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CHAPTER ONE
Development of Accounting Principles and Professional Practice
1.1 . The Environment of Financial Accounting

As a result of globalization many of the largest companies in the world often do more of their
business in foreign lands than in their home countries. in addition to this, companies now access
not only their home country capital markets for financing, but others as well. Companies are
recognizing the need to have one set of financial reporting standards. As a result of this, For
globalization of capital markets to be efficient, what is reported for a transaction in Beijing
should be reported the same way in Paris, New York, or London.
In the past, many countries used their own sets of accounting standards or followed standards
set by larger countries, such as those used in Europe or in the United States. That protocol has
changed through the adoption of a single set of rules, called International Financial Reporting
Standards (IFRS). There is broad acceptance of IFRS around the world, i.e. 126 jurisdictions
require the use of IFRS by all or most public companies, with most of the remaining jurisdictions
permitting their use. Indeed, 27,000 of the 49,000 companies listed on the 88 largest securities
exchanges in the world use IFRS. IFRS also has appeal for non-public companies; since its
publication, the IFRS for SMEs (small and medium-sized entities) is required or permitted in 57
percent or 85 of 150, profiled jurisdictions, while a further 11 jurisdictions are also considering
adopting IFRS.
World markets are increasingly intertwined. International consumers drive Japanese cars, wear
Italian shoes and Scottish woolens, drink Brazilian coffee and Indian tea, eat Swiss chocolate
bars, sit on Danish furniture, watch U.S. movies, and use Arabian oil. The tremendous variety
and volume of both exported and imported goods indicates the extensive involvement in
international trade—for many companies, the world is their market. In addition, due to
technological advances and less onerous regulatory requirements, investors are able to engage in
financial transactions across national borders and to make investment, capital allocation, and
financing decisions involving many foreign companies. Also, many investors, in attempts to
diversify their portfolio risk, have invested more heavily in international markets. Capital
markets are increasingly integrated and companies have greater flexibility in deciding where to
raise capital.

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Accounting is the universal language of business. The essential characteristics of accounting

are (1) the identification, measurement, and communication of financial information about (2)
economic entities to (3) interested parties.

Financial accounting is the process that culminates in the preparation of financial reports on the
enterprise for use by both internal and external parties. Users of these financial reports include
investors, creditors, managers, unions, and government agencies. In contrast, managerial
accountings is the process of identifying, measuring, analyzing, and communicating financial
information needed by management to plan, control, and evaluate a company’s operations.

Financial statements are the principal means through which a company communicates its
financial information to those outside the business. These statements provide a company’s
history quantified in money terms. The financial statements most frequently provided are
(1) the statement of financial position, (2) the income statement (or statement of comprehensive
income), (3) the statement of cash flows, and (4) the statement of changes in equity. Note
disclosures are an integral part of each financial statement.

Some financial information is better provided, or can be provided only, by means of financial
reporting other than formal financial statements. Examples include the president’s letter or
supplementary schedules in the company annual report, prospectuses, reports filed with
government agencies, news releases, management’s forecasts, and social or environmental
impact statements. Companies may need to provide such information because of authoritative
pronouncements and regulatory rules, or custom. Or, they may supply it because management
wishes to disclose it voluntarily.
Resources are limited. As a result, people try to conserve them and ensure that they are used
effectively. Efficient use of resources often determines whether a business thrives. This fact
places a substantial burden on the accounting profession.
Accountants must measure performance accurately and fairly on a timely basis, so that the
right managers and companies are able to attract investment capital. For investors and creditors
in order to make efficient capital allocation decision they need relevant financial information that
faithfully represent the financial result of the company. This is because in order to make effective
capital allocation decision (investment decision), investors and

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creditors should assess the relative return and risk associated with the investment opportunities.
An effective process of capital allocation is critical to a healthy economy. It promotes
productivity, encourages innovation, and provides an efficient and liquid market for buying and
selling securities and obtaining and granting credit. Unreliable and irrelevant information leads
to poor capital allocation, which adversely affects the securities markets.
To facilitate efficient capital allocation, investors need relevant information and a faithful
representation of that information to enable them to make comparisons across borders. For
example, assume you are interested to invest in the telecommunication industry. But, there are
four largest telecommunication companies in the world, which are: Nippon Telegraph and
Telephone (Japan), Deutsche Telecom (Germany), Telefonica (ESP and PRT), and AT&T (USA).
How do you decide in which of these telecommunications companies to invest, if any? How do
you compare, for example, a Japanese company like Nippon Telegraph and Telephone with a
German company like Deutsche Telekom?
A single, widely accepted set of high-quality accounting standards is a necessity to ensure
adequate comparability. Investors are able to make better investment decisions if they receive
financial information from Nippon Telegraph and Telephone that is comparable to information
from Deutsche Telekom. Globalization demands a single set of high quality international
accounting standards.

1.2. Financial reporting requirements in Ethiopia

Financial reporting requirements in Ethiopia is based on the Proclamation No. 847/2014 or 2006
E.C. According to this Proclamation, the financial report standards to be used when preparing
Financial statements shall be:
a) IFRSs; or
b) IFRS for SMEs
c) IPSAS applicable to Charities and Societies

1.3. The IASB and its governance structure

For many years, many nations have relied on their own standard-setting organizations. For
example, Canada has the Accounting Standards Board, Japan has the Accounting Standards
Board of Japan, Germany has the German Accounting Standards Committee, and the United
States has the Financial Accounting Standards Board (FASB). The standards issued by these

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organizations are sometimes principles-based, rules-based, tax-oriented, or business-based. In

other words, they often differ in concept and objective.
The main international standard-setting organization is based in London, England, and is called
the International Accounting Standards Board (IASB). The IASB issues

International Financial Reporting Standards (IFRS), which are used on most foreign
exchanges. As indicated earlier, IFRS is presently used or permitted in over 149 jurisdictions
(similar to countries) and is rapidly gaining acceptance in other jurisdictions as well. IFRS has
the best potential to provide a common platform on which companies can report, resulting in
financial statements investors can use to compare financial information.
The two organizations that have a role in international standard-setting are the International
Organization of Securities Commissions (IOSCO) and the IASB.
1. The International Organization of Securities Commissions (IOSCO)
The international organization of security commissions is an association of organizations that
regulate the world’s securities and futures markets. Members are generally the main financial
regulator for a given country. IOSCO does not set accounting standards. Instead, this
organization is dedicated to ensuring that the global markets can operate in an efficient and
effective basis. IOSCO supports the development and use of IFRS as the single set of high-
quality international standards in cross-border offerings and listings. It recommends that its
members allow multinational issuers to use IFRS in cross-border offerings and listings
2. International Accounting Standards Board (IASB):
The standard-setting structure internationally is composed of the following four organizations:
1. The IFRS Foundation: provides oversight to the IASB, IFRS Advisory Council, and IFRS
Interpretations Committee. In this role, it appoints members, reviews effectiveness, and helps
in the fundraising efforts for these organizations.
2. The International Accounting Standards Board (IASB): develops, in the public interest, a
single set of high-quality, enforceable, and global international financial reporting standards
for general-purpose financial statements.3
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: assists the IASB through the timely identification,
discussion, and resolution of financial reporting issues within the framework of IFRS.

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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.
In establishing financial accounting standards, the IASB has a thorough, open, and transparent
due process. The IASB due process has the following elements:
1. An independent standard-setting board overseen by a geographically and professionally
diverse body of trustees;
2. A thorough and systematic process for developing standards;
3. Engagement with investors, regulators, business leaders, and the global accountancy
profession at every stage of the process; and
4. Collaborative efforts with the worldwide standard-setting community.

Furthermore, the characteristics of the IASB, as shown below, reinforce the importance of an
open, transparent, and independent due process.
A. Membership. The Board consists of 14 full-time members. Members are well-paid,
appointed for five-year renewable terms, and come from different countries.

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B. Autonomy. The IASB is not part of any other professional organization. It is appointed by
and answerable only to the IFRS Foundation.
C. Independence. Full-time IASB members must sever all ties from their past employer. The
members are selected for their expertise in standard-setting rather than to represent a given
country.
D. Voting. A majority of votes are needed to issue a new IFRS. In the event of a tie, the
chairperson is granted an additional vote.
1.4. List of IASB pronouncements
The IASB issues three major types of pronouncements:
A. International Financial Reporting Standards.
B. Conceptual Framework for Financial Reporting.
C. International Financial Reporting Standards Interpretations.

A. International Financial Reporting Standards:

Financial accounting standards issued by the IASB are referred to as International Financial
Reporting Standards (IFRS). The IASB has issued 17 of these standards to date, covering such
subjects as business combinations, share-based payments, and leases.
Prior to the IASB (formed in 2001), standard-setting on the international level was done by the
International Accounting Standards Committee, which issued International Accounting Standards
(IAS). The committee issued 41 IASs, many of which have been amended or superseded by the
IASB. Those still remaining are considered under the umbrella of IFRS.

B. Conceptual Framework for Financial Reporting

The IASB uses an IFRS conceptual framework. This Conceptual Framework for Financial
Reporting sets forth the fundamental objective and concepts that the Board uses in
developing future standards of financial reporting. The intent of the document is to form a
cohesive set of interrelated concepts—a conceptual framework— that will serve as tools for
solving existing and emerging problems in a consistent manner. For example, the objective of
general-purpose financial reporting discussed earlier is part of this Conceptual Framework.
The Conceptual Framework and any changes to it pass through the same due process
(preliminary views, public hearing, exposure draft, etc.) as an IFRS. However, this
Conceptual Framework is not an IFRS and hence does not

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define standards for any particular measurement or disclosure issue. Nothing in this
Conceptual Framework overrides any specific international accounting standard.
C. International Financial Reporting Standards Interpretations

Interpretations issued by the IFRS Interpretations Committee are also considered

authoritative and must be followed. These interpretations cover (1) newly identified financial
reporting issues not specifically dealt with in IFRS and (2) issues where unsatisfactory or
conflicting interpretations have developed, or seem likely to develop, in the absence of
authoritative guidance. The IFRS Interpretations Committee has issued over 20 of these
interpretations to date.
In keeping with the IASB’s own approach to setting standards, the IFRS Interpretations
Committee applies a principles-based approach in providing interpretative guidance. To
this end, the IFRS Interpretations Committee looks first to the Conceptual Framework as the
foundation for formulating a consensus. It then looks to the principles articulated in the
applicable standard, if any, to develop its interpretative guidance and to determine that the
proposed guidance does not conflict with provisions in IFRS.
1.5. The IASB’s conceptual framework for financial reporting
A conceptual framework establishes the concepts that underlie financial reporting. A
conceptual framework is a coherent system of concepts that flow from an objective. The
objective identifies the purpose of financial reporting. The other concepts provide guidance on
(1) identifying the boundaries of financial reporting; (2) selecting the transactions, other events,
and circumstances to be represented; (3) how they should be recognized and measured; and (4)
how they should be summarized and reported.
Why do we need a conceptual framework? First, to be useful, rulemaking should build on
and relate to an established body of concepts. A soundly developed conceptual framework thus
enables the IASB to issue more useful and consistent pronouncements over time, and a
coherent set of standards should result. Indeed, without the guidance provided by a soundly
developed framework, standard setting ends up being based on individual concepts developed by
each member of the standard-setting body. In other words, standard-setting that is based on
personal conceptual frameworks will lead to different conclusions about identical or similar
issues than it did previously. As a result, standards will not be consistent with one another, and
past decisions may not be indicative of future ones. Furthermore, the framework should increase

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financial statement users’ understanding of and confidence in financial reporting. It should also
enhance comparability among companies’ financial statements.
Second, as a result of a soundly developed conceptual framework, the profession should be
able to more quickly solve new and emerging practical problems by referring to an existing
framework of basic theory. For example, assume that Aphrodite Gold Ltd. issued bonds with
two payment options. It can redeem them either with $2,000 in cash or with 5 ounces of gold,
whichever is worth more at maturity. The bonds have a stated interest rate of 8.5 percent. At what
amounts should Aphrodite or the buyers of the bonds record them? What is the amount of the
premium or discount on the bonds? And how

should Aphrodite amortize this amount, if the bond redemption payments are to be made in gold
(the future value of which is unknown at the date of issuance)? Consider that Aphrodite cannot
know, at the date of issuance, the value of future gold bond redemption payments.
It is difficult, if not impossible, for the IASB 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.
In 2018, the IASB published the Conceptual Framework for Financial Reporting (the
Conceptual Framework). This fully revised document replaced the section of the 2010 version of
the Conceptual Framework that had been carried forward from the 1989 version, as well as
addressed some changes introduced in 2010. The conceptual framework comprises eight
chapters, as follows:
Chapter 1: The Objective of General-Purpose Financial Statements.
Chapter 2: Qualitative Characteristics of Useful Financial Information.
Chapter 3: Financial Statements and the Reporting Entity.
Chapter 4: The Elements of Financial Statements.
Chapter 5: Recognition and Derecognition.
Chapter 6: Measurement.
Chapter 7: Presentation and Disclosure.
Chapter 8: Concepts of Capital and Capital Maintenance.
The IASB worked diligently to complete the Conceptual Framework, as the Board recognized
the need for such a document to serve its diverse users. It should be emphasized that while the
Conceptual Framework is not an IFRS, it is part of the authoritative literature. Thus, the

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Conceptual Framework can provide guidance in many situations where an IFRS does not cover
the issue under consideration.
The first level identifies the objective of financial reporting—that is, the purpose of financial
reporting. The second level provides the qualitative characteristics that 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 a cost constraint that describe the
present reporting environment.

1.5.1. Objectives of financial reporting

The objective of financial reporting is the foundation of the Conceptual Framework. Other
aspects of the Conceptual Framework— qualitative characteristics, elements of financial
statements, recognition, measurement, and disclosure—flow logically from the objective. Those
aspects of the Conceptual 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. To make effective decisions, these parties need information to help them assess a
company’s prospects for future net cash flows and/or provide a return to existing and potential
investors, lenders, and other creditors. For example, a lender may need information in order to
decide whether to loan money to a company. Similarly, an equity investor may need information
about a company’s profitability in order to decide whether to purchase or sell shares.
Management stewardship is how well management uses a company’s resources to create and
sustain value. To evaluate stewardship, companies should provide information about their
financial position, changes in financial position, and performance. They should also show how
efficiently and effectively management and the board of directors have discharged their
responsibilities to use the company’s resources wisely. Therefore, information that is useful in
assessing stewardship can also be useful for assessing a company’s prospects for future net cash
inflows.

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Information that is decision-useful to capital providers may also be helpful to users of financial
reporting who are not capital providers. To provide information to decision-makers companies
prepare general purpose financial statements. General-purpose financial statements provide
financial reporting information to a wide variety of users.

These statements help shareholders, creditors, suppliers, employees, and regulators to better
understand its financial position and related performance. In other words, general-purpose
financial statements provide, at the least cost, the most useful information possible.
General purpose financial reporting helps users who lack the ability to demand all the
financial information they need from a company and who must therefore rely, at least partly, on
the information provided in financial reports. However, an implicit assumption is that users 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.

1.5.2. Qualitative characteristics of financial reports

A company should choose an acceptable accounting method, the amount and type of information
to disclose, and the format in which to present it by determining which alternative provides the
most useful information for decision-making purposes (Decision-usefulness). The IASB
identified the qualitative characteristics of accounting information that distinguish better (more
useful) information from inferior (less useful) information for decision-making purposes.
Qualitative characteristics are either fundamental characteristics (relevance and faithful
representation) or enhancing characteristics (comparability, verifiability, timeliness, and
understandability), depending on how they affect the decision-usefulness of information.
Regardless of classification, each qualitative characteristic contributes to the decision-usefulness
of financial reporting information. However, providing useful financial information is limited by
a pervasive constraint on financial reporting—cost should not exceed the benefits of a reporting
practice.

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1. Relevance:
Relevance is one of the two fundamental qualities that make accounting information useful for
decision-making. To be relevant, accounting information must be capable of making a
difference in a decision. Information with no bearing on a decision is irrelevant. Financial
information is capable of making a difference when it has predictive value, confirmatory value,
or both. Relevance has three ingredients which are Predictive value, Confirmatory value and
Materiality.
A. Predictive value: Financial information has predictive value if it has value as an input to
predictive processes used by investors to form their own expectations about the future. For
example, if potential investors are interested in purchasing ordinary shares in Nippon Co.,
they may analyze its current resources and claims to those resources, its dividend payments,
and its past income performance to predict the amount, timing, and uncertainty of Nippon’s
future cash flows.
B. Confirmatory value: financial information has confirmatory value if it helps users to
confirm or correct prior expectations. For example, when Nippon Co. issues its year-end
financial statements, it confirms or changes past (or present) expectations based on previous
evaluations. It follows that predictive value and confirmatory value are interrelated. For
example, information about the current level and structure of Nippon’s assets and liabilities
helps users predict its ability to take advantage of opportunities and to react to adverse
situations. The same information helps to confirm or correct users’ past predictions about that
ability.
C. Materiality: is a company-specific aspect of relevance. Information is material if omitting
it or misstating it could influence decisions that users make on the basis of the reported
financial information. An individual company determines whether information is material
because both the nature and/or magnitude of the item(s) to which the information relates
must be considered in the context of an individual company’s financial report. Information is
immaterial, and therefore irrelevant, if it would have no impact on a decision-maker. In short,
it must make a difference or a company need not disclose it.
Assessing materiality is one of the more challenging aspects of accounting because it
requires evaluating both the relative size and importance of an item. However, it is difficult
to provide firm guidelines in judging when a given item is or is not material. Materiality
varies both with relative amount and with relative importance. Companies must consider
both quantitative and qualitative factors in determining whether an

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item is material. It is generally not feasible to specify uniform quantitative thresholds at

which an item becomes material. Rather, materiality judgments should be made in the
context of the nature and the amount of an item.
2. Faithful Representation:
Faithful representation is the second fundamental quality that makes accounting information
useful for decision-making. Faithful representation means that the numbers and descriptions
match what really existed or happened. Faithful representation is a necessity because most users
have neither the time nor the expertise to evaluate the factual content of the information. Like
that of relevance faithful representation has three ingredients which are: Completeness,
Neutrality and Free from error.
A. Completeness: Completeness means that all the information that is necessary for faithful
representation is provided. An omission can cause information to be false or misleading and
thus not be helpful to the users of financial reports. For example, when Société Générale
(FRA) fails to provide information needed to assess the value of its subprime loan
receivables (toxic assets), the information is not complete and therefore not a faithful
representation of the value of the receivable.
B. Neutrality: Neutrality means that a company cannot select information to favor one set of
interested parties over another. Providing neutral or unbiased information must be the
overriding consideration. Accounting rules (and the standard-setting process) must be free
from bias, or we will no longer have credible financial statements. Without credible financial
statements, individuals will no longer use this information. If financial information is biased
or rigged, the public will lose confidence and no longer use it. For example, in the notes to
financial statements, tobacco companies such as British American Tobacco (GBR) 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.
C. Free from Error:
An information item that is free from error will be a more accurate (faithful) representation of a
financial item. For example, if UBS Company misstates its loan losses, its financial statements
are misleading and not a faithful representation of its financial results. However, faithful
representation does not imply total freedom from error. This is because most financial reporting
measures involve estimates of various types that incorporate management’s judgment. For
example, management must estimate the amount of uncollectible accounts to determine bad debt
expense.
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Enhancing Qualities
Enhancing qualitative characteristics are complementary to the fundamental qualitative
characteristics. These characteristics distinguish more useful information from less useful
information. Enhancing characteristics of useful information are comparability, verifiability,
timeliness, and understandability.
A. 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 Japan differed from that in the United States. In
Japan, companies generally recorded little or no charge to income for these costs. U.S.
companies recorded pension cost as incurred. As a result, it is difficult to compare the
financial results of Toyota (JPN) or Honda (JPN) to General Motors (USA) or Ford
(USA). Investors can only make valid evaluations if comparable information is available.

Another type of comparability, consistency, is present when a company applies the same
accounting treatment to similar events, from period to period. Through such application, 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 deemed appropriate by the auditor, 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
generally 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.
B. Verifiability: Verifiability means that different knowledgeable and independent observers
could reach consensus, although not necessarily complete agreement, that a particular
depiction is a faithful representation Verifiability occurs in the following situations:
 Two independent auditors count the company’s inventory and arrive at the same physical
quantity amount for inventory.
 Two independent auditors compute the company’s inventory value at the end of the year
using the FIFO method of inventory valuation.

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C. Timeliness: Timeliness means having information available to decision-makers before it

loses its capacity to influence decisions. Having relevant information available sooner can
enhance its capacity to influence decisions, and a lack of timeliness can rob information of its
usefulness.
D. 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 to see its
significance. Understandability is enhanced when information is classified, characterized,
and presented clearly and concisely.
Users of financial reports are assumed to have a reasonable knowledge of business and economic
activities. In making decisions, users also should review and analyze the information with
reasonable diligence. Information that is relevant and faithfully represented should not be
excluded from financial reports solely because it is too complex or difficult for some users to
understand without assistance.

1.5.3. Elements of financial statements

The elements directly related to the measurement of financial position are assets, liabilities, and
equity. These are defined as follows.
 Asset: A present economic resource controlled by the entity as a result of past events. (An
economic resource is a right that has the potential to produce economic benefits).
 Liability: A present obligation of the entity to transfer an economic resource as a result of
past events.
 Equity: The residual interest in the assets of the entity after deducting all its liabilities.

The elements of income and expenses are defined as follows.

 Income: Increases in assets, or decreases in liabilities, that result in increases in equity, other
than those relating to contributions from holders of equity claims.
 Expenses: Decreases in assets, or increases in liabilities, that result in decreases in equity,
other than those relating to distributions to holders of equity claims.
Note that: assets, liabilities, and equity describe amounts of resources and claims to resources at
a moment in time. The second group of two elements describes transactions, events, and

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circumstances that affect a company during a period of time. The first group, affected by
elements of the second group, provides at any time the cumulative result of all changes. This
interaction is referred to as “articulation.”

1.5.4. Recognition, measurement, and disclosure concepts

Basic Principles of Accounting

We generally use four basic principles of accounting to record and report transactions:
(1) measurement, (2) revenue recognition, (3) expense recognition, and (4) full disclosure.

1. Measurement Principles:
We presently have a “mixed-attribute” system in which one of two measurement principles is
used. The most commonly used measurements are based on historical cost and current cost.

A. Historical Cost

IFRS requires that companies account for and report many assets and liabilities on the basis of
acquisition price. This is often referred to as the historical cost principle. Cost has an
important
advantage over other valuations: It is generally thought to be a faithful representation of the
amount paid for a given item. For example: if companies select current selling price for
measurement of items, Companies might have difficulty establishing a value for unsold items.
Every member of the accounting department might value the assets differently. Furthermore,
Companies issue liabilities, such as bonds, notes, and accounts payable, in exchange for assets
(or services), for an agreed-upon price. This price, established by the exchange transaction, is
the “cost” of the liability. A company uses this amount to record the liability in the accounts and
report it in financial statements. Thus, many users prefer historical cost because it provides them
with a verifiable benchmark for measuring historical trends.
B. Current Value
Current value measures provide monetary information about assets, liabilities, and related
income and expenses, using information updated to reflect conditions at the measurement date.
Because of the updating, current values of assets and liabilities reflect changes in amounts since
the previous measurement date. Current value bases include:
I. Fair value.
II. Value in use for assets and fulfillment value for liabilities.

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III. Current cost.

I. Fair value

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.” Fair
value is therefore a market-based measure. Recently, IFRS has increasingly called for use of fair
value measurements in the financial statements. This is often referred to as the fair value
principle. Fair value information may be more useful than historical cost for certain types of
assets and liabilities and in certain industries. For example, companies report many financial
instruments, including derivatives, at fair value. Certain industries, such as brokerage houses and
mutual funds, prepare their basic financial statements on a fair value basis. At initial acquisition,
historical cost equals fair value. In subsequent periods, as market and economic conditions
change, historical cost and fair value often diverge. Thus, fair value measures or estimates often
provide more relevant information about the expected future cash flows related to the asset or
liability. For example, when long-lived assets decline in value, a fair value measure determines
any impairment loss.
The IASB believes that fair value information in some circumstances is more relevant to users
than historical cost. In these cases, fair value measurement provides better insight into the value
of a company’s assets and liabilities (its financial position) and a better basis for assessing future
cash flow prospects. The IASB provides an option to use fair value (referred to as the fair value
option) as the basis for measurement of financial assets and financial liabilities. The primary
purpose of this option is to increase the relevance of the accounting information by eliminating
cases where an accounting mismatch is created by using a different measurement method. As a
result, companies now have the option to record fair value in their accounts for most financial
instruments, including such items as receivables, investments, and debt securities.
Use of fair value in financial reporting is increasing. However, measurement based on fair value
introduces increased subjectivity into accounting reports when fair value information is not
readily available. To increase consistency and comparability in fair value measures, the IASB
established a fair value hierarchy that provides insight into the priority of valuation techniques to
use to determine fair value. The fair value hierarchy is divided into three broad levels, these are:

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Level 1: Observable inputs that reflect quoted prices for identical assets or liabilities in active
market. It is the least subjective because it is based on quoted prices.
Level 2: Inputs other than quoted prices included in level 1 that are observable for the asset or
liability either directly or through corroboration with observable data. It is more
subjective and would rely on evaluating similar assets or liabilities in active markets.
Level 3: Unobservable inputs (for example, a company’s own data or assumption). It is the most
subjective level and much judgment is needed, based on the best information
available, to arrive at a relevant and representationally faithful fair value measurement.

II. Value in Use / Fulfillment Value:

Value in use is the present value of the cash flows, or other economic benefits that a company
expects to derive from the use of an asset and from its ultimate disposal. Fulfillment value is
the present value of the cash, or other economic resources that a company expects to be obliged
to transfer as it fulfills a liability. Value in use and fulfillment value cannot be observed
directly and are determined using cash-flow-based measurement techniques. Value in use and
fulfillment value reflect the same factors described for fair value but from a company-specific
perspective rather than from a market-participant perspective.

III. Current Cost

The current cost of an asset is the cost of an equivalent asset at the measurement date,
comprising the consideration that would be paid at the measurement date plus the transaction
costs that would be incurred at that date. The current cost of a liability is the consideration that
would be received for an equivalent liability at the measurement date minus the transaction costs
that would be incurred at that date. Similar to historical cost, current cost is an entry value: It
reflects prices in the market in which the company would acquire the asset or would incur the
liability. As a result, current cost is distinguished from fair value, value in use, and fulfillment
value, which are exit values.
However, unlike historical cost, current cost reflects conditions at the measurement date. Current
cost frequently cannot be determined directly by observing prices in an active market and must
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available only for new assets, the current cost of a used asset might need to be estimated by
adjusting the current price of a new asset to reflect the current age and condition of the asset held
by the entity.

2. Recognition

Recognition is the process of capturing for inclusion in the statement of financial position or the
statement(s) of financial performance an item that meets the definition of one of the elements of
financial statements—an asset, a liability, equity, income, or expenses. Recognition involves
depicting the item in one of those statements—either alone or in aggregation with other items—
in words and by a monetary amount, and including that amount in one or more totals in that
statement. The amount at which an asset, a liability, or equity is recognized in the statement of
financial position is referred to as its “carrying amount.” Two important recognition principles
relate to revenue and expense recognition.

A. Revenue Recognition Principle

When a company agrees to perform a service or sell a product to a customer, it has a

performance obligation. When the company satisfies this performance obligation, it recognizes
revenue. The revenue recognition principle therefore requires that companies recognize
revenue in the accounting period in which the performance obligation is satisfied. For example,
assume that Klinke Cleaners cleans clothing on June 30 but customers do not claim and pay for
their clothes until the first week of July. Klinke should record revenue in June when it performed
the service (satisfied the performance obligation) rather than in July when it received the cash. At
June 30, Klinke would report a receivable on its statement of financial position and revenue in its
income statement for the service performed.
Note that: if the revenue transaction is initiated and completed in the same period, it poses few
problems for recognizing revenue. However, when the revenue transaction is initiated and
completed in different periods it poses difficulty for the company to recognize revenue. In such
situations a company should recognize revenue by following the following steps:

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Step 1: identify the contract with the customers.

Step 2: identify the separate performance obligations in the contract.
Step 3: determine the transaction price.
Step 4: allocate the transaction price to the separate performance obligations.
Step 5: recognize revenue when each performance obligation is satisfied.

B. Expense Recognition Principle

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. The 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. Therefore, 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.
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 to apply
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 Nokia allocates the cost of equipment 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 (period costs). This indicates since product costs have
direct relationship with revenue, these costs are recognized as an expense by matching with
revenue recognition. However, period costs have no direct relationship with revenue as a result
of this period costs are recognized as expense when they are incurred.

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3. Full Disclosure Principle

In deciding what information to report, companies follow the general practice of providing
information that is of sufficient importance to influence the judgment and decisions of an
informed user. Often referred to as the full disclosure principle, this practice recognizes that the
nature and amount of information included in financial reports reflects a series of judgmental
trade-offs. These trade-offs strive for (1) sufficient detail to disclose matters that make a
difference to users, yet (2) sufficient condensation to make the information understandable,
keeping in mind costs of preparing and using it.
Users find information about financial position, income, cash flows, and investments in one of
three places: (1) within the main body of financial statements, (2) in the notes to those
statements, or (3) as supplementary information.
Financial statement is a structured means of communicating financial information. It includes
statement of financial position, income statement (or statement of comprehensive income),
statement of cash flows and statement of changes in equity. An item that meets the definition of
an element should be recognized in the financial statements. In situations in which an element is
not recognized in the financial statements (for example, due to existence or measurement
uncertainty), the company may provide information relevant to the item through disclosure in the
notes.
Disclosure is not a substitute for proper accounting. This means good disclosure does not cure
bad accounting. The notes to financial statements generally amplify or explain the items
presented in the main body of the statements. If the main body of the financial statements gives
an incomplete picture of the performance and position of the company, the notes should provide
the additional information needed. Information in the notes does not have to be quantifiable, nor
does it need to qualify as an element. Notes can be partially or totally narrative. Examples of
notes include descriptions of the accounting policies and methods used in measuring the
elements reported in the statements, explanations of uncertainties and contingencies, and
statistics and details too voluminous for presentation in the financial statements.

Cost constraint

In providing information with the qualitative characteristics that make it useful, companies must
consider an overriding factor that limits (constrains) the reporting. This is referred to as the cost
constraint. That is, companies must weigh the costs of providing the information against the

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benefits that can be derived from using it and the benefits perceived to be derived from it must
exceed the costs perceived to be associated with it. The costs are of several kinds: costs of
collecting and processing, of disseminating, of auditing, of potential litigation, of disclosure to
competitors, and of analysis and interpretation. Benefits to preparers may include greater
management control and access to capital at a lower cost. Users may receive better information
for allocation of resources, tax assessment, and rate regulation.

1.6. IFRS-based Financial Statements

Financial statements are the principal means through which an entity communicates its financial
information to external users. Financial statements provide information about the financial
position, financial performance and cash flows of an entity that is useful to a wide range of users
in making economic decisions. Financial statements also show the results of the management’s
stewardship of the resources entrusted to it. To meet this objective, financial statements provide
information about an entity’s assets, liabilities, equity, income and expenses including gains and
losses, contributions by and distributions to owners their capacity as owners, and cash flows.
This information, along with other information in the notes, assists users of financial statements
in predicting the entity’s future cash flows and, in particular, their timing and certainty.
International Accounting Standard 1(IAS 1) states about the presentation of financial
statements. This standard prescribes the basis for presentation of general purpose financial
statements to ensure comparability both with the entity’s financial statements of previous periods
and with the financial statements of other entities. It sets out overall requirements for the
presentation of financial statements, guidelines for their structure and minimum requirements for
their content.

An entity shall apply this Standard in preparing and presenting general purpose financial
statements in accordance with International Financial Reporting Standards (IFRSs). A complete
set of financial statements comprises:
A. A statement of financial position as at the end of the period;
B. A statement of profit or loss and other comprehensive income for the period;
C. A statement of changes in equity for the period;
D. A statement of cash flows for the period;
E. Notes, comprising significant accounting policies and other explanatory information
 According to IAS 1 Financial statements shall present fairly the financial position, financial
performance and cash flows of an entity. Fair presentation requires the faithful representation

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of the effects of transactions, other events and conditions in accordance with the definitions
and recognition criteria for assets, liabilities, income and expenses set out in the Framework.
 In virtually all circumstances, an entity achieves a fair presentation by compliance with
applicable IFRSs. A fair presentation also requires an entity:
 to select and apply accounting policies in accordance with IAS 8 Accounting Policies,
Changes in Accounting Estimates and Errors.
 to present information, including accounting policies, in a manner that provides
relevant, reliable, comparable and understandable information
 to provide additional disclosures when compliance with the specific requirements in
IFRSs is insufficient to enable users to understand the impact of particular transactions,
other events and conditions on the entity’s financial position and financial performance.
 An entity whose financial statements comply with IFRSs shall make an explicit and
unreserved statement of such compliance in the notes. An entity shall not describe financial
statements as complying with IFRSs unless they comply with all the requirements of IFRSs.
 When preparing financial statements, management shall make an assessment of an entity’s
ability to continue as a going concern. An entity shall prepare financial statements on a
going concern basis unless management either intends to liquidate the entity or to cease
trading, or has no realistic alternative but to do so. When

management is aware, in making its assessment, of material uncertainties related to events or

conditions that may cast significant doubt upon the entity’s ability to continue as a going
concern, the entity shall disclose those uncertainties. When an entity does not prepare
financial statements on a going concern basis, it shall disclose that fact, together with the
basis on which it prepared the financial statements and the reason why the entity is not
regarded as a going concern.
 An entity shall prepare its financial statements, except for cash flow information, using
the accrual basis of accounting. When accrual basis of accounting is used, an entity
recognizes items as assets, liabilities, equity, income and expenses when they satisfy the
definition and recognition criteria for those elements in the conceptual framework.
 An entity shall present separately each material class of similar items. An entity shall present
separately items of a dissimilar nature or function unless they are immaterial.
 An entity shall not offset assets and liabilities or income and expenses, unless required or
permitted by an IFRS.

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 An entity shall present a complete set of financial statements (including comparative

information) at least annually. When an entity changes the end of its reporting period and
presents financial statements for a period longer or shorter than one year, an entity shall
disclose, in addition to the period covered by the financial statements:
A. the reason for using a longer or shorter period, and
B. the fact that amounts presented in the financial statements are not entirely comparable
 Except when IFRSs permit or require otherwise, an entity shall present comparative
information in respect of the preceding period for all amounts reported in the current period’s
financial statements. An entity shall include comparative information for narrative and
descriptive information if it is relevant to understanding the current period’s financial
statements. An entity shall present, as a minimum, two statements of financial position,
two statements of profit or loss and other comprehensive income, two separate statements
of profit or loss (if presented), two statements of cash flows and two statements of changes
in equity, and related notes.

 An entity shall present a third statement of financial position as at the beginning of the
preceding period in addition to the minimum comparative financial statements required if:
A. it applies an accounting policy retrospectively, makes a retrospective restatement of items
in its financial statements or reclassifies items in its financial statements; and
B. the retrospective application, retrospective restatement or the reclassification has a
material effect on the information in the statement of financial position at the beginning
of the preceding period.
 If an entity changes the presentation or classification of items in its financial statements, it
shall reclassify comparative amounts unless reclassification is impracticable. When an entity
reclassifies comparative amounts, it shall disclose (including as at the beginning of the
preceding period):
A. the nature of the reclassification;
B. the amount of each item or class of items that is reclassified; and
C. the reason for the reclassification.
 When it is impracticable to reclassify comparative amounts, an entity shall disclose:
A. the reason for not reclassifying the amounts, and
B. the nature of the adjustments that would have been made if the amounts had been
reclassified.

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 An entity shall retain the presentation and classification of items in the financial statements
from one period to the next unless:
A. it is apparent, following a significant change in the nature of the entity’s operations or a
review of its financial statements, that another presentation or classification would be
more appropriate having regard to the criteria for the selection and application of
accounting policies in IAS 8; or
B. an IFRS requires a change in presentation.

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