, it needs predictive or feedback value, presented
on a timely basis.
Reliability: Accounting information is reliable to the extent that it is verifiable, is a faithful
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 match what really
existed or happened. If General Motors’ income statement reports sales of $225 billion when it
had sales of $193.5 billion, then the statement fails to faithfully represent the proper sales
amount.
Neutrality: means that a company cannot select information to favor one set of interested
parties over another. Unbiased information must be the overriding consideration. For example, in
the notes to financial statements, tobacco companies such as R. J. Reynolds should not suppress
information about the numerous lawsuits that have been filed because of tobacco-related health
concerns—even though such disclosure is damaging to the company.

Sitota Tadesse, MSc, Lecturer, Mettu University

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Secondary Qualities: Comparability and Consistency
Information about a company is more useful if decision makers can compare it with similar
information about another company and with similar information about the same company at
other points in time. The first of these qualities is comparability, and the second is consistency.
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.
For example, historically the accounting for pensions in the United States differs from that in
Japan. U.S. companies record pension cost as incurred. In Japan, companies generally recorded
little or no charge to income for these costs. As a result, it is difficult to compare and evaluate the
financial results of General Motors or Ford to Japanese competitors. Also, resource allocation
decisions involve evaluating alternatives. A valid evaluation can be made only if comparable
information is available.
Consistency: When a company applies the same accounting treatment to similar events, from
period to period, the company shows consistent use of accounting standards. The idea of
consistency does not mean, however, that companies cannot switch from one accounting method
to another. A company can change 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 the justification 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 change and refers the
reader to the note in the financial statements that discusses the change in detail

1.5 Elements of Financial Statements of Business Enterprise

ASSETS: Probable future economic benefits obtained or controlled by a particular entity as a
result 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 as a result
of past transactions or events.
EQUITY: 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. Assets are most commonly received as investments by owners, but that which is
received may also include services or 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 includes all changes
in equity during a period except those resulting from investments by owners and distributions to
owners.
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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 others 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.

1.6. THE GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

The main controversy in setting accounting standards is, “Whose rules should we play by, and
what should they be?” The answer is not immediately clear. Users of financial accounting
statements have both coinciding and conflicting needs for information of various types. To meet
these needs, and to satisfy the fiduciary reporting responsibility of management, companies
prepare a single set of general-purpose financial statements. Users expect these statements to
present fairly, clearly, and completely the company’s financial operations.

The accounting profession has attempted to develop a set of standards that are generally accepted
and universally practiced. Otherwise, each enterprise would have to develop its own standards.
Further, readers of financial statements would have to familiarize themselves with every
company’s peculiar accounting and reporting practices. It would be almost impossible to prepare
statements that could be compared. This common set of standards and procedures is called
generally accepted accounting principles (GAAP). The term “generally accepted” means
either that an authoritative accounting rule-making body has established a principle of reporting
in a given area or that over time a given practice has been accepted as appropriate because of its
universal application. Although principles and practices continue to provoke both debate and
criticism, most members of the financial community recognize them as the standards that over
time have proven to be most useful

What is GAAP? The major sources of GAAP come from the organizations discussed earlier in
this chapter. It is composed of a mixture of over 2,000 documents that have developed over the
last 60 years or so. It includes such items as FASB Standards, Interpretations, and Staff Positions
and AICPA Research Bulletins. Generally accepted accounting principles (GAAP) have
substantial authoritative support. The AICPA’s Code of Professional Conduct requires that
members prepare financial statements in accordance with GAAP. Specifically, Rule 203 of this
Code prohibits a member from expressing an unqualified opinion on financial statements that
contain a material departure from generally accepted accounting principles.

Sitota Tadesse, MSc, Lecturer, Mettu University

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1.7 Cash flow and Income Measurement

Cash Flow
Cash flow refers to the incomings and outgoings of cash, representing the operating activities of
an organization.

In accounting, cash flow is the difference in amount of cash available at the beginning of a
period (opening balance) and the amount at the end of that period (closing balance). It is called
positive if the closing balance is higher than the opening balance, otherwise called negative.
Cash flow is increased by (1) selling more goods or services, (2) selling an asset, (3) reducing
costs, (4) increasing the selling price, (5) collecting faster, (6) paying slower, (7) bringing in
more equity, or (8) taking a loan. The level of cash flow is not necessarily a good measure of
performance, and vice versa: high levels of cash flow do not necessarily mean high or even any
profit; and high levels of profit do not automatically translate into high or even positive cash
flow.

Income Measurement

Revenue Recognition Principle

A crucial question for many companies is when to recognize revenue. Revenue recognition
generally occurs (1) when realized or realizable and (2) when earned. This approach has often
been referred to as the revenue recognition principle. A company realizes revenues when it
exchanges products (goods or services), merchandise, or other assets for cash or claims to cash.
Revenues are realizable when assets received or held are readily convertible into cash or claims
to cash. Assets are readily convertible when they are salable or interchangeable in an active
market at readily determinable prices without significant additional cost.

In addition to the first test (realized or realizable), a company delays recognition of revenues
until earned. Revenues are considered earned when the company substantially accomplishes
what it must do to be entitled to the benefits represented by the revenues. Generally, an objective
test, such as a sale, indicates the point at which a company recognizes revenue. The sale provides
an objective and verifiable measure of revenue—the sales price. Any basis for revenue
recognition short of actual sale opens the door to wide variations in practice. Recognition at the
time of sale provides a uniform and reasonable test.

Upon Receipt of Cash: Receipt of cash is another basis for revenue recognition. Companies use
the cash-basis approach only when collection is uncertain at the time of sale. One form of the
cash basis is the installment-sales method. Here, a company requires payment in periodic
installments over a long period of time. Its most common use is in retail, such as for farm and
home equipment and furnishings. Companies frequently justify the installment-sales method
based on the high risk of not collecting an account receivable. In some instances, this reasoning
may be valid.

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Generally, if a sale has been completed, the company should recognize the sale; if bad debts are
expected, the company should record them as separate estimates. To summarize, a company
records revenue in the period when realized or realizable and when earned. 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.

Expense Recognition Principle

As indicated in the discussion of financial statement elements, expenses are defined as outflows
or other “using up” of assets or incurring of liabilities (or a combination of both) during a period
as a result of delivering or producing goods and/or rendering services. It follows then that
recognition of expenses is related to net changes in assets and earning revenues. In practice, the
approach for recognizing expenses is, “Let the expense follow the revenues.” This approach is
the expense recognition principle.

To illustrate, companies recognize expenses not when they pay wages or make a product, but
when the work (service) or the product actually contributes to revenue. Thus, companies tie
expense recognition to revenue recognition. That is, by matching efforts (expenses) with
accomplishment (revenues), the expense recognition principle is implemented in accordance
with the definition of expense (outflows or other using up of assets or incurring of liabilities).
Some costs, however, are difficult to associate with revenue. As a result, some other approach
must be developed. Often, companies use a “rational and systematic” allocation policy that will
approximate the expense recognition principle. This type of expense recognition involves
assumptions about the benefits that a company receives as well as the cost associated with those
benefits. For example, a company like Intel or Motorola allocates the cost of a long-lived asset
over all of the accounting periods during which it uses the asset because the asset contributes to
the generation of revenue throughout its useful life.

Companies charge some costs to the current period as expenses (or losses) simply because they
cannot determine a connection with revenue. Examples of these types of costs are officers’
salaries and other administrative expenses. Costs are generally classified into two groups:
product costs and period costs. Product costs, such as material, labor, and overhead, attach to
the product. Companies carry these costs into future periods if they recognize the revenue from
the product in subsequent periods. Period costs, such as officers’ salaries and other
administrative expenses, attach to the period. Companies charge off such costs in the immediate
period, even though benefits associated with these costs may occur in the future. Why? Because
companies cannot determine a direct relationship between period costs and revenue. This
approach is commonly referred to as the matching principle.

Sitota Tadesse, MSc, Lecturer, Mettu University

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